MCX Study material

Contents

1 Introduction to derivatives 91.1 Derivatives defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91.2 Products, participants and functions . . . . . . . . . . . . . . . . . . . . . . . . 101.3 Derivatives markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.3.1 Spot versus forward transaction . . . . . . . . . . . . . . . . . . . . . . 121.3.2 Exchange traded versus OTC derivatives . . . . . . . . . . . . . . . . . . 121.3.3 Some commonly used derivatives . . . . . . . . . . . . . . . . . . . . . 14

2 Commodity derivatives 172.1 Difference between commodity and financial derivatives . . . . . . . . . . . . . 17

2.1.1 Physical settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172.1.2 Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192.1.3 Quality of underlying assets . . . . . . . . . . . . . . . . . . . . . . . . 20

2.2 Global commodities derivatives exchanges . . . . . . . . . . . . . . . . . . . . . 202.2.1 Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222.2.2 Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222.2.3 Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.3 Evolution of the commodity market in India . . . . . . . . . . . . . . . . . . . . 222.3.1 The Kabra committee report . . . . . . . . . . . . . . . . . . . . . . . . 232.3.2 Latest developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3 The NCDEX platform 293.1 Structure of NCDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3.1.1 Promoters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303.1.2 Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3.2 Exchange membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303.2.1 Trading cum clearing members (TCMs) . . . . . . . . . . . . . . . . . . 303.2.2 Professional clearing members (PCMs) . . . . . . . . . . . . . . . . . . 31

3.3 Capital requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313.4 The NCDEX system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

3.4.1 Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323.4.2 Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333.4.3 Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

4 CONTENTS

4 Commodities traded on the NCDEX platform 354.1 Agricultural commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

4.1.1 Cotton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364.1.2 Crude palm oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.1.3 RBD Palmolein . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404.1.4 Soy oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414.1.5 Rapeseed oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434.1.6 Soybean . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444.1.7 Rapeseed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

4.2 Precious metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474.2.1 Gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484.2.2 Silver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

5 Instruments available for trading 575.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

5.1.1 Limitations of forward markets . . . . . . . . . . . . . . . . . . . . . . 585.2 Introduction to futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

5.2.1 Distinction between futures and forwards contracts . . . . . . . . . . . . 595.2.2 Futures terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

5.3 Introduction to options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605.3.1 Option terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

5.4 Basic payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625.4.1 Payoff for buyer of asset: Long asset . . . . . . . . . . . . . . . . . . . . 635.4.2 Payoff for seller of asset: Short asset . . . . . . . . . . . . . . . . . . . . 63

5.5 Payoff for futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635.5.1 Payoff for buyer of futures: Long futures . . . . . . . . . . . . . . . . . 635.5.2 Payoff for seller of futures: Short futures . . . . . . . . . . . . . . . . . 65

5.6 Payoff for options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665.6.1 Payoff for buyer of call options: Long call . . . . . . . . . . . . . . . . . 665.6.2 Payoff for writer of call options: Short call . . . . . . . . . . . . . . . . 675.6.3 Payoff for buyer of put options: Long put . . . . . . . . . . . . . . . . . 675.6.4 Payoff for writer of put options: Short put . . . . . . . . . . . . . . . . . 68

5.7 Using futures versus using options . . . . . . . . . . . . . . . . . . . . . . . . . 69

6 Pricing commodity futures 756.1 Investment assets versus consumption assets . . . . . . . . . . . . . . . . . . . . 756.2 The cost of carry model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

6.2.1 Pricing futures contracts on investment commodities . . . . . . . . . . . 786.2.2 Pricing futures contracts on consumption commodities . . . . . . . . . . 80

6.3 The futures basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

CONTENTS 5

7 Using commodity futures 857.1 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

7.1.1 Basic principles of hedging . . . . . . . . . . . . . . . . . . . . . . . . . 857.1.2 Short hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 867.1.3 Long hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 877.1.4 Hedge ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 897.1.5 Advantages of hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . 907.1.6 Limitation of hedging: basis Risk . . . . . . . . . . . . . . . . . . . . . 91

7.2 Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 927.2.1 Speculation: Bullish commodity, buy futures . . . . . . . . . . . . . . . 927.2.2 Speculation: Bearish commodity, sell futures . . . . . . . . . . . . . . . 93

7.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 937.3.1 Overpriced commodity futures: buy spot, sell futures . . . . . . . . . . . 947.3.2 Underpriced commodity futures: buy futures, sell spot . . . . . . . . . . 95

8 Trading 998.1 Futures trading system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998.2 Entities in the trading system . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

8.2.1 Guidelines for allotment of client code . . . . . . . . . . . . . . . . . . . 1008.3 Contract specifications for commodity futures . . . . . . . . . . . . . . . . . . . 1018.4 Commodity futures trading cycle . . . . . . . . . . . . . . . . . . . . . . . . . . 1018.5 Order types and trading parameters . . . . . . . . . . . . . . . . . . . . . . . . . 102

8.5.1 Permitted lot size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1068.5.2 Tick size for contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 1068.5.3 Quantity freeze . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1078.5.4 Base price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1078.5.5 Price ranges of contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 1078.5.6 Order entry on the trading system . . . . . . . . . . . . . . . . . . . . . 108

8.6 Margins for trading in futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1108.7 Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

9 Clearing and settlement 1159.1 Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

9.1.1 Clearing mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1169.1.2 Clearing banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1169.1.3 Depository participants . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

9.2 Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1179.2.1 Settlement mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . 1179.2.2 Settlement methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1209.2.3 Entities involved in physical settlement . . . . . . . . . . . . . . . . . . 122

9.3 Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1239.4 Margining at NCDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

9.4.1 SPAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

6 CONTENTS

9.4.2 Initial margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1249.4.3 Computation of initial margin . . . . . . . . . . . . . . . . . . . . . . . 1249.4.4 Implementation aspects of margining and risk management . . . . . . . . 1269.4.5 Effect of violation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

10 Regulatory framework 13310.1 Rules governing commodity derivatives exchanges . . . . . . . . . . . . . . . . 13310.2 Rules governing intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

10.2.1 Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13410.2.2 Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

10.3 Rules governing investor grievances, arbitration . . . . . . . . . . . . . . . . . . 14210.3.1 Procedure for arbitration . . . . . . . . . . . . . . . . . . . . . . . . . . 14310.3.2 Hearings and arbitral award . . . . . . . . . . . . . . . . . . . . . . . . 144

11 Implications of sales tax 147

List of Tables

2.1 The global derivatives industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 212.2 Volume on existing exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . 252.3 Registered commodity exchanges in India . . . . . . . . . . . . . . . . . . . . . 26

3.1 Fee/ deposit structure and networth requirement: TCM . . . . . . . . . . . . . . 313.2 Fee/ deposit structure and networth requirement: PCM . . . . . . . . . . . . . . 31

4.1 Country–wise share in gold production, 1968 and 1999 . . . . . . . . . . . . . . 49

5.1 Distinction between futures and forwards . . . . . . . . . . . . . . . . . . . . . 595.2 Distinction between futures and options . . . . . . . . . . . . . . . . . . . . . . 70

6.1 NCDEX – indicative warehouse charges . . . . . . . . . . . . . . . . . . . . . . 80

7.1 Refined soy oil futures contract specification . . . . . . . . . . . . . . . . . . . . 877.2 Silver futures contract specification . . . . . . . . . . . . . . . . . . . . . . . . . 887.3 Gold futures contract specification . . . . . . . . . . . . . . . . . . . . . . . . . 92

8.1 Commodity futures contract and their symbols . . . . . . . . . . . . . . . . . . . 1018.2 Gold futures contract specification . . . . . . . . . . . . . . . . . . . . . . . . . 1028.3 Long staple cotton futures contract specification . . . . . . . . . . . . . . . . . . 1038.4 Commodity futures: Quantity freeze unit . . . . . . . . . . . . . . . . . . . . . . 1078.5 Commodity futures: Lot size and other parameters . . . . . . . . . . . . . . . . 109

9.1 MTM on a long position in cotton futures . . . . . . . . . . . . . . . . . . . . . 1189.2 MTM on a short position in cotton futures . . . . . . . . . . . . . . . . . . . . . 1199.3 Calculating outstanding position at TCM level . . . . . . . . . . . . . . . . . . . 1259.4 Minimum margin percentage on commodity futures contracts . . . . . . . . . . . 1259.5 Exposure limit as a multiple of liquid net worth . . . . . . . . . . . . . . . . . . 1289.6 Number of days for physical settlement on various commodities . . . . . . . . . 129

List of Figures

5.1 Payoff for a buyer of gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645.2 Payoff for a seller of gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645.3 Payoff for a buyer of gold futures . . . . . . . . . . . . . . . . . . . . . . . . . . 655.4 Payoff for a seller of cotton futures . . . . . . . . . . . . . . . . . . . . . . . . . 665.5 Payoff for buyer of call option on gold . . . . . . . . . . . . . . . . . . . . . . . 675.6 Payoff for writer of call option on gold . . . . . . . . . . . . . . . . . . . . . . . 685.7 Payoff for buyer of put option on long staple cotton . . . . . . . . . . . . . . . . 695.8 Payoff for writer of put option on long staple cotton . . . . . . . . . . . . . . . . 70

6.1 Variation of basis over time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

7.1 Payoff for buyer of a short hedge . . . . . . . . . . . . . . . . . . . . . . . . . . 867.2 Payoff for buyer of a long hedge . . . . . . . . . . . . . . . . . . . . . . . . . . 88

8.1 Contract cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

Chapter 1

Introduction to derivatives

The origin of derivatives can be traced back to the need of farmers to protect themselves againstfluctuations in the price of their crop. From the the time it was sown to the time it was readyfor 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 meansof reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive for hisharvest 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. Clearlythis 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 pricerisk – that of having to pay exorbitant prices during dearth, although favourable prices could beobtained during periods of oversupply. Under such circumstances, it clearly made sense for thefarmer and the merchant to come together and enter into a contract whereby the price of the grainto be delivered in September could be decided earlier. What they would then negotiate happenedto 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 andmerchants together. A group of traders got together and created the ‘to–arrive’ contract thatpermitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contractsproved useful as a device for hedging and speculation on price changes. These were eventuallystandardised, 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 financialunderlyings 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 underlyingvariables 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 theirharvest at a future date to eliminate the risk of a change in prices by that date. Such a transactionis an example of a derivative. The price of this derivative is driven by the spot price of wheatwhich is the “underlying” in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts incommodities all over India. As per this the Forward Markets Commission (FMC) continues tohave jurisdiction over commodity forward/ futures contracts. However when derivatives tradingin 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 governedby 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 instrumentor 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, optionsand swaps. Participants who trade in the derivatives market can be classified under the followingthree broad categories – hedgers, speculators, and arbitragers.

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

2. Speculators: Speculators are participants who wish to bet on future movements in the price of anasset. Futures and options contracts can give them leverage; that is, by putting in small amounts ofmoney upfront, they can take large positions on the market. As a result of this leveraged speculativeposition, 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 pricesof the same product across different markets. If, for example, they see the futures price of an assetgetting out of line with the cash price, they would take offsetting positions in the two markets to lockin the profit.

Whether the underlying asset is a commodity or a financial asset, derivative markets performsa 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 convergewith the prices of the underlying at the expiration of the derivative contract. Thus derivatives help indiscovery 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 hundredyears. Financial derivatives came into spotlight in the post-1970 period due to growing instability inthe financial markets. However, since their emergence, these products have become very popular andby 1990s, they accounted for about two-thirds of total transactions in derivative products. In recentyears, the market for financial derivatives has grown tremendously in terms of variety of instrumentsavailable, their complexity and also turnover. In the class of equity derivatives the world over, futuresand options on stock indices have gained more popularity than on individual stocks, especially amonginstitutional investors, who are major users of index-linked derivatives. Even small investors find theseuseful due to high correlation of the popular indexes with various portfolios and ease of use. The lowercosts associated with index derivatives vis–a–vis derivative products based on individual securities isanother 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 tothose who have an appetite for them.

� Derivatives, due to their inherent nature, are linked to the underlying cash markets. With theintroduction of derivatives, the underlying market witnesses higher trading volumes because ofparticipation by more players who would not otherwise participate for lack of an arrangement totransfer risk.

� Speculative traders shift to a more controlled environment of the derivatives market. In the absenceof an organised derivatives market, speculators trade in the underlying cash markets. Margining,monitoring and surveillance of the activities of various participants become extremely difficult inthese kind of mixed markets.

� An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for newentrepreneurial activity. Derivatives have a history of attracting many bright, creative, well–educatedpeople with an entrepreneurial attitude. They often energize others to create new businesses, newproducts 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 enablesmarket participants to expand their volume of activity.

1.3 Derivatives markets

Derivative markets can broadly be classified as commodity derivative market and financialderivatives markets. As the name suggest, commodity derivatives markets trade contracts forwhich 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 derivativesmarkets trade contracts that have a financial asset or variable as the underlying. The morepopular 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 optionswhich 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 aspot and derivatives contract. Every transaction has three components – trading, clearing andsettlement. 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 moneythe two should exchange. For instance A buys goods worth Rs.100 from B and sells goods worthRs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchangingmoney and goods.

In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. “onthe spot”. Consider this example. On 1st January 2004, Aditya wants to buy some gold. Thegoldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 gramsof 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 ita 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 paysthe goldsmith Rs.12,030 and collects his gold. This is a forward contract, a contract by whichtwo parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. Nomoney changes hands when the contract is signed. The exchange of money and the underlyinggoods only happens at the future date as specified in the contract. In a forward contract theprocess of trading, clearing and settlement does not happen instantaneously. The trading happenstoday, 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 derivesvalue from the price of the asset underlying the contract, in this case gold. If on the 1st ofFebruary, gold trades for Rs.6,050 in the spot market, the contract becomes more valuable toAditya because it now enables him to buy gold at Rs.6,015. If however, the price of gold dropsdown to Rs.5,990, he is worse off because as per the terms of the contract, he is bound to payRs.6,015 for the same gold. The contract has now lost value from Aditya’s point of view. Notethat the value of the forward contract to the goldsmith varies exactly in an opposite manner to itsvalue 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 beforethen. These contracts were typically OTC kind of contracts. Over the counter(OTC) derivativesare privately negotiated contracts. Merchants entered into contracts with one another for futuredelivery of specified amount of commodities at specified price. A primary motivation for pre–arranging a buyer or seller for a stock of commodities in early forward contracts was to lessenthe 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 buyersand sellers for commodities. However “credit risk” remained a serious problem. To deal with thisproblem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. Theprimary intention of the CBOT was to provide a centralised location known in advance for buyers andsellers 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”. In1919, 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 thetwo largest organised futures exchanges, indeed the two largest “financial” exchanges of any kind inthe world today.The first stock index futures contract was traded at Kansas City Board of Trade. Currently themost popular stock index futures contract in the world is based on S&P 500 index, traded on ChicagoMercantile Exchange. During the mid eighties, financial futures became the most active derivativeinstruments generating volumes many times more than the commodity futures. Index futures, futureson T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Otherpopular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGXin 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 totrade on an exchange.

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

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

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 forsafeguarding 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, bankingsupervision and market surveillance.

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

The largest OTC derivative market is the interbank foreign exchange market. Commodityderivatives 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, namelyfutures 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 theunderlying 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 afuture date at today’s future price. Futures contracts differ from forward contracts in the sense thatthey are standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the underlying asset, at a given price on or before a given futuredate. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlyingasset 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 optionsexchanges having a maximum maturity of nine months. Longer–dated options are called warrantsand are generally traded over–the–counter.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually aweighted 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 accordingto a prearranged formula. They can be regarded as portfolios of forward contracts. The twocommonly used swaps are :

� Interest rate swaps: These entail swapping only the interest related cash flows between theparties 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 oppositedirection.

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

Solved ProblemsQ: Futures trading commenced first on

1. Chicago Board of Trade

2. Chicago Mercantile Exchange

3. Chicago Board Options Exchange

4. London International Financial Futures andOptions Exchange

A: The correct answer is number 1. ��


Q: Derivatives first emerged as products

1. Speculative

2. Hedging

3. Volatility

4. Risky

A: The correct answer is number 2. ��Q: Which of the following exchanges offer commodity derivatives trading

1. National Commodity Derivatives Exchange

2. Interconnected Stock Exchange

3. Over The Counter Exchange of India

4. ICICI Securities Limited

A: The correct answer is number 1. ��Q: OTC derivatives are considered risky because

1. There is no formal margining system.

2. They do not follow any formal rules or mech-anisms.

3. They are not settled on a clearing house.

4. All of the above

A: The correct answer is number 4. ��Q: The first exchange traded financial derivative in India commenced with the trading of

1. Index futures

2. Index options

3. Stock options

4. Interest rate futures

A: The correct answer is number 1. ��Q: A is the simplest derivative contract

1. Option

2. Future

3. Forward

4. Swap

A: The correct answer is number 3. ��Q: In a transaction, trading involves

1. The buyer and seller agreeing upon a price.

2. The buyer and seller exchanging goods andmoney.

3. The buyer and seller calculating the net out-standing.

4. None of the above.



Q: In a transaction, clearing involves






Q: In a transaction, settlement involves






Chapter 2

Commodity derivatives

Derivatives as a tool for managing risk first originated in the commodities markets. They werethen found useful as a hedging tool in financial markets as well. In India, trading in commodityfutures has been in existence from the nineteenth century with organised trading in cotton throughthe establishment of Cotton Trade Association in 1875. Over a period of time, other commoditieswere permitted to be traded in futures exchanges. Regulatory constraints in 1960s resultedin virtual dismantling of the commodities future markets. It is only in the last decade thatcommodity future exchanges have been actively encouraged. However, the markets have beenthin with poor liquidity and have not grown to any significant level. In this chapter we look athow commodity derivatives differ from financial derivatives. We also have a brief look at theglobal 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 tobe a commodity or a financial asset. However there are some features which are very peculiarto commodity derivative markets. In the case of financial derivatives, most of these contractsare cash settled. Even in the case of physical settlement, financial assets are not bulky and donot need special facility for storage. Due to the bulky nature of the underlying assets, physicalsettlement in commodity derivatives creates the need for warehousing. Similarly, the conceptof 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 varylargely. 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 anaccredited warehouse. The seller intending to make delivery would have to take the commoditiesto the designated warehouse and the buyer intending to take delivery would have to go to thedesignated 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 areenormous. There are limits on storage facilities in different states. There are restrictions oninterstate movement of commodities. Besides state level octroi and duties have an impact onthe cost of movement of goods across locations. The process of taking physical delivery incommodities 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 onwe 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 togive 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 sellerin an options market. However what is interesting and different from a typical options exerciseis that in the commodities market, both positions can still be closed out before expiry of thecontract. The intention of this notice is to allow verification of delivery and to give adequatenotice to the buyer of a possible requirement to take delivery. These are required by virtue of thefact that the actual physical settlement of commodities requires preparation from both deliveringand receiving members.

Typically, in all commodity exchanges, delivery notice is required to be supported bya warehouse receipt. The warehouse receipt is the proof for the quantity and quality ofcommodities being delivered. Some exchanges have certified laboratories for verifying thequality of goods. In these exchanges the seller has to produce a verification report from theselaboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receiptsas quality verification documents while others like BMF–Brazil have independent grading andclassification 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 tothe 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 identifiesthe buyer to whom this notice may be assigned. Exchanges follow different practices for theassignment process. One approach is to display the delivery notice and allow buyers wishingto take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOTand CME display delivery notices. Alternatively, the clearing houses may assign deliveries tobuyers on some basis. Exchanges such as COMMEX and the Indian commodities exchangeshave 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 tosquare 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 typicallyeither on random basis or first–in–first out basis. In some exchanges (CME), the buyer has theoption 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 forquality and freight costs. The discount/ premium for quality and freight costs are published bythe clearing house before introduction of the contract. The most active spot market is normallytaken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determinedbased 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. Theexchange also informs the respective warehouse about the identity of the buyer. The buyer isrequired to deposit a certain percentage of the contract amount with the clearing house as marginagainst 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 thephysical stocks against the delivery order. Proof of physical delivery having been effected isforwarded by the seller to the clearing house and the invoice amount is credited to the seller’saccount.

In India if a seller does not give notice of delivery then at the expiry of the contract thepositions 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 derivatives is the need forwarehousing. In case of most exchange–traded financial derivatives, all the positions are cashsettled. Cash settlement involves paying up the difference in prices between the time the contractwas entered into and the time the contract was closed. For instance, if a trader buys futureson a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, hedoes not really have to buy the underlying stock. All he does is take the difference of Rs.20 incash. Similarly the person who sold this futures contract at Rs.100, does not have to deliver theunderlying 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. Whichmeans that if the seller chooses to hand over the commodity instead of the difference in cash, thebuyer must take physical delivery of the underlying asset. This requires the exchange to makean arrangement with warehouses to handle the settlements. The efficacy of the commoditiessettlements depends on the warehousing system available. Most international commodityexchanges 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.SGrade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19for 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

��s 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 thequantity 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, lodgepolepine, 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 systemis that a warehouse receipt becomes a good collateral, not just for settlement of exchange tradesbut also for other purposes too. In India, the warehousing system is not as efficient as it is insome of the other developed markets. Central and state government controlled warehouses arethe major providers of agri–produce storage facilities. Apart from these, there are a few privatewarehousing being maintained. However there is no clear regulatory oversight of warehousingservices.

2.1.3 Quality of underlying assets

A derivatives contract is written on a given underlying. Variance in quality is not an issue incase of financial derivatives as the physical attribute is missing. When the underlying asset is acommodity, the quality of the underlying asset is of prime importance. There may be quite somevariation in the quality of what is available in the marketplace. When the asset is specified, itis therefore important that the exchange stipulate the grade or grades of the commodity that areacceptable. Commodity derivatives demand good standards and quality assurance/ certificationprocedures. A good grading system allows commodities to be traded by specification.

Currently there are various agencies that are responsible for specifying grades forcommodities. For example, the Bureau of Indian Standards (BIS) under Ministry of ConsumerAffairs specifies standards for processed agricultural commodities whereas AGMARK under thedepartment of rural development under Ministry of Agriculture is responsible for promulgatingstandards for basic agricultural commodities. Apart from these, there are other agencies likeEIA, 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 ofcommodities exchanges across the world. The CBOT and CME are two of the oldest derivatives

2.2 Global commodities derivatives exchanges 23

Table 2.1 The global derivatives industry

Country Exchange

United States of America Chicago Board of Trade (CBOT)Chicago Mercantile ExchangeMinneapolis Grain ExchangeNew York Cotton ExchangeNew York Mercantile ExchangeKansas Board of TradeNew York Board of Trade

Canada The Winnipeg Commodity ExchangeBrazil Brazilian Futures Exchange Commodities

and Futures ExchangeAustralia Sydney Futures Exchange Ltd.People’s Republic Of China Beijing Commodity Exchange Shanghai

Metal ExchangeHong Kong Hong Kong Futures ExchangeJapan Tokyo International Financial Futures Exchange

Kansai Agricultural Commodities ExchangeTokyo Grain Exchange

Malaysia Kuala Lumpur commodity ExchangeNew Zealand New Zealand Futures& Options Exchange Ltd.Singapore Singapore Commodity Exchange Ltd.France Le Nouveau Marche MATIFItaly Italian Derivatives MarketNetherlands Amsterdam Exchanges Option TradersRussia The Russian Exchange

MICEX/ Relis Online St. Petersburg FuturesExchange

Spain The Spanish Options ExchangeCitrus Fruit and Commodity Futures Market ofValencia

United Kingdom The London International Financial FuturesOptions exchangeThe London Metal Exchange

exchanges in the world. The CBOT was established in 1948 to bring farmers and merchantstogether. Initially its main task was to standardise the quantities and qualities of the grains thatwere traded. Within a few years the first futures–type contract was developed. It was know asthe to–arrive contract. Speculators soon became interested in the contract and found tradingin 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. Onthese 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 goldfutures 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 futurescontracts for commodities, in which trade was liberalised, namely, white and yellow maize, breadmilling wheat and sunflower seeds.

2.2.2 Asia

China’s first commodity exchange was established in 1990 and at least forty had appearedby 1993. The main commodities traded were agricultural staples such as wheat, corn and inparticularly soybeans. In late 1994, more than half of China’s exchanges were closed downor reverted to being wholesale markets, while only 15 restructured exchanges received formalgovernment approval. At the beginning of 1999, the China Securities Regulatory Committeebegan a nationwide consolidation process which resulted in three commodity exchangesemerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange andthe Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: ShanghaiMetal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launchedin 1998. Malaysia and Singapore have active commodity futures exchanges. Malaysia hostsone futures and options exchange. Singapore is home to the Singapore Exchange (SGX), whichwas formed in 1999 by the merger of two well–established exchanges, the Stock Exchange ofSingapore (SES) and Singapore International Monetary Exchange (SIMEX).

2.2.3 Latin America

Latin America’s largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F) inBrazil. 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 inBrazil, spread throughout the country. Argentina’s futures market Mercado a Termino de BuenosAires, founded in 1909, ranks as the world’s 51st largest exchange. Mexico has only recentlyintroduced 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

2.3 Evolution of the commodity market in India 25

amongst leading cotton mill owners and merchants over functioning of Bombay Cotton TradeAssociation. The Futures trading in oilseeds started in 1900 with the establishment of theGujarati 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 mostnotable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futurestrading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute beganonly in 1927 with the establishment of East Indian Jute Association Ltd. These two associationsamalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised tradingin both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry ofConsumer Affairs and Public Distribution. In due course, several other exchanges were createdin 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 tradeand industry liberalisation in both the domestic and external sectors, the Government of Indiaappointed 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 makesuitable 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 witha view to making it compatible with similar regulatory agencies in other countries so as tosee how effectively these agencies can cope up with the reality of the fast changing economicscenario.

