sunayanipandit
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INTRODUCTION: -
Rapid economic growth in recent years with more than 6 per cent GDP growth rate has made India one of the fastest growing economies of the world. With higher incomes giving significant purchasing power to over a billion strong population, demand for all kinds of goods and services is set to grow rapidly.
With liberalisation measures in place, commodity markets in India are likely to make an overwhelming impact on the global commodity markets. Indian Corporate entities are now in a position to hedge their price risks in the domestic and international commodity exchanges. Online trading at the three nationwide multi-commodity futures exchanges allows domestic hedging, while some of the established commodity-specific, exchanges are gearing up to meet the needs of the expanding market. There is no doubt that the commodities market in India is definitely in for a big spent offering enormous opportunities of growth to investors, speculators, arbitragers and even big corporations in manufacturing sector.
MARKET: -
Markets have existed for centuries in India and abroad for selling and buying of goods and services. The concept of market started with agricultural products and hence it is as old as the agro products or the business of farming itself. Traditionally, the farmers used to bring their produce to a central place (called Mandi\Bazar) in a town\village where grain merchants\traders would also come and buy the produce and transport, distribute it to other markets.
In a traditional market, agriculture produce would be brought and kept in the market and the potential buyers would come and see the quality of the produce and negotiate with the farmers directly for a price that they would be willing to pay and the quantity that they would like to buy. The deals were then struck once mutual agreement was reached on the price and the quantity to be bought / sold.
In the system of traditional markets, shortages of a commodity in a given season would lead to increase in price for the commodity or oversupply on even a single day (due to heavy arrivals) could result into decline in prices sometimes below the cost of production to the farmers. Neither the farmers nor the food grain merchants were happy with this situation since they could predict what the prices
would be on a given: ay or in a given season. As a result many times me farmers were required to return from the market with their produce since it did not fetch reasonable price and since there were no storage facilities available near the market place. It was in this context that farmers and food grain merchants in negotiating for future supplies of grains in exchange of cash at a agreeable price. This type of agreement was acceptable to both parties since the farmer would know how much he would be paid for his produce, and the dealer would know his cost of procurement in advance. This effectively started the system of commodity market, forward contracts, which subsequently evolved to futures market
COMMODITY: -
“A commodity is a product having commercial value, which can be produced, bought, sold and consumed. Commodities are basically the products of primary sector of an economy. Primary sector of an economy is that part of the economy, which is concerned with agriculture and extraction of raw material.”
In order to qualify as a commodity, an article or a product has to meet some basic characteristics. These are listed below:
a. The product has not gone through any complicated manufacturing activity, though simple processing (like mining, cropping, etc.) is not ruled out. In other words, the product must be in a basic, raw, unprocessed state. (For instance wheat is a commodity; but wheat flour and bread are not commodities). There are of course some exceptions to this rule e.g. in case of metals and products like sugar.
b. Major consideration while buying a particular commodity is its price (since there is hardly any difference in quality from seller to seller)
c. The product has to be fairly standardized in the sense that there cannot such differentiation in a product based on its quality (e.g. Rice is rice though different varieties of rice can be treated as different commodities and hence traded as separate contracts).
d. Prices of the product are determined by market forces, demand 'and supply and they undergo rapid changes / fluctuations (price must fluctuate enough to create uncertainty, which means both risk and potential profit / loss for buyers and sellers)
e. Usually there would be many competing sellers of the product in the market.
f. The product should have adequate shelf life so that delivery of a futures contract can be deferred.
COMMODITY MARKET: -
Market is a place where buyers and sellers meet to transact a business i.e. for exchange of goods or services for a consideration, which is usually money. Markets are usually and traditionally at a place or location, where buyers and sellers could meet. However, in modern world, buyers and sellers on telephone lines or on Internet can transact the business. Hence, in today's world markets need not Exist in physical form as long as the exchange of goods or services take place for a consideration.
Commodity market is therefore logically a market where commodities or commodity derivatives are bought or sold for a consideration. It is thus an important constituent of the financial system for any country.
Existence of a vibrant, active and liquid commodity market is normally considered as a healthy sign of development of any economy. Commodity markets quite often have their centers in developed countries though the primary commodities in many cases are produced in developing countries. Birth and growth of transparent commodity market is thus a sign of development of an economy. This has particular significance in case of countries like India, which produce agri-products as well as a number of other basic commodities, which are traded on commodity exchanges world over.
Commodity futures in particular help price discovery and assist investors in hedging their risks by taking positions in commodities and exploiting arbitrage opportunities in the market.
CONSTITUENTS OF COMMODITY MARKET
The system includes following elements:
a. Buyers / Sellers / Users / Producers: Farmers, Farmer' Cooperatives, Metal (Precious & other) producers / suppliers / stockiest, APMC Mandies, Traders, Brokers, Members of Commodity Exchanges, State Civil Supply Corporations, Hedgers, Speculators and arbitragers (these could include corporate houses, FMCG Companies, etc.)
b. Logistics Companies: Storage and Transport Companies/ Operator Quality Testing and Certifying Companies, Valuers, etc.
c. Markets and Exchanges: Spot Markets (Mandies, Bazars, etc.) and Commodity Exchanges (National Level and Regional level),
d. Support agencies: Depositories / De-materializing agencies, Central and State Warehousing Corporation and Private sector warehousing companies.
e. Lending Agencies: Banks, Financial Institutions.
FUNCTIONING OF COMMODITY MARKET IN INDIA: -
There are three types of regulated markets in India:
• Spot Markets: Direct purchases for immediate consumption.
• Futures and Forward Markets: Agreements new to pay and received deliver later.
Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered in the future.
• Derivatives Market is Purely financial transactions based on physical trading.
The system includes following elements:
• Hedgers, Speculators, Investors, Arbitragers
• Producers - Farmers
• Consumers, refiners, food processing companies, jewelers, textile mills, exporters & importers.
The biggest benefits of commodity trading will accrue to commodity traders, farmers and companies dealing in commodity-based products (like wheat and metals) by allowing them to hedge their risks. Then there are speculators, who are in the game only to make money out of the volatility in prices. But unlike in stocks, few retail investors are expected to trade in commodity futures since it
requires a fair bit of expertise. Even those who do will probably restrict themselves to trading in gold or silver.
OVER THE COUNTER\SPOT MARKET: -
Direct purchases and sales are achieved in spot markets normally for immediate consumption. Buyers and sellers meet ‘‘face-to-face" and deals are struck. This is akin to "over the counter (OTC)" market where there is no need for organization like a commodity change. These are traditional markets c1assic example of a spot market is a Mandi where food grains are sold in bulk. Farmers would bring their produce to this market and food grain merchants/traders would purchase the produce "on the spot" and settle the deal in Spot markets thus call for immediate delivery of goods/services against actual payment.
BENEFITS OF TRADING IN COMMODITY: -
A future trading performs two important functions of price discovery and price risk management with reference to the given commodity. It is therefore useful to all the segments of the economy and particularly to all the constituents of the Commodity Market System.
Benefits to Consumer & user: -
a It is useful for the consumer because he gets an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. Predictable pricing & transparency is an added advantage.
b. Hedging their risks if they are using some of the commodities as their raw materials in particular can benefit corporate entities. They can hedge the risk even if the commodity traded does not meet their requirements of exact quality / technical specifications.
c. 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
Benefits to Investors: -
a. High financial leverage is possible in commodity markets. In case of stocks, an investor needs to put up the full amount of the stock value to buy the stock. With commodities, you control commodity futures contracts with a margin, which is usually between 5% to 10% of the value of the commodity. Investor can effectively hedge the risk in price fluctuations of a commodity.
b. Investor can also hedge his risk on investments in stocks and debt markets since commodities provide a choice and provide one more alternative avenue in the investment port for. It may be mentioned here that the Commodities are less volatile compared to equity market, though more volatile as compared to G-Sec's
c. Commodity markets are extremely transparent in the sense that the manipulation of prices of a commodity is extremely difficult. Given the knowledge of the commodity, the investor can be thus clear about what he can expect in foreseeable future.
d. Business involves just you and the market.
e. With the rapid spread of derivatives trading in commodities, this route too has become an option for high net worth and savvy investors to consider in their overall asset allocation.
f. The fact that the stock indices and commodity indices are not correlated implies that the commodity markets can be used as an effective diversification tool, where investors can park their money.
g. A look at the performance of the commodities markets during the last year shows that the positive movement was witnessed during most parts of the year.
Benefits to Producers: -
a It is useful to the producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him.
Farmers for instance, can get assured prices, decide on the crop that they want to take and since there is transparency in prices, he can decide when and where to sell.
Benefits to the Economy: -
As the constituents of the commodity market system get benefited Indian economy in turn is also expected to gain a Lot. Growth in the commodity markets implies that there could be tremendous benefits to the Indian economy in terms of business generation and employment opportunities.
General benefits & other advantages for all players: -
a Improved Product Quality: Since the contracts for commodities are standardized, it becomes essential for the producers / sellers to ensure that the quality of the commodity is as specified in the contract.
b. Credit Accessibility: Buyers and sellers can avail of the bank finances for trading in commodities. As mentioned here, some nationalized banks as also some banks in the private sector have come forward to offer credit facilities for commodity trading. More and more banks are likely to fall in line looking at the huge potential that commodity market offers in India. Commodities are less volatile compared to equity market, but more volatile as compared to government securities.
OBJECTIVES
Following are the objectives of project: -
1. To understand the fundamentals of commodity market.
2. To understand the need of evaluation of commodity markets in the world.
3. Getting knowledge of current Scenario of commodity market over the entire world.
4. Getting knowledge of functioning of commodity markets through exchanges.
5. To find out the area of economic growth contributed by commodity markets.
SCOPE OF COMMODITY MARKET: -
Investment in commodity markets has been very popular and rewarding for investors in U.K. and U.S.A. For investors looking for diversification beyond stock markets, commodity markets offer another investment option. The commodity markets activity, volume and players multiplied in the recent past. In India, although the trading in commodity markets and commodity exchanges is booming, it has to cross few more hurdles like permitting Fills, banks and other financial institutions to operate in these markets. The reason why investors may look for opportunities in commodity markets may take us to the basic tenets of risk and return theory viz. expected return and risk. Normally it is a risk - reward relationship. The higher the risk higher is the expected return and vice versa.
LIMITATION OF COMMODITY MARKET: -
Commodity markets, like any other markets, have their own limitations too. Some of them are:
Commodity market prices can fluctuate wildly depending on the factors, which are sometimes beyond human control (floods, storms, natural calamities like earthquakes, etc. can create temporary shortages of commodities and hence result in drastic changes in their prices in a very short time).
Forward / futures trading involve a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc.
Hence, it is necessary that the investors/players in the commodity markets understand the functioning of commodity markets, mechanism of commodity Exchanges properly and study the factors that can affect the commodity prices carefully.
“Methodology can be considered as the backbone of any project work.” Methodology refers to the scientific methods used in the project for the purpose of investigation and research.
This project is to analyze the future prospects of commodity market as the Indian Commodity markets and futures trading in the commodity exchanges have great potential to develop as one of the fastest growing centers in the world. India belong an agrarian economy can definitely bolster its commodity trading volumes. Similarly India is also a large producer in various commodities and metals. If we consider consumption aspects of certain commodities, India again will figure as one of the largest consumers of such products. Being one of world's largest agrarian economies, commodities contribution (agricultural produce and other commodities) to the Indian economy said to account for about 50% to India's GDP.
Thus one can visualize the potential of Indian commodity exchanges to become a global hub for futures trading with the expected turnover of this segment outgrowing the stock market within a few years to come.
It is a Conceptual Research fully based on abstract ideas, concepts or theory. It results in the development of new concepts or reinterpretation of existing one.
TOOLS OF DATA COLLECTION
PRIMARY DATA: -
“Data collected for very first time for analysis is primary data.”
Since the primary data is not required in this project it is not collected.
SECONDARY DATA: -
“Data that already exists is known as secondary data.”
It provides a starting point for the project and offers the advantages of low cost and ready availability.
