|
Commodity
|
|
A
commodity is a good for which there is demand, but which is
supplied without qualitative differentiation across a market. It is
a physical substance, such as food, grains, and metals, which is
interchangeable with another product of the same type, and which
investors buy or sell, usually through futures contracts. The price
of the commodity is subject to supply and demand. Risk is actually
the reason exchange trading of the basic agricultural products
began. Commodities are often substances that come out of the earth
and maintain roughly a universal price. A commodity is fungible,
that is, equivalent no matter who produces it.
|
|
In the
broadest sense, a commodity is anything that has value, from
watches to time to oranges. In a more specific market sense,
however, a commodity is an item which is roughly the same market
value across the board, with no difference based on
quality.
|
|
The
mainstream commodity market can be split into a number of different
markets: precious metals, industrial metals, livestock,
agricultural products, energy, and some commodities that don’t
easily fall into a classification. Precious metals include gold,
silver, platinum, and palladium. Industrial metals include
aluminum, aluminum alloy, nickel, lead, zinc, tin, recycled steel,
and copper. Livestock includes live cattle, feeder cattle, pork
bellies, and lean hogs. Agricultural products include soybeans,
soybean oil, soybean meal, wheat, cotton number two, sugar numbers
eleven and fourteen, wheat, corn, oats, rice, cocoa, and coffee.
Energy includes ethanol, heating oil, propane, natural gas, WTI
crude oil, Brent crude oil, Gulf Coast gasoline, RBOB gasoline, and
uranium. The commodity market also includes rubber, wool,
polypropylene, polyethylene, and palm oil.
|
|
Commodity derivatives
market
|
|
commodity derivatives trade contracts for which
the underlying assets is a commodity like, wheat, soyabean, cotton
etc or precious metal like Gold and Silver. The commodity
derivatives differ from the financial derivatives mainly in the
following two aspects: Firstly, due to the bulky nature of the
Underlying assets, physical settlement in commodity derivatives
creates the need for warehousing. Secondly, in the case of
commodities, the quality of the asset underlying a contract can
vary largely.
|
|
Commodity market in
India
|
|
India
has a long history of future trading in commodities. In India,
trading in Commodity future has been existence from the 19th
Century with organised trading in Cotton, through the establishment
at Bombay Cotton Association Ltd. in 1875. Over a period of time,
other commodities were permitted to be traded in future exchanges.
Spot trading in India occurs mostly in regional mandis and
unorganized market, which are fragmented and isolated.
There were booming activities in this market at one time as many as
100 Unorganized exchanges were conducting forward trade in various
commodities. The securities market was a poor competitor of this
market as there were not many papers to be traded at that
time.
However, many feared that derivatives fuelled unnecessary
speculation and were detrimental to the healthy functioning of the
market for the underlying commodities. As a result, after
independence, commodity option trading and cash settlement of
commodity future were banned in 1952.
A further blow come in 1960’s when following several years of
several droughts has forced many farmers to default on forward
contact and even caused some suicides, forward trading was banned
in many commodities considered primary or essential. Consequently,
the commodities derivatives market dismantled and remained dormant
for about four decades until the new millennium when the Govt. in a
complete change in policy, started actively encouraging the
commodity derivatives market.
The year 2003 marked the real turning point in the policy frame
work for commodity market when the government issued notifications
for withdrawing all prohibitions and opening up forward trading in
all commodities. This period also witnessed other reforms, such as,
amendments to the Essential Commodities Act, Securities (contract)
Rules, which have reduced bottlenecks in the development and growth
of commodity markets of the country is total GDP, commodities
related and dependent industries constitute about roughly 50-60%
which itself cannot be ignored.
|
|
Why are commodity
derivatives required:
|
|
India
is among the top 5 producer of the most of the commodities in
addition to being a major consumer of bullion and energy products.
Agriculture contributes more than 23% to be GDP of Indian economy.
It employees around 57% of the labour force on a total of 185
million hectares of land. Agriculture sector is an important factor
to achieving a GDP growth of 8.10. All this indicates that India
can be promoted as a major centre for trading of commodity
derivatives.