2. To review the role that forward trading has played in the Indian commodity markets during the last10 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 therecommendations, particularly with a view to effective enforcement of the Act to check illegalforward 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 beoperative 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 commoditiesin which forward trading is possible, particularly in commodities in which resumption of forwardtrading is generally demanded.


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

� The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, wouldneed to be strengthened.

� Due to the inadequate infrastructural facilities such as space and telecommunication facilities thecommodities exchanges were not able to function effectively. Enlisting more members, ensuringcapital adequacy norms and encouraging computerisation would enable these exchanges to placethemselves on a better footing.

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

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

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

� The majority of the committee recommended that futures trading be introduced in the followingcommodities:

1. Basmati rice

2. Cotton and kapas

3. Raw jute and jute goods

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

5. Rice bran oil

6. Castor oil and its oilcake

7. Linseed

8. Silver

9. Onions

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

The national agriculture policy announced in July 2000 and the announcements in the budgetspeech for 2002–2003 were indicative of the governments resolve to put in place a mechanism offutures trade/market. As a follow up, the government issued notifications on 1.4.2003 permittingfutures trading in the commodities, with the issue of these notifications futures trading is notprohibited in any commodity. Options trading in commodity is, however presently prohibited.


Table 2.2 Volume on existing exchangesCommodity exchange Products Approx. annual vol

(Rs.Crore)

National board of trade, Indore Soya, mustard 80000National multicommodity exchange, Ahmedabad Multiple 40000Ahmedabad commodity exchange Castor, cotton 3500Rajdhani Oil & oilseeds Mustard 3500Vijai Beopar Chamber Ltd. Muzzaffarnagar Gur 2500Rajkot seeds, oil & bullion exchange Castor, groundnut 2500IPSTA, Cochin Pepper 2500Chamber of commerce, Hapur Gur, mustard 2500Bhatinda Om and oil exchange Gur 1500Other (mostly inactive) 1500Total 140000

2.3.2 Latest developments

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

� National Board of Trade

� Multi Commodity Exchange of India

� National Commodity & Derivatives Exchange of India Ltd


Table 2.3 Registered commodity exchanges in IndiaExchange Product traded

Bhatinda Om & Oil Exchange Ltd. GurThe Bombay Commodity Exchange Ltd. Sunflower oil

Cotton (Seed and oil)Safflower (Seed, oil and oil cake)Groundnut (Nut and oil)Castor oil, CastorseedSesamum (Oil and oilcake)Rice bran, rice bran oil and oilcakeCrude palm oil

The Rajkot Seeds oil & Bullion Merchants Groundnut oilAssociation, Ltd. CastorseedThe Kanpur Commodity Exchange Ltd. Rapeseed/ Mustardseed oil and cakeThe Meerut Agro Commodities Exchange Co. Ltd. GurThe Spices and Oilseeds Exchange Ltd.Sangli TurmericAhmedabad Commodities Exchange Ltd. Cottonseed, CastorseedVijay Beopar Chamber Ltd., Muzaffarnagar GurIndia Pepper & Spice Trade Association, Kochi PepperRajdhani Oils and Oilseeds Exchange Ltd., Delhi Gur, Rapeseed/ Mustardseed

Sugar Grade-MNational Board of Trade, Indore Rapeseed/ Mustard seed/ Oil/ Cake

Soybean/ Meal/ Oil, Crude Palm OilThe Chamber of Commerce, Hapur Gur, Rapeseed/ MustardseedThe East India Cotton Association, Mumbai CottonThe Central India Commercial Exchange Ltd., Gwaliar GurThe East India Jute & Hessian Exchange Ltd., Kolkata Hessian, SackingFirst Commodity Exchange of India Ltd., Kochi Copra, Coconut oil & Copra cakeThe Coffee Futures Exchange India Ltd., Bangalore CoffeeNational Multi Commodity Exchange of Gur, RBD PamolienIndia Limited, Ahmedabad Crude Palm Oil, Copra

Rapeseed/ Mustardseed, Soy beanCotton (Seed, oil, oilcake)Safflower (seed, oil, oilcake)Groundnut (seed, oil, oilcake)Sugar, Sacking, gramCoconut (oil and oilcake)Castor (oil and oilcake)Sesamum (Seed,oil and oilcake)Linseed (seed, oil and oilcake)Rice Bran Oil, Pepper, GuarseedAluminium ingots, Nickel, tinVanaspati, Rubber, Copper, Zinc, lead

National Commodity & Derivatives Exchange Limited Soy Bean, Refined Soy OilMustard SeedExpeller Mustard OilRBD Palmolein Crude Palm OilMedium Staple CottonLong Staple CottonGold, Silver


Solved ProblemsQ: Which of the following feature differentiates a commodity futures contract from a financial futurescontract?

1. Exchange traded product

2. Standardised contract size

3. MTM settlement

4. Varying quality of underlying asset


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

1. an accredited warehouse

2. the exchange

3. the buyers requested destination

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

2. Warehouse receipt

3. Undertaking

4. Advance payment


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

1. The exchange

2. The clearing corporation

3. The warehouse

4. The seller


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

1. National Commodity Derivative Exchange

2. Multi Commodity Exchange of India

3. National Board of Trade

4. National Stock Exchange



Q: On the NCDEX

1. The clearing house assigns delivery to thebuyer

2. The seller assigns delivery to the buyer

3. The buyer chooses which delivery to take

4. The warehouse assigns the delivery to thebuyer


Q: The committee recommended that the Forward Markets Commission(FMC) and the ForwardContracts (Regulation) Act, 1952, need to be strengthened.

1. L C Gupta Committee

2. Kabra Committee

3. Khusro Committee

4. J R Varma Committee


Chapter 3

The NCDEX platform

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodityexchange. It is a public limited company registered under the Companies Act, 1956 with theRegistrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Boardof Directors and professionals not having any vested interest in commodity markets. It has beenlaunched to provide a world–class commodity exchange platform for market participants to tradein a wide spectrum of commodity derivatives driven by best global practices, professionalism andtransparency.

NCDEX is regulated by Forward Markets Commission in respect of futures trading incommodities. 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 inabout 91 cities throughout India at the moment.

NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, refinedsoy bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crudepalm oil and cotton – medium and long staple varieties. At subsequent phases trading in morecommodities 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 costsolutions 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 andRural Development (NABARD) and National Stock Exchange of India Limited (NSE). NCDEXis the only commodity exchange in the country promoted by national level institutions. Thisunique parentage enables it to offer a variety of benefits which are currently in short supplyin the commodity markets. The four institutional promoters of NCDEX are prominent playersin their respective fields and bring with them institution building experience, trust, nationwidereach, 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 today activities of the exchange. The directors are appointed in accordance with the provisions ofthe Articles of Association of the company. The board is responsible for managing and regulatingall the operations of the exchange and commodities transactions. It formulates the rules andregulations related to the operations of the exchange. Board appoints an executive committeeand other committees for the purpose of managing activities of the exchange.

The executive committee consists of Managing Director of the exchange who would be actingas 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 Membershipcommittee, Audit Committee, Risk Committee, Nomination Committee, CompensationCommittee 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–operativesocieties, companies etc. that fulfills the eligibility criteria set by the exchange. All the membersof the exchange have to register themselves with the competent authority before commencingtheir operations. The members of NCDEX fall into two categories, Trading cum ClearingMembers (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 whofulfill the specified eligibility criteria for trading in commodities. The TCM membership entitlesthe members to trade and clear, both for themselves and/ or on behalf of their clients. Applicantsaccepted for admission as TCM are required to pay the required fees/ deposits and also maintainnet worth as given in Table 3.1.

3.3 Capital requirements 33

Table 3.1 Fee/ deposit structure and networth requirement: TCMParticulars (Rupees in Lakh)

Interest free cash security deposit 15.00Collateral security deposit 15.00Annual subscription charges 0.50Advance minimum transaction charges 0.50Net worth requirement 50.00

Table 3.2 Fee/ deposit structure and networth requirement: PCMParticulars (Rupees in Lakh)

Interest free cash security deposit 25.00Collateral security deposit 25.00Annual subscription charges 1.00Advance minimum transaction charges 1.00Net worth requirement 5000.00

3.2.2 Professional clearing members (PCMs)

NCDEX also invites applications for Professional Clearing Membership (PCMs) from personswho fulfill the specified eligibility criteria for trading in commodities. The PCM membershipentitles 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 asPCMs are required to pay the following fee/ deposits and also maintain net worth as given inTable 3.2.

3.3 Capital requirements

NCDEX has specified capital requirements for its members. On approval as a member ofNCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. BaseMinimum 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 oftheir trading terminal. Members can opt to meet the security deposit requirement by way of thefollowing:

� Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour ofNational Commodity & Derivatives Exchange Limited.


� Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approvedbanks. The minimum term of the bank guarantee should be 12 months.

� Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. TheFDR 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 theapproved custodian for acceptance of Government of India securities. The securities are valued on adaily basis and a haircut of 25% is levied.

Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in caseof TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit fallsbelow the minimum required level, NCDEX may initiate suitable action including withdrawal oftrading facilities as given below:

� If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would bewithdrawn with immediate effect.

� If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendarweeks’ time to replenish the shortages and if the same is not done within the specified time thetrading facility would be withdrawn.

Members who wish to increase their limit can do so by bringing in additional capital in theform 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 onthe NCDEX’s market.

3.4.1 Trading

The trading system on the NCDEX, provides a fully automated screen–based trading forfutures on commodities on a nationwide basis as well as an online monitoring and surveillancemechanism. It supports an order driven market and provides complete transparency of tradingoperations. The trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading hasalso 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 quantityfields are in units and price in rupees. The exchange specifies the unit of trading and the deliveryunit for futures contracts on various commodities . The exchange notifies the regular lot size andtick size for each of the contracts traded from time to time. When any order enters the tradingsystem, it is an active order. It tries to find a match on the other side of the book. If it findsa 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 eachtrade 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 Januaryexpiration contract would expire on the 20th of January and a February expiry contract wouldcease 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 thetrading day following the expiry of the near month contract.

3.4.2 Clearing

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of tradesexecuted on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX.Only clearing members including professional clearing members (PCMs) only are entitled toclear and settle contracts through the clearing house. At NCDEX, after the trading hours on theexpiry date, based on the available information, the matching for deliveries takes place firstly, onthe basis of locations and then randomly, keeping in view the factors such as available capacity ofthe vault/ warehouse, commodities already deposited and dematerialized and offered for deliveryetc. Matching done by this process is binding on the clearing members. After completion of thematching process, clearing members are informed of the deliverable/ receivable positions andthe unmatched positions. Unmatched positions have to be settled in cash. The cash settlement isonly 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 acontinuous basis at the end of each day, and the final settlement which happens on the lasttrading day of the futures contract. On the NCDEX, daily MTM settlement and final MTMsettlement in respect of admitted deals in futures contracts are cash settled by debiting/ creditingthe clearing accounts of CMs with the respective clearing bank. All positions of a CM, eitherbrought forward, created during the day or closed out during the day, are market to market at thedaily 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. Theresponsibility of settlement is on a trading cum clearing member for all trades done on his ownaccount and his client’s trades. A professional clearing member is responsible for settling allthe participants trades which he has confirmed to the exchange. On the expiry date of a futurescontract, members submit delivery information through delivery request window on the traderworkstations provided by NCDEX for all open positions for a commodity for all constituentsindividually. NCDEX on receipt of such information, matches the information and arrives at adelivery 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 commoditieshave to meet the contract specifications with allowed variances. If the commodities meet the


specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updatedin the depository system giving a credit in the depositor’s electronic account. The seller thengives the invoice to his clearing member, who would courier the same to the buyer’s clearingmember. On an appointed date, the buyer goes to the warehouse and takes physical possessionof the commodities.

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

1. Cotton futures

2. Gold futures

3. Silver futures

4. Energy futures


Q: NCDEX is regulated by

1. The Forward Markets Commission

2. SEBI

3. Reserve Bank of India

4. Controller of Capital Issues


Q: The net worth requirement for a TCM is

1. Rs.5 Lakh

2. Rs.50 Lakh

3. Rs.500 Lakh

4. Rs.5000 Lakh


Chapter 4

Commodities traded on the NCDEXplatform

In December 2003, the National Commodity and Derivatives Exchange Ltd (NCDEX) launchedfutures 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 arebeing offered.

We have a brief look at the various commodities that trade on the NCDEX and look at somecommodity specific issues. The commodity markets can be classified as markets trading thefollowing 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 andprecious metals. For derivatives with a commodity as the underlying, the exchange must specifythe exact nature of the agreement between two parties who trade in the contract. In particular, itmust specify the underlying asset, the contract size stating exactly how much of the asset will bedelivered under one contract, where and when the delivery will be made. In this chapter we lookat the various underlying assets for the futures contracts traded on the NCDEX. Trading, clearingand 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 andlong 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 totalfibre consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17million 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 fluctuationin prices of cotton traded across India has been at around 4.5% during the last three years. Themaximum fluctuation has been as high as 11%. Historically, cotton prices in India have beenfluctuating in the range of 3-6% on a monthly basis.

Cotton is among the most important non–food crops. It occupies a significant position, bothfrom agricultural and manufacturing sectors’ points of view. It is the major source of a basichuman need – clothing, apart from other fibre sources like jute, silk and synthetic. Today, cottonoccupies a significant position in the Indian economy on all fronts as a commodity that formsa means of livelihood to over millions of cotton cultivating farmers at the primary agriculturalsector. It is also a source of direct employment to over 35 million people in the secondarymanufacturing 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 minimumtemperature of �� is required. The optimum temperature range for vegetative growth is� �� . It can tolerate temperatures as high as �� , but does not do well if the temperaturefalls bellow

� �� C. During the period of fruiting, warm days and cool nights, with large diurnalvariations 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 isthe minimum requirement. More than the actual rainfall, a favourable distribution is the decidingfactor in obtaining good yields from the rainfed cotton. Cotton is grown on a variety of soils. Itrequires a soil amenable to good drainage, as it does not tolerate water logging. It is grown mainlyas 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 (1)Alluvial soils predominant inthe 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, MadhyaPradesh, Andhra Pradesh, Karnataka and Tamil Nadu, and (4)Lateritic soils – found in parts ofTamil Nadu, Assam and Kerala.

Cotton is a 90–120 day annual crop. In the main producing countries of USA, China, Indiaand 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 producingcentres) from October-November onwards. Kappas are bought by ginners, who separate theseeds 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 offull pressed bales (1 bale = 170 kg cotton lint in India; in USA, it is 480 pounds). Spinned cottonyarn is used by clothe manufacturers/ textile industry.

4.1 Agricultural commodities 39

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 alongwith Turkey, Brazil, Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% ofthe world’s annual cotton consumption. Global production of cotton during the post 1990 (tilldate 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 andimport 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 rangeof 12–17 million bales (i.e. between 2.2–2.8 million tons), constituting about 15% of the globalcotton 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 changeduring the post 1995 period. The country has turned from being net exporter to net importer. Thecountry’s raw cotton exports, which stood at 1.2–1.6 million bales during the pre–1996 periodhave dipped to less than 100 thousand bales. Contrary to this, the imports have sharply risenfrom 30000–50000 bales during the pre–1995 to little over 2.2 million bales during the last threeyears. Among several other reasons, it is the lack of availability of desired quality cotton that hasmade many Indian buyers (particularly the export oriented units) to opt for purchases of foreigncotton 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 ginningout–turn) and better credit terms (3–6 months vs. 15–30 days for local). Mills using ELS (extralong staple) have been pleased with US Pima and its fibre characteristics. US has emerged as animportant 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 deliveryperiods.

Price trends and factors that influence prices

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

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

The central government establishes minimum support prices (MSP) for Kappas at the startof 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 limitedto commercial purchases and sales (except for a few years like 2001–02 when the prices wereabysmally low).


Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the referenceprice for cotton traded in the international market. World cotton prices fell sharply during mostpart of 2001, NyBOT witnessing a sharp downfall in prices from 61.78 US Cents/ lb (as on Jan2, 2001) to the low of 28.20 US Cents/ lb (as on Oct 26, 2001), a sharp fall by 54.35%. Towardsmid–2002, prices recovered to 53 cents, and toward end of 2003 were currently ruling at 58.85cents.

Cotton prices in India are therefore influenced by various demand–supply factors operatingwithin the country, international raw cotton prices, demand for finished readymade garmentsfrom 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 nearly20% (Rs.80-90 billion). The country is over–dependent on CPO imports to the extent of over50% of its annual vegetable oil imports. There is a close inter linkage between the variousvegetable oils produced, traded and consumed across the world. The average monthly fluctuationin prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) hasbeen at 9.7% during the past two and a half years, the maximum monthly fluctuation being ashigh 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 palmoil (CPO), crude palmolein, RBD (refined, bleached, deodorized) palm oil, RBD palmolein andcrude 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 throughoutthe year. Rainfall less than 100 mm for a period of more than three months is not suitable foroil palm cultivation. Oil palm thrives well at temperatures of

�� C with at least 5 hourssunshine 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 ismarginally suitable, the water–holding capacity of the soil is of greatest importance. Flat orgentle 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 ofpalm oil (both food and industrial consumption put together) in the world is growing at the rateof 7.37% compounded annually during the last 12 years period. While in the importing countrieslike 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 theEuropean Union are the major importers of palm oil. India is the largest importer of CPO witha share of over 15% of the total quantity traded in the international market. The total importsof India, China, Pakistan and European Union amount to approximately 56% of the total globalexports 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 exportsof CPO is to the tune of 90%. The major trading centres of CPO in the world are Malaysiaand Indonesia in Asia and Rotterdam in Europe. The Kuala Lumpur based Malaysia DerivativesExchange 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 ofpalm 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 pricecompetitiveness 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 industrialsectors apart from human consumption as RBD palmolein. The major importing and tradingcentres for palm in India are Chennai, Kakinada, Mumbai and Kandla. The other centerslike Mundra, Kolkata, Mangalore and Karwar also play important role, but next to the fourmajor trading centers. Palm oil trade in India is influenced by the supply–demand scene inthe 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 theGovernment, mainly the export–import policy, overall health of the economy that has a bearingon the purchasing power of ultimate consumers, etc. The entire industry of CPO in India isdominated by importers, large refiners, corporate involved in wholesale and retail trade throughvalue–addition and retail–regional level players along with a few national level players. Theindustry is dominated by over 200 importing companies, who are mostly refiners too. Domesticoilseed and edible oil industry is organised in the form of oilseed crushers, processors, solventextractors, technologists, commodity–specific producers and traders.


There exists a clear trough and crest in the seasonality of CPO production, indicating a typicalseasonality 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 aperennial 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 ina monthly. However, it exhibits seasonal highs and lows once in a year. Yield levels of theplantations are influenced by climatic conditions like rainfall, temperature, etc. Factors thatinfluence price are market related factors viz. supply–demand scenario of palm and its competingsoy oil in the global market apart from other vegetable oil sources viz. canola/ rapeseed, coconutoil, 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–termforecast 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 oilat 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 thecountry, and is the major source of cooking oil to over one billion consuming populace of thecountry, like any other welfare state, Government of India (GoI) adopts a protection policy withregard to production and trade in vegetable oils, so as to protect the interests of both the producersand consumers. While the strategy of farm subsidies and minimum support price (MSP) are onthe production side, the duty structure on various forms of palm oil is the major trade–relatedprotectionist 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 palmplantations. 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 solidat 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 formof 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 RBDpalmolein. 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 importingnations who refine domestically and consume. RBD palmolein exports from Malaysia haveincreased 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, importsnearly 3 million tons of palm oil annually (mainly from Malaysia, followed by Indonesia). Thisimplies that the country is dependent on palm oil imports for over 25% of its annual edible oilconsumption. There has been a sharp rise in the imports of palm oil into the country duringthe post 1998 period. At the same time, there has been a drastic change in the composition ofvarious forms of palm oil imported owing to the differential duty structure adopted by Indiangovernment for crude and refined palm oil imports. The import is mainly through the ports ofKandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and Chennai.

The domestic production of palm oil forms almost a negligible part of the total edible oilconsumption 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 milliontons 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 natureof the Indian edible oil consumers.


Palm oil trade in India is influenced by the supply–demand scene in the domestic marketincluding the factors influencing various oilseed production in the country, prices of variousdomestically produced and imported oils, production and trade policies of the Governmentmainly the export–import policy, overall health of the economy that has a bearing on thepurchasing 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 domesticconsumer 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 worthover Rs.440 billion in the country, soy oils share is over 20–21% at Rs.90–92 billion in termsof value. Being an agricultural commodity, which is often subjected to various production andmarket–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 havebeen fluctuating in the range of 4.5–8.5%. This offers immense opportunity for the investors toprofitably deploy their funds in this sector apart from those actually associated with the valuechain of the commodity, which could use soy oil futures contract as the most effective hedgingtool to minimise price risk in the market.

Soy oil is the derivative of soybean. On crushing mature beans, 18% oil and 78–80% mealis obtained. While the oil is mainly used for human consumption, meal serves as the mainsource of protein in animal feeds. Soy oil is the leading vegetable oil traded in the internationalmarkets, next only to palm. Palm and soy oils together constitute around 68% of global edible oilexport trade volume, with soy oil constituting 22.85%. It accounts for nearly 25% of the world’stotal oils and fats production. Increasing price competitiveness, and aggressive cultivation andpromotion from the major producing nations have given way to widespread soy oil growth bothin terms of production as well as consumption.


In India, soybean is purely a Kharif crop, whose sowing begins by end–June with the arrivalof 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 fromOctober, 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 growingat 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 consumptionof soy oil in USA is to the extent of 90% of its production; growing at the rate of 2.95%, slightlyhigher than the growth rate of its production (2.92%). The domestic consumption of soy oil inBrazil and Argentina are to an extent of 63% and 3% of their respective domestic production ofsoy oil.

The current world production of soy oil stands at 29–30 million tons. It has been growing atthe rate of 5.8% compounded annually during the last decade. The production growth rate hasbeen the highest for Argentina at 10.8%, while that of Brazil and USA has been at 5.6% and2.9% respectively. United States is the major producer of soy oil in the world. It accounts toapproximately 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 duringthe last five years, growing at the rate of 5%. In addition to domestic production, around 1.5–1.8million 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% ofits annual soy oil requirement and 48% of its annual vegetable oil imports. Imports have beengrowing at the rate of approximately 20% over the period of last five years. Madhya Pradesh isconsidered 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 Gujaratalso produce in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangliin Maharashtra are major trading centres of soybean, in and around which the crushing andsolvent extraction units are mostly located. The refining units are located at the importing portsof 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 solventextracted), Mumbai price indicates the imported soy oil price. Indian edible oil market is highlyprice sensitive in nature. Hence, the quantity of soy oil imports mainly depends on the pricecompetitiveness of soy oil vis-a-vis its sole competitor, palm oil apart from prices of domesticallyproduced oils, production and trade policies of the government – mainly the export–importpolicy, over–all health of the economy that has a bearing on the purchasing power of ultimateconsumers, 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 productionbase in limited countries as against its widespread consumption base, its close link with severalof its substitutes and its base raw material soybean in addition to its co–derivative (soy meal), thenature of the existing supply and value chain, etc. throw tremendous opportunity for trade in thiscommodity. The opportunity is further enhanced by the expected rise in consumption base andthe consequent expected rise in imports of vegetable oils in the years to come. In addition is thestiffening 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 oilrecovery from the seed is about 33%. The remaining is obtained as oil cake/ meal, which isrich in proteins and is used as an ingredient in animal feed. Mustard oil, which is known for itspungency, 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 rapeseedis sown during the months of June–July and harvested by August–September. Crushing foroil 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 istraditionally 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 fromthe producers moves into the hands of crushers via the regulated markets (mandies), gets crushedfor oil and cake in the ghanis or the expeller mills. It is largely consumed in the crude form inthe 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 unitsforms a major portion of our oil meal basket, part of which is consumed by the domestic animalfeed industry, and the rest exported. Refining of rapeseed oil was almost absent in the countrytill the end of the last century. As a result, the sector was more unorganised when comparedto 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 edibleoil packaging order in 1998, which made refining and packing of all oils sold in the retail sectormandatory. 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 milliontons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has beenthe fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China andEuropean 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 internationalmarket. Hong Kong and Russia are the major importers, whose share has been declining overthe 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 amoderate compounded annual growth rate (over the last decade) of 4.65%. While the productiongrowth rates in major producing countries viz. Canada and India have posted negative valuesof 1.2% and 7.8% respectively during the past decade, China, France and Germany’s rapeseedoil production during the period has been growing at 10%, 6.8% and 4.7% respectively. Chinacontributes more than one thirds of world rapeseed oil production while that of India has gonedown 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. Itforms over one–third of the country’s annual edible oil production, which is substantial. Theimports of mustard oil have drastically come down in the country from around 172000 tons in1998–99 to a mere 10000 tons (of crude rapeseed oil) in 2001–02, owing to stiff price competitionfrom palm and soy oils. There have been no imports of refined rapeseed oil for the last fewyears due to the differential duty structure. Unlike other oils, consumption of rapeseed oil isconcentrated in northern, north–eastern and western part of the country.

Rapeseed oil has several industrial applications too viz. as lubricant, its erucic acidderivatives 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 monsoondependent. 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 preferablyfor 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 largelydependent on the domestic production of rapeseed during the year, availability of others edibleoils, 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, wideconsumption 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 anannual production of 5.0–5.4 million tons, soybean constitutes nearly 25% of the country’s totaloilseed 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 twoyears, 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 rangeof 5–9%. Soybean is the single largest oilseed produced in the world. The commodity has beencommercially 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 primesource of protein in animal feeds.


