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 commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged.
However, the markets have been thin with poor liquidity and have not grown to any significant level. Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz. , precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded. It is important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market. Evolution of the commodity market in India
Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the state and forwards and futures trading are selectively introduced with stringent controls. While free trade in many commodity items is restricted under the Essential Commodities Act (ECA), 1955, forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952.
The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd. , and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. The Gujrati Vyapari Mandali came into existence in 1900 which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures trade in raw jute.
In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association (EICA). Many exchanges were set up in major agricultural centres in north India before world war broke out and they were mostly engaged in wheat futures until it was prohibited. The existing exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was first organized by India Pepper and Spices Trade Association (IPSTA) in Cochin in 1957. Futures in gold and silver began in Mumbai in 1920 and continued until it was prohibited by the government by mid-1950s.
Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until they along with futures were banned in 1939 (Ministry of Food and Consumer Affairs, 1999). However, the government withdrew the ban on futures with passage of FCRA in 1952. The Act has provided for the establishment and constitution of Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers assigned to it by the Act.
Later, futures trade was altogether banned by the government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities. After the ban of futures trade all the exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc. As part of economic liberalization of 1990s an expert committee on forward markets under the chairmanship of Prof. K. N.
Kabra was appointed by the government of India in 1993. Its report submitted in 1994 recommended the reintroduction of futures which were banned in 1966 and also to widen its coverage to many more agricultural commodities and silver. In order to give more thrust on agricultural sector, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk arising from price fluctuations.
In line with the proposal many more agricultural commodities are being brought under futures trading. The Present Status Presently futures trading is permitted in all the commodities. Trading is taking place in about 78 commodities through 25 Exchanges/Associations as given in the table below:- No. ExchangeCOMMODITY 1. India Pepper & Spice Trade Association, Kochi (IPSTA)Pepper (both domestic and international contracts) 2. Vijai Beopar Chambers Ltd. , MuzaffarnagarGur, Mustard seed 3. Rajdhani Oils & Oilseeds Exchange Ltd. , DelhiGur, Mustard seed its oil & oilcake 4.
Bhatinda Om & Oil Exchange Ltd. , BhatindaGur 5. The Chamber of Commerce, HapurGur, Potatoes and Mustard seed 6. The Meerut Agro Commodities Exchange Ltd. , MeerutGur 7. The Bombay Commodity Exchange Ltd. , MumbaiOilseed Complex, Castor oil international contracts 8. Rajkot Seeds, Oil & Bullion Merchants Association, RajkotCastor seed, Groundnut, its oil & cake, cottonseed, its oil & cake, cotton (kapas) and RBD palmolein. 9. The Ahmedabad Commodity Exchange, AhmedabadCastorseed, cottonseed, its oil and oilcake 10. The East India Jute & Hessian Exchange Ltd. CalcuttaHessian & Sacking 11. The East India Cotton Association Ltd. , MumbaiCotton 12. The Spices & Oilseeds Exchange Ltd. , Sangli. Turmeric 13. National Board of Trade, IndoreSoya seed, Soyaoil and Soya meals, Rapeseed/Mustardseed its oil and oilcake and RBD Palmolien 14. The First Commodities Exchange of India Ltd. , KochiCopra/coconut, its oil & oilcake 15. Central India Commercial Exchange Ltd. , GwaliorGur and Mustard seed 16. E-sugar India Ltd. , MumbaiSugar 17. National Multi-Commodity Exchange of India Ltd. , AhmedabadSeveral Commodities 18.
Coffee Futures Exchange India Ltd. , BangaloreCoffee 19. Surendranagar Cotton Oil & Oilseeds, SurendranagarCotton, Cottonseed, Kapas 20. E-Commodities Ltd. , New DelhiSugar (trading yet to commence) 21. National Commodity & Derivatives, Exchange Ltd. , MumbaiSeveral Commodities 22. Multi Commodity Exchange Ltd. , MumbaiSeveral Commodities 23. Bikaner commodity Exchange Ltd. , BikanerMustard seeds its oil & oilcake, Gram. Guar seed. Guar Gum 24. Haryana Commodities Ltd. , HissarMustard seed complex 25. Bullion Association Ltd. , JaipurMustard seed Complex
Futures trading perform two important functions of price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It is useful to the producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him. It enables the consumer, in that he gets an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts.
Futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to hedge his risk by operating in futures market. Forward/futures trading involves a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc. Hence there is a need for the regulatory functions to be exercised by an exchange that is the Forward Markets Commission (FMC).
Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. Exchange is an association of members which provides all organizational support for carrying out futures trading in a formal environment. These exchanges are managed by the Board of Directors which is composed primarily of the members of the association.