The secondary data is collected from various books like NCFM Commodity Dealer Module – NSE India and Diploma In Commodities trading (DITC) - By Welingkar Institute Of Management Development & Research.
And for getting knowledge of current Scenario of commodity market over the entire world and in India different sites are used like
• http://www.karvycomtrade.com
• http://www.mcx.com
• http://www.ncdex.com
• http://www.commoditiescontrol.com
GLOBAL COMMODITY MARKET
Today commodity markets are situated throughout the world. In many cases, the markets deal in specialized commodities. Notable among them are, Chicago Board of Trade in U.S.A., London Commodity Exchange in U.K., Sydney Futures Exchange in Australia, Tokyo Commodity Exchange in Japan and Singapore International Monetary Futures Exchange in Singapore.
In India we have a number of small / regional exchanges for trading in different commodities and at national level we have three commodity exchanges. The commodities are traded both in cash market and in futures markets. It is the futures markets that take lead in commodity trading as compared to cash markets.
COMMODITY FUTURES:
The first recorded instance of futures trading occurred in rice in Japan and China some 6,000 years ago. In the United States, futures trading started in the grain markets in the middle of the nineteenth Century. Major development in forward trading in commodities work place in middle of eighteenth century in Chicago in United States.
CHICAGO AND COMMODITY TRADING:
In the 1840s, Chicago had become a commercial center since it had good railroad and telegraph lines connecting it with the East. Around this same time, good agriculture technologies were developed in the area, which led to higher wheat- production. Midwest farmers therefore used to come to Chicago to sell their wheat to dealers who, in turn, used to ship it all over the country. The farmers would bring their wheat to Chicago hoping to sell it at a good price. The city had very limited storage facilities and hence, the farmers were often left at the mercy of the dealers. The situation changed for the better when in 1848 a central place was opened where farmers and dealers could meet to deal in “spot” grain – that is, to exchange cash for immediate delivery of wheat.
Farmers (sellers) and food merchants\dealers (buyers) slowly started entering into contract for future exchanges of grain for cash so that farmers could avoid taking the trouble of transporting\storing wheat (at very high costs), if the price was not acceptable. This system was suitable to farmers as well as the dealers. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs of procurement well in advance.
Such (forward) contracts became common and were even used as collateral for bank loans subsequently. The contracts slowly got “Standardized” on quantity and quality of wheat being traded. They also began to change hands before the delivery date. If the dealer decided he didn’t want the wheat~ he would
sell the contract to someone who needed it. On other side if the fan-her who didn’t want to deliver his wheat could also pass on his obligation on to another farmer. The price of the contract would go up and down depending on what was happening in the wheat market. If bad weather had come, supply of wheat would be less and the people who had contracted to sell wheat would hold on to more valuable contracts expecting to fetch better price; if the harvest were bigger than expected, the seller’s contract would become less valuable since the supply of wheat would be aplenty.
Slowly, even those individuals who had no intention of ever buying or selling wheat began trading in these contracts expecting to make some profits based on their knowledge of the situation in the market for wheat. They were called peculators. They hoped to buy contracts at low price and sell them at high price• or sell the contracts in advance for high price and buy later at a low price. This is how the futures market in commodities developed in United States.
Futures industry has changed a great deal over the last 20 year including usage of term futures itself. The industry was never referred to as futures” but rather “commodity”. Until 1970s the agricultural markets dominated the industry, and the trading was known as “commodity trading”. Today these markets are known as the futures market or are referred to as the new commodity futures market.
FINANCIAL FUTURE:
The biggest increase in futures trading activity occurred in the 1970s when futures on financial instruments started trading in Chicago. Currency futures began trading in the International Money Market (IMM) of the Chicago Mercantile Exchange in 1972. Since then many other futures markets have opened up such as London International Financial Futures Exchange (LIFFE).
Currencies such as the Swiss Franc and the Japanese Yen were the earliest currencies to be traded in currency futures market. The other financial assets traded in the exchanges include, stock indices, futures and options in interest rate instruments such as United States Treasury Bonds and T-Bills. In the 1980s futures began trading on stock market indices such as the S&P 500.
INDIAN COMMODITY MARKET
History of trading in commodities in India is quite old. Even Kautilya's 'Arthashastra' makes a mention of commodity markets in India, which dates back to Maurya dynasty.
In India there used to be a class called "Mahajans" who performed important role in trade and banking. They had social influence and were able to enforce integrity and honesty in trade and used to settle matters of dispute. The system continued till middle of nineteenth century.
EVALUTION OF ORGANISED FUTURE TRADING:
The history of futures trading in commodities in India is almost as old as that in the US. It has, however, passed through a turbulent past. India's first organized futures market was the Bombay Cotton Trade Association Ltd., which was set up in 1875. Futures trading in oilseeds started with the setting up of Gujarati Vyapari Mandali in 1900. Gold futures trading began in Mumbai in 1920. During the first half of the 20th century, there were several commodity futures exchange trading in jute, pepper, turmeric, potatoes, sugar, etc
India's history of commodity futures has been however turbulent. This is evident from the following historical developments:
• Trading in forwards and futures became difficult as a result of price controls by the Government in mid 1940s.
• Options were banned in cotton in 1939 by the Govt. of Bombay to curb widespread speculation.
• The Forward Contract Regulation Act was passed in 1952. This put restrictions on futures trading.
• During 1960s and 70s, Govt. of India suspended trading in several commodities like jute, edible oil seeds, cotton, etc. since the Govt. felt that futures markets were causing excessive increase in prices of commodities.
• Govt. offered to buy agricultural produce at Minimum Support Price (MSP), had virtual monopoly on storage\transportation\ distribution of agriculture produce along with ban on futures and options trading. All these weakened the agro commodity markets in the country.
The Government appointed four main committees (Shorff Commodity in 1950, Datwala Committee in 1966, Khusro Committee in 1980 and Kabra Committee in 1994) to go into the details of Forward and Futures Trading perspectives in Indian context.
It was Kabra Committee, which really assessed the scope for forwards and futures trading in commodities and recommended steps to vitalize the futures trading in India, which was then at the initial stages of its liberalization of economy.
The Kabra Committee made significant contribution to the cause of commodity trading in the country and is in a way responsible for today's modern system of commodity trading with three national level and 22 other commodity exchanges / associations in operation. The recommendations of this Committee finally led to the development of futures trading in India with the establishment of
National level Commodity Exchange (NCDEX)
Multinational Commodity Exchange (MCX)
National & Multinational Commodity Exchange (NMCE)
With this introduction to commodity markets, it is essential to understand how the entire Commodity Market System works and what are its constituents. Commodity Market System comprises several elements. These are shown in the following figure
INDIAN COMMODITY MARKET STRUCTURE
INDIA’S SHARE IN GLOBAL COMMODITY MARKETS: -
At present, India's share in the global commodity markets - both agricultural and industrial, especially of energy products and base metals - is not big enough to make a major impact on international prices (bullion being an exceptional case). India currently accounts for only around 3 per cent of the global oil demand and 2 per cent of the global copper demand. In comparison, China accounts for 8 per cent and for oil and as high as 22 per cent of the global demand
However, in the gold market, bout 20 per cent of the world demand and remains a key buying support on price corrections. In case of agricultural commodities, India’s production base is large, but international trade volumes are still rather
India is the world's largest producer of World’s second largest producer of rice and wheat after China aid the world 3 third largest producer of cotton after China and the US; though foreign trace (export and import) in these commodities is rather limited. However, in getable oil, India is the world's largest importer (with 4.5-5.0 million tones annually), as is the case with pulses (close to 2 million tones) also.
Despite a modest share in the industrial products market, the prospects for growth for the industrial commodities in India are considerable. Despite a slowdown in industrial production at times overall the domestic economy in India continues to grow while imports and growth in demand for corporate borrowing also indicate a positive outlook.
In addition, large infrastructure works are being undertaken across the country, covering rail, road, energy and sports. The outgoing Golden Quadrilateral project is an excellent example of road connective to the four corners of the country. Port modernization and involvement of the private sector in infrastructure development are likely to be the key growth drivers.
A sectoral study of India conducted by consultants McKinsey had suggested that global steel consumption would increase to around 80-100 million tones by 2015, up from 33 million tones in 2003. due to robust demand growth from infrastructure, construction, manufacture and automotive sectors mainly in India and China.
All these factors point out a very encouraging outlook for the growth of Indian commodity markets.
NEED TO REGULATE FUTURE MARKET: -
The fact that the benefits of futures markets accrue only in true and fair competitive conditions and transparency of operations, the regulation is needed to create such competitive conditions. Many times, unscrupulous participants are in a position to use leveraged commodity contracts for manipulating prices if there were no regulations. This in turn can have undesirable influence on the spot prices; there is an affecting interest of common man or society at large.
In the absence of such a system, a player in the commodity market could default which in turn could lead to a chain reaction and financial crisis in a futures market in general and in a commodity exchange in particular.
Regulations are also necessary to ensure transparency and fairness in the entire system including trading, clearing, settlement operations and management of the exchange. This is useful in protecting and promoting the interest of various stakeholders, particularly non-member users of the market and retail investors or "common man".
PRESENT SYSTEM: -
At present, there are three tiers of regulations of forward & futures trading system in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges. The Commodity Exchanges in India are governed and regulated under the Forward Contracts (Regulation) Act, 1952 and the rules framed there in.
The FC(R) Act, 1952 prohibits options in commodities. It is reported that the Government is actively considering removal of this restriction and allow options to be traded on registered national commodity exchanges (to start with) and other Associations. It is learnt that the decision in this regard will be announced in January 2006. For the purpose of forward contracts in certain commodities, forward trading can be allowed by notifying those commodities U/S 15 of the Act; notifying these commodities u/s 17 of the Act can prohibit forward trading in certain other commodities.
The Forward Markets Commission was set up in 1953 under the Ministry of Consumer affairs, Food and Public Distribution under the Forward Contracts (Regulation) Act, 1952. It is the regulating authority for all Commodity Futures Exchanges in India. It is responsible for regulating and promoting futures/ forward trade in commodities. The Forward Markets Commission-is located in Mumbai with a regional office in Kolkata.
The FC(R) Act, 1952 provides that the FMC shall consist of at least two but not more than four members appointed by the Central Government. A person nominated by the Central Government is also to be the Chairman of the FMC.
Legal and Regulatory provisions for customer protection:
a) In any country or markets, it is extremely necessary to make regulatory provisions so that the customer is protected adequately from frauds/manipulation by large investors/traders"
b) The F.C.(R) Act provides that the member of the Exchange cannot appropriate client’s position, except when a written consent is taken within three days' time.
c) It has asked many commodity Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. This ensures free and fair-trading with complete transparency.
d) It has also recommended simultaneous reporting system for the Exchanges following open out-cry system.
FUNCTIONS: -
a) FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association.
b) It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assigned to it.
c) It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submits to the Government periodical reports on the operations of the Act and working of forward markets in commodities.
d) It makes recommendations for improving the organization and working of forward markets.
e) It undertakes inspection of books of accounts and other documents of recognized/registered Associations.
f) FMC performs such other duties and exercise such other powers as may be assigned to it by or under the Forward Contracts (Regulation) Act, 1952 or as may be prescribed by the Government of India.
INTRODUCTION: -
A derivative can be defined as “ a financial instrument/ contract, which derives its value from the underlying asset (i.e. the asset mentioned in the contract). The underlying asset could be (quite often the price of traded assets) equity, commodity, currency/foreign exchange or real estate or any other asset. Depending on what the underlying asset is, the derivative could be named differently.
Thus a commodity derivative is “a contract to either sell or buy a commodity at a certain time in future at a price agreed upon at the time of entering into such a contract.”
Derivatives are used both in financial and commodity markets. The numbers of derivative products used in financial markets are more diverse than those in commodity markets. However, major derivative products in the commodity markets are basically future, options and options on futures.
Derivatives have now assumed great importance in the world of finance. Different types of derivative have been developed and actively traded on not only stock exchange but also on commodity exchange and “over the counter” markets. Futures contracts are now traded very actively all over the world.
