MCX Study material

Contents 1 Introduction to derivatives 1.1 Derivatives defined . . . . . . . . . . . . . . . . 1.2 Products, participants and functions . . . . . . . 1.3 Derivatives markets . . . . . . . . . . . . . . . . 1.3.1 Spot versus forward transaction . . . . . 1.3.2 Exchange traded versus OTC derivatives . 1.3.3 Some commonly used derivatives . . . .

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2 Commodity derivatives 2.1 Difference between commodity and financial derivatives 2.1.1 Physical settlement . . . . . . . . . . . . . . . . 2.1.2 Warehousing . . . . . . . . . . . . . . . . . . . 2.1.3 Quality of underlying assets . . . . . . . . . . . 2.2 Global commodities derivatives exchanges . . . . . . . . 2.2.1 Africa . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Asia . . . . . . . . . . . . . . . . . . . . . . . . 2.2.3 Latin America . . . . . . . . . . . . . . . . . . 2.3 Evolution of the commodity market in India . . . . . . . 2.3.1 The Kabra committee report . . . . . . . . . . . 2.3.2 Latest developments . . . . . . . . . . . . . . . 3 The NCDEX platform 3.1 Structure of NCDEX . . . . . . . . . . . . . . 3.1.1 Promoters . . . . . . . . . . . . . . . . 3.1.2 Governance . . . . . . . . . . . . . . . 3.2 Exchange membership . . . . . . . . . . . . . 3.2.1 Trading cum clearing members (TCMs) 3.2.2 Professional clearing members (PCMs) 3.3 Capital requirements . . . . . . . . . . . . . . 3.4 The NCDEX system . . . . . . . . . . . . . . 3.4.1 Trading . . . . . . . . . . . . . . . . . 3.4.2 Clearing . . . . . . . . . . . . . . . . . 3.4.3 Settlement . . . . . . . . . . . . . . .

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4 4 Commodities traded on the NCDEX platform 4.1 Agricultural commodities . . . . . . . . . . 4.1.1 Cotton . . . . . . . . . . . . . . . . 4.1.2 Crude palm oil . . . . . . . . . . . 4.1.3 RBD Palmolein . . . . . . . . . . . 4.1.4 Soy oil . . . . . . . . . . . . . . . 4.1.5 Rapeseed oil . . . . . . . . . . . . 4.1.6 Soybean . . . . . . . . . . . . . . . 4.1.7 Rapeseed . . . . . . . . . . . . . . 4.2 Precious metals . . . . . . . . . . . . . . . 4.2.1 Gold . . . . . . . . . . . . . . . . 4.2.2 Silver . . . . . . . . . . . . . . . .

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5 Instruments available for trading 5.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . 5.1.1 Limitations of forward markets . . . . . . . . . . 5.2 Introduction to futures . . . . . . . . . . . . . . . . . . . 5.2.1 Distinction between futures and forwards contracts 5.2.2 Futures terminology . . . . . . . . . . . . . . . . 5.3 Introduction to options . . . . . . . . . . . . . . . . . . . 5.3.1 Option terminology . . . . . . . . . . . . . . . . . 5.4 Basic payoffs . . . . . . . . . . . . . . . . . . . . . . . . 5.4.1 Payoff for buyer of asset: Long asset . . . . . . . . 5.4.2 Payoff for seller of asset: Short asset . . . . . . . . 5.5 Payoff for futures . . . . . . . . . . . . . . . . . . . . . . 5.5.1 Payoff for buyer of futures: Long futures . . . . . 5.5.2 Payoff for seller of futures: Short futures . . . . . 5.6 Payoff for options . . . . . . . . . . . . . . . . . . . . . . 5.6.1 Payoff for buyer of call options: Long call . . . . . 5.6.2 Payoff for writer of call options: Short call . . . . 5.6.3 Payoff for buyer of put options: Long put . . . . . 5.6.4 Payoff for writer of put options: Short put . . . . . 5.7 Using futures versus using options . . . . . . . . . . . . .

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6 Pricing commodity futures 6.1 Investment assets versus consumption assets . . . . . . . . . . 6.2 The cost of carry model . . . . . . . . . . . . . . . . . . . . . 6.2.1 Pricing futures contracts on investment commodities . 6.2.2 Pricing futures contracts on consumption commodities 6.3 The futures basis . . . . . . . . . . . . . . . . . . . . . . . .

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75 75 76 78 80 81

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7 Using commodity futures 7.1 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1.1 Basic principles of hedging . . . . . . . . . . . . . . . 7.1.2 Short hedge . . . . . . . . . . . . . . . . . . . . . . . 7.1.3 Long hedge . . . . . . . . . . . . . . . . . . . . . . . 7.1.4 Hedge ratio . . . . . . . . . . . . . . . . . . . . . . . 7.1.5 Advantages of hedging . . . . . . . . . . . . . . . . . 7.1.6 Limitation of hedging: basis Risk . . . . . . . . . . . 7.2 Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2.1 Speculation: Bullish commodity, buy futures . . . . . 7.2.2 Speculation: Bearish commodity, sell futures . . . . . 7.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.1 Overpriced commodity futures: buy spot, sell futures . 7.3.2 Underpriced commodity futures: buy futures, sell spot 8 Trading 8.1 Futures trading system . . . . . . . . . . . . . 8.2 Entities in the trading system . . . . . . . . . . 8.2.1 Guidelines for allotment of client code . 8.3 Contract specifications for commodity futures . 8.4 Commodity futures trading cycle . . . . . . . . 8.5 Order types and trading parameters . . . . . . . 8.5.1 Permitted lot size . . . . . . . . . . . . 8.5.2 Tick size for contracts . . . . . . . . . 8.5.3 Quantity freeze . . . . . . . . . . . . . 8.5.4 Base price . . . . . . . . . . . . . . . . 8.5.5 Price ranges of contracts . . . . . . . . 8.5.6 Order entry on the trading system . . . 8.6 Margins for trading in futures . . . . . . . . . . 8.7 Charges . . . . . . . . . . . . . . . . . . . . . 9 Clearing and settlement 9.1 Clearing . . . . . . . . . . . . . . . . . . . . . 9.1.1 Clearing mechanism . . . . . . . . . . 9.1.2 Clearing banks . . . . . . . . . . . . . 9.1.3 Depository participants . . . . . . . . . 9.2 Settlement . . . . . . . . . . . . . . . . . . . . 9.2.1 Settlement mechanism . . . . . . . . . 9.2.2 Settlement methods . . . . . . . . . . . 9.2.3 Entities involved in physical settlement 9.3 Risk management . . . . . . . . . . . . . . . . 9.4 Margining at NCDEX . . . . . . . . . . . . . . 9.4.1 SPAN . . . . . . . . . . . . . . . . . .

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CONTENTS 9.4.2 9.4.3 9.4.4 9.4.5

Initial margin . . . . . . . . . . . . . . . . . . . . . . . . . Computation of initial margin . . . . . . . . . . . . . . . . Implementation aspects of margining and risk management . Effect of violation . . . . . . . . . . . . . . . . . . . . . .

10 Regulatory framework 10.1 Rules governing commodity derivatives exchanges 10.2 Rules governing intermediaries . . . . . . . . . . . 10.2.1 Trading . . . . . . . . . . . . . . . . . . . 10.2.2 Clearing . . . . . . . . . . . . . . . . . . . 10.3 Rules governing investor grievances, arbitration . . 10.3.1 Procedure for arbitration . . . . . . . . . . 10.3.2 Hearings and arbitral award . . . . . . . . 11 Implications of sales tax

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133 133 134 134 138 142 143 144 147

List of Tables 2.1 2.2 2.3

The global derivatives industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Volume on existing exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Registered commodity exchanges in India . . . . . . . . . . . . . . . . . . . . . 26

3.1 3.2

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

4.1

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

5.1 5.2

Distinction between futures and forwards . . . . . . . . . . . . . . . . . . . . . 59 Distinction between futures and options . . . . . . . . . . . . . . . . . . . . . . 70

6.1

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

7.1 7.2 7.3

Refined soy oil futures contract specification . . . . . . . . . . . . . . . . . . . . 87 Silver futures contract specification . . . . . . . . . . . . . . . . . . . . . . . . . 88 Gold futures contract specification . . . . . . . . . . . . . . . . . . . . . . . . . 92

8.1 8.2 8.3 8.4 8.5

Commodity futures contract and their symbols . . . Gold futures contract specification . . . . . . . . . Long staple cotton futures contract specification . . Commodity futures: Quantity freeze unit . . . . . . Commodity futures: Lot size and other parameters

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9.1 9.2 9.3 9.4 9.5 9.6

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

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List of Figures 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8

Payoff for a buyer of gold . . . . . . . . . . . . . . Payoff for a seller of gold . . . . . . . . . . . . . . Payoff for a buyer of gold futures . . . . . . . . . . Payoff for a seller of cotton futures . . . . . . . . . Payoff for buyer of call option on gold . . . . . . . Payoff for writer of call option on gold . . . . . . . Payoff for buyer of put option on long staple cotton Payoff for writer of put option on long staple cotton

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64 64 65 66 67 68 69 70

6.1

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

7.1 7.2

Payoff for buyer of a short hedge . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Payoff for buyer of a long hedge . . . . . . . . . . . . . . . . . . . . . . . . . . 88

8.1

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

Chapter 1 Introduction to derivatives The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking–in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk – that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures–type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the ‘to–arrive’ contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlyings like stocks, interest rate, exchange rate, etc.

1.1

Derivatives defined

A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity

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Introduction to derivatives

or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. However when derivatives trading in securities was introduced in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines “derivative” to include – 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities.

1.2

Products, participants and functions

Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories – hedgers, speculators, and arbitragers. 1. Hedgers: The farmer’s example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk. 2. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses. 3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.

Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions. Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

1.3 Derivatives markets

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

Box 1.1: Emergence of financial derivative products The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well–educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.

1.3

Derivatives markets

Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as

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

1.3.1

Spot versus forward transaction

Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. Every transaction has three components – trading, clearing and settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves finding out the net outstanding, that is exactly how much of goods and money the two should exchange. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money and goods. In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. “on the spot”. Consider this example. On 1st January 2004, Aditya wants to buy some gold. The goldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 grams of gold. He pays Rs.12,000, takes the gold and leaves. This is a spot transaction. Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it a month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the “forward” price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith Rs.12,030 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period. A forward is the most basic derivative contract. We call it a derivative because it derives value from the price of the asset underlying the contract, in this case gold. If on the 1st of February, gold trades for Rs.6,050 in the spot market, the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs.6,015. If however, the price of gold drops down to Rs.5,990, he is worse off because as per the terms of the contract, he is bound to pay Rs.6,015 for the same gold. The contract has now lost value from Aditya’s point of view. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya.

1.3.2

Exchange traded versus OTC derivatives

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

1.3 Derivatives markets

15

Early forward contracts in the US addressed merchants’ concerns about ensuring that there were buyers and sellers for commodities. However “credit risk” remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first “exchange traded” derivatives contract in the US, these contracts were called “futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organised futures exchanges, indeed the two largest “financial” exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

Box 1.2: History of commodity derivatives markets many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralised and located within individual institutions. 2. There are no formal centralised limits on individual positions, leverage, or margining. 3. There are no formal rules for risk and burden–sharing. 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants. 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self– regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. The largest OTC derivative market is the interbank foreign exchange market. Commodity derivatives the world over are typically exchange–traded and not OTC in nature.

16


1.3.3

Some commonly used derivatives

Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage. Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today’s future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded. Options: There are two types of options - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer–dated options are called warrants and are generally traded over–the–counter. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are :

Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.

Solved Problems Q: Futures trading commenced first on 1. Chicago Board of Trade

3. Chicago Board Options Exchange

2. Chicago Mercantile Exchange

4. London International Financial Futures and Options Exchange

A: The correct answer is number 1.

1.3 Derivatives markets Q: Derivatives first emerged as

17 products

1. Speculative

3. Volatility

2. Hedging

4. Risky

A: The correct answer is number 2. Q: Which of the following exchanges offer commodity derivatives trading 1. National Commodity Derivatives Exchange

3. Over The Counter Exchange of India

2. Interconnected Stock Exchange

4. ICICI Securities Limited

A: The correct answer is number 1. Q: OTC derivatives are considered risky because 1. There is no formal margining system.