There are also representatives of the government and public nominated by the Forward Markets Commission. The majority of members of the Board have been chosen from among the members of the Association who have trading and business interest in the exchange. The Board is assisted by the chief executive officer and his team in day-to-day administration. National Exchanges In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd. (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. “National Status” implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively. MCX MCX (Multi Commodity Exchange of India Ltd. an independent and de-mutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd. , State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd. , Union Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank. Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets.
Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Centers, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure. MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange.
MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading. NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz. warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC.
It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN). NMCE follows best international risk management practices. The contracts are marked to market on daily basis.
The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.
NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.
Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres.
NCDEX currently facilitates trading of thirty six commodities – Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed – Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal. The current profile of futures trading in India with respect to the various exchanges in India:-
Commodity 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. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. 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 assets 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. A brief look at these issues. Physical settlement Physical settlement 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 o to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. They are:- ? Limits on storage facilities in different states. ?Restrictions on interstate movement of commodities. ?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 process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities.
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’. The intention of the notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt.
The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. 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. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method. Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice.
After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first-in-first out basis. In some exchanges, the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract.
The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day. Delivery After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt.
The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised 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 account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts. Warehousing
One of the main differences between financial and commodity derivatives is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. In case of commodity derivatives however, there is a possibility of physical settlement. Which means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset.
This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Quality of underlying assets
A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures.
A good grading system allows commodities to be traded by specification. Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.
The NCDEX Platform Structure of NCDEX Promoters A consortium of institutions promotes NCDEX. These include the ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Punjab National Bank (PNB), CRISIL Limited (formerly the Credit Rating Information Services of India Limited), Indian Farmers Fertiliser Cooperative Limited (IFFCO) and Canara Bank by subsciribing to the equity shares have joined the initial promoters as shareholders of the Exchange.
NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience, trust, nationwide reach, technology and risk management skills. Governance NCDEX is run by an independent Board of Directors. Promoters do not participate in the day-to-day activities of the exchange.
The directors are appointed in accordance with the provisions of the Articles of Association of the company. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. It formulates the rules and regulations related to the operations of the exchange. Board appoints an executive committee and other committees for the purpose of managing activities of the exchange. The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange, and also other members appointed by the board.
Apart from the executive committee the board has constitute committee like Membership committee, Audit Committee, Risk Committee, Nomination Committee, Compensation Committee and Business Strategy Committee, which, help the Board in policy formulation. Exchange membership Membership of NCDEX is open to any person, association of persons, partnerships, co-operative societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of the exchange have to register themselves with the competent authority before commencing their operations. The members of NCDEX fall into two categories.
Trading cum clearing members (TCMs) NCDEX invites applications for (TCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The TCM membership entitles the members to trade and clear, both for themselves and/ or on behalf of their clients. Applicants accepted for admission as TCM are required to satisfy the following: Particulars (Rupees in Lakh) 1)Interest free cash security deposit 15. 00 2)Collateral Security deposit 15. 00 3)Annual subscription charges 0. 50 4)Advance minimum transaction charges 0. 50 5)Net worth requirement 50. 00 Professional clearing members (PCMs)
NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs), both for themselves and/ or on behalf of their clients. Applicants accepted for admission as PCMs are required to satisfy the following: Particulars (Rupees in Lakh) 1)Interest free cash security deposit 25. 00 2)Collateral security deposit 25. 00 3)Annual subscription charges 1. 00 4)Advance minimum transaction charges 1. 00 5)Net worth requirement 5000. 00
Capital requirements NCDEX has specified capital requirements for its members. On approval as a member of NCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. Base Minimum Capital comprises of the following: 1. Interest free cash security deposit 2. Collateral security deposit All Members have to comply with the security deposit requirement before the activation of their trading terminal. Members can opt to meet the security deposit requirement by way of the following: ? Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited. Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. The minimum term of the bank guarantee should be 12 months. ?Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period of 36 months from any of the approved banks. ?Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities.
The securities are valued on a daily basis and a haircut of 25% is levied. Members are required to maintain minimum level of security deposit i. e. Rs. 15 Lakh in case of TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls below the minimum required level, NCDEX may initiate suitable action including withdrawal of trading facilities as given below: ? If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be withdrawn with immediate effect. ?If the security deposit shortageis less than Rs. Lakh the member would be given one calendar weeks’ time to replenish the shortages and if the same is not done within the specified time the trading facility would be withdrawn. Members who wish to increase their limit can do so by bringing in additional capital in the form of cash, bank guarantee, fixed deposit receipts or Government of India securities. Participants of Commodity Derivatives For a market to succeed, it must have all three kinds of participants – hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on the market.