Soybean could be grown under rain fed conditions, provided a good amount of soil moistureis ensured at the germination, vegetative growth and pod setting stages. The planting date ofvegetable soybean is dependent upon temperature and day length. The optimum temperaturerange of soybean cultivation is

� �� C with short day length (14 hours or less). However,planting should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.0–6.5is 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 isconsumed 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 soybeanconsumption. Mexico, Japan, India and Taiwan are among the other major consumers. Duringthe past five years period, global consumption of soybean has grown at the rate of 5.25%, higherthan the production growth rate of 5.19%.

Of the total 310–320 million tons of oilseeds produced annually, soybean production alonestands 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 globallevel. USA, followed by Brazil and Argentina are the major producing countries; India and Chinaare among the other producers.

The market size of the popularly known miracle bean in India is over Rs.5000 crore. Withan annual production of 5.0–5.4 million tons, soybean constitutes nearly 25% of the country’stotal oilseed production. Of the total bean produced, 6–7 lakh tons goes for direct consumptionin the form of bean itself (sowing, human consumption as bean itself), leaving the rest of thequantity for crushing for meal and oil. While the country imports soy oil, it is a leading exporterof 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, UttarPradesh, 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 1.5million 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 ofrapeseed 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 ashigh 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 producersare Germany, France, Australia, Pakistan and Poland. The commodity has been commerciallyexploited in the form of seeds, oil (seed to oil recovery is 39–40%) and meal. The hybrid formof rapeseed, known as canola, is more popular internationally.


Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown inIndia. 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 requirerelatively cool temperatures for satisfactory growth. In India, they are grown during the Rabiseason from September–October to February–March. Rapeseed and mustard crops grow well inareas having 25 to 40 cm of rainfall. Sarson is preferred in low–rainfall areas, whereas Rai andToria are grown in medium and high rainfall areas respectively. Rapeseed and mustard thrivebest in light to heavy loams. Rai may be grown on all types of soils, but Toria does best in loamto heavy loams. Sarson is suited to light–loam soils and Taramira is mostly grown on very lightsoils.


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

Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tonsin 1999, and declined from there on to the current (2002) level of 32.5 million tons. It has beengrowing at the rate of 2.2% during the last 12 years period. The major contributors to globalrapeseed production are China, India, Germany, France, Canada and Australia with a share of32%, 12.6%, 12.1%, 10%, 9.8% and 3% respectively. Among the major contributors to worldproduction, Australian rapeseed production grew at the fastest rate of 21%. While China, Franceand Germany are growing at a moderate rate of 2–4%, India and Canada have shown a decline

4.2 Precious metals 49

in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997to 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 toohave fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and Chinaconsume 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 1.5million tons of oil and 3–3.2 million tons of meal on crushing. It is the largest produced edibleoil in India (groundnut oil production also stands on par with it during good years). It formsover one–third of the country’s annual edible oil production, which is substantial. The importsof mustard oil have drastically come down in the country from around 172000 tons in 1998–99to a mere 10000 tons (of crude rapeseed oil) in 2001–02, owing to stiff price competition frompalm and soy oils. There have been no imports of refined rapeseed oil for the last few years dueto the differential duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producingStates in the country. Together, they produce about 50% of the produce. The production fromRajasthan 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 isknown and consumed preferably for its unique pungency, it is mostly crushed in the local kacchiand 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 influencerapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed duringthe year, availability of others edible oils, and general sentiments in the overall edible oil industrywithin and outside the country. Being an important source of edible oil, it is undoubtedly thefocus of Indian edible oil industry. The seasonal nature of the production of rapeseed and itsvulnerability to natural fallacies, wide consumption spread all through the year, the nature of theexisting supply and value chain, susceptibility to the sentiments in the overall edible oil and mealindustry 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 everyonein 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 dutyon crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oilfor 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 lookbriefly at both.


Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November1972. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the CanadianImperial Bank of Commerce. The gold contracts became so popular that by 1974 there was as manyas 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 hada relationship with the Comex where participants could take open positions in one exchange and liquidatethem in the other.

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

� The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the fewcommodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked withseven million contracts.

� On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago MercantileExchange 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, NationalBank for Agriculture and Rural Development and National Stock Exchange of India Limited, introducesgold futures contracts.

Gold has a very active derivative market compared with other commodities. Gold accounts for 45 percent 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 havemade it precious to men and women alike. Owning gold has long been a safeguard againstdisaster. Many times when paper money has failed, men have turned to gold as the one truesource of monetary wealth. Today is no different. While there have been fluctuations in everymarket and decided downturns in some, the expectation is that gold will hold its own. There isa limited amount of gold in the world, so investing in gold is still a good way to plan for thefuture. Gold is homogeneous, indestructible and fungible. These attributes set gold apart fromother commodities and financial assets and tend to make its returns insensitive to business cyclefluctuations. Gold is still bought (and sold) by different people for a wide variety of reasons – asa use in jewellery, for industrial applications, as an investment and so on.


Table 4.1 Country–wise share in gold production, 1968 and 1999Country Tonnes, 1968 Share 1968 Tonnes, 1999 Share, 1999

South Africa 972 67 437 17Australia 309 12Canada 87 6 154 6USA 44 3 334 13China 154 6Indonesia 154 6India 51 2Rest 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 foralmost 80% of all non–communist output in 1970. Although it retained its position as thesingle largest gold producing country, its share had fallen to around 17% by 1999 because ofhigh costs of mining and reduced resources. Table 4.1 gives the country–wise share in goldproduction. In contrast other countries like US, Australia, Canada and China have increased theiroutput exponentially with output from developing countries like Peru and other Latin Americancountries also increasing impressively.

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

Melting & refining assaying facility in India

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


The demand for gold may be categorised under two heads – consumption demand and investmentdemand. Consumption of gold differs according to type, namely industrial applications andjewellery. The special feature of gold used in industrial and dental applications is that some ofit cannot be salvaged and thus is truly consumed. This is unlike consumption in the form ofjewellery, 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 jewelryforms 89% of consumer demand.


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

There are several ways in which investors can invest in gold either directly or through avariety 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 $40billion worth. More than 80% of the gold consumed is in the form of jewellery, which is generallypredominated by women. The Indian demand to the tune of 800 tonnes per year is making it thelargest market for gold followed by USA, Middle East and China. About 80% of the Physicalgold is consumed in the form of jewellery while bars and coins occupy not higher than 10% ofthe gold consumed. If we include jewellery ownership, then India is the largest repository ofgold in terms of total gold within the national boundaries.

Regarding pattern of demand, there are no authentic estimates, the available evidence showsthat 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 preferencefor a variety of reasons – religious, ritualistic, a preferred form of wealth for women, and as ahedge against inflation. It will be difficult to prioritise them but it may be reasonable to concludethat it is a combined effect, and to treat any major part as exclusively a store of value or hedginginstrument would be unrealistic. It would not be realistic to assume that it is only the affluent thatcreates demand for gold. There is reason to believe that a part of investment demand for goldassets is out of black money.

Rural India continues to absorb more than 70% of the gold consumed in India and it has itsown 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 Sikhcommunity, where women did not inherit landed property whereas gold and silver jewellerywas, 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 goldalso occupies a significant position in the temple system where gold is used to prepare idol anddevotees offer gold in the temple. These temples are run in trust and gold with the trust rarelycomes into re-circulation. The existing social and cultural system continues to cause net goldbuyer 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 wasestimated at 65 tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it islikely that, with prosperity and enlightenment, there may be deceleration in demand, particularlyin urban areas, it would be made good by growing demand on account of prosperity in ruralareas. In the near future, therefore, the annual demand will continue to be over 600 tonnes peryear.

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% ofIndian consumption is met through imports. The domestic production of the gold is very limitedwhich is around 9 tonnes in 2002 resulting more dependence on imported gold. The availabilityof recycled gold is price sensitive and as such the dominance of the gold supply through importis in existence. The fabricated old gold scraps is price elastic and was estimated to be near 450tonnes in 2002. It rose almost more than 40% compared to the previous year because of rise ingold 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 ofliberalisation in 1990.


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

Since the demand for gold is closely tied to the production of jewelry, gold prices tend toincrease during the time of year when demand for jewellery is greatest. Christmas, Mothers Dayand Valentine Day are all major shopping seasons and hence the demand for metals tends tobe strong a few months ahead of these holidays. Also, the summer wedding season sees a largeincrease 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 jewellerstend to have holiday inventory to unwind.

4.2.2 Silver

The dictionary describes it as a white metallic element, sonorous, ductile, very malleable andcapable of high degree of polish. It also has the highest thermal and electrical conductivity ofany substance. Silver is somewhat harder than gold and is second only to gold in malleabilityand ductility. Silver remains one of the most prominent candidates in the metals complex asfar as futures’ trading is concerned. Thanks to its unique volatility, silver has remained a hotfavourite speculative vehicle for the small time traders. Though futures trading was bannedin 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 ofIndian 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, Rajkotand 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. Cashmarkets remain highly unorganised in the silver and impurity and excessive speculation remainkey issue for the trade. Taking cue from gold, government of India is planning to introducehallmarking in silver which is likely to address quality and credibility of Indian silverware andjeweller 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 andtreasured longer than any of the other precious metals. Mexico is the worlds leading producer ofsilver, followed by Peru, Canada, the United States, and Australia. The main consumer countriesfor silver are the United States, which is the worlds largest consumer of silver, followed byCanada, Mexico, the United Kingdom, France, Germany, Italy, Japan and India. The mainfactors affecting these countries demand for silver are macro economic factors such as GDPgrowth, industrial production, income levels, and a whole host of other financial macro economicindicators.

Demand

Demand for silver is built on three main pillars; industrial and decorative uses, photography andjewelry & silverware. Together, these three categories represent more than 95 percent of annualsilver 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 demandfor silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is thesecond largest component, with more demand from the flatware industry than from the jewelryindustry in recent years. India, the largest consumer of silver, is gearing up to start hallmarkingof 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 inthe 17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The Londonmarket has a fix which offers the chance to buy or sell silver at a single price. The fix begins at 12:15p.m. and is a balancing exercise; the price is fixed at the point at which all the members of the fixingcan 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. TheLondon Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968and 1969, respectively. In the United States, the silver futures market functions under the surveillanceof an official body, the Commodity Futures Trading Commission (CFTC). Although London remainsthe true center of the physical silver trade for most of the world, the most significant paper contractstrading market for silver in the United States is the COMEX division of the New York MercantileExchange. Spot prices for silver are determined by levels prevailing at the COMEX. Although there isno American equivalent to the London fix, Handy & Harman, a precious metals company, publishes aprice 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 by177 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. Mineproduction is surprisingly the largest component of silver supply. It normally accounts for a littleless than 2/3 rd of the total (last year was slightly higher at 68%). Fifteen countries produceroughly 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 frommines. Peru is the worlds second largest producer of silver. Silver is often mined as a byproductof other base metal operations, which accounts for roughly four-fifths of the mined silver supplyproduced annually. Known reserves, or actual mine capacity, is evenly split along the lines ofproduction. 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 whenrecovered from existing manufactured goods or waste. Old scrap normally makes up around afifth of supply. Scrap supply increased marginally last year up by 1.2%. The other major sourceof 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 fromthe waste and recycled. The United States recycles the most silver in the world, accountingfor roughly 43.6 million ounces. Japan is the second largest producer of silver from scrap andrecycling, accounting for roughly 27.8 million troy ounces in 1997. In the United States andJapan, three–quarters of all the recycled silver comes from the photographic scrap, mainly in theform 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 supplyand consumption. Besides, a host of social, economic and political factors have powerful bearingon silver prices. As in the case of gold prices, political tensions, the threat affects the priceof silver too. When trading and movement of silver is restricted, within or outside nationalboundaries, prices move in accordance with demand and supply conditions prevalent in thatenvironment Price of silver is also influenced by changes in factors such as inflation (real orperceived), 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 suchas tastes, technological change and market liberalisation.

Approximately 70 percent of the silver mined in the western hemisphere is mined as a by–product of other metal products, such as gold, copper, nickel, lead, and zinc. As such, the price ofthese metals greatly affects the supply of silver mined in any year. As the price of the other metalproducts increases, the increased profit margin to mine operations stimulates greater productionof the other metals, and as a result, the production of silver increases in tandem. Because silveris a precious metal, its price is determined by the 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 nota product that can be manufactured en masse, and, therefore, is subject to issues such as weatherand politics that may affect silver mining operations.

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

1. Gold

2. Rapeseed

3. Silver

4. Energy

A: The correct answer is number 4. ��Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment?

1. Wheat

2. Rapeseed

3. Soybean

4. Soy oil

A: The correct answer is number 1. ��Q: In India, is the most important non–food crop.

1. Jute

2. Cotton

3. Silk




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

1. Demand–supply scenario

2. Production and prices of synthetic fibre

3. Previous prices of cotton

4. Prices of cotton products.

A: The correct answer is number 4. ��Q: Futures prices of cotton at the serve as the reference price for cotton traded in the internationalmarket.

1. CME

2. CBOT

3. NYBOT

4. SGX

A: The correct answer is number 3. ��Q: Palm oil is extracted from the of oil palm plantations.

1. Mature fresh fruit bunches

2. Dry fruit bunches

3. Stem

4. Leaves

A: The correct answer is number 1. ��Q: RBD Palmolein is the derivative of

1. Soy

2. Rapeseed

3. CPO

4. Coconut kernel

A: The correct answer is number 3. ��Q: Which of the following factor directly influences the price of RBD palmolein?

1. Prices of Rapeseed oil

2. Prices of coconut oil

3. Prices of CPO

4. Prices sunflower oil

A: The correct answer is number 3. ��Q: Soy oil is the derivative of

1. Soy

2. Soybean

3. CPO

4. Sunflower seeds



Q: The market reflects the price of domestically crushed soybean

1. Mumbai

2. Ahmedabad

3. Indore

4. Delhi


Q: The market reflects the price of imported soybean

1. Mumbai

2. Ahmedabad

3. Indore

4. Delhi


Chapter 5

Instruments available for trading

In recent years, derivatives have become increasingly popular due to their applications forhedging, speculation and arbitrage. Before we study about the applications of commodityderivatives, we will have a look at some basic derivative products. While futures and optionsare 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 momentonly commodity futures trade on the NCDEX, eventually, as the market grows, we also havecommodity 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 asseton a certain specified future date for a certain specified price. The other party assumes a shortposition and agrees to sell the asset on the same date for the same price. Other contract detailslike delivery date, price and quantity are negotiated bilaterally by the parties to the contract. Theforward 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 andthe 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, whichoften results in high prices being charged.

However forward contracts in certain markets have become very standardised, as in the caseof foreign exchange, thereby reducing transaction costs and increasing transactions volume. Thisprocess 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 applicationwould be that of an exporter who expects to receive payment in dollars three months later. He isexposed to the risk of exchange rate fluctuations. By using the currency forward market to selldollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importerwho is required to make a payment in dollars two months hence can reduce his exposure toexchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then hecan go long on the forward market instead of the cash market. The speculator would go longon 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 arelatively small proportion of the value of the assets underlying the forward contract. The use offorward 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. Theforward market is like a real estate market in that any two consenting adults can form contractsagainst each other. This often makes them design terms of the deal which are very convenient inthat 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 whenforward markets trade standardized contracts, and hence avoid the problem of illiquidity, still thecounterparty 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 futurescontract is an agreement between two parties to buy or sell an asset at a certain time in thefuture at a certain price. But unlike forward contracts, the futures contracts are standardizedand exchange traded. To facilitate liquidity in the futures contracts, the exchange specifiescertain standard features of the contract. It is a standardized contract with standard underlyinginstrument, 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 suchsettlement. A futures contract may be offset prior to maturity by entering into an equal andopposite 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 significantfinancial innovation of the last twenty years.” The first exchange that traded financial derivatives waslaunched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called theInternational Monetary Market (IMM) and traded currency futures. The brain behind this was a mancalled Leo Melamed, acknowledged as the “father of financial futures” who was then the Chairman ofthe Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchangesold contracts whose value was counted in millions. By 1990, the underlying value of all contractstraded at the Chicago Mercantile Exchange totalled 50 trillion dollars.These currency futures paved the way for the successful marketing of a dizzying array of similarproducts at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago BoardOptions Exchange. By the 1990s, these exchanges were trading futures and options on everythingfrom Asian and American stock indexes to interest–rate swaps, and their success transformed Chicagoalmost overnight into the risk–transfer capital of the world.

Box 5.6: The first financial futures market

Table 5.1 Distinction between futures and forwardsFutures Forwards

Trade on an organised exchange OTC in natureStandardized contract terms Customised contract termshence more liquid hence less liquidRequires margin payments No margin paymentFollows 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 becauseboth serve essentially the same economic functions of allocating risk in the presence of futureprice uncertainty. However futures are a significant improvement over the forward contracts asthey eliminate counterparty risk and offer more liquidity. Table 5.1 lists the distinction betweenthe 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 theNCDEX have one-month, two-months and three-months expiry cycles which expire on the 20thday of the delivery month. Thus a January expiration contract expires on the 20th of January anda February expiration contract ceases trading on the 20th of February. On the next trading dayfollowing 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 contractwill 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, thedelivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for theGold futures contract is 1 kg.

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

� Cost of carry: The relationship between futures prices and spot prices can be summarised in termsof what is known as the cost of carry. This measures the storage cost plus the interest that is paid tofinance 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 contractis 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 accountis adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This iscalled marking–to–market.

� Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that thebalance in the margin account never becomes negative. If the balance in the margin account fallsbelow the maintenance margin, the investor receives a margin call and is expected to top up themargin 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 arefundamentally different from forward and futures contracts. An option gives the holder of theoption the right to do something. The holder does not have to exercise this right. In contrast, ina 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, thepurchase 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 ofvaluation. The first trading in options began in Europe and the US as early as the seventeenth century. Itwas only in the early 1900s that a group of firms set up what was known as the put and call Brokers andDealers Association with the aim of providing a mechanism for bringing buyers and sellers together. Ifsomeone wanted to buy an option, he or she would contact one of the member firms. The firm wouldthen attempt to find a seller or writer of the option either from its own clients or those of other memberfirms. If no seller could be found, the firm would undertake to write the option itself in return for aprice.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, CBOEwas set up specifically for the purpose of trading options. The market for options developed so rapidlythat by early ’80s, the number of shares underlying the option contract sold each day exceeded thedaily 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 ofgold at the price specified in the contract.

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

� Buyer of an option: The buyer of an option is the one who by paying the option premium buys theright 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 andis 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 certaindate for a certain price.

� Option price: Option price is the price which the option buyer pays to the option seller. It is alsoreferred to as the option premium.

� Expiration date: The date specified in the options contract is known as the expiration date, theexercise date, the strike date or the maturity.

� Strike price: The price specified in the options contract is known as the strike price or the exerciseprice.


� American options: American options are options that can be exercised at any time upto the expirationdate. Most exchange-traded options are American.

� European options: European options are options that can be exercised only on the expiration dateitself. European options are easier to analyse than American options, and properties of an Americanoption 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 positivecashflow to the holder if it were exercised immediately. A call option on the index is said to bein-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 thecase 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 cashflowif it were exercised immediately. An option on the index is at-the-money when the current indexequals 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 anegative cashflow it it were exercised immediately. A call option on the index is out-of-the-moneywhen the current index stands at a level which is less than the strike price (i.e. spot price � strikeprice). If the index is much lower than the strike price, the call is said to be deep OTM. In the caseof 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 - intrinsicvalue 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� �"!$# %�&('*),+.-0/2143

which means the intrinsic value of a call is the greater of 0 or'*)5+�-0/61

. Similarly,the intrinsic value of a put is

�7�8!9# %�&:/;-<) + 3,i.e. the greater of 0 or

'=/>-?) + 1. K is the strike price

and) +

is the spot price.

� Time value of an option: The time value of an option is the difference between its premium and itsintrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only timevalue. Usually, the maximum time value exists when the option is ATM. The longer the time toexpiration, the greater is an option’s time value, all else equal. At expiration, an option should haveno time value.

5.4 Basic payoffs

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

5.5 Payoff for futures 65

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 tulipwas brought into Holland by a botany professor from Vienna. Over a decade, the tulip became themost popular and expensive item in Dutch gardens. The more popular they became, the more Tulipbulb prices began rising. That was when options came into the picture. They were initially used forhedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contractcould be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growerscould 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 vehiclefor obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, acall buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbsthemselves. The writers of the put options also prospered as bulb prices spiralled since writers wereable to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unableto 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 per10 gms, and sells it at a future date at an unknown price, @ + . Once it is purchased, the investor issaid 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 perQuintal, and buys it back at a future date at an unknown price, @ + . Once it is sold, the investor issaid 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 atearlier. If the price of the underlying rises, the buyer makes profits. If the price of the underlyingfalls, the buyer makes losses. The magnitude of profits or losses for a given upward or downwardmovement is the same. The profits as well as losses for the buyer and the seller of a futurescontract are unlimited. These linear payoffs are fascinating as they can be combined with optionsand 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 whoholds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.


Figure 5.1 Payoff for a buyer of gold

The figure shows the profits/ losses from a long position on gold. The investor bought gold at Rs.6000 per 10 gms.If the price of gold rises, he profits. If price of gold falls he looses.

0

Loss

Profit

60005500 6500

Gold

−500

+500

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.6500per Quintal. If the price of cotton falls, he profits. If the price of cotton rises, he looses.

0

Loss

Profit

6500 70006000

+500

−500

Long staple cotton

5.5 Payoff for futures 67

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 weretrading at Rs.6000 per 10 gms. If the price of the underlying gold goes up, the gold futures price too would goup and his futures position starts making profit. If the price of gold falls, the futures price falls too and his futuresposition starts showing losses.

0

Loss

Profit

6000

Gold futures price

Take the case of a speculator who buys a two–month gold futures contract on the NCDEX whenit sells for Rs.6000 per 10 gms. The underlying asset in this case is gold. When the prices ofgold in the spot market goes up, the futures price too moves up and the long futures positionstarts making profits. Similarly when the prices of gold in the spot market goes down, the futuresprices too move down and the long futures position starts making losses. Figure 5.3 shows thepayoff 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 shortsan asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Takethe case of a speculator who sells a two–month cotton futures contract when the contract sellsRs.6500 per Quintal. The underlying asset in this case is long staple cotton. When the prices oflong staple cotton move down, the cotton futures prices also move down and the short futuresposition starts making profits. When the prices of long staple cotton move up, the cotton futuresprice also moves up and the short futures position starts making losses. Figure 5.4 shows thepayoff 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 perQuintal. If the price of the underlying long staple cotton goes down, the futures price also falls, and the short futuresposition starts making profit. If the price of the underlying long staple cotton rises, the futures too rise, and the shortfutures position starts showing losses.

0

Loss

Profit

Cotton futures price

6500

5.6 Payoff for options

The optionality characteristic of options results in a non–linear payoff for options. In simplewords, it means that the losses for the buyer of an option are limited, however the profits arepotentially unlimited. The writer of an option gets paid the premium. The payoff from the optionwritten is exactly the opposite to that of the option buyer. His profits are limited to the optionpremium, however his losses are potentially unlimited. These non–linear payoffs are fascinatingas they lend themselves to be used for generating various complex payoffs using combinationsof 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 inthe option. The profit/ loss that the buyer makes on the option depends on the spot price of theunderlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higherthe spot price, more is the profit he makes. If the spot price of the underlying is less than thestrike price, he lets his option expire un–exercised. His loss in this case is the premium he paidfor buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option ongold (often referred to as long call) with a strike of Rs.7000 per 10 gms, bought at a premium ofRs.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 10gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes in–the–money. If uponexpiration, gold trades above the strike of Rs.7000, the buyer would exercise his option and profit to the extent ofthe difference between the spot gold–close and the strike price. The profits possible on this option are potentiallyunlimited. However if the price of gold falls below the strike of Rs.7000, he lets the option expire. His losses arelimited to the extent of the premium he paid for buying the option.

0

Loss

Profit

Gold

7000

500

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 inthe option. For selling the option, the writer of the option charges a premium. The profit/ lossthat the buyer makes on the option depends on the spot price of the underlying. Whatever is thebuyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, thebuyer will exercise the option on the writer. Hence as the spot price increases the writer of theoption starts making losses. Higher the spot price, more is the loss he makes. If upon expirationthe 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 ofa three month call option on gold (often referred to as short call) with a strike of Rs.7000 per 10gms, 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 inthe 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.7000per 10 gms. As the price of gold in the spot market rises, the call option becomes in–the–money and the writer startsmaking losses. If upon expiration, gold price is above the strike of Rs.7000, the buyer would exercise his option onthe 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 islimited to the extent of the up–front option premium of Rs.500 charged by him.

0

Loss

Profit

7000 Gold

500

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lowerthe spot price, more is the profit he makes. If the spot price of the underlying is higher than thestrike price, he lets his option expire un–exercised. His loss in this case is the premium he paidfor buying the option. Figure 5.7 gives the payoff for the buyer of a three month put option oncotton (often referred to as long put) with a strike of Rs.6000 per Quintal, bought at a premiumof Rs.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 inthe option. For selling the option, the writer of the option charges a premium. The profit/ lossthat the buyer makes on the option depends on the spot price of the underlying. Whatever is thebuyer’s profit is the seller’s loss. If upon expiration, the spot price happens to be below the strikeprice, the buyer will exercise the option on the writer. If upon expiration the spot price of theunderlying is more than the strike price, the buyer lets his option expire un–exercised and thewriter gets to keep the premium. Figure 5.8 gives the payoff for the writer of a three month putoption 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 beseen, as the price of cotton in the spot market falls, the put option becomes in–the–money. If at expiration, cottonprices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and profit to the extent of thedifference between the strike price and spot cotton–close. The profits possible on this option can be as high as thestrike 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.400in this case.

