RISK MANAGEMENT

NATIONAL COMMODITY EXCHANGE LIMITED PAKISTAN

5/10/2010

Shaad Alvi (3697) Nazish Naeem (3687) Ufaq Ashfaque (3451) Sadia Tabassum (3451)

Contents
EXECUTIVE SUMARRY: ............................................................................................................................. 4 INTRODUCTION TO COMMODITY MARKETS:............................................................................................ 5 Definition of a commodity: .................................................................................................................. 5 COMMODITY EXCHANGE: ........................................................................................................................ 5 Definition of commodity futures: ......................................................................................................... 5 Need for future markets: ..................................................................................................................... 5 Objectives of commodity futures: ........................................................................................................ 6 Benefits of future markets: .................................................................................................................. 6 EVOLUTION OF COMMODITY MARKETS: .................................................................................................. 8 HISTORY OF COMMODITY MARKET IN PAKISTAN: .................................................................................. 10 INTRODUCTION TO NCEL: ...................................................................................................................... 10 VISION AND MISSION: ........................................................................................................................... 10 OBJECTIVES: .......................................................................................................................................... 11 THE PRODUCTS OF NCEL: ....................................................................................................................... 12 RICE: .................................................................................................................................................. 12 PALM OIL: .......................................................................................................................................... 12 GOLD: ................................................................................................................................................ 12 SILVER:............................................................................................................................................... 12 CRUDE OIL: ........................................................................................................................................ 12 INTEREST RATES: ................................................................................................................................ 12 INTERNATIONAL COMMODITY EXCHANGES: .......................................................................................... 13 The New York Mercantile Exchange (NYMEX):.................................................................................... 13 London Metal Exchange: .................................................................................................................... 13 CBOT: ................................................................................................................................................ 13 Tokyo Commodity Exchange: (TOCOM): ............................................................................................. 13 Chicago Mercantile Exchange: ........................................................................................................... 14 THE FUNCTIONING OF COMMODITY MARKETS: ..................................................................................... 15 Steps of Commodity Trading System: ................................................................................................. 16 CURRENT SCENARIO OF NCEL: ............................................................................................................... 17 2

Technical set up: ................................................................................................................................ 17 CONCLUSION: ........................................................................................................................................ 18

EXECUTIVE SUMARRY:
Commodities are a center of concentration for last two decades. The population is increasing and the demand for the commodities ever increasing because of the increase in the demand. The emergence of open market system has exposed the commodities to the price fluctuations. The emerging economies like the central Asian and south Asian countries are consuming the commodities and hence the commodity market is much larger than the stock markets all over the world. Another reason for the growth of the commodity futures is; less regulations and capital requirements for investment in derivatives market. Pakistan is one of the biggest producers of commodities like, rice and cotton. Pakistan also possesses large markets for the precious metals and gemstones. 130 tons of gold is traded on average every year in Pakistan. The agricultural and textile sector has been facing many business risks in the growing economy of Pakistan. The need for the risk management has been fulfilled by the establishment of National Commodity Exchange Limited (NCEL) in the country. Lead by the technical assistance of the KSE the NCEL has attracted investments in many commodities futures as it has provided a centralized and regulated market for the commodities to be traded with transparency. The price discovery has helped the investors to make production and investment decisions and many individuals have profited from price speculations. The formal commodity market is new in Pakistan, so there is a need to benchmark the rules and regulations according to the leading mercantile exchanges like the Chicago mercantile and Tokyo commodity exchange. More and more commodities like steel and some non ferrous metals, sugar and sugarcane, wheat and gemstones should also be introduced on the exchange. Along with the futures the options contracts on the commodities can also increase the trade volume of the commodities.

INTRODUCTION TO COMMODITY MARKETS:

Definition of a commodity:
Any product that can be used for commerce or an article of commerce which is traded

on an authorized commodity exchange is known as commodity. Anything which is movable, transferable and usable is a commodity. Commodities include all types of goods but money, and financial instruments are an exception. All the goods and agricultural products, minerals and fossils are allowed to be traded on most of the commodity exchanges through out the world. The precious metals like gold and silver and some other metals like copper an bronze are also traded on the commodity exchanges. Cereals, pulses, grains, cotton and cotton products, jute and jute products, vegetable and fruit seeds, oil seeds, sugar, tea, coffee, vegetables and fruits and spices are also traded on commodity exchanges.