Derivative contents have several variants .The most common variants of commodity are, FORWARDS, FUTURES & OPTIONS
FORWARD MARKETS: -
Forward markets are markets where delivery takes place some time in the future, unlike spot markets that call for immediate delivery. These advance sales help both buyers and sellers who can then resort to long term planning.
A forward contract is one of the simplest forms of derivatives. It is an agreement to buy or sell an asset (commodity) at a certain time in future for a certain price mentioned in the contract. It is different from the ‘spot contract’, which is an agreement to buy or sell the asset ‘on the spot, i.e. today/immediately.
A forward contract is usually traded in over the counter (OTC) mode. The forward contract can be between a manufacturer of a product (who want to hedge his risk lest the price rises in future) and a producer/supplier of raw material (who wants to hedge his risk by ensuring minimum price lest the price declines in future) used by it.
Under forward contracts (regulation) act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contract.
Forward contracting solved the basic problem of arranging long-term transaction between buyers and sellers but did little to manage the financial risk that occurred with sudden or unforeseen price changes resulting from crop failures, inadequate storage facilities, transportation bottlenecks, or other economic or unforeseen factors like floods or earthquakes.
Forward contract can be of two types: -
• Non Transferable Specific Delivery (N.T.S.D.) Contracts
• Transferable Specific Delivery (T.S.D.) Contracts
Non Transferable Specific Delivery (N.T.S.D.) Contracts:-
It is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. Transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods cannot transfer the rights or liabilities under this contract.
Transferable Specific Delivery (T.S.D.) Contracts: -
It is an enforceable customized agreement where unlike non transferable specific delivery contracts, the rights or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.
FUTURES MARKET: -
Futures markets have existed for more than 250years. They basically started with agricultural products. Major objective of these markets was to help farmers, and grain merchants to improve their marketing and purchasing practices.
CASH MARKET AND FUTURES MARKET: -
Although futures contracts are part of the commodity markets, they are not part of the cash market. It is because, that though the underlying in the. futures contracts, is the cash commodity, the subject 01 trades on the futures exchanges are futures contracts and not the physical commodity. Thus, the cash market is the physical goods or commodity market in which everybody normally trades. The term 'Cash', accordingly refers neither to the method of payment nor to the time of payment. The cash market therefore refers to the actual commodity like gold, copper, sugar, oil etc.
FUTURES CONTRACTS: -
Futures contracts are derivative instruments. Over a period of time forward markets laid the foundation for futures contracts. The main difference between forward contract and a futures contract is the way in which they are negotiated. For forward contracts, terms like amount, quality, delivery date and price are discussed in person between the buyer and the seller and are thus unique in each case. In futures contracts however, all terms are standardized except price, which is discovered through the interaction of supply and demand in a centralized marketplace or exchange.
Presently, futures contract is the only product used in the derivative segment of Indian commodity exchanges.
“A commodity futures contract is an agreement between two parties, to buy or sell a specified quantity and defined quality of a commodity, at a certain time in future, at a price agreed upon at the time of entering into the contract on a commodity exchange.”
NEED OF COMMODITY FUTURE: -
The need for a futures contract and its trading through the exchange arose mainly due to the hedging function that it can perform for both buyers as well as the sellers.
Commodity markets like any other financial instrument, involve risks associated with frequent price volatility. The prices volatility in general can be attributed to the following two reasons:
a. Consumer preference: due to change in preferences of customers, the demand for a commodity could suddenly increase or decrease affecting its price. However, their impact on prices would normally be slow and quite often short lived. This is also because the manufacturers, dealers, stockiest and wholesalers get sufficient time to adjust their inventories.
b. Changes in supply: these are abrupt and unpredictable and bring about wild fluctuations in prices. This is more likely in case of agricultural commodities where weather plays a major role in determining the success or failure of a particular crop.
The futures markets tries to reduce such risk through the mechanism that is called hedging
OBJECTIVES: -
• Hedging with a view to transfer the price risk;
• Price discovery through a large number of transactions and players;
• Maintenance of buffer stock and better allocation of resources;
• Reduction in inventory requirement and thereby reduction in cost of carry;
• Price stabilization through balanced demand and supply positions;
• Helps raise ban finance through transparency and flexibility coming with futures contracts;
FEATURES OF FUTURES CONTRACT: -
Thus commodities futures contracts will always have a fixed period, like one month, three month etc. as the life of the contract. The life of the may be different in different commodity exchanges. At the end of contract period, the futures contract would expire and the concerned parties will have to give and receive delivery of the commodity mentioned in the contract. Both the time and the places of delivery are prescribed by the exchange and this will form part of the futures contract.
There is usually a time difference between futures contract and the delivery period. As a. result of this intervening period, the cash price for a commodity would be different home its futures price mentioned in the contract.
There are mainly three participants of derivatives
a) Hedgers
b) Speculators
c) Arbitrages
PARTICIPANTS OF DERIVATIVE: -
HEDGING: -
Hedging Means taking a position in the futures market that is opposite to a position in the physical market with a view to reducing or limiting risk associated with unpredictable changes in prices.
Hedging is a strategy usually adopted by companies who would be using tradable commodities as the raw materials for their products / processes. Hedging strategies could be different for buyers and sellers.
For instance if the Hedger is going to buy a commodity in cash market (because he needs it as a raw material) at a future date, he buys the future contract now and when he actually buys the commodity in the physical market, he squares off the futures contract to reduce or limit the risk of the purchase price.
Similarly if the hedger is planning to sell a commodity in the cash market in future, he instead sells the futures contract for that commodity now and when he actually sells the commodity in the physical market in future, he squares off his futures contract to reduce or limit the risk of the selling price.
Buying Hedge Or Long Hedge: -
` Buying hedge means buying futures contracts to hedge cash Position. Buying hedge is also known as Long Hedge. Strategy of buying hedge is normally used by the Consumers, Dealers, Manufacturers, etc. who have taken or would be taking exposure for that commodity in the physical market.
Buying Hedge is used in following cases:
• To protect against possible rise in the prices of raw materials.
• To replace inventory at a lower prevailing cost and
• To protect uncovered sale of finished products.
Buying Hedge is necessary for the purpose of protecting against increase in prices on the spot market of a commodity~ which has been already sold but not purchased yet. This is a very common practice among the exporters and importers. They would sell commodities at an agreed price for delivery in future. If the commodity is not still in possession and a commitment has been given for sales, the forward delivery is considered as uncovered.
Long hedgers also include traders and processors / manufacturers who have made formal commitments to deliver the specified amount of raw materials or processed / manufactured products at a later date at a price currently agreed upon but do not have the stocks of raw materials necessary to fulfill their commitments for forward deliveries.
Selling Hedge or Short Hedge: -
Selling Hedge is also known as short hedge. Selling hedge means selling futures contract to hedge a cash position. This strategy is usually adopted by users (manufacturers/ fabricators, who need the commodity as raw material), dealers, consumers, etc. who have taken or would be taking an exposure to the commodity in the physical market since they need it for their own consumption or rely on it for their business.
Following are the uses of selling hedge strategy:
• To protect the price of products for which sales commitment has been made.
• To protect the inventory not covered by forward sales.
• To protect prices of estimated production of finished products
Short Hedgers are merchants or processors who build inventories of a commodity by purchasing it in the spot market and who simultaneously sell an equivalent amount (either less or more depending on the anticipated rise or decline in spot prices) in the futures market. Hedgers in this case are said to be long in their spot transactions and short on their futures transactions.
Rolling over the hedge positions: -
If the time required for a hedge position is later than the expiry date of the Futures contracts, the hedger can decide to roll over the position i.e. he can close out the current position in futures contract and simultaneously take a new position in a futures contract with a later date of expiry.
If a person wants to reduce or limit the risks due to fall in prices of the material to be sold after say six moths and if the futures contracts have 'expiry of two months, then he can roll over his short hedge position three times i.e. till the date of physical sale. Every time the hedge position is rolled over, there is a possibility if basis risk but at the same time it limits or reduces the price risk considerably.
ADVANTAGES OF HEDGING: -
a. Hedging reduces or limits the price risk associated with the physical possession of commodity.
b. Hedging is used to protect the price risk of a commodity for long periods by rolling over positions on futures contracts adequately.
c. Hedging makes business planning more flexible without interfering with the regular/ routine business operations of a company.
d. Hedging can facilitate low cost financing.
LIMITATION OF HEDGING: -
a. Due to standardized nature of futures contracts, it is not possible to completely eliminate the price risk associated with the physical commodity.
b. Because of basis risk, hedging may not provide full protection against adverse price movements.
SPECULATION: -
Speculation means anticipating price movement of a commodity and Accordingly making profits by selling and buying a commodity at appropriate / opportune times. Main objective of speculation in commodity futures market is to take risks and profit from anticipated price changes in the futures of that asset / commodity. A speculator will buy futures contracts of a commodity (long position) only if he is anticipating the prices of that commodity and hence its futures to rise in the future. On the other hand a speculator will sell futures contracts (Short position) if he is anticipating that the commodity prices are likely to decline in future.
Long Position In Futures: -
Long position in a commodity futures contract by a person who does not have any intention to take delivery of the commodity or does not have any exposure to the cash market means a speculative transaction. Long position in commodity futures contract for speculative purposes implies that the buyer of the contract is bullish on the commodity i.e. he is expecting that the price of the said commodity would continue to rise before the expiry of the contract so that he/she can profit by squaring off his/her position before the expiry date. If the price of, the commodity futures contract increases before the expiry
The holder of the contract (speculator) would make profit by squaring off the contract before its expiry. If the prices of the futures contract decline, the speculator stands to incur loss on squaring off the contract.
Short Position in Futures: -
Short Position in a commodity futures contract by a person who does not have any intention to give delivery of the commodity or does not have any exposure to the cash market means a speculative transaction. Short position in commodity futures contract for speculative purposes implies that the buyer of the contract is bearish on the commodity i.e. he is expecting that the price of the said commodity would continue to decline before the expiry of -the contract so that he / she can profit by squaring off his/her position before the expiry date.
It the price of the commodity futures contract declines before the expiry date, the holder of the contract (speculator) would make profit by squaring off the contract before its expiry. If the prices of the futures contract increase, the speculator stands to incur loss on squaring off the contract.
The Role Of Speculation In Futures Markets:-
One of the prominent concerns about the functioning of the commodity futures Markets and its impact on common man / masses is speculation. Speculation provides the depth and flow that is key to the functioning of a futures market. There will be very high liquidity in the futures market if firms after entering a trade to buy or sell have lo wait till a suitable bid or offer arose since the availability of commodities in physical may not always necessarily match with the firm's decision lo buy or sell commodities.
There is also misconceptions fife about speculation being similar to gambling. Although the intention of both the speculators and gamblers is to profit by taking risks, the gambler creates risk where none exists, the speculator on the other hand takes risk that is already prevalent in the market and as a result plays an economically significant role. A proper’ and accurate assessment and
interpretation of the fundamental factors that drive the market forces determines the extent of success in speculating in the futures markets while in gambling it is only a matter of chance, in fact, the important function of price discovery in the futures markets is a direct outcome of the exercise of information gathering in the underlying commodities being done by the speculators.
Speculation is also not similar to manipulation. A manipulator tries to push prices in the reverse direction of the market equilibrium while the speculator forecasts the movement in prices and this effort would eventually bring the prices closer to the market equilibrium. If the f futures markets do not adhere lo the relevant risk management requirements of growers, manufacturers, traders and processors, they would not survive since their correlation with the underlying physical market would be nonexistent.
ARBITRAGE
Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relationship between spot prices and futures prices in terms of basis or between prices of two futures contracts in terms of spread changes, it gives rise to arbitrage opportunities. Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage.
The futures price must be equal to the spot price plus cost of carrying the commodity to the futures delivery date else arbitrage opportunity arises.
Mathematically it can be expressed as
F (o, n) = So (1 +C).