Commodity markets give opportunity for all three kinds of participants. Hedgers Many participants in the commodity futures market are hedgers. They use the futures market to reduce a particular risk that they face. This risk might relate to the price of any commodity that the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a predetermined price.
Hedging does not necessarily improve the financial outcome; indeed, it could make the outcome worse. What it does however is, that it makes the outcome more certain. Hedgers could be government institutions, private corporations like financial institutions, trading companies and even other participants in the value chain, for instance farmers, extractors, ginners, processors etc. , who are influenced by the commodity prices. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position.
This is called a short hedge. A short hedge is a hedge that requires a short position in futures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. Speculators
If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. These are the people who takes positions in the market & assume risks to profit from price fluctuations in fact the speculators consume market information make forecasts about the prices & put money in these forecasts. An entity having an opinion on the price movements of a given commodity can speculate using the commodity market. While the basics of speculation apply to any market, speculating in commodities is not as simple as speculating on stocks in the financial market.
For a speculator who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for whatever duration he wants to. However, commodities are bulky products and come with all the costs and procedures of handling these products. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. To trade commodity futures on the NCDEX, a customer must open a futures trading account with a commodity derivatives broker. Buying futures simply involves putting in the margin money.
This enables futures traders to take a position in the underlying commodity without having to actually hold that commodity. With the purchase of futures contract on a commodity, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). Arbitrage A central idea in modern economics is the law of one price. This states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price.
If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. This activity termed as arbitrage. The buying cheap and selling expensive continues till prices in the two markets reach equilibrium. Hence, arbitrage helps to equalise prices and restore market efficiency. F = (S + U)erT Where: r = Cost of financing (annualised) T = Time till expiration U = Present value of all storage costs The cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets.
The above equation gives the fair value of a futures contract on an investment commodity. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. To capture mispricings that result in overpriced futures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that result in underpriced futures, the arbitrager must sell spot and buy futures. In the case of investment commodities, mispricing would result in both, buying the spot and holding it or selling the spot and investing the proceeds.
However, in the case of consumption assets which are held primarily for reasons of usage, even if there exists a mispricing, a person who holds the underlying may not want to sell it to profit from the arbitrage. The NCDEX system Every market transaction consists of three components namely: trading, clearing and settlement. A brief overview of how transactions happen on the NCDEX’s market. Trading The trading system on the NCDEX provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism.
It supports an order driven market and provides complete transparency of trading operations. The trade timings of the NCDEX are 10. 00 a. m. to 4. 00 p. m. After hours trading has also been proposed for implementation at a later stage. The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time.
When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued in the respective outstanding order book in the system. NCDEX trades commodity futures contracts having one-month, two-month and three-month expiry cycles. All contracts expire on the 20th of the expiry month. If the 20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day.
New contracts will be introduced on the trading day following the expiry of the near month contract. Contract cycle The figure shows the contract cycle for futures contracts on NCDEX. As can be seen, at any given point of time, three contracts are available for trading – a near-month, a middle-month and a far-month. As the January contract expires on the 20th of the month, a new three-month contract starts trading from the following day, once more making available three index futures contracts for trading. Types of Order
An electronic trading system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: ? Time conditions ?Price conditions ?Other conditions Time conditions Good till day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. Good till cancelled (GTC): A GTC order remains in the system until the user cancels it.
Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. The GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from the date of entering an order or when the contract expires, whichever is earlier. Good till date (GTD): A GTD order allows the user to specify the date till which the order should remain in the system if not executed. The maximum days allowed by the system are the same as in GTC order.
At the end of this day/ date, the order is cancelled from the system. Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately. All or none order: All or none order (AON) is a limit order, which is to be executed in its entirety, or not at all. Fill or kill order: This order is a limit order that is placed to be executed immediately and if the order is unable to be filled immediately, it gets cancelled.
Price conditions Limit order: An order to buy or sell a stated amount of a commodity at a specified price, or at a better price, if obtainable at the time of execution. The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price. Stop-loss: A stop-loss order is an order, placed with the broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Futures traders often use stop orders in an effort to limit the amount of loss if the futures price moves against their position.
Stop orders are not executed until the price reaches the specified point. When the price reaches that point the stop order becomes a market order. A buy stop order is initiated when one wants to buy a contract or go long and a sell stop order when one wants to sell or go short. For the stop-loss sell order, the trigger price has to be greater than the limit price. Other conditions Market price: Market orders are orders for which no price is specified at the time the order is entered (i. e. price is market price). For such orders, the system determines the price.
