Introduction

Introduction

The importance of oil in today's world can in no way be undermined. Was going to war in Iraq a pretext for the Unites States of America, the largest economy in the world, to acquire its oil? Keeping away from politics, I shall focus on the economical perspective only.

In the 21st century, the world must solve two great problems. These problems are rarely discussed by the public, have received little media attention and neither are they discussed by those in power, at least not publicly. They are:

• Over Population in the developing world.

• Over Consumption in the developed world.

"Oil Depletion: The primary problem of the developed world"

It is over-consumption where oil comes in. Being a business editor, I have personally always been interested in the subject of oil and its importance to the world.

Do the Arab Financial Markets impact World Oil Prices?

Surely; the vast Middle East and North African regions, depend on oil as its major source of revenue, especially Saudi Arabia.

Apart from the many other geopolitical tensions like Iraq, Iran, Nigeria, and macro-economic factors that heavily influence the oil trading mainly in the USA and the UK, the question that I want to answer though my research is, if there is an impact of the Arab markets on world oil prices.

For my project, I will concentrate only on the financial markets of the GCC and a few other Arab countries - namely: Bahrain, Saudi Arabia, United Arab Emirates, Qatar, Muscat & Kuwait along with Egypt, Lebanon & Jordan.

I don't expect my model to be highly significant, since it excludes all of the other main factors, but want to find out, if any, the strength of their effect only.

Literature Review

I did not find any study on the exact same topic; however, for my project I referred to the following related works:

1. Economic Developments and Prospects 2006 Financial Markets in a New Age of Oil, Middle East and North Africa Region. By Office of the Chief Economist

This paper aims to shed light on recent key economic developments in the Middle East and North African region, and the forces underlying the region's economic outcomes. It analyses the importance of Middle East's financial markets, to understand how financial systems are poised to meet some of the region's development objectives.

2. The Impact of Oil Price Shocks on the U.S. Stock Market Lutz Kilian and Cheolbeom Park, No 6166, CEPR Discussion Papers from C.E.P.R. Discussion Papers

This paper shows that the response of aggregate stock returns may differ greatly depending on whether the increase in the price of crude oil is driven by demand or supply shocks in the crude oil market. Further insights can be gained from the responses of industry-specific stock returns to demand and supply shocks in the crude oil market. We identify the sectors most sensitive to these shocks and study the opportunities for adjusting one's portfolio in response to oil market disturbances.

Economic Theory

Oil prices remain an important macroeconomic variable: higher prices can inflict substantial damage on the economies of oil-importing countries and on the global economy as a whole. While there is a strong presumption in the financial press that oil prices drive the stock market, the empirical evidence on the impact of oil price shocks on stock prices has been mixed. The conventional wisdom that higher oil prices necessarily cause lower returns is shown to apply only to oil-market specific demand shocks such as increases in the precautionary demand for crude oil that reflect fears about the availability of future oil supplies. In contrast, positive shocks to the global aggregate demand for industrial commodities are shown to cause both higher real oil prices and higher stock prices. Shocks to the global production of crude oil, while not trivial, are far less important for understanding changes in stock prices than shocks to global aggregate demand and shocks to the precautionary demand for oil.

Because of oil, the Middle East matters a great deal in the pricing of financial assets. The Middle East's impact on financial markets comes from the manner in which its violent politics affect the price of oil, the global price of global investment risks and the discounted price of global financial assets generally. Unexpected events may affect national or global markets but it is hard to know how much.

As with any commodity, prices for crude oil move according to a number of factors. Some of the larger indicators include:

Current supply in terms of output, especially the production quota set by OPEC.

Oil reserves, including what is available in U.S. refineries and what is stored at the Strategic Petroleum Reserves.

Oil demand, particularly from the U.S. During the summer, forecasts for travel from AAA are used to determine potential gasoline use. During the winter, weather forecasts are used to determine potential home heating oil use.

Of course, potential world crises in oil-producing countries can also dramatically increase oil prices. This happened in July 2006 with the Israel-Lebanon war that raised fears of a potential threat of war with Iran.

Data

For my project, I tried collecting the data from the university library database, but unfortunately, did not find any. I was recommended to search from the websites of the relevant countries.

For that purpose, I went to the website of each GCC's stock market, and got the closing market indices of the 6 GCC states namely:

Bahrain: Bahrain Stock Exchange

Qatar: Doha Stock Exchange

Oman: Oman Stock Market

Saudi Arabia: Saudi Arabia Stock Market

United Arab Emirates: Abu Dhabi Securities Market

Kuwait: Kuwait Stock Exchange

Along with:

Jordan: Amman Stock Exchange

Egypt: Egypt Stock Exchange

For some websites, historical data on the closing market indices were easily accessible, but for others, there was no past data on the website. In that case, I mailed the relevant markets on the contacts

provided. Some gave me a very good reply, by mailing me a complete data set for the required period, but for others, I did not even receive a reply at all.

My project includes:

— Data on the Nymex Crude Oil Future Contract 1 (Dollars per Barrel) for the past two years; namely 2005 & 2006.

— Closing general market indices for the markets mentioned above for again two years, namely: 2005 & 2006.

I was, however, unable to get information on market indices of other Arab markets, as their websites did not have the information, nor were they helpful in any way. Also, for Egypt, the values were not enough as compared with the others, so for simplicity sake, I have only one non-GCC market i.e. Jordan, in my model.

The Model to be Estimated

With a sample size of 344 (trading for 2 years), I will try to find out whether there is an affect of the Arab trading, mainly he GCC, on the world oil prices. I do not expect my model to be highly significant as mentioned earlier, but only wish to find the strength of the effect.

An important point to note here is that, I will regress the closing oil prices of a day against the same day trading of the other financial markets in order for the effect to be measured precisely. Due to this reason, many dates had to be deleted mainly due to the difference in the week days of the West and Middle East and also due to different national days among the GCC states themselves. As a result, my data was substantially reduced from my original number of 500.

For my model, I will take oil prices (NYMEX) as the dependent variable, with the other GCC market indices as the independent variables. For Oil, considering the factors mentioned above, the model is as follows:

Oil Prices = Oil Supply + Oil Demand + Oil Reserves + Geo-political world crisis*

*(explained earlier. Example: we cannot measure a cyclone that hits the Gulf of Mexico, where oil fields are located, but we can measure the extent of the damage it causes to the oil rigs therein.) During the war in Iraq, the BBC reported: "Once the war is launched... I expect big drops in oil prices, and gold prices, a strengthening US dollar and a rally in the stock market"

Tom Carpenter, chief economist

I will try to find a relationship between the independent and dependent variables by running multiple regression and using different statistical approaches, namely: Test of hypothesis, Descriptive Statistics, Correlations, Multicollinearity (i.e. strong relationship between the independent variables themselves) etc.

Multiple: Oil Prices= b0 + b1x1 + b2x2 + b3x3 + b4x4 + b5x5 + b6x6 + e

My model will look like something like this:

Oil Prices = Bahrain Market Index + Kuwait Market Index + Saudi Market Index + UAE Market Index + Oman Market Index + Qatar Market Index

Under this model, I will use different statistical concepts and try to justify my empirical findings.

Empirical Results

Graphs

From the scatter charts that I made (all are present in the excel sheet in the CD), I found a distinct positive relationship between some of the GCC states and Oil prices, like Bahrain, Qatar and also Amman as shown above. While for others, the data did not reveal any distinct trend, especially for Saudi Arabia. I also made a scatter diagram of the Oil prices against the USA Dow Jones Composite Index, but did not find any relevant trend between them as the data was widely dispersed.

Empirical Results

After looking at the different models that I got, the best model that I got is as follows:

Regression Statistics

Multiple R 0.78896666

R Square 0.62246839

Adjusted R square 0.61574676

Standard Error 4.88705446

Observations 344

Coefficients Standard Error t Stat P-value

Intercept 83.9717462 6.85941684 12.2418 9.3E-29

Bahrain Index -0.0358939 0.004221113 -8.50342 6.1E-16

UAE Index -0.00245 0.000684021 -3.58183 0.00039

Qatar Index 0.00162957 0.000312259 5.21865 3.2E-07

Oman Index 0.00750282 0.000784441 9.56454 2.5E-19

Kuwait Index 0.003381 0.000353363 9.56809 2.4E-19

Amman-0.0051299 0.001264821 -4.05584 6.2E-05

Model 5: Oil Prices = 83.97 - 0.0358 Bahrain Index - 0.00413 UAE Index + 0.00108 Qatar Index + 0.0063 Oman Index + 0.0028 Kuwait Index - 0.0051299 Amman Index

Interpretation of coefficients:

1) intercept: If the value of all independent variables is Zero, then the Oil prices will equal 83.97 2) Bahrain: Ceteris Paribas, If

Bahraini Index increases by one unit, then Oil Prices will decrease by 0.035 3) UAE: Ceteris Paribas, if UAE Index increases by one unit, then Oil

Prices decrease by 0.0024 4) Qatar: Ceteris Paribas, if Qatari Index increases by one unit, then Oil Prices increase by 0.00162

5) Oman: Ceteris Paribas, if Omani Index increases by one unit, then Oil Prices also increase by 0.0075

6) Kuwait: Ceteris Paribas, if Kuwaiti Index increases by one unit, then Oil Prices increase by 0.0033 7) Amman: Ceteris Paribas, if Jordan Index increases by one unit, then Oil Prices decrease by 0.0033

Adjusted R = 0.615, indicates that 61.5% of variation in Oil Prices is explained by the independent variables included in the model above. As I had anticipated, the variation is very small due to the main oil price determinants were not included in my model.

Multiple R = 0.788 which indicates that there is again a somewhat strong relationship between the variables in the model.

Standard Error = 4.88, which is very small meaning that the data in my model is not so widely dispersed from the regression line.

Some findings about my Model:

As stated earlier, the GCC financial markets are not correlated with each other; however some markets have shown a positive relationship with world oil prices, while others like Bahraini, Dubai and Amman have shown a negative profile.

An important to mention here is that in my model I was able to include only one non-GCC country as mentioned above due to the un-availability of data from most of the other markets. I believe, including more countries from the Arab region, would make the above model more significant.

Another interesting thing that I noted during my model was that the markets of Saudi Arabia, the largest oil supplier in the world, have a minimum impact on the world oil prices. Although Saudi plays a major role in the pricing of world oil prices, yet its financial side seems to be of little relevance.

Alternate Models

All other models that I developed are included next done on excel sheets, with their interpretations.

I have a total of six models, out of which model 5 was the best fit model as explained earlier.

A report of the models is also enclosed in the cd as a soft copy.

Correlation Analysis of Model 5

Crude Oil Future Contract 1 Bahrain Index UAE Index Qatar Index Oman IndexKuwait Index Amman Index

Crude Oil Future Contract 1 1

Bahrain Indx 0.083632993 1

UAE Index -0.276155555 0.432363703 1

Qatar Index -0.027625134 0.292157668 0.784535387 1

Oman Index 0.504414972 0.616035945 0.223069445 0.175454313 1

Kuwait Index 0.539201914 0.692502463 0.202264044 0.306757235 0.723828065 1

Amman0.027106943 0.438637026 0.817047969 0.815573199 0.466241939 0.4896460721

As we can see, although there is low multicollinearity between most of the independent variables, that are higher than 0.6. In multiple regression, if two independent variables are highly correlated, stepwise regression will return a high standard error. However, in my model I have minimum multicollinearity thus leading to a minimal Standard Error of 4.887054, or 5. Thus, although the R2=61.5% of my model is not very high, as I had expected, the error in my model is very low.

The low correlation among the independent variables can also be explained by the following:

"Financially speaking, we live in a global village. Typically, stock markets are correlated. However, this isn't true of bourses within the Gulf Co-operation Council (GCC) region. While stock markets in Saudi Arabia and Bahrain show a correlation of 0.4, the same goes down to 0.2 in the case of SA and Oman.

— A primary reason for the lack of correlation is investors investing in his/her own local market & each having a different investment pattern and sentiment.

— While the drivers of the stock markets in the Gulf region are not independent, the application and impact of these drivers in each market varies. Each market gives a different interpretation to the same signal.

Isolated islands: Current restrictions on foreign investment in the GCC markets imply that each regional market becomes a macro economy in itself.

As long as the markets are restricted for foreign investors, prices in regional stock markets would move independently.

Source: Dancing to their own tune

September 2006

Possible measures for alleviating multicollinearity are:

Reduce 2 by including further relevant variables in the model

Increase the number of observations

Increase the variance x2 of the explanatory variable

Combine correlated variables

Drop some of the correlated variables

Conclusion

As stated earlier, my best fit model is:

Oil Prices = 83.97 - 0.0358 Bahrain Index - 0.00413 UAE Index + 0.00108 Qatar Index + 0.0063 Oman Index + 0.0028 Kuwait Index - 0.0051299 Amman Index

After testing the model, I reject the null hypothesis and can conclude that there is a significant relationship between the dependent and independent variables.

Arab financial markets are somewhat significant and somehow do affect the world oil prices. With the data of the countries I included in my model, I obtained the above model.

With an R2 of 61.5%, including all other variables mentioned earlier will make the model more significant.

Limitations to My study

In preparing the above model, I faced a few obstacles which I have mentioned below:

i. Arab markets lack the availability of providing data to information seekers. I wanted to include more countries from the Arab world, but due to the un-availability of data on the respective websites, I could not do so. Also, many of the websites that had the information, did not have them in an excel sheet that just added to my misery of searching and inputting data, that consumed a lot of time. Some websites had provided contacts to request information. Upon request, I was contacted quickly; like Qatar, and given the information. But for other sites, like Lebanon, I did not even get a reply.

ii. Another problem was that time was not enough for collecting the data required. As I mentioned above, a lot of my time was spent in just entering the data in excel.

iii. Also, while researching for literature review, I did not find any previous studies on my topic. However, there were some articles that talked bout oil prices and financial markets, but not in an empirical study form.

iv. No matter how many problems I discuss here, in the end, I would definitely like to add that the pros far outweigh the cons. This course and this study has helped me in ways I cannot explain, but can say that I can now read and understand empirical studies on any subject that I want to, as required by my business profession or self study.

References

http://useconomy.about.com

Q. How Are Oil Prices Determined?

By: Kimberly Amadeo.

Websites:

www.tadawul.com, www.bahrainstock.com, www.dsm.com, www.gulfbase.com, www.kuwaitse.com, www.dfm.ae, www.egyptse.com,

www.ase.com, www.djindexes.com

Zawya.com/Dancing to their own tune

September 2006

RESEARCH PAPERS

AN EMPIRICAL STUDY ON GOLD AS A COMMODITY DERIVATIVE

By DR.SURESH CHANDRA BIHARI * RAJIV AGARWAL **

* Associate Professor, IBS, Hyderabad, A.P India. , ** MBA Class of 2011, IBS, Hyderabad, A.P India. ,

ABSTRACT 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 labor 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 center for trading of commodity derivatives. It is important to understand why commodity derivatives are required and the role they can play in risk management. It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibilities of adverse price change in future create risk for business. Derivatives are used to reduce or eliminate price risk arising from unforeseen price change. A derivative is a financial contract whose price depends on, or is derived from the price of other assets. The present study focuses primarily on how gold can be used as a commodity tool for hedging portfolio, medium of exchange, savings and investment. It first explains what is commodity, the structure of commodity market, the various types of derivative market. The study also explains the functioning of the derivative market. The various exchange for commodity market like NCDEX, MCX etc. are described. Keywords: Gold, Commodity Derivative, Hedging, Relative Strength Index, Open Interest. INTRODUCTION The high volatility in equity market with high risk and the arrival of low interest rates have increased the investor presence in alternative investments such as gold. In India, gold has traditionally played a multi-faceted role. Apart from being used for ornament purpose, it has also served as an asset of the last resort and a hedge against inflation and currency depreciation. But most importantly, it has most often been treated as an investment due to the below reasons:

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Gold supply primarily comes from mine production, official sector sales of global central banks, old gold scrap and net disinvestments of invested gold. Out of the total supply of 3385.8 tons last year, 59% was from mine production, 40% from old gold scrap and 1% from official sector sales1. Demand globally generate from fabrication (jewellery and other fabrication), bar hoarding, net producer hedging and implied investment. Gold continues to occupy a prominent part in rural India economy and a significant part of the rural credit market revolves around bullion as security. India is the largest consumer of gold in the world accounting for more than 26.25% of the total world demand annually due to the sustained rural buying and heavy demand from retail investors. According to unofficial estimates, India has more

than 15000 tonnes of hoarded gold, which translates to around $200 billion. Inspite of its predominant position, especially in the gold market where India is the

1 http://www.gold.org/deliver.php?file=/value/stats/statistics/pdf/Supply_Deman d.pdf

The first reason is security, gold offers full security as

long as it is retained by central banks. There is no credit risk attached to gold.

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Secondly, gold is able to maintain its liquidity even at

times of crisis situations like high global inflation or political turbulence.

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The third reason for holding gold is to build a diversified

portfolio.

i-manager’s Journal on Management, Vol. 5 l1 l - August 2010 No. June

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largest importer, India has traditionally been a price. seeker in the global bullion market. As considering the Indian growth scenario in GDP and increase importance in world economy near future, at present position India might guide the world gold economy prices. Bullion trading in India received a major fillip. Government of India announced the changes in the gold policy in 1997 under export-import Policy (1997-2002). As per the policy, scheduled commercial banks are authorized by the Reserve Bank of India (RBI) to import gold and silver for sale in domestic market without an importer license or surrendering the Special Import License (SIL). Bullion is imported into India by banks and four designated trading agencies acting as canalizing agents and consignees for overseas suppliers, who in turn sell to domestic wholesale traders, fabricators, etc. The price risk is borne either by the fabricator or the retail consumer. The wholesale traders, fabricators and investors do not have any effective tool to hedge their price risk in gold/silver. India being the largest consumer of gold in the world, with minimal domestic supply, the demand is met mainly from imports. Above facts certainly make the gold study, investment in gold a good opportunity for generating revenue to the broking firm dealing in commodities trading (like Anagram stock holding corporation) in gold and other commodities. This study certainly discuss the various effecting gold price movements in commodity exchange especially MCX vis-à-vis comparing it with International prices of gold. 1. Objective of Study

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3. Production of Gold

Symbol Description Trading period Trading session Trading unit Quotation/Base value / Price quote Maximum order size Tick size (minimum price movement) Delivery unit Delivery center(s) Quality Specifications Tender period Delivery period Tender Period Margin GOLD GOLDMMMYY Mondays through Saturdays Mondays to Friday:10.00 am. to 11.30 p.m. Saturday : 10.00 am. to 2.00 p.m. 1 kg 10 grams Ex- Ahmedabad (inclusive of all taxes) 10 kg Re.1 per 10 grams 1 kg Ahmedabad, Mumbai and additional delivery centers at Chennai, and 995 purity 1st to 6th day of the contract expiry month . 1st to 6th day of the contract expiry month . 5% incremental margin for last 5 days on all Outstanding positions. Such margin will be addition to initial and special margins as applicable. Borne by the seller till the date of pay-out-of delivery and the buyer after the date- of pay-out2 .

Vault,Insurance and Transportation charges

All the gold ever mined would easily fit under the Eiffel Tower, forming a cube of nearly 19 m each side. Annual gold production world wide is about US$90 billion and by far the one of the largest trading world commodity. Worldwide, gold mines produce about 2,554 tonnes in the year 2009 from the total supply of 3,890 tonnes which was sufficient to meet the demand of 3,386 tonnes (Figure1). Gold is mined in

more than 125 countries around the world, with the large number of development projects in these countries expected to keep production growing well into the next century. Currently, China is the largest gold producing country, followed by USSR, South Africa, Uzbekistan, Indonesia, Papua and others. Mine production provides the lion's share of gold supplied to the market each year – 66% but recycled gold – gold scrap – accounts for 2/5th, with the sales of gold by central banks and similar organizations making a balance of 1%. Production of gold in India is negligible comparing to world gold mine production, total gold availability in India is about 400 tonnes where mines produce around 250 tonnes of gold and the rest is through recycled gold and

2 http://www.mcxindia.com/SitePages/ContractSpecification.aspx?ProductCod e=GOLD

To study and understand the important factors

effecting gold prices movements.

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To analyze the price movements through various

sources and techniques.

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To suggest the reasons, the future conditions and

situations (buy, hold and sell) on gold price movements.

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The overall objective of this project is either to

minimize the risk or maximize profit of the investors, by expecting the future gold price movements. 2. Gold Specification While Trading In Mcx

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tonnes of gold every year. India is also the largest importer of the yellow metal; in 2008, India imported around 400 tonnes of gold. Gold Fabrication for domestic and international market also formed large part of business in India with 375 tonnes of gold fabricated in India in 2009, making world largest fabricator which is 17% of the total world gold fabrication. Its close competitor is China in gold fabrication (Figure 2). 5. Uses & Applications of Gold Gold has various usages. The four major sources of

Figure 1. Global Annual Gold Production

demand of gold are: 5.1 Jewelry Fabrication

scraps. Some of the Indian gold mines are Deccan gold mine, Hutti gold mines, Bharat gold mines, Kolar, Gadag and many more. 4. Demand and Consumption of Gold Demand for Gold for the year of 2010 will be underpinned by the following market forces:

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The largest source of demand is the jewelry industry. In recent years, demand from the jewelry industry alone has exceeded Western mine production. This shortfall has been bridged by supplies from reclaimed jewelry and other industrial scrap, as well as the release of official sector reserves. Gold's workability, unique beauty, and universal appeal make this rare precious metal the favorite of jewelers all over the world3. Because of the softness of pure (24k) gold, it is usually alloyed with base metals for use in jewelry, altering its hardness and ductility, melting point, color and other properties. Alloys with lower cartage, typically 22k, 18k, 14k or 10k, contain higher percentages of copper, or other base metals or silver or palladium in the alloy. Copper is the most commonly used base metal, yielding a redder color. Eighteen-carat gold containing 25% copper is found in antique & Russian jewelry. It has a

India and China will continue to provide the main

thrust of overall growth in demand, particularly for Gold jewellery, for the remainder of 2010. A report recently published by The People's Bank of China and five other organizations to foster the development of the domestic gold market will add impetus to the growth in gold ownership among Chinese consumers.

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Retails investment will continue to be a substantial

source of gold demand in Europe. The largest contribution of the demand of gold came from the ETF segment of investment demand in Q2 2010. Gold produced from different sources and demanded for consumption in form of Jewellery, Industrial applications, Government & Central bank investment and Private investors. Total of world gold produced is mostly consumed by different sectors such as Jewellery (52%), Industrial & Dental application (11%) and rest of gold is used as investment purpose i.e., (37%). Considering the situation in India, the demand for gold consumption is far more ahead than its availability through production, scrap or recycled gold. India is the world's largest consumer of gold, as Indians buy about 25% of the world's gold, purchasing approximately 800

Figure 2. World Gold Fabrication Demand

3

Source: http:// www.onlygold.com


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distinct, though not dominant, copper cast, creating raised gold. Fourteen-carat gold-copper alloy is nearly identical in color to certain bronze alloys, and both may be used to produce police, as well as other, badges. 5.2 Industrial Applications Besides jewelry, gold has many applications in a variety of industries including aerospace, medicine, electronics and dentistry. The electronics industry needs gold for the manufacture of computers, telephones, televisions, and other equipment. Gold's unique properties provide superior electrical conducting qualities and corrosion resistance, which are required in the manufacture of sophisticated electronic circuitry. In dentistry, gold alloys are popular because they are highly resistant to corrosion and tarnish. For this reason gold alloys are used for crowns, bridges, gold inlays, and partial dentures. Gold solder is used for joining the components of gold jewelry by high-temperature hard soldering or brazing. Gold can be made into thread and used in embroidery. Gold dissolves in alkaline solutions of potassium/sodium cyanide, and gold cyanide is the electrolyte used in commercial electroplating of gold onto base metals and electroforming. Gold chloride (chloroauric acid) solutions are used to make colloidal gold by reduction with citrate or ascorbate ions. Gold chloride and gold oxide are used to make highly valued cranberry glass. 5.3 Food & drink Gold leaf, flake or dust is used on and in some gourmet foods, notably sweets and drinks as decorative ingredient. Gold flake was used by the nobility in Medieval Europe as a decoration in food and drinks, in the form of leaf, flakes or dust, either to demonstrate the host's wealth or in the belief that something that valuable and rare must be beneficial for one's health. Gold foil along with silver is sometimes used in South Asian sweets such as barfi. Goldwasser (English: Goldwater) is a traditional herbal liqueur produced in Gdańsk, Poland, and Schwabach, Germany, and contains flakes of gold leaf. There are also some expensive (~$1000) cocktails which contain flakes of gold leaf. However, since metallic gold is inert to all body chemistry, it adds no taste nor has it any other nutritional effect and leaves the body unaltered. 5.4 Monetary Exchange Gold has been widely used throughout the world as a vehicle for monetary exchange, either by issuance and recognition of gold coins or other bare metal quantities, or through gold-convertible paper instruments by establishing gold standards in which the total value of issued money is represented in a store of gold reserves. However, the amount of gold in the world is finite and production has not grown in relation to the world's economies. Today, gold mining output is declining. With the sharp growth of economies in the 20th century, and increasing foreign exchange, the world's gold reserves and their trading market have become a small fraction of all markets and fixed exchange rates of currencies to gold became unsustainable. 5.5 Governments and Central Banks The third source of gold demand is governments and central banks that buy gold to increase their official reserves. 5.6 Private Investors Finally, there are private investors. Depending upon market circumstances, the investment component of demand can vary substantially from year to year. Many holders of gold store it in form of bullion coins or bars as a hedge against inflation or other economic disruptions. 5.7 Hedging A sale/purchase of futures contracts to offset the ownership/sale or purchase of the underlying cash commodity in order to protect it against adverse price moves. Gold Hedging is being introduced with the basic purpose of safeguarding to the producer, manufacturer, banks, and retailer due to high volatility in the prices of the gold, earning income on their gold holding and managing them more flexibly to their gold reserves and even against currencies price fluctuation. To avoid risk, they use the derivative market for holder to hedged, Dehedge and Re-hedge their holdings of gold. Gold is traded through out the

world in terms of dollar, since dollar is considered as world local currency (nearly 85% of world trade in dollar and forms 69% of world reserves) and even