COMMODITY EXCHANGE:
A commodity exchange is an association or a company or any other body corporate organizing futures trading in commodities for which license has been granted by regulating authority.

Definition of commodity futures:

A Commodity futures is an agreement between two parties to buy or sell a specified and standardized quantity of a commodity at a certain time in future at a price agreed upon at the time of entering into the contract on the commodity futures exchange.

Need for future markets:

A major reason for the need of the futures market is its ability to perform hedging function. Heeding is defined as the transferring the risk of future losses from risk neutral to risk takers on a minimum cost. The commodity futures also carry some risk like any other financial instrument. This risk is due to the volatility in the prices. The reasons for the price volatility are: y Consumer Preferences: With the passage of time the consumers choices change and their preferences as well, so the demand for one commodity falls where as the demand of another commodity rise. This shift in demand curve causes the prices of one commodity to fall and the prices of the other to rise. But this shift in demand is a slow process and it gives time to the manufacturers and the sellers of the commodities to adjust their products according to the demand. Hence, the effect of the

consumer preferences on the price volatility of commodities is lesser in the short term. y Changes in supply: Weather plays an important role in the production and supply of the agricultural commodities. Whenever there is a bad effect of weather on the crops and the supply of a commodity decreases, its prices jump up. But futures market has decreased the disastrous effects of these price fluctuations through hedging.

Objectives of commodity futures:

y Its most important objective is to hedge the risk related to the possession of any physical asset. Any adverse movement in the price of the physical asset possessed by a seller can cause him heavy losses. But, the futures give an opportunity to hedge that type of associated risks. To help the investors better allocate their resources and reduce the inventor requirements. The investors get an idea about the future demand and supply and keep the inventory accordingly. To maintain price stability by providing predictability to about the future prices and demand and supply. To reduce the risk of the investors and make it easier for them to arrange finances. As the future trading leads to predictability of the prices, demand and supply so the risk decrease and the financial institutions finance the commodity producers.

y y

Benefits of future markets:

y

Price discovery: The market information, demand and supply equilibrium, weather forecasts, buyers and sellers behavior, government policies, rules and regulations and inflation rates are the inputs of the futures markets. This whole procedure of future trading along with the above mentioned inputs creates a mechanism of continuous price discovery. The trade volumes between the parties assess the fair values and the information immediately spreads on the trading floors.

Price risk management: Price risk is inherent in the business of spot markets. The farmers, processors, merchandisers, exporters and importers etc can hedge this risk by taking an equal but opposite position in the future market.

Import export competitiveness: For the exporters, the purchase made from the physical market can expose them to the price risk and the risk of the possession of the commodities if the commodity is perishable. The future markets can help the exporters to hedge the proposed purchase by temporarily substituting for the actual physical purchase until the right time arrives.

Predictable pricing: To maintain the stability in prices the sellers need to heavily invest in the inventory reserves and maintain the supply. They do this to avoid the short term price fluctuations in the prices. With the help of futures markets they can maintain the supply just by locking the purchase of a particular commodity on a particular price on a future date. This cost them just the price for the future contract and not for the inventory to be held itself. The investors can use the money for other profitable investment options.

Benefits for the farmers: To avoid the price fluctuations the farmers stock the seeds for the future crops. They also stock the grains for future sales. But this exposes them to the risk of loss if the reserved commodities perish or a parasite attacks their agricultural reserves. The futures markets can help them to avoid these losses. The price predictability of the futures trading also help the farmers to take the production decisions. They can decide from the prices how much, when and what to produce.

Credit accessibility: Without futures hedging the processing and marketing of the commodities is a risky business. The adverse effects of weather which are not controllable can even eat up the profits of the farmers. This behavior of commodity spot markets did not allow the financial institutions to fund the farmers and traders in the commodity business. But the futures hedging reduce the risks involved in the business and therefore the investors have a better access to finances.