F (o, n) = Futures price of the commodity at t = o for expiry at t = n
So = Spot price of the commodity at t = o
C = Cost of carry from t = o (present) to t = n (expiry date of futures) expressed as a percentage of the spot price
INTRODUCTION: -
An option is the right to buy or sell a particular commodity or a currency or an asset for a limited period at a predetermined price. An option contract gives the buyer (holder) of the option the right to perform under the contract or do nothing as it pleases him. It means that the buyer of the option contract has a right or privilege of one-way bet. Thus, the basic fact about an option is that it is a one-way bet. However this privilege of one-way bet comes with a cost to the buyer of the option. That cost is termed as premium. You pay a price (premium) and buy an option. The premium has to be paid to the seller (writer) of the option, up-front i.e. at the time of entering into option contract. Options are derivative products.
“Options are contracts under which the buyer of option contract has a right without obligation to perform under the contract for payment of a price, called premium. Option contracts provide a right or privilege to buy or sell some thing, say a commodity, at a predetermined price over the contract period. The right or privilege is available to the option buyer only upto the expiry dates of contract.”
COMMODITY OPTION: -
Commodity options are options with a commodity as the underlying. For instance, a gold options contract would give the holder i.e. the buyer of option, the right to buy or sell a specified quantity of gold at the price specified in the contract irrespective of the price ruling in the market at the time of exercising the option.
Option markets are very divers and they have their own jargons. As such understanding of options requires a grasp of institutional details and terminology employed in option markets
There are two basic types of options known as call options and put options.
• Call option: A call option gives the buyer (holder) the right but not the obligation to buy an asset by a certain Rate for a certain price.
• Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
Value of Call and Put Options: -
The value of a call option generally increases as the current spot price of the commodity, the time to expiration of the contract and the volatility increases. Conversely, the value of a call option decreases as the strike price increases and time to expiration and volatility of market price decreases.
The value of a put option generally increases as the strike price, time to expiration and the volatility of the commodity price increases. The value of a put option decreases as the current market price increases and the time to expiration and volatility of the commodity price decreases.
OPTIONS & THEIR UTILISATION: -
Option contracts are a useful technique when the buyer or holder of option desires to limit his downside risk (loss) while keeping the upside gain open to unlimited level. Under all cases, the maximum loss for option holders will be limited to the extent of option premium. This happens when the holder does not deal at the strike price with the option writer since he may find the ruling spot price in the market is more favorable or advantageous to him.
However at the same time his upside gain may be enormous depending upon the price movements. Of course, this price movement makes his strike price more favorable as compared to market price. Thus a long call at the strike price of Rs.2000 per quintal may lead to huge profit, if market price keeps on rising beyond the strike price enabling the option buyer to buy the commodity from the option writer at the strike price. We must remember that the option buyer's opportunity to make profit under the circumstances is limited to the extent of contracts bought. Thus unlike forward contracts, option contracts provide opportunity to limit losses or make gains.
OPTIONS MARKET: -
Options are now traded on many exchanges throughout the world. Option contracts are available on commodities, currencies, stocks, metals, oil etc. Until 1973, it was possible to buy an option, but it was not really possible to trade it. Exchange traded options were first introduced in 1973 on stocks by the Chicago Board Options Exchange (CBOE). The single most important innovation of CBOE was to set up standard option prices and standard expiration dates. '
The Chicago Board Options Exchange was followed by many of the American Stock exchanges, such as Philadelphia Stock Exchange, Pacific Stock Exchange. Today option contracts are traded in London International Financial Futures Exchange (IIFFE), Singapore International Monetary Exchange (SIMEX), Chicago Board of Trade CBOT) and many other exchanges. In India, currently stock options are traded in Stock Exchanges. Currency options are written by banks as the over-the-counter (OTC) product but exchange traded options on commodities are not available in India. However it is a matter of time, huge exchange traded options on commodities are introduced in commodity exchanges like Multi Commodity Exchange.
INTRODUCTION: -
Significantly developing countries are producers and exporters of most of the commodities globally traded. This is applicable to various products such as agricultural produce, metals, oils etc. lack of demand for such products from the developed world affects the export earnings as well as terms of trade of the producer (developing) countries. In fact, commodity prices had been in a long bear market phase during 1980s and 1990s. Thank to improved manufacturing and economic activities notably in Asia, particularly in countries like china and India and in the United States there is a growing demand for raw material in the global market. Today global growth comes from four important developing countries viz. China, India, Brazil and Russia.
INVESTMENT OPPORTUNITIES: -
The stock market witnessed strong growth during 1980s till the market crashed, first in New York, on October 19, 1987 (Black Monday). Indian stock markets also witnessed scams and large rise and fall in prices occasionally leading to sudden and big wealth accumulation and destruction. These price changes were essentially acts of rampant speculation from few market players who have large chunk of funds to move the market on either side. Such downslide in stock markets provided alternative investment opportunities in commodity markets.
Markets in developing countries provide an excellent opportunity for all types of investors since most of the commodities trade globally are produced and exported from developing countries. India is no exception to this rule, since a variety of commodities ranging in agricultural category and commodities like iron (steel), copper, aluminum, gold, silver in the category of metals, and petroleum products in the category of oil are traded in the Indian markets. Hence trading in commodity exchanges offer equal opportunity and benefit for investors and traders in commodity exchanges is the first hand knowledge about the products, their sources of demand and supply etc. which primarily influence price movements in the commodity markets as against unbridled speculation in stock markets.
COMMODITIES & ECONOMIC EXPANSION: -
Economic expansion led to a rapid demand for many commodities particularly for petroleum, metal and other rnineral resources and agricultural commodities. Further rising population in 1960s and later, increased the demand for commodities. Although the population was rising in many developing countries, improved technology, extensive and intensive method of collation increased agricultural production and other commodities more than the rise in population. New countries also emerged as new producers. The net result was that the stock of commodities was piling up and commodity prices started falling relative to the prices of other goods, particularly that of manufactured goods. This led to adverse terms of trade for the producers and exporters of commodities during 1970s and 1980s. Buffer stocks were used by organizations to stabilize prices. Countries had entered into commodity agreements to ensure fair price realizations, but most of the agreements failed and prices were destabilized.
CURRENT SCENARIO: -
The high scale production going on in China due to cheap labor and manufacturing facilities have suddenly brought the commodities alive. Today the word "commodity" is the new buzzword in the global market as well as in India. At the same time all Asian countries are experiencing high growth, increasing trade volumes and rising prices income fetidities. During 1980s & 1990s, commodities were traded at all time low prices. Today, gold prices are shooting up. Metals like copper, nickel, and aluminum are trading @t all time high. Crude oil price was at all time high at $67 per barrel in mid-August, 2005.
The commodity price index is continuously rising which reflects the rising consumer demand and money spent on commodities. The rising commodity prices are driving the commodity companies. Turning to capital markets for their funding requirements. The current commodity prices also provided excellent trading opportunities for large investors like hedge funds and pension fun4s besides small investors like retail investors looking for investments linked to commodities.
Additionally demand is certainly encouraging supply. Global capital market players estimate that institutional funds tracking commodity indices worldwide had gone up four times between 2000 and 2004 from $ 10 billion to $ 40 billion. Similarly U.S. mutual funds exposure to commodities has reportedly gone up from $ 300 million in 2002 to a level of more than $ 7 billion in early 2005. Thus investors are looking for extra and alternative return in commodities markets to compensate for the poor bond market return and to certain extent the not so high equity market return. Many commodity prices are running all time high in the global market. The best example for this is the price of oil, steel and gold. However investors prefer investment in commodities rather than investment in the equity of relative companies.
This awareness of investment opportunities in commodity markets has entered in to the Indian soil. Commodity Exchanges, at national level, have suddenly come up one after another. Their volume is growing at a pace faster than the growth witnessed in equity markets in 1980s and 1990s. Everybody is now more aware of commodities because the oil price is regularly on the front pages of economic newspapers. Talk of oil price and assessment of performance of oil companies are the daily discussions in print and electronic media.
This has both a positive and negative impact-on the Indian economy. While India may benefit from increased commodity prices, which it exports, the increase in oil prices - its major import item, affects its growth adversely. In the global investment market, currently commodity market is the most attractive asset market for investment.
Money In Commodity Markets & its peculiarity:
Marc Faber, an Investment Expert and business cycle analyst predicts that the next big profit will be in hard assets and not in financial assets. The hard asset he referred to was that of commodity markets. Investors however have to find out which commodities will boom and which will not. One has to be selective in choosing the commodity. Investors will have to study individual markets and buy sell commodities accordingly. This will be a different ball game for investors. It is a different kind of research as compared to stock markets. The reason, there are no balance sheets to read, no quarterly or half yearly results for comparison, no announcement for future growth or dividend Policy to keep tract of events and prices. Yet commodity markets provide Huge investment opportunity for investors and speculators.
FINDINGS
Majority of commodities traded on commodity exchanges world over are agro based. Commodity Markets therefore are of great importance and hold great potential in case of Agrarian Economies like India where the agriculture sector contributes 22% to the country's GDP and employs 70% of the working population.
There is a huge domestic market for commodities in India since India consumes a major portion of its agro production locally. However our exports of agro-products are very insignificant. Indian commodities market therefore has excellent growth potential and has created good opportunities for market players. The following salient features of the Indian economy / commodity markets and their related aspects would adequate to stress the relevance of commodity markets and the great potential that they offer for future development in India:
a. India is the world's leading producer of 17 agricultural commodities and is also the world's largest consumer of edible oils and gold,
b. India has 30 major markets and nearly 7,000 Mandies with substantial arrivals of a variety of commodities,
c. Over 27,000 haats (rural bazaars) exist in the country with seasonal arrivals of various commodities,
d. Nearly 5 million traders are engaged in commodity trading in India,
e. Commodities related and dependent industries constitute approximately 58 per cent of country's GDP of Rs 1,320,700 corers,
f. State and Central Governments have invested substantial resources to boost production of agricultural commodities. Many of these would be traded on the futures markets as food processing increases from the current level of 2% to 40-50% comparable to other countries,
g. There are three national level Commodity Exchanges that trade in approximately 100 commodities at present and the list continues to expand,
h. Indian spot market for commodities such as bullion, metals, agriculture produce and energy is estimated at approximately Rs 11,00,000 corers annually. According to the experts ins the field, global trends indicate that the volume in futures trading tend to be 5-7 times the size of commodities' spot trading in the country (Internationally, the multiple for physical versus derivatives is much higher at 15 to 20 times). This implies that the potential for futures trading market in India currently stands at staggering Rs. 55,00,000 corers to Rs. 77,00,000 corer annually.
i. Three nationwide electronic exchanges and 22 recognized regional or small commodity exchanges in India had an estimated total combined turnover of Rs 569277.92 corer in the first quarter of current financial year (April-August 2005).
j. Many nationalized and private sector banks have announced plans to disburse substantial amounts to finance commodity-trading business. (Private sector giant viz. HDFC Bank alone is planning to disburse over Rs 1,000 corer for financing agriculture commodities in 2005-06).
k. The Government of India has initiated several measures to stimulate active trading interest in commodities. Some of these measures are:
- Lifting the ban on futures trading in commodities;
- Approving new exchanges;
- Developing exchanges with modern infrastructure and systems such as online trading
- Removing legal hurdles to attract more participants.
As a result of the above developments, both the spot and futures markets in India are witnessing rapid growth. The trading volumes are increasing as the list of commodities traded on national commodity exchanges also continues to expand. The volumes are likely to surge further as a result of the increased interest from the international players in the Indian commodity markets. If these international players are allowed to participate in commodity markets (like in case of capital markets), the growth in commodity futures can be expected to be phenomenal.
The commodity markets are normally ten times bigger than stock markets all over the world. There is no reason why similar proportions would not exist in India in the next five to ten years.
“Potential of commodity market in India is very high thus Commodity trading and commodity financing are going to be a rapidly growing business in coming years in India”.
BIBLIOGRAPHY
Books Referred:
1. NCFM Commodity Dealer Module – NSE India
2. Diploma In Commodities trading (DITC)
- By Welingkar Institute Of Management Development & Research
Internet Websites:
• http://www.karvycomtrade.com
• http://www.mcx.com
• http://www.ncdex.com
• http://www.commoditiescontrol.com
Rapid economic growth in recent years with more than 6 per cent GDP growth rate has made India one of the fastest growing economies of the world. With higher incomes giving significant purchasing power to over a billion strong population, demand for all kinds of goods and services is set to grow rapidly.