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monetary contracts are signed either between the two nations or companies are represented in terms of dollar. It has been generally accepted or proved that dollar hold inverse-relationship against gold. Decline in the value of dollar against other currencies or due high inflation or decline in interest-rate, or in a situation of economic and political crisis or war or natural calamities causes the holder to shift its position from dollar to gold or to other secure security like Bonds, Treasury bill, etc., for their safeguard or with a intention of making profit with trading instrument in the market. 6. Motives of Holding Gold 6.1 Economic Security The value of currencies held in reserves, like the US dollar or the Euro, depends on the economic policies of the issuing government. Gold does not suffer from defects in reserve centers policies (and may in fat even benefit from them) nor is there any possibility of it being repudiated. A sharp depreciation in the value of reserve currencies on the foreign exchange market can also amount to repudiation, entailing huge losses for foreign holders of those reserves. 6.2 Physical Security Experience shows that countries quite frequently impose exchange controls affecting the free transfer of their currencies or, at the worst, the total asset freezes which prevent other countries accessing their cash and securities. If external reserves are held entirely in the form of financial instruments or bank deposits denominated in the currency of a reserve centre, they are vulnerable to such freezes. Where appropriately located, gold is much less vulnerable. 6.3 Unexpected Needs Economic developments both at home and in the rest of the world can upset individual countries plan, while global shocks can change the whole basis of the international monetary system. Owing gold owns an option against and unknown future. It provides a form of insurance against highly damaging events. Such events might

Source: http://www.marketoracle.co.uk Source: http://genuineforextrading.com

include war, an unexpected surge in inflation, the international isolation of the country etc. 6.4 Confidence The public takes confidence from knowing that it's Government holds Gold- An indestructible asset and one not prone to the inflationary worries over hanging paper money. Some countries give explicit recognition to its support for the domestic currency. And rating agencies will take comfort from the presence of Gold in a country's reserves. 6.5 Diversification In any asset portfolio, it rarely makes sense to have all your eggs in one basket. Obviously, the price of gold can fluctuate- but so to do the exchange and interest rates of

Figure 3. Gold Price in Various Currencies

Source: http://www.marketoracle.co.uk

Figure 4. Gold and USDX

currencies held in reserves, a strategy of reserve diversification will normally provide a less volatile return


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than one based on a single asset. Portfolio is formed by investor, whether they are individual, Investment institutions, Mutual Fund, etc., getting a moderate return with having minimal risk, on such scenario including gold as portfolio investment strategy with other financial assets, which has features of minimal fluctuation in price comparing to its rival $, equity stocks, and other metals with high liquidity. It gives a moderate return on economic crisis, depreciation in currency, etc. 6.6 Income Usually Gold is considered as a non income earning but it is not true any more. Nowadays we have Gold market and gold can be traded to generated income. The only cost incurred may be the “Opportunity Cost” of holding Gold which may be set off by the various advantages of it. 7. Suggestion & Recommendation Most of the volatility in gold is affected from fundamental factors like world currencies as Dollar, Euro, Rand, the relationship holding directly (indirectly) with gold is discussed later in this same topic are the main factors effecting gold world wide, policies by countries, Central banks, Gold production companies have effect on demand, supply and price of gold, investor perception of U.S and global economic growth prospects, etc. So, a trader generally has to take closer look at such factors. Either to capitalize on such opportunities or safeguard them liquidating or holding, hedging or Dehedging its respective position. The following discussion might help in understanding this relationship of Gold with the others. 7.1 Dollar and other currencies As we have discuss, where Dollar is considered as the world local currency with nearly 85% of world trade in dollar and forms 69% of world reserves, which is world most traded currency (even oil, gold and commodities have all been priced in U.S dollars since 1975 when OPEC officially agreed to sell its oil exclusively for US dollars. From 1944 until 1971, US dollars were convertible into gold by central banks in order to adjust for any trade imbalances between countries). So weakness in dollar, due to economic or political factors or unforeseen conditions gives other currency strength against dollar. Where investors view gold as a “safe heaven” from dollar weakness and that any expectations of further decline in the dollar will cause gold prices to strengthen. So it certainly gives there is an inverse relationship exist, which is formidable, between gold and dollar up to certain extent. Figures 5 & 6 shows the relationship of dollar and euro with gold as basis, where decline in dollar against and that any expectations of further decline in the dollar will cause gold prices to strengthen. So it certainly gives there is an inverse relationship exist, which is formidable, between gold and dollar up to certain extent. The Figure shows the relationship of dollar and euro with gold as basis, where decline in $ against euro gives lift to gold price. 7.2 Inflation and Crude Oil Generally speaking, an increasing oil prices results in increasing inflation, negatively impacting the global economy, particularly oil-dependent economies such as the US, India, Taiwan, Japan, etc. which certainly effect the other commodities, which give rise to inflationary situation. An increases in price or supply disruptions will negatively impact the US economy to a greater degree with nations largely depend on US Imports like Latin American Countries and south-east Asian countries with high US GDP deficit could further decline the dollar with investor holding dollar as reserve will start selling dollar which will put more pressure on dollar. Even countries like Russia, Venezuela, Arabia and some Arabian Nations are planning to Price Oil in Euro, Islamic Gold and Dinar with dollar, which could affect the

Figure 5. Gold Price in Various Currencies

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RESEARCH PAPERS

which increased/decreased the demand and the price of gold.

l

Economic or Political crisis in producing countries.

l

Lockouts on major gold mine producers.

8. Fundamental Factors Effecting Gold in India

l

Most of gold consumption is account from rural areas

in India. Gold demand in such region depends on monsoon, which has direct relationship with gold demand. Good monsoon result in good harvesting

Figure 6. Gold & US CPI

means high demand for gold.

l

countries to shift by transferring their reserves to other precious metals, other currencies which might lead to free fall of dollar. 7.3 Interest Rate & Deficit GDP deficit of nations based on their Current Account balance and interest rate play a major role in deciding the movement of Gold prices. A good example could be recent news of hike in interest rate by Fed Depart. In US for bank deposits, much better GDP growth rate than expected with low deficit leading to strengthen the dollar with gold prices declining comparing to its strengthen dollar. 7.4 Supply & Demand Fundamentals Gold production is

relatively flat over the last several years. Limited new production coming online in the near future, it is likely that overall mine production will continue to remain relatively stagnant over the next few years. GFMS said that mine supply will peak in 2005 at levels only slightly higher than those seen in 2004, and then decline by approx. 30 tonnes per year through 2010, or roughly 1.2% per year. While additional supply could come into the market in the form of scrap gold sales, which may be inspired by recently higher gold prices, it is doubt these sales would materially impact gold supply going forward. Recent data suggests confirm this, suggesting that new scrap sales is one of the major contributing factor to supply growth (Figures 7 & 8). Other factors effecting gold

l

Socio-culture event like Deepawali, Ugadi, Dasshera

and Marriage season have much needed demand for gold.

l

Lack of trust in banking system for making deposit and

tradition form of savings in gold in rural areas are still being followed.

l

Appreciation/Depreciation in rupee or low inflation

has minimal effect on gold consumption.

l

Macro economic factors at large as depreciation/

appreciation of dollar, physical demand of gold by other countries, unforeseen conditions, etc. 9. Methodology

l

For daily closing prices of gold, data is collected from

various websites like MCX India, USA gold, etc.

l

Theoretical information like daily news, articles,

research papers and reports collected and downloaded from company's website, newspapers and published books.

l

Technical analysis methods follow on this research

give relative closer picture of the expected price movement on gold. Certainly, 7 DMA & 14 DMA form a firm base for price expectations, support and resistance level, strength and weakness in market, signal for market comeback, etc., for a period of time with inclusion of Open Interest(OI) and volumes. Some important situation in gold closing price on MCX with respect to Daily Moving Averages (DMA), OI and Volumes are:

●

Government(s) policies towards gold.

When closing price curve cut 7DMA & 14DMA from above, certainly shows weakness in market and give

97

l

War, Famines or drought, other natural calamities


RESEARCH PAPERS

sell signal.

●

Time Jan 1 Jan 2 Jan 3 Jan 4 Trading Activity A buys 1 option and B sells 1 option contract C buys 5 options and D sells 5 options contracts A his sells 1option and D buys 1 option contract E buys 5 option from C who sells 5 option contract Open Interest 1 6 5 5

When closing price is moving up and cutting 7DMA & 14DMA from below, it shows strength in market and rise in price of gold in near future. 7DMA & 14DMA act as support line on declining prices most of the time. Increasing price while stagnant DMA's curve shows weakness in market predict decline in future gold prices.

●

●

Table 1. Example of Open Interest ●

●

On Jan 1 A, buys an option, which leaves an open interest and also creates trading volume of 1. On Jan 2 C & D create trading volume of 5 and there are also 5 more options left open. On Jan 3 A, takes an off setting position and therefore open interest is reduced by 1 and trading volume is 1. On Jan 4, E simply replaces C and therefore open interest does not change, trading volume increases by 5.

Gold prices of consecutive four years (2007, 2008, 2009, and 2010 till date) are taken and daily moving average is calculated keeping 7 days and 14 days as the base. A graph is plotted between the date, 7DMA and 14DMA. From the graph we can determine whether the market is weak or strong or may be we should buy or sell the stock. 7DMA & 14DMA is calculated as, 7DMA1 = Avg. (Day1, Day2, Day3, Day4, Day5, Day6, Day7) 7DMA2 = Avg. (Day2, Day3, Day4, Day5, Day6, Day7, Day8) and so on. 14DMA1 = Avg. (Day1, Day2, Day3, Day4, Day5,... Day14) 14DMA2 = Avg. (Day2, Day3, Day4, Day5, Day6, ..., Day15) and so on. The price4 of gold for three years is taken. The calculations are done in the excel

sheet and the graphs are plotted for the DMA. 9.1 Open Interest and Volume On OI & Volumes, A comprehensive study of following chapters will necessarily help and give clear picture of market, on technical analysis. What is Open Interest

l

●

●

The total number of open contracts on a security applies primarily to the futures market. It is often used to confirm trends and trend reversals for futures and options contracts. What Open Interest Tells Us A contract has both a buyer and a seller, so the two market players combine to make one contract. The openinterest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal. Rules of Open Interest Now, there are certain rules to open interest that must be understood and remembered. They have been written in many different publications, so here I have included an excellent version of these rules written by chartist Martin Pring in his book “Martin Pricing on Market Momentum”: 1. If prices are rising and open interest is increasing at a rate faster than its five year seasonal average, this is a bullish sign. More participants are entering the market,

Total number of options or futures contracts that are

not closed or delivered on a particular day.

l

The number of buy market orders before the stock

market opens. A common misconception is that open interest is the volume of options and futures trades. This is not correct, as demonstrated in the following example:

4

http://www.usagold.com/reference/prices/2005.html

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involving additional buying, and any purchases are generally aggressive in nature. 2. If the openinterest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top. 3. High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral. 4. An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway. 1. A breakout fro trading range will be much stronger of open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move. 2. Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. The market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of market. Consequently, when the short covering has run its course, prices will decline. 3. If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is bearish factor, but once the shorts begin to cover it turns bullish. 4. A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again. Volume Used in conjunction with open interest, volume represents the total number of shares or contracts that have changed hands in a one-day trading session in the commodities or options market. The greater the amount of trading during a market session the more is the trading volume. A new student to technical analysis can easily see the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the ore we can expect the existing trend to continue rather than reverse (Table 2). Technicians believe that volume precedes price, which means that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart. The rules that have been set in stone for both volume and open interest are combined because of their similarity; however, having said that, there are always exceptions to the rule, and we should look at them. So, price action increasing in an uptrend and open interest on the rise are interpreted as new money coming

Price Rising Rising Falling Falling

Figure 7. Graph showing 7&14 DMA & Price of Gold for the year 2009

Figure 8. Graph showing 7&14 DMA & Price of Gold for the year 2010

Volume Up Down Up Down Open Interest Up Down Up Down Market Strong Weak Weak Strong

Table 2.General Rules for Volume and Open Interest


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RESEARCH PAPERS

into the market (reflecting new buyers) and is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers covering their positions are causing the rally. Money is therefore leaving the marketplace and is considered bearish. If prices are in a downtrend and open interest is on the rise, chartists know that new Money is coming into the market, showing aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is being caused by disgruntled long position holders being forced to liquidate their positions. Technician view this scenario as a strong position technically because the downtrend will end as all the sellers have sold their positions. The following table therefore emerges (Table 3): When open interest is high at a market top and the prices falls off drastically, this scenario should be considered bearish. In other terms, this means that all of the long position holders that bought near the top of the market are now in a loss position, and their panic to sell keeps the price action under pressure. There is no need to study a chart for this indicator since the rules are the most important area to study and remember. If you are a new technician starting to understand the basic parameters of this study, look at many different charts of gold, silver, and other commodities so you can begin to recognize the patterns that develop. 9.2 Relative Strength Index (RSI 30/70 rule) RSI Analysis also helps in tracking situation of gold future market position,

l l

When it is at 20 and a consolidation is happening in

the market it gives strong buy signals.

l

SMI curve show the relationship with that of RSI curve,

when SMI lying above RSI means RSI will increase or RSI lying above SMI means, commodity is over priced and it will come closer to SMI curve. Gold prices of consecutive four years (2007, 2008, 2009, and 2010 till date) are taken and Relative Strength Index for each year is calculated using the following formula, RSI = 100 – [100/(1+RS)] where, RS = (Avg. Gain) / (Avg. Loss), Avg. Gain = Total Gain / n, Avg. Loss = Total Loss / n, n = number of RSI periods The price of gold for three years is taken. The calculations

Figure 9. Graph showing RSI 14 for the year 2009

It gives weak signal when RSI and SMI curves stay


between 50 to 70 levels for a long period of time.

l

It shows strength in market when it was trading above

70 levels and suggests a sell signal and As the RSI and SMI curves lies in between 30 to 50 levels give hold.

Bullish Bearish Bearish Bullish - an increasing open interest in a rising - a declining opean interest in a rising market - an increasing open interest in a falling market - a declining open interest in a falling market


Table 3. Effect of Open Interest on the Market

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affected from fundamental factors like world currencies as Dollar, Euro, Rand, the relationship holding directly (indirectly) with gold as discussed in the paper above. The main factors effecting gold world wide is policies by countries, Central banks. Further close substitutes like silver


also impacts the price of gold. Gold production companies have effect on demand, supply and price of gold, investor perception of U.S and global economic growth prospects, etc. At last we can conclude that we have various methods like 7 DMA & 14 DMA, Open Interest etc. to predict the future trends of Gold Prices but they can only tell us the direction of Gold Prices but can't help us in the exact forecasting of prices for the same. Besides, the equity culture in India is not as developed as in some other parts of the world. Gold has not lost its prime importance as a hedge against loss of wealth in times of crises. References [1]. Vuyyuri, Srivyal and Mani, Ganesh, S. (2002). Gold Pricing in India: An Econometric Analysis. Journal of Economic Research, Vol. 16, No. 1, pp. 1-8. [2]. Agarwal, R. (1992). Gold Markets, in: Newman, P ., Milgate, M., and Eatwell, J. (eds.) The New Palgrave Dictionary of Money and Finance (Vol. 2), Basingstoke, Macmillan, pp. 257-258. [3]. Koutsoyiannis, A. (1983). A Short-Run Pricing Model for a Speculative Asset, Tested with Data from the Gold Bullion Market, Applied Economics, Vol. 15, pp. 563-581.

are done in the excel sheet and the graphs are plotted for the RSI (Figures 9 to 12). 10. Limitation of the Study

l

It is based on Research done by authors & organization

like WGC, GFMS, news, articles and its affect on gold and the suggestions are based on the study on Fundamental and Technical Analysis such as price movement, Relationship of gold with other factors, Volumes and Open Interest.

l

Technical Analysis is done on two methods i.e. 7 & 14

DMA and RSI. Buying and selling is done on the characteristics of these methods.

l

This analysis will be holding good for a limited time period

that is based on present scenario and study conducted, future movement on gold price may or may not be similar. Conclusion In this study, the authors have studied the importance of gold to Indians and also the factors behind the demand for gold. After doing the above analysis we came to know that the demand for gold will be high till end of 2010. We can also conclude that most of the volatility in gold is

ABOUT THE AUTHOR

Dr. Suresh Chandra Bihari is currently working as an Associate Professor in Finance Area of IBS, Hyderabad-a constituent of IFHE deemed-to-be- University as per Section 3 of UGC Act 1956. And he is a practical banker with an experience of 28 years as an Officer in a large size Public sector Bank and Winner of the Macro Research Award of 2009-10 of Indian Institute of Banking & Finance, Dr Bihari is a doctorate in Banking and is presently pursuing his post doctorate from the MBA department of Utkal University. He has written 16 books and study materials in diverse areas of Management, mainly banking and Finance and has presentation of more than 50 papers in various International/National Conferences and Seminars and has publications in International and National Journals.


101

CHAPTER N0-1

Company Profile

1. COMPANY PROFILE

1.1 NAME OF THE COMPANY

INDIA INFOLINE PVT LTD.

1.2 LOGO OF THE COMPANY

1.3 VISION OF THE COMPANY

“To be a world class financial services provider by arranging all conceivable

financial services under one roof at affordable price through cost-effective delivery

systems and achieve organic growth in business by adding newer lines of business.”

1.4 COMPANY PROFILE:

The India Infoline group, comprising the holding company, India Infoline Ltd (NSE: INDIAINFO, BSE:532636) and it’s subsidiaries, is one of the leading players in the Indian financial services space. India Infoline offers advice and execution platform for the entire gamut of financial services covering products ranging from Equities and derivatives, Commodities, Wealth management, Asset management, Insurance, Fixed deposits, Loans, Investment Banking, GoI bonds and other small savings instruments. It owns and operates the website, www.indiainfoline.com, which is one of India’s leading online destinations for personal finance, stock markets, economy and business.

India Infoline has recently been awarded the ‘Best Broker, India’ by Finance Asia. A forerunner in the field of equity research, India Infoline’s research is acknowledged by none other than Forbes as ‘Best of the Web’ and ‘…a must read for investors in Asia’. India Infoline’s research is available not just over the Internet but also on international wire services like Bloomberg, Thomson First Call and Internet Securities where it is amongst one of the most read Indian brokers. A network of 2500 business locations spread over 500 cities across India facilitates the smooth acquisition and servicing of a large customer base. Most of our offices are connected with the corporate office in Mumbai with cutting edge networking technology. The group helps service more than a

million customers, over a variety of mediums viz. online, over the phone and at our branches.

Products & Services offers:

Equity & Derivatives:

Can look for an easy and convenient way to invest in equity and take positions in the futures and options market using their research and tools. To start trading in Equity, all you need to do is open an online trading account. You can call them and they will have their representative meet you. You can get help opening the account and get guidance on how to trade in Equity.

Commodity:

You can enter the whole new world of commodity futures. Investors looking for a

fast-paced dynamic market with excellent liquidity can NOW trade in Commodity Futures Market. The Commodity Exchange is a Public Market forum and anyone can play in these vital Commodity Markets. INDIA INFOLINE (P) Ltd can certainly be your point 0f entry to the Commodity Markets. INDIA INFOLINE is a registered trading-cum-clearing member of NCDEX, MCX and DGCX

Internet Trading:

Making the right trade at the right time! E-Broking service, which brings you

experience of online buying and selling of shares with just a click.

A detail resource like live quotes, charts, research and advice helps you take proper decisions. Their robust risk management system and 128 bit encryption gives you a complete security about money, shares, and transaction documents.

IPO:

An active player in the primary market with waste customer base and reaching

distribution network spread throughout the lands

Mutual Funds:

Transact in a wide range of Mutual Funds. Mutual Funds are an attractive means of

saving taxes and diversifying your investment portfolio. So if you are looking to invest in mutual funds, IIFL offers you a host of mutual fund choices under one roof; backed by

in-depth information and research to help you invest smartly.

PMS:

Can you analyze the prices of 1,500 shares every morning? Can you afford to gamble only on the recommendations from your friends and the information overload from magazines and financial dailies? And, of course, more importantly, if you happen to be a High Net worth Individual, do you have the time to judge which advice is reliable, authentic and has the least chance of failure?

Research |

|

Sound investment decisions depend upon reliable fundamental data and stock selection techniques. Indiainfoline Equity Research is proud of its reputation for, and we want you to find the facts that you need. Equity investment professionals routinely use our research and models as integral tools in their work.

They choose Ford Equity Research when they can clear your doubts. |

SMS |

|

Stay connected to the market

The trader of today, you are constantly on the move. But how do you stay connected to the market while on the move? Simple, subscribe to India infoline's Stock Messaging Service and get Market on your Mobile!

There are three products under SMS Service: * Market on the move. * Best of the lot. * VAS (Value Added Service) |

Insurance |

|

An entry into this segment helped complete the client’s product basket; concurrently, it graduated the Company into a one-stop retail financial solutions provider. To ensure maximum reach to customers across India, we have employed a multi pronged approach and reach out to customers via our Network, Direct and Affiliate channels. Following the opening of the sector in 1999-2000, a number of private sector insurance service providers commenced operations aggressively and helped grow the market.

The Company’s entry into the insurance sector derisked the Company from a predominant dependence on broking and equity-linked revenues. The annuity based income generated from insurance intermediation result in solid core revenues across the tenure of the policy. |

Wealth Management Service |

|

Imagine a financial firm with the heart and soul of a two-person organization. A world-leading wealth management company that sits down with you to understand your needs and goals. We offer you a dedicated group for giving you the most personal attention at every level. Mortgages |

|

During the year under review, Indiainfoline acquired a 75%(2007) stake in Money tree Consultancy Services to mark its foray into the business of mortgages and other loan products distribution. The business is still in the investing phase and at the time of the acquisition was present only in the cities of Mumbai and Pune. The Company brings on board expertise in the loans business coupled with existing

relationships across a number of principals in the mortgage and personal loans businesses. Indiainfoline now has plans to roll the business out across its pan-Indian network to provide it with a truly national scale in operations. |

|

Home Loans

Get expert advice that suits your needs Loan against residential and commercial property

Expert recommendations

Easy documentation

Quick processing and disbursal

No guarantor requirement | Personal Loans

Freedom to choose from 4 flexible options to repay Expert recommendations

Easy documentation

Quick processing and disbursal

No guarantor requirement |

|

|

1.5 HIRARCHY STRUCTURE

Board of Director

General Manager

Technology

Account

Trading

DP Front

DP Back

Software

Audit

(Compliance)

Figure 2.

1.6 COMPANY INFORMATION:

Name: INDIAINFOLINE Ltd.

Board of Directors

Directors

Mr Nirmal Jain Chairman and Managing Director

Mr R Venkataraman Executive Director

Mr Sat Pal Khattar Non Executive Director

Mr Sanjiv Ahuja Independent Director

Mr Nilesh Vikamsey Independent Director

Mr Kranti Sinha Independent Director

Company Secretary

Ms Komal Parikh

Bankers

UTI Bank Ltd

Citibank N A

HDFC Bank Ltd

ICICI Bank Ltd

Auditors Internal Auditors

M/s Sharp & Tannan Associates M/s Kalyaniwalla & Mistry

Chartered Accountants Chartered Accountants

Mumbai Mumbai

Registered Office Corporate Office

Bldg No 24, Nirlon Complex, 84, Nariman Bhavan,

Nariman Point, Off Western Express Highway,

Mumbai – 400 021 Goregaon (East), Mumbai – 400 0

Website:

www.indiainfoline.com

www.5paisa.com

1.7 Milestones

1995 |

|

Incorporated as an equity research and consulting firm with a client base that included leading FIIs, banks, consulting firms and corporates. |

|

1999 |

|

Restructured the business model to embrace the internet; launched archives.indiainfoline.com mobilized capital from reputed private equity investors. |

|

2000 |

|

Commenced the distribution of personal financial products; launched online equity trading; entered life insurance distribution as a corporate agent. Acknowledged by Forbes as ‘Best of the Web’ and ‘...must read for investors’. |

|

2004 |

|

Acquired commodities broking license; launched Portfolio Management Service. |

|

2005 |

|

Listed on the Indian stock markets. |

|

2006 |

|

Acquired membership of DGCX; launched investment banking services. |

|

2007 |

|

Launched a proprietary trading platform; inducted an institutional equities team; formed a Singapore subsidiary; raised over USD 300 mn in the group; launched consumer finance business under the ‘Moneyline’ brand. |

|

2008 |

|

Launched wealth management services under the ‘IIFL Wealth’ brand; set up India Infoline Private Equity fund; received the Insurance broking license from IRDA; received the venture capital license; received inprinciple approval to sponsor a mutual fund; received ‘Best broker- India’ award from Finance Asia; ‘Most Improved Brokerage- India’ award from Asia money. |

|

2009 |

|

Received registration for a housing finance company from the National Housing Bank; received ‘Fastest growing Equity Broking House - Large firms’ in India by Dun & Bradstreet. |

|

1.8 MEMBERSHIP:

Capital Market:

National Stock Exchange of India Ltd.

Bombay Stock Exchange Ltd.

Commodities Derivatives:

National Commodity & Derivatives Exchange Ltd.

Multi Commodity Exchange of India Ltd.

DGCX

Depository Operations:

National Securities Depositories Ltd. (NSDL)

Central Depository Services (India) Ltd. (CDSL)

1.9 SERVICES OF IIFL :

Stock broking:

Cash Market

Derivatives Trading

Margin Trading

Internet Trading

Commodities Broking:

Commodities Futures

Financing Against Commodities

Depository Service:

NSDL

CDSL

IPO Subscription Services

Mutual Fund Products

Portfolio management

Insurance Services

Qualitative Research in Stock & Commodities

1.10 THE COMPLETE INVESTMENT DESTINATION:

It provides comprehensive range of investment services. That’s advantage of having all the services investor need under one roof.

Stock broking:

It offers complete range of pre-trade and post-trade services on the BSE and the NSE. Whether an investor come into its conveniently environment, or issue instruction over the phone, its highly trained team and sophisticated equipment ensure smooth transactions and prompt services.

E-Broking and Web-Based Services:

It is one of the offers online trading on site www.marwadionline.com, high bandwidth leased lines, secure services and a customs-built user interface give you an international Standards trading experience. It also gives regular trading hours, and access to information, analysis of information, and a range of monitoring tools.

Trading Terminals-Money pore Express:

It offer its sub-broker and approved/authorized user fully equipped trading terminals- Money pore Express, at the location of investors choice. It is fully functional terminal,

with a variety of helpful features like market watch, order entry, order confirmation, charts, and trading calls, all available in resizable windows. And it can be operated through the keyboard using F1 for buy, F2 for sell.

