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Commodity market is a place where trading in commodities takes place. It is similar to an Equity market, but
instead of buying or selling shares one buys or sells commodities.
  

 





 
The commodities markets are one of the oldest prevailing markets in the human history. In fact derivatives
trading started off in commodities with the earliest records being traced back to the 17th century when Rice
futures were traded in Japan.


 

 






 
 



 


World-over one will find that a market exits for almost all the commodities known to us. These commodities
can be broadly classified into the following:
  

 
  





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The commodities market exits in two distinct forms namely the Over the Counter (OTC) market and the
Exchange based market. Also, as in equities, there exists the spot and the derivatives segment. The spot
markets are essentially over the counter markets and the participation is restricted to people who are involved
with that commodity say the farmer, processor, wholesaler etc. Majority of the derivative trading takes place
through exchange-based markets with standardized contracts, settlements etc.
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The OTC markets are essentially spot markets and are localized for specific commodities. Almost all the
trading that takes place in these markets is delivery based. The buyers as well as the sellers have their set of
brokers who negotiate the prices for them. This can be illustrated with the help of the following example: A
farmer, who produces castor, wishing to sell his produce would go to the local ¶mandi·. There he would contact
his broker who would in turn contact the brokers representing the buyers. The buyers in this case would be
wholesalers or refiners. In event of a deal taking place the goods and the money would be exchanged directly
between the buyer and the seller. Thus it can be seen that this market is restricted to only those people who
are directly involved with the commodity.
In addition to the spot transactions, forward deals also take place in these markets. However, they too happen
on a delivery basis and hence are restricted to the participants in the spot markets.
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The exchange-traded markets are essentially only derivative markets and are similar to equity derivatives in
their working. I.e. everything is standardized and a person can purchase a contract by paying only a percentage
of the contract value. A person can also go short on these exchanges. Also, even though there is a provision for
delivery most of the contracts are squared-off before expiry and are settled in cash. As a result, one can see
an active participation by people who are not associated with the commodity.
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The commodity exchanges do facilitate delivery, although it has been observed world-over that only 2% of all
the trades result in actual delivery.
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Many people who participate in the exchanges are those who are not involved with the physical trading of the
commodity. Thus they would not like receiving delivery and would not be in a position to give delivery.
Standardized contracts make an unfeasible proposition for any trader to give or take delivery. E.g. if the size
of
1 soya contract is 10MT, a trader cannot buy / sell 15MT of soya through the exchange. Also one cannot avail a
credit facility in the exchanges that may be available in the local market. These and a host of other factors
deter a person from giving / receiving delivery through the exchanges.
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In the developed markets the volumes on the exchange-based commodity derivates markets are about five
times more than that of the equity markets.
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India, being an agro-based economy, has markets for most of the agro-based commodities. India is the largest
consumer of Gold in the world, which implies a huge market for the yellow metal. India has huge spot markets
for all these commodities. E.g. Indore has a huge market for soya, Ahmedabad for castor seeds and
Surendranagar for Cotton etc.
During the pre-independence era India also had a thriving futures market for commodities such as gold, silver,
cotton, edible oils etc. In mid 1960·s, due to wars, natural calamities and the consequent shortages, futures
trading in most commodities were banned.
Currently, the futures markets that exist in India are localized for specific commodities. For example, Kerala
has an exchange for pepper; Ahmedabad for castor seeds and Mumbai is the major center for Gold etc. These
exchanges, however, have only a regional presence and are dominated by people who are involved with the
physical trade of that commodity.
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The government has now allowed national commodity exchanges, similar to the BSE & NSE, to come up and let
them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to
offer a nation-wide anonymous, order driven, screen based trading system for trading. The Forward Markets
Commission (FMC) will regulate these exchanges.

Consequently four commodity exchanges have been approved to commence business in this regard. They are:


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Asit Mehta Comdex Services (Private) Ltd has taken the membership of National Commodity & Derivatives
Exchange (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX).
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The biggest advantage of having an exchange-based platform is reach. A wider reach ensures greater
participation, which results into a more efficient price discovery mechanism. In fact it comes to a stage where
the derivative market guides the spot market in terms of pricing.
This can be well understood by looking at the following example:
Imagine a soy wholesaler in Madhya Pradesh who, having bought the crop from the farmer, wishes to sell it to
the oil refiners. To sell his crop he has to go to the local market at Indore. The price that he will get for his
crop would be solely dependent upon the demand supply condition prevailing at that point of time at that
market place. Also as the number of players is less there are chances of the prices being biased. In contrast
the prices in the futures market are determined not only by the local demand supply conditions but also by the
global scenario. Add to that the view taken on a commodity by various sets of people depending upon different
parameters such as technical analysis, political news, exchange rates etc. The price that is thus quoted can be
safely regarded as the most efficient price.
So, now looking at the futures price the trader can price his crop appropriately.
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Futures contract in the commodities market, similar to equity derivatives segment, will facilitate the activities
of speculation, hedging and arbitrage to all class of investors.

 
It facilitates speculation by providing opportunity to people, although not involved with the commodity, to
trade on the views in the movement of commodity prices. The speculative position is taken with a small margin
amount that is paid to the exchange, and the contract can be squared-off anytime during the trading hours.

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For the people associated with the commodities the futures market can provide an effective hedging
mechanism against price movements.
For example an oil-seed farmer may go short in oil-seed futures, thus ¶locking· his sale price and in the process
hedging against any adverse price movements. On the other hand a processor of oil seeds may buy oil-seed
futures and thus assure him a supply of oil-seeds at a pre-determined price. Similarly the oil-seed processor
may go short in oil futures, which may be bought by a wholesaler of oil.
Also, there is a saying that ¶Gold shines when everything fails·. Thus, gold can be used as a hedging tool against
other investments.
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Traders may exploit arbitrage opportunities that arise on account of different prices between the two
exchanges or between different maturities in the same underlying.