1

CONTENTS

TOPIC PAGE

1 Evolution of commodity exchanges 3

Evolution of Commodity Exchanges

Leading Commodity Exchanges

Commodity exchanges in Developing Economies

3

4

5

2 Commodity exchanges in India 6

Evolution of Commodity Markets in India

List of Commodity Exchanges in India

List of commodities in which futures trading is permitted

6

6

9

3 Introduction to Derivatives 11

Traditional markets

Emergence and growth of derivatives markets

What are derivatives?

Forward and Future contracts

Forwards v/s Futures in a nutshell

Swaps

Options

Options Glossary

11

12

12

13

17

18

19

22

4 Futures market functioning 24

Trading

Placing the Order

Methods of Trading

Kinds of Orders

Kinds of Margins

Pricing of Futures

Closing out the positions

Clearing and Settlement

Clearing House

Functions of a clearing house

Processes of a clearing house

Proposed Systems and Regulations at NCDEX – Clearing

house

Settlement Methods

Proposed Systems and Regulations at NCDEX –

Accredited Warehouse, R&T Agents, Assayers

Clearing and Settlement at NCDEX in a nutshell

24

24

24

25

27

28

30

31

31

31

32

33

34

37

41

5 Characteristics of commodity trading 44

Hedging

Hedging Strategies

Hedge Ratio

44

45

45

2

Advantages of Hedging

Limitations of Hedging

Basis Risk

Speculation

Arbitrage

Cash and Carry Arbitrage

47

47

48

49

49

50

6 NCDEX and its functioning 51

Objectives

Promoters

Governance

Membership

Commodities Traded

Institutional Tie-Up

51

51

51

52

52

52

7 Regulatory provisions 54

Forward Contract (Regulation) Act

Forward Markets Commission (FMC)

Functions of FMC

Powers of The Commission

Regulatory measures of FMC

Securities Contracts (Regulation) Act

Agricultural Markets

Proposed rules and regulations of NCDEX

54

54

54

55

55

55

56

57

8 Sample Problems and Answers 64

Multiple Choices

Fill in the blanks

Problems

Answers

64

71

72

79

9 Frequently Asked Questions 81

10 Economic Benefits of Futures trading 93

11 Glossary of Futures Terms 94

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1. EVOLUTION OF COMMODITY EXCHANGES

Most of the commodity exchanges, which exist today, have their origin in the late 19th and

earlier 20th century. The first central exchange was established in 1848 in Chicago under

the name Chicago Board Of Trade. The emergence of the derivatives markets as the

effective risk management tools in 1970s and 1980s has resulted in the rapid creation of

new commodity exchanges and expansion of the existing ones. At present, there are major

commodity exchanges all over the world dealing in different types of commodities.

Commodity Exchange

Commodity exchanges are defined as centers where futures trade is organized In a wider

sense, it is taken to include any organized market place where trade is routed through one

mechanism, allowing effective competition among buyers and among sellers - this would

include auction-type exchanges, but not wholesale markets, where trade is localized, but

effectively takes place through many non-related individual transactions between different

permutations of buyers and sellers.

Role of Commodity Exchanges

Exchanges can concentrate on the trade in futures and options contracts, or they could

primarily function as centers for facilitating physical trade. They act as a focal point for trade

transactions, and increase the security of these transactions.

Well-organized commodity exchanges form natural reference points for physical trade, and

in this way, they help the price discovery process. If a commodity exchange manages to link

different warehouses in the country, this allows trade to take place more efficiently.

Evolution of Commodity Exchanges

The creation of exchanges goes back to the late 19th century with the development of

national and international market places. The main rationale, was the reduction of transaction

costs, the major potential for it lying in organizing a physical market place, where buyers and

sellers could be sure of finding a ready market .

One of the factors that led to the creation of the Chicago Board of Trade, over a century old

and still one of the world's largest commodity exchanges, was that farmers coming to Chicago

at times found no buyers, and had to dump their cereals unsold in Lake Michigan, adjoining the

city. These ―old‖ exchanges are located mainly in developed countries. However, a few were

created in developing countries, too. The Buenos Aires Grain Exchange in Argentina, founded in

1854, is one of the oldest in the world.

We're now seeing the onset of a new phase in the evolution of commodity exchanges, driven

by technology. Established traditional exchanges seem convinced that the Internet is

providing them with unprecedented opportunities. This is equally true for commodity

exchanges in developing countries - Technology has made it possible for them to offer new

products at a lower cost. They now need to grasp these possibilities.

4

Some of the leading commodity exchanges across the globe are:

North and South America

United States Of America Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange

Minneapolis Grain Exchange

New York Cotton Exchange

New York Mercantile Exchange

Kansas Board of Trade

New York Board of Trade

Canada

The Winnipeg Commodity Exchange

Brazil

Brazilian Futures Exchange

Commodities and Futures Exchange

Asia/Pacific

Australia Sydney Futures Exchange Ltd.

People’s Republic Of China

Beijing Commodity Exchange

Shanghai Metal Exchange

Hong Kong

Hong Kong Futures Exchange

Japan

Tokyo International Financial Futures

Exchange

Kansai Agricultural Commodities Exchange

Tokyo Grain Exchange

Malaysia Kuala Lumpur commodity Exchange

New Zealand New Zealand Futures & Options Exchange

Ltd.

Singapore Singapore Commodity Exchange Ltd.

Europe

France

Le Nouveau Marche

MATIF

Italy Italian Derivatives Market

Netherlands

Amsterdam Exchanges

Option Traders Combination

Russia

The Russian Exchange

MICEX/Relis Online

St. Petersburg Futures Exchange

Spain

The Spanish Options Exchange

Citrus Fruit and Commodity Futures Market

of Valencia

United Kingdom

The London International Financial Futures

and Options Exchange

The London Metal Exchange

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Commodity Exchanges in Developing Economies

Africa

Africa`s most active and important commodity exchange is the South African Futures

Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial

futures and gold futures for a long time, but the creation of the Agricultural Markets

Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range

of agricultural futures contracts for commodities, in which trade was liberalized, namely,

white and yellow maize, bread milling wheat and sunflower seeds.

Maize contracts are also traded on new exchanges in Zambia and Zimbabwe. Farmers

established the Zimbabwe Agricultural Commodity Exchange (ZIMACE) in 1994, in response

to the gradual liberalization of state-controlled agricultural marketing.

Asia

China’s first commodity exchange was established in 1990 and at least forty had appeared

by 1993. The main commodities traded were agricultural staples such as wheat, corn and in

particularly soybeans.

In late 1994, more than half of China's exchanges were closed down or reverted to being

wholesale markets, while only 15 restructured exchanges received formal government

approval. At the beginning of 1999, the China Securities Regulatory Committee began a

nationwide consolidation process which resulted in three commodity exchanges emerging;

the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the

Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai

Metal, Commodity, Cereals & Oils Exchanges.

The Taiwan Futures Exchange was launched in 1998

Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one

futures and options exchange. Singapore is home to the Singapore Exchange (SGX), which

was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange

of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).

Latin America

Latin America’s largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F)

in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange

by 2001, with 98 million contracts traded.

There are also many other commodity exchanges operating in Brazil, spread throughout the

country. They trade largely in commodities for immediate or forward delivery, but through

an electronic network (which links most of the country’s exchanges) they also make it

possible to trade in futures contracts.

Argentina’s futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as

the world’s 51st largest exchange.

Mexico has only recently introduced a futures exchange to its markets. The Mercado

Mexicano de Derivados (Mexder) was launched in 1998.

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7

2. COMMODITY EXCHANGES IN INDIA

EVOLUTION OF COMMODITY DERIVATIVE MARKETS IN INDIA

First organized futures market evolved in India by setting up of Bombay Cotton Trade

Association Ltd. in 1875.

Bombay Cotton Exchange Ltd. was established in 1893 following the widespread

discontent amongst leading cotton mill owners and merchants over the functioning of

Bombay Cotton Trade Association.

The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati

Vyapari Mandali which carried on futures trading in groundnut, castor seed and cotton.

Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But

out of all the most notable futures exchange for wheat was chamber of commerce at

Hapur set up in 1913.

Futures trading in bullion began in Mumbai in 1920.

Calcutta Hessian Exchange Ltd. was established in 1919 for Futures trading in rawjute

and jute goods. But organized futures trading in raw jute began only in 1927 with the

establishment of East Indian Jute Association Ltd. These two associations amalgamated

in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both

Raw Jute and Jute goods.

Enactment of Forward Contracts (Regulation) Act, 1952

Establishment of the Forwards Markets Commission (FMC) in 1953 under the Ministry

of Consumer Affairs and Public Distribution.

In due course several other exchanges were created in the country to trade in diverse

commodities.

COMMODITY EXCHANGES IN INDIA

A comprehensive list of the registered commodity exchanges in India is given below:

S.No. EXCHANGE PRODUCTS TRADED

1 Bhatinda Om & Oil Exchange Ltd. Bhatinda. Gur

2 The Bombay Commodity Exchange Ltd.

Mumbai

Sunflower Oil

cotton (seed and oil)

Safflower (Seed, Oil and Oil cake)

Groundnut (Nuts and Oil)

Castor oil-Int'l

Castorseed

Sesamum (oil and Oilcake)

Rice Bran, Rice Bran Oil and Oilcake

Crude Palm Oil

3 The Rajkot Seeds oil & Bullion Merchants

Association Ltd.

Groundnut Oil

Castorseed

8

Rajkot

4 The Kanpur Commodity Exchange Ltd, Kanpur

Rapeseed/Mustardseed

Rapeseed/Mustardseed Oil

Rapeseed/Mustardseed oil-Cake

5 The Meerut Agro Commodities Exchange Co.

Ltd., Meerut.

Gur

6 The Spices and Oilseeds Exchange Ltd.

Sangli, Maharashtra.

Turmeric

7 Ahmedabad Commodity Exchange Ltd. cottonseed

Castorseed

8 Vijay Beopar Chamber Ltd., Muzaffarnagar Gur

9 India Pepper & Spice Trade Association.

Kochi

Pepper

10 Rajdhani Oils and Oilseeds Exchange Ltd.

Delhi

Gur

Rapeseed/Mustardseed

Sugar Grade - M

11 National Board of Trade.

Indore.

Rapeseed/Mustard seed/Oil/Cake

Soybean/Meal/Oil

Crude Palm Oil

12 The Chamber Of Commerce.

Hapur

Gur

Rapeseed/Mustardseed

13 The East India Cotton Association Mumbai Indian Cotton

14 The Central India Commercial Exchange Ltd.

Gwaliar

Gur

15 The East India Jute & Hessian Exchange

Ltd.,

Kolkata.

Hessian

Sacking

16 First Commodity Exchange of India Ltd.

Kochi

Copra

Coconut oil

Copra cake

17 Bikaner Commodity Exchange Ltd.

Bikaner

No commodity is traded at present

18 The Coffee Futures Exchange India Ltd.

Bangalore.

Coffee

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19 E sugarindia Limited.

Mumbai

Sugar

20 National Multi Commodity Exchange of India

Limited.

Ahmedabad

Gur

RBD Pamolein

Crude Palm Oil

Sunflower (Seed and Oil)

Rapeseed/Mustardseed (seed, oil and

oilcake)

Soy bean (Beans, oil and oilcake)

Copra

Cotton (Seed, oil and oilcake)

Safflower (seed, oil and oilcake)

Groundnut (Nuts, oil and oilcake)

Sugar

Sacking

Coconut (oil and oilcake)

Castor (seed, oil and oilcake)

Sesamum (Seed, Oil and oilcake)

Linseed (seed, oil and oilcake)

Rice Bran Oil

Pepper

Guarseed

Gram

Aluminium Ingots

Nickel

Vanaspati

Rubber

Copper

Zinc

Lead

Tin

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COMMODITIES IN WHICH FUTURES TRADING IS PERMITTED

Govt. of India has the ultimate powers to decide the commodities in which futures trading

can be allowed. At present forward trading is allowed in the following commodities in India.

Commodity Group Products

Fibers and Manufacturers Kapas,

Hessian

Indian Cotton

Staple Fiber Yarn

Sacking

Gram

Spices Pepper

Turmeric

Edible Oilseeds and Oil RBD Pamolein

Rapeseed/Mustard (seed, oil and cake)

Soy bean (beans, meal, oil and cake)

Copra

Cotton (seed, oil and cake)

Groundnut (nuts, oil and cake)

Castor oil-Int'l

Coconut (oil and cake)

Copra cake

Cottonseed oil

Sesamum (seeds, oil and cake)

Safflower (seed, oil and cake)

Rice Bran, Rice Bran Oil and cake

Sunflower (Seed, oil)

Crude Palm Oil

Vanaspati

Linseed (seed, oil and cake)

Others Gur

Potato

Sugar

Sugar Grade – M

Sugar Grade - S

Coffee-Robusta Cherry AB

Raw Coffee Arabica Parchment

Raw Coffee Robusta Cherry

Coffee

Coffee-Plantation A.

Coffee-Robusta Cherry AB.

Raw Coffee Robusta Cherry.

Raw Coffee Arabica parchment

Rubber

Metals Aluminium Ingots

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Nickel

Copper

Zinc

Lead

Tin

Gold

Silver

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3. INTRODUCTION TO DERIVATIVES

TRADITIONAL MARKETS

Traditional markets are the Cash and Carry markets. They are also called Spot markets. The

contract is called a Spot contract. A spot contract is an agreement where the seller agrees

to deliver an asset and a buyer agrees to pay for that asset ―on the spot‖. They are used in

all forms of business to transfer title to goods.

The advantage with the traditional markets is that the buyer can find the precise

commodity that suits him, pay the money and become the owner of the merchandise

immediately. However, transactions in traditional markets are inherently high-risk. The

following example is illustrative of this drawback of traditional markets.

Example: Company X has Poultry feed business and sells the feed in the retail market under

their own brand name.

The prices in the retail market fluctuate less and vary according to the competitor prices.

The raw material for the poultry feed consists of Soy meal, Maize, wheat bran and brokens,

oilcakes, etc. The prices of the raw materials vary according to the supply-demand situation

of the commodities like Soybean, Maize, Wheat etc. The production of these commodities is

in turn largely dependent on the vagaries of the monsoon.

The raw materials approximately constitute 70% of the cost of manufacturing the feed.

The profit margins at current price levels are 10% of the sales of the feed

The Company, in June (for example) needs to plan the buying of raw materials in the month

of December to manufacture the feed. In June the company anticipates the raw material

prices in December to be more or less similar as in the previous year.

However, in the month of December it finds that the cost of the raw materials have

increased by 20% from the previous year because of a bad monsoon resulting in fall in

production and the consequent supply shortage. The increase in raw material prices resulted

in increased cost of manufacturing of the feed and decreased profit margins for the

company.

This above example illustrates the need for a system, which can minimize the risk in the

traditional markets and protect the buyers and sellers from the unexpected price

fluctuations.

The Disadvantages of the traditional markets can thus be summed as follows:

Price uncertainty which makes it difficult to predict the market accurately

Lack of effective mechanism to eliminate the price risk which arises due to demand and

supply variations and uncertainties in the economic and market conditions

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EMERGENCE AND GROWTH OF DERIVATIVES MARKETS

Derivatives have emerged out of spot contracts as an effective risk management tool.

There are evidences indicating that futures trading existed in Japan and China even in the

17th century.

In the mid 1800’s Chicago was developing as a commercial center. Wheat farmers and

traders across the country used to assemble in Chicago to sell and buy wheat. There was a

heavy supply of wheat, but poor methods of grading and weighing almost left the farmers at

the mercy of the traders. As a result of this a central exchange was established in 1848 for

farmers and traders to deal in spot markets. Soon after this with the increase in trade,

farmers and traders started entering into forward contracts at a predetermined price to

minimize the risk. The first forward contract was recorded at CBOT (Chicago Board Of

Trade) in March 1851 for Maize corn to be delivered in June of that year. At that time the

forward contracts created confusion for the users as they were traded privately and were

not standardized. As a result of this, CBOT formalized grain trading by developing

standardized agreements called futures contracts in 1865.

For the next hundred years the derivatives segment grew steadily, but were still small

compared to spot markets. During the post 1970’s derivatives started growing exponentially

in the USA. The key economic and technological factors that drove this growth were:

Breakdown of the Bretton woods system of fixed exchange rates in 1971 (Bretton

woods System- US dollar is the anchor of this system and the dollar was pegged to

gold. It was convertible to gold at the rate of $35 to an ounce. The currencies of all

other nations were pegged to US dollar, which could be revalued or devalued when

necessary. With the breakdown of this system, dollar was no longer convertible to

gold, which resulted in inflation and currency turmoil).

Oil price shocks in 1973

Excess government spending and high inflation in USA in 1970’s

Exponential increase in the magnitude of world trade, capital flows and progressive

dismantling of tariff barriers.

Technological innovations like advancements in communication and information

technologies enabled effective implementation of derivatives

Implementation of financial innovations including 24 hours global trading and online

risk management systems.

WHAT ARE DERIVATIVES?

A derivative is a financial instrument whose value depends on the value of the underlying

variables. There are broadly 4 types of derivatives:

Forwards: A forward contract is a bilateral agreement in which the buyer and the seller

agree upon the delivery of a specified quality and quantity of an asset on a specified

future date at a price agreed today. These are not traded on the exchanges.

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Futures: Future contracts are exchange-traded contracts to sell or buy financial

instruments or physical commodities for future delivery at an agreed upon price.

MEANING :WHICH PRICE EITHER SPOT OR……

Swaps: The word ―Swap‖ literally means an exchange. A Swap may be defined as a

contract whereby two parties (known as counter parties), exchange two different

streams of cash flows over a definite period of time, usually through an intermediary

like a financial institution. The nature of the exchange flows to be exchanged is defined

in the contract.

Options: An option is an agreement between two parties-one of whom is the buyer and

the other is the seller. An option gives the holder or buyer of the option the right but

not the obligation, to buy or sell an asset at a known fixed price at a given point in the

future. The seller in turn has the obligation (and not the right) to sell the asset to the

buyer. For assuming this obligation the seller charges a premium called Option premium

from the buyer.

In less than three decades of their coming into vogue, derivatives markets have become

part of the day-to-day life in trading for ordinary people in most parts of the world.

FORWARD AND FUTURE CONTRACTS

Forward Contracts

A forward contract is traded in the Over the Counter Market, usually between two financial

institutions or between a financial institution and client. One of the parties assumes a long

position and agrees to buy the underlying asset on a certain specified future date for a

certain specified price. The other party assumes a short position and agrees to sell the

asset on the same date for the same price. The price in a forward contract is known as the

delivery price.

Future Contracts

Future contracts have evolved out of forward contracts and are exchange-traded versions

of forward contracts. In futures contract there is an agreement to buy or sell a specified

quantity of financial instrument/ commodity in a designated future month at a price agreed

upon by the buyer and seller. The contracts have certain standardized specifications with

the date and time of expiry of the contract.

Types of Future Contracts:

The common underlying for which the futures are construed, are:

Commodity Futures: Futures in which the underlying asset is a commodity. It can be

agricultural commodity like wheat, corn, soybeans, perishable commodities like pork or

even precious assets like gold, silver etc.

Financial futures: Futures in which the underlying assets are financial instruments like

money market paper, notes, bonds. Currency futures on major convertible currencies

like the US Dollar, Pound, Euro or Yen. Security futures such as single stock futures and

stock index futures.

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Index Futures: The underlying asset is an Index. Most, of these contracts are for stock

indices. The more famous indices on which futures are traded are Standard and Poor

Composite 500,The New York Stock Exchange Index.

Long and Short Positions in a Forward/ Futures contract

Long Position

The party, who buys the contract, is considered, as assuming a long position in the

market with the expectation that price will go up. If the market goes down the party

with the long position tends to lose money.

The payoff from a long position in a forward contract for one unit of an asset is St – K.

(Where, St is the spot price of the asset at the time of the maturity of the contract

and K is the delivery price)

Short Position

The party, who sells the contract, assumes a short position. Going short is selling off

expecting the price to go down. At the time of the maturity if the delivery price is

higher than the spot price the seller makes profit. If the delivery price is less than the

spot price at the time of maturity of the contract the seller incurs a loss.