3. They are not settled on a clearing house.

2. They do not follow any formal rules or mechanisms.

4. All of the above

A: The correct answer is number 4. Q: The first exchange traded financial derivative in India commenced with the trading of 1. Index futures

3. Stock options

2. Index options

4. Interest rate futures

A: The correct answer is number 1. Q: A

is the simplest derivative contract

1. Option

3. Forward

2. Future

4. Swap

A: The correct answer is number 3. Q: In a transaction, trading involves 1. The buyer and seller agreeing upon a price. 2. The buyer and seller exchanging goods and money.


3. The buyer and seller calculating the net outstanding. 4. None of the above.

18


Q: In a transaction, clearing involves 1. The buyer and seller agreeing upon a price. 2. The buyer and seller exchanging goods and money.


A: The correct answer is number 3. Q: In a transaction, settlement involves 1. The buyer and seller agreeing upon a price. 2. The buyer and seller exchanging goods and money.



Chapter 2 Commodity derivatives Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. In this chapter we look at how commodity derivatives differ from financial derivatives. We also have a brief look at the global commodity markets and the commodity markets that exist in India.

2.1

Difference between commodity and financial derivatives

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.

2.1.1

Physical settlement

Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical

20

Commodity derivatives

settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities. Later on we will look into details of how physical settlement happens on the NCDEX. Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as ‘delivery notice period’. Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options market. However what is interesting and different from a typical options exercise is that in the commodities market, both positions can still be closed out before expiry of the contract. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF–Brazil have independent grading and classification agency to verify the quality. In the case of BMF-Brazil a seller typically has to submit the following documents: A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods. A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse. A warehouse certificate showing that storage and regular insurance have been paid.

Assignment Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method.

2.1 Difference between commodity and financial derivatives

21

Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first–in–first out basis. In some exchanges (CME), the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day. Delivery After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller’s account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts.

2.1.2

Warehousing

One of the main differences between financial and commodity derivatives is the need for warehousing. In case of most exchange–traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. Which means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets

22


The New York Cotton Exchange has specified the asset in its orange juice futures contract as “U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94”. The Chicago Mercantile Exchange in its random–length lumber futures contract has specified that “Each delivery unit shall consist of nominal s of random lengths from 8 feet to 20 feet, gradestamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir”.

Box 2.3: Specifications of some commodities underlying derivatives contracts and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri–produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.

2.1.3

Quality of underlying assets

A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.

2.2

Global commodities derivatives exchanges

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

2.2 Global commodities derivatives exchanges

23

Table 2.1 The global derivatives industry Country

Exchange

United States of America

Chicago Board of Trade (CBOT) Chicago Mercantile Exchange Minneapolis Grain Exchange New York Cotton Exchange New York Mercantile Exchange Kansas Board of Trade New York Board of Trade The Winnipeg Commodity Exchange Brazilian Futures Exchange Commodities and Futures Exchange Sydney Futures Exchange Ltd. Beijing Commodity Exchange Shanghai Metal Exchange Hong Kong Futures Exchange Tokyo International Financial Futures Exchange Kansai Agricultural Commodities Exchange Tokyo Grain Exchange Kuala Lumpur commodity Exchange New Zealand Futures& Options Exchange Ltd. Singapore Commodity Exchange Ltd. Le Nouveau Marche MATIF Italian Derivatives Market Amsterdam Exchanges Option Traders The Russian Exchange MICEX/ Relis Online St. Petersburg Futures Exchange The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia The London International Financial Futures Options exchange The London Metal Exchange

Canada Brazil Australia People’s Republic Of China Hong Kong Japan

Malaysia New Zealand Singapore France Italy Netherlands Russia

Spain

United Kingdom

exchanges in the world. The CBOT was established in 1948 to bring farmers and merchants together. Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a few years the first futures–type contract was developed. It was know as the to–arrive contract. Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges exist all over the world. On these exchanges, a wide range of commodities and financial assets form the underlying assets in

24


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

2.2.1

Africa

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

2.2.2

Asia

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

2.2.3

Latin America

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

2.3

Evolution of the commodity market in India

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

2.3 Evolution of the commodity market in India

25

amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution. In due course, several other exchanges were created in the country to trade in diverse commodities.

2.3.1

The Kabra committee report

After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the following objectives: 1. To assess (a) The working of the commodity exchanges and their trading practices in India and to make suitable recommendations with a view to making them compatible with those of other countries (b) The role of the Forward Markets Commission and to make suitable recommendations with a view to making it compatible with similar regulatory agencies in other countries so as to see how effectively these agencies can cope up with the reality of the fast changing economic scenario. 2. To review the role that forward trading has played in the Indian commodity markets during the last 10 years. 3. To examine the extent to which forward trading has special role to play in promoting exports. 4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the recommendations, particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act. 5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be operative remains constructive and helps in maintaining prices within reasonable limits. 6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible, particularly in commodities in which resumption of forward trading is generally demanded.

26


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

The recommendations of the

The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would need to be strengthened. Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing. In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further. The FMC which regulates forward/ futures trading in the country, should continue to act a watch–dog and continue to monitor the activities and operations of the commodity exchanges. Amendments to the rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. In the context of globalisation, commodity markets in India could not function effectively in an isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and castor seed, be upgraded to the level of international futures markets. The majority of the committee recommended that futures trading be introduced in the following commodities: 1. Basmati rice 2. Cotton and kapas 3. Raw jute and jute goods 4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them. 5. Rice bran oil 6. Castor oil and its oilcake 7. Linseed 8. Silver 9. Onions

The liberalised policy being followed by the government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. The national agriculture policy announced in July 2000 and the announcements in the budget speech for 2002–2003 were indicative of the governments resolve to put in place a mechanism of futures trade/market. As a follow up, the government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited.


27

Table 2.2 Volume on existing exchanges Commodity exchange

Products

National board of trade, Indore National multicommodity exchange, Ahmedabad Ahmedabad commodity exchange Rajdhani Oil & oilseeds Vijai Beopar Chamber Ltd. Muzzaffarnagar Rajkot seeds, oil & bullion exchange IPSTA, Cochin Chamber of commerce, Hapur Bhatinda Om and oil exchange Other (mostly inactive) Total

Soya, mustard Multiple Castor, cotton Mustard Gur Castor, groundnut Pepper Gur, mustard Gur

2.3.2

Approx. annual vol (Rs.Crore) 80000 40000 3500 3500 2500 2500 2500 2500 1500 1500 140000

Latest developments

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

28


Table 2.3 Registered commodity exchanges in India Exchange

Product traded

Bhatinda Om & Oil Exchange Ltd. The Bombay Commodity Exchange Ltd.

Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed, oil and oil cake) Groundnut (Nut and oil) Castor oil, Castorseed Sesamum (Oil and oilcake) Rice bran, rice bran oil and oilcake Crude palm oil Groundnut oil Castorseed Rapeseed/ Mustardseed oil and cake Gur Turmeric Cottonseed, Castorseed Gur Pepper Gur, Rapeseed/ Mustardseed Sugar Grade-M Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil, Crude Palm Oil Gur, Rapeseed/ Mustardseed Cotton Gur Hessian, Sacking Copra, Coconut oil & Copra cake Coffee Gur, RBD Pamolien Crude Palm Oil, Copra Rapeseed/ Mustardseed, Soy bean Cotton (Seed, oil, oilcake) Safflower (seed, oil, oilcake) Groundnut (seed, oil, oilcake) Sugar, Sacking, gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed,oil and oilcake) Linseed (seed, oil and oilcake) Rice Bran Oil, Pepper, Guarseed Aluminium ingots, Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead Soy Bean, Refined Soy Oil Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton Gold, Silver

The Rajkot Seeds oil & Bullion Merchants Association, Ltd. The Kanpur Commodity Exchange Ltd. The Meerut Agro Commodities Exchange Co. Ltd. The Spices and Oilseeds Exchange Ltd.Sangli Ahmedabad Commodities Exchange Ltd. Vijay Beopar Chamber Ltd., Muzaffarnagar India Pepper & Spice Trade Association, Kochi Rajdhani Oils and Oilseeds Exchange Ltd., Delhi National Board of Trade, Indore The Chamber of Commerce, Hapur The East India Cotton Association, Mumbai The Central India Commercial Exchange Ltd., Gwaliar The East India Jute & Hessian Exchange Ltd., Kolkata First Commodity Exchange of India Ltd., Kochi The Coffee Futures Exchange India Ltd., Bangalore National Multi Commodity Exchange of India Limited, Ahmedabad

National Commodity & Derivatives Exchange Limited


29

Solved Problems Q: Which of the following feature differentiates a commodity futures contract from a financial futures contract? 1. Exchange traded product

3. MTM settlement

2. Standardised contract size

4. Varying quality of underlying asset


Q: Physical settlement involves the physical delivery of the underlying commodity at 1. an accredited warehouse

3. the buyers requested destination

2. the exchange

4. None of the above

A: The correct answer is number 1

Q: Typically, in all commodity exchanges, delivery notice is required to be supported by a 1. Letter of credit

3. Undertaking

2. Warehouse receipt

4. Advance payment


Q: Who identifies the buyer to whom the delivery notice is assigned? 1. The exchange

3. The warehouse

2. The clearing corporation

4. The seller


Q: Which of the following exchanges do not offer commodity derivatives trading? 1. National Commodity Derivative Exchange

3. National Board of Trade

2. Multi Commodity Exchange of India

4. National Stock Exchange


30


Q: On the NCDEX 1. The clearing house assigns delivery to the buyer 2. The seller assigns delivery to the buyer

3. The buyer chooses which delivery to take 4. The warehouse assigns the delivery to the buyer

A: The correct answer is number 1. Q: The

committee recommended that the Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, need to be strengthened. 1. L C Gupta Committee

3. Khusro Committee

2. Kabra Committee

4. J R Varma Committee


Chapter 3 The NCDEX platform National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world–class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency. NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment. NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, refined soy bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude palm oil and cotton – medium and long staple varieties. At subsequent phases trading in more commodities would be facilitated.

3.1

Structure of NCDEX

NCDEX has been formed with the following objectives: To create a world class commodity exchange platform for the market participants. To bring professionalism and transparency into commodity trading. To inculcate best international practices like de–modularization, technology platforms, low cost solutions and information dissemination without noise etc. into the trade. To provide nation wide reach and consistent offering. To bring together the entities that the market can trust.

32

3.1.1

The NCDEX platform

Promoters

NCDEX is promoted by a consortium of institutions. These include the ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience, trust, nationwide reach, technology and risk management skills.

3.1.2

Governance

NCDEX is run by an independent Board of Directors. Promoters do not participate in the day to day activities of the exchange. The directors are appointed in accordance with the provisions of the Articles of Association of the company. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. It formulates the rules and regulations related to the operations of the exchange. Board appoints an executive committee and other committees for the purpose of managing activities of the exchange. The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange, and also other members appointed by the board. Apart from the executive committee the board has constitute committee like Membership committee, Audit Committee, Risk Committee, Nomination Committee, Compensation Committee and Business Strategy Committee, which, help the Board in policy formulation.

3.2

Exchange membership

Membership of NCDEX is open to any person, association of persons, partnerships, co–operative societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of the exchange have to register themselves with the competent authority before commencing their operations. The members of NCDEX fall into two categories, Trading cum Clearing Members (TCM) and Professional Clearing Members (PCM).

3.2.1

Trading cum clearing members (TCMs)

NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The TCM membership entitles the members to trade and clear, both for themselves and/ or on behalf of their clients. Applicants accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net worth as given in Table 3.1.

3.3 Capital requirements

33

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

(Rupees in Lakh)

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

15.00 15.00 0.50 0.50 50.00

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

(Rupees in Lakh)

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

3.2.2

25.00 25.00 1.00 1.00 5000.00

Professional clearing members (PCMs)

NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs), both for themselves and/ or on behalf of their clients. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and also maintain net worth as given in Table 3.2.

3.3

Capital requirements

NCDEX has specified capital requirements for its members. On approval as a member of NCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. Base Minimum Capital comprises of the following: 1. Interest free cash security deposit 2. Collateral security deposit

All Members have to comply with the security deposit requirement before the activation of their trading terminal. Members can opt to meet the security deposit requirement by way of the following: Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited.