It is common knowledge that prices of commodities, metals, shares
and currencies fluctuate over time. The possibilities of adverse
price change in future creates risk for business. Derivatives are
used to reduce or eliminate price risk arising from unforeseen
price change. A derivatives is a financial contract whose price
depends on, or is derived from the price of another
assets.
|
|
|
Two important derivatives
are future and options
|
|
1. Commodity Future Contract:
A
future contract is an agreement for buying or selling a commodity
for a predetermined delivery price at a specific future time.
Futures are standardized contract that are traded on organized
facture exchanges that ensure performance of the contract and
remove the default risk. The commodity futures have existed since
the Chicago Board of Trade (CBOT) was established in 1848 to bring
farmers and merchants together the major function of future market
is toe transfer price risk from hedger to speculators. For example
suppose a farmer who is expecting the crop of wheat to be ready in
three months time, but is worried that the price of wheat may
decline in this period, in order to minimize his risk, he can enter
into a future contract to sell his crop in three months time at a
price determined now.
Just take an another example. All we know that woolen garments
demand picks up in winter season. A garment factory owner can by a
factory contract of cotton to get the raw material for his products
as predetermined price. This way both time is able to hedge their
risk arising from a possible adverse change in the price of theirs
commodity or raw material.
2. Commodity Option
Contract:
Like
futures, option are also financial instruments used for hedging and
speculation. The commodity option holder has the right, but not the
obligation to buy (or sell) a specified quantity of a commodity at
specified price on or before a specified date. Option contract
involve two parties – the seller of the option writes the option in
favour of the buyer (holder) who pays a certain premium to the
seller as a price for the option. There are two types of commodity
options. A ‘call’ option gives the holder a right to buy a
commodity at an agreed price, while a ‘put’ option gives the holder
a right to sell a commodity at an agreed price on or before a
specified date which is called expiry date.
The option holder will exercise the option only if it is beneficial
to him, otherwise he will let the option lapse. Suppose a farmer
buys a put option to sell 10 MT of wheat of Rs. 13000/- MT and pays
a ‘premium’ of Rs. 500/- MT. If the price wheat decline, to say Rs.
1000/- MT before expiry, the farmer will the exercise his option
and sell his wheat at the agreed price of Rs. 1300/- MT. However,
if the market price of wheat increases by Rs. 1000/-MT, it will be
better for the farmer to sell it directly in the open market at the
spot price, rather than his option to sell at Rs. 13000/- MT.
Future and options trading therefore helps in hedging the price
risk and also provide investment opportunity to speculators who are
willing to assume risk for a possible return. Future trading and
the ensuing discovery of price can help farmers to deciding which
crops to grow.
Thus future and options market perform important functions that
cannot be ignored in modern business environment. At the same time,
it is true that too much speculative activity in essential
commodities would destabilize the markets and therefore, these
markets are normally regulated as per the law of the country.
Commodity Options trading is not permitted in India till
now.
|
|
Modern commodity
exchange
|
|
To make
up the loss of growth and development during the four decades of
restrictive Govt. policies, FMC and the government encouraged
setting up commodity exchanges using the most modern system and
practices in the world. Some of the main regulatory measures
imposed in the FMC include daily market to market system of
margins, creation of trade guarantee fund, back office
computerization for the existing single commodity exchanges ,
online trading for the new exchanges, demutualization for the new
exchanges and one third representation of independent Directions
the Board of existing Exchanges etc.
National Level Commodity Exchanges in India are:-
- NMCE : National Multi Commodity
Exchange of India.
- NCDEX : National Commodity
Derivatives Exchange Ltd.
- MCX : Multi Commodity Exchange of
India Ltd.
- NSEL : National Stock Exchange
Ltd.
NMCE : (National Multi Commodity Exchange of India
Ltd
It is the first demutualised
electronic commodity exchange of India granted the National
exchange on Govt. of India and operational since 26th Nov, 2002.
The Head Office of NMCE is located in Ahmadabad. There are various
commodity trades on NMCE Platform including Agro and non-agro
commodities.
NCDEX (National Commodity & Derivates Exchange
Ltd
NCDEX is a public limited co. incorporated on April 2003 under the
Companies Act 1956, It obtained its certificate for commencement of
Business on May 9, 2003. It commenced its operational on Dec 15,
2003. NCDEX is located in Mumbai and currently facilitates trading
in 57 commodity mainly in Agro product.
NSEL (National Spot Exchange Limited)
National Spot Exchange Limited (NSEL) is a National level
Institutionalized, Electronic, Transparent Spot trading platform
which commenced its live operations on 15th Oct, 2008. At present
NSEL is operational in 13 states, providing delivery based spot
trading of 26 commodities.