Depository Participant Services:

It offers DP services mean hassle-free, speedy settlements. It is depository

participants with NSDL and CDSL.

Premium Research Services:

Its research team offers a package of fee-based services, including daily technical

analysis, research reports, and advice on clients existing investments. It is research beyond desk and company-provider reports. If you have an equity portfolio, you know that the pace of life in the world of stocks and shares is frantic. Managing your portfolio means you have to take firm, informed decisions, and quickly!

1.11 Competitors of IIFL

* RELIGARE

* INDIABULLS

* Kotak Street (online)

* Motilal Oswal

* ICICI Direct. Com

1.12 BRANCHES

A network of over 2,500 business locations spread over more than 500 cities and towns across India facilitates the smooth acquisition and servicing of a large customer base. All our offices are connected with the corporate office in Mumbai with cutting edge networking technology. The group caters to a customer base of about a million customers, over a variety of mediums viz. online, over the phone and at our branches. |

|

There Are Following Branches All Over India In State:

Andhra Pradesh Kerala

Assam Madhya Pradesh

Bihar Maharashtra

Chattishgarh Meghalaya

Delhi Orrisa

Goa Punjab

Gujarat Rajasthan

Haryana Tamilnadu

Himachal Pradesh Tripura

Jharkhand UP

Karnataka Uttarakhand

West Bengal

CHAPTER N0-2

COMMODITY

2. ABOUT THE COMMODITY

2.1 INTRODUCTION

Keeping in view the experience of even strong and developed economies of the world, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments which allow fund managers to better manage or reduce these risks.

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

2.2 HISTORICAL PERSPECTIVE

Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oil seeds were organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab.

A three-pronged approach has been adopted to revive and revitalize the market. Firstly, on policy front many legal and administrative hurdles in the functioning of the market have been removed. Forward trading was permitted in cotton and jute goods in 1998, followed by some oilseeds and their derivatives, such as groundnut, mustard seed, sesame, cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy, issued in July, 2000 by the government that futures trading will be encouraged in

increasing number of agricultural commodities was indicative of welcome change in the government policy towards forward trading.

Secondly, strengthening of infrastructure and institutional capabilities of the regulator and the existing exchanges received priority. Thirdly, as the existing exchanges are slow to adopt reforms due to legacy or lack of resources, new promoters with resources and professional approach were being attracted with a clear mandate to set up dematerialized, technology driven exchanges with nationwide reach and adopting best international practices.

The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all

the 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's total GDP, commodities related (and dependent) industries constitute about roughly50-60 %, which itself cannot be ignored.

Most of the existing Indian commodity exchanges are single commodity platforms;

are regional in nature, run mainly by entities which trade on them resulting in substantial conflict of interests, opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. But with the strong emergence of: National Multi-commodity Exchange Ltd., Ahmadabad (NMCE), Multi Commodity Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai (NCDEX), and

National Board of Trade, Indore (NBOT), all these shortcomings will be addressed rapidly. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges.

The current mindset of the people in India is that the Commodity exchanges are

speculative (due to non delivery) and are not meant for actual users. One major reason being that the awareness is lacking amongst actual users. In India, Interest rate risks, commodity risks. Some additional impediments are centered on the safety, transparency and taxation issues.

2.3 WHY COMMODITIES MARKET?

India is among the top-5 producer of most of the commodities, in addition to being a major consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian economy. It employees around 57% of the labor force on a total of 163 million hectares of land. Agriculture sector is an important factor in achiving a GDP growth of 8-10%. All this indicates that India can be promoted as a major center for trading of commodity derivatives.( according to 2007 survey by the IIFL).

It is unfortunate that the policies of FMC during the most of 1950s to 1980s suppressed the very markets it was supposed to encourage and nurture to grow with times. It was a mistakes other emerging

economies of the world would want to avoid. however, it is not in India alone that derivatives were suspected of creating too much speculation that would be to the detriment of the healthy growth of the markets and the farmers. Such suspicions might normally arise due to a misunderstanding of the characteristics and role of derivative product.

It’s important to understand why commodity derivatives are required and the role they can play in risk management. It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibility of adverse price changes in future creates risk for businesses. Derivatives are used to

reduce or eliminate price risk arising from unforeseen price changes. A derivative is a financial contract whose price depends on or is derived from the price of another asset. two important derivatives are future and option.

(i) Commodity futures contracts : A futures contract is an agreement for buying or selling a commodity for an predetermined delivery price at a specific future time. Futures are standardized contracts that are traded on organized futures exchanges that ensure performance of the contracts and thus remove the default risk. The commodity futures have existed since the Chicago Board of Trade (CBOT, www.cbot.com) Was established in 1948 to bring farmers and merchants together. The major function of future markets is to transfer price risk from hedgers to speculators.

For example: suppose a farmer is expecting his crop of wheat to be ready in two months times, but is worried that the price of wheat may decline in this period. In order to minimize his risk, he can enter into futures contract to sell his crop in two months time at a price determined now. This way he is able to hedge his risk arising from a possible adverse change in the price of his commodity.

(ii) Commodity options contracts : Like futures, options are also financial instrument used for hedging and speculation. The commodity option holder has the right, but not the obligation to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date. Option contracts 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 option: a ‘call’ option gives the holder 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 ( called expiry date ). The option holder will exercise the option only if it is beneficial to him; otherwise he will let the option lapse.

For example : suppose a farmer buys a put option to sell 100 quintals of wheat at a price of $25 per quintal and pays a ‘premium’ of $0.5 per quintal (or a total of $50). If the price of wheat decline to say $20 before expiry, the farmer will exercise his option and sell his wheat at the agreed price of $25 per quintal. However, if the market price of wheat increases to say $30 per quintal, it would be advantageous for the farmer to sell it directly in the open market at the spot price, rather than exercise his option to sell at $25 per quintal.

Future and option 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. Further, futures trading and the ensuing discovery of price can help farmers in deciding which crops to grow. They can also help in building a competitive edge and enable businesses to smoothen their earnings because non-hedging of the risk would increase the volatility of their quarterly earnings. Thus, futures and option markets perform important function that can not 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 laws of the country.

2.4 WHY TRADE IN COMMODITIES?

1. Big market-diverse opportunities

India, a country with a population of over one billion, has an economy based on

agriculture, precious metals and base metals. Thus, trading in commodities provides lucrative market opportunities for a wider section of participants of diverse interests like investors, arbitragers, hedgers, traders, manufacturers, planters, exporters and importers.

2. Get to the sore

Commodity trading has been a breakthrough in expanding the investment from

investing in a metal company to trading in metal itself.

3. Huge potential

Commodity exchanges see a tremendous daily turnover of more than Rs.15, 000 cores. This gives a lunge potential to market participant to make profits.

4. Exploitable fundamental

The fundamental for commodity trading is simple “price is a function of demand and supply” so is hedging, by taking appropriate contract. This makes things really easy to understand and exploit.

5. Portfolio diversifier

Commodity futures derive their prices from the underlying commodity and commodity prices cannot become zero. Commodity has a global presence and their prices move with global economics and hence, it’s a good portfolio diversifier.

2.5

Demand

Supply

Stocks,

Stock

Change

&

Stocks

Ratio

Seasonal

Technical

PRICE

Factors Affecting Commodity Prices

Supply refers to the quantity of a commodity offered for sale

at different prices during a certain period of time. The supply of an item is influenced by various factors that include price, cost and techniques of production, weather conditions and government policies. A change in any one of the above mentioned factors would affect the supply. However, price is the most dominant factor. Thus the change in supply is categorized in the following two types:

Extension & Contraction: This effect results only from a change in price of a commodity. When the price of an item rises, more quantity is offered for sale. This phenomenon is called extension. Contraction in supply occurs when a fall in price reduces the quantity offered for sale.

Rise and fall: Changes due to factors other than price are called the rise and fall of supply. An increase in the cost of inputs may cause a fall in the supply. For example, a

change in the cost of fertilizers may result in reduced supply of wheat. An improvement in technology permits more unit output in the same cost. Factors such as weather conditions and wars affect production and consequently the supply of an item is affected .

There exist several factors, which can affect the supply of a commodity. All of the factors are not equally applicable in all the cases. Following are the major contributing factors, besides the unforeseen natural calamity and war, affecting the supply of a commodity:

a) Production: Production is the major factor that controls the supply of a commodity. If there is less production or no production then certainly the supply of that commodity gets disturbed. With enough production, the item becomes easily available in the every store of the market.

b) Demand: Demand for a particular commodity necessitates arrangement for more production and supply to the market. (I don't know who has invoiced for more human being forcing the production to put at the war footing!).

c) Cost: If cost is reduced, demand becomes more and thereby necessitating more supply of the commodity. Do you purchase more potato when the rate goes high? Then why to supply more?

d) Transport system: A good transport system helps increasing the supply. If there is inferior infrastructure for transportation, supply gets reduced.

e) Govt. orders and regulations: Sometimes, government imposes restrictions on some commodity in order to regulate the price or planned availability on the market. Supply of the commodity gets regulated accordingly. (Govt. does it frequently to regularize any scam, etc.).

f) Un-ethical business practices : Dishonest businesspersons are also affecting greatly in controlling the supply chain of any commodity.

2.6 Comparison between commodity and financial derivatives

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 (CME), 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 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 account.

Warehousing:

One of the main differences between financial and commodity derivative 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. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person who sold this futures contract at Rs.100 does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash.

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. The advantage of this system is that a warehouse receipt becomes good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.

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

What makes commodity trading attractive?

* A good low-risk portfolio diversifier

* A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate.

* Less volatile, compared with, equities and bonds.

* Investors can leverage their investments and multiply potential earnings.

* Better risk-adjusted returns.

* A good hedge against any downturn in equities or bonds as there is little correlation with equity and bond markets.

* High co-relation with changes in inflation.

* No securities transaction tax levied.

Investors' choice:

The futures market in commodities offers both cash and delivery-based settlement. Investors can choose between the two. If the buyer chooses to take delivery of the commodity, a transferable receipt from the warehouse where goods are stored is issued in favour of the buyer. On producing this receipt, the buyer can claim the commodity from the warehouse. All open contracts not intended for delivery are cash-settled. While speculators and arbitrageurs generally prefer cash settlement, commodity stockists and wholesalers go for delivery. The option to square off the deal or to take delivery can be changed before the last day of contract expiry. In the case of delivery-based trades, the margin rises to 0-25% of the contract value and the seller is required to pay sales tax on the transaction.

Trading in any contract month will open on the twenty first day of the month, three months prior to the contract month. For example, the December 2004 contracts open on 21 September 2004 and the due date is the 20-day of the delivery month. All contracts settling in cash will be settled on the following day after the contract expiry date. Commodity trading follows a T+1 settlement system, where the settlement date is the next working day after expiry. However, in case of delivery-based traders, settlement takes place five to seven days after the expiry.

Returns from Commodity trading:

Absolute returns from stocks and bonds are definitely higher than pure commodities. But commodity trading carries a lower downside risk than other asset classes, as pricing in commodity future is less volatile compared to equities and bonds. While the average annual volatility is 25-30% in benchmark equity indices like the BSE Sensex or NSE's Nifty, it is 12-18% in gold, 15-25% in silver, 10-12% in cotton and 5-10% in government securities.

According to study, if an investor had put his money only in silver and bonds from 1997-2003, his absolute returns would above been 24%. Commodities are also good bets to hedge against inflation. Gold offers good protection against exchange rate fluctuations, and, in particular, against fluctuations in the value of the US dollar against other leading currencies. However, unlike stocks, commodity prices are dependent on their demand-supply position, global weather patterns, government policies related to subsidies and taxation and international trading norms as guided by the World Trade Organisation (WTO).

Growth of commodity trading:

A soft interest rate regime and a weak US dollar increased the demand for the commodities. In a short span of over a year, online commodity markets are witnessing good growth in India. The daily volume of trading of Rs.2500 crore at NCDEX alone has surpassed that of Rs.2000 crore on the Bombay Stock Exchange (BSE). It registered a record daily traded volume of Rs.2617 crore on 8 December 2004. Commodities like chana, urad, soya bean oil, sugar, pepper, mustard seeds and wheat contributed to the balance trading volume. MCX, on the other hand, has achieved a peak daily turnover of Rs.1889 crore. Though the most popular commodities for trading in India are gold, silver, soya bean and guar gum, the market is divided equally between bullion and agricultural commodities in terms of trading volumes.

Expecting the turnover on the three online commodity exchanges to spurt to Rs.10000 crore per day, banks are keen to tap the commodity trade-financing front. Commercial banks are chasing the commodity industry with attractive lending rates between 8% and 8.5% as against the normal lending rate between 11% and 14%.

[pic]

NCFM

NSE's CERTIFICATION IN FINANCIAL MARKETS

Commodities Market Module Work Book

NATIONAL STOCK EXCHANGE OF INDIA LIMITED

Contents

1 Introduction to derivatives 11

1. Derivatives defined 11

2. Products, participants and functions 12

3. Derivatives markets 13

1. Spot versus forward transaction 14

2. Exchange traded versus OTC derivatives 14

3. Some commonly used derivatives 16

2 Commodity derivatives 19

2.1 Difference between commodity and financial derivatives 19

1. Physical settlement 19

2. Warehousing 21

3. Quality of underlying assets 22

2.2 Global commodities derivatives exchanges 22

1. Africa 24

2. Asia 24

3. Latin America 24

2.3 Evolution of the commodity market in India 24

1. The Kabra committee report 25

2. Latest developments 27

3 The NCDEX platform 31

3.1 Structure of NCDEX 31

3.1:1 Promoters 32

3.1.2 Governance 32

3.2 Exchange membership 32

1. Trading cum clearing members (TCMs) 32

2. Professional clearing members (PCMs) 33

3. Capital requirements 33

4. The NCDEX system 34

1. Trading 34

2. Clearing 35

3. Settlement 35

4. CONTENTS 4

4 Commodities traded on the NCDEX platform 37

4.1 Agricultural commodities 37

1. Cotton 38

2. Crude palm oil 40

3. RBD Palmolein 42

4. Soy oil 43

5. Rapeseedoil 45

6. Soybean 46

7. Rapeseed 47

4.2 Precious metals 49

1. Gold 50

2. Silver 54

5 Instruments available for trading 59

5.1 Forward contracts 59

5.1.1 Limitations of forward markets 60

5.2 Introduction to futures 60

1. Distinction between future and forwards contracts 61

2. Futures terminology 62

5.3 Introduction to options 62

5.3.1 Option terminology 63

5.4 Basic payoffs 64

1. Payoff for buyer of asset: Long asset 65

2. Payoff for seller of asset: Short asset 65

5.5 Payoff for futures 65

1. Payoff for buyer of futures: Long futures 65

2. Payoff for seller of futures: Short futures 67

5.6 Payoff for options 68

1. Payoff for buyer of call options: Long call 68

2. Payoff for writer of call options: Shortcall 69

3. Payoff for buyer of put options: Longput 69

4. Payoff for writer of put options: Shortput 70

5.7 Using futures versus us mg options 71

6 Pricing commodity futures 77

1. Investment assets versus consumption assets 77

2. The cost of carry model 78

1. Pricing futures contracts on investment commodities 80

2. Pricing .futures contracts on consumption commodities 82

6.3 The futures basis 83

CONTENTS 5

7 Using commodity futures 87

7.1 Hedging 87

1. Basic principles of hedging 87

2. Short hedge 88

3. Long hedge 89

4. Hedge ratio 91

5. Advantages of hedging 92

6. Limitation of hedging: basis Risk 93

7.2 Speculation 94

1. Speculation: Bullish commodity, buy futures 94

2. Speculation: Bearish commodity, sell futures 95

7.3 Arbitrage 95

1. Overpriced commodity futures: buy spot, sell futures 96

2. Underpriced commodity futures: buy futures, sell spot 97

8 Trading 101

1. Futures trading system 101

2. Entities in the trading system 101

8.2.1 Guidelines for allotment of client code 102

3. Contract specifications for commodity futures 103

4. Commodity futures trading cycle 103

5. Order types and trading parameters 104

1. Permitted lot size 108

2. Tick size for contracts 108

3. Quantity freeze 109

4. Base price 109

5. Price ranges of contracts 109

6. Order entry on the trading system 110

6. Margins for trading in futures 112

7. Charges 113

9 Clearing and settlement 117

9.1 Clearing 117

9.1.1. Clearing mechanism 118

2. Clearing banks 118

3. Depository participants 119

9.2 Settlement 119

1. Settlement mechanism 119

2. Settlement methods 122

3. Entities involved in physical settlement 124

3. Risk management 125

4. Margining at NCDEX 126

9.4.1 SPAN 126

6 CONTENTS

2. Initial margin 126

3. Computation of initial margin 126

4. Implementation aspects of margining and risk management 128

5. Effect of violation 130

10 Regulatory framework 135

1. Rules governing commodity derivatives exchanges 135

2. Rules governing intermediaries 136

1. Trading 136

2. Clearing 140

10.3 Rules governing investor grievances, arbitration 144

1. Procedure for arbitration 145

2. Hearings and arbitral award 146

11 Implications of sales tax 149

List of Tables

The global derivatives industry 23

Volume on existing exchanges 27

Registered commodity exchanges in India 28

1. Fee / deposit structure and networth requirement: TCM 33

2. Fee / deposit structure and networth requirement: PCM 33

4.1 Country-wise share in gold production; 1968 and 1999 51

1. Distinction between futures and forwards 61

2. Distinction between futures and options 72

6.1 NCDEX - indicative ware house charges 82

1. Refined soy oil futures contract specification 89

2. Silver futures contract specification 90

3. 8 List of Tables

7.3 Gold futures contract specification 93

1. Commodity futures contract and their symbols 103

2. Gold futures contract specification 104

3. Long staple cotton futures contract specification 105

4. Commodity futures: Quantity freeze unit 109

5. Commodity futures: Lot size another parameters 111

1. MTM on along position in cotton futures 120

2. MTM on a short position in cotton futures 121

3. Calculating outstanding position at TCM level 127

4. Minimum margin percentage on commodity futures contracts 127

5. Exposure limit as a multiple of liquid net worth 130

6. Number of days for physical settlement on various commodities 131

7. List of Figures

1. Payoff for a buyer of gold 66

2. Payoff for a seller of gold 66

3. Payoff for a buyer of gold futures 67

4. Payoff for a seller of cotton futures 68

5. Payoff for buyer of call option on gold 69

6. Payoff for writer of call option on gold 70

7. Payoff for buyer of put option on long staple cotton 71

8. Payoff for writer of put option on long staple cotton 72

6.1 Variation of basis overtime 84

1. Payoff for buyer of a short hedge 88

2. Payoff for buyer of a long hedge 90

8.1 Contract cycle 106

| |Distribution of weights | |

|Chapter No. |Title |Weights |

| | |(%) |

|1 |Introduction to derivatives |6 |

|2 |Commodity Derivatives |7 |

|3 |The NCDEX Platform |5 |

|4 |Commodities traded on the NCDEX platform |3 |

|5 |Instruments available for trading |15 |

|6 |Pricing commodity futures |16 |

|7 |Using commodity futures |14 |

|8 |Trading |16 |

|9 |Clearing and settlement |17 |

|10 |Regulatory framework | 8 |

|11 |Implications of sales tax | 3 |

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Chapter 1

Introduction to derivatives

The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board of Trade, or 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. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence.

Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlyings like stocks, interest rate, exchange rate, etc.

1.1 Derivatives defined

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

12 Introduction to derivatives

or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying" in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. However when derivatives trading in securities was introduced in 2001, the term "security" in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 (SC(R)A) 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 its value from the prices, or index of prices, of underlying securities.

1.2 Products, participants and functions

Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories - hedgers, speculators, and arbitragers.

1. Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

2. 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 the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.

Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions.

Prices in an organised 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.

1.3 Derivatives markets 13

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs

associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use.

Box 1.1: Emergence of financial derivative products

* 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.

* 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 organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

* 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 their volume of activity.

1.3 Derivatives markets

Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or

precious metals like gold, silver, etc. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as


the underlying. The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later.

1.3.1 Spot versus forward transaction

Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. 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. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money and goods.

In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. "on the spot". Consider this example. On 1st January 2004, Aditya wants to buy some gold. The goldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 grams of gold. He pays Rs. 12,000, takes the gold and leaves. This is a spot transaction.

Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it a month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the "forward" price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith Rs. 12,030 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settie 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, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period.

A forward is the most basic derivative contract. We call it a derivative because it derives value from the price of the asset underlying the contract, in this case gold. If on the 1st of February, gold trades for Rs.6,050 in the spot market, the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs.6,015. If however, the price of gold drops down to Rs.5,990, he is worse off because as

per the terms of the contract, he is bound to pay Rs.6,015 for the same gold. The contract has now lost value from Aditya's point of view. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya.

1.3.2 Exchange traded versus OTC derivatives

Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. These contracts were typically OTC kind of contracts. Over the counter(OTC) derivatives are privately negotiated contracts. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Later


Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However "credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US, these contracts were called "futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organised futures exchanges, indeed the two largest "financial" exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

Box 1.2: History of commodity derivatives markets

many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange.

The OTC derivatives markets have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralised and located within individual institutions.

2. There are no formal centralised limits on individual positions, leverage, or margining.

3. There are no formal rules for risk and burden-sharing.

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter.

The largest OTC derivative market is the interbank foreign exchange market. Commodity derivatives the world over are typically exchange-traded and not OTC in nature.


1.3.3 Some commonly used derivatives

Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage.

Forwards: As we discussed, 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 standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give 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 date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on 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 portfolios of forward contracts. The two commonly used swaps are :

* 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 cashflows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.

Solved Problems

Q: Futures trading commenced first on

1. Chicago Board of Trade 3. Chicago Board Options Exchange

4. London International Financial Futures and

2. Chicago Mercantile Exchange Options Exchange

A: The correct answer is number 1. • •


Q: Derivatives first emerged as products

1. Speculative 3. Volatility

2. Hedging 4. Risky


Q: Which of the following exchanges offer commodity derivatives trading

1. National Commodity Derivatives Exchange 3. Over The Counter Exchange of India

2. Interconnected Stock Exchange 4. ICICI Securities Limited


Q: OTC derivatives are considered risky because

1. There is no formal margining system. 3. They are not settled on a clearing house.

2. They do not follow any formal rules or mechanisms. 4. All of the habove


Q: The first exchange traded financial derivative in India commenced with the trading of

1. Index futures 3. Stock options

2. Index options4. Interest rate futures


Q: A is the simplest derivative contract

1. Option 3. Forward

2. Future 4. Swap


Q: In a transaction, trading involves

1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net

out-standing.

2. The buyer and seller exchanging goods and

money. 4. None of the above.



Q: In a transaction, clearing involves

1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out-

standing.




Q: In a transaction, settlement involves

1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out-

standing.




Chapter 2

Commodity derivatives

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. In this chapter we look at how commodity derivatives differ from financial derivatives. We also have a brief look at the global commodity markets and the commodity markets that exist in India.

2.1 Difference between commodity and financial 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 underlyings 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. We have a brief look at these issues.

2.1.1 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 go to the designated warehouse and pick up the commodity. This may sound simple, but the physical

20 Commodity derivatives

settlement of commodities is a complex process. The issues faced in physical settlement are enormous. 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 process of taking physical delivery in financial assets. We take a general overview at the process flow of

physical settlement of commodities. Later on we will look into details of how physical settlement happens on the NCDEX.

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'. Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options market. However what is interesting and different from a typical options exercise is that in the commodities market, both positions can still be closed out before expiry of the contract. The intention of this 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.

In the case of BMF-Brazil a seller typically has to submit the following documents:

• A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods.

• A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.

• A warehouse certificate showing that storage and regular insurance have been paid.

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.

2.1 Difference between commodity and financial derivatives 21

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 (CME), 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.

2.1.2 Warehousing

One of the main differences between financial and commodity derivative 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. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash.

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


The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94".

The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y- is of random lengths from 8 feet to 20 feet, grade-stamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir".

Box 2.3: Specifications of some commodities underlying derivatives contracts

and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but also for

other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.

2.1.3 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.

2.2 Global commodities derivatives exchanges

Globally commodities derivatives exchanges have existed for a long time. Table 2.1 gives a list of commodities exchanges across the world. The CBOT and CME are two of the oldest derivatives

|Table 2.1 The global derivatives industry |

|Country |Exchange |

|United States of America |Chicago Board of Trade (CBOT) |

| |Chicago Mercantile Exchange |

| |Minneapolis Grain Exchange |

| |Valencia |

|United Kingdom |The London International Financial Futures |

| |Options exchange |

| |The London Metal Exchange |

2.2 Global Commodities derivatives exchanges 23

exchanges in the world. The CBOT was established in 1848 to bring farmers and merchants together. Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a few years the first futures-type contract was developed. It was know as the to-arrive contract. Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges exist all over the world. On these exchanges, a wide range of commodities and financial assets form the underlying assets in


various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminium, gold and tin. We look at commodity exchanges in some developing countries.

2.2.1 Africa

Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial futures and gold futures for a long time, but the creation of the Agricultural Markets Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities, in which trade was liberalised, namely, white and yellow maize, bread milling wheat and sunflower seeds.

2.2.2 Asia

China's first commodity exchange was established in 1990 and at least forty had appeared by 1993. The main commodities traded were agricultural staples such as wheat, corn and in particularly soybeans. In late 1994, more than half of China's exchanges were closed down or reverted to being wholesale markets, while only 15 restructured exchanges received formal government approval. At the beginning of 1999, the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai Metal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launched in 1998. Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one futures and options exchange. Singapore is home to the Singapore Exchange (SGX), which was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).

2.2.3 Latin America

Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures, (BM&F) in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange by 2001, with 98 million contracts traded. There are also many other commodity exchanges operating in Brazil, spread throughout the country. Argentina's futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as the world's 51st largest exchange. Mexico has only recently introduced a futures exchange to its markets. The Mercado Mexicano de Derivados (Mexder) was launched in 1998.

2.3 Evolution of the commodity market in India

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organised futures market. Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent


amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion began

in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution. In due course, several other exchanges were created in the country to trade in diverse commodities.