34

The NCDEX platform Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. The minimum term of the bank guarantee should be 12 months. Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period of 36 months from any of the approved banks. Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. The securities are valued on a daily basis and a haircut of 25% is levied.

Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in case of TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls below the minimum required level, NCDEX may initiate suitable action including withdrawal of trading facilities as given below: If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be withdrawn with immediate effect. If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks’ time to replenish the shortages and if the same is not done within the specified time the trading facility would be withdrawn.

Members who wish to increase their limit can do so by bringing in additional capital in the form of cash, bank guarantee, fixed deposit receipts or Government of India securities.

3.4

The NCDEX system

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

3.4.1

Trading

The trading system on the NCDEX, provides a fully automated screen–based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. The trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been proposed for implementation at a later stage. The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets

3.4 The NCDEX system

35

queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. NCDEX trades commodity futures contracts having one–month, two–month and three– month expiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day. New contracts will be introduced on the trading day following the expiry of the near month contract.

3.4.2

Clearing

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. Only clearing members including professional clearing members (PCMs) only are entitled to clear and settle contracts through the clearing house. At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price.

3.4.3

Settlement

Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward, created during the day or closed out during the day, are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. On the date of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client’s trades. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. On the expiry date of a futures contract, members submit delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. NCDEX on receipt of such information, matches the information and arrives at a delivery position for a member for a commodity. The seller intending to make delivery takes the commodities to the designated warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the

36

The NCDEX platform

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

Solved Problems Q: Which of the following futures do not trade on the NCDEX? 1. Cotton futures

3. Silver futures

2. Gold futures

4. Energy futures

A: The correct answer is number 4. Q: NCDEX is regulated by 1. The Forward Markets Commission

3. Reserve Bank of India

2. SEBI

4. Controller of Capital Issues

A: The correct answer is number 1. Q: The net worth requirement for a TCM is 1. Rs.5 Lakh

3. Rs.500 Lakh

2. Rs.50 Lakh

4. Rs.5000 Lakh


Chapter 4 Commodities traded on the NCDEX platform In December 2003, the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures trading in nine major commodities. To begin with contracts in gold, silver, cotton, soyabean, soya oil, rape/ mustard seed, rapeseed oil, crude palm oil and RBD palmolein are being offered. We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. The commodity markets can be classified as markets trading the following types of commodities. 1. Agricultural products 2. Precious metal 3. Other metals 4. Energy

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

4.1

Agricultural commodities

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

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4.1.1

Commodities traded on the NCDEX platform

Cotton

Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17 million bales (average annual consumption, 1 bale = 170 kg) of raw cotton trade in the country. The market size of raw cotton in India is over Rs.130 billion. The average monthly fluctuation in prices of cotton traded across India has been at around 4.5% during the last three years. The maximum fluctuation has been as high as 11%. Historically, cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis. Cotton is among the most important non–food crops. It occupies a significant position, both from agricultural and manufacturing sectors’ points of view. It is the major source of a basic human need – clothing, apart from other fibre sources like jute, silk and synthetic. Today, cotton occupies a significant position in the Indian economy on all fronts as a commodity that forms a means of livelihood to over millions of cotton cultivating farmers at the primary agricultural sector. It is also a source of direct employment to over 35 million people in the secondary manufacturing textile industry that contributes to 14% of the country’s industrial production, 27–30% of the country’s export earnings and 4% of its GDP. Cropping and Growth pattern Cotton is a tropical and sub–tropical crop. For the successful germination of its seeds, a minimum temperature of is required. The optimum temperature range for vegetative growth is . It can tolerate temperatures as high as , but does not do well if the temperature falls bellow C. During the period of fruiting, warm days and cool nights, with large diurnal variations are conducive to good boll and fibre development. In the case of the rain–fed cotton, which predominates and occupies nearly 75% of the area under this crop, a rainfall of 50 cm is the minimum requirement. More than the actual rainfall, a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton. Cotton is grown on a variety of soils. It requires a soil amenable to good drainage, as it does not tolerate water logging. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils. The predominant types of soils on which the crop is grown are (1)Alluvial soils predominant in the northern states of Punjab, Haryana, Rajasthan and Uttar Pradesh, (2)The black cotton soils, (3)The red sandy loams to loams – predominant in the states of Gujarat, Maharashtra, Madhya Pradesh, Andhra Pradesh, Karnataka and Tamil Nadu, and (4)Lateritic soils – found in parts of Tamil Nadu, Assam and Kerala. Cotton is a 90–120 day annual crop. In the main producing countries of USA, China, India and Pakistan, the crop is sown during the June–July period and harvested during SeptemberOctober. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. Kappas are bought by ginners, who separate the seeds from the lint (cotton fibre), a process called ginning (lint recovery from kappas is 30– 31%). The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in India; in USA, it is 480 pounds). Spinned cotton yarn is used by clothe manufacturers/ textile industry.

4.1 Agricultural commodities

39

Global and domestic demand–supply dynamics China, USA, India and Pakistan top the list of cotton producing countries. Uzbekistan, Brazil, Turkey and Australia are the other major producers. These eight countries produced over 80% of the world’s cotton production during 2001–02. China, India, USA and Pakistan top the list of cotton consuming countries. These along with Turkey, Brazil, Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% of the world’s annual cotton consumption. Global production of cotton during the post 1990 (till date i.e. 2002–03 forecast) has been fluctuating in the narrow range of 16.5–21 million tons. Similarly, consumption has been in the range in the 18–20.5 million tons. The global export and import trade of cotton during the post 1990 era has been in the range of 5.5 to 6.5 million tons. Production of cotton in India during the post 1990 period has been fluctuating in the range of 12–17 million bales (i.e. between 2.2–2.8 million tons), constituting about 15% of the global cotton production. Currently, the country’s cotton consumption stands at 17-19 million bales (2.7–2.9 million tons). India’s position on the global trade front has witnessed a drastic change during the post 1995 period. The country has turned from being net exporter to net importer. The country’s raw cotton exports, which stood at 1.2–1.6 million bales during the pre–1996 period have dipped to less than 100 thousand bales. Contrary to this, the imports have sharply risen from 30000–50000 bales during the pre–1995 to little over 2.2 million bales during the last three years. Among several other reasons, it is the lack of availability of desired quality cotton that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supply. Most importing mills in India are ready to pay 5–10% premium for foreign cotton due to its higher quality (less trash, uniform lots, higher ginning out–turn) and better credit terms (3–6 months vs. 15–30 days for local). Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from Egypt, West Africa, and the CIS countries and Australia on account of lower freight and shorter delivery periods. Price trends and factors that influence prices Cotton production and trade is influenced by various factors. Production (acreage under the crop) of cotton varies from year to year based on the climatic factors that are crucial for the productivity of crop. Cotton trade is influenced by the supply–demand scenario, production and prices of synthetic fibre (polyester, viscose and acrylic) and prices of cotton itself, etc. The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are closely watched by the trading community. The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season. The CCI is responsible for establishing the price support in all States. Typically, market prices remain well above the MSP, and CCI operations are generally limited to commercial purchases and sales (except for a few years like 2001–02 when the prices were abysmally low).

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Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for cotton traded in the international market. World cotton prices fell sharply during most part of 2001, NyBOT witnessing a sharp downfall in prices from 61.78 US Cents/ lb (as on Jan 2, 2001) to the low of 28.20 US Cents/ lb (as on Oct 26, 2001), a sharp fall by 54.35%. Towards mid–2002, prices recovered to 53 cents, and toward end of 2003 were currently ruling at 58.85 cents. Cotton prices in India are therefore influenced by various demand–supply factors operating within the country, international raw cotton prices, demand for finished readymade garments from abroad, prices of synthetic fibre, etc. Jute, silk, wool and khadi – the other fibre sources, are less likely to have any major impact on cotton prices in India.

4.1.2

Crude palm oil

Annual edible oil trade in India is worth over Rs.440 billion, with the share of CPO being nearly 20% (Rs.80-90 billion). The country is over–dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports. There is a close inter linkage between the various vegetable oils produced, traded and consumed across the world. The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9.7% during the past two and a half years, the maximum monthly fluctuation being as high as 25% during the period. Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. One hectare of oil palm yields approximately 20 FFBs, which when crushed yields 6 tons of oil (including the kernel oil, which is used both for edible and industrial purposes). Crude palm oil (CPO), crude palmolein, RBD (refined, bleached, deodorized) palm oil, RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market. Cropping and growth patterns Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. Rainfall less than 100 mm for a period of more than three months is not suitable for C with at least 5 hours oil palm cultivation. Oil palm thrives well at temperatures of sunshine per day throughout the year. Oil palm can be grown on a wide range of soil. In general, the soil should be deep, well structured and well drained. However, in areas where rainfall is marginally suitable, the water–holding capacity of the soil is of greatest importance. Flat or gentle undulating land is preferred. Oil palm is sensitive to pH above 7.5 and stagnant water. Global and domestic demand–supply dynamics CPO is used for human consumption as well as for industrial purposes. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7.37% compounded annually during the last 12 years period. While in the importing countries like China and European Union, the consumption of palm oil is growing at the rate of 5.2% and 4.8% respectively, the consumption growth rate for the worlds leading palm oil importer


41

(in specific, and edible oils in general), India, stands at 25%. India, China, Pakistan and the European Union are the major importers of palm oil. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. The total imports of India, China, Pakistan and European Union amount to approximately 56% of the total global exports of palm oil annually. Production of palm oil stands at 24–25 million tons (over 22% of the global vegetable oil). Palm oil dominates the global vegetable oil export trade. The two producing countries viz. Malaysia and Indonesia dominate the global trade in CPO. Their share in the global exports of CPO is to the tune of 90%. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. (MDEX) could be considered as the price maker of palm oil traded world over. This exchange trades only CPO among several derivatives of palm. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Rising consumption of palm oil in India, which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports. Palm oil supports many other industries in India like refining, vanaspati and other industrial sectors apart from human consumption as RBD palmolein. The major importing and trading centres for palm in India are Chennai, Kakinada, Mumbai and Kandla. The other centers like Mundra, Kolkata, Mangalore and Karwar also play important role, but next to the four major trading centers. Palm oil trade in India is influenced by the supply–demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government, mainly the export–import policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. The entire industry of CPO in India is dominated by importers, large refiners, corporate involved in wholesale and retail trade through value–addition and retail–regional level players along with a few national level players. The industry is dominated by over 200 importing companies, who are mostly refiners too. Domestic oilseed and edible oil industry is organised in the form of oilseed crushers, processors, solvent extractors, technologists, commodity–specific producers and traders. Price trends and factors that influence prices There exists a clear trough and crest in the seasonality of CPO production, indicating a typical seasonality in the production cycle. The production bottoms down in the months of February, March and April, while the it is at its peak during the months of August, September and October. Palm oil trade is influenced by various production, market and policy related factors. Being a perennial plantation crop, acreage under palm plantation does not vary from season to season. Production is almost evenly distributed throughout the year between 0.8–1.1 million tons in a monthly. However, it exhibits seasonal highs and lows once in a year. Yield levels of the plantations are influenced by climatic conditions like rainfall, temperature, etc. Factors that influence price are market related factors viz. supply–demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. canola/ rapeseed, coconut oil, sunflower, groundnut, etc.; supply–demand status of various consuming/ importing countries;

42


over–all status of the edible oil industry during the immediate past; current and a short–term forecast of the future status of the industry in various producing and consuming countries. Production and trade related policies of various exporting and importing nations of palm oil at the international scene have a major bearing on the prices of palm oil. Trade policies in India Since oilseed is one among the major crops cultivated by millions of farmers spread across the country, and is the major source of cooking oil to over one billion consuming populace of the country, like any other welfare state, Government of India (GoI) adopts a protection policy with regard to production and trade in vegetable oils, so as to protect the interests of both the producers and consumers. While the strategy of farm subsidies and minimum support price (MSP) are on the production side, the duty structure on various forms of palm oil is the major trade–related protectionist measure.