MCX Multi Commodity Exchange of India Ltd
Headquartered in Mumbai, the exchange started operation in Nov,
2003. MCX is a demutalised nation wide electronic commodity future
exchange. Set up by Financial Technologies (India) Ltd. permanent
recognition from government of India for facilitating online
trading, clearing and settlement operations for future market
across the country. MCX is well known for bullion and metal trading
platform.
MCX offers futures trading in
|
|
Metal
|
Aluminium, Copper, Lead, Nickel, Sponge Iron,
Steel Long (Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin,
Zinc
|
|
BULLION
|
Gold,
Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver
|
|
FIBER
|
Cotton
L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn,
Kapas
|
|
ENERGY
|
Brent
Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude
Oil
|
|
SPICES
|
Cardamom, Jeera, Pepper, Red Chilli
|
|
PLANTATIONS
|
Arecanut, Cashew Kernel, Coffee (Robusta),
Rubber
|
|
PULSES
|
Chana,
Masur, Yellow Peas
|
|
PETROCHEMICALS
|
HDPE,
Polypropylene(PP), PVC
|
|
OIL
& OIL SEEDS
|
Castor
Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed, Crude
Palm Oil, Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard Seed
(Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil,
Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame
Seed, Soymeal, Soy Bean, Soy Seeds
|
|
CEREALS
|
Maize
|
|
OTHERS
|
Guargum, Guar Seed, Gurchaku, Mentha Oil, Potato
(Agra), Potato (Tarkeshwar), Sugar M
|
|
|
Regulator of commodity
exchanges:
|
|
FMCL
(Forward Market commission) headquarted in Mumbai, is regulation
authority which is overseen by the minister of consumer affairs,
food and public distribution Govt. of India, It is a statutory body
set up in 1953 under the forward contract (Regulation) Act
1952.
|
|
Needs for future trading in
commodities:
|
|
Commodity futures, which terms an essential
component of commodity exchanges, can be broadly classified into
precious metals, agriculture, energy and other metals. Current
future volumes are miniscule compared to underlying spot market
volumes and thus have a tremendous potential in the near future.
Future trading in commodities result in transparent and fair price
discovery. It reflects videos and expectations of wider section of
people related to a particular commodity. It provides effective
platform for price risk management for all segment of players
ranging from producers, trades and processors of a commodity. It
aids in improving the cropping platform for farmers, thus mimizing
the losses to the farmers. It also acts as a smart investment
choice in providing hedging, trading and arbitrage opportunities to
market players. Historically, pricing, in Commodities future has
been less volatile compared with equity and bonds, thus providing
an efficient portfolio diversification option. Raw Materials form
the most key element of industries. The significance of raw
materials can further be strengthened by the fact that the increase
in raw material cost means reduction in share prices. Industry in
India a today runs the raw material price risk. Hence going forward
the industry can hedge this risk by trading in commodities
market.
|
|
Risk associated with
commodities market:
|
|
No risk
can be eliminated, but the same can be transferred to someone who
can handle it better or to someone who has the appetite for risk.
Commodity enterprises primarily face the following classes of risk.
Namely: The price Risk, the quantity risk, the yield/output risk
and the political risk, talking about the nationwide commodity
exchanges, the risk of the counter party not fulfilling his
obligations on due date or at any time therefore is the most common
risk.
This risk is mitigated by collection of the following
margins:-
- Initial margins
- Exposure margins
- Mark to Market on daily
positions.
- Surveillance.
|
|
Key factors for success of
commodities market:
|
|
The
following are source of the key factors for the success of the
commodities market:
- How can one make the business
grow
- How many products are covered
- How many people participate in the
Platform.
|
|
Key factors for success of
commodity exchanges:
|
|
Strategy, method of execution, background of
promoters, credibility of the institution, transparency of
platforms, scaleable technology, robustness of settlement
structure, wider participation of Hedgers, speculators and
arbitragers, acceptable clearing mechanism, financial soundness and
capability, covering a wide range of commodity, reach of the
organization and adding value to the ground.
|
|
Basic terminologies in
commodities
|
|
Arbitrage: The simultaneous purchase and sale of similar
commodities in different markets to take advantage of a perceived
price discrepancy.