Better product quality: The exchange always set some quality standards and allow the grading and pricing of the commodities according to their quality. Hence it gives an incentive to the producers to improve the quality of their products and compete for the higher grade in the exchange.
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EVOLUTION OF COMMODITY MARKETS:

When the need for the continuous supply of the seasonal crops arouse, the futures markets were evolved. The history of the commodities exchange lies back to 1848. The concept of organized trading in the commodities first emerged in CHICAGO in 1848. But an unorganized type of future trading was found in Japan much before 1848. In Japan merchants used to store rice in warehouses for future use. To generate cash and to maintain the warehouses they used to sell the receipts for the rice. Those receipts were called the rice tickets. Later on the rice tickets were accepted as a commercial currency and rules were established to standardize trading in rice tickets. In 19th century CHICAGO emerged as the business centre of U.S. it attracted the farmers from the surroundings to sell their wheat in Chicago to the dealers and the distributors. Due to the lack of storing facilities, uniform weighing and grading facilities, the farmers were dependant upon the mercy of the dealers. It lead to the need for a common place for all the farmers and dealers to gather and trade on the rules uniformity. Gradually the farmers and the buyers started making commitments for the future exchange of the commodities for cash and the future contracts were evolved. The futures contracts allow the buyer to know the price he will be paying for the commodity on the future. This type of contracts proved beneficial for both the producers and the buyers. After signing a contract if the buyer is no more interested in the underlying commodity he was able to sell his right to someone else who is interested and the producer will be selling his product. Similarly the producers if not interested to produce can pass on his responsibility of delivering the product to the dealer in the future. The prices for the contracts were dependant upon the market prices of the underlying commodity (wheat at that time), hence the name derivative evolved. Latter on by making some modifications these contracts transformed in to an instrument to protect involved parties against adverse factors such as unexpected price movements and unfavorable climatic factors. This promoted traders entry in futures market, which had no intentions to buy or sell wheat but would purely speculate on price movements in market to earn profit. Trading of wheat in the futures market was proved very profitable and it attracted other commodities as well to the futures exchanges. This created a platform for establishment of a body to regulate and supervise these contracts and the Chicago Board Of Trade was established in 1848. In 1870 and 1880s many new commodity exchanges emerged including New York exchange of coffee and cotton. Initially the agricultural commodities were traded on the commodity exchanges. After 1872 the dairy products were introduced on the exchanges. In the early 1900s some metals and rubber were introduced. In 1933, during the Great Depression, the Commodity Exchange, Inc. was
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established in New York through the merger of four small exchanges the National Metal Exchange, the Rubber Exchange of New York, the National Raw Silk Exchange, and the New York Hide Exchange. Largest commodity exchange is CBOT and today there are many big and small commodity exchanges in more than 30 countries of world including South Asian countries.

HISTORY OF COMMODITY MARKET IN PAKISTAN:

In Pakistan the commodity futures market is still not very wide spread. The first commodity futures exchange; National Commodity Exchange of Pakistan, was incorporated on April 20, 2002 and it started functioning in the July of the year 2003. The exchange is the only company to provide a centralized and regulated place for commodity futures to be traded in Pakistan. It aims to develop a premier Commodity Exchange not only in Pakistan but also in the region to provide fully automated trading, settlement and risk management systems complying to the national and the international standards. Initially the gold was the only trading commodity and the rest of the commodities; wheat, rice, sugar, cotton yarn, etc were started trading later in phases. The establishment of the exchange is the continuation of economic policies of the government to stimulate investment in the country, regulate trading in commodities and document the national economy.

INTRODUCTION TO NCEL:
National Commodity Exchange Limited (NCEL) is the first technology driven, demutualised, on-line commodity futures exchange in Pakistan. NCELs shareholders are National Bank of Pakistan, Karachi Stock Exchange (the largest shareholder, holding 40% shares), Lahore Stock Exchange, Islamabad Stock Exchange, Pak Kuwait Investment Company (Pvt.) Limited and the Zarai Taraqiati Bank Ltd and it is regulated by Securities and Exchange Commission of Pakistan.