4.1.3

RBD Palmolein

The RBD (refined, bleached and deodorized) palmolein is the derivative of crude palm oil (CPO), which is obtained from the crushing of fresh–fruit-bunches (FFBs) harvested from oil palm plantations. When CPO is subjected to refinement, RBD palm oil and fatty acids are obtained. Fractionation of RBD palm oil yields RBD palmolein along with stearin, which is a white solid at room temperature. While Oil is a stable derivative saturated fat, solid at room temperature), Olein is relatively unstable (unsaturated fat, liquid at room temperature, but low cholesterol). The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. Cropping of growth patterns of CPO has been already covered. Global and domestic demand–supply dynamics The European Union, Pakistan and Middle–East countries are the major importers of RBD palmolein. Malaysia and Indonesia, which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil, export largely as CPO as is demanded by the importing nations who refine domestically and consume. RBD palmolein exports from Malaysia have increased from 3.2 million tons in 1998 to 4.5 million tons in 2002. India, which is one of the largest importer and consumer of edible oils in the world, imports nearly 3 million tons of palm oil annually (mainly from Malaysia, followed by Indonesia). This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period. At the same time, there has been a drastic change in the composition of various forms of palm oil imported owing to the differential duty structure adopted by Indian government for crude and refined palm oil imports. The import is mainly through the ports of Kandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and Chennai. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Its production grew from 5000 tons in 1991 to 35,000 tons in 2002,


43

while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million tons during 2001–02, growing at the rate of 25% compounded annually during the past decade. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers. Price trends and factors that influence prices Palm oil trade in India is influenced by the supply–demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government mainly the export–import policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Unlike the price of CPO imported into the country, which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India, RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time.

4.1.4

Soy oil

Soy oil is among the major sources of edible oils in India. Of the annual edible oil trade worth over Rs.440 billion in the country, soy oils share is over 20–21% at Rs.90–92 billion in terms of value. Being an agricultural commodity, which is often subjected to various production and market–related uncertainties, soy oil prices traded across the world are highly volatile in nature. The average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6.6% during the past two and a half years, the maximum monthly fluctuation being as high as 17% during the period. Historically, soy oil prices in the major spot markets across the country have been fluctuating in the range of 4.5–8.5%. This offers immense opportunity for the investors to profitably deploy their funds in this sector apart from those actually associated with the value chain of the commodity, which could use soy oil futures contract as the most effective hedging tool to minimise price risk in the market. Soy oil is the derivative of soybean. On crushing mature beans, 18% oil and 78–80% meal is obtained. While the oil is mainly used for human consumption, meal serves as the main source of protein in animal feeds. Soy oil is the leading vegetable oil traded in the international markets, next only to palm. Palm and soy oils together constitute around 68% of global edible oil export trade volume, with soy oil constituting 22.85%. It accounts for nearly 25% of the world’s total oils and fats production. Increasing price competitiveness, and aggressive cultivation and promotion from the major producing nations have given way to widespread soy oil growth both in terms of production as well as consumption. Cropping and growth patterns In India, soybean is purely a Kharif crop, whose sowing begins by end–June with the arrival of southwest monsoon. The crop, which is ready for harvest by the end of September, starts

44


entering the market from October beginning onwards. Crushing for oil and meal starts from October, peaking during the subsequent two–three months. Global and domestic demand–supply dynamics Global consumption of soy oil during 2001–02 shot up to 29.38 million tons. It has been growing at the rate of 5.63%. Notable upward movement in consumption of soy oil is being seen in EU, Central Europe, Russia, Egypt, Morocco, US, Mexico, Brazil, China and India. The consumption of soy oil in USA is to the extent of 90% of its production; growing at the rate of 2.95%, slightly higher than the growth rate of its production (2.92%). The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of soy oil. The current world production of soy oil stands at 29–30 million tons. It has been growing at the rate of 5.8% compounded annually during the last decade. The production growth rate has been the highest for Argentina at 10.8%, while that of Brazil and USA has been at 5.6% and 2.9% respectively. United States is the major producer of soy oil in the world. It accounts to approximately 29% of world soy oil production with an annual production of 8.5 million tons. Brazil and Argentina with 5.1 and 4.1 million tons of production, contribute to 17% and 14% of world production. Of the total world exports, Argentina contributes to an extent of 40.4%, growing at the rate of 11.36% compounded annually during the past decade. Production of soy oil in India has been fluctuating in the range of 0.7–0.9 million tons during the last five years, growing at the rate of 5%. In addition to domestic production, around 1.5–1.8 million tons of imports take the country’s annual soy oil consumption to 2.2–2.7 million tons, with a market value of over Rs.90 billion. Imports constitute to the extent of over 65–68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Imports have been growing at the rate of approximately 20% over the period of last five years. Madhya Pradesh is considered as the soybean bowl of India, contributing 80% of the country’s soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangli in Maharashtra are major trading centres of soybean, in and around which the crushing and solvent extraction units are mostly located. The refining units are located at the importing ports of Mumbai and Gujarat. Price trends and factors the influence prices In India, spot markets of Indore and Mumbai serve as the reference market for soy oil prices. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted), Mumbai price indicates the imported soy oil price. Indian edible oil market is highly price sensitive in nature. Hence, the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor, palm oil apart from prices of domestically produced oils, production and trade policies of the government – mainly the export–import policy, over–all health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Soy oil is among the most vibrant commodities in terms of price volatility. Its


45

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

4.1.5

Rapeseed oil

Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world, after soy and palm oils. On crushing rapeseed, oil and meal are obtained. The average oil recovery from the seed is about 33%. The remaining is obtained as oil cake/ meal, which is rich in proteins and is used as an ingredient in animal feed. Mustard oil, which is known for its pungency, is traditionally the most favoured oils in the major production tracts world over. Cropping and growth patterns Rapeseed is a 90–110 day crop. In the countries of Canada, Australia and China, the rapeseed is sown during the months of June–July and harvested by August–September. Crushing for oil begins from October onwards. In India, rapeseed is sown in the Rabi season (November– December sowing). China also grows partly during this season. Mustard/ Rapeseed is traditionally the most important oil for the northern, central and eastern parts of the country. The pungency of the oil is considered as the major quality determining factor. Therefore, traditional millers producing unrefined oil are more favoured by the consumers. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies), gets crushed for oil and cake in the ghanis or the expeller mills. It is largely consumed in the crude form in the local crushing regions. The cake obtained from the seed crush contains some amount of oil, which is extracted by the solvent extractors. The left over meal at the solvent extraction units forms a major portion of our oil meal basket, part of which is consumed by the domestic animal feed industry, and the rest exported. Refining of rapeseed oil was almost absent in the country till the end of the last century. As a result, the sector was more unorganised when compared to the other edible oil sectors in the country. This resulted in rampant adulteration of the oil. However, with the occurrence of dropsy in the country, Government of India issued the edible oil packaging order in 1998, which made refining and packing of all oils sold in the retail sector mandatory. Now, refining is present in rapeseed oil too. Global and domestic demand–supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth

46


rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major importers, whose share has been declining over the years. At an annual production level of 13–14 million tons, rapeseed oil accounts for about 12% of the total world’s edible oil production. Globally, rapeseed oil production has witnessed a moderate compounded annual growth rate (over the last decade) of 4.65%. While the production growth rates in major producing countries viz. Canada and India have posted negative values of 1.2% and 7.8% respectively during the past decade, China, France and Germany’s rapeseed oil production during the period has been growing at 10%, 6.8% and 4.7% respectively. China contributes more than one thirds of world rapeseed oil production while that of India has gone down from 18.2% in 1997 to 11.3% in 2001. Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. It forms over one–third of the country’s annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998–99 to a mere 10000 tons (of crude rapeseed oil) in 2001–02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Unlike other oils, consumption of rapeseed oil is concentrated in northern, north–eastern and western part of the country. Rapeseed oil has several industrial applications too viz. as lubricant, its erucic acid derivatives are used in plastic industry, and it could also be transformed into a liquid biofuel. Rajasthan and Uttar Pradesh are the major rapeseed producing states in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres. Price trends and factors the influence prices Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations.

4.1.6

Soybean

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


47

active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two years, the maximum monthly fluctuation being as high as 24–30% during the period. Historically, soybean prices in the major spot markets across the country have been fluctuating in the range of 5–9%. Soybean is the single largest oilseed produced in the world. The commodity has been commercially exploited for its utility as edible oil and animal feed. On crushing mature beans, around 18% oil could be obtained; the rest being the oil cake/ meal, which forms the prime source of protein in animal feeds. Cropping and growth patterns Soybean could be grown under rain fed conditions, provided a good amount of soil moisture is ensured at the germination, vegetative growth and pod setting stages. The planting date of vegetable soybean is dependent upon temperature and day length. The optimum temperature range of soybean cultivation is C with short day length (14 hours or less). However, planting should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.0–6.5 is suitable for its cultivation, but the field should be well drained. Global and domestic demand–supply dynamics About 82–85% of the global soybean production is crushed for oil and meal, while the rest is consumed either in the form of bean itself or for value–added soybean snack foods. USA, Brazil, Argentina, China and European Union countries constitute for the bulk of world’s annual soybean consumption. Mexico, Japan, India and Taiwan are among the other major consumers. During the past five years period, global consumption of soybean has grown at the rate of 5.25%, higher than the production growth rate of 5.19%. Of the total 310–320 million tons of oilseeds produced annually, soybean production alone stands at 170–190 million tons, contributing to over 55% of the global oilseeds production. During the last decade, the production of the commodity grew at the rate of 5.35% at the global level. USA, followed by Brazil and Argentina are the major producing countries; India and China are among the other producers. The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual production of 5.0–5.4 million tons, soybean constitutes nearly 25% of the country’s total oilseed production. Of the total bean produced, 6–7 lakh tons goes for direct consumption in the form of bean itself (sowing, human consumption as bean itself), leaving the rest of the quantity for crushing for meal and oil. While the country imports soy oil, it is a leading exporter of meal in the Asian region. Madhya Pradesh is the soybean bowl of India, contributing 65–70% of the country’s soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities.

4.1.7

Rapeseed

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

48


oil meal, the major protein source in animal feeds. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9.8% during the past two years (July 2001 to July 2003), the maximum monthly fluctuation being as high as 23.4% during the period. Rapeseed/ Mustard/ Canola is a traditionally important oilseed. China, Canada and India are the major producers of this commodity. The other major producers are Germany, France, Australia, Pakistan and Poland. The commodity has been commercially exploited in the form of seeds, oil (seed to oil recovery is 39–40%) and meal. The hybrid form of rapeseed, known as canola, is more popular internationally. Cropping and growth patterns Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown in India. They are generally divided into three groups: 1. Brown mustard, commonly called rai (raya or laha) 2. Sarson: (i) Yellow sarson (ii) Brown sarson 3. Toria (Lahi or Maghi Labi)

Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool temperatures for satisfactory growth. In India, they are grown during the Rabi season from September–October to February–March. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. Sarson is preferred in low–rainfall areas, whereas Rai and Toria are grown in medium and high rainfall areas respectively. Rapeseed and mustard thrive best in light to heavy loams. Rai may be grown on all types of soils, but Toria does best in loam to heavy loams. Sarson is suited to light–loam soils and Taramira is mostly grown on very light soils. Global and domestic demand–supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major importers, whose share has been declining over the years. Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tons in 1999, and declined from there on to the current (2002) level of 32.5 million tons. It has been growing at the rate of 2.2% during the last 12 years period. The major contributors to global rapeseed production are China, India, Germany, France, Canada and Australia with a share of 32%, 12.6%, 12.1%, 10%, 9.8% and 3% respectively. Among the major contributors to world production, Australian rapeseed production grew at the fastest rate of 21%. While China, France and Germany are growing at a moderate rate of 2–4%, India and Canada have shown a decline

4.2 Precious metals

49

in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997 to 1.2 million tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada. Germany follows Canada in the export of domestically produced rapeseed oil. Its exports too have fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and China consume most of the rapeseed oil that is produced domestically. Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5– 4.8 million tons of rapeseed available for produced annually in the country supplies over 1.5 million tons of oil and 3–3.2 million tons of meal on crushing. It is the largest produced edible oil in India (groundnut oil production also stands on par with it during good years). It forms over one–third of the country’s annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998–99 to a mere 10000 tons (of crude rapeseed oil) in 2001–02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres. Price trends and factors the influence prices Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil traded across the country. Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations. Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value chain of the commodity- the producing farmers, processors, brokers, speculators, mustard oil and traders of other oils. Import of both refined and crude rapeseed oil is permitted into the country. The import duty on crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oil for the last few years due to the differential duty structure.