With liberalisation measures in place, commodity markets in India are likely to make an overwhelming impact on the global commodity markets. Indian Corporate entities are now in a position to hedge their price risks in the domestic and international commodity exchanges. Online trading at the three nationwide multi-commodity futures exchanges allows domestic hedging, while some of the established commodity-specific, exchanges are gearing up to meet the needs of the expanding market. There is no doubt that the commodities market in India is definitely in for a big spent offering enormous opportunities of growth to investors, speculators, arbitragers and even big corporations in manufacturing sector.
MARKET: -
Markets have existed for centuries in India and abroad for selling and buying of goods and services. The concept of market started with agricultural products and hence it is as old as the agro products or the business of farming itself. Traditionally, the farmers used to bring their produce to a central place (called Mandi\Bazar) in a town\village where grain merchants\traders would also come and buy the produce and transport, distribute it to other markets.
In a traditional market, agriculture produce would be brought and kept in the market and the potential buyers would come and see the quality of the produce and negotiate with the farmers directly for a price that they would be willing to pay and the quantity that they would like to buy. The deals were then struck once mutual agreement was reached on the price and the quantity to be bought / sold.
In the system of traditional markets, shortages of a commodity in a given season would lead to increase in price for the commodity or oversupply on even a single day (due to heavy arrivals) could result into decline in prices sometimes below the cost of production to the farmers. Neither the farmers nor the food grain merchants were happy with this situation since they could predict what the prices
would be on a given: ay or in a given season. As a result many times me farmers were required to return from the market with their produce since it did not fetch reasonable price and since there were no storage facilities available near the market place. It was in this context that farmers and food grain merchants in negotiating for future supplies of grains in exchange of cash at a agreeable price. This type of agreement was acceptable to both parties since the farmer would know how much he would be paid for his produce, and the dealer would know his cost of procurement in advance. This effectively started the system of commodity market, forward contracts, which subsequently evolved to futures market
COMMODITY: -
“A commodity is a product having commercial value, which can be produced, bought, sold and consumed. Commodities are basically the products of primary sector of an economy. Primary sector of an economy is that part of the economy, which is concerned with agriculture and extraction of raw material.”
In order to qualify as a commodity, an article or a product has to meet some basic characteristics. These are listed below:
a. The product has not gone through any complicated manufacturing activity, though simple processing (like mining, cropping, etc.) is not ruled out. In other words, the product must be in a basic, raw, unprocessed state. (For instance wheat is a commodity; but wheat flour and bread are not commodities). There are of course some exceptions to this rule e.g. in case of metals and products like sugar.
b. Major consideration while buying a particular commodity is its price (since there is hardly any difference in quality from seller to seller)
c. The product has to be fairly standardized in the sense that there cannot such differentiation in a product based on its quality (e.g. Rice is rice though different varieties of rice can be treated as different commodities and hence traded as separate contracts).
d. Prices of the product are determined by market forces, demand 'and supply and they undergo rapid changes / fluctuations (price must fluctuate enough to create uncertainty, which means both risk and potential profit / loss for buyers and sellers)
e. Usually there would be many competing sellers of the product in the market.
f. The product should have adequate shelf life so that delivery of a futures contract can be deferred.
COMMODITY MARKET: -
Market is a place where buyers and sellers meet to transact a business i.e. for exchange of goods or services for a consideration, which is usually money. Markets are usually and traditionally at a place or location, where buyers and sellers could meet. However, in modern world, buyers and sellers on telephone lines or on Internet can transact the business. Hence, in today's world markets need not Exist in physical form as long as the exchange of goods or services take place for a consideration.
Commodity market is therefore logically a market where commodities or commodity derivatives are bought or sold for a consideration. It is thus an important constituent of the financial system for any country.
Existence of a vibrant, active and liquid commodity market is normally considered as a healthy sign of development of any economy. Commodity markets quite often have their centers in developed countries though the primary commodities in many cases are produced in developing countries. Birth and growth of transparent commodity market is thus a sign of development of an economy. This has particular significance in case of countries like India, which produce agri-products as well as a number of other basic commodities, which are traded on commodity exchanges world over.
Commodity futures in particular help price discovery and assist investors in hedging their risks by taking positions in commodities and exploiting arbitrage opportunities in the market.
CONSTITUENTS OF COMMODITY MARKET
The system includes following elements:
a. Buyers / Sellers / Users / Producers: Farmers, Farmer' Cooperatives, Metal (Precious & other) producers / suppliers / stockiest, APMC Mandies, Traders, Brokers, Members of Commodity Exchanges, State Civil Supply Corporations, Hedgers, Speculators and arbitragers (these could include corporate houses, FMCG Companies, etc.)
b. Logistics Companies: Storage and Transport Companies/ Operator Quality Testing and Certifying Companies, Valuers, etc.
c. Markets and Exchanges: Spot Markets (Mandies, Bazars, etc.) and Commodity Exchanges (National Level and Regional level),
d. Support agencies: Depositories / De-materializing agencies, Central and State Warehousing Corporation and Private sector warehousing companies.
e. Lending Agencies: Banks, Financial Institutions.
FUNCTIONING OF COMMODITY MARKET IN INDIA: -
There are three types of regulated markets in India:
• Spot Markets: Direct purchases for immediate consumption.
• Futures and Forward Markets: Agreements new to pay and received deliver later.
Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered in the future.
• Derivatives Market is Purely financial transactions based on physical trading.
The system includes following elements:
• Hedgers, Speculators, Investors, Arbitragers
• Producers - Farmers
• Consumers, refiners, food processing companies, jewelers, textile mills, exporters & importers.
The biggest benefits of commodity trading will accrue to commodity traders, farmers and companies dealing in commodity-based products (like wheat and metals) by allowing them to hedge their risks. Then there are speculators, who are in the game only to make money out of the volatility in prices. But unlike in stocks, few retail investors are expected to trade in commodity futures since it
requires a fair bit of expertise. Even those who do will probably restrict themselves to trading in gold or silver.
OVER THE COUNTER\SPOT MARKET: -
Direct purchases and sales are achieved in spot markets normally for immediate consumption. Buyers and sellers meet ‘‘face-to-face" and deals are struck. This is akin to "over the counter (OTC)" market where there is no need for organization like a commodity change. These are traditional markets c1assic example of a spot market is a Mandi where food grains are sold in bulk. Farmers would bring their produce to this market and food grain merchants/traders would purchase the produce "on the spot" and settle the deal in Spot markets thus call for immediate delivery of goods/services against actual payment.
BENEFITS OF TRADING IN COMMODITY: -
A future trading performs two important functions of price discovery and price risk management with reference to the given commodity. It is therefore useful to all the segments of the economy and particularly to all the constituents of the Commodity Market System.
Benefits to Consumer & user: -
a It is useful for the consumer because he gets an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. Predictable pricing & transparency is an added advantage.
b. Hedging their risks if they are using some of the commodities as their raw materials in particular can benefit corporate entities. They can hedge the risk even if the commodity traded does not meet their requirements of exact quality / technical specifications.
c. 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
Benefits to Investors: -
a. High financial leverage is possible in commodity markets. In case of stocks, an investor needs to put up the full amount of the stock value to buy the stock. With commodities, you control commodity futures contracts with a margin, which is usually between 5% to 10% of the value of the commodity. Investor can effectively hedge the risk in price fluctuations of a commodity.
b. Investor can also hedge his risk on investments in stocks and debt markets since commodities provide a choice and provide one more alternative avenue in the investment port for. It may be mentioned here that the Commodities are less volatile compared to equity market, though more volatile as compared to G-Sec's
c. Commodity markets are extremely transparent in the sense that the manipulation of prices of a commodity is extremely difficult. Given the knowledge of the commodity, the investor can be thus clear about what he can expect in foreseeable future.
d. Business involves just you and the market.
e. With the rapid spread of derivatives trading in commodities, this route too has become an option for high net worth and savvy investors to consider in their overall asset allocation.
f. The fact that the stock indices and commodity indices are not correlated implies that the commodity markets can be used as an effective diversification tool, where investors can park their money.
g. A look at the performance of the commodities markets during the last year shows that the positive movement was witnessed during most parts of the year.
Benefits to Producers: -
a It is useful to the producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him.
Farmers for instance, can get assured prices, decide on the crop that they want to take and since there is transparency in prices, he can decide when and where to sell.
Benefits to the Economy: -
As the constituents of the commodity market system get benefited Indian economy in turn is also expected to gain a Lot. Growth in the commodity markets implies that there could be tremendous benefits to the Indian economy in terms of business generation and employment opportunities.
General benefits & other advantages for all players: -
a Improved Product Quality: Since the contracts for commodities are standardized, it becomes essential for the producers / sellers to ensure that the quality of the commodity is as specified in the contract.
b. Credit Accessibility: Buyers and sellers can avail of the bank finances for trading in commodities. As mentioned here, some nationalized banks as also some banks in the private sector have come forward to offer credit facilities for commodity trading. More and more banks are likely to fall in line looking at the huge potential that commodity market offers in India. Commodities are less volatile compared to equity market, but more volatile as compared to government securities.
OBJECTIVES
Following are the objectives of project: -
1. To understand the fundamentals of commodity market.
2. To understand the need of evaluation of commodity markets in the world.
3. Getting knowledge of current Scenario of commodity market over the entire world.
4. Getting knowledge of functioning of commodity markets through exchanges.
5. To find out the area of economic growth contributed by commodity markets.
SCOPE OF COMMODITY MARKET: -
Investment in commodity markets has been very popular and rewarding for investors in U.K. and U.S.A. For investors looking for diversification beyond stock markets, commodity markets offer another investment option. The commodity markets activity, volume and players multiplied in the recent past. In India, although the trading in commodity markets and commodity exchanges is booming, it has to cross few more hurdles like permitting Fills, banks and other financial institutions to operate in these markets. The reason why investors may look for opportunities in commodity markets may take us to the basic tenets of risk and return theory viz. expected return and risk. Normally it is a risk - reward relationship. The higher the risk higher is the expected return and vice versa.
LIMITATION OF COMMODITY MARKET: -
Commodity markets, like any other markets, have their own limitations too. Some of them are:
Commodity market prices can fluctuate wildly depending on the factors, which are sometimes beyond human control (floods, storms, natural calamities like earthquakes, etc. can create temporary shortages of commodities and hence result in drastic changes in their prices in a very short time).
Forward / futures trading involve a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc.
Hence, it is necessary that the investors/players in the commodity markets understand the functioning of commodity markets, mechanism of commodity Exchanges properly and study the factors that can affect the commodity prices carefully.
“Methodology can be considered as the backbone of any project work.” Methodology refers to the scientific methods used in the project for the purpose of investigation and research.
This project is to analyze the future prospects of commodity market as the Indian Commodity markets and futures trading in the commodity exchanges have great potential to develop as one of the fastest growing centers in the world. India belong an agrarian economy can definitely bolster its commodity trading volumes. Similarly India is also a large producer in various commodities and metals. If we consider consumption aspects of certain commodities, India again will figure as one of the largest consumers of such products. Being one of world's largest agrarian economies, commodities contribution (agricultural produce and other commodities) to the Indian economy said to account for about 50% to India's GDP.
Thus one can visualize the potential of Indian commodity exchanges to become a global hub for futures trading with the expected turnover of this segment outgrowing the stock market within a few years to come.
It is a Conceptual Research fully based on abstract ideas, concepts or theory. It results in the development of new concepts or reinterpretation of existing one.
TOOLS OF DATA COLLECTION
PRIMARY DATA: -
“Data collected for very first time for analysis is primary data.”
Since the primary data is not required in this project it is not collected.
SECONDARY DATA: -
“Data that already exists is known as secondary data.”
It provides a starting point for the project and offers the advantages of low cost and ready availability.