VISION AND MISSION:

FROM Price Distortion Wide spreads or one way quote Lack of storage Absence of standardization Counterparty risk Impediments in financing Price manipulation TO Observable prices Narrow spreads and two way quotes State of the art warehousing Quality certification & standardization Complete risk mitigation Ease in financing Price dissemination

To provide an opportunity to the farmers to farm for the market

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OBJECTIVES:
y The objective of the exchange is to establish, conduct, regulate and control the trade of futures commodity contracts within and outside the country and to perform all the associated functions to facilitate setup and carry on the business of chosen commodities. It will also regulate the imports and exports in the country. Its objective is to maintain high standards of commercial honor and integrity, to promote and inculcate honorable practices and just and equitable principles of trade. The exchange aims to discourage and suppress malpractices, to settle and decide points of practice, disputes, questions of usage, custom and courtesy in the conduct of trade and business. One of the most important objectives of the exchange which would have a positive impact on exports is that it will communicate with the chambers of commerce and other mercantile and public bodies in and outside the country for the protection of the commodity trade.

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THE PRODUCTS OF NCEL:

RICE:
NCEL IRRI-6 Weekly Rice Futures Contract NCEL IRRI-6 Rice Futures Contract

y y

PALM OIL:
NCEL Palm Olein Futures Contract

GOLD:
NCEL Gold (1 Ounce) Futures Contract NCEL 100 Ounces Gold Futures Contract NCEL 100 Tola Gold Futures Contract NCEL 50 Tola Gold Futures Contract NCEL 10 Tola Gold Futures Contract NCEL Mini Gold Futures Contract NCEL Gold Futures Contract

y y y y y y y

SILVER:
NCEL Silver (500 Ounces) Futures Contract

CRUDE OIL:
NCEL Crude Oil Futures Contract new

INTEREST RATES:
NCEL 3-Month KIBOR Futures Contract

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INTERNATIONAL COMMODITY EXCHANGES:

Commodities markets were evolved as a solution to the problem of maintaining the supply of the seasonal products like agricultural products. The U.S, Japan, Brazil, U.K, Australia and Singapore are the homes of the major commodity exchanges.

The New York Mercantile Exchange (NYMEX):

NYMEX is the worlds largest exchange for the trade of physical goods. Its primary products are precious metals and energy products. This exchange is in existence for the last 132 years and is trading through two trading divisions. The NYMEX that trades in the energy products and the platinum and the COMEX that deals in all the other metals. Light sweet crude oil, Natural Gas, Heating Oil, Gasoline, RBOB Gasoline, Electricity Propane, Gold, Silver, Copper, Aluminum, Platinum; Palladium, etc are traded on the exchange.

London Metal Exchange:

This exchange was formed in 1877and is the worlds premier non ferrous metals exchange. The objective of this exchange is to provide a market for the participants from non ferrous metals related industries and to provide them a risk hedging against price fluctuations. The exchange trades 24 hours a day through telephone and electronic terminals. It still holds the open outcry trading on the floors as well. The commodities traded are Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy, North American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density Polyethylene, etc.

CBOT:
It is one of the oldest exchanges on the world map. It was formed in 1848 by the merchants of Chicago. More than 50 contracts are being offered on the exchange. This exchange also holds the outcry trading and the primary commodities are agricultural products like; , Soybean, Oil, Soybean meal, Wheat, Oats, Ethanol, Rough Rice and the non agricultural products like gold and silver etc.

Tokyo Commodity Exchange: (TOCOM):

TOCOM is the 2nd largest commodity exchange in the world. It was formed about 20 years back. It has played an important role in benchmarking price discovery and risk management in the Asian continent for the products like crude oil etc. the association of TOCOM with MCX has provided a platform for the Asian investors Crude Oil since the demand-supply situation in U.S. that drives NYMEX is different from demand-supply situation in Asia. This step is taken for cooperation to benefit from the business and investment opportunities. In Jan 2003 TOCOM became the first exchange in Japan to introduce in house clearing system. In Jan 2004 TOCOM also launched the first gold future contract in the Japanese commodity market. The commodities traded on the
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exchange are; Gasoline, Kerosene, Crude Oil, Gold, Silver, Platinum, Aluminum, Rubber, etc.