Loss

Profit

06000 Long staple cotton

400

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 optionbuyer 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 anyfurther losses to him (other than the funds already paid for the option). This is different fromfutures, which is free to enter into, but can generate very large losses. This characteristic makesoptions attractive to many occasional market participants, who cannot put in the time to closelymonitor 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 ofcotton in the spot market falls, the put option becomes in–the–money and the writer starts making losses. If uponexpiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option on thewriter who would suffer a loss to the extent of the difference between the strike price and spot cotton–close. Theprofit 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 thatthe price of the underlying asset falls to zero.

Profit

0

Loss

Long staple cotton6000

400

Table 5.2 Distinction between futures and optionsFutures 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 ProblemsQ: Which of the following cannot be an underlying asset for a financial derivative contract?

1. Equity index

2. Commodities

3. Interest rate

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

2. Gold

3. Cotton

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

2. Chicago Mercantile Exchange

3. Chicago Board Options Exchange

4. London International Financial Futures andOptions Exchange

A: The correct answer is 3. ��

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

1. Buyer

2. Seller

3. Both

4. 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

2. Unlimited

3. a function of the volatility of the index




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

1. Futures contract

2. Forward contract

3. Spot contract



Q: Typically option premium is

1. Less than the sum of intrinsic value and timevalue

2. Greater than the sum of intrinsic value andtime value

3. Equal to the sum of intrinsic value and timevalue

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 valueof the option is

1. Rs.18

2. Rs.4

3. Rs.14

4. Rs.12


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

1. OTC contract

2. Exchange traded contract

3. Spot contract



Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buysfutures 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

2. (-)5000

3. (+)50,000

4. (-)50,000

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

2. (-)5000

3. (+)50,000

4. (-)50,000

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

2. (-)5000

3. (+)50,000

4. (-)50,000

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

2. (-)5000

3. (+)50,000

4. (-)50,000

A: Each unit is for 10 Quintals. He sells 10 units which means a futures position in 100 Quintals. Hemakes 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 apremium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold isRs.7080/10 gms. What is his net payoff?

1. (+) 10,000

2. (+) 1,000

3. (-) 10,000

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 1000gms. So he makes a net profit of Rs.1000 on his position

'8A4BCBCBA4B �ED %81 . 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 apremium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold isRs.6080/10 gms. What is his net payoff?

1. (-) 7000

2. (+) 1,000

3. (-) 700

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 in1000 gms of gold. He pays an option premium of Rs.70 per 10 gms. He losses the premium amount ofRs.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 ata premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold isRs.7080/10 gms. What is his net payoff?

1. (+) 10,000

2. (+) 1,000

3. (-) 10,000

4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is thesellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short position in1000 gms. So he makes a net loss of Rs.1000 on his position

'8A4BCBCBA4B �?D %81 . The correct answer is number4. ��

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

1. (-) 7000

2. (+) 1,000

3. (-) 700

4. (-) 1,000

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

Chapter 6

Pricing commodity futures

Commodity futures began trading on the NCDEX from the 14th December 2003. The market isstill in its nascent phase, however the volumes and open interest on the various contracts tradingin this market have been steadily growing.

The process of arriving at a figure at which a person buys and another sells a futures contractfor a specific expiration date is called price discovery. In an active futures market, the processof price discovery continues from the market’s opening until its close. The prices are freely andcompetitively derived. Future prices are therefore considered to be superior to the administeredprices or the prices that are determined privately. Further, the low transaction costs and frequenttrading encourages wide participation in futures markets lessening the opportunity for control bya few buyers and sellers.

In an active futures markets the free flow of information is vital. Futures exchanges act as afocal point for the collection and dissemination of statistics on supplies, transportation, storage,purchases, exports, imports, currency values, interest rates and other pertinent information. Anysignificant change in this data is immediately reflected in the trading pits as traders digest thenew information and adjust their bids and offers accordingly. As a result of this free flow ofinformation, the market determines the best estimate of today and tomorrow’s prices and it isconsidered 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 functioningof futures market.

In this chapter we try to understand the pricing of commodity futures contracts and look athow 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 offutures.

6.1 Investment assets versus consumption assets

When studying futures contracts, it is essential to distinguish between investment assets andconsumption assets. An investment asset is an asset that is held for investment purposes bymost 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 beheld exclusively for investment. As we saw earlier, silver, for example, has a number of industrialuses. However, to classify as investment assets, these assets do have to satisfy the requirementthat they are held by a large number of investors solely for investment. A consumption asset isan asset that is held primarily for consumption. It is not usually held for investment. Examplesof 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 ofan investment asset from its spot price and other observable market variables. For pricingconsumption assets, we need to review the arbitrage arguments a little differently. To beginwith, we look at the cost–of–carry model and try to understand the pricing of futures contractson 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 treatthe forward and the futures market as one and the same. A futures contract is nothing but aforward contract that is exchange traded and that is settled at the end of each day. The buyerwho needs an asset in the future has the choice between buying the underlying asset today in thespot market and holding it, or buying it in the forward market. If he buys it in the spot markettoday, it involves opportunity costs. He incurs the cash outlay for buying the asset and he alsoincurs costs for storing it. If instead he buys the asset in the forward market, he does not incuran initial outlay. However the costs of holding the asset are now incurred by the seller of theforward contract who charges the buyer a price that is higher than the price of the asset in thespot market. This forms the basis for the cost–of–carry model where the price of the futurescontract is defined as:

F F S G 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 F S HI�JG K�LCM (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 forarbitrage. If NPOQ@RH:�SG<K�L M or N>TQ@RH:�SG<K�L M , arbitrage would exist. We know what are the spotand futures prices, but what are the components of holding costs? The components of holdingcost vary with contracts on different assets. At times the holding cost may even be negative. Inthe case of commodity futures, the holding cost is the cost of financing plus cost of storage andinsurance purchased. In the case of equity futures, the holding cost is the cost of financing minusthe dividends returns.

Equation 6.2 uses the concept of discrete compounding, where interest rates are compoundedat discrete intervals, for example, annually or semiannually. Pricing of options and other complexderivative securities requires the use of continuously compounded interest rates. Most books onderivatives use continuous compounding for pricing futures too. When we use continuous com-pounding, equation 6.2 is expressed as:

F F S UWV M (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 ofcommodity futures, let us start with the simplest derivative contract – a forward contract. Weuse examples of forward contracts to explain pricing concepts because forward contracts areeasier to understand. However, the logic for pricing a futures contract is exactly the same as thelogic for pricing a forward contract. We begin with a forward contract on an asset that providesthe holder with no income and has no storage or other costs. Then we introduce real world factorsas 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 thatthe price of the underlying stock is Rs.40 and the three–month interest rate is 5% per annum. Weconsider 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 themarket at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in theforward market at Rs.43. At the end of three months, the arbitrager delivers the share and receivesRs.43. The sum of money required to pay off the loan is

� %.X B�Y BCZ([�B�Y \CZ^] � %�_a`�%. 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 monthperiod.


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 athree–month forward contract. The proceeds of the short sale grow to

� %.X B�Y BCZ([�B�Y \CZJ] � %�_a`�%in three

months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share underthe terms of the forward contract and uses it to close his short position, in the process making a netgain 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 sucha situation, arbitragers will sell the asset in the forward market, eventually driving the forwardprice 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 toRs.40.50. At a forward price of Rs.40.50 there will be no arbitrage. This is the fair value of theforward 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 theexample of a futures contract on a commodity and work out the price of the contract. The spotprice of gold is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be thefutures price of 10 gms of gold one month down the line ? Let us assume that we’re on 1stJanuary 2004. How would we compute the price of a gold futures contract expiring on 30thJanuary? From the discussion above we know that the futures price is nothing but the spot priceplus 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?X B�YbA4Z([dcfecfgih .

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.7174.

F Fj@kU V M2F � ��U B�YbA4Z([dlnmlno*p Frqts�u � ��v�wxuyv��If the contract was for a three–month period i.e. expiring on 30th March, the cost of financingwould increase the futures price. Therefore, the futures price would be NzF � ��U B�YbA4Z([d{nmlno*p Fqts�u �� w��xu � .

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 arbitragearguments and the cost–of–carry model. In the example we considered, the gold contract wasfor 10 grams of gold. Hence we ignored the storage costs. However, if the one–month contractwas for a 100 kgs of gold instead of 10 gms, then it would involve non–zero holding costs whichwould include storage and insurance costs. The price of the futures contract would then beRs.7086.80 plus the holding costs.

Table 6.1 gives the indicative warehouse charges for accredited warehouses/ vaults that willfunction 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)k' D}|?~ 1 M . 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 StockExchange far exceeded all previous records. For most of the day, futures traded at significant discountto the underlying index. This was largely because delays in processing orders to sell equity made indexarbitrage too risky. On the next day, October 20,1987, the New York Stock Exchange placed temporaryrestrictions on the way in which program trading could be done. The result was that the breakdown ofthe traditional linkages between stock indexes and stock futures continued. At one point, the futuresprice for the December contract was 18% less than the S&P 500 index which was the underlying indexfor these futures contracts! However, the highlight of the whole episode was the fact that inspite ofhuge losses, there were no defaults by futures traders. It was the ultimate test of the efficiency of themargining 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. Theper 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 aninvestment asset is given by NjFj@kU V M . Storage costs add to the cost of carry. If � is the presentvalue of all the storage costs that will be incurred during the life of a futures contract, it followsthat the futures price will be equal to

F F (S + U) U V M (6.4)

where:

r Cost of financing (annualised)


U Present value of all storage costs

For ease of understanding let us consider a one–year futures contract on gold. Suppose thefixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 perweek, it costs Rs.3170 to store one kg of gold for a year(52 weeks). Assume that the paymentis made at the beginning of the year. Assume further that the spot gold price is Rs.6000 per 10grams and the risk–free rate is 7% per annum. What would the price of one year gold futures beif the delivery unit is one kg?

F F (S + U) U V MF H4w��G7�x��G � v�w��L�U B�Y B:��[�AF w��w��,u � w


Table 6.1 NCDEX – indicative warehouse chargesCommodity Fixed charges Warehouse charges per

(Rs.) unit per week (Rs.)

Gold 310 55 per kgSilver 610 1 per kgSoy Bean 110 13 per MTSoya oil 110 30 per MTMustard seed 110 18 per MTMustard oil 110 42 per MTRBD Palmolein 110 26 per MTCPO 110 25 per MTCotton – long 110 6 per BaleCotton – 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–yearfutures 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.55per week. It costs Rs.1025 to store one kg of gold for three months(13 weeks). Assume that thestorage costs are paid at the time of deposit. Assume further that the spot gold price is Rs.6000per 10 grams and the risk–free rate is 7% per annum. What would the price of three month goldfutures if the delivery unit is one kg?

F F (S + U) U V MF H4w��G7�x��G � �.�L�U B�Y B:��[�B�Y \CZF w��w��u��

We see that the three–month futures price of a kg of gold would be Rs.6,11,635.50. Thethree–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 commoditiesthat are consumption commodities rather than investment assets, the arbitrage arguments used todetermine futures prices need to be reviewed carefully. Suppose we have

F T (S + U) U V M (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) |��

at the risk–free interest rate and use it to purchase one unit of the commodityand 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 ofN��H�@6G7��L�U V M 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 holdgood.

Suppose next that

F O (S + U) UWV M (6.6)

In case of investment assets such as gold and silver, many investors hold the commoditypurely for investment. When they observe the inequality in equation 6.6, they will find itprofitable 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 H�@�Gr��LIU V M �QN relative to the position that theinvestors would have been in had they held the underlying commodity. As arbitragers exploitthis opportunity, the spot price will decrease and the futures price will increase until equation 6.6does not hold good. This means that for investment assets, equation 6.4 holds good. However, forcommodities like cotton or wheat that are held for consumption purpose, this argument cannotbe used. Individuals and companies who keep such a commodity in inventory, do so, becauseof its consumption value – not because of its value as an investment. They are reluctant tosell these commodities and buy forward or futures contracts because these contracts cannot beconsumed. Therefore there is unlikely to be arbitrage when equation 6.6 holds good. In short,for a consumption commodity therefore,

F OdF (S + U) UWV M (6.7)

That is the futures price is less than or equal to the spot price plus the cost of carry.

6.3 The futures basis

The cost–of–carry model explicitly defines the relationship between the futures price and therelated spot price. The difference between the spot price and the futures price is called the basis.We see that as a futures contract nears expiration, the basis reduces to zero. This means that thereis a convergence of the futures price to the price of the underlying asset. This happens because ifthe futures price is above the spot price during the delivery period it gives rise to a clear arbitrage


Figure 6.1 Variation of basis over time

The figure shows how basis changes over time. As the time to expiration of a contract reduces, the basis reduces.Towards the close of trading on the day of settlement, the futures price and the spot price converge. The closingprice for the April gold futures contract is the closing value of gold in the spot market on that day.

Futures price

Spot price

t2t1 TTime

Price

opportunity for traders. In case of such arbitrage the trader can short his futures contract, buy theasset from the spot market and make the delivery. This will lead to a profit equal to the differencebetween the futures price and spot price. As traders start exploiting this arbitrage opportunity thedemand for the contract will increase and futures prices will fall leading to the convergence ofthe future price with the spot price. If the futures price is below the spot price during the deliveryperiod all parties interested in buying the asset will take a long position. The trader would buy thecontract and sell the asset in the spot market making a profit equal to the difference between thefuture price and the spot price. As more traders take a long position the demand for the particularasset would increase and the futures price would rise nullifying the arbitrage opportunity.

Nuances� As the date of expiration comes near, the basis reduces - there is a convergence of the futures price

towards the spot price(Figure 6.1). On the date of expiration, the basis is zero. If it is not, then thereis an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference betweenspot and futures price) or the spreads (difference between prices of two futures contracts) during thelife of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities canbe exploited.

� There is nothing but cost–of–carry related arbitrage that drives the behaviour of the futures price inthe case of investment assets. In the case of consumption assets, we need to factor in the benefitprovided by holding the physical commodity.

� Transactions costs are very important in the business of arbitrage.

6.3 The futures basis 85

Note: The pricing models discussed in this chapter give an approximate idea about the truefuture price. However the price observed in the market is the outcome of the price–discoverymechanism (demand–supply principle) and may differ from the so-called true price.

Solved problemsQ: The model is used for pricing futures contracts.

1. Black & Scholes

2. Cost–of–carry

3. Miller

4. Time–value


Q: What is the fair value of one month futures if the spot value of gold is Rs.6000 per 10 grams? Themoney can be invested at 10% p.a. and warehousing cost are Rs.25

1. 6025.00

2. 6075.40

3. 6090.00

4. 6050.30

A: The fair value is � % � `X B�YbA��B�Y BC�C�C��] � %8��`�_ � % . The correct answer is number 2. ��

Q: As the a futures contract nears expiration, the basis

1. Increases

2. Reduces

3. Remains unchanged

4. Reduces to half


Q: An investment asset is an asset that is held for investment purposes by

1. Large investors

2. Some investors

3. Most investors

4. All investors


Q: An investment asset is an asset that is held for consumption purposes by

1. Large investors

2. Some investors

3. Most investors

4. All investors



Q: When the futures price happens to be higher than the fair value of the futures contract, arbitragersprofit by

1. Selling futures

2. Buying the underlying asset

3. Selling futures and buying the underlying as-

set

4. Selling the underlying asset and buying fu-tures


Q: When the futures price happens to be lower than the fair value of the futures contract, arbitragers profitby

1. Selling futures

2. Buying the underlying asset

3. Selling futures and buying the underlying as-

set

4. Selling the underlying asset and buying fu-tures


Chapter 7

Using commodity futures

For a market to succeed, it must have all three kinds of participants – hedgers, speculators andarbitragers. The confluence of these participants ensures liquidity and efficient price discoveryon the market. Commodity markets give opportunity for all three kinds of participants. In thischapter we look at the use of commodity derivatives for hedging, speculation and arbitrage.

7.1 Hedging

Many participants in the commodity futures market are hedgers. They use the futures marketto reduce a particular risk that they face. This risk might relate to the price of wheat or oil orany other commodity that the person deals in. The classic hedging example is that of wheatfarmer who wants to hedge the risk of fluctuations in the price of wheat around the time thathis crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking into a predetermined price. Hedging does not necessarily improve the financial outcome; indeed,it could make the outcome worse. What it does however is, that it makes the outcome morecertain. Hedgers could be government institutions, private corporations like financial institutions,trading companies and even other participants in the value chain, for instance farmers, extractors,ginners, processors etc., who are influenced by the commodity prices.

7.1.1 Basic principles of hedging

When an individual or a company decides to use the futures markets to hedge a risk, the objectiveis to take a position that neutralises the risk as much as possible. Take the case of a companythat knows that it will gain Rs.1,00,000 for each 1 rupee increase in the price of a commodityover the next three months and will lose Rs.1,00,000 for each 1 rupee decrease in the price ofa commodity over the same period. To hedge, the company should take a short futures positionthat is designed to offset this risk. The futures position should lead to a loss of Rs.1,00,000for each 1 rupee increase in the price of the commodity over the next three months and a gainof Rs.1,00,000 for each 1 rupee decrease in the price during this period. If the price of thecommodity goes down, the gain on the futures position offsets the loss on the commodity. If

88 Using commodity futures

Figure 7.1 Payoff for buyer of a short hedge

The figure shows the payoff for a soy oil producer who takes a short hedge. Irrespective of what the spot price ofsoy oil is three months later, by going in for a short hedge he locks on to a price of Rs.450 per MT.

Price of soya oil

465

Short position in soya oil futures

Long position in soya oil

Profit

Loss

the price of the commodity goes up, the loss on the futures position is offset by the gain on thecommodity.

There are basically two kinds of hedges that can be taken. A company that wants to sell anasset at a particular time in the future can hedge by taking short futures position. This is calleda short hedge. Similarly, a company that knows that it is due to buy an asset in the future canhedge by taking long futures position. This is known as long hedge. We will study these twohedges in detail.

7.1.2 Short hedge

A short hedge is a hedge that requires a short position in futures contracts. As we said, a shorthedge is appropriate when the hedger already owns the asset, or is likely to own the asset andexpects to sell it at some time in the future. For example, a short hedge could be used by a cottonfarmer who expects the cotton crop to be ready for sale in the next two months. A short hedgecan also be used when the asset is not owned at the moment but is likely to be owned in thefuture. For example, an exporter who knows that he or she will receive a dollar payment threemonths later. He makes a gain if the dollar increases in value relative to the rupee and makes aloss if the dollar decreases in value relative to the rupee. A short futures position will give himthe hedge he desires.

Let a look at a more detailed example to illustrate a short hedge. We assume that today is the

7.1 Hedging 89

Table 7.1 Refined soy oil futures contract specification

Trading system NCDEX trading systemTrading hours Monday to Friday

Normal market hours – 10:00 am to 4:00 pmClosing session – 4:15 pm to 4:30 pm

Unit of trading 1000 Kgs (=1 MT)Delivery unit 10000 Kgs (=10 MT)Quotation/ base value Rs. per 10 KgsTick size 5 paisa

15th of January and that a refined soy oil producer has just negotiated a contract to sell 10,000Kgs of soy oil. It has been agreed that the price that will apply in the contract is the market priceon the 15th April. The oil producer is therefore in a position where he will gain Rs.10000 foreach 1 rupee increase in the price of oil over the next three months and lose Rs.10000 for eachone rupee decrease in the price of oil during this period. Suppose the spot price for soy oil onJanuary 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465 per10 Kgs. Table 7.1 gives the soy oil futures contract specification. The producer can hedge hisexposure by selling 10,000 Kgs worth of April futures contracts(10 units). If the oil producerscloses his position on April 15, the effect of the strategy would be to lock in a price close toRs.465 per 10 Kgs. Figure 7.1 gives the payoff for a short hedge. Let us look at how this works.On April 15, the spot price can either be above Rs.465 or below Rs.465.

1. Case 1: The spot price is Rs.455 per 10 Kgs. The company realises Rs.4,55,000 under its salescontract. Because April is the delivery month for the futures contract, the futures price on April 15should be very close to the spot price of Rs.455 on that date. The company closes its short futuresposition at Rs.455, making a gain of Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs.10,000 on its shortfutures position. The total amount realised from both the futures position and the sales contract istherefore about Rs.465 per 10 Kgs, Rs.4,65,000 in total.

2. Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its salescontract. Because April is the delivery month for the futures contract, the futures price on April 15should be very close to the spot price of Rs.475 on that date. The company closes its short futuresposition at Rs.475, making a loss of Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs.10,000 on its shortfutures position. The total amount realised from both the futures position and the sales contract istherefore about Rs.465 per 10 Kgs, Rs.4,65,000 in total.

7.1.3 Long hedge

Hedges that involve taking a long position in a futures contract are known as long hedges. Along hedge is appropriate when a company knows it will have to purchase a certain asset in thefuture and wants to lock in a price now.

Suppose that it is now January 15. A firm involved in industrial fabrication knows that it willrequire 300 kgs of silver on April 15 to meet a certain contract. The spot price of silver is Rs.1680


Figure 7.2 Payoff for buyer of a long hedge

The figure shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what the spot priceof silver is three months later, by going in for a long hedge he locks on to a price of Rs.1730 per kg.

Profit

Loss

1730

Price of silver

Long position in silver futures

Short position in silver

Table 7.2 Silver futures contract specification



Unit of trading 5 KgsDelivery unit 30 KgsQuotation/ base value Rs.per kg of Silver with 999 finenessTick size 5 paisa

per kg and the April silver futures price is Rs.1730. Table 7.2 gives the contract specification forsilver. A unit of trading is 5 Kgs. The fabricator can hedge his position by taking a long positionin sixty units of futures on the NCDEX. If the fabricator closes his position on April 15, theeffect of the strategy would be to lock in a price close to Rs.1730 per kg. Figure 7.2 gives thepayoff for the buyer of a long hedge. Let us look at how this works. On April 15, the spot pricecan either be above Rs.1730 or below Rs.1730.

1. Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver fromthe spot market. Because April is the delivery month for the futures contract, the futures price onApril 15 should be very close to the spot price of Rs.1780 on that date. The company closes its long

7.1 Hedging 91

futures position at Rs.1780, making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000 on itslong futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT,or Rs.5,19,000 in total.

2. Case 2: The spot price is Rs.1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver fromthe spot market. Because April is the delivery month for the futures contract, the futures price onApril 15 should be very close to the spot price of Rs.1690 on that date. The company closes its longfutures position at Rs.1690, making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on itslong futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT,or Rs.5,19,000 in total.

Note that the purpose of hedging is not to make profits, but to lock on to a price to be paidin the future upfront. In the industrial fabricator example, since prices of silver rose in threemonths, on hind sight it would seem that the company would have been better off buying thesilver in January and holding it. But this would involve incurring interest cost and warehousingcosts. Besides, if the prices of silver fell in April, the company would have not only incurredinterest and storage costs, but would also have ended up buying silver at a much higher price.

In the examples above we assume that the futures position is closed out in the delivery month.The hedge has the same basic effect if delivery is allowed to happen. However, making or takingdelivery can be a costly process. In most cases, delivery is not made even when the hedger keepsthe futures contract until the delivery month. Hedgers with long positions usually avoid anypossibility of having to take delivery by closing out their positions before the delivery period.

7.1.4 Hedge ratio

Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of theexposure in the underlying asset. So far in the examples we used, we assumed that the hedgerwould take exactly the same amount of exposure in the futures contract as in the underlying asset.For example, if the hedgers exposure in the underlying was to the extent of 11 bales of cotton,the futures contracts entered into were exactly for this amount of cotton. We were assuming herethat the optimal hedge ratio is one. In situations where the underlying asset in which the hedgerhas an exposure is exactly the same as the asset underlying the futures contract he uses, and thespot and futures market are perfectly correlated, a hedge ratio of one could be assumed. In allother cases, a hedge ratio of one may not be optimal. Equation 7.1 gives the optimal hedge ratio,one that minimizes the variance of the hedger’s position.

� F��

(7.1)

where:

� � ) : Change in spot price, S, during a period of time equal to the life of the hedge

� �0¡ : Change in futures price, F, during a period of time equal to the life of the hedge

�£¢ � : Standard deviation of � )


�£¢ � : Standard deviation of �t¡�¥¤ : Coefficient of correlation between � ) and �0¡� ¦ : Hedge ratio

Let us consider an example. A company knows that it will require 11,000 bales of cotton inthree months. Suppose the standard deviation of the change in the price per Quintal of cottonover a three–month period is calculated as 0.032. The company chooses to hedge by buyingfutures contracts on cotton. The standard deviation of the change in the cotton futures price overa three–month period is 0.040 and the coefficient of correlation between the change in price ofcotton and the change in the cotton futures price is 0.8. The unit of trading is 11 bales and thedelivery unit for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How manycotton futures contracts should it buy?

If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, asshown in Equation 7.3, the hedger would have to buy 1000 units (one unit of trading = 11 balesof cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.

Number of contracts F ��§¨�� (7.2)©tª�« A F �� (7.3)

However, in this case as shown in Equation 7.5, the hedge ratio works out to be 0.64. Thecompany will hence require to take a long position in 140 units of cotton futures to get an effectivehedge (Equation 7.7).

Optimal hedge ratio F ��u¬vE �xuy��

�xuy�� (7.4)� F ��u¬w�� (7.5)

Number of contracts F �xuyw��® ��§¨�� (7.6)©^ª�« B�Y ¯�° F w�� (7.7)

7.1.5 Advantages of hedging

Besides the basic advantage of risk management, hedging also has other advantages:

1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait untilhis cattle are ready to market before he can sell them. The futures market permits him to sell futurescontracts to establish the approximate sale price at any time between the time he buys his calves forfeeding and the time the fed cattle are ready to market, some four to six months later. He can takeadvantage of good prices even though the cattle are not ready for market.

7.1 Hedging 93

2. Hedging protects inventory values. For example, a merchandiser with a large, unsold inventory cansell futures contracts that will protect the value of the inventory, even if the price of the commoditydrops.