The secondary data is collected from various books like NCFM Commodity Dealer Module – NSE India and Diploma In Commodities trading (DITC) - By Welingkar Institute Of Management Development & Research.
And for getting knowledge of current Scenario of commodity market over the entire world and in India different sites are used like
• http://www.karvycomtrade.com
• http://www.mcx.com
• http://www.ncdex.com
• http://www.commoditiescontrol.com
GLOBAL COMMODITY MARKET
Today commodity markets are situated throughout the world. In many cases, the markets deal in specialized commodities. Notable among them are, Chicago Board of Trade in U.S.A., London Commodity Exchange in U.K., Sydney Futures Exchange in Australia, Tokyo Commodity Exchange in Japan and Singapore International Monetary Futures Exchange in Singapore.
In India we have a number of small / regional exchanges for trading in different commodities and at national level we have three commodity exchanges. The commodities are traded both in cash market and in futures markets. It is the futures markets that take lead in commodity trading as compared to cash markets.
COMMODITY FUTURES:
The first recorded instance of futures trading occurred in rice in Japan and China some 6,000 years ago. In the United States, futures trading started in the grain markets in the middle of the nineteenth Century. Major development in forward trading in commodities work place in middle of eighteenth century in Chicago in United States.
CHICAGO AND COMMODITY TRADING:
In the 1840s, Chicago had become a commercial center since it had good railroad and telegraph lines connecting it with the East. Around this same time, good agriculture technologies were developed in the area, which led to higher wheat- production. Midwest farmers therefore used to come to Chicago to sell their wheat to dealers who, in turn, used to ship it all over the country. The farmers would bring their wheat to Chicago hoping to sell it at a good price. The city had very limited storage facilities and hence, the farmers were often left at the mercy of the dealers. The situation changed for the better when in 1848 a central place was opened where farmers and dealers could meet to deal in “spot” grain – that is, to exchange cash for immediate delivery of wheat.
Farmers (sellers) and food merchants\dealers (buyers) slowly started entering into contract for future exchanges of grain for cash so that farmers could avoid taking the trouble of transporting\storing wheat (at very high costs), if the price was not acceptable. This system was suitable to farmers as well as the dealers. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs of procurement well in advance.
Such (forward) contracts became common and were even used as collateral for bank loans subsequently. The contracts slowly got “Standardized” on quantity and quality of wheat being traded. They also began to change hands before the delivery date. If the dealer decided he didn’t want the wheat~ he would
sell the contract to someone who needed it. On other side if the fan-her who didn’t want to deliver his wheat could also pass on his obligation on to another farmer. The price of the contract would go up and down depending on what was happening in the wheat market. If bad weather had come, supply of wheat would be less and the people who had contracted to sell wheat would hold on to more valuable contracts expecting to fetch better price; if the harvest were bigger than expected, the seller’s contract would become less valuable since the supply of wheat would be aplenty.
Slowly, even those individuals who had no intention of ever buying or selling wheat began trading in these contracts expecting to make some profits based on their knowledge of the situation in the market for wheat. They were called peculators. They hoped to buy contracts at low price and sell them at high price• or sell the contracts in advance for high price and buy later at a low price. This is how the futures market in commodities developed in United States.
Futures industry has changed a great deal over the last 20 year including usage of term futures itself. The industry was never referred to as futures” but rather “commodity”. Until 1970s the agricultural markets dominated the industry, and the trading was known as “commodity trading”. Today these markets are known as the futures market or are referred to as the new commodity futures market.
FINANCIAL FUTURE:
The biggest increase in futures trading activity occurred in the 1970s when futures on financial instruments started trading in Chicago. Currency futures began trading in the International Money Market (IMM) of the Chicago Mercantile Exchange in 1972. Since then many other futures markets have opened up such as London International Financial Futures Exchange (LIFFE).
Currencies such as the Swiss Franc and the Japanese Yen were the earliest currencies to be traded in currency futures market. The other financial assets traded in the exchanges include, stock indices, futures and options in interest rate instruments such as United States Treasury Bonds and T-Bills. In the 1980s futures began trading on stock market indices such as the S&P 500.
INDIAN COMMODITY MARKET
History of trading in commodities in India is quite old. Even Kautilya's 'Arthashastra' makes a mention of commodity markets in India, which dates back to Maurya dynasty.
In India there used to be a class called "Mahajans" who performed important role in trade and banking. They had social influence and were able to enforce integrity and honesty in trade and used to settle matters of dispute. The system continued till middle of nineteenth century.
EVALUTION OF ORGANISED FUTURE TRADING:
The history of futures trading in commodities in India is almost as old as that in the US. It has, however, passed through a turbulent past. India's first organized futures market was the Bombay Cotton Trade Association Ltd., which was set up in 1875. Futures trading in oilseeds started with the setting up of Gujarati Vyapari Mandali in 1900. Gold futures trading began in Mumbai in 1920. During the first half of the 20th century, there were several commodity futures exchange trading in jute, pepper, turmeric, potatoes, sugar, etc
India's history of commodity futures has been however turbulent. This is evident from the following historical developments:
• Trading in forwards and futures became difficult as a result of price controls by the Government in mid 1940s.
• Options were banned in cotton in 1939 by the Govt. of Bombay to curb widespread speculation.
• The Forward Contract Regulation Act was passed in 1952. This put restrictions on futures trading.
• During 1960s and 70s, Govt. of India suspended trading in several commodities like jute, edible oil seeds, cotton, etc. since the Govt. felt that futures markets were causing excessive increase in prices of commodities.
• Govt. offered to buy agricultural produce at Minimum Support Price (MSP), had virtual monopoly on storage\transportation\ distribution of agriculture produce along with ban on futures and options trading. All these weakened the agro commodity markets in the country.
The Government appointed four main committees (Shorff Commodity in 1950, Datwala Committee in 1966, Khusro Committee in 1980 and Kabra Committee in 1994) to go into the details of Forward and Futures Trading perspectives in Indian context.
It was Kabra Committee, which really assessed the scope for forwards and futures trading in commodities and recommended steps to vitalize the futures trading in India, which was then at the initial stages of its liberalization of economy.
The Kabra Committee made significant contribution to the cause of commodity trading in the country and is in a way responsible for today's modern system of commodity trading with three national level and 22 other commodity exchanges / associations in operation. The recommendations of this Committee finally led to the development of futures trading in India with the establishment of
National level Commodity Exchange (NCDEX)
Multinational Commodity Exchange (MCX)
National & Multinational Commodity Exchange (NMCE)
With this introduction to commodity markets, it is essential to understand how the entire Commodity Market System works and what are its constituents. Commodity Market System comprises several elements. These are shown in the following figure
INDIAN COMMODITY MARKET STRUCTURE
INDIA’S SHARE IN GLOBAL COMMODITY MARKETS: -
At present, India's share in the global commodity markets - both agricultural and industrial, especially of energy products and base metals - is not big enough to make a major impact on international prices (bullion being an exceptional case). India currently accounts for only around 3 per cent of the global oil demand and 2 per cent of the global copper demand. In comparison, China accounts for 8 per cent and for oil and as high as 22 per cent of the global demand
However, in the gold market, bout 20 per cent of the world demand and remains a key buying support on price corrections. In case of agricultural commodities, India’s production base is large, but international trade volumes are still rather
India is the world's largest producer of World’s second largest producer of rice and wheat after China aid the world 3 third largest producer of cotton after China and the US; though foreign trace (export and import) in these commodities is rather limited. However, in getable oil, India is the world's largest importer (with 4.5-5.0 million tones annually), as is the case with pulses (close to 2 million tones) also.
Despite a modest share in the industrial products market, the prospects for growth for the industrial commodities in India are considerable. Despite a slowdown in industrial production at times overall the domestic economy in India continues to grow while imports and growth in demand for corporate borrowing also indicate a positive outlook.
In addition, large infrastructure works are being undertaken across the country, covering rail, road, energy and sports. The outgoing Golden Quadrilateral project is an excellent example of road connective to the four corners of the country. Port modernization and involvement of the private sector in infrastructure development are likely to be the key growth drivers.
A sectoral study of India conducted by consultants McKinsey had suggested that global steel consumption would increase to around 80-100 million tones by 2015, up from 33 million tones in 2003. due to robust demand growth from infrastructure, construction, manufacture and automotive sectors mainly in India and China.
All these factors point out a very encouraging outlook for the growth of Indian commodity markets.
NEED TO REGULATE FUTURE MARKET: -
The fact that the benefits of futures markets accrue only in true and fair competitive conditions and transparency of operations, the regulation is needed to create such competitive conditions. Many times, unscrupulous participants are in a position to use leveraged commodity contracts for manipulating prices if there were no regulations. This in turn can have undesirable influence on the spot prices; there is an affecting interest of common man or society at large.
In the absence of such a system, a player in the commodity market could default which in turn could lead to a chain reaction and financial crisis in a futures market in general and in a commodity exchange in particular.
Regulations are also necessary to ensure transparency and fairness in the entire system including trading, clearing, settlement operations and management of the exchange. This is useful in protecting and promoting the interest of various stakeholders, particularly non-member users of the market and retail investors or "common man".
PRESENT SYSTEM: -
At present, there are three tiers of regulations of forward & futures trading system in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges. The Commodity Exchanges in India are governed and regulated under the Forward Contracts (Regulation) Act, 1952 and the rules framed there in.
The FC(R) Act, 1952 prohibits options in commodities. It is reported that the Government is actively considering removal of this restriction and allow options to be traded on registered national commodity exchanges (to start with) and other Associations. It is learnt that the decision in this regard will be announced in January 2006. For the purpose of forward contracts in certain commodities, forward trading can be allowed by notifying those commodities U/S 15 of the Act; notifying these commodities u/s 17 of the Act can prohibit forward trading in certain other commodities.
The Forward Markets Commission was set up in 1953 under the Ministry of Consumer affairs, Food and Public Distribution under the Forward Contracts (Regulation) Act, 1952. It is the regulating authority for all Commodity Futures Exchanges in India. It is responsible for regulating and promoting futures/ forward trade in commodities. The Forward Markets Commission-is located in Mumbai with a regional office in Kolkata.
The FC(R) Act, 1952 provides that the FMC shall consist of at least two but not more than four members appointed by the Central Government. A person nominated by the Central Government is also to be the Chairman of the FMC.
Legal and Regulatory provisions for customer protection:
a) In any country or markets, it is extremely necessary to make regulatory provisions so that the customer is protected adequately from frauds/manipulation by large investors/traders"
b) The F.C.(R) Act provides that the member of the Exchange cannot appropriate client’s position, except when a written consent is taken within three days' time.
c) It has asked many commodity Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. This ensures free and fair-trading with complete transparency.
d) It has also recommended simultaneous reporting system for the Exchanges following open out-cry system.
FUNCTIONS: -
a) FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association.
b) It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assigned to it.
c) It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submits to the Government periodical reports on the operations of the Act and working of forward markets in commodities.
d) It makes recommendations for improving the organization and working of forward markets.
e) It undertakes inspection of books of accounts and other documents of recognized/registered Associations.
f) FMC performs such other duties and exercise such other powers as may be assigned to it by or under the Forward Contracts (Regulation) Act, 1952 or as may be prescribed by the Government of India.
INTRODUCTION: -
A derivative can be defined as “ a financial instrument/ contract, which derives its value from the underlying asset (i.e. the asset mentioned in the contract). The underlying asset could be (quite often the price of traded assets) equity, commodity, currency/foreign exchange or real estate or any other asset. Depending on what the underlying asset is, the derivative could be named differently.
Thus a commodity derivative is “a contract to either sell or buy a commodity at a certain time in future at a price agreed upon at the time of entering into such a contract.”
Derivatives are used both in financial and commodity markets. The numbers of derivative products used in financial markets are more diverse than those in commodity markets. However, major derivative products in the commodity markets are basically future, options and options on futures.
Derivatives have now assumed great importance in the world of finance. Different types of derivative have been developed and actively traded on not only stock exchange but also on commodity exchange and “over the counter” markets. Futures contracts are now traded very actively all over the world.