4.2

Precious metals

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

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

The London gold futures exchange started operations in the early 1980s. The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange had

a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other.

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

The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few

commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with seven million contracts.

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

The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002. Mumbai’s first multi–commodity exchange, the National Commodities and Derivatives Exchange,

NCDEX launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation, National Bank for Agriculture and Rural Development and National Stock Exchange of India Limited, introduces gold futures contracts.

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

Box 4.4: History of derivatives markets in gold

4.2.1

Gold

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

4.2 Precious metals

51

Table 4.1 Country–wise share in gold production, 1968 and 1999 Country South Africa Australia Canada USA China Indonesia India Rest of the world Total

Tonnes, 1968

Share 1968

Tonnes, 1999

Share, 1999

972

67

87 44

6 3

87

6

437 309 154 334 154 154 51 463

17 12 6 13 6 6 2 18

1450

100

2571

100

Production Traditionally South Africa has been the largest producers of gold in the world accounting for almost 80% of all non–communist output in 1970. Although it retained its position as the single largest gold producing country, its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Table 4.1 gives the country–wise share in gold production. In contrast other countries like US, Australia, Canada and China have increased their output exponentially with output from developing countries like Peru and other Latin American countries also increasing impressively. Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly from the Kolar gold mines in Karnataka) as against a total world production of about 2,272 tonnes in 1995. Melting & refining assaying facility in India At present, gold is mainly refined in Bombay where a few refineries like the India Government Mint and National refinery are active. Some private refineries are also operating elsewhere with limited capacity. As none of the refineries is LBMA recognised, there is a need to upgrade and also increase the refining capacity. Global and domestic demand–supply dynamics The demand for gold may be categorised under two heads – consumption demand and investment demand. Consumption of gold differs according to type, namely industrial applications and jewellery. The special feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly consumed. This is unlike consumption in the form of jewellery, which remains as stock and can reappear at future time in market in another form. Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry forms 89% of consumer demand.

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In markets with poorly developed financial systems, inaccessible or insecure banks, or where trust in the government is low, gold is attractive as a store of value. If gold is held primarily as an investment asset, it does not need to be held in physical form. The investor could hold gold–linked paper assets or could lend out the physical gold on the market attaining a higher return in addition to savings on the storage costs. Japan has the highest investment demand for gold followed closely by India. These two countries together account for over 50% of total world demand of gold for retail investment. Investment demand can be split broadly into two, private and public sector holdings. There are several ways in which investors can invest in gold either directly or through a variety of investment products, each of which lends it to specific investor preferences: Coins and small bars Gold accounts: allocated and unallocated Gold certificates and pool accounts Gold Accumulation Plan Gold backed bonds and structured notes Gold futures and options Gold–oriented funds

Demand The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth. More than 80% of the gold consumed is in the form of jewellery, which is generally predominated by women. The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by USA, Middle East and China. About 80% of the Physical gold is consumed in the form of jewellery while bars and coins occupy not higher than 10% of the gold consumed. If we include jewellery ownership, then India is the largest repository of gold in terms of total gold within the national boundaries. Regarding pattern of demand, there are no authentic estimates, the available evidence shows that about 80% is for jewellery fabrication for domestic demand, and 15% is for investor–demand (which is relatively elastic to gold-prices, real estate prices, financial markets, tax–policies, etc.). Barely 5% is for industrial uses. The demand for gold jewellery is rooted in societal preference for a variety of reasons – religious, ritualistic, a preferred form of wealth for women, and as a hedge against inflation. It will be difficult to prioritise them but it may be reasonable to conclude that it is a combined effect, and to treat any major part as exclusively a store of value or hedging instrument would be unrealistic. It would not be realistic to assume that it is only the affluent that creates demand for gold. There is reason to believe that a part of investment demand for gold assets is out of black money. Rural India continues to absorb more than 70% of the gold consumed in India and it has its own role to fuel the barter economy of the agriculture community. The yellow metal used to

4.2 Precious metals

53

play an important role in marriage and religious festivals in India. In the Hindu, Jain and Sikh community, where women did not inherit landed property whereas gold and silver jewellery was, and still is, a major component of the gifts given to a woman at the time of marriage. The changeover hands of gold at the time of marriage are from few grams to kgs. The gold also occupies a significant position in the temple system where gold is used to prepare idol and devotees offer gold in the temple. These temples are run in trust and gold with the trust rarely comes into re-circulation. The existing social and cultural system continues to cause net gold buyer market and the government policies have to take note of the root cause of gold demand, which lies in the social and cultural system of India. The annual consumption of gold, which was estimated at 65 tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it is likely that, with prosperity and enlightenment, there may be deceleration in demand, particularly in urban areas, it would be made good by growing demand on account of prosperity in rural areas. In the near future, therefore, the annual demand will continue to be over 600 tonnes per year. Supply Indian gold holding, which are predominantly private, is estimated to be in the range of 1000013000 tonnes. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%. The demand–supply for gold in India can be summed up thus: Demand for gold has an autonomous character. Supply follows demand. Demand exhibits income elasticity, particularly in the rural and semi-urban areas. Price differential creates import demand, particularly illegal import prior to the commencement of liberalisation in 1990.

Price trends and factors that influence prices Indian gold prices follow more or less the international price trends. However, the strong domestic demand for gold and the restrictive policy stance are reflected in the higher price of gold in the domestic market compared to that in the international market at the available exchange rate. Since the demand for gold is closely tied to the production of jewelry, gold prices tend to increase during the time of year when demand for jewellery is greatest. Christmas, Mothers Day and Valentine Day are all major shopping seasons and hence the demand for metals tends to be strong a few months ahead of these holidays. Also, the summer wedding season sees a large increase in the demand for metals, so price strength in March and April is not uncommon. On the

54


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

4.2.2

Silver

The dictionary describes it as a white metallic element, sonorous, ductile, very malleable and capable of high degree of polish. It also has the highest thermal and electrical conductivity of any substance. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. Silver remains one of the most prominent candidates in the metals complex as far as futures’ trading is concerned. Thanks to its unique volatility, silver has remained a hot favourite speculative vehicle for the small time traders. Though futures trading was banned in India since late sixties, parallel futures markets are still very active in Delhi and Indore. Speculative interest in the white metal is so intense that it is believed that combined volume of Indian punters represent almost 40 percent of volume traded at New York Commodity Exchange. Delhi, Rajasthan, MP and UP are the active pockets for the silver futures. Until recently, Rajkot and Mathura were conducting futures but now players have diverted toward comex trade. Most of the world’s silver is mined in the US, Australia, Mexico, Peru, and Canada. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. Taking cue from gold, government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry. The unique properties of silver restrict its substitution in most applications. Production Silver ore is most often found in combination with other elements, and silver has been mined and treasured longer than any of the other precious metals. Mexico is the worlds leading producer of silver, followed by Peru, Canada, the United States, and Australia. The main consumer countries for silver are the United States, which is the worlds largest consumer of silver, followed by Canada, Mexico, the United Kingdom, France, Germany, Italy, Japan and India. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth, industrial production, income levels, and a whole host of other financial macro economic indicators. Demand Demand for silver is built on three main pillars; industrial and decorative uses, photography and jewelry & silverware. Together, these three categories represent more than 95 percent of annual silver consumption. In recent years, the main world demand for silver is no longer monetary, but industrial. With the growing use of silver in photography and electronics, industrial demand for silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is the second largest component, with more demand from the flatware industry than from the jewelry industry in recent years. India, the largest consumer of silver, is gearing up to start hallmarking of the white precious metal by April. India annually consumes around 4,000 tonnes of silver,

4.2 Precious metals

55

Major markets like the London market (London Bullion Market Association), which started trading in the 17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The London market has a fix which offers the chance to buy or sell silver at a single price. The fix begins at 12:15 p.m. and is a balancing exercise; the price is fixed at the point at which all the members of the fixing can balance their own, plus clients, buying and selling orders. Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969, respectively. In the United States, the silver futures market functions under the surveillance of an official body, the Commodity Futures Trading Commission (CFTC). Although London remains the true center of the physical silver trade for most of the world, the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. Spot prices for silver are determined by levels prevailing at the COMEX. Although there is no American equivalent to the London fix, Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at noon each working day.

Box 4.5: Historical background of silver markets

with the rural areas accounting for the bulk of the sales. India’s demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. According to GFMS, India has emerged as the third largest industrial user of silver in the world after the US and Japan. Supply The supply of silver is based on two facts, mine production and recycled silver scraps. Mine production is surprisingly the largest component of silver supply. It normally accounts for a little less than 2/3 rd of the total (last year was slightly higher at 68%). Fifteen countries produce roughly 94 percent of the worlds silver from mines. The most notable producers are Mexico, Peru, the United States, Canada and Australia. Mexico, the largest producer of silver from mines. Peru is the worlds second largest producer of silver. Silver is often mined as a byproduct of other base metal operations, which accounts for roughly four-fifths of the mined silver supply produced annually. Known reserves, or actual mine capacity, is evenly split along the lines of production. The mine production is not the sole source – others being scrap, disinvestments, government sales and producers hedging. Scrap is the silver that returns to the market when recovered from existing manufactured goods or waste. Old scrap normally makes up around a fifth of supply. Scrap supply increased marginally last year up by 1.2%. The other major source of silver is from refining, or scrap recycling. Because silver is used in the photography industry, as well as by the chemical industry, the silver used in solvents and the like can be removed from the waste and recycled. The United States recycles the most silver in the world, accounting for roughly 43.6 million ounces. Japan is the second largest producer of silver from scrap and recycling, accounting for roughly 27.8 million troy ounces in 1997. In the United States and Japan, three–quarters of all the recycled silver comes from the photographic scrap, mainly in the form of spent fixer solutions and old X-ray films.

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Factors influencing prices of the silver The prices of silver, like that of other commodities, are dictated by forces of demand and supply and consumption. Besides, a host of social, economic and political factors have powerful bearing on silver prices. As in the case of gold prices, political tensions, the threat affects the price of silver too. When trading and movement of silver is restricted, within or outside national boundaries, prices move in accordance with demand and supply conditions prevalent in that environment Price of silver is also influenced by changes in factors such as inflation (real or perceived), changing values of paper currencies, and fluctuations in deficits and interest rates, etc. Although prices and incomes are important factors, they are also influenced by factors such as tastes, technological change and market liberalisation. Approximately 70 percent of the silver mined in the western hemisphere is mined as a by– product of other metal products, such as gold, copper, nickel, lead, and zinc. As such, the price of these metals greatly affects the supply of silver mined in any year. As the price of the other metal products increases, the increased profit margin to mine operations stimulates greater production of the other metals, and as a result, the production of silver increases in tandem. Because silver is a precious metal, its price is determined by the supply and demand ratio at any given moment. As is the case with other precious metals, there is a limited amount of silver in the world. It is not a product that can be manufactured en masse, and, therefore, is subject to issues such as weather and politics that may affect silver mining operations.

Solved Problems Q: Which of the following commodities do not trade on the NCDEX? 1. Gold

3. Silver

2. Rapeseed

4. Energy

A: The correct answer is number 4. Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment? 1. Wheat

3. Soybean

2. Rapeseed

4. Soy oil

A: The correct answer is number 1. Q: In India,

is the most important non–food crop.

1. Jute

3. Silk

2. Cotton

4. None of the above.


4.2 Precious metals

57

Q: Which of the following factors do not influence the price of cotton? 1. Demand–supply scenario

3. Previous prices of cotton

2. Production and prices of synthetic fibre

4. Prices of cotton products.

A: The correct answer is number 4. Q: Futures prices of cotton at the market.

serve as the reference price for cotton traded in the international

1. CME

3. NYBOT

2. CBOT

4. SGX

A: The correct answer is number 3. Q: Palm oil is extracted from the

of oil palm plantations.