2.3.1 The Kabra committee report

After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the following objectives:

1. To assess

a) The working of the commodity exchanges and their trading practices in India and to make suitable recommendations with a view to making them compatible with those of other countries

b) The role of the Forward Markets Commission and to make suitable recommendations with a view to making it compatible with similar regulatory agencies in other countries so as to see how effectively these agencies can cope up with the reality of the fast changing economic scenario.

2. To review the role that forward trading has played in the Indian commodity markets during the last 10 years.

3. To examine the extent to which forward trading has special role to play in promoting exports.

4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the recommendations, particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act.

5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be operative remains constructive and helps in maintaining prices within reasonable limits.

6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible, particularly in commodities in which resumption of forward trading is generally demanded.

7. 26 Commodity derivatives

The committee submitted its report in September 1994. The recommendations of the committee were as follows:

* The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would need to be strengthened.

* Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing.

* In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further.

* The FMC which regulates forward/ futures trading in the country, should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges. Amendments to the rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC only.

* In the context of globalisation, commodity markets in India could not function effectively in an isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and castor seed, be upgraded to the level of international futures markets.

* The majority of me committee recommended that futures trading be introduced in the following commodities:

1. Basmatirice

2. Cotton and kapas

3. Raw jute and jute goods

1. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them.

4. Rice bran oil

5. Castor oil and its oilcake

6. Linseed

7. Silver

8. Onions

The liberalised policy being followed by the government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management.

The national agriculture policy announced in July 2000 and the announcements in the budget speech for 2002-2003 were indicative of the governments resolve to put in place a mechanism of futures trade/market. As a follow up, the government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited.

|Table 2.2 Volume on existing exchanges |

|Commodity exchange |Products |Approx. annual vol (Rs.Crore) |

|National board of trade, Indore |Soya, mustard |80000 |

| National multicommodity exchange, Ahmedabad |Multiple |40000 |

|Ahmedabad commodity exchange |Castor, cotton |3500 |

|Rajdhani Oil & oilseeds |Mustard |3500 |

| Vijai Beopar Chamber Ltd. Muzzaffarnagar |Gur |2500 |

|Rajkot seeds, oil & bullion exchange |Castor, groundnut |2500 |

|IPSTA, Cochin |Pepper |2500 |

|Chamber of commerce, Hapur |Gur, mustard |2500 |

|Bhatinda Om and oil exchange |Gur |1500 |

|Other (mostly inactive) | |1500 |

|Total | |140000 |


2.3.2 Latest developments

Commodity markets have existed in India for a long time. Table 2.3 gives the list of registered commodities exchanges in India. Table 2.2 gives the total annualised volumes on various exchanges. While the implementation of the Kabra committee recommendations were rather slow, today, the commodity derivative market in India seems poised for a transformation. National level commodity derivatives exchanges seem to be the new phenomenon. The Forward Markets Commission accorded in principle approval for the following national level multi commodity exchanges. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game.

* National Board of Trade

* Multi Commodity Exchange of India

* National Commodity & Derivatives Exchange of India Ltd

*

|28 |Commodity derivatives |

| |

|Table 2.3 Registered commodity exchanges in India |


Solved Problems

Q: Which of the following feature differentiates a commodity futures contract from a financial futures contract?

1. Exchange traded product 3. MTM settlement

2. Standardised contract size 4. Varying quality of underlying asset


Q: Physical settlement involves the physical delivery of the underlying commodity at

1. an accredited warehouse 3. the buyers requested destination

2. the exchange 4. None of the above

A: The correct answer is number 1 • •

Q: Typically, in all commodity exchanges, delivery notice is required to be supported by a

1. Letter of credit 3. Undertaking

2. Warehouse receipt 4. Advance payment


Q: Who identifies the buyer to whom the delivery notice is assigned?

1. The exchange 3. The warehouse

2. The clearing corporation 4. The seller


Q: Which of the following exchanges do not offer commodity derivatives trading?

1. National Commodity Derivative Exchange 3. National Board of Trade

2. Multi Commodity Exchange of India 4. National Stock Exchange

A: The correct answer is number 4. ••


Q: On the NCDEX

1. The clearing house assigns delivery to the 3. The buyer chooses which delivery to take

buyer

4. The warehouse assigns the delivery to the

2. The seller assigns delivery to the buyer buyer


Q: The committee recommended that the Forward Markets Commission(FMC) and the Forward

Contracts (Regulation) Act, 1952, need to be strengthened.

1. L C Gupta Committee 3. Khusro Committee

2. Kabra Committee 4. J R Varma Committee


Chapter 3

The NCDEX platform

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.

NCDEX is regulated by Forward Markets Commission 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 about 91 cities throughout India at the moment.

NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, refined soy bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude palm oil and cotton - medium and long staple varieties. At subsequent phases trading in more commodities would be facilitated.

3.1 Structure of NCDEX

NCDEX has been formed with the following objectives:

* To create a world class commodity exchange platform for the market participants.

* To bring professionalism and transparency into commodity trading.

* To inculcate best international practices like de-modularization, technology platforms, low cost solutions and information dissemination without noise etc. into the trade.

* To provide nation wide reach and consistent offering.

* To bring together the entities that the market can trust.

* 32 The NCDEX platform

3.1.1 Promoters

NCDEX is promoted by a consortium of institutions. 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). 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.

3.1.2 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.

3.2 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 (TCM) and Professional Clearing Members (PCM).

3.2.1 Trading cum clearing members (TCMs)

NCDEX invites applications for Trading cum Clearing Members (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 pay the required fees/ deposits and also maintain net worth as given in Table 3.1.

|3.3 Capital requirements | |33 |

| |

|Table 3.1 Fee/ deposit structure and networth requirement: TCM |

|Particulars (Rupees |in Lakh) | |

|Interest free cash security deposit Collateral security deposit Annual |15.00 | |

|subscription charges Advance minimum transaction charges Net worth requirement |15.00 | |

| |0.50 | |

| |0.50 | |

| |50.00 | |

| | | |

| |

|Table 3.2 Fee/ deposit structure and networth requirement: PCM |

|Particulars (Rupees |in Lakh) | |

|Interest free cash security deposit Collateral security deposit Annual |25.00 | |

|subscription charges Advance minimum transaction charges Net worth requirement |25.00 | |

| |1.00 | |

| |1.00 | |

| |5000.00 | |

| | | |

3.2.2 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 pay the following fee/ deposits and also maintain net worth as given in Table 3.2.

3.3 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.

34 The NCDEX platform

* 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 shortage is less than Rs.5 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.

3.4 The NCDEX system

As we saw in the first chapter, every market transaction consists of three components - trading, clearing and settlement. This section provides a brief overview of how transactions happen on the NCDEX's market.

3.4.1 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. All quantity fields are in units and price in rupees. 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

3.4 The NCDEX system 35

queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.

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. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February. 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.

3.4.2 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) only 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.

3.4.3 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

36 The NCDEX platform

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.

Solved Problems

Q: Which of the following futures do not trade on the NCDEX?

1. Cotton futures 3. Silver futures

2. Gold futures 4. Energy futures


Q: NCDEX is regulated by

1. The Forward Markets Commission 3. Reserve Bank of India

2. SEBI 4. Controller of Capital Issues


Q: The net worth requirement for a TCM is

1. Rs.5Lakh 3. Rs.500Lakh

2. Rs.50Lakh 4. Rs.5000Lakh


Chapter 4

Commodities traded on the NCDEX platform

In December 2003, the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures trading in nine major commodities. To begin with contracts in gold, silver, cotton, soyabean, soya oil, rape/ mustard seed, rapeseed oil, crude palm oil and RBD palmolein are being offered.

We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. The commodity markets can be classified as markets trading the following types of commodities.

1. Agricultural products

2. Precious metal

3. Other metals

4. Energy

Of these, the NCDEX has commenced trading in futures on agricultural products and precious metals. For derivatives with a commodity as the underlying, the exchange must specify the exact nature of the agreement between two parties who trade in the contract. In particular, it must specify the underlying asset, the contract size stating exactly how much of the asset will be delivered under one contract, where and when the delivery will be made. In this chapter we look at the various underlying assets for the futures contracts traded on the NCDEX. Trading, clearing and settlement details will be discussed later.

4.1 Agricultural commodities

The NCDEX offers futures trading in the following agricultural commodities - Refined soy oil, mustard seed, expeller mustard oil, RBD palmolein, crude palm oil, medium staple cotton and long staple cotton. Of these we study cotton in detail and have a quick look at the others.

38 Commodities traded on the NCDEX platform

4.1.1 Cotton

Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17 million bales (average annual consumption, 1 bale = 170 kg) of raw cotton trade in the country. The market size of raw cotton in India is over Rs.130 billion. The average monthly fluctuation in prices of cotton traded across India has been at around 4.5% during the last three years. The maximum fluctuation has been as

high as 11%. Historically, cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis.

Cotton is among the most important non-food crops. It occupies a significant position, both from agricultural and manufacturing sectors' points of view. It is the major source of a basic human need - clothing, apart from other fibre sources like jute, silk and synthetic. Today, cotton occupies a significant position in the Indian economy on all fronts as a commodity that forms a means of livelihood to over millions of cotton cultivating farmers at the primary agricultural sector. It is also a source of direct employment to over 35 million people in the secondary manufacturing textile industry that contributes to 14% of the country's industrial production, 27-30% of the country's export earnings and 4% of its GDP.

Cropping and Growth pattern

Cotton is a tropical and sub-tropical crop. For the successful germination of its seeds, a minimum temperature of 150°C is required. The optimum temperature range for vegetative growth is 21- 270°C- It can tolerate temperatures as high as 430°C , but does not do well if the temperature falls bellow 210°C. During the period of fruiting, warm days and cool nights, with large diurnal variations are conducive to good boll and fibre development. In the case of the rain-fed cotton, which predominates and occupies nearly 75% of the area under this crop, a rainfall of 50 cm is the minimum requirement. More than the actual rainfall, a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton. Cotton is grown on a variety of soils. It requires a soil amenable to good drainage, as it does not tolerate water logging. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils. The predominant types of soils on which the crop is grown are (l)Alluvial soils predominant in the northern states of Punjab, Haryana, Rajasthan and Uttar Pradesh, (2)The black cotton soils, (3)The red sandy loams to loams - predominant in the states of Gujarat, Maharashtra, Madhya Pradesh, Andhra Pradesh, Karnataka and Tamil Nadu, and (4)Lateritic soils - found in parts of Tamil Nadu, Assam and Kerala.

Cotton is a 90-120 day annual crop. In the main producing countries of USA, China, India and Pakistan, the crop is sown during the June-July period and harvested during September-October. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. Kappas are bought by ginners, who separate the seeds from the lint (cotton fibre), a process called ginning (lint recovery from kappas is 30-31%). The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in India; in USA, it is 480 pounds). Spinned cotton yarn is used by clothe manufacturers/ textile industry.


Global and domestic demand-supply dynamics

China, USA, India and Pakistan top the list of cotton producing countries. Uzbekistan, Brazil, Turkey and Australia are the other major producers. These eight countries produced over 80% of the world's cotton production during 2001-02.

China, India, USA and Pakistan top the list of cotton consuming countries. These along with Turkey, Brazil, Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% of the world's annual cotton consumption. Global production of cotton during the post 1990 (till date i.e. 2002-03 forecast) has been fluctuating in the narrow range of 16.5-21 million tons. Similarly, consumption has been in the range in the 18-20.5 million tons. The global export and import trade of cotton during the post 1990 era has been in the range of 5.5 to 6.5 million tons.

Production of cotton in India during the post 1990 period has been fluctuating in the range of 12-17 million bales (i.e. between 2.2-2.8 million tons), constituting about 15% of the global cotton production. Currently, the country's cotton consumption stands at 17-19 million bales (2.7-2.9 million tons). India's position on the global trade front has witnessed a drastic change during the post 1995 period. The country has turned from being net exporter to net importer. The country's raw cotton exports, which stood at 1.2-1.6 million bales during the pre-1996 period have dipped to less than 100 thousand bales. Contrary to this, the imports have sharply risen from 30000-50000 bales during the pre-1995 to little over 2.2 million bales during the last three years. Among several other reasons, it is the lack of availability of desired quality cotton that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supply. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash, uniform lots, higher ginning out-turn) and better credit terms (3-6 months vs. 15-30 days for local). Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from Egypt, West Africa, and the CIS countries and Australia on account of lower freight and shorter delivery periods.

Price trends and factors that influence prices

Cotton production and trade is influenced by various factors. Production (acreage under the crop) of cotton varies from year to year based on the climatic factors that are crucial for the productivity of crop. Cotton trade is influenced by the supply-demand scenario, production and prices of synthetic fibre (polyester, viscose and acrylic) and prices of cotton itself, etc.

The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are closely watched by the trading community.

The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season. The CCI is responsible for establishing the price support in all States. Typically, market prices remain well above the MSP, and CCI operations are generally limited to commercial purchases and sales (except for a few years like 2001-02 when the prices were abysmally low).


Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for cotton traded in the international market. World cotton prices fell sharply during most part of 2001, NyBOT witnessing a sharp downfall in prices from 61.78 US Cents/ lb (as on Jan 2, 2001) to the low of 28.20 US Cents/ lb (as on Oct 26, 2001), a sharp fall by 54.35%. Towards mid-2002, prices recovered to 53 cents, and toward end of 2003 were currently ruling at 58.85 cents.

Cotton prices in India are therefore influenced by various demand-supply factors operating within the country, international raw cotton prices, demand for finished readymade garments from abroad, prices of synthetic fibre, etc. Jute, silk, wool and khadi - the other fibre sources, are less likely to have any major impact on cotton prices in India.

4.1.2 Crude palm oil

Annual edible oil trade in India is worth over Rs.440 billion, with the share of CPO being nearly 20% (Rs.80-90 billion). The country is over-dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports. There is a close inter linkage between the various vegetable oils produced, traded and consumed across the world. The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9.7% during the past two and a half years, the maximum monthly fluctuation being as high as 25% during the period.

Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. One hectare of oil palm yields approximately 20 FFBs, which when crushed yields 6 tons of oil (including the kernel oil, which is used both for edible and industrial purposes). Crude palm oil (CPO), crude palmolein, RBD (refined, bleached, deodorized) palm oil, RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market.

Cropping and growth patterns

Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm cultivation. Oil palm thrives well at temperatures of 22 - 33°C with at least 5 hours sunshine per day throughout the year. Oil palm can be grown on a wide range of soil. In general, the soil should be deep, well structured and well drained. However, in areas where rainfall is marginally suitable, the water-holding capacity of the soil is of greatest importance. Flat or gentle undulating land is preferred. Oil palm is sensitive to pH above 7.5 and stagnant water.


CPO is used for human consumption as well as for industrial purposes. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7.37% compounded annually during the last 12 years period. While in the importing countries like China and European Union, the consumption of palm oil is growing at the rate of 5.2% and 4.8% respectively, the consumption growth rate for the worlds leading palm oil importer


(in specific, and edible oils in general), India, stands at 25%. India, China, Pakistan and the European Union are the major importers of palm oil. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. The total imports of India, China, Pakistan and European Union amount to approximately 56% of the total global exports of palm oil annually.

Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). Palm oil dominates the global vegetable oil export trade. The two producing countries viz. Malaysia and Indonesia dominate the global trade in CPO. Their share in the global exports of CPO is to the tune of 90%. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. (MDEX) could be considered as the price maker of palm oil traded world over. This exchange trades only CPO among several derivatives of palm. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country.

Rising consumption of palm oil in India, which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports. Palm oil supports many other industries in India like refining, vanaspati and other industrial sectors apart from human consumption as RBD palmolein. The major importing and trading centres for palm in India are Chennai, Kakinada, Mumbai and Kandla. The other centers like Mundra, Kolkata, Mangalore and Karwar also play

important role, but next to the four major trading centers. Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government, mainly the export-import policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. The entire industry of CPO in India is dominated by importers, large refiners, corporate involved in wholesale and retail trade through value-addition and retail-regional level players along with a few national level players. The industry is dominated by over 200 importing companies, who are mostly refiners too. Domestic oilseed and edible oil industry is organised in the form of oilseed crushers, processors, solvent extractors, technologists, commodity-specific producers and traders.


There exists a clear trough and crest in the seasonality of CPO production, indicating a typical seasonality in the production cycle. The production bottoms down in the months of February, March and April, while the it is at its peak during the months of August, September and October. Palm oil trade is influenced by various production, market and policy related factors. Being a perennial plantation crop, acreage under palm plantation does not vary from season to season. Production is almost evenly distributed throughout the year between 0.8-1.1 million tons in a monthly. However, it exhibits seasonal highs and lows once in a year. Yield levels of the plantations are influenced by climatic conditions like rainfall, temperature, etc. Factors that influence price are market related factors viz. supply-demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. canola/ rapeseed, coconut oil, sunflower, groundnut, etc.; supply-demand status of various consuming/importing countries;


over-all status of the edible oil industry during the immediate past; current and a short-term forecast of the future status of the industry in various producing and consuming countries. Production and trade related policies of various exporting and importing nations of palm oil at the international scene have a major bearing on the prices of palm oil.

Trade policies in India

Since oilseed is one among the major crops cultivated by millions of farmers spread across the country, and is the major source of cooking oil to over one billion consuming populace of the country, like any other welfare state, Government of India (Gol) adopts a protection policy with regard to production and trade in vegetable oils, so as to protect the interests of both the producers and consumers. While the strategy of farm subsidies and minimum support price (MSP) are on the production side, the duty structure on various forms of palm oil is the major trade-related protectionist measure.

4.1.3 RBD Palmolein

The RBD (refined, bleached and deodorized) palmolein is the derivative of crude palm oil (CPO), which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations. When CPO is subjected to refinement, RBD palm oil and fatty acids are obtained. Fractionation of RBD palm oil yields RBD palmolein along with stearin, which is a white solid at room temperature. While Oil is a stable derivative saturated fat, solid at room temperature), Olein is relatively unstable (unsaturated fat, liquid at room temperature, but low cholesterol).

The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. Cropping of growth patterns of CPO has been already covered.


The European Union, Pakistan and Middle-East countries are the major importers of RBD palmolein. Malaysia and Indonesia, which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil, export largely as CPO as is demanded by the importing nations who refine domestically and consume. RBD palmolein exports from Malaysia have increased from 3.2 million tons in 1998 to 4.5 million tons in 2002.

India, which is one of the largest importer and consumer of edible oils in the world, imports nearly 3 million tons of palm oil annually (mainly from Malaysia, followed by Indonesia). This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period. At the same time, there has been a drastic change in the composition of various forms of palm oil imported owing to the differential duty structure adopted by Indian government for crude and refined palm oil imports. The import is mainly through the ports of Kandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and Chennai.

The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Its production grew from 5000 tons in 1991 to 35,000 tons in 2002,


while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million tons during 2001-02, growing at the rate of 25% compounded annually during the past decade. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers.


Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government mainly the export-import policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Unlike the price of CPO imported into the country, which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India, RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time.

4.1.4 Soy oil

Soy oil is among the major sources of edible oils in India. Of the annual edible oil trade worth over Rs.440 billion in the country, soy oils share is over 20-21% at Rs.90-92 billion in terms of value. Being an agricultural commodity, which is often subjected to various production and market-related uncertainties, soy oil prices traded across the world are highly volatile in nature. The average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6.6% during the past two and a half years, the maximum monthly fluctuation being as high as 17% during the period. Historically, soy oil prices in the major spot markets across the country have been fluctuating in the range of 4.5-8.5%. This offers immense opportunity for the investors to profitably deploy their funds in this sector apart from those actually associated with the value chain of the commodity, which could use soy oil futures contract as the most effective hedging tool to minimise price risk in the market.

Soy oil is the derivative of soybean. On crushing mature beans, 18% oil and 78-80% meal is obtained. While the oil is mainly used for human consumption, meal serves as the main source of protein in animal feeds. Soy oil is the leading vegetable oil traded in the international markets, next only to palm. Palm

and soy oils together constitute around 68% of global edible oil export trade volume, with soy oil constituting 22.85%. It accounts for nearly 25% of the world's total oils and fats production. Increasing price competitiveness, and aggressive cultivation and promotion from the major producing nations have given way to widespread soy oil growth both in terms of production as well as consumption.


In India, soybean is purely a Kharif crop, whose sowing begins by end-June with the arrival of southwest monsoon. The crop, which is ready for harvest by the end of September, starts


entering the market from October beginning onwards. Crushing for oil and meal starts from October, peaking during the subsequent two-three months.


Global consumption of soy oil during 2001-02 shot up to 29.38 million tons. It has been growing at the rate of 5.63%. Notable upward movement in consumption of soy oil is being seen in EU, Central Europe, Russia, Egypt, Morocco, US, Mexico, Brazil, China and India. The consumption of soy oil in USA is to the extent of 90% of its production; growing at the rate of 2.95%, slightly higher than the growth rate of its production (2.92%). The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of soy oil.

The current world production of soy oil stands at 29-30 million tons. It has been growing at the rate of 5.8% compounded annually during the last decade. The production growth rate has been the highest for Argentina at 10.8%, while that of Brazil and USA has been at 5.6% and 2.9% respectively. United States is the major producer of soy oil in the world. It accounts to approximately 29% of world soy oil production with an annual production of 8.5 million tons. Brazil and Argentina with 5.1 and 4.1 million tons of production, contribute to 17% and 14% of world production. Of the total world exports, Argentina contributes to an extent of 40.4%, growing at the rate of 11.36% compounded annually during the past decade.

Production of soy oil in India has been fluctuating in the range of 0.7-0.9 million tons during the last five years, growing at the rate of 5%. In addition to domestic production, around 1.5-1.8 million tons of

imports take the country's annual soy oil consumption to 2.2-2.7 million tons, with a market value of over Rs.90 billion. Imports constitute to the extent of over 65-68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Imports have been growing at the rate of approximately 20% over the period of last five years. Madhya Pradesh is considered as the soybean bowl of India, contributing 80% of the country's soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangli in Maharashtra are major trading centres of soybean, in and around which the crushing and solvent extraction units are mostly located. The refining units are located at the importing ports of Mumbai and Gujarat.

Price trends and factors the influence prices

In India, spot markets of Indore and Mumbai serve as the reference market for soy oil prices. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted), Mumbai price indicates the imported soy oil price. Indian edible oil market is highly price sensitive in nature. Hence, the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor, palm oil apart from prices of domestically produced oils, production and trade policies of the government - mainly me export-import policy, over-all health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Soy oil is among the most vibrant commodities in terms of price volatility. Its


exposure in the international edible trade scene (9-10 million tons), concentration of production base in limited countries as against its widespread consumption base, its close link with several of its substitutes and its base raw material soybean in addition to its co-derivative (soy meal), the nature of the existing supply and value chain, etc. throw tremendous opportunity for trade in this commodity. The opportunity is further enhanced by the expected rise in consumption base and the consequent expected rise in imports of vegetable oils in the years to come. In addition is the stiffening competition among substitutable oils under the WTO regime.

4.1.5 Rapeseed oil

Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world, after soy and palm oils. On crushing rapeseed, oil and meal are obtained. The average oil recovery from the seed is about 33%. The remaining is obtained as oil cake/ meal, which is rich in proteins and is used as an ingredient in animal feed. Mustard oil, which is known for its pungency, is traditionally the most favoured oils in the major production tracts world over.


Rapeseed is a 90-110 day crop. In the countries of Canada, Australia and China, the rapeseed is sown during the months of June-July and harvested by August-September. Crushing for oil begins from October onwards. In India, rapeseed is sown in the Rabi season (November-December sowing). China also grows partly during this season. Mustard/ Rapeseed is traditionally the most important oil for the northern, central and eastern parts of the country. The pungency of the oil is considered as the major quality determining factor. Therefore, traditional millers producing unrefined oil are more favoured by the consumers. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies), gets crushed for oil and cake in the ghanis or the expeller mills. It is largely consumed in the crude form in the local crushing regions. The cake obtained from the seed crush contains some amount of oil, which is extracted by the solvent extractors. The left over meal at the solvent extraction units forms a major portion of our oil meal basket, part of which is consumed by the domestic animal feed industry, and the rest exported. Refining of rapeseed oil was almost absent in the country till the end of the last century. As a result, the sector was more unorganised when compared to the other edible oil sectors in the country. This resulted in rampant adulteration of the oil. However, with the occurrence of dropsy in the country, Government of India issued the edible oil packaging order in 1998, which made refining and packing of all oils sold in the retail sector mandatory. Now, refining is present in rapeseed oil too.


Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth


rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major importers, whose share has been declining over the years.

At an annual production level of 13-14 million tons, rapeseed oil accounts for about 12% of the total world's edible oil production. Globally, rapeseed oil production has witnessed a moderate compounded annual growth rate (over the last decade) of 4.65%. While the production growth rates in major producing countries viz. Canada and India have posted negative values of 1.2% and 7.8% respectively during the past decade, China, France and Germany's rapeseed oil production during the period has been growing at 10%, 6.8% and 4.7% respectively. China contributes more than one thirds of world rapeseed oil production while that of India has gone down from 18.2% in 1997 to 11.3% in 2001.

Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. It forms over one-third of the country's annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Unlike other oils, consumption of rapeseed oil is concentrated in northern, north-eastern and western part of the country.

Rapeseed oil has several industrial applications too viz. as lubricant, its erucic acid derivatives are used in plastic industry, and it could also be transformed into a liquid biofuel. Rajasthan and Uttar Pradesh are the major rapeseed producing states in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres.


Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations.

4.1.6 Soybean

The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual production of 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total oilseed production. The average monthly fluctuation in prices of soybean traded at one of the


active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two years, the maximum monthly fluctuation being as high as 24-30% during the period. Historically, soybean prices in the major spot markets across the country have been fluctuating in the range of 5-9%. Soybean is the single largest oilseed produced in the world. The commodity has been commercially exploited for its utility as edible oil and animal feed. On crushing mature beans, around 18% oil could be obtained; the rest being the oil cake/ meal, which forms the prime source of protein in animal feeds.


Soybean could be grown under rain fed conditions, provided a good amount of soil moisture is ensured at the germination, vegetative growth and pod setting stages. The planting date of vegetable soybean is dependent upon temperature and day length. The optimum temperature range of soybean cultivation is 20 - 30°C with short day length (14 hours or less). However, planting should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.0-6.5 is suitable for its cultivation, but the field should be well drained.


About 82-85% of the global soybean production is crushed for oil and meal, while the rest is consumed either in the form of bean itself or for value-added soybean snack foods. USA, Brazil, Argentina, China and European Union countries constitute for the bulk of world's annual soybean consumption. Mexico, Japan, India and Taiwan are among the other major consumers. During the past five years period, global consumption of soybean has grown at the rate of 5.25%, higher than the production growth rate of 5.19%.