3. Hedging permits forward pricing of products. For example, a jewelry manufacturer can determinethe cost for gold, silver or platinum by buying a futures contract, translate that to a price for thefinished products, and make forward sales to stores at firm prices. Having made the forward sales,the manufacturer can use his capital to acquire only as much gold, silver, or platinum as may beneeded to make the products that will fill its orders.

7.1.6 Limitation of hedging: basis Risk

In the examples we used above, the hedges considered were perfect. The hedger was able toidentify the precise date in the future when an asset would be bought or sold. The hedger wasthen able to use the futures contract to remove almost all the risk arising out of price of the asseton that date. In reality, hedging is not quite this simple and straightforward. Hedging can onlyminimise the risk but cannot fully eliminate it. The loss made during selling of an asset may notalways be equal to the profits made by taking a short futures position. This is because the valueof the asset sold in the spot market and the value of the asset underlying the future contract maynot be the same. This is called the basis risk. In our examples, the hedger was able to identifythe precise date in the future when an asset would be bought or sold. The hedger was then ableto use the perfect futures contract to remove almost all the risk arising out of price of the asseton that date. In reality, this may not always be possible for a various reasons.

� The asset whose price is to be hedged may not be exactly the same as the asset underlying the futurescontract. For example, in India we have a large number of varieties of cotton being cultivated.It is impractical for an exchange to have futures contracts with all these varieties of cotton as anunderlying. The NCDEX has futures contracts on two varieties of cotton, long staple cotton andmedium staple cotton. If a hedger has an underlying asset that is exactly the same as the one thatunderlies the futures contract, he would get a better hedge. But in many cases, farmers producingsmall staple cotton could use the futures contract on medium staple cotton for hedging. While thiswould still provide the farmer with a hedge, since the price of the farmers cotton and the price of thecotton underlying the futures contract do match perfectly, the hedge would not be perfect.

� The hedger may be uncertain as to the exact date when the asset will be bought or sold. Often thehedge may require the futures contract to be closed out well before its expiration date. This couldresult in an imperfect hedge.

� The expiration date of the hedge may be later than the delivery date of the futures contract. Whenthis happens, the hedger would be required to close out the futures contracts entered into and takethe same position in futures contracts with a later delivery date. This is called a rollover. Hedgescan be rolled forward many times. However, multiple rollovers could lead to short–term cash flowproblems.


Table 7.3 Gold futures contract specification



Unit of trading 100 gmDelivery unit 1 kgQuotation/ base value Rs.per 10 gms of gold with 999 finenessTick size 5 paisa

7.2 Speculation

An entity having an opinion on the price movements of a given commodity can speculate usingthe commodity market. While the basics of speculation apply to any market, speculating incommodities is not as simple as speculating on stocks in the financial market. For a speculatorwho thinks the shares of a given company will rise, it is easy to buy the shares and hold themfor whatever duration he wants to. However, commodities are bulky products and come with allthe costs and procedures of handling these products. The commodities futures markets providespeculators with an easy mechanism to speculate on the price of underlying commodities.

To trade commodity futures on the NCDEX, a customer must open a futures trading accountwith a commodity derivatives broker. Buying futures simply involves putting in the marginmoney. This enables futures traders to take a position in the underlying commodity withouthaving to to actually hold that commodity. With the purchase of futures contract on a commodity,the holder essentially makes a legally binding promise or obligation to buy the underlyingsecurity at some point in the future (the expiration date of the contract).

We look here at how the commodity futures markets can be used for speculation.

7.2.1 Speculation: Bullish commodity, buy futures

Take the case of a speculator who has a view on the direction of the price movements of gold.Perhaps he knows that towards the end of the year due to festivals and the upcoming weddingseason, the prices of gold are likely to rise. He would like to trade based on this view. Goldtrades for Rs.6000 per 10 gms in the spot market and he expects its price to go up in the nexttwo–three months. How can he trade based on this belief? In the absence of a deferral product,he would have to buy gold and hold on to it. Suppose he buys a 1 kg of gold which costs himRs.6,00,000. Suppose further that his hunch proves correct and three months later gold tradesat Rs.6400 per 10 grms. He makes a profit of Rs.40,000 on an investment of Rs.6,00,000 for aperiod of three months. This works out to an annual return of about 26 percent.

Today a speculator can take exactly the same position on gold by using gold futures contracts.Let us see how this works. Gold trades at Rs.6000 per 10 gms and three–month gold futurestrades at Rs.6150. Table 7.3 gives the contract specifications for gold futures. The unit of trading

7.3 Arbitrage 95

is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. He buysone kg of gold futures which have a value of Rs.6,15,000. Buying an asset in the futures marketonly require making margin payments. To take this position, he pays a margin of Rs.1,20,000.Three months later gold trades at Rs.6400 per 10 gms. As we know, on the day of expiration, thefutures price converges to the spot price (else there would be a risk–free arbitrage opportunity).He closes his long futures position at Rs.6400 in the process making a profit of Rs.25,000 onan initial margin investment of Rs.1,20,000. This works out to an annual return of 83 percent.Because of the leverage they provide, commodity futures form an attractive tool for speculators.

7.2.2 Speculation: Bearish commodity, sell futures

Commodity futures can also be used by a speculator who believes that there is likely to be excesssupply of a particular commodity in the near future and hence the prices are likely to see a fall.How can he trade based on this opinion? In the absence of a deferral product, there wasn’t muchhe could do to profit from his opinion. Today all he needs to do is sell commodity futures.

Let us understand how this works. Simple arbitrage ensures that the price of a futures contracton a commodity moves correspondingly with the price of the underlying commodity. If thecommodity price rises, so will the futures price. If the commodity price falls, so will the futuresprice. Now take the case of the trader who expects to see a fall in the price of cotton. He sells tentwo–month cotton futures contract which is for delivery of 550 bales of cotton. The value of thecontract is Rs.4,00,000. He pays a small margin on the same. Three months later, if his hunchwere correct the price of cotton falls. So does the price of cotton futures. He close out his shortfutures position at Rs.3,50,000, making a profit of Rs.50,000.

7.3 Arbitrage

A central idea in modern economics is the law of one price. This states that in a competitivemarket, if two assets are equivalent from the point of view of risk and return, they should sell atthe same price. If the price of the same asset is different in two markets, there will be operatorswho will buy in the market where the asset sells cheap and sell in the market where it is costly.This activity termed as arbitrage, involves the simultaneous purchase and sale of the same oressentially similar security in two different markets for advantageously different prices. Thebuying cheap and selling expensive continues till prices in the two markets reach an equilibrium.Hence, arbitrage helps to equalise prices and restore market efficiency.

F F (S + U) UWV M (7.8)

where:

r Cost of financing (annualised)



U Present value of all storage costs

In the chapter on pricing, we discussed that the cost–of–carry ensures that futures pricesstay in tune with the spot prices of the underlying assets. Equation 7.8 gives the fair value of afutures contract on an investment commodity. Whenever the futures price deviates substantiallyfrom its fair value, arbitrage opportunities arise. To capture mispricings that result in overpricedfutures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that resultin underpriced futures, the arbitrager must sell spot and buy futures. In the case of investmentcommodities, mispricing would result in both, buying the spot and holding it or selling the spotand investing the proceeds. However, in the case of consumption assets which are held primarilyfor reasons of usage, even if there exists a mispricing, a person who holds the underlying maynot want to sell it to profit from the arbitrage.

7.3.1 Overpriced commodity futures: buy spot, sell futures

An arbitrager notices that gold futures seem overpriced. How can he cash in on this opportunityto earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market.Three month gold futures on the NCDEX trade at Rs.625 and seem overpriced. He could makeriskless profit by entering into the following set of transactions.

1. On day one, borrow Rs.60,07,460 at 6% per annum to cover the cost of buying and holding gold.Buy 10 kgs of gold on the cash/ spot market at Rs.60,00,000. Pay (310 + 7150) as warehouse costs.(We assume that fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs areRs.55 per kg per week for 13 weeks).

2. Simultaneously, sell 10 gold futures contract at Rs.62,50,000.

3. Take delivery of the gold purchased and hold it for three months.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

5. Say gold closes at Rs.615 in the spot market. Sell the gold for Rs.61,50,000.

6. Futures position expires with profit of Rs.1,00,000.

7. From the Rs.62,50,000 held in hand, return the borrowed amount plus interest of Rs.60,98,251.

8. The result is a riskless profit of Rs.1,51,749.

When does it make sense to enter into this arbitrage? If the cost of borrowing funds to buy thecommodity is less than the arbitrage profit possible, it makes sense to arbitrage. This is termed ascash–and–carry arbitrage. Remember however, that exploiting an arbitrage opportunity involvestrading on the spot and futures market. In the real world, one has to build in the transactionscosts into the arbitrage strategy.

7.3 Arbitrage 97

7.3.2 Underpriced commodity futures: buy futures, sell spot

An arbitrager notices that gold futures seem underpriced. How can he cash in on this opportunityto earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market.Three month gold futures on the NCDEX trade at Rs.605 and seem underpriced. If he happensto hold gold, he could make riskless profit by entering into the following set of transactions.

1. On day one, sell 10 kgs of gold in the spot market at Rs.60,00,000.

2. Invest the Rs.60,00,000 plus the Rs.7150 saved by way of warehouse costs for three months 6%.

3. Simultaneously, buy three–month gold futures on NCDEX at Rs.60,50,000.

4. Suppose the price of gold is Rs.615 per gram. On the futures expiration date, the spot and the futuresprice of gold converge. Now unwind the position.

5. The gold sales proceeds grow to Rs.60,97,936.

6. The futures position expires with a profit of Rs.1,00,000.

7. Buy back gold at Rs.61,50,000 on the spot market.

8. The result is a riskless profit of Rs.47,936.

If the returns you get by investing in riskless instruments is more than the return from thearbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carryarbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line withthe cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. Asmore and more players in the market develop the knowledge and skills to do cash–and–carry andreverse cash–and–carry, we will see increased volumes and lower spreads in both the cash aswell as the derivatives market.

Solved problemsQ: A speculator thinks that the price of mustard seed will rise. He should

1. buy mustard seed futures

2. sell mustard seed

3. sell mustard seed futures

4. sell index futures


Q: A speculator thinks that the price of silver will fall. He should

1. buy silver futures

2. buy silver

3. sell silver futures

4. sell index futures



Q: A long hedge should be taken by a person who

1. Wants to buy the underlying asset in the fu-ture.

2. Sell the underlying asset in the future

3. Expects to own the underlying asset in the fu-ture



Q: A short hedge should be taken by a person who

1. Wants to buy the underlying asset in the fu-ture.

2. Wants to sell the underlying asset in the fu-ture.

3. Wants to sell the underlying asset today.



Q: A farmer who has just sown wheat can hedge his position by

1. buying wheat futures

2. selling wheat futures

3. buying index futures

4. selling the wheat


Q: On the 15th of January a refined soy oil producer has negotiated a contract to sell 10,000 Kgs of soyoil. It has been agreed that the price that will apply in the contract is the market price on the 15th April.The spot price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on theNCDEX is Rs.465 per 10 Kgs. Unit of trading in soy oil futures is 1000 Kgs (=1 MT) and the deliveryunit is 10000 Kgs (=10 MT). The producer can hedge his exposure by

1. Selling 10 units of April futures.

2. Buying 10 units of April futures.

3. Selling 100 units of April futures.

4. Buying 100 units of April futures.

A: The producer needs to take a short hedge to the extent of 10,000 Kgs of soy oil. One trading unit is for1000 Kgs of soy oil. He gets the hedge by selling 10 units of April futures. The correct answer is number1. ��

7.3 Arbitrage 99

Q: On the 15th of January a firm involved in industrial fabrication knows that it will require 300 kgs ofsilver on April 15 to meet a certain contract. The spot price of silver is Rs.1680 per kg and the April silverfutures price is Rs.1730. A unit of trading is 5 Kgs and the delivery unit is 30 Kgs. The fabricator canhedge his position by

1. Selling 60 units of April silver futures.

2. Buying 60 units of April silver futures.

3. Buying 30 units of April silver futures.

4. Selling 30 units of April silver futures.

A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. One trading unit is for 5Kgs of silver. He gets the hedge by selling 60 units of April silver futures. The correct answer is number2. ��

Q: A company knows that it will require 33,000 bales of cotton in three months. The hedge ratio worksout to be 0.85. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales.The company can obtain a hedge by

1. Buying 2550 units of three–month cotton fu-tures.

2. Selling 2550 units of three–month cotton fu-tures.

3. Buying 2550 units of three–month cotton fu-tures.

4. Selling 600 units of three–month cotton fu-tures.

A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a hedge bybuying

�C��± BCBCBACA � %�_a²` units of futures. The correct answer is number 3. ��

Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three–month gold futures trade at Rs.6150.One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg.A speculator who expects gold prices to rise in the near future buys 10 units of gold futures. Two monthslater gold futures trade at Rs.6400 per 10 gms. He makes a profit/loss of

1. (+)2,500

2. (-)2,500

3. (+)25,000

4. (-)25,000

A: One unit of trading is 100 gms. He is long 10 units of futures, or 1000 grms of gold. He makes a profitof Rs.250 per 10 gms. His total profit from the position is

\CZCBA4B D %%% . The correct answer is number 3. ��


Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three–month gold futures trade at Rs.6150.One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg.A speculator who expects gold prices to fall in the near future sells 10 units of gold futures. Two monthslater gold futures trade at Rs.6000 per 10 gms. He makes a profit/loss of

1. (+)1,500

2. (-)1,500

3. (-)15,000

4. (+)15,000

A: One unit of trading is 100 gms. He is short 10 units of futures, or 1000 grms of gold. He makes a profitof Rs.150 per 10 gms. His total profit from the position is

A4ZCBA4B �³D %%% . The correct answer is number 4.��

Chapter 8

Trading

In this chapter we shall take a brief look at the trading system for futures on NCDEX. However,the best way to get a feel of the trading system is to actually watch the screen and observe how itoperates.

8.1 Futures trading system

The trading system on the NCDEX, provides a fully automated screen-based trading forfutures on commodities on a nationwide basis as well as an online monitoring and surveillancemechanism. It supports an order driven market and provides complete transparency of tradingoperations. The trade timings on the NCDEX are 10.00 a.m. to 4.00 p.m. After hours tradinghas 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 quantityfields are in units and price in rupees. The exchange specifies the unit of trading and the deliveryunit for futures contracts on various commodities . The exchange notifies the regular lot size andtick size for each of the contracts traded from time to time. When any order enters the tradingsystem, it is an active order. It tries to find a match on the other side of the book. If it findsa match, a trade is generated. If it does not find a match, the order becomes passive and getsqueued in the respective outstanding order book in the system. Time stamping is done for eachtrade and provides the possibility for a complete audit trail if required.

8.2 Entities in the trading system

There are two entities in the trading system of NCDEX – trading cum clearing members andprofessional clearing members.

1. Trading cum clearing members (TCMs) : Trading cum clearing members are members of NCDEX.They can trade and clear either on their own account or on behalf of their clients includingparticipants. The exchange assigns an ID to each TCM. Each TCM can have more than one user.The number of users allowed for each trading member is notified by the exchange from time to time.

102 Trading

While most exchanges the world over are moving towards the electronic form of trading, some stillfollow the open outcry method. Open outcry trading is a face–to–face and highly activate form oftrading used on the floors of the exchanges. In open outcry system the futures contracts are tradedin pits. A pit is a raised platform in octagonal shape with descending steps on the inside that permitbuyers and sellers to see each other. Normally only one type of contract is traded in each pit like aEurodollar pit, Live Cattle pit etc. Each side of the octagon forms a pie slice in the pit. All the tradersdealing with a certain delivery month trade in the same slice. The brokers, who work for institutions orthe general public stand on the edges of the pit so that they can easily see other traders and have easyaccess to their runners who bring orders.The trading process consists of an auction in which all bids and offers on each of the contracts aremade known to the public and everyone can see the market’s best price. To place an order under thismethod, the customer calls a broker, who time-stamps the order and prepares an office order ticket.The broker then sends the order to a booth on the exchange floor called broker’s floor booth. There,a floor order ticket is prepared, and a clerk hand delivers the order to the floor trader for execution.In some cases, the floor clerk may use hand signals to convey the order to floor traders. Large orderstypically go directly from the customer to the broker’s floor booth. The floor trader, standing in acentral location i.e. trading pit, negotiates a price by shouting out the order to other floor traders, whobid on the order using hand signals. Once filled, the order is recorded manually by both parties in thetrade. At the end of each day, the clearing house settles trades by ensuring that no discrepancy existsin the matched–trade information.

Box 8.10: The open outcry system of trading

Each user of a TCM must be registered with the exchange and is assigned an unique user ID. Theunique TCM ID functions as a reference for all orders/ trades of different users. This ID is commonfor all users of a particular TCM. It is the responsibility of the TCM to maintain adequate controlover persons having access to the firm’s User IDs.

2. Professional clearing members: Professional clearing members are members of NSCCL. The PCMmembership entitles the members to clear trades executed through Trading cum Clearing Members(TCMs), both for themselves and/ or on behalf of their clients. They carry out risk managementactivities and confirmation/ inquiry of trades through the trading system.

8.2.1 Guidelines for allotment of client code

The trading members are recommended to follow guidelines outlined by the exchange forallotment and use of client codes at the time of order entry on the futures trading system:

1. All clients trading through a member are to be registered clients at the member’s back office.

2. A unique client code is to be allotted for each client. The client code should be alphanumeric and nospecial characters can be used.

3. The same client should not be allotted multiple codes.

8.3 Contract specifications for commodity futures 103

Table 8.1 Commodity futures contract and their symbols

1. Pure Gold Mumbai GLDPURMUM2. Pure Silver New Delhi SLVPURDEL3. Soybean Indore SYBEANIDR4. Refined Soya Oil Indore SYOREFIDR5. Rapeseed Mustard Seed Jaipur RMSEEDJPR6. Expeller Rapeseed Mustard Oil Jaipur RMOEXPJPR7. RBD Palm Olein Kakinada RBDPLNKAK8. Crude Palm Oil Kandla CRDPOLKDL9. J34 Medium Staple Cotton Bhatinda COTJ34BTD10. S06 L S Cotton Ahmedabad COTS06ABD

8.3 Contract specifications for commodity futures

NCDEX plans to trade in all the major commodities approved by FMC (Forwards MarketCommission) but in a phased manner. In the first phase, under the category of bullion, it hasalready started trading in gold and silver, and in agri commodities, trading has commenced incotton (long and medium staple), soybean, soya oil, rape/ mustardseed, rape/ mustard oil, crudepalm oil and RBD palmolein.

In the second phase NCDEX plans to offer the following commodities for trading – rice,wheat, coffee, tea. edible oil products like groundnut, sunflower, castor (seed, oil and cake), basemetals (aluminium, copper, zinc and nickel) and commodity indices like agri commodity indexand metal commodity index.

Table 8.1 gives the list and symbols of underlying commodities on which futures contractsare available. Table 8.2 and Table 8.3 give the futures contract specifications for gold and longstaple cotton.

8.4 Commodity futures trading cycle

NCDEX trades commodity futures contracts having one–month, two–month and three–monthexpiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expirationcontract would expire on the 20th of January and a February expiry contract would cease tradingon the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shallexpire on the previous trading day. New contracts will be introduced on the trading day followingthe expiry of the near month contract. Figure 8.1 shows the contract cycle for futures contractson NCDEX.

104 Trading

Table 8.2 Gold futures contract specification



Unit of trading 100 gmsDelivery unit 1 KgQuotation/ base value Rs. per 10 gms of Gold with 999.9

fineness (called “Pure Gold” in trade circles)Tick size 5 paisaPrice band Limit 10%. Limits will not apply if the limit is

reached during final 30 minutes of trading.Quality specification Not less than 995 fineness bearing a serial

number and identifying stamp of a refinerapproved by NCDEX. List of approvedrefiners will be available with theexchange and also on its web site:www.ncdex.com

Quantity variation NoneNo. of active contracts At any date, 3 concurrent month contracts

will be active. There will be a total oftwelve month contracts in a year.

Delivery center MumbaiOpening date Trading in any contract month will open on

the 21st day of the month, 3 months priorto the contract month i.e. January 2004contract opens on 21st October 2003.

Due date 20th day of the delivery month, if 20thhappens to be a holiday then previousworking day.

Position limits Member–wise: Max (Rs.200 crore, 15% of open interest)Client–wise: Max (Rs.100 crore, 10% of Open interest)

Premium/ Discount The discount will be given for the finenessbelow 999.9. The settlement price for lessthan 999.9 fineness will be calculated as:(Actual fineness/ 999.9) * Settlement price

8.5 Order types and trading parameters

An electronic trading system allows the trading members to enter orders with various conditionsattached to them as per their requirements. These conditions are broadly divided into the

8.5 Order types and trading parameters 105

Table 8.3 Long staple cotton futures contract specification



Unit of trading 18.7 Quintal (=11 bales)Delivery unit 93.5 Quintals (=55 bales)Quotation/ base value Rs. per QuintalTick size 5 paisaPrice band Limit 10%. Limits will not apply if the limit is

reached during final 30 minutes of trading.Quality specification Main/ Base Variety: Shankar-6

Staple Length: 27-30 mm (Basis: 29 mm)Micronaire: 3.4-4.5 (Basis: 3.7-4.2)Strength, Min: 21 G/ TexGrade: ‘Good to Fully Good’, ‘Fully Good’, ‘Fine’,‘Superfine’, ‘Extra Superfine’, (Basis: ‘Fine’)Crop: Current Year Crop in which thedelivery date falls (current year forShankar-6 is defined as from 1st Nov ofone year to 31st Oct of the subsequentyear), Moisture, % Max: 8.5

No. of active contracts At any date, 3 concurrent month contractswill be active. There will be a total oftwelve month contracts in a year.

Delivery center AhmedabadOpening date Trading in any contract month will open on

the 21st day of the month, 3 months priorto the contract month i.e. January 2004contract opens on 21st October 2003.

Due date 20th day of the delivery month, if 20thhappens to be a holiday then previousworking day.

Position limits Member–wise: Max (Rs.40 crore, 15% of open interest)Client–wise: Max (Rs.20 crore, 10% of Open interest)

Premium/ Discount Will be given on the basis of StapleLength (at 0.5 mm intervals) & gradecombinations. The exchange willcommunicate the premium/ discountsapplicable before the settlement date.

106 Trading

Figure 8.1 Contract cycle

The figure shows the contract cycle for futures contracts on NCDEX. As can be seen, at any given point of time,three contracts are available for trading – a near-month, a middle-month and a far-month. As the January contractexpires on the 20th of the month, a new three–month contract starts trading from the following day, once moremaking available three index futures contracts for trading.

Jan 20 contract

Feb 20 contract

March 20 contract

April 20 contract

May 20 contract

Jun 20 contract

Time

Jan Feb AprMar

following categories:� Time conditions

� Price conditions

� Other conditions

Several combinations of the above are possible thereby providing enormous flexibility tousers. The order types and conditions are summarised below. Of these, the order types availableon the NCDEX system are regular lot order, stop loss order, immediate or cancel order, good tillday order, good till cancelled order, good till date order and spread order.

� Time conditions

– Good till day order: A day order, as the name suggests is an order which is valid for the dayon which it is entered. If the order is not executed during the day, the system cancels the orderautomatically at the end of the day. Example: A trader wants to go long on March 1, 2004 inrefined palm oil on the commodity exchange. A day order is placed at Rs.340/ 10 kg. If themarket does not reach this price the order does not get filled even if the market touches Rs.341and closes. In other words day order is for a specific price and if the order does not get filledthat day, one has to place the order again the next day.

– Good till cancelled (GTC): A GTC order remains in the system until the user cancels it.Consequently, it spans trading days, if not traded on the day the order is entered. The maximumnumber of days an order can remain in the system is notified by the exchange from time to timeafter which the order is automatically cancelled by the system. Each day counted is a calendarday inclusive of holidays. The days counted are inclusive of the day on which the order is


placed and the order is cancelled from the system at the end of the day of the expiry period.Example: A trader wants to go long on refined palm oil when the market touches Rs.400/ 10kg.Theoritically, the order exists until it is filled up, even if it takes months for it to happen. TheGTC order on the NCDEX is cancelled at the end of a period of seven calendar days from thedate of entering an order or when the contract expires, whichever is earlier.

– Good till date (GTD): A GTD order allows the user to specify the date till which the ordershould remain in the system if not executed. The maximum days allowed by the system arethe same as in GTC order. At the end of this day/ date, the order is cancelled from the system.Each day/ date counted are inclusive of the day/ date on which the order is placed and the orderis cancelled from the system at the end of the day/ date of the expiry period.

– Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soonas the order is released into the system, failing which the order is cancelled from the system.Partial match is possible for the order, and the unmatched portion of the order is cancelledimmediately.

– All or none order: All or none order (AON) is a limit order, which is to be executed in itsentirety, or not at all. Unlike a fill-or-kill order, an all-or-none order is not cancelled if it isnot executed as soon as it is represented in the exchange. An all-or-none order position can beclosed out with another AON order.

– Fill or kill order: This order is a limit order that is placed to be executed immediately and ifthe order is unable to be filled immediately, it gets cancelled.

� Price condition

– Limit order: An order to buy or sell a stated amount of a commodity at a specified price, or ata better price, if obtainable at the time of execution. The disadvantage is that the order maynot get filled at all if the price for that day does not reach the specified price.