Only the position to be taken long/ short is stated. Market on open: The order will be executed on the market open within the opening range. This trade is used to enter a new trade, or exit an open trade. Market on close: The order will be executed on the market close. The fill price will be within the closing range, which may, in some markets, be substantially different from the settlement price. This trade is also used to enter a new trade, or exit an open trade. Trigger price: Price at which an order gets triggered from the stop-loss book. Limit price: Price of the orders after triggering from stop-loss book.
Spread order: A simple spread order involves two positions, one long and one short. They are taken in the same commodity with different months or in closely related commodities. Prices of the two futures contract therefore tend to go up and down together, and gains on one side of the spread are offset by losses on the other. The spreaders goal is to profit from a change in the difference between the two futures prices. One cancels the other order: An order placed so as to take advantage of price movement, which consists of both a stop and a limit price.
Once one level is reached, one half of the order will be executed (either stop or limit) and the remaining order cancelled (either limit or stop). This type of order would close the position if the market moved to either the stop rate or the limit rate, thereby closing the trade and at the same time, cancelling the other entry order. Trading parameters Permitted lot size The permitted trading lot size for the futures contracts on individual commodities is stipulated by the exchange from time to time. The lot size currently applicable on individual commodity contracts is given as follows : Tick size for contracts
The tick size is the smallest price change that can occur for the trades on the exchange. The tick size in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise. Quantity freeze Orders placed have to be within the quantity specified by the exchange regard. Any order exceeding this specified quantity will not be executed but will lie pending with the exchange as a quantity freeze. In respect of orders which have come under quantity freeze, the member is required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine.
On such confirmation, the exchange can approve such order. However, in exceptional cases, the exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution. Margins for trading in futures Margin is the deposit money that needs to be paid to buy or sell each contract. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract. Charges Members are liable to pay transaction charges for the trade done through the exchange during the previous month.
The transaction charges are payable at the rate of Rs. 6 per Rs. one Lakh trade done. This rate is subject to change from time to time. The transaction charges are payable on the 7th day from the date of the bill every month in respect of the trade done in the previous month. Clearing National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house.
At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash.
The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. Settlement Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank.
All positions of a CM, either brought forward, created during the day or closed out during the day, are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. On the date of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client’s trades. A professional clearing member is responsible for settling all the participants’ trades which he has confirmed to the exchange.
On the expiry date of a futures contract, members submit delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. NCDEX on receipt of such information matches the information and arrives at a delivery position for a member for a commodity. The seller intending to make delivery takes the commodities to the designated warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contract specifications with allowed variances.
If the commodities meet the specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor’s electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer’s clearing member. On an appointed date, the buyer goes to the warehouse and takes physical possession of the commodities. Risk management NCDEX has developed a comprehensive risk containment mechanism for the commodity futures market.
The salient features of risk containment mechanism are: 1. The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent. 2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies the initial margin requirements for each futures contract on a daily basis. It also follows value-at-risk (VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively. 3.
The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis. 4. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation by the PCM. 5. A separate settlement guarantee fund for this segment has been created out of the capital of members. Pricing commodity futures Commodity futures began trading on the NCDEX from the 14th December 2003.
The market is still in its nascent phase, however the volumes and open interest on the various contracts trading in this market have been steadily growing. The process of arriving at a figure at which a person buys and another sells a futures contract for a specific expiration date is called price discovery. In an active futures market, the process of price discovery continues from the market’s opening until its close. The prices are freely and competitively derived. Future prices are therefore considered to be superior to the administered prices or the prices that are determined privately.
Further, the low transaction costs and frequent trading encourages wide participation in futures markets lessening the opportunity for control by a few buyers and sellers. In an active futures markets the free flow of information is vital. Futures exchanges act as a focal point for the collection and dissemination of statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates and other pertinent information. Any significant change in this data is immediately reflected in the trading pits as traders digest the new information and adjust their bids and offers accordingly.
As a result of this free flow of information the market determines the best estimate of today and tomorrow’s prices and it is considered to be the accurate reflection of the supply and demand for the underlying commodity. The cost-of-carry model explains the dynamics of pricing that constitute the estimation of fair value of futures. The cost of carry model We use arbitrage arguments to arrive at the fair value of futures. For pricing purposes, we treat the forward and the futures market as one and the same. A futures contract is nothing but a forward contract that is exchange traded and that is settled at the end of each day.