The payoff from a short position in a forward contract for one unit of an asset is K – St.

K is the delivery price and St is the spot price of the asset at the time of the maturity

of the contract.

Figure: Pay-off in Forward contracts

Forward contracts have linear/symmetric pay-off profiles, highlighting the fact that both

the buyer and the seller of these products have equal rights and obligations. Consequently,

the buyer pays no compensation to the seller, upfront. The pay-offs to the buyer and seller

are a linear function of the price of the underlying.

Profit

Loss

Seller’s Pay-

off

Buyer’s Pay

-off

Spot price (St)

of the

commodity at

the time of

the maturity

Delivery

Price (k)

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K is the delivery price of the contract (the price at which the underlying commodity or

security moves from the seller to the buyer) and St is the spot price of the commodity at

the maturity of the contract. This is because the holder of the contract is obligated to buy

an asset worth St for K.

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Forward and Futures contract

i) Characteristics

Forward Contracts Future Contracts

Forward contracts are OTC (Over the

Counter) contracts.

They are bilateral contracts and hence

exposed to counter-party risk.

Each contract is custom designed, and

hence is unique in terms of contract

size, expiration date and the asset type

and quality.

The contract has to be settled by

delivery of the asset on expiration date.

In case, the party wishes to reverse the

contract, it has to compulsorily go to the

same counter party.

Futures are essentially exchange traded.

Futures contracts are standardized in

terms of its various characteristics like

quantity, quality, settlement dates and

market conventions etc., for the easy and

convenient access by a large number of

market participants.

It is a price fixing contract. The

buyer/seller is obligated to take/give

delivery or closeout the positions at the

pre agreed price for the purpose of

settlement.

In futures market actual delivery of goods

takes place only in a very few cases.

Transactions are mostly squared up before

the due date and are settled by payment

of differences without any physical

delivery of goods taking place.

ii) Determining Prices

Forward Contracts Future Contracts

In principle the forward price for an asset would

be equal to the spot or the cash price at the time

of the transaction and the cost of carry. The cost

of carry includes all the costs incurred for

carrying the asset forward in time. Depending

upon the type of asset or commodity the cost of

carry takes into account factors including

payments and receipts for storage, transport

costs, interest payments, dividend receipts,

capital appreciation etc.

Forward Price = Spot or the cash price + Cost of

Carry

Price discovery mechanism is similar.

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iii) Functions of the markets

Forward Markets Future Markets

Forward contract is a simple agreement to buy

or sell an asset at a certain future time for a

certain price. Since, the forward contract is

traded in over the counter market and not in

an exchange the market/exchange has no role

to play in a forward transaction.

Futures markets perform certain important

economic functions. They meet the needs of

three groups of future market users.

1.Those who wish to discover information

about the future prices of commodities.

2.Those who wish to speculate

3.Those who wish to hedge

iv) Advantages

Forward Markets Future Markets

Forward contract has no

margin system. This means

the cost of entering into a

transaction for both the

buyer and the seller is zero.

Absence of credit risk. At any point of time the maximum

credit risk is limited to one-day movement in futures

prices.

High Liquidity: Futures market gives the participants the

option to come out of their positions at any time they

want.

High leverage: Futures are highly leveraged instruments,

which attracts large number of market participants who

ensure high liquidity at all times.

Price stabilization: In times of violent price fluctuations,

the futures mechanism enables to reduce the price

fluctuations

v) Limitations

Forward Markets Future Markets

The contracts are private and are negotiated

bilaterally between the parties. Therefore,

there are no exchange guarantees.

The prices are not transparent, as there is no

reporting requirement.

The profit or loss is realized only on the

maturity date.

Settlement is only through actual delivery or

offsetting by cash delivery. Closing out is not

possible.

Futures are not versatile for

hedging strategies due to

standardization of commodities.

This limitation is overcome by

―options‖

Exact hedge is not possible.

Futures contracts cannot be

tailored to the particular needs of

firms and financial institutions.

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FORWARDS VS FUTURES IN A NUTSHELL

Particulars Forward Contracts Future Contracts

Trading Traded on a private basis

and bilaterally negotiated

Traded on the floor of an

exchange through open

outcry or electronically

Nature Forward contracts are

customized by the two

counter parties as per their

requirements.

Future contracts are

exchange traded

standardized contracts.

Process Private and negotiated

bilaterally between the

parties with no exchange

guarantees

Transaction takes place

through a clearing house

which provides protection

for both the parties

Margin Requirements Involves no margin Requires a margin to be

paid

Liquidity Less liquid as the contract

prices are not transparent

and there is no reporting

requirement

More liquid as their prices

are transparent due to

standardization and market

reporting of volumes and

price

Settlement By actual delivery or offset

with cash settlement. A

forward contract can be

reversed only

Usually by closing out

through offsetting of

positions.

Credit risk Credit risk is substantial as

the contracts are not bound

by strict rules and

regulations

Credit risk is largely

eliminated by the use of

margins (initial, additional,

mark to market margins

etc.)

A typical futures price quotation will look like: (example taken from National Stock

Exchange, September 29th, 2003, mid-day)

Instrument

Type Underlying

Expiry

Date

High

Price

Low

Price

Prev

Close

Last

Price

Number

of

contracts

traded

Turnover

in Rs.

Lakhs

Underlying

Value

FUTSTK TISCO 30OCT2003 277.25 267.10 269.05 276.65 8029 39494.97 273.30

The underlying stock is Tisco. The expiry date of the futures is 3oth October. The last

price quoted for the futures was 276.65, whereas the spot price at that precise moment

was quoting at 273.30

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SWAPS

A Swap is an agreement between two parties to exchange different cash flows in the future

usually through an intermediary like a financial institution.

The agreement defines the dates when the cash flows are to be paid and the way that they

are to be calculated. Usually the calculation of the cash flows involves the future values of

one or more market variables.

Swaps are the most versatile of derivative products. The development of the swap market

was an important milestone in the evolution of Indian markets in the 1980’s. It has changed

fundamentally the way in which today’s financier or bankers look at funding choices.

While forwards and futures are single period price fixing contracts which means

future/forward contract leads to exchange of cash flows on just one future date, swaps are

multi-period price-fixing contracts which means cash flow exchanges occur on several

future dates.

Swaps were developed essentially as OTC products; but today, a number of exchange-

related versions of swaps are available as well.

Example: A forward contract can be viewed as a simple example of a swap. Suppose it is

September 1, 2003 and a company enters into a forward contract to buy 1 kg of gold at

Rs.5,600 per 10 gms one year forward. The forward contract is, therefore, equivalent to a

swap agreement where the company pays a cash flow of Rs. 5,60,000 on September 1, 2004,

and receives a cash flow equal to 100 times S on the same date, where S is the market price

of 10 gms of gold.

It is necessary to distinguish financial swaps from foreign exchange swaps. In the case of

foreign exchange swaps, a currency is simultaneously bought and sold for two value dates.

One of these may be spot and the other may be forward or both the legs may relate to two

different forward rates. Swaps in the derivatives context, refers mostly to contracts

where two parties exchange two streams of cash flows over a definite period of time.

Foreign exchange swaps essentially involve short-term exchanges while financial swaps, are

essentially long term in nature.

Swaps fundamentally exist because different institutions have varied access to financial

markets and due to different needs. It is more advantageous to swap payments with

another party thus transforming one’s liability, rather than to borrow directly in the market

of choice. Currency and interest rate swaps are techniques that transform the currency and

interest rate characteristics of a liability or an asset, from one form to another. Thus, swap

is a utility for transforming the characteristics of financial claims.

Swap also has Linear/Symmetric Pay-off profile like a forward/future contract. The pay-

off profile for a Swap would be similar to forward and futures contract. Refer to Figure: 1

under the section forward and futures contract for the pay-off profile

21

OPTIONS

There are two types of Options

Call Option: A Call option gives the buyer the right (option) to buy the underlying asset

by a certain date for a certain price. He can choose not to exercise the option. The

seller of the call option has an obligation to sell the asset.

Put Option. A Put option gives the buyer the right (option) to sell the underlying asset

by a certain date for a certain price. He can choose not to exercise the option. The

seller of the option has an obligation to buy the asset.

There are several specific terms used in the context of options. They are:

Buyer/Holder/Owner

This refers to the person who buys the option and as a result has the right (option) to

either buy/sell the underlying without the attendant obligation to do so.

Seller/Writer

The person who sells the option and as a result has only the obligation to either buy/sell the

underlying, having surrendered his rights to the contract for a price known as the option

premium.

Option Premium

Amount paid by a buyer to the seller for acquiring the right to buy or sell an underlying.

Alternately, it is the price received by the seller for surrendering his rights in an option

contract. It is usually paid upfront, i.e. at the time of entering into the option contract.

Strike price

The price at which the right to buy or sell the underlying is exercisable, which is agreed

upon upfront. It is also known as the exercise/agreed price.

Expiry Date

The date on which the options contract expires or becomes invalid.

Call Option

An option acquired to obtain the right to buy/call an underlying in the market.

Put Option

An option acquired to obtain the right to sell/put an underlying the market

American Option

In this type of option, the buyer can exercise the right (buy/sell) at any time during the life

of the option contract

European Option

In this type of option, the right can be exercised by the buyer only at the end of the life of

the option contract

22

Figure: Pay-off in a Call Option

Options are non-linear in their pay-offs to the buyer and seller. Since the rights and

obligations are skewed in favor of the buyer to the detriment of the seller, the latter is

compensated upfront, by way of a fee known as option premium. The pay-offs to the buyer

and seller are not linear vis-à-vis the price of the underlying/commodity.

Figure: Pay

off in a Put Option

The following example illustrates the pay-offs.

Example:

A trader wants to sell a commodity 8 weeks hence. The commodity is quoting at a price of

USD 300 per tonne. If the price, during the period, increases to USD 310 per tonne, the

Profit

Loss

Seller’s Call

Option

Buyer’s Call

Option

Spot price of the

commodity at the time

of the maturity of the

contract

Strike

price

Profit

Loss

Seller’s Put

Option

Buyer’s Put

Option

Spot price of the

commodity at the time

of the maturity of the

contract

Strike

price

23

trader would gain, if he buys today. However, if the price falls to USD 280 per tonne, he

would incur a loss, if he buys today.

The trader, instead, takes a put option on the same commodity at say, USD 300 per tonne

for the same date at a premium of USD 10. If the spot price indeed falls to USD 280, he

exercises his option. Thus he sells at USD 300 and buys in the spot market at USD 280 to

close his position. His gain will be the difference of the two prices – the premium (USD 10 in

this example). The more the spot price falls, the more his gain.

However, if the spot price rises to say USD 315, he will choose not to exercise the sell

option. In fact, whenever the spot price rises above the put option price, he will choose not

to exercise the option, because he will incur a loss by buying in the spot market to square up

his position.

Thus, even in the worst case, his loss is limited to the options premium. All buyers of options

(call or put) can limit their losses, since they can choose not to exercise their option when

conditions are adverse. On the other hand when conditions are favorable, there is no limit to

their gains.

In a Call/Put option, if the buyer does not exercise the option (as it is only a right and not

an obligation) he only foregoes the option premium. Thus, his loss is restricted to only the

premium, whereas his potential profits are unlimited. In the case of the seller, since he is

obligated to sell the option and cannot choose not to do so, his profit is what he gains from

the option premium, while his loss could be unlimited.

Call Buyer Call Seller

Pays premium

Has right to exercise, resulting in

long futures position

Time works against call buyer

Has no performance bond requirement

Collects premium

Has obligation if assigned, resulting

in a short position in the underlying

futures contract

Time works in favor of call seller

Has performance bond requirement

Put Buyer Put Seller

Pays premium

Has right to exercise, resulting in

short futures position

Time works against put buyer

Has no performance bond requirement

Collects premium

Has obligation if assigned, resulting

in a long position in the underlying

futures contract

Time works in favor of put seller

Has performance bond requirement

24

OPTIONS GLOSSARY

Call

Gives the holder the right to buy a futures contract at the strike price.

Delta

A measurement of the rate of change of an option premium with respect to a price change

in the underlying futures contract. Delta is always expressed as a number between -1 and +1.

Exercise

The process whereby the option buyer asserts his right and goes long the underlying

futures (in the case of exercising a call) or short the underlying futures (in the case of

exercising a put). Only option buyers can exercise options. Options sellers have the

obligation to take the opposite and possibly adverse futures position to the buyers’ and for

this risk they receive the premium.

Expiration Date

This is last day on which an option can be exercised into the underlying futures contract.

After this point the option will cease to exist, the buyer cannot exercise and the seller has

no obligation.

In-the-Money

An option is said to be ―in-the-money‖ when the underlying futures price is greater than a

call option’s strike price or less than a put option’s strike price.

Intrinsic Value

The amount the futures price is higher than a call’s strike; or the amount the futures price

is below a put’s strike:

For calls:

Futures price – Strike price = Intrinsic Value (amount must be positive or 0)

For puts:

Strike price – Futures price = Intrinsic Value (amount must be positive or 0)

Offset

A trader may offset a position if they wish to take profits before expiration or limit losses

on the downside. A buyer can offset an option by instructing their broker to sell the option

before expiration. An option seller can offset a position by buying back or ―covering‖ a short

position.

Out-of-the-money

An option is said to be ―out-of-the-money‖ when the underlying futures price is less than a

call option’s strike price or greater than a put option’s strike.

Premium

The price that the buyer of an option pays and the seller of an option receives for the

rights conveyed by an option.

Put

Gives the buyer the right to sell a futures contract at the strike price.

Strike (or Exercise) Price

The price at which the underlying futures contract will be bought (in the case of calls) or

sold (in the case of puts); the price at which the option buyer may buy or sell the underlying

25

futures contract.

Tick

Each exchange establishes the minimum increment that the price of a product can fluctuate

upward or downward. This is known as the tick, and a tick's value varies with each product.

Time Value

The part of the option price that is not intrinsic value; the amount option traders are willing

to pay over intrinsic value, given the amount of time left to expiration for the futures to

advance in the case of calls, or decline in the case of puts:

Options Premium – Intrinsic Value = Time Value

26

4. FUTURES MARKET FUNCTIONING

The functioning of futures market consists of three important steps. They are trading,

clearing and settlement.

TRADING

The various aspects in trading are:

a) Placing the order

b) Methods of trading

c) Kinds of orders

d) Kinds of margins

e) Pricing of futures

f) Closing out the positions

a) Placing the order

In futures market an order should contains specifications such as buy or sell, the number of

contracts, the month of contract, type and quality of the commodity, the exchange, the

price specification and the period of validity. Usually, orders are placed, by telephone, with

brokers representing users and producers. If an order is executed the client receives a

confirmation. The investor who agrees to buy assumes a long futures position and the

investor who agrees to sell assumes a short futures position.

b) Methods of Trading

The trading in futures exchanges is carried out through two methods. They are

i) Open outcry

ii) Electronic trading

Open Outcry:

Open outcry trading is a face-to-face and highly activated form of trading used on the

floors of the exchanges. In open outcry system the futures contracts are traded in pits. A

pit is a raised platform in octagonal shape with descending steps on the inside that permit

buyers and sellers to see each other. Normally only one type of contract is traded in each

pit like a Eurodollar pit, Live Cattle pit etc.

Each side of the octagon forms a pie slice in the pit. All the traders dealing with a certain

delivery month trade in the same slice. The brokers, who work for institutions or the

general public stand on the edges of the pit so that they can easily see other traders and

have easy access to their runners who bring orders.

The trading process consists of an auction in which all bids and offers on each of the

contracts are made known to the public and everyone can see the market’s best price. To

place an order under this method, 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

27

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 orders typically go

directly from the customer to the broker’s floor booth. The floor trader, standing in a

central location i.e. trading pit, negotiates a price by shouting out the order to other floor

traders, who bid on the order using hand signals. Once filled, the order is recorded manually

by both parties in the trade. At the end of each day, the clearing house settles trades by

ensuring that no discrepancy exists in the matched-trade information.

Electronic Trading:

Electronic trading systems have become increasingly popular in the past decade. The driving

factor for the rise in the popularity of these systems is their potential to improve

efficiency and lower the cost of transactions. In addition, electronic trading systems make

exchanges available to remote investors in real time, which is an important benefit in the

present situation of increased trading from remote locations.

Electronic trading is an automated trade execution system with three key components

1.Computer terminals, where customer orders are keyed in and trade confirmations are

received.

2. A host computer that processes trade.

3. A network that links the terminals to the host computer.

Customers may enter orders directly into the terminal or phone in the order to a broker.

With electronic order-matching systems, the host computer matches bids with offers

according to certain rules that determine an order’s priority. Priority rules on most systems

include price and time of entry. In some cases, priority rules may also include order size,

type of order and the identity of the customer who placed the order.

In the simplest case, matching occurs when a trader places a buy order at a price equal to

or higher than the price of an existing sell order for the same contract. The host computer

automatically executes the order, so that trades are matched immediately. Trades are then

cleared immediately, as long as the host computer is linked to the clearing house.

After hours Electronic trading system:

After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange).

This was introduced to meet the needs of an increasingly integrated global economy and to

have an access to the currency price protection around the clock. Electronic trading

systems are used in the open outcry exchanges after the day trading is over.

c) Kinds of orders

The orders (under an open outcry/ electronic system) can be placed in different ways,

including:

Market Order: This is the most common type of order. No specific price is mentioned.

Only the position to be taken–long/short is stated. When this kind of order is placed, it

gets executed irrespective of the current market price of that particular asset.

Market on Open: The order will be executed on the market open within the opening

range. This trade is used to enter a new trade, or exit an open trade.

28

Market on Close: The order will be executed on the market close. The fill price will

be within the closing range, which may, in some markets, be substantially different

from the settlement price. This trade is also used to enter a new trade, or exit an

open trade.

Limit Order: An order to buy or sell a stated amount of a commodity at a specified

price, or at a better price, if obtainable at the time of execution. The disadvantage is

that the order may not get filled at all if the price for that day does not reach the

specified price.

Stop-Loss Order: A stop-loss order is an order, placed with the broker, to buy or sell a

particular futures contract at the market price if and when the price reaches a

specified level. Futures traders often use stop orders in an effort to limit the amount

they might lose if the futures price moves against their position. Stop orders are not

executed until the price reaches the specified point. When the price reaches that point

the stop order becomes a market order. Most of the time, stop orders are used to exit

a trade. But, stop orders can be executed for buying/selling positions too. A ―buy‖ stop

order is initiated when one wants to buy a contract or go long and a ―sell‖ stop order

when one wants to sell or go short. The order gets filled at the suggested stop order

price or at a better price

Example: A trader wants to purchase a crude oil futures contract at Rs.750 per barrel.

He wishes to limit his loss to Rs.50 a barrel. A stop order would then be placed to sell an

offsetting contract if the price falls to Rs 700 per barrel. When the market touches

this price, stop order gets executed and the trader would exit the market.

Day Order: Day orders are good for only one day, the day the order is placed.

Example: A trader wants to go long on September 1, 2003 in Refined Palm oil in a

commodity exchange. A day order is placed at Rs.340/10 kg. If the market does not

reach this price the order does not get filled even if the market touches Rs.341 and

closes. In other words day order is for a specific price and if the order does not get

filled that day, one has to place the order again the next day.

Good Till Cancelled (GTC) Order: It is an open order to buy or sell that remains active

until the order gets filled in the market, or is cancelled by the person who placed the

order.

Example: A trader wants to go long on Refined Palm oil when the market touches

Rs.400/10kg. The order exists until it is filled up, even if it takes months for it to

happen. The order is always open until the order is cancelled or the contract expires.

Fill or Kill Order: This order is a limit order that is sent to the pit to be executed

immediately and if the order is unable to be filled immediately, it gets canceled.