– Stop–loss: A stop–loss order is an order, placed with the broker, to buy or sell a particularfutures contract at the market price if and when the price reaches a specified level. Futurestraders often use stop orders in an effort to limit the amount they might lose if the futures pricemoves against their position. Stop orders are not executed until the price reaches the specifiedpoint. When the price reaches that point the stop order becomes a market order. Most of thetime, stop orders are used to exit a trade. But, stop orders can be executed for buying/ sellingpositions too. A buy stop order is initiated when one wants to buy a contract or go long and asell stop order when one wants to sell or go short. The order gets filled at the suggested stoporder price or at a better price. Example: A trader has purchased crude oil futures at Rs.750per barrel. He wishes to limit his loss to Rs.50 a barrel. A stop order would then be placedto sell an offsetting contract if the price falls to Rs 700 per barrel. When the market touchesthis price, stop order gets executed and the trader would exit the market. For the stop–loss sellorder, the trigger price has to be greater than the limit price.

� Other conditions

– Market price: Market orders are orders for which no price is specified at the time the order isentered (i.e. price is market price). For such orders, the system determines the price. Only theposition to be taken long/ short is stated. When this kind of order is placed, it gets executedirrespective of the current market price of that particular asset.

108 Trading

After–hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange). CalledGlobex, this was introduced to meet the needs of an increasingly integrated global economy and tohave an access to the currency price protection around the clock. Typically electronic trading systemsare used in the open outcry exchanges after the day trading is over.

Box 8.11: After hours electronic trading system

– Market on open: The order will be executed on the market open within the opening range. Thistrade is used to enter a new trade, or exit an open trade.

– Market on close: The order will be executed on the market close. The fill price will be withinthe closing range, which may, in some markets, be substantially different from the settlementprice. This trade is also used to enter a new trade, or exit an open trade.

– Trigger price: Price at which an order gets triggered from the stop–loss book.

– Limit price: Price of the orders after triggering from stop–loss book.

– Spread order: A simple spread order involves two positions, one long and one short. Theyare taken in the same commodity with different months (calendar spread) or in closely relatedcommodities. Prices of the two futures contract therefore tend to go up and down together,and gains on one side of the spread are offset by losses on the other. The spreaders goal is toprofit from a change in the difference between the two futures prices. The trader is virtuallyunconcerned whether the entire price structure moves up or down, just so long as the futurescontract he bought goes up more (or down less) than the futures contract he sold.

– One cancels the other order : It is called one cancels the other order (OCO). An order placedso as to take advantage of price movement, which consists of both a stop and a limit price.Once one level is reached, one half of the order will be executed (either stop or limit) and theremaining order cancelled (either limit or stop). This type of order would close the positionif the market moved to either the stop rate or the limit rate, thereby closing the trade andat the same time, cancelling the other entry order. Example: A trader has a buy position atRs.14,000/ tonne on Soybean. He wishes to have both stop and limit orders in order to fill theorder in a particular price range. A stop order is placed at Rs. 14,100/ tonne and a limit orderat Rs.13,900/ tonne. If the market trades at Rs.13,900/ tonne, the limit order gets filled and thestop order is immediately gets cancelled. The trader exits the market at Rs.13,900/ tonne.

8.5.1 Permitted lot size

The permitted trading lot size for the futures contracts on individual commodities is stipulatedby the exchange from time to time. The lot size currently applicable on individual commoditycontracts is given in Table 8.5

8.5.2 Tick size for contracts

The tick size is the smallest price change that can occur for the trades on the exchange. The ticksize in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise.


Table 8.4 Commodity futures: Quantity freeze unit

Instrument Asset QuantityType Asset Symbol Freeze Unit

FUTCOM GLDPURMUM 30,000 Grams (gm)FUTCOM SLVPURDEL 1,500 kilograms (Kgs)FUTCOM SYBEANIDR 300 Metric Tonnes (MT)FUTCOM SYOREFIDR 300 Metric Tonnes (MT)FUTCOM RMSEEDJPR 300 Metric Tonnes (MT)FUTCOM RMOEXPJPR 300 Metric Tonnes (MT)FUTCOM RBDPLNKAK 300 Metric Tonnes (MT)FUTCOM CRDPOLKDL 300 Metric Tonnes (MT)FUTCOM COTJ34BTD 3,300 BalesFUTCOM COTS06ABD 3,300 Bales

8.5.3 Quantity freeze

All orders placed by members have to be within the quantity specified by the exchange in thisregard. Any order exceeding this specified quantity will not be executed but will lie pendingwith the exchange as a quantity freeze. Table 8.4 gives the quantity freeze for each commoditycontract. In respect of orders which have come under quantity freeze, the member is required toconfirm to the exchange that there is no inadvertent error in the order entry and that the order isgenuine. On such confirmation, the exchange can approve such order. However, in exceptionalcases, the exchange may, at its discretion, not allow the orders that have come under quantityfreeze for execution for any reason whatsoever including non–availability of exposure limits.

8.5.4 Base price

On introduction of new contracts, the base price is the previous days’ closing price of theunderlying commodity in the prevailing spot markets. These spot prices are polled acrossmultiple centers and a single spot price is determined by the bootstrapping method. The baseprice of the contracts on all subsequent trading days is the daily settlement price of the futurescontracts on the previous trading day.

8.5.5 Price ranges of contracts

In order to prevent erroneous order entry by trading members, operating price ranges on theNCDEX are kept at +/- 10% from the base price. Orders exceeding the range specified are notexecuted and lie pending with the exchange as a price freeze. In respect of orders which havecome under price freeze, the members are required to confirm to the exchange that there is noinadvertent error in the order entry and that the order is genuine. The exchange can approve or

110 Trading

disapprove such orders solely at its own discretion. Unless specifically notified by the exchange,there will be no price ranges applicable in the last half hour of normal market trading.

8.5.6 Order entry on the trading system

The NCDEX trading system has a set of function keys built into the trading front–end. Thesekeys have been provided to facilitate faster operation of the system and enable quicker trading onthe system. The function keys can be operated from the keyboard of the user. The set of functionkeys enable the following:

� Buy open

� Sell open

� Order cancellation

� Order modification

� Exercise/ Position liquidation

� Outstanding orders

� Quick order cancel

� Spread order entry

� Market watch setup

� Trade modify

� Trade cancel

� Client master maintenance

� Market by order

� Market by price

� Activity log

� Security list/ portfolio setup

� Portfolio offline order entry

� Spread market by price

� Previous trades

� Contract description

� Alphabetical sorting of contracts


Table 8.5 Commodity futures: Lot size and other parameters

Instrument Asset Market Quantity Price Delivery DeliveryType Asset Symbol Lot Unit Unit Lot Unit

FUTCOM GLDPURMUM 100 GM Rs./ 10 GM 1 KGFUTCOM SLVPURDEL 5 Kg Rs./ Kg 30 KGFUTCOM SYBEANIDR 1 MT Rs./ Quintal 10 MTFUTCOM SYOREFIDR 1 MT Rs./ 10 Kg 10 MTFUTCOM RMSEEDJPR 1 MT Rs./ 20 Kg 10 MTFUTCOM RMOEXPJPR 1 MT Rs./ 10 Kg 10 MTFUTCOM RBDPLNKAK 1 MT Rs./ 10 Kg 10 MTFUTCOM CRDPOLKDL 1 MT Rs./ 10 Kg 10 MTFUTCOM COTJ34BTD 11 Bales Rs./ Quintal 55 BalesFUTCOM COTS06ABD 11 Bales Rs./ Quintal 55 Bales

� Spread order status

� Spread activity log

� Snap quote

� Online offline order entry

� Message log

� Market movement

� Full message display

� Market inquiry

� Spread outstanding orders

� Net position upload

� Order status

� Liquidity schedule

� Buy close

� Sell close

112 Trading

8.6 Margins for trading in futures

Margin is the deposit money that needs to be paid to buy or sell each contract. The marginrequired for a futures contract is better described as performance bond or good faith money. Themargin levels are set by the exchanges based on volatility (market conditions) and can be changedat any time. The margin requirements for most futures contracts range from 2% to 15% of thevalue of the contract.

In the futures market, there are different types of margins that a trader has to maintain. Wewill discuss them in more details when we talk about risk management in the next chapter. Atthis stage we look at the types of margins as they apply on most futures exchanges.

� Initial margin: The amount that must be deposited by a customer at the time of entering into acontract is called initial margin. This margin is meant to cover the largest potential loss in one day.The margin is a mandatory requirement for parties who are entering into the contract.

� Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excessof the initial margin. To ensure that the balance in the margin account never becomes negative, amaintenance margin, which is somewhat lower than the initial margin, is set. If the balance in themargin account falls below the maintenance margin, the trader receives a margin call and is requestedto deposit extra funds to bring it to the initial margin level within a very short period of time. Theextra funds deposited are known as a variation margin. If the trader does not provide the variationmargin, the broker closes out the position by offsetting the contract.

� Additional margin: In case of sudden higher than expected volatility, the exchange calls for anadditional margin, which is a preemptive move to prevent breakdown. This is imposed when theexchange fears that the markets have become too volatile and may result in some payments crisis,etc.

� Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted toreflect the trader’s gain or loss. This is known as marking to market the account of each trader. Allfutures contracts are settled daily reducing the credit exposure to one day’s movement. Based onthe settlement price, the value of all positions is marked–to–market each day after the official close.i.e. the accounts are either debited or credited based on how well the positions fared in that day’strading session. If the account falls below the maintenance margin level the trader needs to replenishthe account by giving additional funds. On the other hand, if the position generates a gain, the fundscan be withdrawn (those funds above the required initial margin) or can be used to fund additionaltrades.

Just as a trader is required to maintain a margin account with a broker, a clearing housemember is required to maintain a margin account with the clearing house. This is known asclearing margin. In the case of clearing house member, there is only an original margin and nomaintenance margin. Clearing house and clearing house margins have been discussed further indetail under the chapter on clearing and settlement.

8.7 Charges 113

8.7 Charges

Members are liable to pay transaction charges for the trade done through the exchange during theprevious month. The important provisions are listed below: The billing for the all trades doneduring the previous month will be raised in the succeeding month.

1. Rate of charges: The transaction charges are payable at the rate of Rs.6 per Rs.one Lakh trade done.This rate is subject to change from time to time.

2. Due date: The transaction charges are payable on the 7th day from the date of the bill every monthin respect of the trade done in the previous month.

3. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) tocollect the transaction charges through Electronic Clearing System.

4. Registration with BJPL and their services: Members have to fill up the mandate form and submitthe same to NCDEX. NCDEX then forwards the mandate form to BJPL. BJPL sends the log–in IDand password to the mailing address as mentioned in the registration form. The members can thenlog on through the website of BJPL and view the billing amount and the due date. Advance emailintimation is also sent to the members. Besides, the billing details can be viewed on the website uptoa maximum period of 12 months.

5. Adjustment against advances transaction charges: In terms of the regulations, members are requiredto remit Rs.50,000 as advance transaction charges on registration. The transaction charges due firstwill be adjusted against the advance transaction charges already paid as advance and members needto pay transaction charges only after exhausting the balance lying in advance transaction .

6. Penalty for delayed payments: If the transaction charges are not paid on or before the due date, apenal interest is levied as specified by the exchange.

Finally, the futures market is a zero sum game i.e. the total number of long in any contractalways equals the total number of short in any contract. The total number of outstanding contracts(long/ short) at any point in time is called the “Open interest”. This Open interest figure is agood indicator of the liquidity in every contract. Based on studies carried out in internationalexchanges, it is found that open interest is maximum in near month expiry contracts.

Solved ProblemsQ: The trading system on the NCDEX, does not provide

1. A fully automated screen-based trading.

2. Trading on a nationwide basis.

3. Online monitoring and surveillance mecha-nism.

4. Trading by open–outcry


114 Trading

Q: Order matching on the NCDEX happens on the basis of

1. Commodity

2. Price and time

3. Quantity

4. All of the above

A: Correct answer is number 4. ��

Q: COTS06ABD is the symbol for

1. Medium staple cotton Bhatinda

2. Long staple cotton Ahmedabad

3. Small staple cotton Aurangabad



Q: Initial margin is meant to cover the largest potential loss over a

1. One day horizon

2. One week horizon

3. One hour horizon

4. One month horizon


Q: NCDEX does not trade commodity futures contracts having expiry cycles

1. One–month

2. Two–month

3. Three–month

4. Six–month


Q: Billing to members for the all trades done on the NCDEX will be raised

1. At the end of each day.

2. In the succeeding month.

3. At the end of each week.

4. Once every two weeks.


8.7 Charges 115

Q: A trader buys 10 units of gold futures at Rs.6,500 per 10 gms. What is the value of his open longposition? Unit of trading is 100 gms and delivery unit is one Kg

1. Rs.6,50,000

2. Rs.65,000

3. Rs.6,500

4. Rs.65,00,000

A: One trading unit is for 100 gms. He has bought 10 units. The value of his long gold futures position is' ¯�± ZCBCBA4B �6D %% �6D %81 . The correct answer is number 1. ��

Q: A trader sells 20 units of gold futures at Rs.7,100 per 10 gms. What is the value of his open longposition? Unit of trading is 100 gms and delivery unit is one Kg

1. Rs.1,42,000

2. Rs.14,200

3. Rs.1,420

4. Rs.14,20,000

A: One trading unit is for 100 gms. He has bought 20 units. The value of his long gold futures position is' ��±bA4BCBA4B �6D %% �� %81 . The correct answer is number 4. ��

Q: A trader requires to take a long gold futures position worth Rs.10,00,000 as part of his hedging strategy.Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg.Roughly how many units must he purchase to give him the hedge?

1. 10 units

2. 20 units

3. 14 units

4. 28 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. He hasto take a position in

A4B�± BCB�± BCBCB��BCB , i.e. in 1428.57 gms of gold gms. He has to buy 14 units of gold futurescontracts. The correct answer is number 3. ��

Q: A trader requires to take a long gold futures position worth Rs.7,00,000 as part of his hedging strategy.Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg.How many units must he purchase to give him the hedge?

1. 10 units

2. 100 units

3. 1,000 units

4. 10,000 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To takea position in 1000 gms of gold he has to buy 10 units of gold futures contracts. The correct answer isnumber 1. ��

116 Trading

Q: A trader requires to take a short gold futures position worth Rs.7,00,000 as part of his hedging strategy.Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg.How many units must he sell to give him the hedge?

1. 10 units

2. 100 units

3. 1,000 units

4. 10,000 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To takea position in 1000 gms of gold he has to sell 10 units of gold futures contracts. The correct answer isnumber 1. ��

Chapter 9

Clearing and settlement

Most futures contracts do not lead to the actual physical delivery of the underlying asset. Thesettlement is done by closing out open positions, physical delivery or cash settlement. Allthese settlement functions are taken care of by an entity called clearing house or clearingcorporation. National Securities Clearing Corporation Limited (NSCCL) undertakes clearingof trades executed on the NCDEX. The settlement guarantee fund is maintained and managed byNCDEX.

9.1 Clearing

Clearing of trades that take place on an exchange happens through the exchange clearing house.A clearing house is a system by which exchanges guarantee the faithful compliance of alltrade commitments undertaken on the trading floor or electronically over the electronic tradingsystems. The main task of the clearing house is to keep track of all the transactions that takeplace during a day so that the net position of each of its members can be calculated. It guaranteesthe performance of the parties to each transaction. Typically it is responsible for the following:

1. Effecting timely settlement.

2. Trade registration and follow up.

3. Control of the evolution of open interest.

4. Financial clearing of the payment flow.

5. Physical settlement (by delivery) or financial settlement (by price difference) of contracts.

6. Administration of financial guarantees demanded by the participants.

The clearing house has a number of members, who are mostly financial institutionsresponsible for the clearing and settlement of commodities traded on the exchange. The marginaccounts for the clearing house members are adjusted for gains and losses at the end of eachday (in the same way as the individual traders keep margin accounts with the broker). Onthe NCDEX, in the case of clearing house members only the original margin is required (and

118 Clearing and settlement

not maintenance margin). Everyday the account balance for each contract must be maintainedat an amount equal to the original margin times the number of contracts outstanding. Thusdepending on a day’s transactions and price movement, the members either need to add fundsor can withdraw funds from their margin accounts at the end of the day. The brokers who arenot the clearing members need to maintain a margin account with the clearing house memberthrough whom they trade in the clearing house

9.1.1 Clearing mechanism

Only clearing members including professional clearing members (PCMs) are entitled to clearand settle contracts through the clearing house.

The clearing mechanism essentially involves working out open positions and obligations ofclearing members. This position is considered for exposure and daily margin purposes. The openpositions of PCMs are arrived at by aggregating the open positions of all the TCMs clearingthrough him, in contracts in which they have traded. A TCM’s open position is arrived at bythe summation of his clients’ open positions, in the contracts in which they have traded. Clientpositions are netted at the level of individual client and grossed across all clients, at the memberlevel without any set–offs between clients. Proprietary positions are netted at member levelwithout any set–offs between client and proprietary positions.

At NCDEX, after the trading hours on the expiry date, based on the available information, thematching for deliveries takes place firstly, on the basis of locations and then randomly, keepingin view the factors such as available capacity of the vault/ warehouse, commodities alreadydeposited and dematerialized and offered for delivery etc. Matching done by this process isbinding on the clearing members. After completion of the matching process, clearing membersare informed of the deliverable/ receivable positions and the unmatched positions. Unmatchedpositions have to be settled in cash. The cash settlement is only for the incremental gain/ loss asdetermined on the basis of final settlement price.

9.1.2 Clearing banks

NCDEX has designated clearing banks through whom funds to be paid and/ or to be receivedmust be settled. Every clearing member is required to maintain and operate a clearing accountwith any one of the designated clearing bank branches. The clearing account is to be usedexclusively for clearing operations i.e., for settling funds and other obligations to NCDEXincluding payments of margins and penal charges. A clearing member can deposit funds into thisaccount, but can withdraw funds from this account only in his self–name. A clearing memberhaving funds obligation to pay is required to have clear balance in his clearing account on orbefore the stipulated pay–in day and the stipulated time. Clearing members must authorise theirclearing bank to access their clearing account for debiting and crediting their accounts as perthe instructions of NCDEX, reporting of balances and other operations as may be required byNCDEX from time to time. The clearing bank will debit/ credit the clearing account of clearingmembers as per instructions received from NCDEX. The following banks have been designated

9.2 Settlement 119

as clearing banks – ICICI Bank Limited, Canara Bank, UTI Bank Limited and HDFC BankLimited.

9.1.3 Depository participants

Every clearing member is required to maintain and operate a CM pool account with any oneof the empanelled depository participants. The CM pool account is to be used exclusively forclearing operations i.e., for effecting and receiving deliveries from NCDEX.

9.2 Settlement

Futures contracts have two types of settlements, the MTM settlement which happens on acontinuous basis at the end of each day, and the final settlement which happens on the lasttrading day of the futures contract. On the NCDEX, daily MTM settlement and final MTMsettlement in respect of admitted deals in futures contracts are cash settled by debiting/ creditingthe clearing accounts of CMs with the respective clearing bank. All positions of a CM, eitherbrought forward, created during the day or closed out during the day, are marked to market at thedaily settlement price or the final settlement price at the close of trading hours on a day.

� Daily settlement price: Daily settlement price is the consensus closing price as arrived after closingsession of the relevant futures contract for the trading day. However, in the absence of trading for acontract during closing session, daily settlement price is computed as per the methods prescribed bythe exchange from time to time.

� Final settlement price: Final settlement price is the closing price of the underlying commodity onthe last trading day of the futures contract. All open positions in a futures contract cease to exist afterits expiration day.

9.2.1 Settlement mechanism

Settlement of commodity futures contracts is a little different from settlement of financial futureswhich are mostly cash settled. The possibility of physical settlement makes the process a littlemore complicated.

Daily mark to market settlement

Daily mark to market settlement is done till the date of the contract expiry. This is done to takecare of daily price fluctuations for all trades. All the open positions of the members are markedto market at the end of the day and the profit/ loss is determined as below:

� On the day of entering into the contract, it is the difference between the entry value and dailysettlement price for that day.

� On any intervening days, when the member holds an open position, it is the difference between thedaily settlement price for that day and the previous day’s settlement price.


Table 9.1 MTM on a long position in cotton futures

A clearing member buys one December expiration long staple cotton futures contract at Rs.6435 per Quintal onDecember 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The membercloses the position on December 19. The MTM profits/ losses get added/ deducted from his initial margin on a dailybasis.

Date Settlement price MTM

Dec 15,2003 6320 -115Dec 16,2003 6250 -70Dec 17,2003 6312 +62Dec 18,2003 6310 -2Dec 19,2003 6315 +5

� On the expiry date if the member has an open position, it is the difference between the final settlementprice and the previous day’s settlement price.

Table 9.1 explains the MTM margins to be paid by a member who buys one unit of Decemberexpiration long staple cotton contract at Rs.6435 per Quintal (18.7 Quintals = 11 bales) onDecember 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales ofcotton. The member closes the position on December 19. The MTM profit/ loss per unit oftrading shows at he makes a total loss of Rs.120 per Quintal of trading. So upon closing hisposition, he makes a total loss of Rs.2244, i.e. H:�vxu � ´� � ��L on the long position taken by him.The profit/ loss made by him however gets added/ deducted from his initial margin on a dailybasis.

Table 9.2 explains the MTM margins to be paid by a member who sells December expirationlong staple cotton futures contract at Rs.6435 per Quintal on December 15. The unit of tradingis 11 bales(18.7 Quintals) and each contract is for delivery of 55 bales of cotton. The membercloses the position on December 19. The MTM profit/ loss shows that he makes a total profitof Rs.120 per Quintal. So upon closing his position, he makes a total profit of Rs.2244 on theshort position taken by him. The profit/ loss made by him however gets added/ deducted fromhis initial margin on a daily basis.

Final settlement

On the date of expiry, the final settlement price is the spot price on the expiry day. The spotprices are collected from members across the country through polling. The polled bid/ ask pricesare bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price.The responsibility of settlement is on a trading cum clearing member for all trades done on hisown account and his client’s trades. A professional clearing member is responsible for settlingall the participants trades which he has confirmed to the exchange.

On the expiry date of a futures contract, members are required to submit delivery information

9.2 Settlement 121

Table 9.2 MTM on a short position in cotton futures

A clearing member sells one December expiration long staple cotton futures contract at Rs.6435 on December 15.The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the positionon December 19. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.

Date Settlement price MTM

Dec 15,2003 6320 +115Dec 16,2003 6250 +70Dec 17,2003 6312 -62Dec 18,2003 6310 +2Dec 19,2003 6315 -5

through delivery request window on the trader workstations provided by NCDEX for allopen positions for a commodity for all constituents individually. NCDEX on receipt of suchinformation, matches the information and arrives at a delivery position for a member for acommodity. A detailed report containing all matched and unmatched requests is provided tomembers through the extranet.

Pursuant to regulations relating to submission of delivery information, failure to submitdelivery information for open positions attracts penal charges as stipulated by NCDEX fromtime to time. NCDEX also adds all such open positions for a member, for which no deliveryinformation is submitted with final settlement obligations of the member concerned and settledin cash.

Non–fulfilment of either the whole or part of the settlement obligations is treated as aviolation of the rules, bye–laws and regulations of NCDEX and attracts penal charges asstipulated by NCDEX from time to time. In addition NCDEX can withdraw any or all ofthe membership rights of clearing member including the withdrawal of trading facilities of alltrading members clearing through such clearing members, without any notice. Further, theoutstanding positions of such clearing member and/ or trading members and/ or constituents,clearing and settling through such clearing member, may be closed out forthwith or any timethereafter by the exchange to the extent possible, by placing at the exchange, counter ordersin respect of the outstanding position of clearing member without any notice to the clearingmember and/ or trading member and/ or constituent. NCDEX can also initiate such other riskcontainment measures as it deems appropriate with respect to the open positions of the clearingmembers. It can also take additional measures like, imposing penalties, collecting appropriatedeposits, invoking bank guarantees or fixed deposit receipts, realizing money by disposing offthe securities and exercising such other risk containment measures as it deems fit or take furtherdisciplinary action.


9.2.2 Settlement methods

Settlement of futures contracts on the NCDEX can be done in three ways – by physical deliveryof the underlying asset, by closing out open positions and by cash settlement. We shall lookat each of these in some detail. On the NCDEX all contracts settling in cash are settled on thefollowing day after the contract expiry date. All contracts materialising into deliveries are settledin a period 2–7 days after expiry. The exact settlement day for each commodity is specified bythe exchange.

Physical delivery of the underlying asset

For open positions on the expiry day of the contract, the buyer and the seller can announceintentions for delivery. Deliveries take place in the electronic form. All other positions aresettled in cash.

When a contract comes to settlement, the exchange provides alternatives like delivery place,month and quality specifications. Trading period, delivery date etc. are all defined as per thesettlement calendar. A member is bound to provide delivery information. If he fails to giveinformation, it is closed out with penalty as decided by the exchange. A member can choose analternative mode of settlement by providing counter party clearing member and constituent. Theexchange is however not responsible for, nor guarantees settlement of such deals. The settlementprice is calculated and notified by the exchange. The delivery place is very important forcommodities with significant transportation costs. The exchange also specifies the precise period(date and time) during which the delivery can be made. For many commodities, the deliveryperiod may be an entire month. The party in the short position (seller) gets the opportunity tomake choices from these alternatives. The exchange collects delivery information. The pricepaid is normally the most recent settlement price (with a possible adjustment for the quality ofthe asset and the delivery location). Then the exchange selects a party with an outstanding longposition to accept delivery.

As mentioned above, after the trading hours on the expiry date, based on the availableinformation, the matching for deliveries is done, firstly, on the basis of locations andthen randomly keeping in view factors such as available capacity of the vault/ warehouse,commodities already deposited and dematerialized and offered for delivery and any other factoras may be specified by the exchange from time to time. After completion of the matching process,clearing members are informed of the deliverable/ receivable positions and the unmatchedpositions. Unmatched positions have to be settled in cash. The cash settlement is done onlyfor the incremental gain/ loss as determined on the basis of the final settlement price.