Of the total 310-320 million tons of oilseeds produced annually, soybean production alone stands at 170-190 million tons, contributing to over 55% of the global oilseeds production. During the last decade, the production of the commodity grew at the rate of 5.35% at the global level. USA, followed by Brazil and Argentina are the major producing countries; India and China are among the other producers.

The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual production of 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total oilseed production. Of the total bean produced, 6-7 lakh tons goes for direct consumption in the form of bean itself (sowing, human consumption as bean itself), leaving the rest of the quantity for crushing for meal and oil. While the country imports soy oil, it is a leading exporter of meal in the Asian region. Madhya Pradesh is the soybean bowl of India, contributing 65-70% of the country's soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities.

4.1.7 Rapeseed

Rapeseed/ Mustard is one of the major sources of oil and meal to India. It supplies over 1.5 million tons of oil (15-18% of India's annual edible oil requirement) and 3-3.2 million tons of


oil meal, the major protein source in animal feeds. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9.8% during the past two years (July 2001 to July 2003), the maximum monthly fluctuation being as high as 23.4% during the period. Rapeseed/ Mustard/ Canola is a traditionally important oilseed. China, Canada and India are the major producers of this commodity. The other major producers are Germany, France, Australia, Pakistan and Poland. The commodity has been commercially exploited in the form of seeds, oil (seed to oil recovery is 39-40%) and meal. The hybrid form of rapeseed, known as canola, is more popular internationally.


Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown in India. They are generally divided into three groups:

1. Brown mustard, commonly called rai (raya or laha)

2. Sarson: (i) Yellow sarson (ii) Brown sarson

3. Toria (Lahi or Maghi Labi)

Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool temperatures for satisfactory growth. In India, they are grown during the Rabi season from September-October to February-March. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. Sarson is preferred in low-rainfall areas, whereas Rai and Toria are grown in medium and high rainfall areas respectively. Rapeseed and mustard thrive best in light to heavy loams. Rai may be grown on all types of soils, but Toria does best in loam to heavy loams. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils.


Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major importers, whose share has been declining over the years.

Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tons in 1999, and declined from there on to the current (2002) level of 32.5 million tons. It has been growing at the rate of 2.2% during the last 12 years period. The major contributors to global rapeseed production are China, India, Germany, France, Canada and Australia with a share of 32%, 12.6%, 12.1%, 10%, 9.8% and 3% respectively. Among the major contributors to world production, Australian rapeseed production grew at the fastest rate of 21%. While China, France and Germany are growing at a moderate rate of 2-4%, India and Canada have shown a decline


in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997 to 1.2 million tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada. Germany follows Canada in the export of domestically produced rapeseed oil. Its exports too have fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and China consume most of the rapeseed oil that is produced domestically.

Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5-4.8 million tons of rapeseed available for produced annually in the country supplies over 1.5 million tons of oil and 3-3.2 million tons of meal on crushing. It is the largest produced edible oil in India (groundnut oil production also stands on par with it during good years). It forms over one-third of the country's annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres.


Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil traded across the country. Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations. Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value chain of the commodity- the producing farmers, processors, brokers, speculators, mustard oil and traders of other oils.

Import of both refined and crude rapeseed oil is permitted into the country. The import duty on crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oil for the last few years due to the differential duty structure.

4.2 Precious metals

The NCDEX offers futures trading in following precious metals - gold and silver. We will look briefly at both.


Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November 1972. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. The gold contracts became so popular that by 1974 there was as many as 10,00,000 contracts floating in the market. The futures trading in gold started in other countries too. This included the following:

* The London gold futures exchange started operations in the early 1980s.

* The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange had a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other.

* The Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance between the Gold Exchange of Singapore and the International Monetary Market (TMM) of Chicago.

* The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with seven million contracts.

* On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange and the Mid-America Commodity Exchange introduced gold futures contracts.

* The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002.

* Mumbai's first multi-commodity exchange, the National Commodities and Derivatives Exchange, NCDEX launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation, National Bank for Agriculture and Rural Development and National Stock Exchange of India Limited, introduces gold futures contracts.

Gold has a very active derivative market compared with other commodities. Gold accounts for 45 per cent of the worlds commercial banks commodity derivatives portfolio.

Box 4.4: History of derivatives markets in gold

4.2.1 Gold

For centuries, gold has meant wealth, prestige, and power, and its rarity and natural beauty have made it precious to men and women alike. Owning gold has long been a safeguard against disaster. Many times when paper money has failed, men have turned to gold as the one true source of monetary wealth. Today is no different. While there have been fluctuations in every market and decided downturns in some, the expectation is that gold will hold its own. There is a limited amount of gold in the world, so investing in gold is still a good way to plan for the future. Gold is homogeneous, indestructible and fungible. These attributes set gold apart from other commodities and financial assets and tend to make its returns insensitive to business cycle fluctuations. Gold is still bought (and sold) by different people for a wide variety of reasons - as a use in jewellery, for industrial applications, as an investment and so on.

|4.2 Precious metals |51 |

| |

|Table 4.1 Country-wise share in gold production, 1968 and 1999 |

|Country |Tonnes, 1968 |Share 1968 |Tonnes, 1999 |Share, 1999 | |

|South Africa |972 |67 |437 |17 | |

|Australia | | |309 |12 | |

|Canada | 87 |6 |154 | 6 | |

|USA | 44 |3 |334 |13 | |

|China | | |154 | 6 | |

|Indonesia | | |154 | 6 | |

|India | | | 51 | 2 | |

|Rest of the world | 87 |6 |463 |18 | |

|Total |1450 | 100 |2571 |100 | |

| |

Production

Traditionally South Africa has been the largest producers of gold in the world accounting for almost 80% of all non-communist output in 1970. Although it retained its position as the single largest gold producing country, its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Table 4.1 gives the country-wise share in gold production. In contrast other countries like US, Australia, Canada and China have increased their output exponentially with output from developing countries like Peru and other Latin American countries also increasing impressively.

Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly from the Kolar gold mines in Karnataka) as against a total world production of about 2,272 tonnes in 1995.

Melting & refining assaying facility in India

At present, gold is mainly refined in Bombay where a few refineries like the India Government Mint and National refinery are active. Some private refineries are also operating elsewhere with limited capacity. As none of the refineries is LBMA recognised, there is a need to upgrade and also increase the refining capacity.


The demand for gold may be categorised under two heads - consumption demand and investment demand. Consumption of gold differs according to type, namely industrial applications and jewellery. The special feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly consumed. This is unlike consumption in the form of jewellery, which remains as stock and can reappear at future time in market in another form. Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry forms 89% of consumer demand.


In markets with poorly developed financial systems, inaccessible or insecure banks, or where trust in the government is low, gold is attractive as a store of value. If gold is held primarily as an investment asset, it does not need to be held in physical form. The investor could hold gold-linked paper assets or could lend out the physical gold on the market attaining a higher return in addition to savings on the storage costs. Japan has the highest investment demand for gold followed closely by India. These two countries together account for over 50% of total world demand of gold for retail investment. Investment demand can be split broadly into two, private and public sector holdings.

There are several ways in which investors can invest in gold either directly or through a variety of investment products, each of which lends it to specific investor preferences:

* Coins and small bars

* Gold accounts: allocated and unallocated

* Gold certificates and pool accounts

* Gold Accumulation Plan

* Gold backed bonds and structured notes

* Gold futures and options

* Gold-oriented funds

Demand

The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth. More than 80% of the gold consumed is in the form of jewellery, which is generally predominated by women. The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by USA, Middle East and China. About 80% of the Physical gold is consumed in the form of jewellery while bars and coins occupy not higher than 10% of the gold consumed. If we include jewellery ownership, then India is the largest repository of gold in terms of total gold within the national boundaries.

Regarding pattern of demand, there are no authentic estimates, the available evidence shows that about 80% is for jewellery fabrication for domestic demand, and 15% is for investor-demand (which is

relatively elastic to gold-prices, real estate prices, financial markets, tax-policies, etc.). Barely 5% is for industrial uses. The demand for gold jewellery is rooted in societal preference for a variety of reasons - religious, ritualistic, a preferred form of wealth for women, and as a hedge against inflation. It will be difficult to prioritise them but it may be reasonable to conclude that it is a combined effect, and to treat any major part as exclusively a store of value or hedging instrument would be unrealistic. It would not be realistic to assume that it is only the affluent that creates demand for gold. There is reason to believe that a part of investment demand for gold assets is out of black money.

Rural India continues to absorb more than 70% of the gold consumed in India and it has its own role to fuel the barter economy of the agriculture community. The yellow metal used to


play an important role in marriage and religious festivals in India. In the Hindu, Jain and Sikh community, where women did not inherit landed property whereas gold and silver jewellery was, and still is, a major component of the gifts given to a woman at the time of marriage. The changeover hands of gold at the time of marriage are from few grams to kgs. The gold also occupies a significant position in the temple system where gold is used to prepare idol and devotees offer gold in the temple. These temples are run in trust and gold with the trust rarely comes into re-circulation. The existing social and cultural system continues to cause net gold buyer market and the government policies have to take note of the root cause of gold demand, which lies in the social and cultural system of India. The annual consumption of gold, which was estimated at 65 tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it is likely that, with prosperity and enlightenment, there may be deceleration in demand, particularly in urban areas, it would be made good by growing demand on account of prosperity in rural areas. In the near future, therefore, the annual demand will continue to be over 600 tonnes per year.

Supply

Indian gold holding, which are predominantly private, is estimated to be in the range of 10000-13000 tonnes. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%.

The demand-supply for gold in India can be summed up thus:

* Demand for gold has an autonomous character. Supply follows demand.

* Demand exhibits income elasticity, particularly in the rural and semi-urban areas.

* Price differential creates import demand, particularly illegal import prior to the commencement of liberalisation in 1990.


Indian gold prices follow more or less the international price trends. However, the strong domestic demand for gold and the restrictive policy stance are reflected in the higher price of gold in the domestic market compared to that in the international market at the available exchange rate.

Since the demand for gold is closely tied to the production of jewelry, gold prices tend to increase during the time of year when demand for jewellery is greatest. Christmas, Mothers Day and Valentine Day are all major shopping seasons and hence the demand for metals tends to be strong a few months ahead of these holidays. Also, the summer wedding season sees a large increase in the demand for metals, so price strength in March and April is not uncommon. On the


other hand in November, December, January and February prices tend to decline and jewellers tend to have holiday inventory to unwind.

4.2.2 Silver

The dictionary describes it as a white metallic element, sonorous, ductile, very malleable and capable of high degree of polish. It also has the highest thermal and electrical conductivity of any substance. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. Silver remains one of the most prominent candidates in the metals complex as far as futures' trading is concerned. Thanks to its unique volatility, silver has remained a hot favourite speculative vehicle for the small time traders. Though futures trading was banned in India since late sixties, parallel futures markets are still very active in Delhi and Indore. Speculative interest in the white metal is so intense that it is believed that combined volume of Indian punters represent almost 40 percent of volume traded at New York Commodity

Exchange. Delhi, Rajasthan, MP and UP are the active pockets for the silver futures. Until recently, Rajkot and Mathura were conducting futures but now players have diverted toward comex trade.

Most of the world's silver is mined in the US, Australia, Mexico, Peru, and Canada. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. Taking cue from gold, government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry. The unique properties of silver restrict its substitution in most applications.

Production

Silver ore is most often found in combination with other elements, and silver has been mined and treasured longer than any of the other precious metals. Mexico is the worlds leading producer of silver, followed by Peru, Canada, the United States, and Australia. The main consumer countries for silver are the United States, which is the worlds largest consumer of silver, followed by Canada, Mexico, the United Kingdom, France, Germany, Italy, Japan and India. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth, industrial production, income levels, and a whole host of other financial macro economic indicators.

Demand

Demand for silver is built on three main pillars; industrial and decorative uses, photography and jewelry & silverware. Together, these three categories represent more than 95 percent of annual silver consumption. In recent years, the main world demand for silver is no longer monetary, but industrial. With the growing use of silver in photography and electronics, industrial demand for silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is the second largest component, with more demand from the flatware industry than from the jewelry industry in recent years. India, the largest consumer of silver, is gearing up to start hallmarking of the white precious metal by April. India annually consumes around 4,000 tonnes of silver,


Major markets like the London market (London Bullion Market Association), which started trading in the 17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The London

market has a fix which offers the chance to buy or sell silver at a single price. The fix begins at 12:15 p.m. and is a balancing exercise; the price is fixed at the point at which all the members of the fixing can balance their own, plus clients, buying and selling orders.

Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969, respectively. In the United States, the silver futures market functions under the surveillance of an official body, the Commodity Futures Trading Commission (CFTC). Although London remains the true center of the physical silver trade for most of the world, the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. Spot prices for silver are determined by levels prevailing at the COMEX. Although there is no American equivalent to the London fix, Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at noon each working day.

Box 4.5: Historical background of silver markets

with the rural areas accounting for the bulk of the sales. India's demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. According to GFMS, India has emerged as the third largest industrial user of silver in the world after the US and Japan.

Supply

The supply of silver is based on two facts, mine production and recycled silver scraps. Mine production is surprisingly the largest component of silver supply. It normally accounts for a little less than 2/3 rd of the total (last year was slightly higher at 68%). Fifteen countries produce roughly 94 percent of the worlds silver from mines. The most notable producers are Mexico, Peru, the United States, Canada and Australia. Mexico, the largest producer of silver from mines. Peru is the worlds second largest producer of silver. Silver is often mined as a byproduct of other base metal operations, which accounts for roughly four-fifths of the mined silver supply produced annually. Known reserves, or actual mine capacity, is evenly split along the lines of production. The mine production is not the sole source - others being scrap, disinvestments, government sales and producers hedging. Scrap is the silver that returns to the market when recovered from existing manufactured goods or waste. Old scrap normally makes up around a fifth of supply. Scrap supply increased marginally last year up by 1.2%. The other major source of silver is from refining, or scrap recycling. Because silver is used in the photography industry, as well as by the chemical industry, the silver used in solvents and the like can be removed from the waste and recycled. The United States recycles the most silver in the world, accounting for roughly 43.6 million ounces. Japan is the second largest producer of silver from scrap and recycling, accounting for roughly

27.8 million troy ounces in 1997. In the United States and Japan, three-quarters of all the recycled silver comes from the photographic scrap, mainly in the form of spent fixer solutions and old

X-ray films.


Factors influencing prices of the silver

The prices of silver, like that of other commodities, are dictated by forces of demand and supply and consumption. Besides, a host of social, economic and political factors have powerful bearing on silver prices. As in the case of gold prices, political tensions, the threat affects the price of silver too. When trading and movement of silver is restricted, within or outside national boundaries, prices move in accordance with demand and supply conditions prevalent in mat environment Price of silver is also influenced by changes in factors such as inflation (real or perceived), changing values of paper currencies, and fluctuations in deficits and interest rates, etc. Although prices and incomes are important factors, they are also influenced by factors such as tastes, technological change and market liberalisation.

Approximately 70 percent of the silver mined in the western hemisphere is mined as a byproduct of other metal products, such as gold, copper, nickel, lead, and zinc. As such, the price of these metals greatly affects the supply of silver mined in any year. As die price of die omer metal products increases, die increased profit margin to mine operations stimulates greater production of die omer metals, and as a result, die production of silver increases in tandem. Because silver is a precious metal, its price is determined by die supply and demand ratio at any given moment. As is the case with other precious metals, there is a limited amount of silver in the world. It is not a product mat can be manufactured en masse, and, merefore, is subject to issues such as weamer and politics mat may affect silver mining operations.

Solved Problems

Q: Which of the following commodities do not trade on the NCDEX?

1. Gold 3. Silver

2. Rapeseed 4. Energy


Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment?

1. Wheat 3. Soybean

2. Rapeseed 4. Soy oil


Q: In India, is the most important non-food crop.

1. Jute 3. Silk

2. Cotton 4. None of the above.



Q: Which of the following factors do not influence the price of cotton?

1. Demand-supply scenario 3. Previous prices of cotton

2. Production and prices of synthetic fibre 4. Prices of cotton products.


Q: Futures prices of cotton at the serve as the reference price for cotton traded in the international

market.

1. CME 3. NYBOT

2. CBOT4. SGX


Q: Palm oil is extracted from the of oil palm plantations.

1. Mature fresh fruit bunches 3. Stem

2. Dry fruit bunches 4. Leaves


Q: RBD Palmolein is the derivative of

1. Soy 3. CPO

2. Rapeseed 4. Coconut kernel


Q: Which of the following factor directly influences the price of RBD palmolein?

1. Prices of Rapeseed oil 3. Prices of CPO

2. Prices of coconut oil 4. Prices sunflower oil


Q: Soy oil is the derivative of

1. Soy 3. CPO

2. Soybean 4. Sunflower seeds



Q: The market reflects the price of domestically crushed soybean

1. Mumbai 3. Indore

2. Ahmedabad 4. Delhi


Q: The market reflects the price of imported soybean

1. Mumbai 3. Indore

2. Ahmedabad 4. Delhi


Chapter 5

Instruments available for trading

In recent years, derivatives have become increasingly popular due to their applications for hedging, speculation and arbitrage. Before we study about the applications of commodity derivatives, we will have a look at some basic derivative products. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts. While at the moment only commodity futures trade on the NCDEX, eventually, as the market grows, we also have commodity options being traded.

5.1 Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are:

* They are bilateral contracts and hence exposed to counter-party risk.

* Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

* The contract price is generally not available in public domain.

* On the expiration date, the contract has to be settled by delivery of the asset.

* If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

However forward contracts in certain markets have become very standardised, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardisation reaches its limit in the organised futures market.

60 Instruments available for trading

Forward contracts are very useful in hedging and speculation. The classic hedging application

would be that of an exporter who expects to receive payment in dollars three months later. He is

exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell

dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer

who is required to make a payment in dollars two months hence can reduce his exposure to

exchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then he

can go long on the forward market instead of the cash market. The speculator would go long

on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a

relatively small proportion of the value of the assets underlying the forward contract. The use of

forward markets here supplies leverage to the speculator.

5.1.1 Limitations of forward markets

Forward markets world-wide are afflicted by several problems:

* Lack of centralisation of trading,

* Illiquidity, and

* Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each

other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradeable.

Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

5.2 Introduction to futures

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are:

|5.2 Introduction to futures |

|61 |

| |

|Merton Miller, the 1990 Nobel laureate had said that "financial futures represent the most significant |

|financial innovation of the last twenty years." The first exchange that traded financial derivatives was |

|launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the |

|International Monetary Market (EMM) and traded currency futures. The brain behind this was a man |

|called Leo Melamed, acknowledged as the "father of financial futures" who was then the Chairman of |

|the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange |

|sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts |

|traded at the Chicago Mercantile Exchange totalled 50 trillion dollars. |

|These currency futures paved the way for the successful marketing of a dizzying array of similar |

|products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board |

|Options Exchange. By the 1990s, these exchanges were trading futures and options on everything |

|from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago |

|almost overnight into the risk-transfer capital of the world. |

|Box 5.6: The first financial futures market |

|Table 5.1 Distinction between futures and forwards |

|Futures |Forwards |

|Trade on an organised exchange |OTC in nature |

|Standardized contract terms |Customised contract terms |

|hence more liquid |hence less liquid |

|Requires margin payments |No margin payment |

|Follows daily settlement |Settlement happens at end of period |

* Quantity of the underlying

* Quality of the underlying

* The date and the month of delivery

* The units of price quotation and minimum price change

* Location of settlement

5.2.1 Distinction between futures and forwards contracts

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. Table 5.1 lists the distinction between the two.


5.2.2 Futures terminology

* Spot price: The price at which an asset trades in the spot market.

* Futures price: The price at which the futures contract trades in the futures market.

* Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day of the delivery month. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a new contract having a three-month expiry is introduced for trading.

* Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

* Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the Gold futures contract is 1 kg.

* Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

* Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

■ Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

* Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

* Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

5.3 Introduction to options

In this section, we look at another interesting derivative contract, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment.

5.3 Introduction to options 63

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price.

This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honour the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early '80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

Box 5.7: History of options

5.3.1 Option terminology

* Commodity options: Commodity options are options with a commodity as the underlying. For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract.

* Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

* Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer.

* Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.

* Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

* Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

* Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

■ Expiration date: The date specified in the options contract is known as the expiration date, the

exercise date, the strike date or the maturity.

• Strike price: The price specified in the options contract is known as the strike price or the exercise

price.


* American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.

* European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart.

* In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-

money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

* At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

* Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

* Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St - K)] which means the intrinsic value of a call is the greater of 0 or (St - K). Similarly, the intrinsic value of a put is Max [0, (K - St )],i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price.

* Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

5.4 Basic payoffs

A payoff is the likely profit/ loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/ losses on the Y-axis. In this section we shall take a look at the payoffs for buyers and sellers of futures and options. But first we look at the basic payoff for the buyer or seller of an asset. The asset could be a commodity like gold or cotton, or it could be a financial asset like like a stock or an index.


Options made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiralled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.

Box 5.8: Use of options in the seventeenth-century

5.4.1 Payoff for buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, gold for instance, for Rs.6000 per 10 gms, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be "long" the asset. Figure 5.1 shows the payoff for a long position on gold.

5.4.2 Payoff for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, cotton for instance, for Rs.6500 per Quintal, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be "short" the asset. Figure 5.2 shows the payoff for a short position on cotton.

5.5 Payoff for futures

Futures contracts have linear payoff, just like the payoff of the underlying asset that we looked at earlier. If the price of the underlying rises, the buyer makes profits. If the price of the underlying falls, the buyer makes losses. The magnitude of profits or losses for a given upward or downward movement is the same. The profits as well as losses for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

5.5.1 Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

| |

|66. Instruments |

|available for trading |

| |

|Figure 5.1 Payoff for a buyer of gold |

|The figure shows the profits/losses from a long position on gold. The investor brought gold at Rs. 6000 per 10 gms. If the |

|price of gold rises, he profits. If price of gold falls he looses. |

[pic]

| |

| |

|Figure 5.2 Payoff for a seller of gold |

|The figure shows the profits/losses from a short position on cotton. The investor sold long staple cotton at Rs. 65000 per |

|Quintal. If the price of cotton falls, he profits. If the price of cotton rises, he looses. |

[pic]


Figure 5.3 Payoff for a buyer of gold futures

The figure shows the profits/ losses for a long futures position.The investor bought futures when gold futures were trading at Rs.6000 per 10 gms. If the price of the underlying gold goes up, the gold futures price too would go up and his futures position starts making profit. If the price of gold falls, the futures price falls too and his futures position starts showing losses.

[pic]

Take the case of a speculator who buys a two-month gold futures contract on the NCDEX when it sells for Rs.6000 per 10 gms. The underlying asset in this case is gold. When the prices of gold in the spot market goes up, the futures price too moves up and the long futures position starts making profits. Similarly when the prices of gold in the spot market goes down, the futures prices too move down and the long futures position starts making losses. Figure 5.3 shows the payoff diagram for the buyer of a gold futures contract.

5.5.2 Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month cotton futures contract when the contract sells Rs.6500 per Quintal. The underlying asset in this case is long staple cotton. When the prices of long staple cotton move down, the cotton futures prices also move down and the short futures position starts making profits. When the

prices of long staple cotton move up, the cotton futures price also moves up and the short futures position starts making losses. Figure 5.4 shows the payoff diagram for the seller of a futures contract.


Figure 5.4 Payoff for a seller of cotton futures

The figure shows the profits/ losses for a short futures position. The investor sold cotton futures at Rs.6500 per Quintal. If the price of the underlying long staple cotton goes down, the futures price also falls, and the short futures position starts making profit. If the price of the underlying long staple cotton rises, the futures too rise, and the short futures position starts showing losses.

[pic]

5.6 Payoff for options

The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. The writer of an option gets paid the premium. The payoff from the option written is exactly the opposite to that of the option buyer. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used for generating various complex payoffs using combinations of options and the underlying asset. We look here at the four basic payoffs.

5.6.1 Payoff for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option on gold (often referred to as long call) with a strike of Rs.7000 per 10 gms, bought at a premium of Rs.500.

5.6 Payoff for options 69

Figure 5.5 Payoff for buyer of call option on gold

The figure shows the profits/ losses for the buyer of a three-month call option on gold at a strike of Rs.7000 per 10 gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes in-the-money. If upon expiration, gold trades above the strike of Rs.7000, the buyer would exercise his option and profit to the extent of the difference between the spot gold-close and the strike price. The profits possible on this option are potentially unlimited. However if the price of gold falls below the strike of Rs.7000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

[pic]

5.6.2 Payoff for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 5.6 gives the payoff for the writer of a three month call option on gold (often referred to as short call) with a strike of Rs.7000 per 10 gms, sold at a premium of Rs.500.

5.6.3 Payoff for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/ loss that the buyer makes on the option depends on the spot price of the


Figure 5.6 Payoff for writer of call option on gold

The figure shows the profits/ losses for the seller of a three-month call option on gold with a strike price of Rs.7000 per 10 gms. As the price of gold in the spot market rises, the call option becomes in-the-money and the writer starts making losses. If upon expiration, gold price is above the strike of Rs.7000, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the spot gold-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.500 charged by him.

[pic]

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.7 gives the payoff for the buyer of a three month put option on cotton (often referred to as long put) with a strike of Rs.6000 per Quintal, bought at a premium ofRs.400.

5.6.4 Payoff for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 5.8 gives the payoff for the writer of a three month put option on long staple cotton (often referred to as short put) with a strike of Rs.6000 per Quintal,

5.7 Using futures versus using options 71

Figure 5.7 Payoff for buyer of put option on long staple cotton

The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. As can be seen, as the price of cotton in the spot market falls, the put option becomes in-the-money. If at expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and profit to the extent of the difference between the strike price and spot cotton-close. The profits possible on this option can be as high as the strike price. However if spot price of cotton on the day of expiration of the contract is above the strike of Rs.6000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option, Rs.400 in this case.

[pic]

sold at a premium of Rs.400.

5.7 Using futures versus using options

An interesting question to ask at this stage is - when would one use options instead of futures? Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.

More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs".