All or None Order: All or None order (AON) is a limit order, which is to be executed in

its entirety, or not at all. Unlike a fill-or-kill order, an all-or-none order is not cancelled

if it is not executed as soon as it is represented in the exchange. An all-or-none order

position can be closed out with another AON order

Spread Order: A simple spread order involves two positions, one long and one short.

They are taken in the same commodity with different months (calendar spread) or in

29

closely related commodities. Prices of the two futures contract therefore tend to go up

and down together, and gains on one side of the spread are offset by losses on the

other. The spreaders goal is to profit from a change in the difference between the two

futures prices. The trader is virtually unconcerned whether the entire price structures

moves up or down, just so long as the futures contract he bought goes up more (or down

less) than the futures contract he sold.

OCO Order: It is called One cancels the Other (OCO) order. An order placed so as to

take advantage of price movement, which consists of both a Stop and a Limit price. Once

one level is reached, one half of the order will be executed (either Stop or Limit) and

the remaining order canceled (either Limit or Stop). This type of order would close the

position if the market moved to either the stop rate or the limit rate, thereby closing

the trade and at the same time, canceling the other entry order.

Example: A trader has a buy position at Rs.14,000/tonne on Soybean. He wishes to have

both stop and limit orders in order to fill the order in a particular price range. A stop

order is placed at Rs. 14,100/tonne and a limit order at Rs.13,900/tonne. If the market

trades at Rs.13,900/tonne, the limit order gets filled and the stop order is immediately

gets cancelled. The trader exits the market at Rs.13,900/tonne

d) Kinds of Margins

Margin is the deposit money that needs to be paid to buy or sell each contract. The margin

required for a futures contract is better described as performance bond or good faith

money. The margin levels are set by the exchanges based on volatility (market conditions)

and can be changed at any time. The margin requirements for most futures contracts range

from 2% to 15% of the value of the contract.

The different types of margins in futures that a trader has to maintain are:

Initial Margin: The amount that must be deposited by a customer at the time of

entering in to a contract 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 excess of the initial margin. To ensure that the balance in the margin account never

becomes negative, a maintenance margin, which is somewhat lower than the initial

margin, is set. If the balance in the margin account falls below the maintenance margin,

the trader receives a margin call and is requested to deposit extra funds to bring it to

the initial margin level within a very short period of time. The extra funds deposited are

known as a variation margin. If the trader does not provide the variation margin, the

broker closes out the position by offsetting the contract.

Additional margin: In case of sudden higher than expected volatility, the exchange calls

for an additional margin, which is a preemptive move to prevent breakdown. This is

imposed when the exchange fears that the markets have become too volatile and may

result in some payments crisis, etc.

Mark-to-Market Margin: At the end of each trading day, the margin account is adjusted

to reflect the trader’s gain or loss. This is known as marking to market the account of

30

each trader. All futures contracts are settled daily reducing the credit exposure to

one-day’s movement. Based on the settlement price, the value of all positions is marked-

to-the-market each day after the official close. I.e. the accounts are either debited or

credited based on how well the positions faired in that day’s trading session. If the

account falls below the maintenance margin level the trader needs to replenish the

account by giving additional funds. On the other hand, if the position generates a gain,

the funds can be withdrawn (those funds above the required initial margin) or can be

used to fund additional trades.

Just as a trader is required to maintain a margin account with a broker, a clearing house

member is required to maintain a margin account with the clearing house. This is known

as clearing margin. In the case of clearing house member, there is only an original margin

and no maintenance margin. Clearing house and clearing house margins has been

discussed further in detail under the section ―Clearing and Settlement‖

e) Pricing of Futures

In futures contract the price is predetermined. The seller knows how much he is going to be

paid and the buyer knows how much he is going to pay at a future date. As futures contracts

are standardized according to quantity, quality and location, it is price that is the only

factor on which buyers and sellers can bargain. The price in futures market is determined

by a mechanism called Price discovery.

Price discovery

It is the process of arriving at a figure in which one person buys and another sells a futures

contract for a specific expiration date. In an active futures market, the process of price

discovery continues from the market’s opening until its close. The prices are freely and

competitively derived. Future prices are therefore considered to be superior to the

administered prices or the prices that are determined privately. Further the low

transaction costs and frequent trading encourages wide participation in futures markets

lessening the opportunity for control by a few buyers and sellers.

In an active futures markets the free flow of information is vital. Futures exchanges act as

a focal point for the collection and dissemination of statistics on supplies, transportation,

storage, purchases, exports, imports, currency values, interest rates and other pertinent

information. Any significant change in this data is immediately reflected in the trading pits

as traders digest the new information and adjust their bids and offers accordingly. As a

result of this free flow of information, the market determines the best estimate of today

and tomorrow’s prices and it is considered to be the accurate reflection of the supply and

demand for the underlying commodity. Price discovery facilitates this free flow of

information, which is vital to the effective functioning of futures market.

Interpretation of Price charts and tables:

Example: CBOT Corn Futures Prices on Thursday, September 4, 2003.

Corn (CBT) 5,000 bushel (bu); cents per bu.

Contract

Months

Open High Low Settle Lifetime

High

Lifetime

Low

Open

Interest

31

Sept 262.75 263.50 261.50 262.00 270.50 238.00 33922

Dec 266.25 267.50 264.75 266.75 268.00 235.50 141307

Estimated Volume 38,000; volume Wed 38,592; open interest 348,967 + 987

The first line of the table: Corn (CBT) 5,000 bu; cents per bu This indicates that the

table applies to the Chicago Board of Trade (CBT) corn contract, the contract size is

5,000 bushels, and the prices shown in the table are in units of cents per bushel.

Opening Price: The open or opening price is the price or range of prices for the day’s

first trades, registered during the period designated as the opening of the market or

the opening call.

Closing price: The closing price is the price or range of prices at which the commodity

futures contracts are traded during the brief period designated as the market close or

on the closing call (i.e. last minute of the trading day).

Highest price: The word high refers to the highest price at which a commodity futures

contract is traded during the day.

Lowest price: Low refers to the lowest price at which a commodity futures contract is

traded during the day.

Settlement Price: This is abbreviated as settle in most of the pricing tables. There will

be many trades occurring in the last few minutes. Settlement price is computed from

the range of closing prices. Settlement price is important to calculate the daily gains,

losses and margin requirements. It is used by the clearing house to calculate the market

value of outstanding positions held by its members.

Change: The change refers to the change in settlement prices from the previous day’s

close to the current day’s close.

Lifetime high and low: They refer to the highest and lowest prices recorded for each

contract from the first day it traded to the present.

Open interest: It refers to the number of outstanding contracts for each maturity

month.

In the line at the bottom of the table, Est. vol. indicates the estimated volume of

trading for that day. Vol. Wed. indicates the trading volume for the previous day. Open

Int. refers to the total open interest for all contract months combined at the end of

the day’s trading session. Then the figure +987 indicates an increase of 987 contracts

from the open interest of the previous day.

Price Charts:

The price movements on any particular day can be shown in Bar charts, in the following

manner.

CLOSE

HIGH

OPEN

LOW

32

Closing price is considered as the most important price for that day’s transaction as it

indicates the trend in the market i.e. either bullish (bulls expects the prices to go up) or

bearish (bears expect the prices to go down)

Patterns of Futures Prices:

As the maturity date approaches the futures prices show different patterns. Based on

these patterns the markets can be predicted

Normal Markets: Markets where the prices increase as the time to maturity increases.

Inverted markets: Markets where the price is a decreasing function of the time to

maturity.

Convergence of futures price to spot price:

As the delivery month of a future contract approaches the futures prices converges to the

spot price of the underlying asset. When the delivery period is reached the futures price

equals or is very close to the spot price. This happens because if the futures price is above

the spot price during the delivery period it gives rise to a clear arbitrage opportunity for

traders. In case of such arbitrage the trader can short his futures contract, buy the asset

from the spot market and make the delivery. This will lead to a profit equal to the

difference between the futures price and spot price. As traders start exploiting this

arbitrage opportunity the demand for the contract will increase and futures prices will fall

leading to the convergence of the future price with the spot price. If the futures price is

below the spot price during the delivery period all parties interested in buying the asset will

take a long position. The trader would buy the contract and sell the asset in the spot market

making a profit equal to the difference between the future price and the spot price. As

more traders take a long position the demand for the particular asset would increase and

the futures price would rise nullifying the arbitrage opportunity

f) Closing out the Positions

The futures contracts are squared-off before the delivery date. Most of the traders

choose to closeout their positions prior to the delivery period specified in the contract.

Closing out means taking opposite positions of trade from the original one.

Continuing from Example 1: The Mumbai investor who bought the December soybean futures

on September 2, 2003 can close out the position by selling (i.e. going short) one December

futures contract on any date before the agreed upon delivery date. The Indore investor

who sold the Soybean futures can closeout by buying one December contract at any time

before the Delivery date. The investor’s total gain or loss is determined by the change in

the futures prices between the date of entering in to the contract and date of closing out

the contract.

33

CLEARING AND SETTLEMENT

INTRODUCTION

Most of the futures contracts do not lead to the actual physical delivery of the underlying

asset. The settlement is by closing out, physical delivery or cash settlement. All these

settlement functions are taken care of by an exchange-clearing house, called clearing

house/ corporation, in futures transactions.

Clearing House

A clearing house is a system by which exchanges guarantee the faithful compliance of all

trade commitments undertaken on the trading floor or electronically over the electronic

trading systems. The main task of the clearing house is to keep track of all the transactions

that take place during a day so that the net position of each of its members can be

calculated. It guarantees the performance of the parties to each transaction. It is

responsible for

Effecting timely settlement

Trade registration and follow up

Control of the evolution of open interest

Financial clearing of the payment flow

Physical settlement (by delivery) or financial settlement (by price difference) of

contracts

Administration of financial guarantees demanded by the participants.

Functions of clearing house

Clearing house has a number of members, who are mostly financial institutions responsible

for the clearing and settlement of commodities traded on the exchanges. The margin

accounts for the clearing house members are adjusted for gains and losses at the end of

each day (in the same way as the individual traders keep margin accounts with the broker).

In the case of clearing house members only the original margin is required (and not

maintenance margin). Everyday the account balance for each contract must be maintained at

an amount equal to the original margin times the number of contracts outstanding. Thus

depending on a day’s transactions and price movement the members either need to add

funds or can withdraw funds from their margin accounts at the end of the day. The brokers

who are not the clearing members need to maintain a margin account with the clearing house

member through whom they trade in the clearing house.

34

Checking Members

Trading Report-

Statement of

commitments

Trading Room

Price information-

Commitments information

Computer Processing

Clearing Section-Report on

Margins In-out

Output

Input

Statement of Margins

Margin Required-

Margin Deposited

Statement of Account for

Daily Settlement

Daily clearing account (Mark

to Market)

• Exchange Trading

fee

• Exchange Tax

• Liability Reserve

• Special Security

Fund

Payment Margin required

or refundable

Amount to be paid or received

Margin required is to be paid by cash or

substitutable securities. Margin Refundable is

to be returned on request

To be made through account

transfer at the contracted bank by

noon of 2 business days after the

date of the statement

Processes of a clearing house

(The narrative above describes the general functions of a clearing house. NCDEX has only trading cum clearing members and Professional Clearing members. The specific differences are highlighted in NCDEX manual on rules and regulations)

35

Proposed Systems and Regulations at NCDEX

CLEARING AND SETTLEMENT PROCESS

CLEARING HOUSE

REGULATION OF CLEARING HOUSE

NCDEX shall prescribe the process from time to time for the functioning and operations of

the Clearing House and to regulate the functioning and operations of the Clearing House for

the settlement of non-depository deals.

EXCHANGE TO MAINTAIN CLEARING HOUSE

The Exchange shall maintain a Clearing House, which shall function as per the instructions,

and supervision of the Exchange. The Clearing House shall act as the common agent of the

members for clearing contracts between members and for delivering commodities to and

receiving commodities from members in connection with any of the contracts and to do all

things necessary or proper for carrying out the foregoing purposes.

CLEARING HOUSE TO DELIVER COMMODITIES AT DISCRETION

The Clearing House is entitled at its discretion to deliver commodities, which it has received

from a member under these Regulations to another member who is entitled under these

Regulations to receive delivery of commodities of a like kind or to instruct a member to give

direct delivery of commodities which he has to deliver.

NO LIEN ON CONSTITUENT’S COMMODITIES

When a member is declared a defaulter neither the Exchange nor the creditors of the

defaulter shall be entitled to any lien on the commodities delivered by him to the Clearing

House on account of his Constituents.

CLEARING CODE AND FORMS

A member shall be allotted a Clearing Code, which must appear on all forms used by the

member connected with the operation of the Clearing House. The Clearing Forms and

Formats to be used by the members shall be as prescribed by the Clearing House.

SIGNING OF CLEARING FORMS

The member or his Clearing Assistant shall sign all Clearing Forms.

SPECIMEN SIGNATURES

A member shall file with the Clearing House specimens of his own signature and of the

signatures of his Clearing Assistants. The member and his Authorized Representative in the

presence of an officer of the Exchange or of the Clearing House shall sign the specimen

signature card.

PROVISIONS REGARDING MEMBERS OF THE CLEARING HOUSE

CLEARANCE BY MEMBERS ONLY

Clearing Members including Professional Clearing Members only shall be entitled to clear and

settle contracts through the Clearing House.

CHARGES FOR CLEARING

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The Exchange shall from time to time prescribe the scale of clearing charges for the

clearance and settlement of transactions through the Clearing House.

CLEARING HOUSE BILLS

The Clearing House shall periodically render bills for the charges, fees, fines and other

dues payable by members to the Exchange which would also include the charges for the use

of the property as well as the charges, fines and other dues payable on account of the

business cleared and settled through the Clearing House and debit the amount payable by

members to their accounts. All such bills shall be paid within a week of the date on which

they are rendered.

LIABILITY OF THE CLEARING HOUSE

The only obligation of the Clearing House shall be to facilitate the delivery and payment in

respect of commodities, transfer deed and any other documents between members.

Settlement Methods

A contract can be settled in three ways

By physical delivery of the underlying asset

Closing out by offsetting positions

Cash settlement.

Closing out

Most of the contracts are settled by closing out. In closing out, the opposite transaction is

effected to close out the original futures position. A buy contract is closed out by a sale

and a sale contract is closed out by a buy.

Cash settlement

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 underlying asset ensuring the convergence of future

prices and the spot prices.

At NCDEX

After the trading hours on the expiry date, based on the available information, the

matching for deliveries would take place firstly, on the basis of locations and then randomly

keeping in view the factors such as available capacity of the vault/warehouse, commodities

already deposited and dematerialized and offered for delivery and any other factor as may

be specified by the Exchange from time to time. Matching done by aforesaid process shall

be binding on the Clearing Members. After completion of the matching process, Clearing

Members would be informed of the deliverable / receivable positions and the unmatched

positions. Unmatched positions shall have to be settled in cash. The cash settlement would

be only for the incremental gain / loss as determined on the basis of Final Settlement Price.

Physical Delivery

When a contract comes to settlement, the exchange provides alternatives like delivery

place, month and quality specifications.

37

Trading period, Delivery date etc. are all defined as per settlement calendar

Member is bound to give Delivery information. If he fails to give information, it is

Closed out with Penalty as decided by the Exchange

Member can choose for an alternative mode of Settlement by providing Counter

party Clearing Member and Constituent. The Exchange will not be responsible for or

guarantee settlement for such deals.

Settlement Price is calculated and notified by the Exchange

The delivery place is very important for commodities 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 delivery period may be an entire month. The party

in the short position (seller) gets the chance to make choices from these alternatives. The

Exchange collects ―delivery information‖. The price paid is normally the most recent

settlement price (with a possible adjustment for the quality of the asset and the delivery

location). Then the exchange selects a party with an outstanding long position to accept

delivery.

At NCDEX

As and when the Buyers intend to take physical delivery of the commodities, held by them

in their respective Demat accounts, they would make such requests to their respective

depository participant (DP) with whom they hold the Demat account. The DP will upload

such requests to the specified Depository who will in turn forward the same to the R&T

Agent concerned. After due verification of the authenticity, the R&T Agent will forward

delivery details to the warehouse who in turn will arrange to release the commodities after

due verification of the identity of recipient.

NCDEX contracts provide a standardized description for each commodity. The description

is given in terms of quality parameters specific to the commodities. At the same time, it is

realized 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

contracts also provide tolerance limits for variances.

A delivery will be treated as good delivery and accepted if the delivery comes within the

tolerance limits. However, to allow for the difference, the concept of premium and discount

has been introduced. The goods that come to the authorized warehouse for delivery would

be tested and graded as per the prescribed parameters. The premium and discount rates

would apply depending on the level of variation. The price payable by the party taking

delivery would then be adjusted as per the premium/ discount rates fixed by the Exchange.

This ensures that some amount of leeway is given for delivery, but at the same time, the

buyer taking delivery does not 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/ quantity of commodity.

An example of a contract specification at NCDEX is provided below:

Contracts: Soyabean

Trading system NCDEX Trading System

Trading hours Monday to Friday 10:00 am to 4:00 pm

Unit of trading 10 Quintal (=1 MT)

38

Quotation/Base Value Rs per Quintal

Tick size Re 0.05

Delivery unit 100 Quintal (=10 MT)

Quantity variation +/- 2%

Quality specification

Moisture: 10% Max

Sand/Silica: 2% Max

Damaged: 2% Max

Green Seed: 7% Max

Delivery center Indore

No. of active contracts 3 concurrent month contracts

Opening of contracts

Trading in any contract month will open on the 21st

day of the month, 3 months prior to the contract

month i.e. December 2003 contract opens on 21st

September 2003

Due date 20th day of the delivery month, if 20th happens to

be a holiday then previous working day

Closing of contract All open positions will be settled as per general and

product specific regulations

Price band

Limit 10% or as specified by Exchange from time to

time. Limits will not apply if the limit is reached

during final 30 minutes of trading

Position limits

Member-wise: Max (Rs. 40 crore, 15% of open

interest)

Client-wise: Max (Rs. 20 crore, 10% of open

interest)

39

Proposed Systems and Regulations at NCDEX pertaining to Accredited

warehouse, Registrar and Transfer Agent and Assayer

ACCREDITED WAREHOUSE

The Exchange shall specify accredited warehouse(s) through which delivery of a specific

commodity shall be effected and which shall facilitate for storage of commodities.

PROCESS AND PROCEDURES FOR ACCREDITED WAREHOUSE

The Exchange shall specify from time to time the processes, procedures, and operations

that every accredited Warehouse, Constituents, Depository Participants and R & T Agents

shall be required to follow for the participation, functioning and operations of the

accredited warehouse.

FUNCTIONS OF ACCREDITED WAREHOUSE

(a) Earmark separate storage area as specified by the Exchange for the purpose of storing

commodities to be delivered against deals made on the Exchange. The Warehouse(s)

shall also meet the specifications prescribed by the Exchange for storage of

commodities.

(b) Ensure and co-ordinate for grading of the commodities received at the Warehouse

before they are being stored.

(c) Store commodities in line with their grade specifications and validity period and shall

facilitate maintenance of identity. On expiry of such validity period of the grade for

such commodities, the Warehouse(s) shall segregate such commodities and store them

in a separate area so that the same are not mixed with commodities which are within

the validity period as per the grade certificate issued by the approved Assayers

DUTIES OF ACCREDITED WAREHOUSE

(a) Shall use uniform and standard description of commodities and units of measurement in

respect of the commodities stored pertaining to the Constituent of the Exchange.

(b) Shall strictly adhere to the Warehousing norms stipulated for a commodity in particular

or group of commodities in general by the Exchange.

(c) Shall ensure that necessary steps and precautions are taken to ensure that the quantity

and the grade of the commodity are maintained during the storage period.

(d) Shall maintain the records for the commodities deposited with it by the Constituents, in

electronic form in the manner and in the system as prescribed by specified Depository.

Warehouse(s) shall avail the services of a Registrar & Transfer (R&T) agent approved

and appointed by the Exchange for the above purpose. The Warehouse shall facilitate

the uploading of instructions by the R&T agent using the system connected to the

depository for the creation of electronic records of the Commodities received by the

Warehouse in the Depository Clearing System. The Warehouse shall execute and

complete necessary documentation with the R&T agent and the Depository in this

regard.