Derivative contents have several variants .The most common variants of commodity are, FORWARDS, FUTURES & OPTIONS
FORWARD MARKETS: -
Forward markets are markets where delivery takes place some time in the future, unlike spot markets that call for immediate delivery. These advance sales help both buyers and sellers who can then resort to long term planning.
A forward contract is one of the simplest forms of derivatives. It is an agreement to buy or sell an asset (commodity) at a certain time in future for a certain price mentioned in the contract. It is different from the ‘spot contract’, which is an agreement to buy or sell the asset ‘on the spot, i.e. today/immediately.
A forward contract is usually traded in over the counter (OTC) mode. The forward contract can be between a manufacturer of a product (who want to hedge his risk lest the price rises in future) and a producer/supplier of raw material (who wants to hedge his risk by ensuring minimum price lest the price declines in future) used by it.
Under forward contracts (regulation) act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contract.
Forward contracting solved the basic problem of arranging long-term transaction between buyers and sellers but did little to manage the financial risk that occurred with sudden or unforeseen price changes resulting from crop failures, inadequate storage facilities, transportation bottlenecks, or other economic or unforeseen factors like floods or earthquakes.
Forward contract can be of two types: -
• Non Transferable Specific Delivery (N.T.S.D.) Contracts
• Transferable Specific Delivery (T.S.D.) Contracts
Non Transferable Specific Delivery (N.T.S.D.) Contracts:-
It is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. Transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods cannot transfer the rights or liabilities under this contract.
Transferable Specific Delivery (T.S.D.) Contracts: -
It is an enforceable customized agreement where unlike non transferable specific delivery contracts, the rights or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.
FUTURES MARKET: -
Futures markets have existed for more than 250years. They basically started with agricultural products. Major objective of these markets was to help farmers, and grain merchants to improve their marketing and purchasing practices.
CASH MARKET AND FUTURES MARKET: -
Although futures contracts are part of the commodity markets, they are not part of the cash market. It is because, that though the underlying in the. futures contracts, is the cash commodity, the subject 01 trades on the futures exchanges are futures contracts and not the physical commodity. Thus, the cash market is the physical goods or commodity market in which everybody normally trades. The term 'Cash', accordingly refers neither to the method of payment nor to the time of payment. The cash market therefore refers to the actual commodity like gold, copper, sugar, oil etc.
FUTURES CONTRACTS: -
Futures contracts are derivative instruments. Over a period of time forward markets laid the foundation for futures contracts. The main difference between forward contract and a futures contract is the way in which they are negotiated. For forward contracts, terms like amount, quality, delivery date and price are discussed in person between the buyer and the seller and are thus unique in each case. In futures contracts however, all terms are standardized except price, which is discovered through the interaction of supply and demand in a centralized marketplace or exchange.
Presently, futures contract is the only product used in the derivative segment of Indian commodity exchanges.
“A commodity futures contract is an agreement between two parties, to buy or sell a specified quantity and defined quality of a commodity, at a certain time in future, at a price agreed upon at the time of entering into the contract on a commodity exchange.”
NEED OF COMMODITY FUTURE: -
The need for a futures contract and its trading through the exchange arose mainly due to the hedging function that it can perform for both buyers as well as the sellers.
Commodity markets like any other financial instrument, involve risks associated with frequent price volatility. The prices volatility in general can be attributed to the following two reasons:
a. Consumer preference: due to change in preferences of customers, the demand for a commodity could suddenly increase or decrease affecting its price. However, their impact on prices would normally be slow and quite often short lived. This is also because the manufacturers, dealers, stockiest and wholesalers get sufficient time to adjust their inventories.
b. Changes in supply: these are abrupt and unpredictable and bring about wild fluctuations in prices. This is more likely in case of agricultural commodities where weather plays a major role in determining the success or failure of a particular crop.
The futures markets tries to reduce such risk through the mechanism that is called hedging
OBJECTIVES: -
• Hedging with a view to transfer the price risk;
• Price discovery through a large number of transactions and players;
• Maintenance of buffer stock and better allocation of resources;
• Reduction in inventory requirement and thereby reduction in cost of carry;
• Price stabilization through balanced demand and supply positions;
• Helps raise ban finance through transparency and flexibility coming with futures contracts;
FEATURES OF FUTURES CONTRACT: -
Thus commodities futures contracts will always have a fixed period, like one month, three month etc. as the life of the contract. The life of the may be different in different commodity exchanges. At the end of contract period, the futures contract would expire and the concerned parties will have to give and receive delivery of the commodity mentioned in the contract. Both the time and the places of delivery are prescribed by the exchange and this will form part of the futures contract.
There is usually a time difference between futures contract and the delivery period. As a. result of this intervening period, the cash price for a commodity would be different home its futures price mentioned in the contract.
There are mainly three participants of derivatives
a) Hedgers
b) Speculators
c) Arbitrages
PARTICIPANTS OF DERIVATIVE: -
HEDGING: -
Hedging Means taking a position in the futures market that is opposite to a position in the physical market with a view to reducing or limiting risk associated with unpredictable changes in prices.
Hedging is a strategy usually adopted by companies who would be using tradable commodities as the raw materials for their products / processes. Hedging strategies could be different for buyers and sellers.
For instance if the Hedger is going to buy a commodity in cash market (because he needs it as a raw material) at a future date, he buys the future contract now and when he actually buys the commodity in the physical market, he squares off the futures contract to reduce or limit the risk of the purchase price.
Similarly if the hedger is planning to sell a commodity in the cash market in future, he instead sells the futures contract for that commodity now and when he actually sells the commodity in the physical market in future, he squares off his futures contract to reduce or limit the risk of the selling price.
Buying Hedge Or Long Hedge: -
` Buying hedge means buying futures contracts to hedge cash Position. Buying hedge is also known as Long Hedge. Strategy of buying hedge is normally used by the Consumers, Dealers, Manufacturers, etc. who have taken or would be taking exposure for that commodity in the physical market.
Buying Hedge is used in following cases:
• To protect against possible rise in the prices of raw materials.
• To replace inventory at a lower prevailing cost and
• To protect uncovered sale of finished products.
Buying Hedge is necessary for the purpose of protecting against increase in prices on the spot market of a commodity~ which has been already sold but not purchased yet. This is a very common practice among the exporters and importers. They would sell commodities at an agreed price for delivery in future. If the commodity is not still in possession and a commitment has been given for sales, the forward delivery is considered as uncovered.
Long hedgers also include traders and processors / manufacturers who have made formal commitments to deliver the specified amount of raw materials or processed / manufactured products at a later date at a price currently agreed upon but do not have the stocks of raw materials necessary to fulfill their commitments for forward deliveries.
Selling Hedge or Short Hedge: -
Selling Hedge is also known as short hedge. Selling hedge means selling futures contract to hedge a cash position. This strategy is usually adopted by users (manufacturers/ fabricators, who need the commodity as raw material), dealers, consumers, etc. who have taken or would be taking an exposure to the commodity in the physical market since they need it for their own consumption or rely on it for their business.
Following are the uses of selling hedge strategy:
• To protect the price of products for which sales commitment has been made.
• To protect the inventory not covered by forward sales.
• To protect prices of estimated production of finished products
Short Hedgers are merchants or processors who build inventories of a commodity by purchasing it in the spot market and who simultaneously sell an equivalent amount (either less or more depending on the anticipated rise or decline in spot prices) in the futures market. Hedgers in this case are said to be long in their spot transactions and short on their futures transactions.
Rolling over the hedge positions: -
If the time required for a hedge position is later than the expiry date of the Futures contracts, the hedger can decide to roll over the position i.e. he can close out the current position in futures contract and simultaneously take a new position in a futures contract with a later date of expiry.
If a person wants to reduce or limit the risks due to fall in prices of the material to be sold after say six moths and if the futures contracts have 'expiry of two months, then he can roll over his short hedge position three times i.e. till the date of physical sale. Every time the hedge position is rolled over, there is a possibility if basis risk but at the same time it limits or reduces the price risk considerably.
ADVANTAGES OF HEDGING: -
a. Hedging reduces or limits the price risk associated with the physical possession of commodity.
b. Hedging is used to protect the price risk of a commodity for long periods by rolling over positions on futures contracts adequately.
c. Hedging makes business planning more flexible without interfering with the regular/ routine business operations of a company.
d. Hedging can facilitate low cost financing.
LIMITATION OF HEDGING: -
a. Due to standardized nature of futures contracts, it is not possible to completely eliminate the price risk associated with the physical commodity.
b. Because of basis risk, hedging may not provide full protection against adverse price movements.
SPECULATION: -
Speculation means anticipating price movement of a commodity and Accordingly making profits by selling and buying a commodity at appropriate / opportune times. Main objective of speculation in commodity futures market is to take risks and profit from anticipated price changes in the futures of that asset / commodity. A speculator will buy futures contracts of a commodity (long position) only if he is anticipating the prices of that commodity and hence its futures to rise in the future. On the other hand a speculator will sell futures contracts (Short position) if he is anticipating that the commodity prices are likely to decline in future.
Long Position In Futures: -
Long position in a commodity futures contract by a person who does not have any intention to take delivery of the commodity or does not have any exposure to the cash market means a speculative transaction. Long position in commodity futures contract for speculative purposes implies that the buyer of the contract is bullish on the commodity i.e. he is expecting that the price of the said commodity would continue to rise before the expiry of the contract so that he/she can profit by squaring off his/her position before the expiry date. If the price of, the commodity futures contract increases before the expiry
The holder of the contract (speculator) would make profit by squaring off the contract before its expiry. If the prices of the futures contract decline, the speculator stands to incur loss on squaring off the contract.
Short Position in Futures: -
Short Position in a commodity futures contract by a person who does not have any intention to give delivery of the commodity or does not have any exposure to the cash market means a speculative transaction. Short position in commodity futures contract for speculative purposes implies that the buyer of the contract is bearish on the commodity i.e. he is expecting that the price of the said commodity would continue to decline before the expiry of -the contract so that he / she can profit by squaring off his/her position before the expiry date.
It the price of the commodity futures contract declines before the expiry date, the holder of the contract (speculator) would make profit by squaring off the contract before its expiry. If the prices of the futures contract increase, the speculator stands to incur loss on squaring off the contract.
The Role Of Speculation In Futures Markets:-
One of the prominent concerns about the functioning of the commodity futures Markets and its impact on common man / masses is speculation. Speculation provides the depth and flow that is key to the functioning of a futures market. There will be very high liquidity in the futures market if firms after entering a trade to buy or sell have lo wait till a suitable bid or offer arose since the availability of commodities in physical may not always necessarily match with the firm's decision lo buy or sell commodities.
There is also misconceptions fife about speculation being similar to gambling. Although the intention of both the speculators and gamblers is to profit by taking risks, the gambler creates risk where none exists, the speculator on the other hand takes risk that is already prevalent in the market and as a result plays an economically significant role. A proper’ and accurate assessment and
interpretation of the fundamental factors that drive the market forces determines the extent of success in speculating in the futures markets while in gambling it is only a matter of chance, in fact, the important function of price discovery in the futures markets is a direct outcome of the exercise of information gathering in the underlying commodities being done by the speculators.
Speculation is also not similar to manipulation. A manipulator tries to push prices in the reverse direction of the market equilibrium while the speculator forecasts the movement in prices and this effort would eventually bring the prices closer to the market equilibrium. If the f futures markets do not adhere lo the relevant risk management requirements of growers, manufacturers, traders and processors, they would not survive since their correlation with the underlying physical market would be nonexistent.
ARBITRAGE
Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relationship between spot prices and futures prices in terms of basis or between prices of two futures contracts in terms of spread changes, it gives rise to arbitrage opportunities. Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage.
The futures price must be equal to the spot price plus cost of carrying the commodity to the futures delivery date else arbitrage opportunity arises.
Mathematically it can be expressed as
F (o, n) = So (1 +C).