1. Mature fresh fruit bunches

3. Stem

2. Dry fruit bunches

4. Leaves

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

3. CPO

2. Rapeseed

4. Coconut kernel

A: The correct answer is number 3. Q: Which of the following factor directly influences the price of RBD palmolein? 1. Prices of Rapeseed oil

3. Prices of CPO

2. Prices of coconut oil

4. Prices sunflower oil

A: The correct answer is number 3. Q: Soy oil is the derivative of 1. Soy

3. CPO

2. Soybean

4. Sunflower seeds


58


Q: The

market reflects the price of domestically crushed soybean

1. Mumbai

3. Indore

2. Ahmedabad

4. Delhi

A: The correct answer is number 3. Q: The

market reflects the price of imported soybean

1. Mumbai

3. Indore

2. Ahmedabad

4. Delhi


Chapter 5 Instruments available for trading In recent years, derivatives have become increasingly popular due to their applications for hedging, speculation and arbitrage. Before we study about the applications of commodity derivatives, we will have a look at some basic derivative products. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts. While at the moment only commodity futures trade on the NCDEX, eventually, as the market grows, we also have commodity options being traded.

5.1

Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter–party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

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

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Instruments available for trading

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

5.1.1

Limitations of forward markets

Forward markets world-wide are afflicted by several problems: Lack of centralisation of trading, Illiquidity, and Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradeable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

5.2

Introduction to futures

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

5.2 Introduction to futures

61

Merton Miller, the 1990 Nobel laureate had said that “financial futures represent the most significant financial innovation of the last twenty years.” The first exchange that traded financial derivatives was launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the International Monetary Market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the “father of financial futures” who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange totalled 50 trillion dollars. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board Options Exchange. By the 1990s, these exchanges were trading futures and options on everything from Asian and American stock indexes to interest–rate swaps, and their success transformed Chicago almost overnight into the risk–transfer capital of the world.

Box 5.6: The first financial futures market Table 5.1 Distinction between futures and forwards Futures

Forwards

Trade on an organised exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement

OTC in nature Customised contract terms hence less liquid No margin payment Settlement happens at end of period

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

5.2.1

Distinction between futures and forwards contracts

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

62


5.2.2

Futures terminology

Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day of the delivery month. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the Gold futures contract is 1 kg. Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to–market. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

5.3

Introduction to options

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

5.3 Introduction to options

63

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honour the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early ’80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

Box 5.7: History of options

5.3.1

Option terminology

Commodity options: Commodity options are options with a commodity as the underlying. For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer. Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price.

64

Instruments available for trading American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is "!$# %&('*),+.-0/2143 '*)5+-0/61 which means the intrinsic value of a call is the greater of 0 or . Similarly, 78!9# %&:/;-<) + 3 '=/>-?) + 1 the intrinsic value of a put is ,i.e. the greater of 0 or . K is the strike price ) + and is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value.

5.4

Basic payoffs

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

5.5 Payoff for futures

65

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

Box 5.8: Use of options in the seventeenth-century

5.4.1

Payoff for buyer of asset: Long asset

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

5.4.2

Payoff for seller of asset: Short asset

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

5.5

Payoff for futures

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

5.5.1

Payoff for buyer of futures: Long futures

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

66


Figure 5.1 Payoff for a buyer of gold The figure shows the profits/ losses from a long position on gold. The investor bought gold at Rs.6000 per 10 gms. If the price of gold rises, he profits. If price of gold falls he looses.

Profit +500

0

5500

6000

6500 Gold

−500 Loss

Figure 5.2 Payoff for a seller of gold The figure shows the profits/ losses from a short position on cotton. The investor sold long staple cotton at Rs.6500 per Quintal. If the price of cotton falls, he profits. If the price of cotton rises, he looses.

Profit +500

0

−500 Loss

6000

6500

7000 Long staple cotton

5.5 Payoff for futures

67

Figure 5.3 Payoff for a buyer of gold futures The figure shows the profits/ losses for a long futures position.The investor bought futures when gold futures were trading at Rs.6000 per 10 gms. If the price of the underlying gold goes up, the gold futures price too would go up and his futures position starts making profit. If the price of gold falls, the futures price falls too and his futures position starts showing losses.

Profit

6000 Gold futures price 0

Loss

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

5.5.2

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two–month cotton futures contract when the contract sells Rs.6500 per Quintal. The underlying asset in this case is long staple cotton. When the prices of long staple cotton move down, the cotton futures prices also move down and the short futures position starts making profits. When the prices of long staple cotton move up, the cotton futures price also moves up and the short futures position starts making losses. Figure 5.4 shows the payoff diagram for the seller of a futures contract.

68


Figure 5.4 Payoff for a seller of cotton futures The figure shows the profits/ losses for a short futures position. The investor sold cotton futures at Rs.6500 per Quintal. If the price of the underlying long staple cotton goes down, the futures price also falls, and the short futures position starts making profit. If the price of the underlying long staple cotton rises, the futures too rise, and the short futures position starts showing losses.

Profit

6500 Cotton futures price 0

Loss

5.6

Payoff for options

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

5.6.1

Payoff for buyer of call options: Long call

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

5.6 Payoff for options

69

Figure 5.5 Payoff for buyer of call option on gold The figure shows the profits/ losses for the buyer of a three–month call option on gold at a strike of Rs.7000 per 10 gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes in–the–money. If upon expiration, gold trades above the strike of Rs.7000, the buyer would exercise his option and profit to the extent of the difference between the spot gold–close and the strike price. The profits possible on this option are potentially unlimited. However if the price of gold falls below the strike of Rs.7000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Profit

0

7000 Gold

500

Loss

5.6.2

Payoff for writer of call options: Short call

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

5.6.3

Payoff for buyer of put options: Long put

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

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Figure 5.6 Payoff for writer of call option on gold The figure shows the profits/ losses for the seller of a three–month call option on gold with a strike price of Rs.7000 per 10 gms. As the price of gold in the spot market rises, the call option becomes in–the–money and the writer starts making losses. If upon expiration, gold price is above the strike of Rs.7000, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the spot gold–close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up–front option premium of Rs.500 charged by him.

Profit

500 0

7000

Gold

Loss

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

5.6.4

Payoff for writer of put options: Short put

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

5.7 Using futures versus using options

71

Figure 5.7 Payoff for buyer of put option on long staple cotton The figure shows the profits/ losses for the buyer of a three–month put option on long staple cotton. As can be seen, as the price of cotton in the spot market falls, the put option becomes in–the–money. If at expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and profit to the extent of the difference between the strike price and spot cotton–close. The profits possible on this option can be as high as the strike price. However if spot price of cotton on the day of expiration of the contract is above the strike of Rs.6000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option, Rs.400 in this case.

Profit

0

6000

Long staple cotton

400

Loss

sold at a premium of Rs.400.

5.7

Using futures versus using options

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

72


Figure 5.8 Payoff for writer of put option on long staple cotton The figure shows the profits/ losses for the seller of a three–month put option on long staple cotton. As the price of cotton in the spot market falls, the put option becomes in–the–money and the writer starts making losses. If upon expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and spot cotton–close. The profit that can be made by the writer of the option is limited to extent of the premium received by him, i.e. Rs.400, whereas the losses are unlimited (actually they are limited to the strike price since the worst that can happen is that the price of the underlying asset falls to zero.

Profit

400 0

6000

Long staple cotton

Loss

Table 5.2 Distinction between futures and options Futures Options Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk

be created.

Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short at risk.


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Solved Problems Q: Which of the following cannot be an underlying asset for a financial derivative contract? 1. Equity index

3. Interest rate

2. Commodities

4. Foreign exchange

A: The correct answer is 2

Q: Which of the following cannot be an underlying asset for a commodity derivative contract? 1. Wheat

3. Cotton

2. Gold

4. Stocks

A: The correct answer is 4

Q: Which of the following exchanges was the first to start trading commodity futures? 1. Chicago Board of Trade

3. Chicago Board Options Exchange

2. Chicago Mercantile Exchange

4. London International Financial Futures and Options Exchange

A: The correct answer is 3.

Q: In an options contract, the option lies with the 1. Buyer

3. Both

2. Seller

4. Exchange

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

Q: The potential returns on a futures position are: 1. Limited

3. a function of the volatility of the index

2. Unlimited



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Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a 1. Futures contract

3. Spot contract

2. Forward contract


A: The correct answer is number 2. Q: Typically option premium is 1. Less than the sum of intrinsic value and time value

3. Equal to the sum of intrinsic value and time value

2. Greater than the sum of intrinsic value and time value

4. Independent of intrinsic value and time value


Q: An asset currently sells at 120. The put option to sell the asset at Rs.134 costs Rs.18. The time value of the option is 1. Rs.18

3. Rs.14

2. Rs.4

4. Rs.12


Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a 1. OTC contract

3. Spot contract

2. Exchange traded contract



Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures on 10 units of soy bean at Rs.1500/Quintal. A week later soy bean futures trade at Rs.1550/Quintal. How much profit/loss has he made on his position? 1. (+)5000

3. (+)50,000

2. (-)5000

4. (-)50,000

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


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Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures on 10 units of soy bean at Rs.1500/Quintal. A week later soy bean futures trade at Rs.1450/Quintal. How much profit/loss has he made on his position? 1. (+)5000

3. (+)50,000

2. (-)5000

4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures on 10 units of soy bean at Rs.1500/Quintal. A week later soy bean futures trade at Rs.1550/Quintal. How much profit/loss has he made on his position? 1. (+)5000

3. (+)50,000

2. (-)5000

4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures on 10 units of soy bean at Rs.1500/Quintal. A week later soy bean futures trade at Rs.1450/Quintal. How much profit/loss has he made on his position? 1. (+)5000

3. (+)50,000

2. (-)5000

4. (-)50,000

A: Each unit is for 10 Quintals. He sells 10 units which means a futures position in 100 Quintals. He makes a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is number 1. Q: A trader buys three–month call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is his net payoff? 1. (+) 10,000

3. (-) 10,000

2. (+) 1,000

4. (-) 1,000

A: Per 10 gms he makes a net profit of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000 '8A4BCBCB ED %81 gms. So he makes a net profit of Rs.1000 on his position A4B . The correct answer is number 2.

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Q: A trader buys three–month call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff? 1. (-) 7000

3. (-) 700

2. (+) 1,000

4. (-) 1,000

A: The option is OTM. Unit of trading is 100 gms and he has bought 10 units. So he has a position in 1000 gms of gold. He pays an option premium of Rs.70 per 10 gms. He losses the premium amount of Rs.7000 on his position. The correct answer is number 1. Q: A trader sells three–month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is his net payoff? 1. (+) 10,000

3. (-) 10,000

2. (+) 1,000

4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short position in '8A4BCBCB ?D %81 . The correct answer is number 1000 gms. So he makes a net loss of Rs.1000 on his position A4B 4.

Q: A trader sells three–month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff? 1. (-) 7000

3. (-) 700

2. (+) 1,000

4. (-) 1,000

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

Chapter 6 Pricing commodity futures Commodity futures began trading on the NCDEX from the 14th December 2003. The market is still in its nascent phase, however the volumes and open interest on the various contracts trading in this market have been steadily growing. The process of arriving at a figure at which a person buys and another sells a futures contract for a specific expiration date is called price discovery. In an active futures market, the process of price discovery continues from the market’s opening until its close. The prices are freely and competitively derived. Future prices are therefore considered to be superior to the administered prices or the prices that are determined privately. Further, the low transaction costs and frequent trading encourages wide participation in futures markets lessening the opportunity for control by a few buyers and sellers. In an active futures markets the free flow of information is vital. Futures exchanges act as a focal point for the collection and dissemination of statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates and other pertinent information. Any significant change in this data is immediately reflected in the trading pits as traders digest the new information and adjust their bids and offers accordingly. As a result of this free flow of information, the market determines the best estimate of today and tomorrow’s prices and it is considered to be the accurate reflection of the supply and demand for the underlying commodity. Price discovery facilitates this free flow of information, which is vital to the effective functioning of futures market. In this chapter we try to understand the pricing of commodity futures contracts and look at how the futures price is related to the spot price of the underlying asset. We study the cost–of– carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

6.1

Investment assets versus consumption assets

When studying futures contracts, it is essential to distinguish between investment assets and consumption assets. An investment asset is an asset that is held for investment purposes by most investors. Stocks and bonds are examples of investment assets. Gold and silver are also

78

Pricing commodity futures

examples of investment assets. Note however that investment assets do not always have to be held exclusively for investment. As we saw earlier, silver, for example, has a number of industrial uses. However, to classify as investment assets, these assets do have to satisfy the requirement that they are held by a large number of investors solely for investment. A consumption asset is an asset that is held primarily for consumption. It is not usually held for investment. Examples of consumption assets are commodities such as copper, oil, and pork bellies. As we will learn, we can use arbitrage arguments to determine the futures prices of an investment asset from its spot price and other observable market variables. For pricing consumption assets, we need to review the arbitrage arguments a little differently. To begin with, we look at the cost–of–carry model and try to understand the pricing of futures contracts on investment assets.