40

(e) Unless and until expressly consented by the Exchange, the Warehouse shall not assign,

shift, transfer and relocate the commodities held by it pertaining to the Constituents

of the Exchange. The Warehouse(s), however, is/are entitled to move the commodities

within the area earmarked in the warehouse for storing the commodities pertaining to

the Constituents of the Exchange.

VERIFICATION OF COMMODITIES STORED IN WAREHOUSE

The Exchange will verify itself or through any agencies / experts, at any time, the

commodities deposited by the Constituents and/or warehouse facilities in general or for

compliance of the warehousing norms stipulated by the Exchange for the specific

commodities.

RELEASE OF COMMODITIES STORED IN WAREHOUSE

As and when the Buyers intend to take physical delivery of the commodities, held by them

in their respective Demat accounts, they would make such requests to their respective

depository participant (DP) with whom they hold the Demat account. The DP will upload

such requests to the specified Depository who will in turn forward the same to the R&T

Agent concerned. After due verification of the authenticity, the R&T Agent will forward

delivery details to the warehouse who in turn will arrange to release the commodities after

due verification of the identity of recipient.

CHARGES FOR WAREHOUSE SERVICES

Warehouse(s) shall charge from the Constituents of the Exchange, storage and other

charges as may be mutually agreed in advance between the Exchange and Warehouse(s)

from time to time. For the purpose of operational convenience, the DPs who will be opening

the Demat account for the Constituents will arrange to collect the storage charges from

them and pay the same to the Warehouse at agreed periodic intervals. The Warehouse(s) is

entitled to levy all incidental charges such as insurance; assaying, handling charges or any

such charges directly from the Constituent depositing the commodities as may be

applicable. The Exchange shall not be responsible in any manner for payment of any of the

charges of Warehouse.

The Exchange may also explore the possibility of availing the services of Collateral

Management Agent (CMA), who can offer the warehousing facilities for the Constituents of

the Exchange. In such a case the Constituents shall be required to shift their holdings in

the warehouses approved / identified by such CMA.

REGISTRAR AND TRANSFER AGENT(R&T AGENT)

APPROVED R&T AGENT

The Exchange shall specify Approved R&T Agent(s) through which commodities shall be

dematerialized and which shall facilitate for dematerialization / re-materialization of

commodities in the manner as prescribed by the Exchange from time to time.

PROCESS AND PROCEDURES FOR R&T AGENT

The Exchange shall specify from time to time the processes, procedures, and operations

that every accredited warehouse, Depository Participants and Constituents shall be

required to follow for the participation, functioning and operations of the R&T Agent. The

41

Regulations relating to the R&T Agent shall be deemed to form a part of any settlement

process so provided.

FUNCTIONS OF R&T AGENT

(a) Establish connectivity with approved warehouse(s) and support them with physical

infrastructure.

(b) Verify the information regarding the commodities accepted by the accredited

warehouse and assign the identification number (ISIN) allotted by the Depository in

line with the grade/validity period.

(c) Further process the information, and ensure the credit of commodity holding to the

Demat account of the Constituent.

(d) Ensure that the credit of commodities goes only to the Demat account of the

Constituents held with the Exchange empanelled DPs

(e) On receiving request for Re-materialization (physical delivery) through the depository,

R&T Agent(s) shall arrange for issuance of authorization to the relevant warehouse for

the delivery of commodities.

MAINTENANCE OF RECORDS AND CO-ORDINATION ACTIVITIES

R&T Agent(s) shall maintain proper records of beneficiary position of Constituents holding

dematerialized commodities in Warehouse(s) and in the Depository for a period and also as

on a particular date. R&T Agent(s) shall furnish the same to the Exchange as and when

demanded by the Exchange.

R&T Agent(s) shall also co-ordinate with DPs and Warehouse(s) for billing of charges for

services rendered on periodic intervals.

R&T Agent(s) shall also reconcile Dematerialized commodities in the Depository and Physical

commodities at the Warehouse(s) on periodic basis and co-ordinate with all parties

concerned for the same.

ASSAYER

APPROVED ASSAYER

The Exchange shall specify Approved Assayer(s) through which grading of commodities

received at approved warehouse(s) for delivery against deals made on the Exchange can be

availed by the Constituents of Clearing Members.

PROCESS AND PROCEDURES FOR ASSAYER

The Exchange shall specify from time to time the processes, procedures, and operations

that every Warehouse, Constituents and R&T Agent shall be required to follow for the

participation, functioning and operations of the Assayer. The Regulations relating to the

approved Assayer shall be deemed to form a part of any settlement process so provided.

FUNCTIONS OF ASSAYERS

(a) Inspect the Warehouse(s) identified by the Exchange on periodic basis to verify the

compliance of technical / safety parameters detailed in the Warehousing Accreditation

42

norms of the Exchange by the Warehouse(s). The compliance certificate so given by the

Assayer would form the basis of Warehouse accreditation by the Exchange.

(b) Make available grading facilities to the Constituents in respect of the specific

commodities traded on the Exchange at specified warehouse. The Assayer shall ensure

that the grading to be done, in a certificate format prescribed by the Exchange from

time to time, in respect of specific commodity shall be as per the norms specified by

the Exchange in the respective Contract specifications

(c) Grading certificate so issued by the Assayer would specify the grade as well as the

validity period up to which the commodities would retain the original grade, and the time

up to which the commodities are fit for trading subject to environment changes at the

warehouses.

DUTIES OF ASSAYER(S)

(a) The issuance of the certificate of compliance by the Assayer would imply that in the

event of deterioration of quality of the commodity before the expiry of the validity

period assigned by the Assayer, the Assayer would make good the losses that may be

incurred. However, the Exchange shall not liable for any losses arising out of such cases.

(b) Assayer(s) shall not allow to store any commodity that does not meet the grading norms

and parameters specified by the Exchange and that the Assayer(s) shall make available

to the Constituents the grading certificate when the commodities are allowed to be

stored in the warehouses.

(c) Assayer(s) shall ensure that it shall at all given times maintain properly records in

respect of grading of specific commodities and validity period of the commodity in

electronic form along with the details with regard to the certificate issued by them

from time to time.

INSPECTION OF GRADING FACILITIES

The Exchange reserves the right to physically verify / inspect itself or through any

agencies / experts, at any time, the grading facilities and processes of the approved

Assayers as and when felt necessary.

43

CLEARING AND SETTLEMENT AT NCDEX IN A NUTSHELL

NCDEX has tied-up with NSCCL for clearing the trades

Settlement guarantee fund would be maintained and managed by NCDEX.

Contracts settlement

All open contracts not intended for delivery and non-deliverable positions at client level

would be cash settled.

Settlement period

All contracts settling in cash would be settled on the following day after the contract

expiry date. All contracts materializing into deliveries would settle in a period of 2-7 days

after the expiry. The exact settlement day would be specified for each commodity.

Are deliveries compulsory?

No. The buyer and the seller have to give delivery information. Deliveries would be matched

randomly at client level. Contracts not assigned delivery would be settled in cash

Would additional margins be levied for deliverable positions?

Yes

Settlement in commodity futures market

For open positions on the expiry day of the contract, the buyer and the seller can give

intentions for delivery. Deliveries would take place in electronic form. All other positions

would be settled in cash.

Taking physical delivery

Any buyer intending to take physicals would have to put a request to its Depository

Participant, who would pass on the same to the registrar and the warehouse. On a specified

day, the buyer would go to the warehouse and pick up the physicals.

Getting the electronic balance for the physical holdings

The seller intending to make delivery would have to take the commodities to the designated

warehouse. These commodities would have to be assayed by the Exchange specified assayer.

The commodities would have to meet the contract specifications with allowed variances. If

the commodities meet the specifications, the warehouse would accept them. Warehouses

would then ensure updating the receipt in the depository system giving a credit in the

depositor's electronic account.

Seller giving an invoice to the buyer

The seller would give the invoice to its clearing member, who would courier, the same to the

buyer's clearing member.

Accrediting warehouses

NCDEX would prescribe the accreditation norms, comprising of financial and technical

parameters, which would have to be met by the warehouses. NCDEX would take

assayer's/Structural Engineer's certificate confirming the compliance of the technical

norms by the warehouses.

Whether the accredited warehouses would be dedicated warehouses?

In case of grains/seeds, warehouses would earmark a definite storage capacity within the

warehouse premises for members of NCDEX, while in case of oils, specified tankers would

be earmarked for NCDEX participants.

Warehousing charges

The warehouse concerned would decide the warehousing charges. However, the warehouse

charges would be made available on NCDEX website

Health checks and inventory verification

44

The assayers and or other experts on behalf of NCDEX would carry out surprise health

checks and inventory verification.

Sales tax

Prices quoted for the futures contracts would be basis warehouse and exclusive of sales tax

applicable at the delivery center. For contracts materializing into deliveries, sales tax would

be added to the settlement amount. The sales tax would be settled on the specified day

after the payout.

How would the buyer give a declaration for re-sale in case of last point collection of

tax?

The buyer intending to take delivery would give declaration for re-sale at the time of giving

intention for delivery. Accordingly the seller would issue the invoice, exclusive of sales tax.

The declaration form duly signed by the buyer would be forwarded through the buyer's

clearing member to the seller's clearing member within a specified time after pay-in and

payout.

Uniformity in delivered grades / varieties

The exchange will specify, in its contract description, the particular grade / variety of a

commodity that is being offered for trade. A range will be specified for all the properties

and only those grades / varieties, which fall within the range, will be accepted for delivery.

In case the properties fall within the range, but differ from the benchmark specifications,

the Exchange will specify a premium / rebate

Premium / rebates for the difference in quality

These would be pre-defined and made available on the website. The settlement obligation

would be impacted on account of the premium / rebates in case of deliverable positions. The

parameters which would be considered for premium / rebate computation as well as the

methodology would be specified by NCDEX

Certifying / assaying agencies.

NCDEX is looking at following assayers: SGS India Pvt. Limited, Geo-Chem Laboratories, Dr.

Amin Superintendents & Surveyors Pvt Ltd., Calib Brett and Stewart. Only certificates

given by specified assayers by NCDEX will be accepted. All the certificates issued will have

time validity

What happens when the commodities reach the validity date?

Those commodities will not be available for delivery on the clearing corporation. Hence the

deliverable electronic balance would be automatically reduced. Warehouse would place the

commodities in a separate area, indicating that they are not available for electronic trading.

Would commodities be accepted without assayer's certificate?

No

Can commodities be re-deposited in the warehouse after the validity period of the

assayer's certificate?

Yes, provided they are re-validated by the assayer.

Transaction charges

Rs.6/- per Rs100,000/-, i.e. 0.006% of the trade value.

Procedure for handling bad delivery / part delivery?

Partial delivery as well as bad delivery would be considered as default. Penalties would be

levied.

How would disputes be resolved?

Any disputes in regard to the quality / quantity will be referred to the Arbitration

45

committee set up for the purpose.

Clearing bankers

Following banks have agreed to act as clearing bankers:

Canara Bank

HDFC Bank

ICICI Bank

UTI Bank

Depository participants

NCDEX has approached

Bank of Baroda

Canara Bank

Global Trust Bank

HDFC Bank

ICICI Bank

IDBI Bank

Indusind Bank

UTI Bank

46

5. CHARACTERISTICS OF COMMODITY TRADING

Commodity trading gives opportunity to the traders for investment and risk management

through different strategies like hedging, speculation and arbitrage. In this section these

aspects have been discussed for a futures market. Most of those who participate in the

futures or options markets can be categorized broadly into one of two groups — hedgers

and speculators — depending on whether they are trying to transfer or accept risk. Brokers

are intermediaries who carry out buying and selling instructions from hedgers or

speculators.

Hedgers

Hedgers are market participants who want to transfer risk. They can be producers or

consumers. A producer hedger wants to transfer the risk that prices will decline by the

time a sale is made. A consumer hedger wants to transfer the risk that prices will increase

before a purchase is made.

Speculators

Speculators include investors and traders who want to profit from price changes. They

accept the price risks and rewards that hedgers wish to avoid. Speculators try to make

money by buying futures contracts at a low price and selling back at a higher price or selling

high and buying back lower. They take on the risk of an adverse price direction and its

effect on their account. Speculators provide risk capital and depth to the market place and

make it possible for hedgers to use the futures market to reduce risk (They don’t do this,

intentionally. They are in the market for profits, but the nature of the market is such that

they become de-facto risk capital providers).

Buyers and sellers of the actual commodities use the futures market as a form of risk management. They use futures to protect themselves against adverse price changes. Speculators accept the price risks and rewards that hedgers wish to avoid. Speculators include investors and traders who want to profit from price changes.

A. HEDGING

Commodity trading involves sizable price risks (due to volatile prices in the cash markets),

which may affect the value of the underlying commodity. Hedging is a strategy used in the

futures markets to protect one’s asset from adverse price changes and minimize risks.

Hedging does not necessarily improve the financial outcome, indeed it could make the

outcome worse. What it does however is, that it makes the outcome more certain. Hedgers

could be Government institutions, private corporations like financial institutions, trading

companies and even other participants in the value chain for instance farmers, extractors,

ginners, processors etc., who are influenced by the commodity prices.

Example:

A company orders a commodity at a price of USD 300 per tonne. The commodity will be

delivered after 8 weeks to the receiving port. If the price, during the period, increases to

USD 310 per tonne, the company would have made a gain. However, if the price falls to USD

280 per tonne, the company would incur a loss. The company hedges its position by taking a

put option on the same commodity at say, USD 300 per tonne for the same date. If the

47

price indeed falls to USD 280, the company exercises its option and offsets its losses (The

company buys an equivalent amount in the spot market and gains USD 20 per tonne. This

offsets the losses due to fall in price during the delivery period). If the prices, on the

other hand go up to say, USD 310 per tonne, the company will choose not to exercise the

option and will lose only the premium. The option premium is thus an insurance against losses.

A company that wants to sell an asset at a particular time in the future can hedge by taking

short futures position. This is known as futures hedge. If the price of the asset goes down,

the company does not fare well on the sale of the asset but makes a gain on the short

futures position. If the price of the asset goes up, the company gains from the sale of the

asset but takes a loss on the futures position. Similarly, a company that knows that it is due

to buy an asset in the futures can hedge by taking long futures position. This is known as

long hedge

Example:

A poultry farmer’s objective is to raise and sell broiler birds at a price that would give him

the most profit. His risk is declining broiler prices. To offset (minimize) this risk, he could

sell futures contracts. If broiler prices fall, he could then buy back the futures contracts

at a price lower than he previously sold them. The subsequent gain on this futures

transaction would help offset his cash loss, thus minimizing his risk. (In this case, if he sold

futures and prices rose, he would lose money on the futures transaction, but gain on the

spot transaction).

Whereas the broiler farmer is the futures seller in this example, the futures buyer could

be a risk taker — a speculator who thinks that broiler prices are going to rise, or a

commercial user — such as a poultry processor, who needs broiler birds and would be

adversely affected by higher prices. A speculator is willing to accept risk in hopes of

generating a profit. The commercial user is using futures to offset the risk of possible

higher bird prices.

Hedging strategies

The hedging strategies are short and long. A hedger takes a closed position where he has an

asset and liability on the same maturity date.

Selling Hedge (Short) – Selling futures contracts to protect against possible declining

prices of commodities that will be sold in the future. At the time the cash commodities are

sold, the open futures position is closed by purchasing an ―equal number and type‖ of

futures contracts as those that were initially sold.

Example. If a company knows that it is due to sell an asset at a particular time in the

future, it hedges by taking a short futures position. If the price of the asset goes down the

sale results in a loss to the company but it makes a gain on the short futures market. If the

price of the asset goes up the company gains from the sale of the asset but makes a loss on

the short futures position.

Purchasing (Long) Hedge – Buying futures contracts to protect against a possible increase in

the price of cash commodities that will be purchased in the future. At the time the physical

commodities are bought, the open futures position is closed by selling an ―equal number and

48

type‖ of futures contracts as those that were initially purchased. This is also referred to as

a buying hedge.

Hedge Ratio

The Hedge Ratio is defined as the ratio of the size of the position taken in futures contract

to the size of the exposure.

Let,

S be the change in spot price, S during the life of the hedge

F be the change in futures price, P during the life of the hedge

S be the standard deviation of S

F be the standard deviation of F

be the coefficient of correlation between S and F

h be the hedge ratio

When the hedger is long on the assets and short on futures (short hedge), the change in

value of the hedger’s position during the life of the hedge is

S - h F

For a long hedge, it is h F - S

The variance, V, of the change in the value of hedged position is given by

V = (S)2 + (h)2 (F)2 - 2 h S) (F)

The variance is minimized when

h = (S/ F)

If these two are perfectly correlated, ie., = 1, h = (S/ F)

When the futures price mirrors the spot price perfectly, S = F and h = 1.0

Example:

A company will buy 100,000 tons of soy-bean in three months. The standard deviation of the

change in price per ton over a three- month period has been calculated as 0.072. The

company hedges by buying futures contracts. The standard deviation of the change in

futures price is 0.08 over a three-month period. The coefficient of correlation between the

three month change in spot prices and futures prices is 0.9. The optimal hedge ratio will be

h = 0.9 x 0.072/ 0.08 = 0.81

If one futures contract is for 1000 tons, the company needs to buy

0.81 x 100,000/ 1000 = 81 contracts

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Advantages of hedging

Hedging stretches the marketing period.

Example: A livestock feeder does not have to wait until his cattle are ready to market

before he can sell them. The futures market permits him to sell futures contracts to

establish the approximate sale price at any time between the time he buys his calves for

feeding and the time the fed cattle are ready to market, some four to six months later.

He can take advantage of good prices even though the cattle are not ready for market.

Hedging protects inventory values.

Example.: A merchandiser with a large, unsold inventory can sell futures contracts that

will protect the value of the inventory, even if the price of the commodity drops.

Hedging permits forward pricing of products.

Example.: A jewelry manufacturer can determine the cost for gold, silver or platinum by

buying a futures contract, translate that to a price for the finished products, and make

forward sales to stores at firm prices. Having made the forward sales, the

manufacturer can use its capital to acquire only as much gold, silver, or platinum as may

be needed to make the products that will fill its orders.

Limitations of hedging

Hedging-using futures does not work perfectly in practice. The limitations are

Hedging can only minimize the risk but cannot fully eliminate it. For Example. The

loss made during selling of an asset is not equal to the profits made by going short.

This is because the underlying value of the asset and the future contract vary

The hedge may require the futures contract to be closed out well before its

expiration date

Hedge ratio, h

h*

Variance of

position

Dependence of variance of hedger’s position on hedge ratio

50

Limitation also exists that the underlying hedged product and the contract

specification might not be exactly the same grade

51

Roll Over

Hedges can be rolled forward. When the expiration date of the hedge is later than the

delivery dates of the future contracts, the hedger closes out the futures contracts

entered into and takes the same position in futures contracts with a later delivery date.

Hedges can be rolled forward many times. However, multiple rollovers could lead to short-

term cash flow problems.

Basis Risk

The limitations of hedging give rise to basis risk. The basis in a hedging situation is defined

as the difference between the current cash price and the futures price of the same

commodity. Unless otherwise specified, the price of the nearby futures contract month is

used to calculate the basis.

Basis = Spot price of asset to be hedged less futures price of contract

When the spot price increases by more than the futures price, the basis increases which is

referred to as strengthening of the basis. When the futures price increases by more than

the spot price the basis declines. This is referred as weakening of the basis.

Example of Hedging

A farmer intends to plant 10 acres of Soybean in June and is willing to forward sell 50 per

cent of his anticipated production before planting (expected yield is 400 kgs/acre and

estimated total production is 4 tons). Only a portion of the expected crop is hedged due to

production uncertainty. Delivery is expected in mid-September. The farmer estimates basis

to be Rs. 25/tonne under the November contract price in mid-September. The farmer

places an order to sell 2 November futures contracts (2 tonnes) on June 15. This is

referred to as a forward pricing hedge.