F (o, n) = Futures price of the commodity at t = o for expiry at t = n
So = Spot price of the commodity at t = o
C = Cost of carry from t = o (present) to t = n (expiry date of futures) expressed as a percentage of the spot price
INTRODUCTION: -
An option is the right to buy or sell a particular commodity or a currency or an asset for a limited period at a predetermined price. An option contract gives the buyer (holder) of the option the right to perform under the contract or do nothing as it pleases him. It means that the buyer of the option contract has a right or privilege of one-way bet. Thus, the basic fact about an option is that it is a one-way bet. However this privilege of one-way bet comes with a cost to the buyer of the option. That cost is termed as premium. You pay a price (premium) and buy an option. The premium has to be paid to the seller (writer) of the option, up-front i.e. at the time of entering into option contract. Options are derivative products.
“Options are contracts under which the buyer of option contract has a right without obligation to perform under the contract for payment of a price, called premium. Option contracts provide a right or privilege to buy or sell some thing, say a commodity, at a predetermined price over the contract period. The right or privilege is available to the option buyer only upto the expiry dates of contract.”
COMMODITY OPTION: -
Commodity options are options with a commodity as the underlying. For instance, a gold options contract would give the holder i.e. the buyer of option, the right to buy or sell a specified quantity of gold at the price specified in the contract irrespective of the price ruling in the market at the time of exercising the option.
Option markets are very divers and they have their own jargons. As such understanding of options requires a grasp of institutional details and terminology employed in option markets
There are two basic types of options known as call options and put options.
• Call option: A call option gives the buyer (holder) the right but not the obligation to buy an asset by a certain Rate for a certain price.
• Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
Value of Call and Put Options: -
The value of a call option generally increases as the current spot price of the commodity, the time to expiration of the contract and the volatility increases. Conversely, the value of a call option decreases as the strike price increases and time to expiration and volatility of market price decreases.
The value of a put option generally increases as the strike price, time to expiration and the volatility of the commodity price increases. The value of a put option decreases as the current market price increases and the time to expiration and volatility of the commodity price decreases.
OPTIONS & THEIR UTILISATION: -
Option contracts are a useful technique when the buyer or holder of option desires to limit his downside risk (loss) while keeping the upside gain open to unlimited level. Under all cases, the maximum loss for option holders will be limited to the extent of option premium. This happens when the holder does not deal at the strike price with the option writer since he may find the ruling spot price in the market is more favorable or advantageous to him.
However at the same time his upside gain may be enormous depending upon the price movements. Of course, this price movement makes his strike price more favorable as compared to market price. Thus a long call at the strike price of Rs.2000 per quintal may lead to huge profit, if market price keeps on rising beyond the strike price enabling the option buyer to buy the commodity from the option writer at the strike price. We must remember that the option buyer's opportunity to make profit under the circumstances is limited to the extent of contracts bought. Thus unlike forward contracts, option contracts provide opportunity to limit losses or make gains.
OPTIONS MARKET: -
Options are now traded on many exchanges throughout the world. Option contracts are available on commodities, currencies, stocks, metals, oil etc. Until 1973, it was possible to buy an option, but it was not really possible to trade it. Exchange traded options were first introduced in 1973 on stocks by the Chicago Board Options Exchange (CBOE). The single most important innovation of CBOE was to set up standard option prices and standard expiration dates. '
The Chicago Board Options Exchange was followed by many of the American Stock exchanges, such as Philadelphia Stock Exchange, Pacific Stock Exchange. Today option contracts are traded in London International Financial Futures Exchange (IIFFE), Singapore International Monetary Exchange (SIMEX), Chicago Board of Trade CBOT) and many other exchanges. In India, currently stock options are traded in Stock Exchanges. Currency options are written by banks as the over-the-counter (OTC) product but exchange traded options on commodities are not available in India. However it is a matter of time, huge exchange traded options on commodities are introduced in commodity exchanges like Multi Commodity Exchange.
INTRODUCTION: -
Significantly developing countries are producers and exporters of most of the commodities globally traded. This is applicable to various products such as agricultural produce, metals, oils etc. lack of demand for such products from the developed world affects the export earnings as well as terms of trade of the producer (developing) countries. In fact, commodity prices had been in a long bear market phase during 1980s and 1990s. Thank to improved manufacturing and economic activities notably in Asia, particularly in countries like china and India and in the United States there is a growing demand for raw material in the global market. Today global growth comes from four important developing countries viz. China, India, Brazil and Russia.
INVESTMENT OPPORTUNITIES: -
The stock market witnessed strong growth during 1980s till the market crashed, first in New York, on October 19, 1987 (Black Monday). Indian stock markets also witnessed scams and large rise and fall in prices occasionally leading to sudden and big wealth accumulation and destruction. These price changes were essentially acts of rampant speculation from few market players who have large chunk of funds to move the market on either side. Such downslide in stock markets provided alternative investment opportunities in commodity markets.
Markets in developing countries provide an excellent opportunity for all types of investors since most of the commodities trade globally are produced and exported from developing countries. India is no exception to this rule, since a variety of commodities ranging in agricultural category and commodities like iron (steel), copper, aluminum, gold, silver in the category of metals, and petroleum products in the category of oil are traded in the Indian markets. Hence trading in commodity exchanges offer equal opportunity and benefit for investors and traders in commodity exchanges is the first hand knowledge about the products, their sources of demand and supply etc. which primarily influence price movements in the commodity markets as against unbridled speculation in stock markets.
COMMODITIES & ECONOMIC EXPANSION: -
Economic expansion led to a rapid demand for many commodities particularly for petroleum, metal and other rnineral resources and agricultural commodities. Further rising population in 1960s and later, increased the demand for commodities. Although the population was rising in many developing countries, improved technology, extensive and intensive method of collation increased agricultural production and other commodities more than the rise in population. New countries also emerged as new producers. The net result was that the stock of commodities was piling up and commodity prices started falling relative to the prices of other goods, particularly that of manufactured goods. This led to adverse terms of trade for the producers and exporters of commodities during 1970s and 1980s. Buffer stocks were used by organizations to stabilize prices. Countries had entered into commodity agreements to ensure fair price realizations, but most of the agreements failed and prices were destabilized.
CURRENT SCENARIO: -
The high scale production going on in China due to cheap labor and manufacturing facilities have suddenly brought the commodities alive. Today the word "commodity" is the new buzzword in the global market as well as in India. At the same time all Asian countries are experiencing high growth, increasing trade volumes and rising prices income fetidities. During 1980s & 1990s, commodities were traded at all time low prices. Today, gold prices are shooting up. Metals like copper, nickel, and aluminum are trading @t all time high. Crude oil price was at all time high at $67 per barrel in mid-August, 2005.
The commodity price index is continuously rising which reflects the rising consumer demand and money spent on commodities. The rising commodity prices are driving the commodity companies. Turning to capital markets for their funding requirements. The current commodity prices also provided excellent trading opportunities for large investors like hedge funds and pension fun4s besides small investors like retail investors looking for investments linked to commodities.
Additionally demand is certainly encouraging supply. Global capital market players estimate that institutional funds tracking commodity indices worldwide had gone up four times between 2000 and 2004 from $ 10 billion to $ 40 billion. Similarly U.S. mutual funds exposure to commodities has reportedly gone up from $ 300 million in 2002 to a level of more than $ 7 billion in early 2005. Thus investors are looking for extra and alternative return in commodities markets to compensate for the poor bond market return and to certain extent the not so high equity market return. Many commodity prices are running all time high in the global market. The best example for this is the price of oil, steel and gold. However investors prefer investment in commodities rather than investment in the equity of relative companies.
This awareness of investment opportunities in commodity markets has entered in to the Indian soil. Commodity Exchanges, at national level, have suddenly come up one after another. Their volume is growing at a pace faster than the growth witnessed in equity markets in 1980s and 1990s. Everybody is now more aware of commodities because the oil price is regularly on the front pages of economic newspapers. Talk of oil price and assessment of performance of oil companies are the daily discussions in print and electronic media.
This has both a positive and negative impact-on the Indian economy. While India may benefit from increased commodity prices, which it exports, the increase in oil prices - its major import item, affects its growth adversely. In the global investment market, currently commodity market is the most attractive asset market for investment.
Money In Commodity Markets & its peculiarity:
Marc Faber, an Investment Expert and business cycle analyst predicts that the next big profit will be in hard assets and not in financial assets. The hard asset he referred to was that of commodity markets. Investors however have to find out which commodities will boom and which will not. One has to be selective in choosing the commodity. Investors will have to study individual markets and buy sell commodities accordingly. This will be a different ball game for investors. It is a different kind of research as compared to stock markets. The reason, there are no balance sheets to read, no quarterly or half yearly results for comparison, no announcement for future growth or dividend Policy to keep tract of events and prices. Yet commodity markets provide Huge investment opportunity for investors and speculators.
FINDINGS
Majority of commodities traded on commodity exchanges world over are agro based. Commodity Markets therefore are of great importance and hold great potential in case of Agrarian Economies like India where the agriculture sector contributes 22% to the country's GDP and employs 70% of the working population.
There is a huge domestic market for commodities in India since India consumes a major portion of its agro production locally. However our exports of agro-products are very insignificant. Indian commodities market therefore has excellent growth potential and has created good opportunities for market players. The following salient features of the Indian economy / commodity markets and their related aspects would adequate to stress the relevance of commodity markets and the great potential that they offer for future development in India:
a. India is the world's leading producer of 17 agricultural commodities and is also the world's largest consumer of edible oils and gold,
b. India has 30 major markets and nearly 7,000 Mandies with substantial arrivals of a variety of commodities,
c. Over 27,000 haats (rural bazaars) exist in the country with seasonal arrivals of various commodities,
d. Nearly 5 million traders are engaged in commodity trading in India,
e. Commodities related and dependent industries constitute approximately 58 per cent of country's GDP of Rs 1,320,700 corers,
f. State and Central Governments have invested substantial resources to boost production of agricultural commodities. Many of these would be traded on the futures markets as food processing increases from the current level of 2% to 40-50% comparable to other countries,
g. There are three national level Commodity Exchanges that trade in approximately 100 commodities at present and the list continues to expand,
h. Indian spot market for commodities such as bullion, metals, agriculture produce and energy is estimated at approximately Rs 11,00,000 corers annually. According to the experts ins the field, global trends indicate that the volume in futures trading tend to be 5-7 times the size of commodities' spot trading in the country (Internationally, the multiple for physical versus derivatives is much higher at 15 to 20 times). This implies that the potential for futures trading market in India currently stands at staggering Rs. 55,00,000 corers to Rs. 77,00,000 corer annually.
i. Three nationwide electronic exchanges and 22 recognized regional or small commodity exchanges in India had an estimated total combined turnover of Rs 569277.92 corer in the first quarter of current financial year (April-August 2005).
j. Many nationalized and private sector banks have announced plans to disburse substantial amounts to finance commodity-trading business. (Private sector giant viz. HDFC Bank alone is planning to disburse over Rs 1,000 corer for financing agriculture commodities in 2005-06).
k. The Government of India has initiated several measures to stimulate active trading interest in commodities. Some of these measures are:
- Lifting the ban on futures trading in commodities;
- Approving new exchanges;
- Developing exchanges with modern infrastructure and systems such as online trading
- Removing legal hurdles to attract more participants.
As a result of the above developments, both the spot and futures markets in India are witnessing rapid growth. The trading volumes are increasing as the list of commodities traded on national commodity exchanges also continues to expand. The volumes are likely to surge further as a result of the increased interest from the international players in the Indian commodity markets. If these international players are allowed to participate in commodity markets (like in case of capital markets), the growth in commodity futures can be expected to be phenomenal.
The commodity markets are normally ten times bigger than stock markets all over the world. There is no reason why similar proportions would not exist in India in the next five to ten years.
“Potential of commodity market in India is very high thus Commodity trading and commodity financing are going to be a rapidly growing business in coming years in India”.
BIBLIOGRAPHY
Books Referred:
1. NCFM Commodity Dealer Module – NSE India
2. Diploma In Commodities trading (DITC)
- By Welingkar Institute Of Management Development & Research
Internet Websites:
• http://www.karvycomtrade.com
• http://www.mcx.com
• http://www.ncdex.com
• http://www.commoditiescontrol.com