6.2

The cost of carry model

We use arbitrage arguments to arrive at the fair value of futures. For pricing purposes, we treat the forward and the futures market as one and the same. A futures contract is nothing but a forward contract that is exchange traded and that is settled at the end of each day. The buyer who needs an asset in the future has the choice between buying the underlying asset today in the spot market and holding it, or buying it in the forward market. If he buys it in the spot market today, it involves opportunity costs. He incurs the cash outlay for buying the asset and he also incurs costs for storing it. If instead he buys the asset in the forward market, he does not incur an initial outlay. However the costs of holding the asset are now incurred by the seller of the forward contract who charges the buyer a price that is higher than the price of the asset in the spot market. This forms the basis for the cost–of–carry model where the price of the futures contract is defined as:

F F

SG C

(6.1)

where: F Futures price S Spot price C Holding costs or carry costs

The fair value of a futures contract can also be expressed as: F F S HIJG K LCM where: r Percent cost of financing

(6.2)

6.2 The cost of carry model

79

T Time till expiration

Whenever the futures price moves away from the fair value, there would be opportunities for arbitrage. If NPOQ@RH:SGTQ@RH:SG
F F S UWV M

(6.3)

where: r Cost of financing (using continuously compounded interest rate) T Time till expiration e 2.71828

So far we were talking about pricing futures in general. To understand the pricing of commodity futures, let us start with the simplest derivative contract – a forward contract. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. However, the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs. Then we introduce real world factors as they apply to investment commodities and later to consumption commodities. Consider a three–month forward contract on a stock that does not pay dividend. Assume that the price of the underlying stock is Rs.40 and the three–month interest rate is 5% per annum. We consider the strategies open to an arbitrager in two extreme situations. 1. Suppose that the forward price is relatively high at Rs.43. An arbitrager can borrow Rs.40 from the market at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in the forward market at Rs.43. At the end of three months, the arbitrager delivers the share and receives %.X BY BCZ([ BY \CZ^] %_a`% Rs.43. The sum of money required to pay off the loan is . By following this strategy, the arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at the end of the three month period.

80

Pricing commodity futures 2. Suppose that the forward price is relatively low at Rs.39. An arbitrager can short one share for Rs.40, invest the proceeds of the short sale at 5% per annum for three months, %.and in a _a`% X BY BCtake Z([ BY \CaZJlong ] %position three–month forward contract. The proceeds of the short sale grow to in three months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share under the terms of the forward contract and uses it to close his short position, in the process making a net gain of Rs.1.50 at the end of three months.

We see that if the forward price is greater than Rs.40.50, there exists arbitrage. Under such a situation, arbitragers will sell the asset in the forward market, eventually driving the forward price down to Rs.40.50. Similarly if the forward price is less than Rs.40.50, there exists arbitrage. Arbitragers will buy the asset in the forward market, eventually pushing the forward price up to Rs.40.50. At a forward price of Rs.40.50 there will be no arbitrage. This is the fair value of the forward contract. The same arguments hold good for a futures contract on an investment asset. Now let us try to extend this logic to a futures contract on a commodity. Let us take the example of a futures contract on a commodity and work out the price of the contract. The spot price of gold is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be the futures price of 10 gms of gold one month down the line ? Let us assume that we’re on 1st January 2004. How would we compute the price of a gold futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost–of–carry. Let us first try to work out the components of the cost–of–carry model. 1. What is the spot price of gold? The spot price of gold, S= Rs.7000/ 10 gms. 2. What is the cost of financing for a month?

X BYbA4Z([dcfe cfgih .

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

In this case the fair value of the futures, works out to be = Rs.7174. F Fj@kU V M2F

U

BYbA4Z([dlnm lno*p Frqtsu vwxuyv

If the contract was for a three–month period i.e. expiring on 30th March, the cost of financing BYbA4Z([d{nm lno*p F would increase the futures price. Therefore, the futures price would be NzF U qtsu wxu .

6.2.1

Pricing futures contracts on investment commodities

In the example above we saw how a futures contract on gold could be priced using arbitrage arguments and the cost–of–carry model. In the example we considered, the gold contract was for 10 grams of gold. Hence we ignored the storage costs. However, if the one–month contract was for a 100 kgs of gold instead of 10 gms, then it would involve non–zero holding costs which would include storage and insurance costs. The price of the futures contract would then be Rs.7086.80 plus the holding costs. Table 6.1 gives the indicative warehouse charges for accredited warehouses/ vaults that will function as delivery centres for contracts that trade on the NCDEX. Warehouse charges include

6.2 The cost of carry model

81

)k' D}|?~ 1

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

Box 6.9: The market crash of October 19, 1987 a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The per unit charges include storage costs and insurance charges. We saw that in the absence of storage costs, the futures price of a commodity that is an investment asset is given by NjFj@kU V M . Storage costs add to the cost of carry. If is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to F F

(S + U) U V M

(6.4)

where: r Cost of financing (annualised) T Time till expiration U Present value of all storage costs

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

(S + U)U V M BY B:[A H4w G7xG vwLU w w ,u w

82


Table 6.1 NCDEX – indicative warehouse charges Commodity

Fixed charges (Rs.)

Warehouse charges per unit per week (Rs.)

310 610 110 110 110 110 110 110 110 110

55 per kg 1 per kg 13 per MT 30 per MT 18 per MT 42 per MT 26 per MT 25 per MT 6 per Bale 6 per Bale

Gold Silver Soy Bean Soya oil Mustard seed Mustard oil RBD Palmolein CPO Cotton – long Cotton – medium

We see that the one–year futures price of a kg of gold would be Rs.6,46,904.76. The one–year futures price for 10 grams of gold would be about Rs.6469. Now let us consider a three–month futures contract on gold. We make the same assumptions – the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week. It costs Rs.1025 to store one kg of gold for three months(13 weeks). Assume that the storage costs are paid at the time of deposit. Assume further that the spot gold price is Rs.6000 per 10 grams and the risk–free rate is 7% per annum. What would the price of three month gold futures if the delivery unit is one kg? F F

F F

(S + U) U V M BY B:[ BY \CZ H4w G7xG . LU w w u

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

6.2.2

Pricing futures contracts on consumption commodities

We used the arbitrage argument to price futures on investment commodities. For commodities that are consumption commodities rather than investment assets, the arbitrage arguments used to determine futures prices need to be reviewed carefully. Suppose we have F T

(S + U) U V M

(6.5)

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

6.3 The futures basis

83

) |

1. Borrow an amount and pay storage costs.

at the risk–free interest rate and use it to purchase one unit of the commodity

2. Short a forward contract on one unit of the commodity.

If we regard the futures contract as a forward contract, this strategy leads to a profit of NH@6G7LU V M at the expiration of the futures contract. As arbitragers exploit this opportunity, the spot price will increase and the futures price will decrease until Equation 6.5 does not hold good. Suppose next that F O

(S + U) UWV M

(6.6)

In case of investment assets such as gold and silver, many investors hold the commodity purely for investment. When they observe the inequality in equation 6.6, they will find it profitable to trade in the following manner: 1. Sell the commodity, save the storage costs, and invest the proceeds at the risk–free interest rate. 2. Take a long position in a forward contract.

This would result in a profit at maturity of H@GrLIU V M QN relative to the position that the investors would have been in had they held the underlying commodity. As arbitragers exploit this opportunity, the spot price will decrease and the futures price will increase until equation 6.6 does not hold good. This means that for investment assets, equation 6.4 holds good. However, for commodities like cotton or wheat that are held for consumption purpose, this argument cannot be used. Individuals and companies who keep such a commodity in inventory, do so, because of its consumption value – not because of its value as an investment. They are reluctant to sell these commodities and buy forward or futures contracts because these contracts cannot be consumed. Therefore there is unlikely to be arbitrage when equation 6.6 holds good. In short, for a consumption commodity therefore, F OdF

(S + U) UWV M

(6.7)

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

6.3

The futures basis

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

84


Figure 6.1 Variation of basis over time The figure shows how basis changes over time. As the time to expiration of a contract reduces, the basis reduces. Towards the close of trading on the day of settlement, the futures price and the spot price converge. The closing price for the April gold futures contract is the closing value of gold in the spot market on that day.

Price Futures price

Spot price

Time t1

t2

T

opportunity for traders. In case of such arbitrage the trader can short his futures contract, buy the asset from the spot market and make the delivery. This will lead to a profit equal to the difference between the futures price and spot price. As traders start exploiting this arbitrage opportunity the demand for the contract will increase and futures prices will fall leading to the convergence of the future price with the spot price. If the futures price is below the spot price during the delivery period all parties interested in buying the asset will take a long position. The trader would buy the contract and sell the asset in the spot market making a profit equal to the difference between the future price and the spot price. As more traders take a long position the demand for the particular asset would increase and the futures price would rise nullifying the arbitrage opportunity. Nuances As the date of expiration comes near, the basis reduces - there is a convergence of the futures price towards the spot price(Figure 6.1). On the date of expiration, the basis is zero. If it is not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference between prices of two futures contracts) during the life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can be exploited. There is nothing but cost–of–carry related arbitrage that drives the behaviour of the futures price in the case of investment assets. In the case of consumption assets, we need to factor in the benefit provided by holding the physical commodity. Transactions costs are very important in the business of arbitrage.

6.3 The futures basis

85

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

Solved problems Q: The

model is used for pricing futures contracts.

1. Black & Scholes

3. Miller

2. Cost–of–carry

4. Time–value


Q: What is the fair value of one month futures if the spot value of gold is Rs.6000 per 10 grams? The money can be invested at 10% p.a. and warehousing cost are Rs.25 1. 6025.00

3. 6090.00

2. 6075.40

4. 6050.30

A: The fair value is

% ` X BYbABY BCCC]

%8` _ %

. The correct answer is number 2.

Q: As the a futures contract nears expiration, the basis 1. Increases

3. Remains unchanged

2. Reduces

4. Reduces to half

A: The correct answer is number 2. Q: An investment asset is an asset that is held for investment purposes by 1. Large investors

3. Most investors

2. Some investors

4. All investors

A: The correct answer is number 3. Q: An investment asset is an asset that is held for consumption purposes by 1. Large investors

3. Most investors

2. Some investors

4. All investors


86


Q: When the futures price happens to be higher than the fair value of the futures contract, arbitragers profit by 1. Selling futures 2. Buying the underlying asset 3. Selling futures and buying the underlying as-

set 4. Selling the underlying asset and buying futures


Q: When the futures price happens to be lower than the fair value of the futures contract, arbitragers profit by 1. Selling futures 2. Buying the underlying asset 3. Selling futures and buying the underlying as-


set 4. Selling the underlying asset and buying futures

Chapter 7 Using commodity futures For a market to succeed, it must have all three kinds of participants – hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on the market. Commodity markets give opportunity for all three kinds of participants. In this chapter we look at the use of commodity derivatives for hedging, speculation and arbitrage.

7.1

Hedging

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

7.1.1

Basic principles of hedging

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

88

Using commodity futures

Figure 7.1 Payoff for buyer of a short hedge The figure shows the payoff for a soy oil producer who takes a short hedge. Irrespective of what the spot price of soy oil is three months later, by going in for a short hedge he locks on to a price of Rs.450 per MT.

Profit Long position in soya oil

465 Price of soya oil

Short position in soya oil futures Loss

the price of the commodity goes up, the loss on the futures position is offset by the gain on the commodity. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. This is called a short hedge. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. We will study these two hedges in detail.