The farmer delivers and sells the harvested soybean crop on September 15. Also on

September 15, the farmer buys back the 2 November soybean futures contracts at the

current price of Rs.14,250/tonne, offsetting his/her position in the futures market.

Date Market Price November Futures Basis

June 15 implied Rs.14,000/t Rs. 14,025/t anticipated Rs.25/tonne

Forward Price Hedge: Soybean seed

Date Action Cash Position Futures Position Basis

June 15 Plant Soybean

Sell 50% of

expected

Production on

Nov. futures

Expect 4 tons

production.

Hedge 2 tons at

expected

price of Rs. 14,000/t

(Rs.14,025-basis

Rs.25/t)

Sell 2 November

Futures contract @

Rs. 14,025/t

anticipated

Rs.25/t

September Sell cash

Soybean seed

Sell 2 tons Buy 2 November

soybean

Rs. 25/t

52

15 Offset

futures

position

@Rs.13,700/t @ Rs.13,725/t

Gains/losses Loss: Rs.300/t

(relative to

expectation)

Gain: Rs.300/t no change

Final Outcome:

The net price received on the 4 tonnes of Soybean hedged is Rs.14,000/t. (Rs.13,700/ton

from the cash sale plus a Rs. 300/ton gain on the futures position).

If all 4 tonnes of production are sold on September 15, the average price for the total crop

is Rs.13,850/t. (average of Rs.14,000/t for the hedged portion and Rs.13,700/t for the un-

hedged portion).

B. SPECULATION

The price of any commodity in the market is a function of the demand and supply. If

supplies fall short prices tend to increase and vice versa. Often the estimation of demand

and supply is the major challenge faced by the market. The traders who speculate are called

Speculators. Speculation is the process of buying or selling something now based on

anticipations of future price changes. Speculators buy (or sell) futures at a time when its

price is low (or high) and sell later (or buy) when the price is higher (or lower). Speculators

are risk takers and they add liquidity and capital to the futures markets. If the price

changes are temporary, speculation reduces fluctuations, reduces risk and enhances

efficiency. The main objective of speculators is to make profit in the trade and not to

minimize risk unlike Hedgers

Positions

Speculators take open positions- i.e. they will have either an asset or liability.

Long position: Buy futures, expecting higher futures price at later date

Short Position: Sell futures, expecting lower futures price at later date.

C. ARBITRAGE

Arbitrage is the process of buying something at a place where its price is low and selling it

where its price is high. Arbitragers try to profit from differencein prices of identical goods

in different locations.

Example: The shares of a particular stock are trading at Rs.410 and Rs 420 in Ahmedabad

and Mumbai stock exchanges simultaneously. An arbitrager will purchase the scrip in

Ahmedabad and sell it in Mumbai to generate a riskless profit of Rs 10 per share.

In arbitrage as both the trades are done simultaneously there is no investment. But in an

efficient market, arbitrage opportunities would not exist. Even though they exist they

cannot last long as arbitrage itself reduces the price differentials. As arbitrageurs start

buying goods from the low price locations it raises the prices of goods and as they sell the

53

scrip in a high price location it lowers the price of goods thereby nullifying any arbitrage

opportunities.

In reality, if such arbitrage opportunities do exist (at first glance), the prospective

arbitrageur would do well to check the hidden transaction costs. In most cases he would

find that such hidden costs nullify the apparent arbitrage opportunity.

Cost-of-carry

This is the cost to carry a storable good forward in time. The carrying charges are of four

basic kinds

Cost of warehousing

Cost of insurance

Transportation costs (moving the goods from origin to the appropriate destination

for delivery).

Financing cost

Cash and carry arbitrage

A trader can buy goods for cash and carry it through to the expiration of the futures

contract. Let us see an example to understand this:

Example

Spot price of gold per 10 gms – Rs 5,100/-

Future price of gold per 10 gms (for delivery in one year) – Rs 5,500/-

Interest rate per annum – 6.5%

The trader borrows Rs 5,100 for 1 year at 6.5%. He buys 10 gms of gold in the spot market

for Rs 5,100 and sells a futures contract for delivery one year hence.

At the end of 1 year, he delivers 10 gms of gold against the futures and realizes Rs 5,500/-.

He also repays the loan of Rs 5,100/- and the interest amount of Rs 331/- (total Rs 5431/-).

Thus, he gets a total profit of Rs 69/-

In the above example, we have assumed that there is only financing charge applicable. When

attempting arbitrage at significant volumes of goods, the trader would have to worry about

storage costs and insurance. The arbitrage opportunity may still exist. However, as

discussed earlier, the market would react to changes in interest rates, insurance premiums

and storage costs and the gaps would close very quickly.

Reverse cash and carry arbitrage

This happens when the spot price is too high. In the above example, let us suppose that the

spot price was Rs 5,200/- instead of Rs 5,100/-.

The trader would now sell 10 gms of gold short, lend Rs 5,200/- for 1 year and buy one gold

future for delivery of 10 gms one year hence.

54

At the end of 1 year, he collects the proceeds from the loan (Rs 5,200/- + interest Rs

338/-), accepts delivery on the futures contract of 10 gms gold (pays out Rs 5,500/-) and

uses the gold from futures delivery to repay the short sale. He thus profits by Rs 38/-

In the end the market ensures that the future price equals the spot price and the cost of

carry to close out the arbitrage opportunities.

6. NCDEX AND ITS FUNCTIONING

National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company

registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in

Mumbai on April 23,2003.

A. OBJECTIVES OF NCDEX

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

To bring professionalism and transparency in to the commodity trading.

To inculcate international best practices like demutualisation, technology platforms, low

cost solutions and information dissemination without noise etc. into our trade.

To provide nation wide reach and consistent offering.

To bring together the names that market can trust.

B. PROMOTERS

NCDEX is promoted by a consortium of Institutions. They are

ICICI Limited

Life Insurance Corporation of India (LIC)

National Bank for agriculture and Rural Development (NABARD)

National Stock Exchange of India Ltd. (NSE)

The consortium brings to the table:

Institution building expertise

Commitment to the Agricultural sector

Nationwide reach

Ability to bring in capital

Technology and risk management skills.

C. GOVERNANCE

Board of Directors

55

NCDEX is run by an independent Board of Directors. Promoters do not participate in the

day to day activities of the Exchange.

The directors are appointed in accordance with the provisions of the Articles ofAssociation

of the company.

The board is responsible for managing and regulating all the operations of the exchange and

commodities transactions.

It formulates the rules and regulations related to the operations of the exchange.

Board appoints Executive committee and other committees for the purpose of managing

activities of the exchange.

Executive Committee

The executive committee consists of Managing Director of the exchange who would be

acting as the Chief Executive of the Exchange, and also other members appointed by the

board.

Other Committees

Apart from the executive committee the board has constitute committee like Membership

committee, Audit Committee, Risk Committee, Nomination Committee, Compensation

Committee and Business Strategy Committee which help the Board in policy formulation.

D. MEMBERSHIP

Membership of NCDEX as trading cum clearing members (TCM) is open to any person,

association of persons, partnerships, co-operative societies, companies etc. that fulfills the

eligibility criteria set by the exchange. All the members of the Exchange have to register

themselves, with the competent authority before commencing their operations.

The members of NCDEX falls in to 2 categories:

TCMs

Trading Cum Clearing Members

PCMs

Professional Clearing Members

Members who carry out the

transactions (Trading, Settling and

Clearing) on their own account and also

on their clients account.

Members who carry out the settlement

and clearing for their clients who have

traded through a TCM

Membership criterion for TCMs

Net worth-Rs.50 lakh

Interest free deposit-Rs.15 lakh

Minimum collateral-Rs.15 lakh

Annual Charges-Rs.50,000

Membership criterion for PCMs

Net worth-Rs.50 crore

Interest free deposit-Rs.25 lakh

Minimum collateral-Rs25 lakh

Annual Charges-Rs.1,00,000

E. COMMODITIES THAT ARE TRADED ON NCDEX

NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market

Commission) but in a phased manner.

Commodities traded in 1st phase

56

NCDEX has approval from FMC to trade in the following commodities in the first phase

Bullion- Gold, Silver

Agri commodities-Cotton (long and medium staple), Soybean, Soyaoil,

Rape/Mustardseed, Rape/Mustard oil, Crude Palm Oil and RBD Palmolein.

Commodities planned to be offered for trading in 2nd phase

Rice, wheat, Coffee, Tea.

Edible oil products like Groundnut, Sunflower, Castor (Seed, Oil and cake)

Base metals (Aluminium, Copper, Zinc and Nickel)

Commodity indices-Agri commodity index, Metal commodity index.

F. INSTITUTIONAL TIE-UP FOR THE FUNCTIONING

NCDEX has tied up with institutions of repute in their field for carrying out the functions

related to the exchange efficiency.

Assayers for certification of the

commodities

Discussions with

SGS India

Geo Chem

Dr.Amin Laboratories

Stewart Assayers

Depository Participants

Discussions with

Bank of Baroda

Canara Bank

Global Trust Bank

HDFC Bank

ICICI Bank

IDBI Bank

Indusind Bank

UTI Bank

Clearing corporation

NSCCL (National securities and Clearing

Corporation Limited)

Clearing Banks

Canara Bank

ICICI bank

UTI bank

HDFC bank

Warehouses

Commodity Location Warehouses currently identified

Crude Palm Oil Kandla CRPL(Chemicals and Resins Pt. Ltd)

RBD Palmolein Kakinada IMC Ltd.

Refined Soy Bean Oil Mumbai IMC Ltd.

Expeller Rapeseed Mustard

Oil Jaipur Sree Ram Fats

Rapeseed-Mustard Jaipur CWC (Central Warehousing

Corporation)

Soy Bean Indore MPSWC(MP State Warehousing

Corporation)

57

Cotton: Long staple Ahmedabad CWC

Cotton: Medium Staple Bathinda

PAICO(Punjab Agricultural and

Industrial Corporation)

Note: this is an initial list and is subject to change in future depending on business

requirements.

58

7. REGULATORY PROVISIONS

THE FORWARD CONTRACTS (REGULATION) ACT:

The Forward Contracts (Regulation) Act, 1952, a Central Act, governs commodity

derivatives trading in India. The Act defines various forms of contract. The Act envisages a

three-tier regulation.

Exchange: The exchange which organizes forward trading in regulated commodities can

prepare its own Articles of Association, Rules and Regulations, byelaws and regulate

trading on a day-to-day basis.

FMC (Forward Markets Commission): The commission approves the rules and byelaws

of the exchange and provides a regulatory oversight. It also acquires concurrent powers

of regulation while approving the rules and byelaws or by making such rules and byelaws

under the delegated powers.

Central Government: Ministry of Consumer affairs and Public Distribution under the

Govt. of India is the ultimate regulatory authority. Only those associations, which are

granted recognition by the Government, are allowed to organize forward trading in

regulated commodities. Government has the power to suspend trading, call for

information nominate directors on the Boards of the Exchanges; supersede Board of

Directors of the Exchange etc. Central Govt. has delegated most of these powers to

FMC.

FORWARD MARKETS COMMISSION (FMC)

The Forward Markets Commission (FMC) regulates commodity futures trading in India. It is

a statutory body set up under the Ministry of Consumer Affairs and Public Distribution in

1953 under the Forward Contracts (Regulation) Act, 1952.

FUNCTIONS OF FMC

As per the Forward Contracts (Regulation) Act 1952, the functions of the FMC are

(a) To advise the Central Government in respect of the recognition of or the withdrawal of

recognition from any association or in respect of any other matter arising out of the

administration of this Act

(b) To keep forward markets under observation and to take such action in relation to them

as it may consider necessary, in exercise of the powers assigned to it by or under this Act

(c) To collect and whenever the Commission thinks it necessary publish information

regarding the trading conditions in respect of goods to which any of the provisions of this

Act is made applicable, including information regarding supply, demand and prices, and to

submit to the Central Government periodical reports on the operation of this Act and on the

working of forward markets relating to such goods

(d) To make recommendations generally with a view to improving the organization and

working of forward markets

59

(e) To undertake the inspection of the accounts and other documents of [any recognized

association or registered association or any member of such association] whenever it

considers it necessary, and

(f) To perform such other duties and exercise such other powers as may be assigned to the

Commission by or under this Act, or as may be prescribed.

POWERS OF THE COMMISSION

As per the Forward Contracts (Regulation) Act 1952, the powers of the FMC are:

(1) The Commission shall, in the performance of its functions, have all the powers of a civil

court under the Code of Civil Procedure, 1908 (5 of 1908), while trying a suit in respect of

the following matters, namely:

(a) Summoning and enforcing the attendance of any person and examining him on

oath;

(b) Requiring the discovery and production of any document;

(c) Receiving evidence on affidavits;

(d) Requisitioning any public record or copy thereof from any office;

(e) Any other matters which may be prescribed.

(2) The Commission shall have the power to require any person, subject to any privilege

which may be claimed by that person under any law for the time being in force, to furnish

information on such points or matters as in the opinion of the Commission may be useful for,

or relevant to any matter under the consideration of the Commission and any person so

required shall be deemed to be legally bound to furnish such information within the meaning

of Sec. 176 of the Indian Penal code, 1860 (45 of 1860).

(3) The Commission shall be deemed to be a civil court and when any offence described in

Sections. 175, 178, 179, 180 or Sec. 228 of the Indian Penal Code, 1860 (45 of 1860), is

committed in the view or presence of the Commission, the Commission may, after recording

the facts constituting the offence and the statement of the accused as provided for in the

Code of Criminal Procedure, 1898 (5 of 1898) forward the case to a Magistrate having

jurisdiction to try the same and the Magistrate to whom any such case is forwarded shall

proceed to hear the complaint against the accused as if the case had been forwarded to him

under Section 482 of the said Code.

(4) Any proceeding before the Commission shall be deemed to be a judicial proceeding

within the meaning of Sections. 193 and 228 of the Indian Penal Code, 1860 (45 of 1860).

REGULATORY MEASURES OF FMC

To inculcate the best practices and to promote financial integrity, market integrity and

transparency into our trade FMC has imposed some regulations on the commodity exchanges

like

Daily mark to market margining

Time stamping of trades

Novation of contracts and creation of trade/ settlement guarantee fund

60

Back-office computerization for the existing single commodity Exchange and online

trading for the new Exchanges

Demutualisation for the new Exchanges

SECURITIES CONTRACTS (REGULATION) ACT

The Securities Contracts (Regulation) Act 1956 governs and regulates transactions in

securities. The functions of The Securities and Exchange Board of India (SEBI) are

regulating the business in the stock exchanges and any other securities market; performing

such functions and exercising such powers under the provisions of Securities Contracts

(Regulation) Act 1956, as may be delegated to it by the Central Government, levying fees or

other charges; conducting research for the above purposes; and performing such other

functions as may be prescribed.

The role of FMC in the commodities markets is similar to the role of SEBI in the stock

markets. The major area of difference is that while the SEBI is required to conduct

research into the different areas relating to the stock exchanges and the securities

market, the FMC is required to collect and publish information regarding supply, demand and

prices of commodities.

The finance ministry has recently amended two main clauses of the Securities Contracts

(Regulation) Rules, 1957 of the Securities Contracts (Regulation) Act 1956, which would

substantially widen participation in commodity futures market. Through a notification issued

in August 2003, the ministry has amended rule 8 (1)(f) of the SC(R) Rules, 1957 that

permits stock brokers to trade in commodity derivatives also. However, stock brokers will

be permitted to trade in commodity derivatives only through a separate subsidiary that

meets all the requisite norms set out by the Forward Markets Commission (FMC), the

commodity futures market regulator.

Further, to allow banks and other entities, the notification indicates that rule 8 (4) also has

been amended to permit banks under the second schedule of the Reserve Bank of India Act,

1934, and other entities, like the Export Import (EXIM) Bank of India, National Bank for

Agriculture and Rural Development (Nabard) and the National Housing Bank (NHB), to trade

in commodity futures.

Their respective statutes prevent these entities from trading in commodity futures.

AGRICULTURAL MARKETS

At present, though agricultural production is largely free from controls, the same is not

true of agricultural markets.

Essential Commodities Act, 1955 (ECA): The Essential Commodities Act provides for the

control of the production, supply and distribution of, and trade and commerce in certain

commodities if it is felt necessary or expedient by the Central Government so to do for

maintaining or increasing supplies of any essential commodity or for securing their equitable

distribution and availability at fair prices. In a liberalized economy, repeal of ECA would

facilitate free, unrestricted movement and storage of agricultural commodities (food

grains, edible oils, cotton or sugar) across the country.

Agricultural Produce Marketing Act (APMC):

Under this Act, State Governments alone are empowered to initiate the process of setting

up of markets for agri-products within a defined area. Currently, the Act places

61

restrictions on farmer from entering into direct marketing/contract with any

processor/manufacturer/bulk purchaser as the produce was required to be canalised

through regulated market. However, State Governments except Maharashtra and Madhya

Pradesh have formulated their own Acts in their legislatures to allow contract farming. The

Govt. of Karnataka has taken the initiative in playing the role of facilitator by providing for

the establishment of an ―Integrated Produce Market‖ to be owned and managed by NDDB

for marketing of fruits, vegetables and flowers in the state.