Basis: The difference between the current cash
price and the futures price of the same commodity for a given
contract month.
Bear Market: A period of declining market
prices.
Bull Market: A period of rising market
prices.
Broker: A company or individual that executes
futures and options orders on behalf of financial and commercial
institutions and/or the general public.
Call Option: An option that gives the buyer the
right, but not the obligation, to purchase (go "long") the
underlying futures contract at the strike price on or before the
expiration date of the option.
Cash (Spot) Market: A place where people buy and
sell the actual (cash) commodities, i.e., grain elevator, livestock
market, etc.
Commission (Brokerage) Fee: A fee charged by a
broker for executing a transaction.
Convergence: A term referring to cash and futures
prices tending to come together as the futures contract nears
expiration.
Cross-hedging: Hedging a commodity using a
different but related futures contract when there is no futures
contract for the cash commodity being hedged and the cash and
futures markets follow similar price trends
Daily Trading Limit: The maximum price change set
by the exchange each day for a contract.
Day Traders: Speculators who take positions in
futures or options contracts and liquidate them prior to the close
of the same trading day.
Delivery: The transfer of the cash commodity from
the seller of a futures contract to the buyer of a futures
contract.
Forward (Cash) Contract: A cash contract in which
a seller agrees to deliver a specific cash commodity to a buyer at
a specific time in the future
Fundamental Analysis: A method of anticipating
future price movement using supply and demand information.
Futures Contract: A legally binding agreement,
made on the trading floor of a futures exchange, to buy or sell a
commodity or financial instrument sometime in the future. Futures
contracts are standardized according to the quality, quantity and
delivery time and location for each commodity. The only variable is
price, which is determined on an exchange trading floor.
Hedger: An individual or company owning or
planning to own a cash commodity - corn, soybeans, wheat, etc. and
concerned that the costs of the commodity may change before they
intend to either buy or sell it in the cash market. A hedger
achieves protection against changing cash prices by purchasing
(selling) futures contracts of the same or similar commodity and
later offsetting that position by selling (purchasing) futures
contracts of the same quantity and type as the initial transaction
and at the same time as the cash transaction occurs.
Hedging: The practice of offsetting the price risk
inherent in any cash market position by taking an equal but
opposite position in the futures market. Hedgers use the futures
markets to protect their business from adverse price changes.
Margin: Margin is the percentage amount required
by the exchange from the trading member for carrying out trading
activities in the particular contract. The member in turn collects
the margin from the client entering into trade in that contract.
Though the margin amount as a whole is more significant, it can be
broken into 4 kinds of margin:
- Initial Margin
- Exposure Margin
- Additional Margin
- Special Margin
Initial Margin: The amount a futures market participant must
deposit into his/her margin account at the time he/she places an
order to buy or sell a futures contract.
In-the-Money Option: An option having intrinsic
value. A call option is in-the-money if its strike price is below
the current price of the underlying futures contract. A put option
is in-the-money if its strike price is above the current price of
the underlying futures contract.
Intrinsic Value: The difference between the strike
price and the underlying futures price for an option that is
in-the-money.
Liquidate: Selling (or purchasing) futures
contracts of the same delivery month purchased (or sold) during an
earlier transaction or making (or taking) delivery of the cash
commodity represented by the futures contract.
Long: One who has bought futures contracts or
plans to own a cash commodity.
Lot Size: There are generally 2 kind of lots
associated with commodity futures
Trading lot
It is the lot size in which trading activities are carried out. It
means that the minimum quantity in which trading would be conducted
for any particular contract of a commodity. Eg. With lot size of
Crude Oil being 100 barrels, any trader / investor would have to
buy / sell a minimum of 100 barrels of crude oil on the trading
platform. No fractions are allowed to trade on the exchanges and
the trading is carried out in multiples of lot size only.
Delivery lot
It is the minimum size for conducting delivery in the particular
commodity. It can differ from the trading lot but would be always
in the multiples of the trading lot. It can’t be smaller than
trading lot as the delivery would not be possible in that case.
Generally, the delivery lot is decided on the basis of the
standards of the delivery procedure carried out in spot
markets.
Maintenance Margin: A set minimum margin (per
outstanding futures contract) that a customer must maintain in his
margin account.
Nearby (Delivery) Month: The futures contract
month closest to expiration. Also referred to as spot month.