By combining futures and options, a wide variety of innovative and useful payoff structures can


Figure 5.8 Payoff for writer of put option on long staple cotton

The figure shows the profits/ losses for the seller of a three-month put option on long staple cotton. As the price of cotton in the spot market falls, the put option becomes in-the-money and the writer starts making losses. If upon expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and spot cotton-close. The profit that can be made by the writer of the option is limited to extent of the premium received by him, i.e. Rs.400, whereas the losses are unlimited (actually they are limited to the strike price since the worst that can happen is that the price of the underlying asset falls to zero.

[pic]

|Table 5.2 Distinction between futures and options |

|Futures |Options |

|Exchange traded, with novation |Same as futures. |

|Exchange defines the product |Same as futures. |

|Price is zero, strike price moves |Strike price is fixed, price moves. |

|Price is zero |Price is always positive. |

|Linear payoff |Nonlinear payoff. |

|Both long and short at risk |Only short at risk. |

| |

| | |

| | |

|be created. | |


Solved Problems

Q: Which of the following cannot be an underlying asset for a financial derivative contract?

1. Equity index 3. Interest rate

2. Commodities 4. Foreign exchange

A: The correct answer is 2 • •

Q: Which of the following cannot be an underlying asset for a commodity derivative contract?

1. Wheat 3. Cotton

2. Gold 4. Stocks

A: The correct answer is 4 • •

Q: Which of the following exchanges was the first to start trading commodity futures?

1. Chicago Board of Trade 3. Chicago Board Options Exchange

4. London International Financial Futures and

2. Chicago Mercantile Exchange Options Exchange

A: The correct answer is 3. • •

Q: In an options contract, the option lies with the

1. Buyer 3. Both

2. Seller4. Exchange

A: The option to exercise lies with the buyer. The correct answer is number 1. • •

Q: The potential returns on a futures position are:

1. Limited 3. a function of the volatility of the index

2. Unlimited 4. None of the above



Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a

1. Futures contract 3. Spot contract

2. Forward contract 4. None of the above


Q: Typically option premium is

1. Less than the sum of intrinsic value and time 3. Equal to the sum of intrinsic value and time valuevalue

1. Greater than the sum of intrinsic value and

time value 4. Independent of intrinsic value and time value


Q: An asset currently sells at 120. The put option to sell the asset at Rs.134 costs Rs.18. The time value of the option is

1. Rs.183. Rs.14

2. Rs.4 4. Rs.12


Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a

1. OTC contract 3. Spot contract

2. Exchange traded contract 4. None of the above


Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at Rs. 1550/Quintal. How much profit/loss has he made on his position?

1. (+)5000 3. (+)50,000

2. (-)5000 4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position 100 Quintals. He makes

a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is number 1. • •


Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at Rs. 1450/Quintal. How much profit/loss has he made on his position?

1. (+)5000 3. (+)50,000

2. (-)5000 4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He

makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. • •

Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at Rs. 1550/Quintal. How much profit/loss has he made on his position?

1. (+)5000 3. (+)50,000

2. (-)5000 4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He

makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. • •

Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at Rs. 1450/Quintal. How much profit/loss has he made on his position?

1. (+)5000 3. (+)50,000

2. (-)5000 4. (-)50,000

A: Each unit is for 10 Quintals. He sells 10 units which means a futures position in 100 Quintals. He makes a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is number 1. • •

Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is his net payoff?

1. (+) 10,000 3. (-) 10,000

2. (+) 1,000 4. (-) 1,000

A: Per 10 gms he makes a net profit of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000 gms. So he makes a net profit of Rs. 1000 on his position [pic]The correct answer is number 2. • •


Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff?

1. (-)7000 3. (-)700

2. (+) 1,000 4. (-) 1,000

A: The option is OTM. Unit of trading is 100 gms and he has bought 10 units. So he has a position in 1000 gms of gold. He pays an option premium of Rs.70 per 10 gms. He losses the premium amount of Rs.7000 on his position. The correct answer is number 1. • •

Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is his net payoff?

1. (+) 10,000 3. (-) 10,000

2. (+) 1,000 4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short position in 1000 gms. So he makes a net loss of Rs.1000 on his position [pic]. The correct answer is number 4.

Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff?

1. (-)7000 3. (-)700

2. (+) 1,000 4. (-) 1,000

A: The option is OTM. The buyer does not exercise so the seller gets to keep the premium. Unit of trading is 100 gms and he has sold 10 units. So he has a position in 1000 gms of gold. He receives an option premium of Rs.70 per 10 gms. He earns the premium amount of Rs.7000 on his position. The correct answer is number 1. • •

Chapter 6

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. Price discovery facilitates this free flow of information, which is vital to the effective functioning of futures market.

In this chapter we try to understand the pricing of commodity futures contracts and look at how the futures price is related to the spot price of the underlying asset. We study the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

6.1 Investment assets versus consumption assets

When studying futures contracts, it is essential to distinguish between investment assets and consumption 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

78 Pricing commodity futures

examples of investment assets. Note however that investment assets do not always have to be held exclusively for investment. As we saw earlier, silver, for example, has a number of industrial uses. 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. 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.

As we will learn, we can use arbitrage arguments to determine the futures prices of an investment asset from its spot price and other observable market variables. For pricing consumption assets, we need to review the arbitrage arguments a little differently. To begin with, we look at the cost-of-carry model and try to understand the pricing of futures contracts on investment assets.

6.2 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(6.1)

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(l + r)T (6.2)

where:

r Percent cost of financing

6.2 The cost of carry model 79

T Time till expiration

Whenever the futures price moves away from the fair value, there would be opportunities for arbitrage. If F < S(1 + r)T or F > S(1 + r)T, arbitrage would exist. We know what are the spot and futures prices, but what are the components of holding costs? The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. 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 6.2 uses the concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. Most books on

derivatives use continuous compounding for pricing futures too. When we use continuous compounding, equation 6.2 is expressed as:

F - SerT (6.3)

where:

r Cost of financing (using continuously compounded interest rate)


e 2.71828

So far we were talking about pricing futures in general. To understand the pricing of commodity futures, let us start with the simplest derivative contract - a forward contract. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. However, the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs. Then we introduce real world factors as they apply to investment commodities and later to consumption commodities.

Consider a three-month forward contract on a stock that does not pay dividend. Assume that the price of the underlying stock is Rs.40 and the three-month interest rate is 5% per annum. We consider the strategies open to an arbitrager in two extreme situations.

1. Suppose that the forward price is relatively high at Rs.43. An arbitrager can borrow Rs.40 from the market at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in the forward market at Rs.43. At the end of three months, the arbitrager delivers the share and receives Rs.43. The sum of money required to pay off the loan is [pic]By following this strategy, the arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at the end of the three month period.

80 Pricing commodity futures

2. Suppose that the forward price is relatively low at Rs.39. An arbitrager can short one share for Rs.40, invest the proceeds of the short sale at 5% per annum for three months, and take a long position in a three-month forward contract. The proceeds of the short sale grow to [pic]in three months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share under the terms of the

forward contract and uses it to close his short position, in the process making a net gain of Rs. 1.50 at the end of three months.

We see that if the forward price is greater than Rs.40.50, there exists arbitrage. Under such a situation, arbitragers will sell the asset in the forward market, eventually driving the forward price down to Rs.40.50. Similarly if the forward price is less than Rs.40.50, there exists arbitrage. Arbitragers will buy the asset in the forward market, eventually pushing the forward price up to Rs.40.50. At a forward price of Rs.40.50 there will be no arbitrage. This is the fair value of the forward contract. The same arguments hold good for a futures contract on an investment asset.

Now let us try to extend this logic to a futures contract on a commodity. Let us take the example of a futures contract on a commodity and work out the price of the contract. The spot price of gold is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be the futures price of 10 gms of gold one month down the line ? Let us assume that we're on 1st January 2004. How would we compute the price of a gold futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry model.

1. What is the spot price of gold? The spot price of gold, S= Rs.7000/ 10 gms.

2. What is the cost of financing for a month? [pic]

3. What are the holding costs? Let us assume that the storage cost = 0.

In this case the fair value of the futures, works out to be = Rs.7086.80

[pic]

If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing

would increase the futures price. Therefore, the futures price would be [pic] Rs.7263.75

6.2.1 Pricing futures contracts on investment commodities

In the example above we saw how a futures contract on gold could be priced using arbitrage arguments and the cost-of-carry model. In the example we considered, the gold contract was for 10 grams of gold. Hence we ignored the storage costs. However, if the one-month contract was for a 100 kgs of gold instead of 10 gms, then it would involve non-zero holding costs which would include storage and insurance costs. The price of the futures contract would then be Rs.7086.80 plus the holding costs.

Table 6.1 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

6.2 The cost of carry model 81

Under normal market conditions, F, the futures price is very close to S(X + r)T. However, on October 19,1987, the US market saw a breakdown in this classic relationship between spot and futures prices. It was the day the markets fell by over 20% and the volume of shares traded on the New York Stock Exchange far exceeded all previous records. For most of the day, futures traded at significant discount to the underlying index. This was largely because delays in processing orders to sell equity made index arbitrage too risky. On the next day, October 20,1987, the New York Stock Exchange placed temporary restrictions on the way in which program trading could be done. The result was that the breakdown of the traditional linkages between stock indexes and stock futures continued. At one point, the futures price for the December contract was 18% less than the S&P 500 index which was the underlying index for these futures contracts! However, the highlight of the whole episode was the fact that inspite of huge losses, there were no defaults by futures traders. It was the ultimate test of the efficiency of the margining system in the futures market.

Box 6.9: The market crash of October 19,1987

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.

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 (6.4)

|CPO |110 |25 per MT |

|Cotton - long |110 |6 per Bale |

|Cotton - medium |110 |6 per Bale |

| |

We see that the one-year futures price of a kg of gold would be Rs.6,46,904.76. The one-year futures price for 10 grams of gold would be about Rs.6469.

Now let us consider a three-month futures contract on gold. We make the same assumptions - the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week. It costs Rs.1025 to store one kg of gold for three months(13 weeks). Assume that the storage costs are paid at the time of deposit. Assume further that the spot gold price is Rs.6000 per 10 grams and the risk-free rate is 7% per annum. What would the price of three month gold futures if the delivery unit is one kg?

F = (S + U)erT

= (600000 + 310 + 715)e0.07 x 0.25

= 611635.50

We see that the three-month futures price of a kg of gold would be Rs.6,11,635.50. The three-month futures price for 10 grams of gold would be about Rs.6116.

6.2.2 Pricing futures contracts on consumption commodities

We used the arbitrage argument to price futures on investment commodities. For commodities mat 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 (6.5)

To take advantage of this opportunity, an arbitrager can implement the following strategy:

6.3 The futures basis 83

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.

2. 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 6.5 does not hold good.

Suppose next that

F < (S+U)erT (6.6)

In case of investment assets such as gold and silver, many investors hold the commodity purely for investment. When they observe the inequality in equation 6.6, 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 6.6 does not hold good. This means that for investment assets, equation 6.4 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 6.6 holds good. In short, for a consumption commodity therefore,

F

Introduction

Instability of commodity prices has always been a major concern of the producers as well as the consumers in an agriculture -dominated country like India. Farmers’ direct exposure to price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise profitable activities. There are various ways to cope with this problem.

Apart from increasing the stability of the market, various factors in the farm sector can better manage their activities in an environment of unstable prices through derivative markets. These markets serve a risk -shifting function, and can be used to lock -in prices instead of relying on uncertain price developments.

There are a number of commodity-linked financial risk management instruments, which are used to hedge prices through formal commodity exchanges, over -the-counter (OTC) market and through intermediation by financial and specialized institutions who extend risk management services. (see UNCTAD, 1998 for a comprehensive survey of instruments) These instruments are forward, futures and option contracts, swaps and commodity linked -bonds. While formal exchanges facilitate trade in standardized contracts like futures and options, other instruments like forwards and swaps are tailor made contracts to suit to the requirement of buyers and sellers and are available over-the counter.

In general, these instruments are classified (as shown in figure-1.1) based on the purpose for which they are primarily used for price hedging, as part of a wider marketing strategy, or for price hedging in combination with other financial deals. While forward contracts and OTC options are trade related instruments, futures, exchange traded options and swaps between banks and customers are primarily price hedging instruments. In the case of swaps between intermediaries and producers, and commodity linked loans and bonds (CL&BS) price hedging are combined with financial deals.

Forwards contracts are mostly OTC agreements to purchase or sell a specific amount of a commodity on a predetermined future date at a predetermined price. The terms and conditions of a forward contract are rigid and both the parties are obligated to give and take physical delivery of the commodity on the expiry of contract. The holders of forward contracts face spot (ready) price risk. When the prevailing spot price of the underlying commodity is higher than the agreed price on expiry of the contract, the buyer gains and the seller looses. The futures contracts are refined version of forwards by which the parties are insulated from bearing spot risk and are traded in organize exchanges. A detailed discussion on the futures contracts is presented in the next chapter.

Both forwards and futures contracts have specific utility to commodity producers, merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgers and from hedgers to speculators, futures markets also play a major role in price discovery.

Typology of risk management instruments

[pic]

The price risk refers to the probability of adverse movements in price s of commodities, services or assets. Agricultural products, unlike others, have an added risk. Many of them being typically seasonal would attract only lower price during the harvest season.

The forward and futures contracts are efficient risk management tools, which insulate buyers, and sellers from unexpected changes in future price movements. These contracts enable them to lock-in the prices of the products well in advance. Moreover, futures prices give necessary indications to producers and consumer s about the likely future ready price and demand and supply conditions of the commodity traded. The cash market or ready delivery market on the other hand is a time-tested market system, which is used in all forms of business to transfer title of goods.

2.1 MCX become First Exchange to Commence World's First Futures Contract in King of Rice – "Basmati"

The multi-billion Rice industries is a key sector in the Indian economy. With its characteristic such as long-grain, subtle aroma and delicious taste,

India is the largest producer & exporter of Basmati Rice in the world. MCX has become the first exchange in the world to launch Basmati Futures Contract so that the exporters, traders, producers, consumers etc. can get opportunities to widen the scope of the industry and can achieve synergies between local and global commodity markets.

After creating several benchmarks MCX has now become the World’s first exchange to launch the King of Rice – "Basmati Futures Trading" to enable the farming community, processing industry, producers, consumers and exporters to manage their price risk and take advantage of the market driven price discovery mechanism. MCX Basmati Rice futures price is expected to act as a benchmark for the entire industry.

Shri Ekanath K. Thakur, M.P. (Rajya Sabha) and President, Maharashtra Chamber of Commerce & Industry, put the first symbolic trade in the Basmati Rice contract in the presence of Shri K. S. Money, Chairman, Agricultural & Processed Food Products Export Development Authority (APEDA) in the SAARC RICE EXPO 2004 - ‘International Conference on Rice’ on 9th December, 2004 at World Trade Centre, Mumbai.

Commenting on this occasion Mr. Joseph Massey, Dy. MD, MCX said, "The launch of these futures contracts will aid Basmati trade and industry in scores of traditions. The contract has been planned keeping in mind the soaring inter and intra-seasonal variation. Considering this the availability of futures markets for this segment will open immense opportunity for the consumers to cover their price risk and will help them to safeguard themselves against any adverse price movement. Same insight and materialistic output has been demonstrated by MCX in many of other contracts as well."

Basmati rice is best known for its characteristic long-grain, subtle aroma and delicious taste.

India is the largest producer & exporter of basmati rice in the world and produces annually around 10-15 lakh tons of basmati of which around two-thirds is exported.

Basmati is grown exclusively in northern part of Western Punjab (on both sides of the Indo-Pakistan border), Haryana, Uttaranchal and Western Uttar Pradesh.

In 2001-02, basmati rice accounted for 0.89 % of India’s total exports, 6.24% of agricultural exports, 36.96% of food grain exports and 58.14% of rice exports, which underlines the importance of basmati in the Indian commodity basket. Gulf region is the major market for Indian basmati and inside Gulf, Saudi Arabia accounts for the major chunk of basmati imports from India.

The multi-billion Rice industries is a key sector in the Indian economy. The Basmati prices are subjected to high inter and intra-seasonal variations, due to profound influence of weather & monsoon, fluctuating import demands from various countries, Government’s export import policy, economic performance of importing countries, overall sentiments in domestic rice market and supply of fragrant rice from other countries.

The launch of this futures contract will give support to Basmati trade and industry in numerous methods. The traders and dealers keeping stock would be able to sell futures contract at MCX in advance and therefore, they would not lose any money even if the price goes down. In case of any price fall, such dealers would get profit from their sale position in the futures contract.

To start with MCX has launched January, February and March 2005 contracts with contract duration of 4 months. Basmati Rice contract has several unique features, which would enable the players in the

Basmati industry to efficiently mitigate their price risk. Trading and delivery unit has been kept as 10 MT to encourage participation from all sections of the trading community. Price has been quoted per quintal Ex-Delhi, which is the benchmark price for the industry. A small tick-size would facilitate factoring of small variations in the supply & demand of Basmati and the delivery would be in 50 Kg new jute bag, machine stitched only which ensures that the Rice remains in good and high quality and the delivery would be at the exchange approved warehouse at Delhi.

2.2 Leader Speak

Turmoil on the bourses, in the recent past, left every one high and dry. Increased volumes and investor interest, on the other hand, energized the commodities derivative markets. Our attempt towards better understanding of commodities derivative market, its potential in India and an overall perspective on commodities trading in India led us to National Commodity & Derivatives Exchange Ltd (NCDEX), the recently incorporated commodities derivatives exchange that facilitates trading of fifteen commodities - some of them being Gold, Silver, soybean, refined soybean Oil.

Mr. Sabnavis is a post-graduate in Economics from Delhi School of Economics and BA (Hon’s) in Economics from St.Stephen’s College, Delhi. He was associated with L&T Ltd. and ICICI Bank as Chief Economist, between 2002-2003 and 1999-2002 respectively. Apart from his current association with NCDEX, he is also Co-Chairman of Economic and Industrial Affairs Committee, Bombay Chamber of Commerce and Industry.

If we look at the potential of commodity markets globally, we have seen a multiple of 3 to 4 times the equity markets. We see a similar potential in India. This would take 3 to 5 years before this potential could be achieved in the Indian Scenario. The commodity base is a percentage of GDP 45-50 percent. This is inclusive of agriculture, base metals, bullion, energy based products such as electricity, crude oil. Weather

▪ Key participants currently (Trader Profile)

There are two kinds, Traditional Commodity Brokers who had to move away from commodities when the ban was imposed on commodity trading in the sixties and who may have operated in the unorganized sector. The Traditional Equity Broker is diversifying his portfolio and entering into commodities. We are also seeing a lot of retail participants too though this would be in an indirect manner. There is 40:60 ratio of traditional commodity broker to equity broker.

.

▪ Opportunity for retail Investor

The retail level is saying that commodities are offering profitable returns as compared to equity markets. Of course, Gold is giving you 10-15 % on a conservative basis compared with equity markets returns for 15-20 %on an annual basis, but it is less risky than your equity markets. The initial margins in commodities are lower and are in the range of 4-5-6 % compared with 25-40% for equity markets. That is one factor that would enable retail investor to come in the market.

▪ Trading volume

Of the total turnover 50 % is bullion market and 50 % are agro-based commodities. We are seeing a spurt in volumes in Soya Oil, Pepper, Chana, and Guar seeds. Traditionally; commodity players use it as a hedge mechanism. Another way, it is used is to make money. For e.g. in the bullion markets, Players hedge their risks by using futures Euro-dollar fluctuations and International prices affect it. However in case of Soya oil, only Soya-oil dealers are trading in the commodity. This market is based on economic fundamentals and is subject to less market manipulation. You can do the guesswork by looking at the Monsoon, the import-export figures, prices etc to make conjectures.

▪ Views on delivery based trading

There is a common misconception that people feel we are a spot market. We make provision for delivery. Delivery is a part of all futures contracts. Both Buyers and Sellers have the option of taking hold of the product that has been certified by us. We guarantee quality of produce, weight of produce in our accredited warehouses, everything is guaranteed by NCDEX.

What we have seen is because of institutional issues, we have had very few deliveries so far. There are a lot of hassles such as octroi duty, logistics. If there is a broker in Mumbai and a broker in Kolkotta, transportation costs, octroi duty, logistical problems prevent trading to take place. Exchanges are used only to hedge price risk on spot transactions carried out in the local markets. Deliveries are 3-4 % of total volume. Market trend is changing. We are setting up an entire warehousing system. A collateral management company is looking at it on our behalf. There should be a system that is able to hedge the farmer’s position. When the produce is harvested, farmers sell it at lower prices, and the buyer sells it at a higher price 2 months hence. With our accredited warehouses, farmers would be able to get loans from banks, and after 2 months will be able to sell his produce at a higher price, and pay off the loan.

[pic]

3.1 TITLE OF THE PROJECT:

“A study of commodity market”

3.1.1 OBJECTIVES:

➢ TO ANALYZE THE VIEW OF COMMODITY TRADERS.

➢ To make understand the process of future commodity trading in India.

➢ To know the investment pattern of commodity traders and government servants.

3.2 SCOPE:

• TO ANALYZE THE TRADING PATTERN AND INVESTMENT PATTERN OF COMMODITY TRADERS AND GOVERNMENT SERVANTS. THE STUDY WAS LIMITED TO WHOLE RAJKOT CITY.

3.2.1 TIME SCOPE

FOR COMPLETING THIS PROJECT WE HAVE TAKEN A TIME PERIOD OF THREE MONTH WITH OUR STUDY OF THE 4TH SEMESTER.

3.3 SAMPLE DESIGN:

3.3.1 SAMPLING TYPE

IN THIS PROJECT CONVENIENT SAMPLING METHOD IS USED FOR THE SELECTION OF CUSTOMER.

3.3.2 SAMPLING UNIT

TO DEFINE SAMPLING UNIT, ONE MUST ANSWER THE QUESTION THAT WHO IS TO BE SURVEYED. IN THIS PROJECT SAMPLING UNITS ARE COMMODITY TRADERS AND GOVERNMENT SERVANTS.

3.3.3 Sample size

THE SAMPLE SIZE OF THE SURVEY WAS 300 PEOPLE.

3.4 METHODS OF DATA COLLECTION

3.4.1 PRIMARY METHODS

1. QUESTIONNAIRE

3.4.2 SECONDARY METHODS

1. MAGAZINES.

2. NEWSPAPERS

3. WEBSITES

4. BOOKS

5. OTHER PROJECTS.

3.5 FIELDWORK:

In order to gather the primary data associated with our survey commodity traders and government servants over a selected hub of areas in Rajkot, we have undergone an extensive fieldwork. The basic purpose of the fieldwork was, obviously, to record responses of target people.

3.6 LIMITATIONS

• OUR SURVEY WAS RESTRICTED TO RAJKOT CITY.

The sample size for the survey of people was limited to 300 respondents, which might not be representing the whole country.

• The results are totally derived from the respondent’s answers. There might be a difference between the actual and projected results.

• Research also depends on surveyors’ bias & his/her ability to analyze the data & draw conclusion.

• The time duration to carry out the survey of all the areas of Rajkot was very short.

[pic]

4.1 Introduction To Derivatives

The term “Derivative” indicates that it has no independent value, i.e. its value is entirely “derived” from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pro determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real of financial asset of to an index of securities. Derivatives in mathematics, means a variable derived from another variable. Similarly in the financial sense, a derivative is a financial product, which has been derived from a market for another product. Without the underlying product, derivatives do not have any independent existence in the market. Derivatives have come into existence because of the existence of risks in business. Thus derivatives are means of managing risks. The parties managing risks in the market are known as HEDGERS. Some people/organizations are in the business of taking risks to earn profits. Such entities represent the SPECULATORS .The third player in the market, known as the ARBITRAGERS take advantage of the market mistakes.

4.2 The need for a derivatives market

The derivatives market performs a number of economic functions:

➢ They help in transferring risk from risk aware people to risk oriented people.

➢ They help in the discovery of future as well as current prices.

➢ They catalyze entrepreneurial activity.

➢ They increase the volume traded in markets because of participation of risk-averse people in greater numbers.

➢ They increase savings and investment in the long run.

4.3 Factors driving the growth of financial derivatives

➢ Increased volatility in asset process in financial markets,

➢ Increased integration of national financial markets with the international markets,

➢ Marked improvement in communication facilities and sharp decline in their costs,

➢ Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and

➢ Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher

➢ Returns, reduced risk as well as transactions cost as compared to individual financial assets.

➢ A derivative is a financial instrument whose value depends on the value of other, more basic underlying variables.

4.4 The main instruments under the derivative are:

➢ Forward contract

➢ Future contract

➢ Options

➢ Swaps

4.4.1 Forward contract:

A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions of between a financial institution and one of its corporate clients. It is not normally traded on an exchange.

One of the parties to forward contract assumes a long position and agrees to buy he underlying asset on a specified future date for a certain specified price. The other party assumes a position and agrees to

sell the asset on the same date for the same price. The specified price in a forward contract will be referred to as delivery price. The forward contract is settled at maturity. The holder of the short position delivers the asset to the holder price. A forward contract is worth zero when it is first entered into. Later it can have position or negative value, depending on movements in the price of the asset.

4.4.2 Future contract:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contract are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other the exchange also provides a mechanism, which gives the two parties a guarantee that the contract will be honored.

One-way in which future contract is different from a forward contract is that an exact delivery date is not specified. The contract is referred to by its delivery month, and the exchange specifies the period during the month when delivery must be made.

Difference between forward and futures contracts

We may now differentiate between forward and future contracts. Broadly, a future contract is different from a forward contract on the following counts:

1) Standardization: A forward contract is a tailor-made contract between the buyer and the seller where the terms are settled in mutual agreement between the parties. On the other hand, a future contract is standardized in regards to the quality, quantity, place of delivery of the asset etc. Only the price is negotiated.

2) Liquidity: There is no secondary market for forward contracts while futures contracts are traded on organized exchanges. Accordingly, futures contracts are usually much more liquid than the forward contracts.

3) Conclusion of contract: A forward contract is generally concluded with a delivery of the asset in question whereas the future contracts are settled sometimes with delivery of the asset and generally with the payment of the price differences. One who is long a contract can always eliminate his/her obligation by subsequently selling a contract for the same asset and same delivery date, before the conclusion of contract one holds. In the same manner, the seller of a futures contract can buy a similar contract and offset his/her position before maturity of the first contract. Each one of these actions is called offsetting a trade.

An option is a contract, which gives the buyer the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be commodities like wheat/rice/cotton/gold/oil/ or financial instruments like equity stocks/ stock index/bonds etc.

