COMMODITI ES MARKET

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Introduction

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.

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Derivatives

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. The price of this derivative is driven by the spot price of wheat which is the 'underlying' in this case. The price of this derivative is driven by the 5/1/12 spot price of wheat which is the 'underlying'

The Forward Contracts (Regulation) Act, 1952

It regulates the forward/ futures contracts in commodities all over India. As per this Act, the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts.

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when derivatives trading in securities was introduced in 2001, the term 'security' in the Securities Contracts (Regulation) Act, 1956 (SC(R)A), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. 5/1/12

Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. 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 its5/1/12 from the prices, value or index of prices, of underlying

Products, participants and functions

Derivative contracts are of different types: forwards, futures, options and swaps. Participants of derivatives market:
a) hedgers - Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk. b) 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 5/1/12 the market. As a result

c) Arbitragers -Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets.

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Economic functionsderivative market:

Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
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 Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives the underlying market witnesses higher trading volumes, because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.
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 An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand 5/1/12

Classification of derivatives market

Derivatives market is classified

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Spot versus forward transaction

Every transaction has three components - trading, clearing and settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves finding out the net outstanding, that is exactly how much of goods and money the two should exchange. Settlement is the actual process of exchanging money and goods. On 1st January 2010, Aditya wants to buy some gold. The goldsmith quotes Rs. 17,000 per 10 grams. They 5/1/12 agree upon this price and Aditya buys 20 grams of

 Forward contract, a contract by which two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract, the process of trading, 5/1/12 clearing and settlement does not happen

Exchange traded versus OTC derivatives

The management of counter-party (credit) risk is decentralized and located within individual institutions. There are no formal centralized limits on individual positions, leverage, or margining. There are no formal rules for risk and burden-sharing. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self5/1/12 regulatory organization, although they are affected

 The largest OTC derivative market is the inter-bank foreign exchange market. Commodity derivatives, the world over are typically exchangetraded and not OTC in nature.

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Some commonly used derivatives

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 standardized 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 5/1/12 date. A Put option gives the buyer the right, but not

 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 5/1/12 portfolios of forward contracts. The two commonly

 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 5/1/12 direction.

Commodities and financial derivatives-difference

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. The concept of varying quality of asset does not really exist as far as financial underlying's 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.
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Physical settlement
It involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity.
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Limitations of physical settlement

There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the 5/1/12

 Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period'. Assignment Whenever delivery notices are given by the seller, the clearing house of the Exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process.
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Delivery

The procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. The period available for the buyer to take physical delivery is stipulated by the Exchange. Buyer or his authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's 5/1/12 account.