Open Interest: The total number of futures or
options contracts of a given commodity that have not yet been
offset by an opposite futures or option transaction nor fulfilled
by delivery of the commodity or option exercise. Each option
transaction has a buyer and a seller, but for calculation of open
interest only one side of the contract is counted.
Option: A contract that conveys the right, but not
the obligation, to buy or sell a futures contract at a certain
price for a specified time period. Only the seller (writer) of the
option is obligated to perform.
Option Premium: The price of an option-the sum of
money that the option buyer pays and the option seller receives for
the rights granted by the option.
Out-of-the-Money Option: An option with no
intrinsic value, i.e., a call whose strike price is above the
current futures price or a put whose strike price is below the
current futures price.
Purchasing Hedge (long hedge): Buying futures
contracts to protect against a possible price increase of cash
commodities that will be purchased in the future. At the time the
cash commodities are bought, the open futures position is closed by
selling an equal number and type of futures contracts as those that
were initially purchased.
Put Option: An option that gives the option buyer
the right but not the obligation to sell (go short) the underlying
futures contract at the strike price on or before the expiration
date of the option.
Price Limit: Price Limit is put into the place by
the Exchanges on directives from FMC, the regulatory body, to keep
a check on extreme price movements within a single trading
session.
A price limit is defined for each commodity in percentage terms
which is calculated from the previous close of the contract. If the
prices hit the circuit limit on either side, the trading is halted
for 15 minutes, which is often termed as cooling period. Then the
trading limit gets relaxed for another 50% of the initial limit
specified and margin on the contract gets increased. The revised
limit is the maximum price on the higher / lower side at which
trading can take place.
Different commodities have different price limits. Same commodity
might be having different price limits on different exchanges but
different contracts of same commodity can’t have varying price
limits (in percentage terms) on same exchange
Selling Hedge (short hedge): Selling futures
contracts to protect against possible declining prices of
commodities that will be sold in the future. At the time the cash
commodities are sold, the open futures position is closed by
purchasing an equal number and type of futures contracts as those
that were initially sold.
Short Position: One who has sold futures contracts
or plans to sell a cash commodity. Selling futures contracts or
initiating a cash forward contract sale without offsetting a
particular market position.
Speculator: A market participant who tries to
profit from buying and selling futures and option contracts by
anticipating future price movements. Speculators assume market
price risk and add liquidity and capital to the futures markets.
They do not hold equal and opposite cash market risks.
Spread: The price difference between two related
markets or commodities. For example, the April-August live cattle
spread.
Strike Price: The price at which the futures
contract underlying a call or put option can be purchased (call) or
sold (put). Also called exercise price.
Symbol: Exchange provides symbol to each commodity
traded on its platform. These symbols are unique within the
exchange.
Symbols on MCX are quite simple and easy to identify as the name is
the symbol in most cases. Eg. Gold is written as 'GOLD', Silver as
'SILVER', Copper as 'COPPER' and Crude Oil as 'CRUDEOIL'
On the other hand, NCDEX has a different method of allotting
symbols. Each symbol carries alphabets from the
following:
- Name of the commodity
- Quality of the commodity
- Delivery centre
Technical Analysis: Anticipating future price movements using
historical prices, trading volume, open interest, and other trading
data to study price patterns.
Time Value: The amount of money option buyers are
willing to pay for an option in the anticipation that, over time, a
change in the underlying futures price will cause the option to
increase in value. In general, an option premium is the sum of time
value and intrinsic value. Any amount by which an option premium
exceeds the option's intrinsic value can be considered time
value.
Tick Size: Tick size is the minimum price movement
permissible for the particular contract. It means that the minimum
price fluctuation (if any) in a commodity would be the tick size.
Eg. Tick Size for Wheat at NCDEX is Rs. 0.20 which means that if
the wheat is quoting at Rs. 850, then the next price on the higher
side should be minimum Rs. 850.2. It cannot be Rs. 850.10.
Underlying Futures Contract: The specific futures
contract that can be bought or sold by exercising an option.
Volatility: A measurement of the change in price
over a given time period. It is often expressed as a percentage and
computed as the annualized standard deviation of percentage change
in daily price.
Volume: The number of purchases or sales of a
commodity futures contract made during a specified period of time,
often the total transactions for one trading day.
|
ekkarill92 answered 2 years ago