There are basic two types of options. A call options gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability.

Call options usually increase in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.

This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

4.4.4 Swaps:

Swaps are private agreements between two companies to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.

4.4.5 Warrants:

Options generally have lives of up to one year, the majority of options traded on options exchange having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the –counter.

4.4.6 Leaps:

The scronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

4.4.7 Baskets:

Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

4.5 Commodity Derivatives in India

Commodity derivatives have a crucial role to play in the price risk management process especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed and developing countries in the world. The Chicago Mercantile Exchange; Chicago Board of Trade; New York Mercantile Exchange; International Petroleum Exchange, London; London Metal Exchange; London Futures and Options Exchange; “Marche a Terme International de France”; Sidney Futures Exchange; Singapore International Monetary Exchange; The Singapore Commodity Exchange; Kuala Lumpur Commodity Exchange ; “Bolsa de Mercadorias & Futuros” (in Brazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China Commodity Futures Exchange; Beijing Commodity Exchange, etc are some of the leading commodity exchanges in the world engaged in trading of derivatives in commodities.

However, they have been utilized in a very limited scale 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 government controls the production, supply and distribution of many agricultural commodities and only forwards and futures trading are permitted in certain commodity items. Free trade in many commodity items is restricted under the Essential Commodities Ac, 195, and forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act, 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. Many exchanges came up in the agricultural centers in north India before world war broke out and engaged in wheat futures until it was prohibited. The exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was firs organized by IPSTA in Cochin in 1957.

Futures in gold and silver began in Mumbai in 1920 and continued until the government prohibited it by mid-1950s. 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. 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 the along with futures were banned in 1939. However, the government withdrew the ban on futures with passage of Forward Contract (Regulation) Act in 1952.

After the ban of futures trade many 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.

Further in 1993 the government of India appointed an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra and the report of the committee was submitted in 1994 which recommended the reintroduction of futures already banned and to introduce futures on many more commodities including silver. In tune with the ongoing economic liberalization, 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 emerging from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading.

In India, currently there are 15 commodity exchanges actively undertaking trading in domestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association (IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recently upgraded to international exchanges to deal in international contracts in pepper and castor oil respectively. Another 8 exchanges are proposed and some of them are expected to start operation shortly. There are 4 exchanges, which are specifically approved for undertaking forward deals in cotton. More detailed account of these exchanges has been presented.

The proposed study is primarily based on the visit of seven leading exchanges viz., IPST Cochin, which deal in domestic and international contracts in pepper; BCE Ltd., a multy-commodity international exchange where futures in castor oil, castor seed, sunflower oil, RBD Palmolein etc are traded; The East India Cotton Association (EICA) Ltd., Bombay, which is a specialized exchange dealing in forwards and futures in cotton; South India Cotton Association (SICA , Coimbatore which deals in forward contracts in cotton; Coffee Futures Exchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading; Kanpur Commodity Exchange (KCE) which deals with futures contracts in mustard oil and gur; and The Chamber of Commerce, Hapur which undertakes futures trading in gur and potatoes.

4.6 MECHANICS OF FUTURES TRADING

Futures are a segment of derivative markets. The value of a futures contract is derived from the spot (ready) price of the commodity underlying the contract. Therefore, they are called derivatives of spot market. The buying and selling of futures contracts take place in organized exchanges. The members of exchanges are authorized to carryout trading in futures. The trading members buy and sell futures contract for their own account and for the account of non-trading members and other clients. All other persons interested to trade in futures contracts, as clients must get themselves registered with the exchange as registered non-members.

1. What is a Commodity Futures Exchange?

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 chief executive officer and his team in day-to-day administration assist the Board. There are different classes of members who capitalize the exchange by way of participation in the form of equity, admission fee, security deposits, registration fee etc.

a. Ordinary Members: They are the promoters who have the right to have own –account transactions without having the right to execute transactions in the trading ring. They have to place orders with trading members or others who have the right to trade in the exchange.

b. Trading Members: These members execute buy and sell orders in the trading ring of the exchange on their account, on account of ordinary members and other clients.

c. Trading-cum-Clearing Members: They have the right to trade and also to participate in clearing and settlement in respect of transactions carried out on their account and on account of their clients.

d. Institutional Clearing Members: They have the right to participate in clearing and settlement on behalf of other members but do not have the trading rights.

e. Designated Clearing Bank: It provides banking facilities in respect of pay-in, payout and other monetary settlements.

The composition of the members in an exchange however varies. In so me exchanges there are exclusive clearing members, broker members and registered non -members in addition to the above category of members.

1. What is Commodity Futures Contract?

Futures contracts are an improved variant of forward contracts. They are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. While forward contracts are mainly over-the-counter and tailor-made which physical delivery futures settlement standardized contracts whose transactions are made in formal exchanges

through clearing houses and generally closed out before delivery. The closing out involves buying a different times of two identical contracts for the purchase and sale o the commodity in question, with each canceling the other out. The futures contracts are standardized in terms of quality and quantity, and place and date of delivery of the commodity. The commodity futures contracts in India as defined by the FMC has the following features:

(a) Trading in futures is necessarily organized under the auspices of a recognized association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules and Bye-laws of the association.

(b) It is invariably entered into for a standard variety known as the “basis variety” with permission to deliver other identified varieties known as “tender able varieties”.

(c) The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units.

(d) The delivery periods are specified.

(e) The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers.

(f) In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. The terms and specifications of futures contracts vary depending on the commodity and the exchange in which it is traded.

The major terms and conditions of contracts traded in six sample exchanges in India. These terms are standardized and applicable across the trading community in the respective exchanges and are framed to promote trade in the respective commodity For example, the contract size is important for better management of risk by the customer. It has implications for the amount of money that can be gained or lost relative to a given change in price levels. I also affect the margins required and the commission

charged. Similarly, the margin to be deposited with the clearing house has implications for the cash position of customers because it blocks cash for the period of the contract to which he is a party the strength and weaknesses of contract specifications are discussed under constraints and policy options.

2. Who are the Participants in Futures Market?

Broadly, speculators who take positions in the market in an attempt to benefit from a correct anticipation of future price movements, and hedgers who transact in futures market with an objective of offsetting a price risk on the physical market for a particular commodity make the futures market in that commodity. Although it is difficult to draw a line of distinction between hedgers and speculators, the former category consists of manufacturing companies, merchandisers, and farmers. Manufacturing companies who use the commodity as a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at a predetermined price, which facilitates immunity against price fluctuations. While exporters in addition to using the price discovery mechanism for getting better prices for their commodities seek to hedge against their overseas exposure by way of locking-in the price by way of buying futures contracts, the importers utilize the liquid futures market for the purpose of hedging their outstanding position by way of selling futures contracts. Futures market helps farmers taking informed decisions about their crop pattern on the basis of the futures prices and reduces the risk associated with variations in their sales revenue due to unpredictable future supply demand conditions. Above all, there are a large number of brokers who intermediate between hedgers and speculators create the market for futures contracts.

3. Commodity Orders

The buy and sell orders for commodity futures are executed on the trading floor where floor brokers congregate during the trading hours stipulated by the exchange. The floor brokers/trading members on receipt of orders from clients or from their office transmits the same to others on the trading floor by hand signal and by calling out the orders (in an open outcry system they would like to place and price. After trade is made with another floor broker who takes the opposite side of the transaction for another customer or for his own account, the details of transactions are passed on to the clearing house through a transaction slip on the basis o which the clearinghouse verifies the match and adds to its records.

Following the experiences of stock exchanges with electronic screen based trading commodity exchanges are also moving from outdated open outcry system to automated trading system. Many leading commodity exchanges in the world including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International Petroleum Exchange (IPE), London, have already computerized the trading activities. In India, coffee futures exchange, Bangalore has already put in

place the screen based trading and many others are in the process of computerization. To add to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for a common electronic trading platform connecting all commodity exchanges to conduct screen based trading. In electronic trading, trading takes place through a centralized computer network system to which all buy and sell orders and their respective prices are keyed in from various terminals of trading members. The deal takes place when the central computer finds matching price quotes for buy and sell. The entire procedural steps involved in electronic trading beginning from placing the buy/sell order to the confirmation of the transaction have been shown in figure -2.1 below.

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4. Role of Clearing House

Clearinghouse is the organizational set up adjunct to the futures exchange which handles all back-office operations including matching up of each buy and sell transactions, execution, clearing and reporting of all transactions, settlement of all transactions on maturity by paying the price difference or by arranging physical delivery, etc., and assumes all counterparty risk on behalf of buyer and seller. It is important to understand that the futures market is designed to provide a proxy for the ready (spot) market and thereby acts as a pricing mechanism and not as part of, or as a substitute for, the ready market.

The buyer or seller of futures contracts has two options before the maturity of the contract. First, the buyer (seller) may take (give) physical delivery of the commodity at the delivery point approved by the exchange after the contract matures. The second option, which distinguishes futures from forward contracts is that, the buyer (seller) can offset the contract by selling (buying) the same amount of commodity and squaring off his position. For squaring of a position, the buyer (seller) is not obligated to sell (buy) the original contract. Instead, the clearinghouse may substitute any contract of the same specifications in the process of daily matching. As delivery time approaches, virtually all contracts are settled by offset as those who have bought (long) sell to those who have sold (short). This offsetting reduces the open position in the account of all traders as they approach the maturity date of the contract. The contracts, if any, which remain unsettled by offset until maturity date are settled by physical delivery.

The clearinghouse plays a major role in the process explained above by intermediating between the buyer and seller. There is no clearinghouse in a forward market due to which buyers and sellers face counterparty risk. In a futures exchange all transactions are routed through and guaranteed by the clearinghouse which automatically becomes a counterpart to each transaction. It assumes the position

of counterpart to both sides of the transaction. It sells contract to the buyer and buys the identical contract from the seller. Therefore, traders obtain a position vis -à-vis the clearing house. It ensures default risk-free transactions and provides financial guarantee on the strength of funds contributed by its members and through collection of margins (discussed in section 2.3), marking-to-market all outstanding contracts, position limits imposed on traders, fixing the daily price limits and settlement guarantee fund.

The organizational structure and membership requirements of clearinghouses vary from one exchange to the other. The Bombay Commodity Exchange and Cochin pepper exchange have set up separate independent corporations (namely, Prime Commodities Clearing Corporation of India Ltd, and First Commodities Clearing Corporation of India Ltd., respectively) for handling clearing and guarantee of all futures transactions in the respective exchanges. While coffee exchange has clearing house as a separate division of the exchange, many other exchanges like Chamber of Commerce, Hapur; Kanpur Commodity Exchange and cotton exchange in Bombay run in-house clearinghouse as part of the respective exchanges. The clearing and guaranty are managed in these exchanges by a separate committee (normally called the Clearing House Committee).

The membership in the clearinghouse requires capital contribution in the form of equity, security deposit, admission fee, registration fee, guarantee fund contribution in addition to net worth requirement depending on its organizational structure. For example, in the Bombay Commodity Exchange the minimum capital requirement for membership in its clearinghouse as applicable to trading-cum-clearing members is Rs.50,000 each toward equity and security deposit, Rs. 500 as annual subscription , and additionally, members are required to have net worth of Rs.3 lakhs. Similarly, coffee exchange prescribed Rs.5 lakh each towards equity and guarantee fund contribution and Rs.40,000 towards admission fee for a trading-cum-clearing member. However, in exchanges where clearing house is a part of the exchange the payment requirements are lower. For example, Kanpur Commodity Exchange prescribed only Rs.25,00,000 Rs.1000 and Rs.500 respectively towards security deposit, registration fee and annual fee for a clearing cum-trading member.

For ensuring financial integrity of the exchange and for counterparty risk -free trade position (exposure) limits have been imposed on clearing members. These limits which are stringent in some cases and are liberal in other cases are normally linked to the members’ contribution towards equity capital or security deposit or a combination of both and settlement guarantee fund.

In Bombay Commodity Exchange the exposure limit of a clearing member is the sum of 50 times the face value of contribution to equity capital of the clearinghouse and 30 times the security deposit the

member has maintained with the clearinghouse. While coffee exchange prescribes the limit of 80 times the sum of member’s equity investment and the contribution to the guarantee fund, the cotton exchange, Bombay, has stipulated a liberal exposure limit on open positions. It has a limit of 200 and 1500 units (recall that one contract unit is equivalent to 93.5 quintals respectively for composite and institutional members. The Cochin pepper exchange has fixed a net exposure limit of 60 units (equivalent to 1500 quintals) for domestic contract and 90 units (equivalent to 2250 quintals) for international contract. Moreover, setting up of settlement guarantee fund ensures enough financial strength in case the clearinghouse faces default.

The Kanpur Commodity Exchange maintains a trade guarantee fund with a corpus of Rs.100 lakhs while the coffee exchange in addition to a guarantee fund the exchange has substituted itself as party to clear all transactions.

Yet another check on the possible default is through prescribing maximum price fluctuation on any trading day, which helps limit the probable profit/loss from each unit of transaction. The relevant data on permitted price limit has been presented. Its clear from the table that the maximum profit/loss potential from trade in each contract unit varies from as low as Rs. 800 for potato futures in Chamber of Commerce, Hapur to as high as Rs. 15,000 in pepper exchange, Cochin. Similarly, given the permissible open position of 200 units for a trading-cum-clearing member and maximum price fluctuation of Rs. 150 per 100 kg for cotton futures in the cotton exchange, Bombay, the maximum potential loss/profit in a trading day works out to be Rs.28.05 lakhs!

5. Margins

Margins (also called clearing margins) are good -faith deposits kept with a clearinghouse usually in the form of cash. There are two types of margins to be maintained by the trader with the clearinghouse: initial margin and maintenance or variation margins. Initial margin is a fixed amount per contract and does not vary with the current value of the commodity traded. Margins are deposited with the clearing house in advance against the expected exposure of the trading member on his account and on account of the clients. The member who executes trade for them in turn collects this amount from the clients. Generally, the margin is payable on the net exposure of the member.

Net exposure is the sum of gross exposure (buy quantity or sale quantity, whichever is higher, multiplied by the current price of the contract) on account of trades executed through him for each of his clients and gross exposure of trades carried out on his own account. However, for squaring-off transactions carried out only at the clients’ level, fresh margins are not required. The margin is refundable after the client liquidates his position or after the maturity of the contract.

Maintenance margin which usually ranges from 60 to 80 per cent of initial margin is also required by the exchange. Variation margin is to compensate the risk borne by the clearinghouse on account of price volatility of the commodity underlying the contract to which it is a counterparty. A debit in the margin account due to adverse market conditions and consequent change in the value of contract would lead to initial margin falling below the maintenance level. The clearinghouse restores initial margin through margin calls to the client for collecting variation margin. In case of an increase in value of the contract, marking-to-market ensures that the holder gets the payment equivalent to the difference between the initial contract value and its change over the lifetime of the contract on the basis of its daily price movements. If the member is not able to pay the variation margin, he is bound to square off his position or else the clearinghouse will be liquidating the position.

The margins have important bearing on the success of futures. As they are non-interest bearing deposits payable to the clearinghouse up-front working capital of any trading entity gets blocked to that extent. While a higher margin requirement prevents traders from participating in trading, a lower margin makes the clearinghouse vulnerable to any default due to its weak financial strength otherwise. Internationally, many developed exchanges maintain a low margin on positions due to their better financial strength along with massive volume of trade resulting in large income accruing to them.

However, this has not been the case with many exchanges in India. For example, as shown in table 2.2 the initial margin liability for transacting the minimum lot size in pepper is Rs.30, 000 for domestic contracts and US$ 312.50 for international contracts .Similarly, the volume of transactions. These clearinghouses deal in many exchanges in India is abysmally low making their existence financially unviable.

Most of the exchanges in additions to keeping mandatory margins maintain a settlement guarantee fund. The fund set up with the contribution from members of clearing house is used for guaranteeing financial performance of all members. This fund absorbs losses not covered by margin deposits of the defaulted member. The clearinghouse ensures this by settling the default transactions by properly compensating the traders paying the amount of difference at the closing out rate.

6. How does Futures Contract Facilitate Hedging against Price Risk?

The futures contracts are designed to deal directly with the credit risk involved in locking-in prices and obtaining forward cover. These contracts can be used for hedging price risk and discovering future prices. For commodities that compete in world or national markets, such as coffee, there are many

relatively small producers scattered over a wide geographic area. These widely dispersed producers find it difficult to know what prices are available, and the opportunity for producer, processor, and merchandiser to ascertain their likely cost for coffee and develop long range plans is limited. Futures trading, used in the Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955, provides the industry with a guide to what coffee is worth now as well as today’s best estimate for the future. Moreover, since all transactions are guaranteed through a central body, clearing house, which is the counter party to each buyer and seller ensuring zero default risk, market participants need not worry about their counterpart’s creditworthiness.

Hedge is a purchase or sale on a futures market intended to offset a price risk on the physical (ready) market. It involves establishing a position in the futures market again one’s position or firm commitments in the physical market. The producers who seek to protect themselves from an expected decline in prices of their commodity in future go for short hedge (also called sell hedge). He undertakes the following operations in the market to lock-in the price in advance which he is going to receive after the product. I ready for physical sale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2 units of contracts in Cochin pepper exchange) of pepper in March, the futures price for March delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and the prevailing (say, October) ready market price is Rs.8100 per quintal.

a) In October, the producer goes short (sells) in the futures market selling 2 March futures contracts at Rs.8400 per quintal. This is called “price fixing”.

b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sells pepper in the ready market for Rs.8200.

c) Simultaneously, he closes out his short position in futures by buying (long position) 2 March futures contracts at Rs.8200 per quintal. The result is that the producer sold futures contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a net gain of Rs.200 per quintal or Rs.5000 per contract.

For the physical sale, the producer received the market price of Rs.8200 prevailing on the day of the sale and the gain of Rs.200 per quintal from closing-out of futures contracts makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the price realized in the ready market is lower than the price in future contract, the loss on the physical market is compensated by the higher price realized on the future contract. On the other hand, if the price in the ready market is higher than in

futures contract, the gain in the ready market is offset by the loss on the repurchase of the futures contract.

Since futures market prices move in tandem with the ready market prices over the course of time tending to converge as the contract matures, a gain in the futures market in a developed commodity market under normal conditions, will be offset by a loss in the ready market, or vice versa. However, market imperfections will lead to the basis risk emerging from the mismatch between the gain/loss from the futures market not compensated by loss/gain in the ready market.

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COMMODITY FUTURES EXCHANGES –

THE PROFILE AND REGULATORY ENVIRONMENT

4.7 The Profile of Futures Exchanges (mcx and ncdex)

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4.7.1 Overview of MCX

MCX 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 include Financial Technologies (I) Ltd., State Bank of India (India’s largest commercial bank) & associates, Fidelity International, National Stock Exchange of India Ltd. (NSE), National Bank for Agriculture and Rural Development (NABARD), HDFC

Bank, SBI Life Insurance Co. Ltd., Union Bank of India, Canara Bank, Bank of India, Bank of Baroda and Corporation Bank.

Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Through the integration of dedicated resources, robust technology and scalable infrastructure, since inception MCX has recorded many first to its credit.

Inaugurated in November 2003 by Shri Mukesh Ambani, Chairman & Managing Director, Reliance Industries Ltd, MCX offers futures trading in the following commodity categories: Agri Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & Oilseeds, Energy, Plantations, Spices and other soft commodities.

MCX has built strategic alliances with some of the largest players in commodities eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade Association.

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, is well placed to tap this vast potential.

4.7.2 Vision and Mission

The vision of MCX is to revolutionize the Indian commodity markets by empowering the market participants through innovative product offerings and business rules so that the benefits of futures markets can be fully realized .Offering 'unparalleled efficiencies', 'unlimited growth' and 'infinite opportunities' to all the market participants.

| Commodities |

| | |Gold, Gold HNI, Gold M, I-Gold, Silver, Silver HNI, Silver M |

|[pic] | |High Density Polyethylene (HDPE), |

| | |Polypropylene (PP), PVC |

|[pic] |

| | |Guar Seed, Guar gum, Gurchaku, Mentha Oil, Potato, Sugar M-30, Sugar S-30, |

4.7.3 Benefits to Participants

The mark of a true exchange market is that it provides equal opportunities to all participants without any bias. This is the central belief of MCX and towards that it shall be our endeavor to provide all our participants with equally rewarding opportunities. MCX would harmoniously meet the requirements of all the stakeholders in the commodity ecosystem in the most impartial manner.

Benefits to Industry

• Hedging the price risk associated with futures contractual commitments.

• Spaced out purchases possible rather than large cash purchases and its storage.

• Efficient price discovery prevents seasonal price volatility.

• Greater flexibility, certainty and transparency in procuring commodities would aid bank lending.

• Facilitate Informed lending

• Hedged positions of producers and processors would reduce the risk of default faced by banks

• Lending for agricultural sector would go up with greater transparency in pricing and storage.

• Commodity Exchanges to act as distribution network to retail agri-finance from Banks to rural households.

• Provide trading limit finance to Traders in commodities Exchanges.

Benefits to Exchange Members

• Access to a huge potential market much greater than the securities and cash market in commodities.

• MCX would leverage on the vast experience of NSE in the capital markets and NABARD for its strong presence in the rural agricultural markets

• Robust, scalable, state-of-art technology deployment.

• Member can trade in multiple commodities from a single point, on real time basis.

Traders would be trained to be Rural Advisors and Commodity Specialists and through them multiple rural needs would be met, like bank credit, information dissemination, etc.

4.7.4 Winning Edge

Value Proposition - MCX's most important differentiator and strength is that it is an independent and a de-mutualized exchange since inception. This is further strengthened by participation from different constituents of the market, such as banks, financial institutions, warehousing companies and other stakeholders of the marketplace. Moreover, experienced professionals with deep knowledge of the commodity markets as well as exchange management experience manage MCX.

Neutral Image - MCX has de-mutualized status from inception that allows formation of a broad, collaborative business partnership.

Strategic Equity Partnerships - MCX has consolidated it base by entering into strategic equity partnership with leading nationalized banks like State Bank of India, HDFC Bank, National Stock Exchange (NSE), National Bank for Agriculture and Rural Development (NABARD), 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.

Trade Support - MCX has already tied up exclusively with some of the largest players in this eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade Association.

FTIL: Technology Partner - It is here that MCX gets the strategic advantage of having Financial Technologies (India) Ltd. as its technology partner for delivering technologically advanced solutions to market participants. FTIL's proven class of end-to-end Exchange Trading technologies

addressing Trading / Surveillance / Clearing and Settlement operations would deliver a cutting-edge to the MCX Trade Life Cycle i.e. Pre-Trade, Trade and Post-Trade operations. In addition to its (technology) technological capabilities, FTIL also brings to MCX its deep engagements with technology giants such as Microsoft / Intel and HP which would be used to gain the competitive edge in gaining foothold in global markets.

4.7.5 Operations

Trading

The trading system of MCX is state-of-the-art, new generation trading platform that permits extremely cost effective operations at much greater efficiency. The Exchange Central System is located in Mumbai, which maintains the Central Order Book. Exchange Members located across the country are connected to the central system through VSAT or any other mode of communication as may be decided by the Exchange from time to time. The Exchange would gradually also consider providing an internet based access. The controls in the system are system driven requiring minimum human intervention. The Exchange Members places orders through the Traders Work Station (TWS) of the Member linked to the Exchange, which matches on the Central System and sends a confirmation back to the Member.

Risk Management

The macro objective of MCX's Risk Management System is to financially secure the marketplace and its participants at all times, without increasing the operational cost or compliance overheads of market participants. Some of the basic parameters of Risk Management are as follows:

Risk Management parameters

➢ Real-time Margining.

➢ Quantity (position) limits.

➢ Exposure limits linked to value of outstanding positions and the capital deployed.

➢ Daily Loss Limits.

➢ Daily Price Limits.

➢ Special Margins.

Settlement

The Clearing and Settlement System of the Exchange is system driven and rule based.[pic]

Clearing Bank Interface

Exchange maintains electronic interface with its Clearing Bank. All Members of the Exchange are having their Exchange operations account with the Clearing Bank. All debits and credits are affected electronically through such accounts only.

Delivery and Final Settlement

All contracts on maturity are for delivery. MCX specifies tender and delivery periods. For example, such periods can be from 8th working day till the 15th day of the month - where 15th is the last trading day of the contract month - as tender and/or delivery period. A seller or a short open position holder in that contract may tender documents to the Exchange expressing his intention to deliver the underlying commodity. Exchange would select from the long open position holder for the tendered quantity. Once the buyer is identified, seller has to initiate the process of giving delivery and buyer has to take delivery according to the delivery schedule prescribed by the Exchange.

4.7.6 Technology Edge

Exchange markets and operations will undergo a paradigm shift in their behavior and would be increasingly driven for providing integrated processes and services to the trading community. Moreover, Exchanges today need to deliver highest levels of service backed by strong technology to bring increased participation at lowest possible costs .It is here that MCX gets the strategic advantage of having Financial Technologies (India) Ltd. as its technology partner for delivering technologically advanced solutions to market participants. FTIL's proven class of end-to-end Exchange Trading technologies addressing Trading / Surveillance / Clearing and Settlement operations would deliver a cutting-edge to the MCX Trade Life Cycle i.e. Pre-Trade, Trade and Post-Trade operations.

4.8 NCDEX PROFILE

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4.8.1 Profile

National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed online multi commodity exchange promoted by 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 Fertilizer Cooperative Limited (IFFCO) and Canara Bank by subscribing 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 bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nationwide reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has commenced its operations on December 15, 2003.

NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an independent Board of Directors and professionals not having any vested interest in commodity markets. It is committed 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 Market 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.

NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India. The reach will gradually be expanded to more centers.

NCDEX currently facilitates trading of 45 commodities - Cashew, Castor Seed, Chana, Chilli, Coffee - Arabica, Coffee - Robusta, Common Parboiled Rice, Common Raw Rice, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Groundnut (in shell), Groundnut Expeller Oil, Grade A Parboiled Rice, Grade A Raw Rice, Guar gum, Guar Seeds, Guar, Jeera, Jute sacking bags, Indian 28 mm Cotton , Indian 31 mm Cotton , Lemon Tur, Maharashtra Lal Tur, Masoor Grain Bold, Medium Staple Cotton, Mentha Oil , Mulberry Green Cocoons , Mulberry Raw Silk , Rapeseed - Mustard Seed, Pepper, Raw Jute, RBD Palmolein, Refined Soy Oil , Rubber, Sesame Seeds, Soy Bean, Sponge Iron, Sugar, Turmeric, Urad (Black Matpe), V-797 Kapas, Wheat, Yellow Peas, Yellow Red Maize, Yellow Soybean Meal, Electrolytic Copper Cathode, Mild Steel Ingots, Sponge Iron, Gold, Silver, Brent Crude Oil, Furnace Oil. At subsequent phases trading in more commodities would be facilitated.