The buyer who needs an asset in the future has the choice between buying the underlying asset today in the spot market and holding it, or buying it in the forward market. If he buys it in the spot market today, it involves opportunity costs. He incurs the cash outlay for buying the asset and he also incurs costs for storing it. If instead he buys the asset in the forward market, he does not incur an initial outlay. However the costs of holding the asset are now incurred by the seller of the forward contract who charges the buyer a price that is higher than the price of the asset in the spot market.
This forms the basis for the cost-of-carry model where the price of the futures contract is defined as: F= S + C ? eq(1) Where: F = Futures price S = Spot price C = Holding costs or carry costs The fair value of a futures contract can also be expressed as: F = S(1 + r)T ? eq(2) Where: r = Percent cost of financing T = Time till expiration Whenever the futures price moves away from the fair value, there would be opportunities for arbitrage. If F < (1 + r)T or F > (1 + r)T , arbitrage would exist. In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased.
In the case of equity futures, the holding cost is the cost of financing minus the dividends returns. Equation 2 uses the concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of continuously compounded interest rates is expressed as: F = SerT ? eq (3) Where: r = Cost of financing (using continuously compounded interest rate) T = Time till expiration e = 2. 71828 The above equations provides for pricing futures in general. Investment assets
An investment asset is an asset that is held for investment purposes by most investors. Stocks and bonds are examples of investment assets. Gold and silver are also examples of investment assets. Note however that investment assets do not always have to be held exclusively for investment. However, to classify as investment assets, these assets do have to satisfy the requirement that they are held by a large number of investors solely for investment. we can use arbitrage arguments to determine the futures prices of an investment asset from its spot price and other observable market variables.
Pricing futures contracts on investment commodities In above equations the storage costs is ignored. The table bellow gives the indicative warehouse charges for accredited warehouses/ vaults that will function as delivery centres for contracts that trade on the NCDEX. Warehouse charges include a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The per unit charges include storage costs and insurance charges. NCDEX – indicative warehouse charges Commodity Fixed charges Warehouse charges per (Rs. ) unit per week (Rs. Gold 310 55 per kg Silver 610 1 per kg Soy Bean 110 13 per MT Soya oil 110 30 per MT Mustard seed 110 18 per MT Mustard oil 110 42 per MT RBD Palmolein 110 26 per MT CPO 110 25 per MT Cotton – long 110 6 per Bale Cotton – medium 110 6 per Bale We saw that in the absence of storage costs, the futures price of a commodity that is an investment asset is given by F = SerT. Storage costs add to the cost of carry. If U is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to F = (S + U)erT ? q(4) Where: r = Cost of financing (annualised) T = Time till expiration U = Present value of all storage costs Consumption assets A consumption asset is an asset that is held primarily for consumption. It is not usually held for investment. Examples of consumption assets are commodities such as copper, oil, and pork bellies. For pricing consumption assets, we need to review the arbitrage arguments a little differently. We consider the cost-of-carry model and the pricing of futures contracts on investment assets to determine the price of consumption assets.
Pricing futures contracts on consumption commodities The arbitrage argument is used to price futures on investment commodities. For commodities that are consumption commodities rather than investment assets, the arbitrage arguments used to determine futures prices need to be reviewed carefully. Suppose we have F > (S + U)erT ? eq(5) To take advantage of this opportunity, an arbitrager can implement the following strategy: 1. Borrow an amount S + U at the risk-free interest rate and use it to purchase one unit of the commodity and pay storage costs. . Short a forward contract on one unit of the commodity. If we regard the futures contract as a forward contract, this strategy leads to a profit of F- (S + U)erT at the expiration of the futures contract. As arbitragers exploit this opportunity, the spot price will increase and the futures price will decrease until Equation 5 does not hold good. Suppose next that F < (S + U)erT ? eq(6) In case of investment assets such as gold and silver, many investors hold the commodity purely for investment. When they observe the nequality in equation 6, they will find it profitable to trade in the following manner: 1. Sell the commodity, save the storage costs, and invest the proceeds at the risk-free interest rate. 2. Take a long position in a forward contract. This would result in a profit at maturity of (S + U)erT – F relative to the position that the investors would have been in had they held the underlying commodity. As arbitragers exploit this opportunity, the spot price will decrease and the futures price will increase until equation 6 does not hold good.
This means that for investment assets, equation 4 holds good. However, for commodities like cotton or wheat that are held for consumption purpose, this argument cannot be used. Individuals and companies, who keep such a commodity in inventory, do so, because of its consumption value – not because of its value as an investment. They are reluctant to sell these commodities and buy forward or futures contracts because these contracts cannot be consumed. Therefore there is unlikely to be arbitrage when equation 6 holds good. In short, for a consumption commodity therefore, F