Chicago Mercantile Exchange:

The Chicago mercantile was formed in 1898 to trade in the agricultural products. The Chicago Mercantile Exchange (CME) is the largest futures exchange in the US and the largest futures clearing house in the world for futures and options trading. It introduced the worlds first financial futures around 30 years ago. Today a huge volume of daily trade depends upon the trade of interest rate futures, stock indices and foreign exchange futures. Its financial products serve as the benchmarks and witness largest open interest futures. Its products allow both the small family owned farms and the large agricultural producers to hedge their risks against adverse price movements. The commodities primarily traded on the exchange are; Butter milk, Timonium phosphate, Feeder cattle, frozen pork bellies, Lean Hogs, Live cattle, Non-fat Dry Milk, Urea, Urea Ammonium Nitrate, etc.

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THE FUNCTIONING OF COMMODITY MARKETS:

In the commodities markets two types of trades take place the spot trade is one where one party pays cash for the receipt of the commodity at the same time. The other type is the future trading. It involves warehouse receipts. A person deposits a certain amount of a good in the warehouse and receives a receipt against it. This receipt allows him to ask for the delivery of a certain amount of the deposit good from the warehouse. But, someone trading in commodity futures need not necessarily posses such a receipt to strike a deal. Based on his expectations about the future prices one can buy or sell commodity futures. In futures there is an expiry date; the date on which the buyer or seller either closes his position or actually deliver or receive the goods. Another term squaring off is used in futures trading. It means closing a position by an equal but opposite contract. The broker keeps the record of the profit and loss of all dealing parties from the changes in the future prices as the futures are daily marked to the market. In the well developed commodity markets a seller must be able to deposit his goods in a warehouse nearest to him and the buyer must be able to receive the goods from nearest warehouse. But in Pakistan a very few warehouses are available and the delivery of goods is difficult. Following diagram gives a fair idea about working of the Commodity market:

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In most of the commodity markets including Pakistan the trading system is fully computerized and traders do not need to visit the commodity exchanges for speculation. Hey can see the price board on the exchanges websites and make the sales or purchases online on phone or internet through broker or individually themselves.

Steps of Commodity Trading System:

y Trading: o Order receiving o Execution o Matching o Reporting o Surveillance o Price limits o Position limits Clearing: o Matching o Registration o Clearing o Clearing limits o Notation o Margining o Price limits o Position limits o Clearing house Settlement: o Marking to market o Receipts and payments o Reporting o Delivery upon expiration or maturity.

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CURRENT SCENARIO OF NCEL:

Initially the NCEL started trading in the future contracts of gold and then in phases different other commodities were introduced on the exchange for trading. Cotton yarn was the second commodity to be traded on the exchange. Later on the 3rd phase the rice was introduced. In the year 2005 the commission allowed the exchange to introduce the future contracts in crude oil. Today the NCEL deals in 14 different types of contracts in the commodities mentioned above in the introduction section. Following the crude oil futures the silver futures were introduced. The futures on the currencies are under process.

Technical set up:

KSE provides the technical set up for NCEL. Trading is also accommodated from the other two stock exchanges and the universal online trading system from any part of world just by a mouse click. The computerized system provides online market price discovery system ensuring the best bid and offer for all market participants. Brokers are provided the facilities of trading terminals at remote places, online market information system, clearing and settlement and comprehensive risk management system by the exchange as well. Initially the NCEL started with the capital of 310million including initial paid up capital of 50million and 260million raised from the licensing of 260 brokers for 10million each. The initial investment was from the three stock exchanges of which the major share is from KSE i.e. 40%. Today many of the robust financial institutions, including National Bank of Pakistan, Zaraei Taraqiyati Bank and Pak Kuwait investment co are the capital investors of the NCEL as well.

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CONCLUSION:
NCEL the first commodity exchange in Pakistan has introduced the commodity futures and a centralized and regulated market place for the investors. The NCEL has played an important role in the development of the economy and the industry of Pakistan, as it has attracted the investments in different commodities and industries from national and international investors. The future contracts available for the above listed products have increased their trading and the market access for their producers. To further improve the economic conditions of Pakistan the NCEL needs to introduce some more commodities and derivatives types.

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