NCDEX RULES AND REGULATIONS (PROPOSED)

These proposed regulations pertain to trading and other activities on the exchange. NCDEX

has prepared a complete manual covering all aspects of the exchange functioning. It deals

with rules and regulations on the following topics –

Jurisdiction

Definitions

Approved commodity

Approved office

Approved user

Approved workstation

Authorised person

Books of accounts, records and documents

Branch office

Buyer

Clearing bank

Clearing corporation/ house

Clearing member

Closing buy transaction

Closing sell position

Clearing delivery

Constituent

Common pool facility

Contract month

Daily settlement price

Derivatives contract

Delivering member

Deliverable quantity

Expiration day

Final settlement price

Futures contract

Last trading day

Long position

Market type

Member

Member-constituent agreement

Member’s open position

Notification, notice or communication

62

Outstanding obligation

Professional clearing member

Receiving member

relevant authority

Rules and bye laws

Seller

Settlement calendar

Settlement date

Short position

Trading cycle

Trading member

Trading system

Trade type

User

Underlying commodities

Dealings on the exchange

Trading system

Trading members and users

Trading days

Trading hours

Trading cycle

Contract expiration

Trading parameters

Market types / trade types / settlement periods / transaction types

Failure of trading members' terminal

Dealings in derivatives contracts

Dealings in derivatives contracts

Trade operations

Margin requirements

Order management

Order type, Order attributes, Modification and cancellation of

orders, Order validation, Matching rules

Contract note

Brokerage

Margin from the constituents

Conduct of business by trading members

Office related procedure

Supervision

Procedures to be followed, Internal inspections, Written approval,

Qualifications investigated

63

Relation with the constituents

Guidelines governing relationship between trading member and constituent

General principles

Trading principles

General guidelines

Unfair trading practices

Records, annual accounts & audit

Records

Annual accounts and audit

Inspection

Inspection authority

Notice

Obligations of a trading member on inspection

Submission of report

Collection and dissemination of information

Types of deals

Deals, transactions, dealings and contracts

Extension or postponement of contracts by the exchange

Measures to meet emergencies

Procedure for settlement of deals

Eligibility of deals for settlement

Last day of trading

Delivery

Through clearing house, Outside clearing house, Early pay-in,

Additional credit/debits

Procedure for payment of sales tax/vat

Registration with sales tax authorities, Payment of sales tax/vat,

Information submission relating to sales tax/vat to the exchange,

Raising of invoice and determination of sale value, Disputes relating

to incorrect sales tax/vat information / documents for commodities

delivered / received, Failure to submit sales tax information,

Maintenance of records

Penalties for defaults

Process of dematerialization

Validity date

Process of re-materialization

Delivery through the depository clearing system

Payment through the clearing bank

Privity of contract

Contracts subject to change in settlement procedure

Clearing days and scheduled times

Alteration of clearing and clearing days and times

Clearing and settlement process

Settlement obligations statements for trading clearing members

Settlement obligations statements for professional clearing members

64

Delivery and receipt statements

Clearing members

Delivery of commodities

Depository deals

Mode of funds payment

Receipt of commodities

Depository deals

Mode of receipt of funds

Death of a clearing member

Delivery units

Prescribed delivery units

Deliverable grades

Assayers certificate

Delivery in part

Delivery subject to special agreement between buyer and seller constituents

Delivery when complete

Delivery when not complete

Closing out

Delivering member debited

Penalty for bad delivery

Depository delivery

Delivery units

Transfer duties and charges

Delivery in part

Closing out on refusal to accept delivery

Non-delivery and non-payment

Notice of non-delivery and non-payment

Non-delivery and non-payment by clearing member / banks / institutions

Failure to deliver

Closing-out on failure to deliver

Closing-out on failure to pay

Disabling of a member

Declaration of default

Deliveries due to the defaulter

Penalty for failure to give or take delivery

Withholding of commodities and funds

Withheld commodities and funds - how dealt with

Closing-out of contracts

Closing-out when effected

Closing-out in specific cases

Closing out for deals settled through the clearing house

Closing-out without notice

Closing-out contracts with deceased member

Compliance before closing-out

Closing-out how effected

65

Closing-out clearing member’s responsibility

Deferment by the relevant authority

Suspension or postponement of closing-out

Closing-out against defaulter

Charges for closing-out

Loss arising from closing-out

Profit arising from closing -out

Default if closing -out loss and damage not paid

Clearing bank

Exchange to regulate

Functions of clearing bank

Members to have account with the clearing bank

Clearing bank to act as per the instructions of the exchange

Clearing bank to inform exchange of default in funds settlement

Members to authorize the clearing bank to act as per the instructions

received from the exchange

Clearing account(s) of exchange in the clearing bank

Depository clearing system

Exchange to regulate

Clearance by members only

Functions of depository clearing system

Depository, Depository participants, Ring and other accounts,

Specified depository

Clearing members to have account with a depository participant

Specified depository to act as per the instructions of the exchange

Members to authorize depository participants

Clearing account(s) of exchange with the specified depository

Notices and directions

Clearing number id

Exchange to deliver commodities at discretion

Charges for clearing

Exchange bills

Liability of the exchange

Clearing house

Regulation of clearing house

Exchange to maintain clearinghouse

Clearing house to deliver commodities at discretion

No lien on constituent’s commodities

Clearing code and forms

Signing of clearing forms

Specimen signatures

66

Provisions regarding members of the clearing house

Clearance by members only

Trading members responsibility

Notices and directions

Charges for clearing

Clearing house bills

Liability of the clearing house

Liability of the exchange

Clearing and other forms

Clearing forms, special returns and other forms

Clearing number and clearing forms

Signing of clearing forms

False or misleading statements

Accredited warehouse

Process and procedures for accredited warehouse

Functions of accredited warehouse

Warehouse(s) to offer services

Duties of accredited warehouse

Verification of commodities stored in warehouse

Release of commodities stored in warehouse

Charges for warehouse services

Registrar and transfer agent( R & T agent)

Approved r&t agent

Process and procedures for r&t agent

Functions of r&t agent

Services by r&t agent

Maintenance of records and co-ordination activities

Assayer

Approved assayer

Process and procedures for assayer

Functions of assayers

Services by assayer

Duties of assayer(s)

Inspection of grading facilities

Arbitration

Definitions

Seat of arbitration

Jurisdiction of courts

Reference of the claim, difference or dispute

Criteria and procedure for selection of persons eligible to act as arbitrators

67

Procedure for appointment of arbitrators

Vacancy in the office of the arbitrator

Deposit towards cost of arbitration

Procedure for arbitration

Requirement for hearings

Notice of hearing

Adjournment of hearing

Arbitral award on agreed terms

Making of arbitral award

Interest

Arbitration fees and charges, costs, etc.

Administrative assitance, which may be provided by the exchange

Mode of communication

Conflict between rules, bye laws and regulation

Modifications

Forward contract regulation act

Savings

68

8. SAMPLE PROBLEMS AND ANSWERS (Solutions are given at the end of this chapter)

A. Multiple Choices

1) An agreement where the seller agrees to deliver an asset and a buyer agrees to pay for

that asset immediately is called

a) Futures contracts

b) Forwards contract

c) Spot contract

d) Options

2) Derivative markets emerged out of traditional markets to address the need for

a) Effective transactions

b) Effective risk management

c) Immediate delivery of the assets

d) None of the above

3) Forward contracts are generally traded

a) Over the counter

b) In the exchange

c) Both a and b

d) None of the above

4) Futures contracts differ from forwards in being

a) Exchange traded

b) OTC traded

c) In both exchange traded and OTC traded

d) None of the above

5) A Futures contract can be settled by

i) By physical delivery of the underlying asset

ii) Closing out by offsetting positions

iii) Cash Settlement

a) All of the above

b) Only i and ii

c) Only i and iii

d) Only ii and iii

6) Credit risk for the counter-party is higher in which of the following contracts

a) Futures contracts

b) Forwards contracts

c) Options

d) All of the above

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7) In which of the following the prices are not transparent, as there is no requirement for

reporting?

a) Forward contracts

b) Futures contracts

c) Both a and b

d) None of the above

8) The theoretical price of a Forward/Futures contract is determined by taking into

account

a) Spot price

b) Cost of carry

c) Both a and b

d) None of the above

9) Forward contracts provide the opportunity to speculate.

a) True

b) False

10) A long position is taken when the spot prices are expected to

a) Increase

b) Decrease

c) Stay neutral

d) None of the above

11) When a party sells a contract, it is assumed to take a

a) Long position

b) Short position

c) Out position

d) None of the above

12) If a trader is long in the market and spot prices go up it means

a) The trader will make money

b) The trader will lose money

c) Neither gains nor loses.

d) None of the above

13) The payoff from a long position in a forward contract for one unit of an asset is

a) Delivery price less Spot price

b) Spot price less Delivery price

c) Spot price plus delivery price

d) None of the above

14) A buyer is short in a futures/forward contract. At the time of the maturity of the

contract if the delivery price is less than the spot price the buyer makes a

a) Loss

b) Profit

70

c) No profit, No loss

d) None of the above

15) A trader wants to sell an asset. He anticipates the asset price at the time of the sale to

fall. What is the position he should take in the futures market?

a) Go Short

b) Go Long

c) Enter into a forward contracts

d) None of the above

16) Which of the following contracts have a nonlinear payoff profile?

a) Forward contracts

b) Futures contracts

c) Options

d) All of the above

17) In a falling market one can

a) Profit by going short on the futures

b) Profit by going long on the futures

c) Both a and b

d) None of the above.

18) Can a forward contract be settled by closing out?

a) Yes

b) No

c) Depends on the contract

d) None of the above

19) In forward contracts profit or loss is realized

a) On the day of entering in to the contract

b) On the maturity date

c) Everyday by marking to market

d) All of the above

20) In futures contract the credit risk at any point of time is limited to the price movement

of

a) One day

b) Total contract period

c) On the maturity date

d) None of the above

21) The markets where the price decreases as the time to maturity increases are called as

a) Futures markets

b) Forward markets

c) Inverted markets

d) Normal markets

71

22) Options gives buyer of the option, the ………………………………….to buy or sell and the seller

of the option, the ………………………………… to sell or buy a specified quantity of a commodity

at a specific price within a specified period of time

a) Right; Obligation

b) Obligation; Right

c) Both Right and Obligation

d) None of the above

23) What is Call Option?

a) The buyer is granted the right to buy (go long) the underlying asset

b) The buyer is granted the right to sell (go short) the underlying asset

c) Both a and b

d) None of the above

24) What is Put Option?

a) The buyer is granted the right to buy (go long) the underlying asset

b) The buyer is granted the right to sell (go short) the underlying asset

c) Both a and b

d) None of the above

25) When a commitment is made by a trader to purchase an asset, which is the suitable

option he has to purchase to hedge his position/ commitment?

a) Call option

b) Put Option

c) Both a and b

d) None of the above

26) When a commitment is made by a trader to sell an asset, what is the suitable option he

has to purchase to hedge his position/ commitment?

a) Call option

b) Put Option

c) Both a and b

d) None of the above

27) Options provide unlimited profit potential to the buyer with risk limited to the premium

paid to the seller

a) True

b) False

c) Depends on the contract

d) None of the above

28) Which one of the following strategies will allow the trader to profit from an asset, if

the market price for the asset increases?

a) Buying a call option

b) Buying a put option

72

c) Selling a futures contract

d) None of the above

29) The type of option in which the buyer can exercise the right (buy/sell) at any time

during the life of the option contract is called as

a) Call option

b) Put Option

c) American option

d) European Option

30) The contracts are traded in pits in

a) Open out cry system

b) Electronic trading

c) Both a and b

d) None of the above

31) The margin of a contract is like a ―good faith money ―

a) Yes

b) No

32) Marking to the market is

a) An order to buy or sell a futures contract of a given delivery month to be filled at the

best possible price.

b) To debit or credit the margin account of the buyer and seller at the end of the days

trade.

c) A range of prices at which buy and sell transactions take place before the markets

close.

d) The procedure for settling disputes between members or between members and

customers.

33) The period of rising market prices are called

a) Bull markets

b) Bear markets

c) Normal markets

d) Inverted markets

34) The period of falling market prices are called

a) Bull markets

b) Bear markets

c) Normal markets

d) Inverted markets

35) Which price indicates the trend of the market (either bullish or bearish)

a) Opening Price

b) Closing Price

c) High Price

73

d) Low Price

36) In this type of order no specific price is mentioned. Only the position to be taken–

long/short is stated and the order gets executed at the current price on the floor of

exchange

a) Limit order

b) Stop order

c) Market order

d) All of the above

37) In a day order if the order does not get filled on that particular day, one has to place

the order again the next day for execution.

a) True

b) False

38) Hedging involves

a) Taking a futures position opposite to one's cash market position

b) Taking a futures position identical to one's cash market position

c) Taking a futures market position

d) Willingly taking a risk

39) The number of futures contracts required to buy or sell to provide the maximum offset

of risk is calculated using

a) Basis Risk

b) Hedge ratio

c) Swap ratio

d) None of the above

40) Incorrect matching of the offsetting investments in hedging gives rise to

a) Basis Risk

b) Price risk

c) Market risk

d) None of the above

41) Hedgers

a) Protect their existing exposures

b) Willingly take risks

c) Profit from price differentials

d) All of the above

42) The process of selecting investments with higher risk in order to profit from an

anticipated price movement is called

a) Hedging

b) Speculation

c) Arbitrage

74

d) None of the above

43) The person who is willing to take risk and is expectation driven to make profits is known

as a

a) Hedger

b) Speculator

c) Arbitrageur

d) None of the above

44) The role of speculators in the market is to provide

a) Actual buyers and sellers of the commodity

b) Liquidity to the markets

c) Cash to the customers

d) None of the above

45) When would a speculator like to take the delivery of the commodity?

a) At the expiration date of the contract

b) 10 days before the expiry date

c) Never takes the delivery

d) At any point of time before the expiration date

46) A trader by identifying the market opportunities is buying the assets when their prices

are perceived to be low and storing them to sell later in anticipation of a better future

price. He is a

a) Hedger

b) Speculator

c) Arbitrageur

d) None of the above

47) The process of buying something at a place where its price is low and selling it where its

price is high is called

a) Hedging

b) Speculation

c) Arbitrage

d) Marking to the market

48) Arbitrageurs try to profit

a) By willingly taking risks

b) From price differentials

c) By protecting their existing exposures

d) By entering in to future contracts

49) The persons on the floor of exchange who trade for themselves are called

a) Brokers

b) Locals

c) Commission agents

75

d) All of the above

50) In calculating the clearing margins through gross basis the clearing house

a) Adds all the long and short positions entered in to by a client

b) Offsets the contracts against each other

c) Does it in both the ways

d) None of the above

51) Electronic trading systems have high efficiency and low transaction costs when

compared to the open outcry system.

a) True

b) False

B. Fill in the Blanks

52) An actual physical commodity that someone is buying or selling is called as

a…………………………………………… a) financial asset b) physical asset c) asset

53) The financial instruments whose value is derived mathematically from the value of the

underlying are called ……………………………………a) futures b) options c) derivatives

54) What are the two main functions of a futures market?

……………………………….., …………………………………a) price discovery and risk management b)

speculation and hedging c) hedging and risk management

55) Amount paid by a buyer to the seller for acquiring the right to buy or sell an underlying

in an options contract is called ………………………………………………a) basis b) premium c) strike

price

56) The amount a futures market participant must deposit into his margin account at the

time he places an order to buy or sell a futures contract is called………………………………a)

initial margin b) variation margin c) final margin

57) The extra funds deposited in to the margin account to adjust a days gains or losses are

called ………………………………………………………a) initial margin b) variation margin c) final margin

58) The generation of information about future value of a commodity or financial instrument

through the futures markets is called …………………………a) price discovery b) price search

c) hedging

59) The price at which the underlying commodity or security moves from the seller to the

buyer in a futures contract is called as…………………………………………a) basis price b) strike

price c) spot price

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60) The total number of outstanding contracts for each maturity month for a given

commodity is called as……………………………………………a) closed interest b) interest c) open

interest

61) The system by which exchanges guarantee the faithful compliance of all trade

commitments undertaken on the trading floor or electronically over the electronic

trading systems is called as ………………………………………………a) warehouse b) clearing house c)

assayer

62) All the members of the clearing house need to maintain a margin account with the

clearing house called as……………………………………………a) maintenance margin b) initial margin

c) clearing margin

63) The process by which the trader takes opposite position of trade from the original one

to square off the deal is called ………………………………………………a) closing out b) speculation c)

hedging

64) The difference between the current cash price and the futures price of the same

commodity is called as ………………………………………a) basis b) arbitrage c) premium

65) The smallest allowable increment of price movement for a contract is called a

……………………a) Tick b) basis risk c) hedge ratio

66) Part of the order-routing process in which the time of day is stamped on the order is

called ………………………………………a) Time stamping b) order stamping c) Tick

67) The traders who expect the market prices to go down are called as …………………………a)

bears b) bulls c) neither of the two

68) The markets where the prices increase as the time to maturity increases are called as

…………………………………………a) normal markets b) inverted markets c) perfect markets

69) The type of option where the right can be exercised by the buyer only at the end of the

life of the option contract is called an…………………………………a) American option b) European

Option c) British option

70) The highest and lowest prices recorded for each contract from the first day it traded

to the present is referred as………………………………………….a) 52 week high and low b) lifetime

high and low c) none of these

71) Futures trading in India are governed by …………………………………Act. a) Forward Contract

Regulation Act, 1952 b) FMC Act, 1961 c) none of these

72) Statutory body which controls futures trading in India…………………………………….a) Forward

Contract Regulator b) Forward Markets commission c) none of these

77

C. Problems

Futures 1. A trader enters in to a short Soybean futures contract when the futures price is

Rs.11,300/tonne The contract is for the delivery of 50,000 tonnes. How much does the

trader gain or lose if the cotton price at the end of the contract is (a) Rs.11,200 per

tonne (b) Rs. 11,500 per tonne

Answer

a) In the first scenario of, the trader gains Rs.100/tonne This is because he would have

sold the contract at Rs.11,300 per tonne and bought at Rs. 11,200 per tonne to offset

his position when the contract expires. The total gain he would have made is Rs.50 lakhs

on the 50,000 tonnes

b) In the second scenario, the trader loses Rs.200/tonne. This is because he would have

sold the contract at Rs.11,300 per tonne and bought at Rs. 11,500 per tonne to offset

his position when the contract expires. The total loss he would have made is Rs.1 crore

on 50,000 tonnes

2. In July 2003, a palm oil processor decides to purchase crude palm oil in the month of

October 2003. The processor fears a potential fall in prices because of increase in

imports. So, he decides to hedge his purchase. He expects the basis to be

Rs.1000/tonne. The desired forward pricing objective is Rs 33,500/tonne. This is the

price at which he desires to purchase the crude oil in the month of October. The

November futures contract is trading at Rs.32,500/tonne

Determine how his objective will vary under the following scenarios when spot price of

oil increases and decreases

a) When basis is as predicted

b) When basis is larger than predicted

c) When basis is smaller than predicted

Answer

i) When Spot price is increasing

Month Transaction

Spot Price of oil

a) When basis is as

predicted

Buy November contract at

Rs. 32,500/tonne

Rs. 33,500/tonne

Sell November contract at

Rs.32,700/tonne

Buys crude palm oil from the spot

market at Rs.33,700/tonne

Effective Purchase price: Rs.33,700/tonne - Rs.200/tonne(on the sale of future contract)

= Rs.33,500/tonne. Profit objective has been achieved

78

Month Transaction

Spot Price of oil

b) When basis is more than

predicted by Rs.500/tonne

i.e. basis is now

Rs.1500/tonne

Buy November contract at

Rs. 32,500/tonne

Rs. 33,500/tonne

Sell November contract at

Rs.32,700/tonne

Buys crude palm oil from the spot

market at Rs.34,200/tonne

Effective Purchase price: Rs.34,200/tonne - Rs.200/tonne(on the sale of future contract)

= Rs.34,000/tonne. The trader purchases the oil by Rs.500/tonne more than anticipated

c) When basis is less than

predicted by Rs.400/tonne

i.e. the basis is now

Rs.1400/tonne

Buy November contract at

Rs. 32,500/tonne

Rs. 33,500/tonne

Sell November contract at

Rs.32,700/tonne

Buys crude palm oil from the spot

market at Rs.31,300/tonne

Effective Purchase price: Rs.31,300/tonne – Rs.200/tonne (on the sale of future contract)

= Rs.31,100/tonne. The trader purchases the oil cheaper by Rs.400/tonne than anticipated

ii) When Spot price is decreasing

Month Transaction

Spot Price of oil

a) When basis is

as predicted

Buy November contract at Rs.

32,500/tonne

Rs. 33,500/tonne

Sell November contract at

Rs.32,300/tonne

Buys crude palm oil from the spot

market at Rs.33,300/tonne

Effective Purchase price: Rs.33,300/tonne + Rs.200/tonne (on account of loss from the sale of

future contract) = Rs.33,500/tonne. Profit objective has been achieved

b) When basis is more

than predicted by

Rs.500/tonne i.e. basis is

now Rs.1500/tonne

Buy November contract at Rs.

32,500/tonne

Rs. 33,500/tonne

Sell November contract at

Rs.32,300/tonne

Buys crude palm oil from the spot

market at Rs.33,800/tonne

Effective Purchase price: Rs.33,800/tonne + Rs.200/tonne (on account of loss from the sale of

future contract)

= Rs.34,000/tonne. The trader purchases the oil by Rs.500/tonne more than anticipated

c) When basis is less than

predicted by

Rs.400/tonne i.e. the

basis is now

Rs.1400/tonne

Buy November contract at Rs.

32,500/tonne

Rs. 33,500/tonne

79

Month Transaction

Spot Price of oil

Sell November contract at

Rs.32,300/tonne

Buys crude palm oil from the spot

market at Rs.30,900/tonne

Effective Purchase price: Rs.30,900/tonne + Rs.200/tonne (on account of loss from the sale of

future contract) = Rs.31,100/tonne. The trader purchases the oil cheaper by Rs.400/tonne than

anticipated

Thus, irrespective of whether the spot price increases/decreases the profit objective can

be achieved provided the basis does not fluctuate. More often than not, basis does

fluctuate because of location, time and quality reasons. The more predictable the basis is,

the more accurate hedging becomes and vice-versa.

II. Options 3. If a trader takes a put option contract (say on NASDAQ) on 100 IBM shares with a

strike price of $120 and an expiration date of 3 months. The price of IBM stock after 3

months is $121.What will be the result? Gain or loss and how much?

Answer

The trader will lose only on the Option premium, as he would not exercise the option. The

option expires worthless. This is because after 3 months the price of IBM stock is more

than the strike price by $1. The trader will make profit on put option only when the strike

price is more than the stock/current price.