NCDEX PRODUCTS

|Agro Products |

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|Cashew |

|Castor Seed |

|[pic][pic][pic][pic][pic][pic][pic] |

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|Chana |

|Chilli |

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|Coffee - Arabica |

|Coffee - Robusta |

| |

| |

|[pic] |

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| Precious Metals |

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|Gold |

|[pic] |

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|Silver |

| |

| |

| |

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4.8.2 The Shareholders

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ICICI Bank is India's largest private sector bank and the second largest bank in the country, with total assets of over Rs. 1 trillion. ICICI Bank's equity shares are listed at various stock exchanges in India and its American Depositary Receipts (ADRs) are listed on the New York Stock Exchange (NYSE). ICICI Bank’s long-term foreign currency debt is rated one notch higher than the sovereign rating for India by Moody’s, the international rating agency.

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National Stock Exchange (NSE) was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992, with the objective of establishing a nation-wide trading facility for equities, debt instruments and hybrids, by ensuring equal access to investors all over the country through an appropriate communication network. It also provides a fair, efficient and transparent securities market to investors using electronic trading systems. NSE enables shorter settlement cycles and book entry settlements systems, and meeting the current international standards of securities markets.

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CRISIL Limited (formerly The Credit Rating Information Services of India Limited) was incorporated in 1987. CRISIL offers a comprehensive range of integrated product and service offerings - real time news, analyzed data, incisive insights and opinion, and expert advice - to enable investors, issuers, policy makers de-risk their business and financial decision making, take informed investment decisions and develop workable solutions. CRISIL helps to precisely understand measure and calibrate myriad risks - financial and credit risks, price and market risks, exchange and liquidity risks, operational, strategic and regulatory risks.

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An Act of Parliament, Life Insurance Corporation of India Act, 1956, established Life Insurance Corporation of India (LIC). It took over 244 private life insurance business companies then existing. It is a wholly government owned organization with an initial capital of Rs.5 Crores contributed by the GOI. Its mission is to ensure and enhance the quality of life of people through financial security by providing Life Insurance products and services of high quality, and by providing resources for economic development. LIC is the largest life insurer in the country.

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Established in 1895 at Lahore, then undivided India, Punjab National Bank (PNB) has the distinction of being the first Indian bank to have been started solely with Indian capital. The bank was nationalized in July 1969 along with 13 other banks. From its modest beginning, the bank has grown in size and stature to become a front-line banking institution in India at present. It has more than 4000 branches and over 400 extension counters. Strong correspondent banking relationship, which it maintains with over 200

leading international banks all over the world, enhances its capabilities to handle transactions worldwide. More than 50 renowned international banks maintain their Rupee Accounts with PNB.

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National Bank for Agriculture and Rural Development (NABARD) was established on 12 July 1982 with an initial capital of Rs. 100 crore. The capital is enhanced to Rs.2000 crore subscribed by Govt. of India and Reserve Bank of India.

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During mid- sixties, the co-operative sector in India was responsible for distribution of 70 per cent of fertilizers consumed in the country. This Sector had adequate infrastructure to distribute fertilizers but had no production facilities of its own and hence dependent on public/private Sectors for supplies. To overcome this lacuna and to bridge the demand supply gap in the country, a new cooperative society was conceived to specifically cater to the requirements of farmers. It was an unique venture in which the farmers of the country through their own co-operative societies created this new institution to safeguard their interests. The numbers of co-operative societies associated with IFFCO have risen from 57 in 1967 to more than 36,000 now.

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Founded as 'Canara Bank Hindu Permanent Fund' in 1906, by late Sri Ammembal Subba Rao Pai, a philanthropist, this small seed blossomed into a limited company as 'Canara Bank Ltd.' in 1910 and became Canara Bank in 1969 after nationalization. Canara Bank is one of the premier banks in the country, accredited with umpteen distinctions. The present stature of the Bank is due to its strong fundamentals and quality customer orientations. Profit making organization since inception, the Bank today epitomizes a perfect blend of commercial and social banking.

Presently, 15 exchanges are in operation in India carrying out futures trading activities in as many as 30 commodity items (details are given in table-3.1). Moreover, permission has been given to another two exchanges viz., The First Commodities Exchange of India Ltd, Kochi (for copra/coconut, its oil and oilcake), and Keshav Commodity Exchange Ltd., Delhi (for potato), where futures trading is expected to

start soon. The government has also permitted four exchanges viz., East India Cotton Association, Mumbai; The Central Gujarat Cotton Dealers Association, Vadodara; The South India Cotton Association, Coimbatore; and The Ahmedabad Cotton Merchants Association, Ahmedabad, for conducting NTSD contracts (explained below) in cotton. Lately, as part of further liberalization of trade in agriculture and dismantling o Essential Commodities Act (ECA), 1955 futures trade in sugar has been permitted and three new exchanges viz., e-Commodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and e–Sugar India.Com, Mumbai, have been given approval for conducting sugar futures.

A brief profile of the exchanges which are currently in operation has been presented. Many of these exchanges have become weaker in spite of considerable membership strength and potential for large volume of trade. Some of the observations drawn on the basis of visit to six of these exchanges have been presented in the later part of this paper. The number of members who are actively involved in trading in all these exchanges is abysmally low. Any attempt to revive the exchanges and rejuvenate the futures market in India needs an investigation into why members shy away from trading. It is interesting to note that even in case of commodities in which very active domestic and international ready market exists with volatile prices, futures trade in those commodities are no attraction to the merchandisers. The pepper exchange located in Cochin which is known for futures trade in spices for over five decades has not attracted many traders. It is the only exchange in the world engaged in trading of futures in pepper. Kerala being the producer of lion’s share (around 95 per cent) of pepper in India and Cochin being the port city where majority of pepper exporters are operating the existing futures exchange is expected to have a larger role to play. However, in spite of having more than 150 members in the exchange, only around 10 members’ cubicles in the trading ring found to have the presence of their representatives during the trading hour. A further inquiry in to the issue reveals that these members have been trading for generations and no new member is coming forward to the business. The members of the exchange still choose to retain the status of the exchange as a single-commodity exchange!

The Bombay Commodity Exchange arguably the richest exchange in India in terms of it infrastructure is also facing the problem of empty trading ring. Though he exchange has membership strength close to 600, only less than 5 members are actively trading. It is clear from the data given in table-3.1 that the volume in castor seed futures declined from 2.53 lakh tonnes during 1996-97 to just 10,000 tonnes during 2000-01. The cotton exchange in Mumbai which is one of the oldest exchanges in the country has a different story to tell. Cotton has a long tradition of futures trading in India. Cotton futures started in 1857 and continued until it was suspended in 1966. Cotton has large potential for futures trading due to its uncontrolled and uncertain supply and variability of prices. While prices within a crop season fluctuate between 7.5 to 26.2 per cent in the last decade, its output varied as much as 14 percent from one year to the next. It has a very strong domestic and international market. India is the third largest producer and the second largest consumer of cotton in the world. Moreover, cotton is placed under OGL list with zero import duty, and quota system for its exports is likely to be dismantled by 2005. Nevertheless, the present status of cotton exchange and the Indian cotton futures contract is no

different from other exchanges. Although the exchange has membership strength over 400, not more than 10 members actively trade in the exchange. It is often argued by the exchange authorities that the government’s indirect control on supply of cotton and on prices by its procurement makes the futures market unattractive. Futures market in many other commodities indeed shows that there is scope for the rejuvenation of this sector in the country. The buoyant trading activities in the newly started National Board of Trade at Indore, the old exchanges like the Chamber of Commerce, Hapur; Viajai Beopar Ch amber, Muzaffarnagar; Ahmedabad Commodity Exchange; Bhatinda oil exchange; The East India Jute Exchange, Calcutta, etc., are the indications of prospects of futures trade in agricultural commodities.

4.9 Regulation of Commodity Futures

Merchandising and stockholding of many commodities in India have always been regulated through various legislations like the Essential Commodities Act, 1955 (ECA, 1955) and Forward Contracts (Regulation) Act, 1952, (FCRA, 1952) and Prevention of Black marketing and Maintenance of Supplies of Commodities Act, 1980. The ECA, 1955 gives powers to control production, supply, distribution, etc. of essential commodities for maintaining or increasing supplies and for securing their equitable distribution and availability at fair prices. Using the powers under the ECA, 1955 various Ministries/Departments of the Central Government have issued control orders for regulating production/distribution/quality aspects/movement etc. pertaining to the commodities which are essential and administered by them.

The FCRA, 1952 provided for 3-tier regulatory system for commodity futures trading in India:

(a) An association recognized by the Government of India on the recommendation of Forward Market Commission,

(b) The Forward Markets Commission and

(c) The Central Government Stock exchanges and futures markets being a part of the Union list their regulation is the responsibility of the central government.

All types of forward contracts in India are governed by the provisions of the FCRA, 1952. The Act divides commodities into three categories with reference to extent of regulation.

(a) The commodities in which futures trading can be organized under the auspices of recognized association,

(b) The commodities in which futures trading is prohibited and

(c) The free commodities which are neither regulated nor prohibited. While options in goods are prohibited by the FCRA, 1952, the ready delivery contracts remain outside its purview. The ready delivery contract as defined by the Act is the one which provides for the delivery of goods and payment of a price therefore, either immediately or within a period not exceeding eleven days after the date of the contract. All ready delivery contracts where the delivery of goods and/or payment for goods is not completed within eleven days from the date of the contract are forward contracts.

The Act classified forward contracts into two:

(a) Specific delivery contracts and

(b) Other than specific delivery contracts or futures contracts. Specific delivery contract means a forward contract which provides for the actual delivery of specific qualities or types of goods during a specified time period at a price fixed thereby or to be fixed in the manner thereby agreed and in which the names of both the buyer and the seller are mentioned.

The specific delivery contracts are of two types: transferable and non-transferable. The distinction between the transferable specific delivery (TSD) contracts and non - transferable specific delivery (NTSD) contracts is based on the transferability of the rights or obligations under the contract. Forward trading in TSD and NTSD contracts are regulated by the government. As per the section 15 of the FCRA, 1952 every forward contract in notified goods (currently 36 commodity items) which is entered into except those between members of a recognized association or through or with any such member is treated as illegal or void (see appendix I for the list). As per the section 17(1) of the Act, 82 items are prohibited for forward contract (see appendix II for the list). The section 18(1) of the Act exempts the NTSD contracts from the regulatory provisions. However, over the years the regulatory provisions of the Act were applied to the NTSD contracts and 79 commodity items are currently prohibited for NTSD contracts under section 17 of the Act (see appendix III for the list). Moreover, another 15 commodity items are brought under the regulatory provisions of the section 15 of the Act out of which trading in the NTSD contract has been suspended in 12 items (see appendix IV for the list). At present, the NTSD contracts in

cotton, raw jute and jute goods are permitted only between, through or with the members of the associations specifically recognized for the purpose.

Subsequent to the report of the Committee on Forward Markets (known as the Kabra Committee) submitted in 1994 the government has so far permitted futures trading in nearly 35 commodities under the auspices of 23 commodity exchanges located in different parts of the country.

The commodities in which futures trading is permitted are: pepper, turmeric, gur, castorseed, Hessian, jute sacking, cotton, potato, castor oil soyabean and its oil and cake, coffee, mustardseed and its oil and oilcake, ground nut and its oil, sunflower oil, copra/coconut and its oil and oilcake, cottonseed and its oil and oilcake, kapas, RBD palmolein, rice bran and its oil and oilcake, sesame seed and its oil and oilcake, safflower seed and its oil and oilcake, and sugar. This list may get enlarged with the repeal of ECA, 1955 and with further liberalization of farm sector as envisaged in the National Agricultural Policy, 2000 and the Union Budget, 2002-03.

The exchanges are required to get prior approval of the FMC for opening of each contract in commodities which are notified under the relevant sections in FCRA 1952. Regulation is essential especially in a private ownership and market oriented system to ensure the necessary checks and balances in the system. However, stringent and continuous regulation for long period of time would do no good to the system. The initial stringent regulation should ensure that a foolproof and growth oriented control system in terms of set up of the exchange and its sound management, a clearinghouse which can promote trade and its financial integrity, sound and facilitating contract terms and conditions, etc. is in place. The exchanges are already assumed to be self-regulatory agencies. Their role must get strengthened further along with FMC minimizing its role as a facilitator making the existing regulation an ‘appropriate regulation’.

4.9.1 Futures Trading Commodity Exchanges and Forward Markets Commission.

1. 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.

|22.** |Multi Commodity Exchange Ltd., Mumbai |Several Commodities (Please see the site of the|

| | |Exchange at www.mcx.com) |

|23 |Bikaner commodity Exchange Ltd., Bikaner |Mustard seed its oil & oilcake, Gram. Guar |

| | |seed. Guar Gum |

|24 |Haryana Commodities Ltd., Hissar |Mustard seed complex |

|25 |Bullion Association Ltd., Jaipur |Mustard seed Complex |

4. In-principle approval for trading in the specified commodities has been given to the following Exchanges/proposed Exchanges:-

| Serial. No. |Name of the Association |Commodities |

|1. |M/s. NCS InfoTech Ltd., Hyderabad |Sugar |

|2. |Unites Planters Association of South India, Connors (u/s 14B) |Tea |

|3. |SGI Commodity Exchange, Mumbai |Soya bean Ground nut their oils and |

| | |oilcakes. |

These Associations/Exchanges are at different stages of completing the procedural formalities for setting up the exchange/commencing trading.

5. After assessing the market situation and taking into account the recommendations made by the Board of Directors of the Exchange, the FMC prescribes various regulatory measures from time to time, for prudential regulation of futures/forward trading.

6. Under a World Bank aided Grant Scheme to support development of commodity futures markets in India, a number of consultancy assignments, training programmes, study tours, office

automation of FMC etc. have been undertaken. The project was successfully completed on 31st October, 2000. A Plan Scheme under the 10th Five Year Plan for generating awareness about the activities, mechanism and benefit of futures trading among farmers is being implemented.

7. Under a USAID Technical Co-operation programmed on Commodity Futures, the Government of India has entered into an agreement with USAID for capacity building in Indian commodities derivatives market. The capacity building includes training, seminars, consultancy studies and visits to foreign regulators and exchanges. The short term component of this programmes likely to be completed by the end of November, 2004.

8. 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 bye-laws 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.

9. The Government has proposed to initiate steps to integrate the commodities markets and securities markets. A Working Group set up in this connection has submitted its report to the Government indicating the road map for convergence of securities and commodities derivatives markets and their regulatory systems.

4.10 Commodity Futures Markets in India: present scenario

Major reforms have been initiated in commodity futures markets in India since the last few years. An article1 by this author in this Journal compared the growth trajectories being followed by the commodity derivatives market vis-à-vis the securities derivatives markets in India at the dawn of the millennium. It was observed that though derivatives trading commenced in the securities market only in June 2000 it was growing at great speed while the commodity derivatives markets which were operational for about 48 years by then was only gradually waking up. However, subsequent few years have witnessed major changes in the commodity spectrum despite the several institutional constraints in which commodity derivatives markets still function. Commodity futures trading in India was in a state of hibernation for four decades, which was marked by suspicion on the benefits of futures trading. This

is replaced by policy, institutional and market activism in the last few years. This is partly a response to the predominant role being assigned to the market forces in price determination and the consequent need for providing market-based derisking tools. It is also the result of a growing awareness that derivatives trading do perform substantial risk mitigating functions to the stakeholders. This resurgence of interest in commodity derivatives is timely since global commodity cycle is on the upswing, and experts have predicted that we are in the decade of the commodities.

Concomitant to the newfound policy initiatives the market has responded by setting up modern institutions (Nation-wide Multi-Commodity Exchanges, (NMCE) and adapting some of the “best” practices such as electronic trading and clearing.

The projections of commodity derivatives trading, though widely variant in the range of Rs. 30-50 trillion and needs to be calibrated with sound assumptions, indicate the enormous potential of this sector not only in terms of trading but also in terms of the opportunities for developing value-added services in terms of quality warehousing, gradation and certification services, financial intermediation, modern marketing practices, modern clearing and settlement mechanism. Once the market becomes liquid the old complaint, that the Indian commodity derivatives markets do not meet the basic objectives of price discovery (with many studies indicating backwardation common place) and risk management may also vanish.

The most important changes that have taken place in the commodity futures space were the removal of prohibition on futures trading in a large number of commodities and the facilitation of setting up modern, demutualised exchanges by the Government of India. These two initiatives together are becoming instrumental in changing the contours of the commodity futures markets in India in terms of both participation and practices. There are, however, still a number of obstacles in fully exploiting the opportunities available to the commodity eco-system. The views expressed and the approach suggested in this paper is of the author and not necessarily of NSE.

1. ‘Securities Market and Commodity Derivatives Markets – “Rush” vs. Slow Growth?’ (NSE News, December 2001). A comparative profile of the commodity derivatives markets with that of the nascent securities derivatives market was made since no comparison of the Indian derivatives markets would be useful with any counter part. This was because of the chequered history of Indian commodity derivatives trading from that of a flourishing market formally started in 1875 with the setting up of the Bombay Cotton Association but which went into disrepute during the “scarcity decades” of the 1960s and

70s. A comparison revealed that the rapid strides made by the securities derivatives segment in a short span was because of its sound institutional frame work in the spot side while the spot market acted as a drag on the progress of the derivatives markets in commodities.

2. The NMCEs marked a major paradigm shift in the institutional structure and market architecture of commodity futures markets. Drawing heavily from the ‘NSE model’ in the securities markets these institutions are expected to unleash a chain of value added functions in the commodity derivatives markets as well as in the commodity spot market through a host of ‘extra functions’ they are expected to perform. These include warehouse receipt based deliveries which would require transferability and negotiability of warehouse receipts and its de-materialization, entry of corporate, banks, financial institutions and FIIs in commodity futures trading, dissemination of information relating to the physical markets and prices, adoption of the best technology in trading, clearing and settlement and so on. The NMCEs have started exhibiting a penchant for innovations as reflected in their attempts at co-opting warehousing agencies, bringing about transferability and de-mating of warehouse receipts account, though in a limited manner (because of the absence of a legal frame work) association of banks (for other than trading activities as trading in commodities is still prohibited for banks) “polling” of price information from the spot markets(from mandies)commencement of evening trading session to align domestic markets with the global markets and so on(see Economic Survey 2003-04).

3. Several studies particularly by Jain & Naik (1999), Thomas (2003), Sahadevan (2002) etal have indicated that only in a few cases the commodity futures markets performed its basic objective of discovering efficient prices. While the studies’ focus were different the general picture emerging was that only in the case of commodities with reasonable volumes of trading, like castor seed and pepper, the markets achieved the objective of price discovery to some extent. However, since the markets in general were too shallow the results were not unexpected.

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5.1 PESTEL FRAMEWORK

Now, in a particular geographic region, the environment there affects the retailers in the region in various ways. We have studied the effects under the following heads:

1. Political factors

2. Economic factors

3. Social (Socio-Cultural) factors

4. Technological factors

5. Environmental factors

6. Legal factors

5.1.1 Political Factors

With the liberalization of economy, many commodities are imported and exported. Commodities market is directly affected with government by applying octroi duty, stamp duty, import export duty etc. Now-a-days government is also planning for going to introduce compulsory deliveries who are entered into future contracts. This kind of thinking will definitely affect the daily volume (turnover) of exchanges. One of the major factor is quota system which is applied in various commodities like sugar, textile etc.

5.1.2 Economic Factors

The type of economic system (capitalism or socialism etc.) existing in a country has a direct bearing on the potential for and the development of the commodities industry in that country. An investor cannot escape from the effects of the factors in the macroeconomic and microeconomic environment, be it domestic or global that influences the local market.

Inflation, duties, interest rates, tax levels and the GDP are some aspects of the economy, which an investor must cope with.

Real growth makes more income available to investors who then tend to spend more, leading to higher risks and more profits for their investment. As the economy expands, higher demand levels lead more investors into the market, trying to fulfill their ROI.

5.1.3 Social Factors

The demographic trend and lifestyle patterns, of the society that an investor intends to serve, decide the investments strategy. The investors, who are dealing in the equity market, will go to learn the terminology of derivatives and gradually show the interest in commodities market. Secondly, those people who are already doing business as a grain merchant and commission agent for various commodities are also going to take part in commodities market because of recent market situation and past experience will going to help them a lot. They can also predict future movement toward particular commodities and get profit out of them. Thirdly, those who are dealing in metal industry like gold, silver, etc. traditionally known as jewelers, soni are also taking interest in commodities market because of their blood business.

5.1.4 Technological Factors

Technology is probably the most dynamic change agent for the commodity industry. Earlier system was used which was known as barter system. After words a renewed system was introduced by government which was known as currency system. In this system, people are buying and selling goods and services respectively by giving or receiving currency instead.

But drastic change is done when computerize system is introduced. In this particular system, investors can make trade in any commodities at any place any time (during market hours) by only pressing one key. Computerize system is very customize for each and every investor who can select group of commodities in which he or she wants to deal on their computer. It makes the investor’s life a lot easier by facilitating the use and developments of various software like ODIN.

5.1.5 Environmental Factors

In recent market scenario, there are many commodities which are depends on various season like winter, monsoon and summer respectively. There are many agro commodities which are based their crop quality and quantities on the rain fall. There are commodities which are trading most frequently during their seasonal duration and visa-a-versa. In this particular situation, commodities price and volume may going to rise or fall.

5.1.6 Legal Factors

Commodity market is ever affecting industry by legal factors. There are many entities which are regulated by governing bodies like FMC (Forward Market Commission), SEBI (Security Exchange Board of India), MCX (Multi Commodity Exchange), NCDEX (National Commodity & Derivatives Exchange), NMCE (National Multi Commodity Exchange) etc. These bodies are governing bodies so each and every trader and broker have to follow those guidelines which are building and developed by the governing bodies. They have to precise in taking and maintain initial margin, brokerage, stamp duties, demat charges etc.

CHART ANALYSIS

(1) WHICH of the following investment market, you generally prefer for investment?

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Here, we can see that 31% businessmen and government employee are invested their income in their own business out of 100% businessmen and government employee. There are 18% businessmen and government employee who are invested in equity markets for doing speculation and investment purposes. There are 10% businessmen and government employee who are invested in mutual funds for doing speculation and investment. There are 19% businessmen and government employees who are invested their income in bank deposits. There are only 8% businessmen and government employee who are invested in commodity market. We can see that there are not as much as awareness as compare to equity markets yet all businessmen and government employee are related to do business in commodities, which are traded on exchange like shares.

(2) Are you interested to know about the future commodity trading?

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There are only 38% businessmen and government employee who are interested to know about future commodity market because they are also doing trading in future equity markets. There are 68% businessmen and government employee who are not interested to know about future commodity

market because they told that it is all about speculation purpose and also not doing trading in equity market.

(3) how much % of people prefer to deal with tips?

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(4)in which segment people want to deal?

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RESEARCH FINDINGS AND CONCLUSIONS

← Commodity derivatives have a crucial role to play in the price risk management process. Especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed as well as developing countries in the world. However, they have been utilized in a very limited scale in India

← The production, supply and distribution of many agricultural commodities are controlled by the government and only forwards and futures trading are permitted in certain commodity items.

← The most things we have seen are that the awareness of future commodity trading is still not there.

← People who knows, they believe that operators and big players in the market drive this future commodity market.

← Most of people’s feel that the qualities of the commodities are not as per the requirement.

← For the process of taking or giving delivery in future commodity market is lengthy, costly, and required so many documents.

← The option trading is still not allowed in commodity market so the risk management process is incomplete. Because we all know that future trading has its own limits.

← The account opening process of future commodity trading is lengthy and requires more documents.

← The delivery centers of commodities are very less in India compare to other developed countries.

← People still considering that to invest in commodity market is very risky.

← People still considering commodity market for speculation rather than business purpose.

← The whole industry is highly sensitive towards national and international’s environmental and political factors.

Suggestion and recommendation

➢ The FMC should allow Option trading in commodity market in India.

➢ The FMC has to take some steps to increase the awareness of future commodity trading India.

➢ The FMC has to encourage the mutual fund companies and institutional investors to invest in commodity market in India.

➢ The government has to allow FIIs to invest in commodity market in India.

➢ The FMC should have concrete plan to stop “Dabba trading” in commodity market in India.

➢ The FMC should increase the range of commodities in future commodities in commodity market in India.

➢ To motivate the commodity business in India the FMC should come up with some rebate in taxes.

➢ The FMC should increase the delivery centers of commodities in India.

➢ As commodity market is very potential for business, the angel co. should think about various ways to attract the customers.

Questionnaire

Name: - _______________________________________________________

Address: - _____________________________________________________

Contact No: - __________________________________________________

Profession: - ___________________________________________________

E-mail id: - _____________________________________________________

Where do you invest your fund?

Bank post office

Mutual fund Stock market

Insurance Real assets

Govt. Bonds IPO

Gold/ Silver others (specify) _______________

Investment Decision ?

Self analysis

Tips from Experts

Tips from friends / relatives

Business Channels

Others (Specify) __________

Duration of attachments with commodity market ? _________

In which of following you deal with:

Metal Crops

Oil cereals & Pulses

Spices Energy

Bullions

Which type of trading you prefer to deal with?

Square up mode Arbitrage

Intraday Hedging

Delivery based

Exchange you prefer to deal with?

MCX NCDEX

How do you view your self?

Short term investor

Trader

Speculator

9.1 WEBSITES

➢ www.msfpl.com

➢ www.mcxindia.com

➢ www.ncdex.com

➢ www.kitko.com

➢ www.commodityindia.com

➢ www.indiainfoline.com

➢ www.fmc.gov.in

➢ www.dgcx.com

➢ www.lmcx.com

➢ www.cbot.com

9.2 NEWSPAPERS & MAGAZINES

➢ Dalal Street

➢ Commodity World

➢ Chartered Financial Analyst

➢ Economic Times

➢ Business News

➢ Business Standard[pic]