ASSIGNMENT ON

INTRODUCTION TO
COMMIDITIES
DERIVATIVES

Submitted to Submitted by
Prof. T.VISHWANATHAN Manisha Bansal
SECTION –B
Roll No. 46

Introduction to Derivatives

The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time of
sowing to the time of crop harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
partially or fully transfer price risks by locking-in asset prices. These were
simple contracts developed to meet the needs of farmers and were basically a
means of reducing risk. A farmer who sowed his crop in June faced uncertainty
over the price he would receive for his harvest in September. In years of
scarcity, he would probably obtain attractive prices. However, during times of
oversupply, he would have to dispose off his harvest at a very low price.
Clearly this meant that the farmer and his family were exposed to a high risk of
price uncertainty. On the other hand, a merchant with an ongoing requirement
of grains too would face a price risk - that of having to pay exorbitant prices
during dearth, although favourable prices could be obtained during periods of
oversupply. Under such circumstances, it clearly made sense for the farmer and
the merchant to come together and enter into a contract whereby the price of
the grain to be delivered in September could be decided earlier. What they
would then negotiate happened to be a futures-type contract, which would
enable both parties to eliminate the price risk.
In 1848, the Chicago Board of Trade (CBOT) was established to bring farmers
and merchants together. A group of traders got together and created the `to-
arrive' contract that permitted farmers to lock in to price upfront and deliver the
grain later. These to-arrive contracts proved useful as a device for hedging and
speculation on price changes. These were eventually standardised, and in 1925
the first futures clearing house came into existence. Today, derivative contracts
exist on a variety of commodities such as corn, pepper, cotton, wheat, silver,
etc. Besides commodities, derivatives contracts also exist on a lot of financial
Underlying like stocks, interest rate, exchange rate, etc.

Derivatives Defined

A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can
be equity, forex, commodity or any other asset. We saw that wheat farmers may
wish to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction is an example of a derivative. The price
of this derivative is driven by the spot price of wheat which is the 'underlying' in
this case.
The Securities Contracts (Regulation) Act, 1956 defines 'derivative' to include –

1. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of
security.
2. A contract which derives its value from the prices, or index of prices, of
underlying securities.

Products, Participants and Functions

Derivative contracts are of different types. The most common ones are
forwards, futures, options and swaps. Participants who trade in the derivatives
market can be classified under the following three broad categories: hedgers,
Speculators and arbitragers.

1. Hedgers: The farmer's example that we discussed about was a case of

hedging. Hedgers face risk associated with the price of an asset. They use the
futures or options markets to reduce or eliminate this risk.
2. Speculators: Speculators are participants who wish to bet on future
movements in the price of an asset. Futures and options contracts can give them
leverage; that is, by putting in small amounts of money upfront, they can take
large positions on the market. As a result of this leveraged speculative position,
they increase the potential for large gains as well as large losses.
3. Arbitragers: Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across different markets. If, for
example, they see the futures price of an asset getting out of line with the cash
price, they would take offsetting positions in the two markets to lock in the
profit.

Derivatives Markets

Derivatives markets can broadly be classified as commodity derivatives market

and financial derivatives markets. As the name suggest, commodity derivatives
markets trade contracts are those for which the underlying asset is a commodity.
It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc
or precious metals like gold, silver, etc. or energy products like crude oil,
natural gas, coal, electricity etc. Financial derivatives markets trade contracts
have a financial asset or variable as the underlying. The more popular financial
derivatives are those which have equity, interest rates and exchange rates as the
underlying

Some commonly used Derivatives

We define some of the more popularly used derivative contracts

Forwards: A forward contract is an agreement between two entities to buy or
sell the underlying asset at a future date, at today's pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell
the underlying asset at a future date at today's future price. Futures contracts
differ from forward contracts in the sense that they are standardised and
exchange traded.
Options: There are two types of options - call and put. A Call option gives the
buyer the right but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future date. A Put option gives the
buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.
Warrants: Options generally have lives of up to one year, the majority of
options traded on 12 options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally traded over-
the-counter.
Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a weighted average of a basket of assets. Equity
index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different currency
than those in the opposite direction.
Commodity Derivatives

Derivatives as a tool for managing risk first originated in the commodities

markets. They were then found useful as a hedging tool in financial markets as
well. In India, trading in commodity futures has been in existence from the
nineteenth century with organised trading in cotton through the establishment of
Cotton Trade Association in 1875. Over a period of time, other commodities
were permitted to be traded in futures exchanges. Regulatory constraints in
1960s resulted in virtual dismantling of the commodity futures market. It is only
in the last decade that commodity futures exchanges have been actively
encouraged. In the commodity futures market, the quinquennium after the set up
of national level exchanges witnessed exponential growth in trading with the
turnover increasing from 5.71 lakh Crores in 2004-05 to 52.48 lakh Crores in
2008-09. However, the markets have not grown to significant levels as
compared to developed countries. In this chapter, we take a brief look at the
global commodity markets and the commodity markets that exist in India.

Difference between Commodity and Financial Derivatives

The basic concept of a derivative contract remains the same whether the
underlying happens to be a commodity or a financial asset. However, there are
some features which are very peculiar to commodity derivative markets. In the
case of financial derivatives, most of these contracts are cash settled. Since
financial assets are not bulky, they do not need special facility for storage even
in case of physical settlement. On the other hand, due to the bulky nature of
the underlying assets, physical settlement in commodity derivatives creates the
need for warehousing. Similarly, the concept of varying quality of asset does
not really exist as far as financial underlying are concerned. However, in the
case of commodities, the quality of the asset underlying a contract can vary
largely. This becomes an important issue to be managed.

Evolution of Commodity Exchanges

Most of the commodity exchanges, which exist today, have their origin in the
late 19th and earlier 20th century. The first central exchange was established in
1848 in Chicago under the name Chicago Board of Trade. The emergence of the
derivatives markets as the effective risk management tools in 1970s and 1980s
has resulted in the rapid creation of new commodity exchanges and expansion
of the existing ones. At present, there are major commodity exchanges
all over the world dealing in different types of commodities.

Commodity Exchange

Commodity exchanges are defined as centres where futures trade is organized in

a wider sense; it is taken to include any organized market place where trade is
routed through one mechanism, allowing effective competition among buyers
and among sellers. This would include auction-type exchanges, but not
wholesale markets, where trade is localized, but effectively takes place through
many non-related individual transactions between different permutations of
buyers and sellers.

Indian Commodity Exchanges

There are more than 20 recognised commodity futures exchanges in India under
the purview of the Forward Markets Commission (FMC). The country's
commodity futures exchanges are divided majorly into two categories:
• National exchanges
• Regional exchanges
The four exchanges operating at the national level (as on 1st January 2010) are:
i) National Commodity and Derivatives Exchange of India Ltd. (NCDEX)
ii) National Multi Commodity Exchange of India Ltd. (NMCE)
iii) Multi Commodity Exchange of India Ltd. (MCX)
iv) Indian Commodity Exchange Ltd. (ICEX) which started trading operations
on November 27, 2009 .The leading regional exchange is the National Board of
Trade (NBOT) located at Indore. There are more than 15 regional commodity
exchanges in India.
Commodity Futures Trade in India (Rs Crore)
Category 2008-09 FIGURE
Total 52, 48,956.18
Bullion 29, 73,674.60
Agriculture 6, 27,303.14
Others 16, 47,978.45

Trade Performance of leading Indian Commodity Exchanges for January 2010

Traded Value MCX NCDEX NMCE ICEX NBOT
(Rs Crore)
January 2010 5, 62,703 87,824 16,990 32,901 4,245