4. Mr.ShriRam an Indian investor wants to buy 100 shares in the month of December. To

hedge against price fluctuations he buys a Call option at a strike price of Rs.129/share

with a premium of Rs.10/share. How would ShriRam’s pay-off profile vary under the

following price scenarios in the month of December?

a) Rs.132/share

b) Rs.128/share

a) In the month of December, Mr.Shriram would exercise the option and buy 100 shares

for Rs.12,900. This would be his total purchase price.

He could thereafter sell the shares (if he wishes to) at Rs.13,200. The profit he would then

make is Rs. 290 per share (Rs.300 – Rs. 10 per share). The total profit made is

Rs.29,000

b) In the month of December, Mr.Shriram would not exercise his right to buy the option,

as the market price is lesser than the strike price. He would lose on the option premium,

which is Rs.10/share. He would buy the shares directly from the market at Rs.

128/share. His total purchase price would be Rs.129/share (Rs.128+Rs.10 per share)

5. Mr. Rahul wants to sell 100 Reliance Industries in the month of November. To hedge

against price fluctuations he buys a Put option at a strike price of Rs. 130/share wherein

he pays a premium of Rs.2/share. How would Rahul’s pay-off profile vary under the

following price scenarios in the month of November?

80

a) Rs.150/share

b) Rs.120/share

a) In the month of November, Rahul would not exercise his right to sell the option. The

option expires worthless. Instead he would sell the shares directly in the market at

Rs.150/share. He would forego a loss of Rs.2/share, which he has already paid upfront as

Option premium.

b) In the month of November, Rahul would exercise his right to sell the option. Rahul would

sell the 100 shares at the market price of Rs.120/share and exercise the Put option and

make a profit on the difference. He would make a profit of Rs 8/share after accounting for

the option premium.

6. In September with December futures at 70 cents/lb. a merchant seeking to hedge an

inventory purchase (Cotton) in the international market, buys a put on December futures

at a strike price of 70 cents for a premium of 1.7 cents/lb.

a) Why did the merchant buy a Put option?

b) Detail the gain/loss when the December spot prices are as follows.

66 cents/lb

70 cents/lb

71 cents/lb

72 cents/lb

Answer

a) A futures hedge protects against a price decline but eliminates the potential to benefit

from rising prices. A Put option also protects against a price decline, but allows the

merchant to benefit from rising prices.

b) Under the different price scenarios, a Put option minimizes risk as follows

Futures Price in

cents/lb

Gain/(Loss) on

Cotton in

cents/lb

Gain/ (Loss) on

hedged position

after accounting

for the premium in

cents/lb

Net Gain (Loss) on Hedged

position in cents/lb

66 (4) 2.3 (1.7)

68 (2) 0.3 (1.7)

70 0 (1.7) (1.7)

72 2 (1.7) 0.3

74 4 (1.7) 2.3

76 6 (1.7) 4.3

7. In September a merchant sells cotton at 69 cents in the international market. He

covers the sale by the purchase of a call option. At the time of sale December futures

81

are at 70 cents. The Call option is purchased at a strike price of 70 cents for a premium

of 1.7 cents/lb.

a) Why did the merchant buy a Call option?

b) Detail the gain/loss when the December spot prices are as follows.

66 cents/lb

70 cents/lb

71 cents/lb

72 cents/lb

Answer

b) A futures hedge protects against a price decline but eliminates the potential to benefit

from falling prices. A Call option also protects against a price decline, but allows the

merchant to benefit from falling prices.

b) Under the different price scenarios, a Call option minimizes risk as follows

Futures Price in

cents/lb

Gain/(Loss) on

Cotton in

cents/lb

Gain/ (Loss) on

hedged position

after accounting

for the premium in

cents/lb

Net Gain (Loss) on Hedged

position in cents/lb

66 4 (1.7) 2.3

68 2 (1.7) 0.3

70 0 (1.7) (1.7)

72 (2) 0.3 (1.7)

74 (4) 2.3 (1.7)

76 (6) 4.3 (1.7)

Margins 8. A trader has entered in to a short futures contract to sell July silver for Rs.8200 per

kg. The size of the contract is 500 kgs. The initial margin is Rs.40,000 and the

maintenance margin is Rs. 30,000.What changes in the price will lead to a margin call?

A. If the price falls below Rs.20 per kg the trader would get a margin call. If the market

touches a price of Rs.8180 per kg, the trader would have lost Rs.10,000 on 500 Kgs. The

initial margin would become Rs.10,000, which is the same as maintenance margin. If the

market price further falls, the trader would get a margin call.

9. A trader sold (short position) a futures contract at Rs.8100/kg on September 1,2003

and closed out his position by buying the contract at Rs.8000/kg on September 8, 2003.

The future prices for the above week are as follows. The contract size is 100 kgs

(Hypothetical)

82

Day Future Prices in Rs/kg

Sept 1 8100

Sept 2 8007

Sept 3 8006.3

Sept 4 8004.2

Sept 5 8006.8

Sept 6 8002.4

Sept 7 7900

Sept 8 8000

Compute the trader’s Margin account and Margin Call if the Initial margin is

Rs.35,000/contract and maintenance margin is Rs.25,500/contract.

Answer

Day Futures Price in Rs/Kg Daily Gain/ (Loss) in

Rs/Kg

Margin

Account

Balance in

Rs/Kg

Margin Call in

Rs/Kg

1-Sep 8100 35000

2-Sep 8007 -9300 25700

3-Sep 8006.3 -70 25630

4-Sep 8004.2 -210 25420 9580

5-Sep 8006.8 260 35260

6-Sep 8002.4 -440 34820

7-Sep 7900 -10240 24580 10420

8-Sep 8000 10000 45000

Thus, the trader would get margin call from the broker on September 4 and September 7

2003, when the margin account falls below Rs.25,500. It is then adjusted to the difference

between the initial margin and the current margin account.

83

ANSWERS

Multiple Choices

1) c

2) b

3) a

4) a

5) a

6) b

7) a

8) c

9) b

10) a

11) b

12) a

13) b

14) a

15) a

16) c

17) a

18) b

19) b

20) a

21) c

22) a

23) b

24) b

25) a

26) b

27) a

28) a

29) c

30) a

31) a

32) b

33) a

34) b

35) b

36) c

37) a

38) a

39) b

40) a

41) a

84

42) b

43) b

44) d (speculators are actually in the market to make profit for themselves, not for anybody

else’s benefit- if liquidity gets created, it is only incidental)

45) c

46) b

47) c

48) b

49) b

50) a

51) a

Fill in the Blanks

52) b

53) c

54) a

55) b

56) a

57) b

58) a

59) b

60) c

61) b

62) c

63) a

64) a

65) a

66) a

67) a

68) a

69) b

70) b

71) a

72) b

85

9. FREQUENTLY ASKED QUESTIONS (FAQ’s) 1. What are the commodities that might be traded on a commodity exchange?

Commodities traded in an exchange might include

Agricultural products. Example Livestock and meat, Palm oil, Soybean oil, Corn etc

Metals. Examples: Gold, Silver, Bronze etc

Petroleum products. Example: Crude oil, Natural gas etc

2. What are cash commodities?

A cash commodity is an actual physical commodity that someone is buying or selling. They

are also referred to as actuals.

3. What are over the counter (OTC) and exchange traded derivatives?

Over the counter derivatives are Forward contracts, which are not traded in the exchanges.

Exchange traded derivatives are Futures, Swaps and Options

4. What are derivatives?

A derivative is a financial instrument whose value depends on the value of the underlying

variables. They are the financial abstractions whose value is derived mathematically from

the changes in the value of the underlying. There are broadly four kinds of derivatives:

Forwards, Futures, Swaps and Options

5. How derivatives are useful in risk management?

Derivatives are useful risk management tools, which protect the buyers and sellers of

commodities from unexpected price fluctuations in the traditional markets.

6. What is a forward contract?

Forward contracts are the bilateral agreements in which the buyer and the seller agree on

delivery of a specified quality and quantity of an asset on a specified future date at a price

agreed today. Forward contracts are traded privately and are not standardized.

7. What are the drawbacks of a forward contract?

Credit risk is high in forward contracts, which makes the parties wary of each other.

Consequently forward contracts are entered between parties who have good credit

understanding between them.

The contracts are private and are negotiated bilaterally between the parties. Therefore,

there are no exchange guarantees.

The prices are not transparent, as there is no reporting requirement.

86

8. What is a futures contract?

Futures are firm financial agreements to deliver (sell) or to take delivery (buy) of a

standardized quantity of an underlying commodity at a pre-established price at a specified

future date agreed on a regulated exchange.

They are standardized in terms of quantity, quality, delivery time and place.

9. What are the advantages of a futures contract?

Absence of credit risk makes futures contract an attractive tool of risk management.

Futures are exchange-traded products. The clearing house of the exchange takes the

credit risk in respect of all the transactions through the margin system. The profit/loss on

each transaction are settled at the end of the day’s trade. Thus at any point of time the

maximum credit risk is limited to only one-day movement in future prices.

The commodities traded in a futures market are standardized according to quality, quantity,

delivery time and place. Futures operate in highly liquid markets, which gives the option to

the participants to come out of their positions at any point of time.

10. What is the difference between forwards and futures contract?

Futures have evolved out of forward contracts and are the exchange-traded versions of

forward contracts. The credit risk is eliminated in futures contract through margin

payments by buyers and sellers. Settlement in futures contract need not necessarily be in

cash/physical delivery unlike in Forward contracts. The parties can close out their positions

by offsetting their current positions.

Example: A trader who is short (sell) on one contract can go long (buy) on another contract

and close out the first position before the expiry date of the contract.

11. What are the functions of a futures market?

Futures market performs important economic functions like Price discovery and risk

transfer. Price discovery is the process of generating the information to establish the

equilibrium prices, which reflects the current and prospective demand and supply situations.

This process helps the participants in trade to make better investment decisions. Risk

transfer is enabled through hedging (this was discussed in detail under Chapter: 3

Characteristics of commodity trading)

12. How is the price determined in a forward or futures contract?

In principle the forward/future price for an asset would be equal to the spot or the cash

price at the time of the transaction and the cost of carry. The cost of carry includes all the

costs incurred for carrying the asset forward in time. Depending upon the type of asset or

commodity the cost of carry takes into account the payments and receipts for storage,

transport costs, interest payments, dividend receipts, capital appreciation etc.

13. What is going long and going short in a futures contract?

Buying a contract is considered as going long and selling a contract is considered as going

short. A party goes long with the expectation that the prices may increase and a party goes

short with the expectation that the prices might decrease.

87

14. What are options?

An option is a contract that gives the buyer of the option the right (and not an obligation)

to buy or sell a futures contract at a certain price for a limited time. The seller of the

option is obligated to sell the futures contract at the exercise price. This is an important

distinguishing feature between futures and options. In futures the buyer and seller are

both obligated to buy or sell the underlying asset.

15. What are Call and Put options?

A Call option gives the holder/buyer the right, but not the obligation, to purchase the

underlying futures contract at the strike price on or before the expiration date. The seller

is obligated to sell the futures contract.

A Put option gives the holder/buyer the right but not the obligation to sell the underlying

futures contract at the strike price on or before the expiration date. The seller is

obligated to buy the futures contract in this case.

In a Call/Put option, if the buyer does not exercise the option (as it is only a right and not

an obligation to do so) he only foregoes the option premium. Thus, his loss is restricted to

only the premium, whereas his profits are unlimited. In the case of the seller, since he is

obligated to sell the option and cannot choose not to do so, his profit is what he gains from

the option premium, while his loss could be unlimited.

16. What is Option Premium?

Option premium is the amount paid by a buyer to the seller for acquiring the right to buy or

sell an underlying. It is the price received by the seller for surrendering his ―right‖ in an

option contract. It is usually paid upfront at the time of entering into the option contract.

17. How do options differ from a futures contract?

An option gives the buyer the right but not the obligation to buy/sell the underlying where

as in futures contract the buyer is obligated to take the delivery.

In options the buyer pays an upfront payment called option premium to acquire the right.

The cost of entering into a futures contract is zero, as a premium need not be paid by the

buyer/seller unlike in Options.

18. What are Swaps? How do they differ from forward/futures contract?

A Swap is an agreement between two companies to exchange cash flows in the future usually

through an intermediary like a financial institution.

The agreement defines the dates when the cash flows are to be paid and the way that they

are to be calculated. Usually the calculation of the cash flows involves the future values of

one or more market variables.

19. What is an Order? What are the important types of orders?

An order is a requirement placed on the floor of the exchange by any interested party

(through a broker ) for execution of the contract. An order should contains specifications

such as buy or sell, the number of contracts, the month of contract, type and quality of the

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commodity, the exchange, the price specification and the period of validity. The important

types of orders are

Market Order

Limit Order

Stop Loss Order

GTC Order

Day Order

20. What is a Market order?

In a market order no specific price is mentioned. Only the position to be taken, i.e.

long/short is stated. When this kind of order is placed, it gets filled at whatever the

current market price of that particular asset is.

21. What is a Limit order?

Limit order is an order to buy or sell a stated amount of a commodity at a specified price, or

at a better price. This order is placed when one wants to enter a new position, or exit an

open position at a specified price ―or better‖. The disadvantage is that the order may not

get filled at all if the price for that day does not reach the specified price. Limit order is

day order, which means they are good for only one day unless it is specified as a GTC order.

A Limit-GTC order means the order is good till it gets cancelled.

22. What is a stop order?

Stop orders are not executed until the price reaches a specific point. When the price

reaches that point the stop order becomes a market order. Most of the time stop orders

are used to exit a trade. But, stop orders can be executed for buying/selling positions too.

A "buy" stop order is initiated when one wants to buy a contract or go long and a "sell" stop

order when one wants to sell or go short. The order gets filled at the suggested stop order

price or at a better price.

23. What is a GTC order?

It is an order to buy or sell that remains active until the order gets filled in the market. It

is also called an open order.

24. What is a day order?

Day orders are good for only one day, i.e. the day on which the order is placed. If the order

does not get filled that day, the order has to be placed again the next day.

25. What is a Fill or Kill (FOK) Order?

This order is a limit order that is sent to the pit to be executed immediately and if the

order is unable to be filled right away, it is cancelled.

26. What is Spread Order?

A simple spread order involves two positions, one long and one short. They are taken in the

same commodity with different months (calendar spread) or in closely related commodities.

The spreaders goal is to profit from a change in the difference between the two futures

prices.

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27. How an order gets filled up?

The broker executes an order only when the market trades through the mentioned price

and not at that particular price. In instances where the market does not touch the specified

price, the order gets executed at a price lower or above the specified one. This does not

apply in case of a market order where a specific price is not mentioned.

Example: A trader wishes to go long on Corn in the International Market. The current

market price is 275 cents per bushel. The trader wants to buy the contract only after the

market has gained some strength and reaches the price of 285 cents/bushel and above. He

would then place a Stop order to Buy 1 May Corn at 285 cents/bushel. When the market

trades at 285, the order becomes a market order and the trader gets the next best price.

If the market is trading at 284 ½ and the next trade is at 286 ¼, the order gets filled at

286-¼ cents/bushel and not at 285 cents/bushel. This is because an order gets filled up at

a price the market traded through and not at that price

28. What is time stamping of the order?

It is a part of the order-routing process in which the time of day is stamped on an order.

An order is time-stamped twice once when it is received on the trading floor and again when

the order is completed.

29. What is the difference between a broker and a local?

Brokers execute trades for other people i.e. for financial, commercial institutions and the

general public and earn a fee for that. Locals trade for their own account and operate

independently.

30. What are the different trading methods followed?

Open-outcry and electronic trading are the most widely followed trading methods.

Open Outcry: Open outcry trading is a face-to-face and highly activated form of trading

used on the floors of the exchanges. In open outcry system the futures contract are traded

in pits on the floor of the exchange. This is the popular method of trading.

Electronic trading: Electronic trading is an automated trade execution system with three

key components.

Computer terminals, where customer orders are keyed in and trade confirmations

are received.

A host computer that processes trade.

A network that links the terminals to the host computer.

Electronic trading enables transactions to remote investors across the globe. It is cost

effective and efficient.

31. What is a tick?

The smallest allowable increment of price movement for a contract is called a tick.

32. What is a quotation?

The current price that is being offered for a particular security or commodity is called a

quotation.

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33. What is margin money?

Margin money is the minimum balance that needs to be maintained in the exchange to buy or

sell a contract.

34. What is the objective of keeping the margins?

The basic aim of keeping margin is to cover the largest potential loss in one day. This system

of keeping margins eliminates the credit risk involved in the futures transactions.

35. What are the different types of margins?

The different types of margins are

Initial margin

Maintenance margin

Variation margin

36. What is initial margin?

It is the amount that must be deposited with the exchange by the buyer and seller at the

time of entering into a futures contract. This is mandatory on the part of the parties

entering into a contract.

37. What is the concept of maintenance margin?

A trader is entitled to withdraw any balance in the margin account in excess of the initial

margin. To ensure that the balance in the margin account never becomes negative, a

maintenance margin, which is somewhat lower than the initial margin, is required to be

maintained by the buyer and the seller in the contract.

38. What is a Margin call and Variation margin?

Margin call is a call given by the clearing house to a clearing member or from a brokerage

firm to a customer to replenish the account to the minimum required level, when the value

of the account falls below the maintenance margin. The extra funds deposited after the

margin call is given are known as variation margin. If the trader does not provide the

variation margin, the broker closes out the position by offsetting the contract.

39. What is price discovery in futures markets?

Price discovery is the process of generating information to arrive at the equilibrium price,

which reflects the current and prospective demand and supply position of the underlying

asset. This process helps people in making better estimates of futures prices and better

investment decisions.

40. What are the opening and closing prices?

The price at which the commodity opened for trading on a particular day is called an opening

price. Last price that is paid for the commodity before closing of the trade on a particular

day is called closing price.

41. What are the high and low prices?

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Highest price at which a commodity futures contract traded on a particular day is called

―high‖ and the lowest price at which a commodity futures contract traded on a particular

day is called ―low‖.

42. What is settlement price?

The settlement price is determined by averaging the prices over the last few minutes of

trading. The price at which all client/member positions are marked to market at the end of

the day is the settlement price. This is also referred to as ―settle price‖.

43. What is an open interest?

Open interest represents the total number of outstanding or unliquidated contracts in a

commodity at the end of a trading day. A purchase and a sale are required to establish a

contract position. Thus the open interest is the total of either the outstanding purchases or

sales, not both.

44. What are bullish and bearish markets?

A period of rising market price is called a bullish market and a period of declining market

price is called a bearish market. Bulls expect the market prices to go up and bears expect

the market prices to go down. Closing price of a commodity indicates the trend of the

market (either bullish or bearish) for a particular day.

45. What is a clearing house?

Clearing house is an exchange, which is responsible for the faithful compliance of all trade

commitments undertaken on the trading floor through open outcry method or electronically.

It is responsible for settling trading accounts, clearing trades, collecting and maintaining

margin monies, regulating delivery, and reporting trading data.

46. Who are clearing members?

The members of an exchange/clearing house are called clearing members. These members

are responsible for the negotiation and settlement of commodities traded by brokerage

houses. Brokers who are not the members of the clearing house must channel their business

through a clearing member. All TCMs of NCDEX are members of the clearing house.

47. What is a clearing margin?

All the clearing house members are required to maintain a margin account with the clearing

house called as clearing margin. The margin account for the clearing house members is

adjusted for gains and losses at the end of each day (in the same way as the individual

traders keep margin accounts with the broker). In the case of clearing house members, only

the original margin (and not maintenance margin) is required to be maintained.

48. How is a contract settled in a futures market?

A futures contract can be settled in three ways

By physical delivery of the underlying asset

Closing out the transaction by offsetting the current positions

Through cash settlement.

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49. What does closing out in a futures contract mean?

Closing out in a contract means taking an opposite position to close out the original futures

position. A buy contract is closed out by a sale and a sale contract is closed out by a buy.