Any buyer intending to take physicals has to put a request to his depository participant.The DP uploads such requests to the specified depository who in turn forwards the same to theregistrar and transfer agent (R&T agent) concerned. After due verification of the authenticity,the R&T agent forwards delivery details to the warehouse which in turn arranges to release thecommodities after due verification of the identity of recipient. On a specified day, the buyerwould go to the warehouse and pick up the physicals.

The seller intending to make delivery has to take the commodities to the designated

9.2 Settlement 123

warehouse. These commodities have to be assayed by the exchange specified assayer. Thecommodities have to meet the contract specifications with allowed variances. If the commoditiesmeet the specifications, the warehouse accepts them. Warehouses then ensure that the receiptsget updated in the depository system giving a credit in the depositor’s electronic account. Theseller then gives the invoice to his clearing member, who would courier the same to the buyer’sclearing member.

NCDEX contracts provide a standardized description for each commodity. The descriptionis provided in terms of quality parameters specific to the commodities. At the same time, it isrealized that with commodities, there could be some amount of variances in quality/ weight etc.,due to natural causes, which are beyond the control of any person. Hence, NCDEX contractsalso provide tolerance limits for variances. A delivery is treated as good delivery and acceptedif the delivery lies within the tolerance limits. However, to allow for the difference, the conceptof premium and discount has been introduced. Goods that come to the authorised warehousefor delivery are tested and graded as per the prescribed parameters. The premium and discountrates apply depending on the level of variation. The price payable by the party taking delivery isthen adjusted as per the premium/ discount rates fixed by the exchange. This ensures that someamount of leeway is provided for delivery, but at the same time, the buyer taking delivery doesnot face windfall loss/ gain due to the quantity/ quality variation at the time of taking delivery.This, to some extent, mitigates the difficulty in delivering and receiving exact quality/ quantityof commodity

Closing out by offsetting positions

Most of the contracts are settled by closing out open positions. In closing out, the oppositetransaction is effected to close out the original futures position. A buy contract is closed outby a sale and a sale contract is closed out by a buy. For example, an investor who took a longposition in two gold futures contracts on the January 30, 2004 at 6090, can close his position byselling two gold futures contracts on February 27, 2004 at Rs.5928. In this case, over the periodof holding the position, he has suffered a loss of Rs.162 per unit. This loss would have beendebited from his margin account over the holding period by way of MTM at the end of each day,and finally at the price that he closes his position, that is Rs.5928 in this case.

Cash settlement

Contracts held till the last day of trading can be cash settled. When a contract is settled in cash,it is marked to the market at the end of the last trading day and all positions are declared closed.The settlement price on the last trading day is set equal to the closing spot price of the underlyingasset ensuring the convergence of future prices and the spot prices. For example an investor tooka short position in five long staple cotton futures contracts on December 15 at Rs.6950. On 20thFebruary, the last trading day of the contract, the spot price of long staple cotton is Rs.6725. Thisis the settlement price for his contract. As a holder of a short position on cotton, he does not haveto actually deliver the underlying cotton, but simply takes away the profit of Rs.225 per tradingunit of cotton in the form of cash.


9.2.3 Entities involved in physical settlement

Physical settlement of commodities involves the following three entities – an accreditedwarehouse, registrar & transfer agent and an assayer. We will briefly look at the functions ofeach.

Accredited warehouse

NCDEX specifies accredited warehouses through which delivery of a specific commodity canbe effected and which will facilitate for storage of commodities. For the services provided bythem, warehouses charge a fee that constitutes storage and other charges such as insurance,assaying and handling charges or any other incidental charges. Following are the functions of anaccredited warehouse:

1. Earmark separate storage area as specified by the exchange for the purpose of storing commoditiesto be delivered against deals made on the exchange. The warehouses are required to meet thespecifications prescribed by the exchange for storage of commodities.

2. Ensure and co–ordinate the grading of the commodities received at the warehouse before they arestored.

3. Store commodities in line with their grade specifications and validity period and facilitatemaintenance of identity. On expiry of such validity period of the grade for such commodities, thewarehouse has to segregate such commodities and store them in a separate area so that the same arenot mixed with commodities which are within the validity period as per the grade certificate issuedby the approved assayers.

Approved registrar and transfer agents (R&T agents)

The exchange specifies approved R&T agents through whom commodities can be dematerializedand who facilitate for dematerialization/ re–materialization of commodities in the mannerprescribed by the exchange from time to time. The R&T agent performs the following functions:

1. Establishes connectivity with approved warehouses and supports them with physical infrastructure.

2. Verifies the information regarding the commodities accepted by the accredited warehouse and assignsthe identification number (ISIN) allotted by the depository in line with the grade/ validity period.

3. Further processes the information, and ensures the credit of commodity holding to the demat accountof the constituent.

4. Ensures that the credit of commodities goes only to the demat account of the constituents held withthe exchange empanelled DPs.

5. On receiving a request for re–materialization (physical delivery) through the depository, arranges forissuance of authorisation to the relevant warehouse for the delivery of commodities.

9.3 Risk management 125

R&T agents also maintain proper records of beneficiary position of constituents holdingdematerialized commodities in warehouses and in the depository for a period and also as ona particular date. They are required to furnish the same to the exchange as and when demandedby the exchange. R&T agents also do the job of co–ordinating with DPs and warehouses forbilling of charges for services rendered on periodic intervals. They also reconcile dematerializedcommodities in the depository and physical commodities at the warehouses on periodic basis andco–ordinate with all parties concerned for the same.

Approved assayer

The exchange specifies approved assayers through whom grading of commodities (received atapproved warehouses for delivery against deals made on the exchange) can be availed by theconstituents of clearing members. Assayers perform the following functions:

1. Inspect the warehouses identified by the exchange on periodic basis to verify the compliance oftechnical/ safety parameters detailed in the warehousing accreditation norms of the exchange. Thecompliance certificate so given by the assayer forms the basis of warehouse accreditation by theexchange.

2. Make available grading facilities to the constituents in respect of the specific commodities traded onthe exchange at specified warehouse. The assayer ensures that the grading to be done (in a certificateformat prescribed by the exchange) in respect of specific commodity is as per the norms specified bythe exchange in the respective contract specifications.

3. Grading certificate so issued by the assayer specifies the grade as well as the validity period up towhich the commodities would retain the original grade, and the time up to which the commoditiesare fit for trading subject to environment changes at the warehouses.

9.3 Risk management

NCDEX has developed a comprehensive risk containment mechanism for the its commodityfutures market. The salient features of risk containment mechanism are:

1. The financial soundness of the members is the key to risk management. Therefore, the requirementsfor membership in terms of capital adequacy (net worth, security deposits) are quite stringent.

2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies theinitial margin requirements for each futures contract on a daily basis. It also follows value-at-risk(VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin fromthe TCMs and their clients respectively.

3. The open positions of the members are marked to market based on contract settlement price for eachcontract. The difference is settled in cash on a T+1 basis.

4. A member is alerted of his position to enable him to adjust his exposure or bring in additionalcapital. Position violations result in withdrawal of trading facility for all TCMs of a PCM in case ofa violation by the PCM.


5. A separate settlement guarantee fund for this segment has been created out of the capital of members.

The most critical component of risk containment mechanism for futures market on theNCDEX is the margining system and on–line position monitoring. The actual positionmonitoring and margining is carried out on–line through the SPAN (Standard Portfolio Analysisof Risk) system.

9.4 Margining at NCDEX

In pursuance of the bye–laws, rules and regulations, the exchange has defined norms andprocedures for margins and limits applicable to members and their clients. The margining systemfor the commodity futures trading on the NCDEX is explained below.

9.4.1 SPAN

SPAN is a registered trademark of the Chicago Mercantile Exchange, used by NCDEX underlicense obtained from CME. The objective of SPAN is to identify overall risk in a portfolio of allfutures contracts for each member. Its over–riding objective is to determine the largest loss thata portfolio might reasonably be expected to suffer from one day to the next day based on 99%VaR methodology.

9.4.2 Initial margin

This is the amount of money deposited by both buyers and sellers of futures contracts to ensureperformance of trades executed. Initial margin is payable on all open positions of trading cumclearing members, up to client level, at any point of time, and is payable upfront by the membersin accordance with the margin computation mechanism and/ or system as may be adopted by theexchange from time to time. Initial margin includes SPAN margins and such other additionalmargins that may be specified by the exchange from time to time.

9.4.3 Computation of initial margin

The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose ofreal–time initial margin computation. Initial margin requirements are based on 99% VaR (Valueat Risk) over a one–day time horizon.

Initial margin requirements for a member for each contract are as under:

1. For client positions: These are netted at the level of individual client and grossed across all clients,at the member level without any set–offs between clients.

2. For proprietary positions: These are netted at member level without any set–offs between client andproprietary positions.

9.4 Margining at NCDEX 127

Table 9.3 Calculating outstanding position at TCM level

Account Number of Number of Outstandingunits bought units sold position

Proprietary 3000 1000 Long 2000Client A 2000 1500 Long 500Client B 1000 Short 1000

Net outstanding position 3500

Table 9.4 Minimum margin percentage on commodity futures contracts

Commodity Minimum margin percentage

Pure gold Mumbai 4Pure silver New Delhi 4J34 medium staple cotton Bhatinda 3S06 L S cotton Ahmedabad 3Soybean Indore 4Refined soya oil Indore 4Rapeseed mustard seed Jaipur 4Expeller rapeseed mustard oil Jaipur 4Crude palm oil Kandla 4RBD palm olein Kakinada 4

Consider the case of a trading member who has proprietary and client–level positions in aApril 2004 gold futures contract. On his proprietary account, he bought 3000 trading units andsold 1000 trading units within the day. On account of client A, he bought 2000 trading units atthe beginning of the day and sold 1500 units an hour later. And on account of client B, he sold1000 trading units. Table 9.3 gives the total outstanding position for which the TCM would bemargined.

For the purpose of SPAN margin, various parameters as given below will be specified fromtime to time:

1. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated forVaR purpose for the prices of futures contracts. The minimum margin percentages for variouscommodities are given in Table 9.4. These may change from time to time as specified by theexchange.

2. Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may bespecified by the exchange from time to time.

3. Calendar spread charge: Calendar spread is defined as the purchase of one delivery month of a givenfutures contract and simultaneous sale of another delivery month of the same commodity on the same


exchange. Margins are charged on all open calendar spread positions at 2% on the higher value ofthe near month or the far month position, or at such rate as may be specified by the exchange fromtime to time. The near month position is the buy/ sell position on the calendar–spread position thatexpires first. The far month position is the buy/ sell position on the calendar–spread position thatexpires next. A calendar spread position is treated as non–spread (naked) positions in the far monthcontract, 3 trading days prior to expiration of the near month contract. However, calendar spreadposition is reduced gradually at the rate of µµ A� % per day for three days or at such rate as may beprescribed by the exchange from time to time. The reduction of the spread position starts five daysbefore the date of expiry of the near month contract.

9.4.4 Implementation aspects of margining and risk management

We look here at some implementation aspects of the margining and risk management system fortrading on NCDEX.

1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateralsecurity deposits in the form of bank guarantees, fixed deposits receipts and approved Governmentof India securities.

2. Payment of initial margin: The initial margin is payable upfront by members.

3. Effect of failure to pay initial margins: Non–fulfilment of either the whole or part of the initial marginobligations is treated as a violation of the rules, bye–laws and regulations of the exchange and attractspenal charges as stipulated by NCDEX from time to time. In addition, the exchange can withdrawany or all of the membership rights of a member including the withdrawal of trading facilities of themembers clearing through such clearing members, without any notice. The outstanding positions ofsuch members and/ or constituents clearing and settling through such members, can be closed outforthwith or any time thereafter at the discretion of the Exchange, to the extent possible, by placingcounter orders in respect of the outstanding position of members. Such action is final and binding onthe members and/ or constituents.

The exchange can also initiate such other risk containment measures as it deems fit with respect to theopen positions of the members and/ or constituents. The exchange can take additional measures likeimposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts,realizing money by disposing off the securities and exercising such other risk containment measuresas it deems fit.

4. Exposure limits: This is defined as the maximum open positions that a member can take across allcontracts and is linked to the liquid net worth of the member available with the exchange. Themember is not allowed to trade once the exposure limits have been exceeded on the exchange. Thetrader workstation of the member is disabled and trading permitted only on enhancement of exposurelimits by deposit of additional capital.

(a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payableat any point in time. The liquid networth maintained by the members at any point in time cannotbe less than Rs.25 lakh (referred to as minimum liquid net worth) or such other amount, as maybe specified by the exchange from time to time.


(b) Effective deposits: This includes all deposits made by the members in the form of cash or cashequivalents form the effective deposits. For the purpose of computing effective deposits, cashequivalents mean bank guarantees, fixed deposit receipts and Government of Indian securities.

(c) Method of computation of exposure limits: Exposure limits is specified as a multiple of theliquid net worth. i.e. a member can have an exposure limit of

!times his liquid net worth. The

multiple is as specified in Table 9.5 or as may be prescribed by the exchange from time.

(d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures,contracts are treated as open position of one third of the value of the far month futures contract.However the spread positions is treated as a naked position in far month contract three tradingdays prior to expiry of the near month contract.

5. Imposition of additional margins and close out of open positions: As a risk containment measure,the exchange may require the members to make payment of additional margins as may be decidedfrom time to time. This is in addition to the initial margin, which are or may have been imposed.The exchange may also require the members to reduce/ close out open positions to such levels andfor such contracts as may be decided by it from time to time.

6. Failure to pay additional margins: Non–fulfilment of either the whole or part of the additional marginobligations is treated as a violation of the rules, bye-Laws and regulations of the exchange and attractspenal charges as stipulated by NCDEX. The exchange may withdraw any or all of the membershiprights of the members including the withdrawal of trading facilities of trading members clearingthrough such members, without any notice.

In addition, the outstanding positions of such members and/ or constituents, clearing and settlingthrough such members, can be closed out forthwith or any time thereafter, at the discretion of theexchange, to the extent possible, by placing counter orders in respect of their outstanding positions.

7. Return of excess deposit: Members can request the exchange to release excess deposits held by it orby a specified agent on behalf of the exchange. Such requests may be considered by the exchangesubject to the bye–laws, rules and regulations.

8. Initial margin deposit or additional deposit or additional base capital: Members who wish to makea margin deposit (additional base capital) with the exchange and/ or wish to retain deposits and/ orsuch amounts which are receivable by them from the exchange, at any point of time, over and abovetheir deposit requirement towards initial margin and/ or other obligations, must inform the exchangeas per the procedure.

9. Position limits: Position wise limits are the maximum open positions that a member or hisconstituents can have in any commodity at any point of time. This is calculated as the higher ofa specified percentage of the total open interest in the commodity or a specified value. Open interestis the total number of open positions in that futures contract multiplied by its last available tradedprice or closing price, as the case may be.

10. Intra–day price limit: The maximum price movement during a day can be +/- 10% of the previousday’s settlement price prescribed for each commodity. If the price hits the intra day price limit (atupper side or lower side), there will be a cooling period of 15 minutes. During the cooling period,trading in that particular contract will be suspended and normal trading will resume after the coolingperiod. The base price when trading resumes after cooling period will be the last traded price beforethe commencement of cooling period. There would be no cooling period if the price hits the intraday limit during the last 30 minutes of trading.


Table 9.5 Exposure limit as a multiple of liquid net worth

Commodity Multiple


(a) Daily settlement price: The daily profit/ losses of the members are settled using the dailysettlement price. The daily settlement price notified by the exchange is binding on all membersand their constituents.

(b) Mark–to–market settlement: All the open positions of the members are marked to market atthe end of the day and the profit/ loss determined as below: (a) On the day of entering intothe contract, it is the difference between the entry value and daily settlement price for that day.(b) On any intervening days, when the member holds an open position, it is the differencebetween the daily settlement value for that day and the previous day’s settlement price. (c)On the expiry date if the member has an open position, it is the difference between the finalsettlement price and the previous day’s settlement price.

11. Intra–day margin call: The exchange at its discretion can make intra day margin calls as riskcontainment measure if, in its opinion, the market price changes sufficiently. For example, it canmake an intra–day margin call if the intra day price limit has been reached, or any other situationhas arisen, which in the opinion of the exchange could result in an enhanced risk. The exchange atits discretion may make selective margin calls, for example, only for those members whose variationlosses or initial margin deficits exceed a threshold value prescribed by the exchange.

12. Delivery margin: In case of positions materialising into physical delivery, delivery margins arecalculated as ¶ days VaR margins plus additional margins. ¶ days refer to the number of daysfor completing the physical delivery settlement. The number of days are commodity specific, asdescribed hereunder or as may be prescribed by the exchange from time to time. There is a markup on the VaR based delivery margin to cover for default. Table 9.6 gives the number of days forphysical settlement on various commodities.

9.4.5 Effect of violation

Whenever any of the margin or position limits are violated by members, the exchange canwithdraw any or all of the membership rights of members including the withdrawal of trading


Table 9.6 Number of days for physical settlement on various commodities

Commodity Number of days forphysical settlement


facilities of all members and/ or clearing facility of custodial participants clearing through suchtrading cum members, without any notice. In addition, the outstanding positions of such memberand/ or constituents clearing and settling through such member, can be closed out at any time atthe discretion of the exchange. This can be done without any notice to the member and/ orconstituent. The exchange can initiate further risk containment measures with respect to theopen positions of the member and/ or constituent. These could include imposing penalties,collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, realizing moneyby disposing off the securities, and exercising such other risk containment measures it considersnecessary.

Solved ProblemsQ: The settlement of futures contracts cannot be done by

1. Closing out open positions.

2. Physical delivery.

3. Cash settlement.

4. Carrying forward the position.


Q: undertakes clearing and settlement of all trades executed on the NCDEX

1. NSE

2. NSCCL

3. NSDL

4. NCDEX



Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by

1. NSE

2. NSCCL

3. NSDL

4. NCDEX


Q: The clearing house of an exchange is responsible for




4. All of the above.


Q: On expiry of a commodity futures contract, the settlement price is the

1. Spot price of the underlying asset

2. Futures close price

3. Spot price plus cost-of-carry



Q: The clearing house of an exchange is not responsible for


2. Ensuring that the buyer and seller get the bestprice.




Q: The exposure limit for each member is linked to the of the member available with the exchange.

1. Liquid net worth.

2. Security deposits.

3. Bank guarantees.

4. Base capital.



Q: A cotton trader bought ten one–month, long staple cotton futures contracts at Rs.6020 per Quintal atthe beginning of the day. The unit of trading is 11 bales and each contract is for delivery of 55 bales. Thesettlement price at the end of the day was Rs.6050 per Quintal. The trader’s MTM account will show

1. A profit of Rs.5610

2. A loss of Rs.5610



A: He makes a profit of Rs.30 per Quintal on his futures position. One futures contract consists is for18.7 Quintals. He has bought ten futures contract. So he makes a profit of 30 * 18.7 * 10 = Rs.5610. Thecorrect answer is number 1. ��

Q: A gold merchant bought two units of one–month gold futures contracts at Rs.6000 per 10 gms at thebeginning of the day. The unit of trading is 100 gms and each contract is for delivery of one kg of gold.The settlement price at the end of the day was Rs.6025 per 10 gms. The trader’s MTM account will show


2. A loss of Rs.500



A: Each unit of trading is 100 gms. He has bought two units. This means he has a long position in 200gms of gold. He makes a profit of Rs.25 per 10 gms on his futures position. So he makes a profit ofRs.500, i.e.

\CZA4B �®� %% = Rs.500. The correct answer is number 1. ��

Q: A trading member took proprietary positions in a March 2004 cotton futures contract. He bought3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per Quintal. What is the outstandingposition on which he would be margined?

1. Long 3000 units

2. Short 2400 units

3. Long 5400 units

4. Long 600 units

A: After netting, the trading member has a long open position in 600 trading units. The correct answer isnumber 4. ��


Q: A trading member has proprietary and client positions in a March cotton futures contract. On hisproprietary account, he bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 perQuintal. On account of client A, he bought 2000 trading units at Rs.6012 per Quintal, and on account ofclient B, he sold 1000 trading units at Rs.5990 per Quintal. What is the outstanding position on which hewould be margined?

1. Long 3000 units

2. Short 8400 units

3. Long 3600 units

4. Long 1600 units

A: After netting, the trading member has a proprietary open position in 600 trading units. He would bemargined on a net basis at the proprietary level and on a gross basis across clients, i.e. (600 + 2000 +1000). The correct answer is number 3. ��

Q: A trading member has proprietary and client positions in a April 2004 gold futures contract. On hisproprietary account, he bought 3000 trading units at Rs.6000 per 10 gms. On account of client A, hebought 2000 trading units at Rs.6012 per 10 gms and sold 1500 units at Rs.6020 per 10 gms, and onaccount of client B, he sold 1000 trading units at Rs.5990 per 10 gms. What is the outstanding positionon which he would be margined?

1. Long 3000 units

2. Short 4500 units

3. Long 3600 units

4. Long 7500 units

A: He would be margined on a net basis at the proprietary level and at the individual client level and on agross basis across clients. i.e. (3000 + (2000 - 1500) + 1000). The correct answer is number 2. ��

Chapter 10

Regulatory framework

At present, there are three tiers of regulations of forward/futures trading system in India, namely,government of India, Forward Markets Commission(FMC) and commodity exchanges. Theneed for regulation arises on account of the fact that the benefits of futures markets accruein competitive conditions. Proper regulation is needed to create competitive conditions. Inthe absence of regulation, unscrupulous participants could use these leveraged contracts formanipulating prices. This could have undesirable influence on the spot prices, thereby affectinginterests of society at large.. Regulation is also needed to ensure that the market has appropriaterisk management system. In the absence of such a system, a major default could create achain reaction. The resultant financial crisis in a futures market could create systematic risk.Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement andmanagement of the exchange so as to protect and promote the interest of various stakeholders,particularly non–member users of the market.

10.1 Rules governing commodity derivatives exchanges

The trading of commodity derivatives on the NCDEX is regulated by Forward MarketsCommission(FMC). Under the Forward Contracts (Regulation) Act, 1952, forward trading incommodities notified under section 15 of the Act can be conducted only on the exchanges,which are granted recognition by the central government (Department of Consumer Affairs,Ministry of Consumer Affairs, Food and Public Distribution). All the exchanges, which dealwith forward contracts, are required to obtain certificate of registration from the FMC. Besides,they are 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 theirworking.

Forward Markets Commission provides regulatory oversight in order to ensure financialintegrity (i.e. to prevent systematic risk of default by one major operator or group of operators),market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demandand supply conditions) and to protect and promote interest of customers/ non–members. Itprescribes the following regulatory measures:

136 Regulatory framework

1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed onintra–day net open position. The limit is imposed operator–wise, and in some cases, also member–wise.

2. Circuit–filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswingor downswing in prices.

3. Special margin deposit to be collected on outstanding purchases or sales when price moves up ordown sharply above or below the previous day closing price. By making further purchases/salesrelatively costly, the price rise or fall is sobered down. This measure is imposed only on the requestof the exchange.

4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices fromfalling below as rising above not warranted by prospective supply and demand factors. This measureis also imposed on the request of the exchanges.

5. Skipping trading in certain derivatives of the contract, closing the market for a specified period andeven closing out the contract: These extreme measures are taken only in emergency situations.

Besides these regulatory measures, the F.C(R) Act provides that a client’s position cannotbe appropriated by the member of the exchange, except when a written consent is taken withinthree days time. The FMC is persuading increasing number of exchanges to switch over toelectronic trading, clearing and settlement, which is more customer–friendly. The FMC hasalso prescribed simultaneous reporting system for the exchanges following open out–cry system.These steps facilitate audit trail and make it difficult for the members to indulge in malpracticeslike trading ahead of clients, etc. The FMC has also mandated all the exchanges following openoutcry system to display at a prominent place in exchange premises, the name, address, telephonenumber of the officer of the commission who can be contacted for any grievance. The websiteof the commission also has a provision for the customers to make complaint and send commentsand suggestions to the FMC. Officers of the FMC have been instructed to meet the membersand clients on a random basis, whenever they visit exchanges, to ascertain the situation on theground, instead of merely attending meetings of the board of directors and holding discussionswith the office–bearers.

10.2 Rules governing intermediaries

In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framedthereunder, exchanges are governed by its own rules and bye laws(approved by the FMC). Inthis section we have brief look at the important regulations that govern NCDEX. For the sake ofconvenience, these have been divided into two main divisions pertaining to trading and clearing.The detailed bye laws, rules and regulations are available on the NCDEX home page.

10.2.1 Trading

The NCDEX provides an automated trading facility in all the commodities admitted for dealingson the spot market and derivative market. Trading on the exchange is allowed only through

10.2 Rules governing intermediaries 137

approved workstation(s) located at locations for the office(s) of a trading member as approved bythe exchange. If LAN or any other way to other workstations at any place connects an approvedworkstation of a trading Member it shall require an approval of the exchange.

Each trading member is required to have a unique identification number which is providedby the exchange and which will be used to log on (sign on) to the trading system. A tradingmember has a non–exclusive permission to use the trading system as provided by the exchangein the ordinary course of business as trading member. He does not have any title rights or interestwhatsoever with respect to trading system, its facilities, software and the information providedby the trading system.

For the purpose of accessing the trading system, the member will install and use equipmentand software as specified by the exchange at his own cost. The exchange has the right to inspectequipment and software used for the purposes of accessing the trading system at any time. Thecost of the equipment and software supplied by the exchange, installation and maintenance ofthe equipment is borne by the trading member.

Trading members and users

Trading members are entitled to appoint, (subject to such terms and conditions, as may bespecified by the relevant authority) from time to time -� Authorised persons

� Approved users

Trading members have to pass a certification program, which has been prescribed by theexchange. In case of trading members, other than individuals or sole proprietorships, suchcertification program has to be passed by at least one of their directors/ employees/ partners /members of governing body.