50. What is hedging?

Hedging is a way of reducing some of the risk involved in holding an investment/asset.

Hedging is a way of insuring an investment against risk.

51. How hedging is helpful in risk management?

Hedging reduces the risk by taking an opposite position in the derivatives market to that of

the cash or underlying market. Hedging does not necessarily leads to a better outcome but

makes an outcome more certain .It protects an asset from adverse price changes and

stabilizes the total profits.

52. What are the different hedging strategies possible? What are their differences?

Hedging is possible both in Futures and Options. Hedging with options is dearer than

hedging with futures. This is because the Option premium is much higher and has to be paid

upfront by the buyer of the Option. In the case of futures such a premium need not be paid.

Hedging using futures

There are 2 types of hedging strategies- short and long.

Selling Hedge (Short) - It is selling futures contract to protect against possible declining

prices of commodities that would be sold in the future. At the time the cash commodities

are sold, the open futures position is closed by purchasing an ―equal number and type‖ of

futures contract as those that were initially sold.

Purchasing (Long) Hedge –It is buying futures contract to protect against a possible

increase in the price of cash commodities that would be purchased in the future. At the

time the physical commodities are bought, the open futures position is closed by selling an

―equal number and type‖ of futures contract as those that were initially purchased. This is

also referred to as a buying hedge.

Hedging using Options

There are two types of hedging strategies-Put and Call

Hedging using a Put option: When a trader wants to purchase an asset, he can purchase a Put

option to protect himself against any fall in prices and benefits from the rise in prices.

Hedging using a Call option: When a trader commits to sell an asset, he can purchase a Call

option to protect from any rise in prices and benefits from the fall in prices.

A futures hedge in the case of long/short hedge protects the trader against any fall/rise in

prices but eliminates the potential to benefit from rising/falling prices respectively

Hedging in the case of Put/Call option not only protects a trader from any fall/rise in price,

but also takes the benefit of rise/fall in prices respectively. This is because buyers in

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options enjoy limited risk with unlimited profit potential. They can never lose more than the

option premium.

The major disadvantage in using options, as a hedge is that the buyer must pay premium in

full at the time of the purchase of the option.

54. What is a hedge ratio?

It is a ratio comparing the value of futures contract purchased or sold versus the value of

the cash commodity being hedged against. The hedge ratio is important for investors in

futures contract, as it would help to identify and minimize basis risk.

55. What is basis risk?

Basis is the difference between the cash price and the future price of a commodity

Basis is influenced by differences in both the cash and futures markets, which include

Location: The basis for a hedger located further away from the delivery point is

more volatile than for a hedger located nearer to the delivery point. This is because

the transportation costs would be higher for a hedger located farther from the

delivery point

Time (storage costs): Storage costs increase as the time of procurement increases.

Storage costs are higher in the future period than in the current period of delivery

Quality differences: Cash prices will usually be at a premium to futures prices for

commodities that are of higher grade. Similarly, cash prices for commodities of less

quality grade will usually be at a discount to futures prices.

To the degree that the relationship between cash and futures prices (the basis) is not

predictable, hedging effectiveness is reduced, or in other words, to the degree the basis is

predictable, hedging is effective.

56. What is speculation?

Speculation involves selecting investments with higher risk in order to profit from an

anticipated price movement. It is expectation driven and uses market opportunities to

increase ones profitability.

57. What is arbitrage?

Arbitrage is the simultaneous buying and selling of any underlying variable to profit from

the price differentials. This process usually takes place in different exchanges or at

different market places. It is a risk less profit and does not involve any investment as both

the trades take place simultaneously.

58. Who are hedgers, speculators and arbitrageurs?

These three classes of investors operate simultaneously in the exchange

Hedgers: Hedgers wish to eliminate price risk from their already existing exposures and are

essentially safety driven.

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Speculators: Speculators willingly take price risks to profit from price changes and are

expectation driven.

Arbitrageurs: Arbitrageurs profit from price differential existing in two markets by

simultaneously operating in two different markets.

III.

59. What is NCDEX?

National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company

registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in

Mumbai on April 23,2003. It is an online exchange and promises nation wide reach and

consistent offerings along with inculcating international best practices in commodity

trading.

60. Who are the promoters of NCDEX?

A group of institutions are promoting NCDEX. They are

ICICI Limited

LIC (Life Insurance Corporation of India).

NABARD (National Bank for agriculture and Rural Development),

NSE (National Stock Exchange of India Ltd.)

61. What are the criteria for becoming a member in NCDEX?

Membership of NCDEX as trading/clearing members is open to any person, association of

persons, partnerships, co-operative societies, Banks, corporates, foreign individuals, firms

etc, that fulfill the eligibility criteria set by the exchange.

A trading cum clearing member (TCM) should have a net worth of Rs 50 lakh, deposit an

interest free amount of Rs 15 lakh as a base capital, bank guarantee/ fixed deposit of Rs 15

lakh as a collateral deposit and annual charges of Rs 50,000/-.

For a Professional Clearing Member (PCM) the net worth is Rs.50 crore, interest free

deposit of Rs.25 lakh, a minimum collateral of Rs25 lakh and annual Charges of Rs.1 Lakh

62. Who are Trading cum clearing members (TCM) and Professional clearing members

(PCM)?

NCDEX currently has membership for TCM and PCM only.

Trading cum clearing members: TCM can trade and clear his trades or those of his clients.

In addition to this he can also clear the trades of his associate trading members

Professional clearing members: A PCM has no trading rights but has only clearing rights. A

PCM can only clear trades of his clients who have traded through a TCM.

63. What are the commodities that have been given approval for trading on NCDEX?

In the first phase NCDEX has approval from FMC to trade in 9 commodities. They are Gold,

Silver, Cotton (long and medium staple), Soybean, Soyaoil, Rape/Mustardseed,

Rape/Mustard oil, Crude Palm Oil and RBD Palmolein.

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64. What are the trading hours of NCDEX?

The trading hours of NCDEX would be 10.00 a.m. to 4.00 p.m.

65. How many warehouses would be accredited to NCDEX?

NCDEX initially plans to start with one delivery center and one warehouse for each of the

commodities. Over a period of time, it plans to add more warehouses and delivery points

66. How NCDEX will accredit the warehouses?

NCDEX would prescribe the accreditation norms, comprising of financial and technical

parameters, which have to be met by the warehouse owners. NCDEX would take

assayer's/Structural Engineer's certificate for confirming the compliance of the technical

norms of these warehouses.

67. Who will be the assaying agencies or certifying agencies for the commodities?

NCDEX is in discussions with the following agencies for acting as the certifying agencies.

SGS India

Geo Chem

Dr.Amin Laboratories

Stewart Assayers

68. Who would be the depository participants?

NCDEX is in discussions with the following institutions to act as depository recipients.

Bank of Baroda

Canara Bank

Global Trust Bank

HDFC Bank

ICICI Bank,

IDBI Bank

Indus Ind Bank

UTI Bank

69. Who will be the clearing corporation?

NCDEX has tied-up with NSCCL (National securities and Clearing Corporation Limited) to

act as the clearing house. NSSCL would be responsible for all operational aspects of the

clearing activities on NCDEX.

70. Who would be the clearing banks?

The following banks have accepted to act as clearing banks.

Canara Bank

ICICI bank

UTI bank

HDFC bank

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71. What is FMC?

The Forward Markets Commission (FMC) is a statutory body, which regulates commodity

futures trading in India. It was set up under the Ministry of Consumer Affairs and Public

Distribution in 1953 under the Forward Contracts (Regulation) Act, 1952.

72. Who formulates the rules and byelaws of an exchange?

The exchanges, which organize forward trading in regulated commodities, can prepare their

own rules (articles of association) and byelaws. But these have to be approved by the FMC.

73. What are the functions of FMC?

Acts as an advisor to the Central Government in respect any matter arising out of the

non-compliance of the Forward Contracts (Regulation) Act, 1952.

Supervising the activities of various forward market agencies and taking any necessary

action under the powers assigned to it by the act.

Collecting and publishing information regarding the trading conditions of the goods

which come under the provisions of the act.

Submitting periodical reports to the Central Government, on the working of forward

markets.

Giving recommendations to improve the working of forward markets.

Undertaking the inspection of the accounts and other documents of any recognized

association or registered association or any member of such association dealing in

futures markets whenever needed.

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10. ECONOMIC BENEFITS OF FUTURES TRADING

Futures contracts perform two important functions of price discovery and price risk

management with reference to the given commodity. It is useful to all segments of economy.

It is useful to producer because he can get an idea of the price likely to prevail at a future

point of time and therefore can decide between various competing commodities, the best

that suits him. It enables the consumer get an idea of the price at which the commodity

would be available at a future point of time. He can do proper costing and also cover his

purchases by making forward contracts. The futures trading is very useful to the exporters

as it provides an advance indication of the price likely to prevail and thereby help the

exporter in quoting a realistic price and thereby secure export contract in a competitive

market. Having entered into an export contract, it enables him to hedge his risk by

operating in futures market. Other benefits of futures trading are:

(i) Price stabilization-in times of violent price fluctuations - this mechanism dampens the

peaks and lifts up the valleys i.e. the amplititude of price variation is reduced.

(ii) Leads to integrated price structure throughout the country.

(iii) Facilitates lengthy and complex, production and manufacturing activities.

(iv) Helps balance in supply and demand position throughout the year.

(v) Encourages competition and acts as a price barometer to farmers and other trade

functionaries.

Futures trading is also capable of being misused by unscrupulous speculators. In order to

safeguard against uncontrolled speculation certain regulatory measures are introduced from

time to time. They are:

a. Limit on open position of an individual operator to prevent over trading;

b. Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in

prices;

c. Special margin deposits to be collected on outstanding purchases or sales to curb

excessive speculative activity through financial restraints;

d. Minimum/maximum prices to be prescribed to prevent future prices from falling

below the levels that are un remunerative and from rising above the levels not

warranted by genuine supply and demand factors.

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11. GLOSSARY OF FUTURES TERMS

Arbitrage

The simultaneous purchase and sale of identical or equivalent financial instruments or

commodity futures in order to benefit from a discrepancy in their price relationship.

Ask

A motion to sell. The same as offer. Indicates a willingness to sell a futures contract at a

given price.

Back Month

The more distant month(s) in which futures trading is taking place, as distinguished from

the nearby (Delivery) Front month.

Basis

The difference between the current cash price and the futures price of the same

commodity. The basis is determined by the costs of actually holding the commodity versus

contracting to buy it for a later delivery (i.e. a futures contract). The basis is affected by

other influences as well, such as unusual situations in supply or demand. Unless otherwise

specified, the price of the nearby futures contract month is generally used to calculate the

basis.

Broker

A company or individual that executes futures and options orders on behalf of financial and

commercial institutions and/or the general public.

Bid

The price that the market participants are willing to pay. A motion to buy a futures or

options contract at a specified price. Opposite of offer.

Bear

One who expects a decline in prices. The opposite of a "Bull."

Bear Market

A market in which prices are dropping.

Bull

One who expects prices to rise. The opposite of "Bear."

Bull Market

A market in which prices are rising.

Carrying Charge (Cost of Carry)

For physical commodities such as grains and metals, the cost of storage space, insurance,

and finance charges incurred by holding a physical commodity. In interest rate futures

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markets, it refers to the differential between the yield on a cash instrument and the cost

necessary to buy the instrument.

Cash Commodity

An actual physical commodity someone is buying or selling, e.g., soybeans, corn, gold, silver,

Treasury bonds, etc. Also referred to as Actuals.

Cash Market

A place where people buy and sell the actual commodities, i.e., grain elevator, bank, etc.

Cash Price

The price of the actual physical commodity that a futures contracts is based upon.

Commodity

An article of commerce or a product that can be used for commerce. In a narrow sense,

products traded on an authorized commodity exchange. The types of commodities include

agricultural products, metals, petroleum, foreign currencies, and financial instruments and

indexes.

Contract

Unit of trading for a financial or commodity future. Also, actual bilateral agreement

between the parties (buyer and seller) of a futures or options on futures transaction as

defined by an exchange.

Daily Trading Limit

The maximum price range set by the exchange each day for a contract. A Trading Limit

does not halt trading, but rather, limits how far the price can move in a given day.

Day Order

An order that is placed for execution during only one trading session. If the order cannot

be executed (filled) that day, it automatically expires at the close of the trading session.

Day Trade

The purchase and sale of a futures or an options contract in the same day, thus ending the

day with no established position in the market or being flat.

Day Traders

Speculators who take positions in futures or options contracts and liquidate them prior to

the close of the same trading day.

Deferred Month

The more distant month(s) in which futures trading is taking place, as distinguished from

the nearby (delivery) month.

Deliverable Grades

The standard grades of commodities or instruments listed in the rules of the exchanges

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that must be met when delivering cash commodities against futures contracts. Grades are

often accompanied by a schedule of discounts and premiums allowable for delivery of

commodities of lesser or greater quality than the standard called for by the exchange.

Delivery

The transfer of the cash commodity from the seller of a futures contract to the buyer of a

futures contract. Each futures exchanges has specific procedures for delivery of a cash

commodity. Some futures contracts, such as stock index contracts, are cash settled.

Delivery Month

A specific month in which delivery may take place under the terms of a futures contract.

Also referred to as contract month or Front month.

Delivery Points

The locations and facilities designated by a futures exchange where stocks of a commodity

may be delivered in fulfillment of a futures contract, under procedures established by the

exchange.

Forward (Cash) Contract

A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer

sometime in the future. Forward contracts, in contrast to futures contracts, are privately

negotiated and are not standardized.

Futures

A term used to designate all contracts covering the purchase and sale of financial

instruments or physical commodities for future delivery on a commodity futures exchange.

Futures Commission Merchant

A firm or person engaged in soliciting or accepting and handling orders for the purchase or

sale of futures contracts, subject to the rules of a futures exchange and, who, in

connection with solicitation or acceptance of orders, accepts any money or securities to

margin any resulting trades or contracts. The FCM must be licensed.

Futures Contract

A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell

a commodity or financial instrument sometime in the future. Futures contracts are

standardized according to the quality, quantity, and delivery time and location.

Futures Exchange

A central marketplace with established rules and regulations where buyers and sellers meet

to trade futures and options on futures contracts.

Good till Canceled (GTC)

An order worked by a broker until it can be filled or until canceled.

Hedge

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The purchase or sale of a futures contract as a temporary substitute for a cash market

transaction to be made at a later date. Usually it involves opposite positions in the cash

market and futures market at the same time.

Hedger

An individual or company owning or planning to own a cash commodity corn, soybeans, wheat,

etc. and concerned that the cost of the commodity may change before either buying or

selling it in the cash market. A hedger achieves protection against changing cash prices by

purchasing (selling) futures contracts of the same or similar commodity and later offsetting

that position by selling (purchasing) futures contracts of the same quantity and type as the

initial transaction.

Hedging

The practice of offsetting the price risk inherent in any cash market position by taking an

equal but opposite position in the futures market. Hedgers use the futures markets to

protect their businesses from adverse price changes.

Last Trading Day

The final day when trading may occur in a given futures or options contract month. Futures

contracts outstanding at the end of the last trading day must be settled by delivery of the

underlying commodity or securities or by agreement for monetary settlement.

Leverage

The ability to control large amounts of a commodity with a comparatively small amount of

capital.

Liquid

A characteristic of a security or commodity market with enough units outstanding to allow

large transactions without a substantial change in price. Institutional investors are inclined

to seek out liquid investments so that their trading activity will not influence the market

price.

Liquidation

Any transaction that offsets or closes out a long or short futures position.

Long

One who has bought a futures or options on futures contract to establish a market position

through an offsetting sale; the opposite of short.

Long Hedge

The purchase of a futures contract in anticipation of an actual purchase in the cash market.

Used by processors or exporters as protection against an advance in the cash price.

Margin Call

A demand from a clearing house to a clearing member, or from a brokerage firm to a

customer, to bring margin deposits up to a minimum level required to support the positions

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held. This can be done by either depositing more funds or offsetting some or all of the

positions held.

Mark-To-Market

A daily accounting entry that is the bedrock of regulated futures bookkeeping. It's the

end-of-day adjustment made to trading accounts to reflect profits and losses on existing

positions. In other words, winnings are credited and immediately available to the account

and losses are debited and immediately owed. This brings integrity to the marketplace

because participants are not allowed to trade unless funds are available to cover the

positions.

Market Order

An order to buy or sell a specified commodity, including quantity and delivery month at the

best possible prices available, as soon as possible.

Market-If-Touched Order

A price order that automatically becomes a market order if the price is reached.

Market on Close

An order to buy or sell at the end of the trading session at a price within the closing range

of prices.

Offer

Indicates a willingness to sell a futures contract at a given price. Also called "Ask"

Offset

Taking a second futures or options position opposite to the initial or opening position. This

means selling, if one has bought, or buying, if one has sold, a futures or option on a futures

contract.

Open Order

An order to a broker that is good until it is canceled or executed.

Open Outcry

Method of public auction for making verbal bids and offers in the trading pits or rings of

futures exchanges.

Or Better Order

A type of a limit order in which the market is at or better than the limit specified. The

term is often used to help clarify that the order was not mistakenly given as a Limit when it

looks like it should be a Stop Order.

Performance Bond (Margin)

Funds that must be deposited as a performance bond by a customer with his or her broker,

by a broker with a clearing member, or by a clearing member, with the Clearing House. The

performance bond helps to ensure the financial integrity of brokers, clearing members and

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the Exchange as a whole.

Pit

A specially constructed arena on the trading floor of some exchanges where trading in a

futures contract is conducted. On some exchanges the term "ring" designates the trading

area for a commodity.

Position

A market commitment. A buyer of a futures contract is said to have a long position and,

conversely, a seller of futures contracts is said to have a short position.

Price Discovery

The generation of information about "future'' cash market prices through the futures

markets. It has been said that futures markets are often the place of "original price

discovery" because that's where the buyers and sellers are brought together to determine

the price. As in any auction, the last price is considered to reflect the sum total of opinions

about what price an item should be valued.

Price Limit Order

An order that specifies the highest price at which a bidder will pay for a contract, or the

lowest price a seller will sell a contract. This type of order is used to "limit" how much the

trader is willing to "give in" on price to get the order filled.

Settlement Price

The last price paid for a commodity on any trading day. The exchange clearing house

determines a firm's net gains or losses, margin requirements, and the next day's price

limits, based on each futures and options contract settlement price. If there is a closing

range of prices, the settlement price is determined by averaging those prices. Also

referred to as Settle or Closing Price.

Short

One who has sold futures contracts or plans to purchase a cash commodity. Selling futures

contracts or initiating a cash forward contract sale without offsetting a particular market

position.

Speculator

One who attempts to anticipate price changes and, through buying and selling futures

contracts, aims to make profits. A speculator does not use the futures market in connection

with the production, processing, marketing or handling of a product.

Spot

Usually refers to a cash market price for a physical commodity that is available for

immediate delivery.

Spread

The price difference between two related markets or commodities.

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Spreading

The simultaneous buying and selling of two related markets in the expectation that a profit

will be made when the position is offset. Examples include: buying one futures contract and

selling another futures contract of the same commodity but different delivery month;

buying and selling the same delivery month of the same commodity on different futures

exchanges; buying a given delivery month of one futures market and selling the same

delivery month of a different, but related, futures market.

Stop Order

Sometimes called a Stop Loss Order, although it can be used to initiate a new position as

well as offset an existing position. It's an order to buy or sell when the market reaches a

specified point. A stop order to buy becomes a market order when the futures contract

trades (or is bid) at or above the stop price. A stop order to sell becomes a market order

when the futures contract trades (or is offered) at or below the stop price. An order to buy

or sell at the market when and if a specified price is reached.

Stop Limit

A variation of a stop order. A stop with limit order to buy becomes a limit order at the stop

price when the futures contract trades (or is bid) at or above the stop price. A stop order

to sell becomes a limit order at the stop price when the futures contract trades (or is

offered) at or below the stop price.

Tick

Smallest increment of price movement possible in trading a given contract.