Each trading member is permitted to appoint a certain number of approved users as notifiedfrom time to time by the exchange.

The appointment of approved users is subject to the terms and conditions prescribed by theexchange. Each approved user is given a unique identification number through which he willhave access to the trading system. An approved user can access the trading system through apassword and can change the password from time to time.

The trading member or its approved users are required to maintain complete secrecy of itspassword. Any trade or transaction done by use of password of any approved user of the tradingmember, will be binding on such trading member. Approved user shall be required to change hispassword at the end of the password expiry period.

Trading days

The exchange operates on all days except Saturday and Sunday and on holidays that it declaresfrom time to time. Other than the regular trading hours, trading members are provided a facilityto place orders off–line i.e. outside trading hours. These are stored by the system but get tradedonly once the market opens for trading on the following working day.


The types of order books, trade books, price limits, matching rules and other parameterspertaining to each or all of these sessions is specified by the exchange to the members via itscirculars or notices issued from time to time. Members can place orders on the trading systemduring these sessions, within the regulations prescribed by the exchange as per these bye laws,rules and regulations, from time to time.

Trading hours and trading cycle

The exchange announces the normal trading hours/ open period in advance from time to time. Incase necessary, the exchange can extend or reduce the trading hours by notifying the members.Trading cycle for each commodity/ derivative contract has a standard period, during which it willbe available for trading.

Contract expiration

Derivatives contracts expire on a pre–determined date and time up to which the contract isavailable for trading. This is notified by the exchange in advance. The contract expiration periodwill not exceed twelve months or as the exchange may specify from time to time.

Trading parameters

The exchange from time to time specifies various trading parameters relating to the tradingsystem. Every trading member is required to specify the buy or sell orders as either an openorder or a close order for derivatives contracts. The exchange also prescribes different orderbooks that shall be maintained on the trading system and also specifies various conditions on theorder that will make it eligible to place it in those books.

The exchange specifies the minimum disclosed quantity for orders that will be allowed foreach commodity/ derivatives contract. It also prescribes the number of days after which GoodTill Cancelled orders will be cancelled by the system. It specifies parameters like lot size inwhich orders can be placed, price steps in which orders shall be entered on the trading system,position limits in respect of each commodity etc.

Failure of trading member terminal

In the event of failure of trading members workstation and/ or the loss of access to the tradingsystem, the exchange can at its discretion undertake to carry out on behalf of the trading memberthe necessary functions which the trading member is eligible for. Only requests made in writingin a clear and precise manner by the trading member would be considered. The trading memberis accountable for the functions executed by the exchange on its behalf and has to indemnity theexchange against any losses or costs incurred by the exchange.


Trade operations

Trading members have to ensure that appropriate confirmed order instructions are obtained fromthe constituents before placement of an order on the system. They have to keep relevant recordsor documents concerning the order and trading system order number and copies of the orderconfirmation slip/ modification slip must be made available to the constituents.

The trading member has to disclose to the exchange at the time of order entry whether theorder is on his own account or on behalf of constituents and also specify orders for buy or sellas open or close orders. Trading members are solely responsible for the accuracy of details oforders entered into the trading system including orders entered on behalf of their constituents.

Trades generated on the system are irrevocable and ‘locked in’. The exchange specifies fromtime to time the market types and the manner if any, in which trade cancellation can be effected.Where a trade cancellation is permitted and trading member wishes to cancel a trade, it can bedone only with the approval of the exchange.

Margin requirements

Subject to the provisions as contained in the exchange bye–laws and such other regulations asmay be in force, every clearing member, in respect of the trades in which he is party to, has todeposit a margin with exchange authorities.

The exchange prescribes from time to time the commodities/ derivative contracts, thesettlement periods and trade types for which margin would be attracted. The exchange leviesinitial margin on derivatives contracts using the concept of Value at Risk (VaR) or any otherconcept as the exchange may decide from time to time. The margin is charged so as to coverone–day loss that can be encountered on the position on 99% of the days. Additional marginsmay be levied for deliverable positions, on the basis of VaR from the expiry of the contract tillthe actual settlement date plus a mark–up for default.

The margin has to be deposited with the exchange within the time notified by the exchange.The exchange also prescribes categories of securities that would be eligible for a margin deposit,as well as the method of valuation and amount of securities that would be required to be depositedagainst the margin amount.

The procedure for refund/ adjustment of margins is also specified by the exchange from timeto time. The exchange can impose upon any particular trading member or category of tradingmember any special or other margin requirement. On failure to deposit margin/s as requiredunder this clause, the exchange/clearing house can withdraw the trading facility of the tradingmember. After the pay-out, the clearing house releases all margins.

Unfair trading practices

No trading member should buy, sell, deal in derivatives contracts in a fraudulent manner, orindulge in any unfair trade practices including market manipulation. This includes the following:

� Effect, take part either directly or indirectly in transactions, which are likely to have effect ofartificially, raising or depressing the prices of spot/ derivatives contracts.


� Indulge in any act, which is calculated to create a false or misleading appearance of trading, resultingin reflection of prices, which are not genuine.

� Buy, sell commodities/ contracts on his own behalf or on behalf of a person associated with himpending the execution of the order of his constituent or of his company or director for the samecontract.

� Delay the transfer of commodities in the name of the transferee.

� Indulge in falsification of his books, accounts and records for the purpose of market manipulation.

� When acting as an agent, execute a transaction with a constituent at a price other than the price atwhich it was executed on the exchange.

� Either take opposite position to an order of a constituent or execute opposite orders which he isholding in respect of two constituents except in the manner laid down by the exchange.

10.2.2 Clearing

As mentioned earlier, National Securities Clearing Corporation Limited (NSCCL) undertakesclearing of trades executed on the NCDEX. All deals executed on the Exchange are clearedand settled by the trading members on the settlement date by the trading members themselvesas clearing members or through other professional clearing members in accordance with theseregulations, bye laws and rules of the exchange.

Last day of trading

Last trading day for a derivative contract in any commodity is the date as specified in therespective commodity contract. If the last trading day as specified in the respective commoditycontract is a holiday, the last trading day is taken to be the previous working day of exchange.

On the expiry date of contracts, the trading members/ clearing members have to give deliveryinformation as prescribed by the exchange from time to time. If a trading member/ clearingmember fails to submit such information during the trading hours on the expiry date for thecontract, the deals have to be settled as per the settlement calendar applicable for such deals, incash together with penalty as stipulated by the exchange.

Delivery

Delivery can be done either through the clearing house or outside the clearing house. On theexpiry date, during the trading hours, the exchange provides a window on the trading system tosubmit delivery information for all open positions.

After the trading hours on the expiry date, based on the available information, the matchingfor deliveries takes place – firstly, on the basis of locations and then randomly keeping in viewthe factors such as available capacity of the vault/ warehouse, commodities already deposited anddematerialized and offered for delivery and any other factor as may be specified by the exchangefrom time to time. Matching done is binding on the clearing members. After completion of the


matching process, clearing members are informed of the deliverable / receivable positions andthe 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 thefinal settlement price. All matched and unmatched positions are settled in accordance with theapplicable settlement calendar.

The exchange may allow an alternate mode of settlement between the constituents directlyprovided that both the constituents through their respective clearing members notify the exchangebefore the closing of trading hours on the expiry date. They have to mention their preferredidentified counter–party and the deliverable quantity, along with other details required by theexchange. The exchange however, is not be responsible or liable for such settlements or anyconsequence of such alternate mode of settlements. If the information provided by the buyer/seller clearing members fails to match, then the open position would be settled in cash togetherwith penalty as may be stipulated by the exchange.

The clearing members are allowed to deliver their obligations before the pay in date as perapplicable settlement calendar, whereby the clearing house can reduce the margin requirementto that extent.

The exchange specifies the parameters and methodology for premium/ discount, as the casemay be, from time to time for the quality/ quantity differential, sales tax, taxes, governmentlevies/ fees if any. Pay in/ Pay out for such additional obligations is settled on the supplementalsettlement date as specified in the settlement calendar.

Procedure for payment of sales tax/VAT

The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/centraltax/fee applicable to the deals culminating into sale with physical delivery of commodities.

All members have to ensure that their respective constituents, who intend to take or givedelivery of commodity, are registered with sales tax authorities of all such states in which theexchange has a delivery center for a particular commodity in which constituent has or is expectedto have open positions. Members have to maintain records/details of sales tax registration of eachof such constituent and furnish the same to the exchange as and when required.

The seller is responsible for payment of sales tax/VAT, however the seller is entitled to recoverfrom the buyer, the sales tax and other taxes levied under the local state sales tax law to the extentpermitted by law. In no event is the exchange/ clearing house liable for payment of sales tax/VAT or any other local tax, fees, levies etc.

Penalties for defaults

In the event of a default by the seller or the buyer in delivery of commodities or payment of theprice, the exchange closes out the derivatives contracts and imposes penalties on the defaultingbuyer or seller, as the case may be. It can also use the margins deposited by such clearing memberto recover the loss. The settlement for the defaults in delivery is to be done in cash within theperiod as prescribed by the exchange at the highest price from the last trading date till the finalsettlement date with a mark up thereon as may be decided from time to time.


Process of dematerialization

Dematerialization refers to issue of an electronic credit, instead of a vault/ warehouse receipt,to the depositor against the deposit of commodity. Any person (a constituent) seeking todematerialize a commodity has to open an account with an approved depository participant (DP).The exchange provides the list of approved DPs from time to time.

In case of commodities (other than precious metals) the constituent delivers the commodityto the exchange–approved warehouses. The commodity brought by the constituent is checkedfor the quality by the exchange–approved assayers before the deposit of the same is acceptedby the warehouse. If the quality of the commodity is as per the norms defined and notified bythe exchange from time to time, the warehouse accepts the commodity and sends confirmationin the requisite format to the R & T agent who upon verification, confirms the deposit of suchcommodity to the depository for giving credit to the demat account of the said constituent.

In case of precious metals, the commodity must be accompanied with the assayers’ certificate.The vault accepts the precious metal, after verifying the contents of assayers certificate withthe precious metal being deposited. On acceptance, the vault issues an acknowledgement tothe constituent and sends confirmation in the requisite format to the R & T agent who uponverification, confirms the deposit of such precious metal to the depository for giving credit to thedemat account of the said constituent.

Validity date

In case of commodities having validity date assigned to it by the approved assayer, the deliveryof the commodity upon expiry of validity date is not considered as a good delivery. The clearingmember has to ensure that his concerned constituent removes the commodities on or before theexpiry of validity date for such commodities.

For the depository, commodities, which have reached the trading validity date, are movedout of the electronic deliverable quantity. Such commodities are suspended from delivery. Theconstituent has to rematerialize such quantity and remove the same from the warehouse. Failureto remove deliveries after the validity date from warehouse is levied with penalty as specified bythe relevant authority from time to time.

Process of rematerialisation

Re–materialization refers to issue of physical delivery against the credit in the demat accountof the constituent. The constituent seeking to rematerialize his commodity holding has to makea request to his DP in the prescribed format and the DP then routes his request through thedepository system to the R & T agent issues the authorisation addressed to the vault/ warehouse torelease physical delivery to the constituent. The vault/warehouse on receipt of such authorisationreleases the commodity to the constituent or constituent’s authorised person upon verifying theidentity.


Delivery through the depository clearing system

Delivery in respect of all deals for the clearing in commodities happens through the depositoryclearing system. The delivery through the depository clearing system into the account ofthe buyer with the depository participant is deemed to be delivery, notwithstanding that thecommodities are located in the warehouse along with the commodities of other constituents.

Payment through the clearing bank

Payment in respect of all deals for the clearing has to be made through the clearing bank(s);Provided however that the deals of sales and purchase executed between different constituents ofthe same clearing member in the same settlement, shall be offset by process of netting to arriveat net obligations.

Clearing and settlement process

The relevant authority from time to time fixes the various clearing days, the pay–in and pay–out days and the scheduled time to be observed in connection with the clearing and settlementoperations of deals in commodities/ futures contracts.

1. Settlement obligations statements for TCMs: The exchange generates and provides to each tradingclearing member, settlement obligations statements showing the quantities of the different kinds ofcommodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable orreceivable by him in his capacity as clearing member and by professional clearing member for dealsmade by him for which the clearing Member has confirmed acceptance to settle. The obligationsstatement is deemed to be confirmed by the trading member for which deliveries are to be givenand/ or taken and funds to be debited and/ or credited to his account as specified in the obligationsstatements and deemed instructions to the clearing banks/ institutions for the same.

2. Settlement obligations statements for PCMs: The exchange/ clearing house generates and providesto each professional clearing member, settlement obligations statements showing the quantities ofthe different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken andthe funds payable or receivable by him. The settlement obligation statement is deemed to have beenconfirmed by the said clearing member in respect of every and all obligations enlisted therein.

Delivery of commodities

Based on the settlement obligations statements, the exchange generates delivery statement andreceipt statement for each clearing member. The delivery and receipt statement contains detailsof commodities to be delivered to and received from other clearing members, the details ofthe corresponding buying/ selling constituent and such other details. The delivery and receiptstatements are deemed to be confirmed by respective member to deliver and receive on accountof his constituent, commodities as specified in the delivery and receipt statements.

On respective pay–in day, clearing members effect depository delivery in the depositoryclearing system as per delivery statement in respect of depository deals. Delivery has to bemade in terms of the delivery units notified by the exchange.


Commodities, which are to be received by a clearing member, are delivered to him in thedepository clearing system in respect of depository deals on the respective pay–out day as perinstructions of the exchange/ clearing house.

Delivery units

The exchange specifies from time to time the delivery units for all commodities admitted todealings on the exchange. Electronic delivery is available for trading before expiry of the validitydate. The exchange also specifies from time to time the variations permissible in delivery unitsas per those stated in contract specifications.

Depository clearing system

The exchange specifies depository(ies) through which depository delivery can be effected andwhich shall act as agents for settlement of depository deals, for the collection of margins byway of securities for all deals entered into through the exchange, for any other commoditiesmovement and transfer in a depository(ies) between clearing members and the exchange andbetween clearing member to clearing member as may be directed by the relevant authority fromtime to time.

Every clearing member must have a clearing account with any of the Depository Participantsof specified depositories. Clearing Members operate the clearing account only for the purposeof settlement of depository deals entered through the exchange, for the collection of margins byway of commodities for deals entered into through the exchange. The clearing member cannotoperate the clearing account for any other purpose.

Clearing members are required to authorise the specified depositories and depositoryparticipants with whom they have a clearing account to access their clearing account for debitingand crediting their accounts as per instructions received from the exchange and to report balancesand other credit information to the exchange.

10.3 Rules governing investor grievances, arbitration

In matters where the exchange is a party to the dispute, the civil courts at Mumbai have exclusivejurisdiction and in all other matters, proper courts within the area covered under the respectiveregional arbitration center have jurisdiction in respect of the arbitration proceedings falling/conducted in that regional arbitration center.

For the purpose of clarity, we define the following:

� Arbitrator means a sole arbitrator or a panel of arbitrators.

� Applicant means the person who makes the application for initiating arbitral proceedings.

� Respondent means the person against whom the applicant lodges an arbitration application, whetheror not there is a claim against such person.

10.3 Rules governing investor grievances, arbitration 145

If the value of claim, difference or dispute is more than Rs.25 Lakh on the date of application,then such claim, difference or dispute are to be referred to a panel of three arbitrators. If thevalue of the claim, difference or dispute is up to Rs.25 Lakh, then they are to be referred to asole arbitrator. Where any claim, difference or dispute arises between agent of the member andclient of the agent of the member, in such claim, difference or dispute, the member, to whomsuch agent of the member is affiliated, is impeded as a party. In case the warehouse refuses orfails to communicate to the constituent the transfer of commodities, the date of dispute is deemedto have arisen on

1. The date of receipt of communication of warehouse refusing to transfer the commodities in favourof the constituent.

2. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituentfor transfer with the seller, whichever is later.

10.3.1 Procedure for arbitration

The applicant has to submit to the exchange application for arbitration in the specified form(Form No. I/IA) along with the following enclosures:

1. The statement of case (containing all the relevant facts about the dispute and relief sought).

2. The statement of accounts.

3. Copies of member – constituent agreement.

4. Copies of the relevant contract notes, invoice and delivery challan.

The Applicant has to also submit to the exchange the following along with the arbitrationform:

1. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour ofNational Commodity & Derivatives Exchange Limited.

2. Form No. II/IIA containing list of names of the persons eligible to act as arbitrators.

If any deficiency/ defect in the application is found, the exchange calls upon the applicantto rectify the deficiency/ defect and the applicant must rectify the deficiency/ defect within 15days of receipt of intimation from the exchange. If the applicant fails to rectify the deficiency/defect within the prescribed period, the exchange returns the deficient/ defective application tothe applicant. However, the applicant has the right to file a revised application, which will beconsidered as a fresh application for all purposes and dealt with accordingly.

Upon receipt of Form No.I/IA, the exchange forwards a copy of the statement of case andrelated documents to the respondent. The respondent then has to submit Form II/IIA to theexchange within 7 days from the date of receipt. If the respondent fails to submit Form II/IIAwithin the time period prescribed by the exchange, then the arbitrator is appointed in the manneras specified in the regulation. The respondent(s) should within 15 days from the date of receipt


of Form No. I/IA from the exchange, submit to the exchange in Form No. III/IIIA three copiesin case of sole arbitrator and five copies in case of panel of arbitrators along with the followingenclosures:

� The statement of reply (containing all available defences to the claim)

� The statement of accounts

� Copies of the member constituent agreement.

� Copies of the relevant contract notes, invoice and delivery challan

� Statement of the set–off or counter claim along with statements of accounts and copies of relevantcontract notes and bills

The respondent has to also submit to the exchange a cheque/ pay order/ demand draft forthe deposit payable at the seat of arbitration in favour of National Commodity & DerivativesExchange Limited along with Form No.III/IIIA If the respondent fails to submit Form III/IIIAwithin the prescribed time, then the arbitrator can proceed with the arbitral proceedings andmake the award ex–parte. Upon receiving Form No. III/IIIA from the respondent the exchangeforwards one copy to the applicant. The applicant should within ten days from the date of receiptof copy of Form III/IIIA, submit to the exchange, a reply to any counterclaim, if any, which mayhave been raised by the respondent in its reply to the applicant. The exchange then forwards thereply to the respondent. The time period to file any pleading referred to herein can be extendedfor such further periods as may be decided by the relevant authority in consultation with thearbitrator depending on the circumstances of the matter.

10.3.2 Hearings and arbitral award

No hearing is required to be given to the parties to the dispute if the value of the claim differenceor dispute is Rs.25,000 or less. In such a case the arbitrator proceeds to decide the matter on thebasis of documents submitted by both the parties provided. However the arbitrator for reasons tobe recorded in writing may hear both the parties to the dispute.

If the value of claim, difference or dispute is more than Rs.25,000, the arbitrator offers tohear the parties to the dispute unless both parties waive their right for such hearing in writing.

The exchange in consultation with the arbitrator determines the date, the time and place ofthe first hearing. Notice for the first hearing is given at least ten days in advance, unless theparties, by their mutual consent, waive the notice. The arbitrator determines the date, the timeand place of subsequent hearings of which the exchange gives a notice to the parties concerned.

If after the appointment of an arbitrator, the parties settle the dispute, then the arbitratorrecords the settlement in the form of an arbitral award on agreed terms. All fees and chargesrelating to the appointment of the arbitrator and conduct of arbitration proceedings are to borneby the parties to the reference equally or in such proportions as may be decided by the arbitrator.The costs, if any, are awarded to either of the party in addition to the fees and charges, as decidedby the arbitrator.

10.3 Rules governing investor grievances, arbitration 147

Solved ProblemsQ: Which of the following is not involved in regulating forward/futures trading system in India?

1. Government of India

2. Forward Markets Commission(FMC)

3. Commodity exchanges

4. Commodity board of trading


Q: All the exchanges, which deal with forward contracts, are required to obtain certificate of registrationfrom the

1. Government of India

2. Forward Markets Commission(FMC)

3. Commodity exchanges

4. Commodity board of trading


Q: To ensure financial integrity and market integrity, the FMC prescribes certain regulatory measures.Which of the following is not a measure prescribed?

1. Limit on net open positions.

2. Circuit–filters or limit on price fluctuations.

3. Special margin deposits.

4. Price determination


Q: Every trading member is required to specify the buy or sell orders as either an open order or a closeorder for derivatives contracts.

1. Open order or close order

2. call order or put order

3. take order or give order

4. bid order or ask order


Q: In matters where the NCDEX is a party to the dispute, the civil courts at have exclusivejurisdiction.

1. Delhi

2. Mumbai

3. Ahmedabad

4. Calcutta



Q: No hearing is required to be given to the parties to the dispute if the value of the claim difference ordispute is Rs.25,000 or less.

1. Rs.25,000

2. Rs.50,000

3. Rs.1,00,000

4. Rs.10,000


Q: In the case of an arbitration, the exchange in consultation with the determines the date, the timeand place of the first hearing.

1. Respondent

2. Applicant

3. Arbitrator

4. Warehouse


Chapter 11

Implications of sales tax

The physical settlement in the case of commodities futures contracts involves issues concernedwith sales tax. The fact that delivery could happen across various states, and these stateshave different sales tax rules, makes the issue a little complicated. In the case of settlementsculminating into delivery, sales tax at the rates applicable in the state where the delivery centeris located will be payable. In many states, the sales tax laws, also provide for levy of additionaltax, turnover tax, resale tax, etc. which may or may not be recoverable from the buyer dependingon the provisions of the local state sales tax law.

The NCDEX has examined the implications of trading on NCDEX system under the relevantstate sales tax laws and has also sought opinion from independent tax advisors on the matter. Thepresent understanding of the implications are given below for reference.

� Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liablefor payment of sales tax.

� If the futures contract is closed out and settled between the constituents prior to the settlement datewithout actually buying or selling the commodities, there is no liability for payment of sales tax.

� When the futures contract fructifies into a sale and culminates into delivery, there would be liabilityfor payment of sales tax. This liability will arise in the state in which the warehouse (into which thegoods are lodged by the constituent) is situated when the commodities are delivered to the buyer.

� It is the responsibility of the selling constituent to comply with the relevant local state sales tax lawsand other local enactments. The selling constituent will be responsible for the following:

1. Obtaining registration under the relevant state sales tax laws, filing of returns, payment of taxesand due compliance of laws.

2. Payment of entry tax, octroi, etc., when the commodities are brought into the designated localarea for lodging the same with the warehouse.

3. Complying with any check–post regulations prescribed under the local sales tax, entry tax orother municipal laws and ensuring that the prescribed documents accompany the goods.

4. Liability for central sales tax if the commodities are moved from outside the state pursuant toa transaction of sale.

150 Implications of sales tax

5. The selling constituent may move the commodities into the warehouse well in advance andensure compliance of provisions of law.

6. Furnishing of duly completed sales invoices, declaration forms and certificates prescribedunder the local sales tax, entry tax or other municipal laws to enable the buyer to avail ofexemption or deduction as provided in the relevant laws.

� It is the responsibility of the buying constituent to comply with the applicable local state sales taxlaws and other local enactments. The buying constituent will be responsible for the following:

1. Obtaining registration under the relevant state sales tax laws based on the purchase ofcommodities, filing of returns, payment of taxes and due compliance of laws.

2. Furnishing of duly completed declaration forms and certificates prescribed under the local salestax, entry tax or other municipal laws to enable the seller to avail of exemption or deduction asprovided in the relevant laws.

Solved ProblemsQ: When the futures contract fructifies into a sale and culminates into delivery, the payment of sales taxis to be done in the state in which the is situated.

1. Clearing corporation

2. Warehouse

3. Buyer

4. Seller


Q: It is the responsibility of the to comply with the relevant local state sales tax laws and other localenactments.

1. Warehouse

2. Buyer

3. Seller

4. Buyer and seller


Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and culminatesinto of the underlying.

1. Payment

2. Sale

3. Delivery

4. Exchange


151

Sources/references/suggested readings

The readings suggested here are supplementary in nature and would prove to be helpful for thoseinterested in learning more about derivatives.

� Derivatives FAQ by Ajay Shah and Susan Thomas

� Escape to the futures by Leo Melamed

� Futures and options by Hans R.Stoll and Robert E. Whaley.

� Futures and options in risk management by Terry J. Watsham.

� Options, futures and other derivatives by John Hull.

� Futures, options and swaps by Robert W. Kolb.

� Introduction to futures and options markets by John Kolb

� Options and financial future: Valuation and uses by David A. Dubofsky.

� Rubinstein on derivatives by Mark Rubinstein.

� Derivative markets in India 2003 edited by Susan Thomas.

� http://www.ncdex.com

� http://fmc.gov.in

Index

arbitragers, 10assignment, 18

basis, 60baskets, 14

cost of carry, 60cost-of-carry, 76

delivery, 19derivatives

exchange traded, 13OTC, 13

forwards, 57futures, 14

commodity, 77

hedgelong, 87short, 86

hedgers, 10

longcall, 66put, 68

margininitial, 60maintenance, 60MTM, 60

optionamerican, 61at-the-money, 61buyer, 61call, 61european, 61

in-the-money, 61index, 61intrinsic value, 62out-of-money, 61premium, 61put, 61stock, 61time value, 62writer, 61

orderday, 104GTC, 105GTD, 105IOC, 105stop–loss, 105

pricelimit, 106trigger, 106

settlementphysical, 17

shortcall, 67put, 69

speculators, 10spot price, 60swaps, 14

currency, 14interest rate, 14

swaptions, 14

transactionforward, 12spot, 12

warrants, 14

MCX Study material

Documents

Transcript of MCX Study material