7.1.2

Short hedge

A short hedge is a hedge that requires a short position in futures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. For example, a short hedge could be used by a cotton farmer who expects the cotton crop to be ready for sale in the next two months. A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future. For example, an exporter who knows that he or she will receive a dollar payment three months later. He makes a gain if the dollar increases in value relative to the rupee and makes a loss if the dollar decreases in value relative to the rupee. A short futures position will give him the hedge he desires. Let a look at a more detailed example to illustrate a short hedge. We assume that today is the

7.1 Hedging

89

Table 7.1 Refined soy oil futures contract specification Trading system Trading hours

NCDEX trading system Monday to Friday Normal market hours – 10:00 am to 4:00 pm Closing session – 4:15 pm to 4:30 pm Unit of trading 1000 Kgs (=1 MT) Delivery unit 10000 Kgs (=10 MT) Quotation/ base value Rs. per 10 Kgs Tick size 5 paisa

15th of January and that a refined soy oil producer has just negotiated a contract to sell 10,000 Kgs of soy oil. It has been agreed that the price that will apply in the contract is the market price on the 15th April. The oil producer is therefore in a position where he will gain Rs.10000 for each 1 rupee increase in the price of oil over the next three months and lose Rs.10000 for each one rupee decrease in the price of oil during this period. Suppose the spot price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465 per 10 Kgs. Table 7.1 gives the soy oil futures contract specification. The producer can hedge his exposure by selling 10,000 Kgs worth of April futures contracts(10 units). If the oil producers closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs.465 per 10 Kgs. Figure 7.1 gives the payoff for a short hedge. Let us look at how this works. On April 15, the spot price can either be above Rs.465 or below Rs.465. 1. Case 1: The spot price is Rs.455 per 10 Kgs. The company realises Rs.4,55,000 under its sales contract. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.455 on that date. The company closes its short futures position at Rs.455, making a gain of Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures position. The total amount realised from both the futures position and the sales contract is therefore about Rs.465 per 10 Kgs, Rs.4,65,000 in total. 2. Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its sales contract. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.475 on that date. The company closes its short futures position at Rs.475, making a loss of Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures position. The total amount realised from both the futures position and the sales contract is therefore about Rs.465 per 10 Kgs, Rs.4,65,000 in total.

7.1.3

Long hedge

Hedges that involve taking a long position in a futures contract are known as long hedges. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. Suppose that it is now January 15. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. The spot price of silver is Rs.1680

90


Figure 7.2 Payoff for buyer of a long hedge The figure shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what the spot price of silver is three months later, by going in for a long hedge he locks on to a price of Rs.1730 per kg.

Profit

Long position in silver futures 1730 Price of silver

Short position in silver Loss

Table 7.2 Silver futures contract specification Trading system Trading hours

NCDEX trading system Monday to Friday Normal market hours – 10:00 am to 4:00 pm Closing session – 4:15 pm to 4:30 pm Unit of trading 5 Kgs Delivery unit 30 Kgs Quotation/ base value Rs.per kg of Silver with 999 fineness Tick size 5 paisa

per kg and the April silver futures price is Rs.1730. Table 7.2 gives the contract specification for silver. A unit of trading is 5 Kgs. The fabricator can hedge his position by taking a long position in sixty units of futures on the NCDEX. If the fabricator closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs.1730 per kg. Figure 7.2 gives the payoff for the buyer of a long hedge. Let us look at how this works. On April 15, the spot price can either be above Rs.1730 or below Rs.1730. 1. Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver from the spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.1780 on that date. The company closes its long

7.1 Hedging

91

futures position at Rs.1780, making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000 on its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT, or Rs.5,19,000 in total. 2. Case 2: The spot price is Rs.1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver from the spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.1690 on that date. The company closes its long futures position at Rs.1690, making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT, or Rs.5,19,000 in total.

Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in the future upfront. In the industrial fabricator example, since prices of silver rose in three months, on hind sight it would seem that the company would have been better off buying the silver in January and holding it. But this would involve incurring interest cost and warehousing costs. Besides, if the prices of silver fell in April, the company would have not only incurred interest and storage costs, but would also have ended up buying silver at a much higher price. In the examples above we assume that the futures position is closed out in the delivery month. The hedge has the same basic effect if delivery is allowed to happen. However, making or taking delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps the futures contract until the delivery month. Hedgers with long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period.

7.1.4

Hedge ratio

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

where: )

F

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

0¡ : Change in futures price, F, during a period of time equal to the life of the hedge £¢ : Standard deviation of )

(7.1)

92


£¢

: Standard deviation of t¡

¥¤ : Coefficient of correlation between ) and 0¡ ¦ : Hedge ratio Let us consider an example. A company knows that it will require 11,000 bales of cotton in three months. Suppose the standard deviation of the change in the price per Quintal of cotton over a three–month period is calculated as 0.032. The company chooses to hedge by buying futures contracts on cotton. The standard deviation of the change in the cotton futures price over a three–month period is 0.040 and the coefficient of correlation between the change in price of cotton and the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures contracts should it buy? If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, as shown in Equation 7.3, the hedger would have to buy 1000 units (one unit of trading = 11 bales of cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.

§¨

Number of contracts F ©tª« A F

(7.2) (7.3)

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

Number of contracts F ©^ª« BY ¯° F

7.1.5

F

u¬vE u¬w

xuyw ® w

xuy xuy

§¨

(7.4) (7.5)

(7.6) (7.7)

Advantages of hedging

Besides the basic advantage of risk management, hedging also has other advantages: 1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his cattle are ready to market before he can sell them. The futures market permits him to sell futures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices even though the cattle are not ready for market.

7.1 Hedging

93

2. Hedging protects inventory values. For example, a merchandiser with a large, unsold inventory can sell futures contracts that will protect the value of the inventory, even if the price of the commodity drops. 3. Hedging permits forward pricing of products. For example, a jewelry manufacturer can determine the cost for gold, silver or platinum by buying a futures contract, translate that to a price for the finished products, and make forward sales to stores at firm prices. Having made the forward sales, the manufacturer can use his capital to acquire only as much gold, silver, or platinum as may be needed to make the products that will fill its orders.

7.1.6

Limitation of hedging: basis Risk

In the examples we used above, the hedges considered were perfect. The hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use the futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, hedging is not quite this simple and straightforward. Hedging can only minimise the risk but cannot fully eliminate it. The loss made during selling of an asset may not always be equal to the profits made by taking a short futures position. This is because the value of the asset sold in the spot market and the value of the asset underlying the future contract may not be the same. This is called the basis risk. In our examples, the hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, this may not always be possible for a various reasons. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. For example, in India we have a large number of varieties of cotton being cultivated. It is impractical for an exchange to have futures contracts with all these varieties of cotton as an underlying. The NCDEX has futures contracts on two varieties of cotton, long staple cotton and medium staple cotton. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract, he would get a better hedge. But in many cases, farmers producing small staple cotton could use the futures contract on medium staple cotton for hedging. While this would still provide the farmer with a hedge, since the price of the farmers cotton and the price of the cotton underlying the futures contract do match perfectly, the hedge would not be perfect. The hedger may be uncertain as to the exact date when the asset will be bought or sold. Often the hedge may require the futures contract to be closed out well before its expiration date. This could result in an imperfect hedge. The expiration date of the hedge may be later than the delivery date of the futures contract. When this happens, the hedger would be required to close out the futures contracts entered into and take the same position in futures contracts with a later delivery date. This is called a rollover. Hedges can be rolled forward many times. However, multiple rollovers could lead to short–term cash flow problems.

94


Table 7.3 Gold futures contract specification Trading system Trading hours

NCDEX trading system Monday to Friday Normal market hours – 10:00 am to 4:00 pm Closing session – 4:15 pm to 4:30 pm Unit of trading 100 gm Delivery unit 1 kg Quotation/ base value Rs.per 10 gms of gold with 999 fineness Tick size 5 paisa

7.2

Speculation

An entity having an opinion on the price movements of a given commodity can speculate using the commodity market. While the basics of speculation apply to any market, speculating in commodities is not as simple as speculating on stocks in the financial market. For a speculator who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for whatever duration he wants to. However, commodities are bulky products and come with all the costs and procedures of handling these products. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. To trade commodity futures on the NCDEX, a customer must open a futures trading account with a commodity derivatives broker. Buying futures simply involves putting in the margin money. This enables futures traders to take a position in the underlying commodity without having to to actually hold that commodity. With the purchase of futures contract on a commodity, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). We look here at how the commodity futures markets can be used for speculation.

7.2.1

Speculation: Bullish commodity, buy futures

Take the case of a speculator who has a view on the direction of the price movements of gold. Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding season, the prices of gold are likely to rise. He would like to trade based on this view. Gold trades for Rs.6000 per 10 gms in the spot market and he expects its price to go up in the next two–three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy gold and hold on to it. Suppose he buys a 1 kg of gold which costs him Rs.6,00,000. Suppose further that his hunch proves correct and three months later gold trades at Rs.6400 per 10 grms. He makes a profit of Rs.40,000 on an investment of Rs.6,00,000 for a period of three months. This works out to an annual return of about 26 percent. Today a speculator can take exactly the same position on gold by using gold futures contracts. Let us see how this works. Gold trades at Rs.6000 per 10 gms and three–month gold futures trades at Rs.6150. Table 7.3 gives the contract specifications for gold futures. The unit of trading

7.3 Arbitrage

95

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

7.2.2

Speculation: Bearish commodity, sell futures

Commodity futures can also be used by a speculator who believes that there is likely to be excess supply of a particular commodity in the near future and hence the prices are likely to see a fall. How can he trade based on this opinion? In the absence of a deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to do is sell commodity futures. Let us understand how this works. Simple arbitrage ensures that the price of a futures contract on a commodity moves correspondingly with the price of the underlying commodity. If the commodity price rises, so will the futures price. If the commodity price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of cotton. He sells ten two–month cotton futures contract which is for delivery of 550 bales of cotton. The value of the contract is Rs.4,00,000. He pays a small margin on the same. Three months later, if his hunch were correct the price of cotton falls. So does the price of cotton futures. He close out his short futures position at Rs.3,50,000, making a profit of Rs.50,000.

7.3

Arbitrage

A central idea in modern economics is the law of one price. This states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price. If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. This activity termed as arbitrage, involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices. The buying cheap and selling expensive continues till prices in the two markets reach an equilibrium. Hence, arbitrage helps to equalise prices and restore market efficiency. F F where: r Cost of financing (annualised) T Time till expiration

(S + U) UWV M

(7.8)

96

Using commodity futures U Present value of all storage costs

In the chapter on pricing, we discussed that the cost–of–carry ensures that futures prices stay in tune with the spot prices of the underlying assets. Equation 7.8 gives the fair value of a futures contract on an investment commodity. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. To capture mispricings that result in overpriced futures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that result in underpriced futures, the arbitrager must sell spot and buy futures. In the case of investment commodities, mispricing would result in both, buying the spot and holding it or selling the spot and investing the proceeds. However, in the case of consumption assets which are held primarily for reasons of usage, even if there exists a mispricing, a person who holds the underlying may not want to sell it to profit from the arbitrage.

7.3.1

Overpriced commodity futures: buy spot, sell futures

An arbitrager notices that gold futures seem overpriced. How can he cash in on this opportunity to earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market. Three month gold futures on the NCDEX trade at Rs.625 and seem overpriced. He could make riskless profit by entering into the following set of transactions. 1. On day one, borrow Rs.60,07,460 at 6% per annum to cover the cost of buying and holding gold. Buy 10 kgs of gold on the cash/ spot market at Rs.60,00,000. Pay (310 + 7150) as warehouse costs. (We assume that fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per kg per week for 13 weeks). 2. Simultaneously, sell 10 gold futures contract at Rs.62,50,000. 3. Take delivery of the gold purchased and hold it for three months. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say gold closes at Rs.615 in the spot market. Sell the gold for Rs.61,50,000. 6. Futures position expires with profit of Rs.1,00,000. 7. From the Rs.62,50,000 held in hand, return the borrowed amount plus interest of Rs.60,98,251. 8. The result is a riskless profit of Rs.1,51,749.

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

7.3 Arbitrage

7.3.2

97

Underpriced commodity futures: buy futures, sell spot

An arbitrager notices that gold futures seem underpriced. How can he cash in on this opportunity to earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market. Three month gold futures on the NCDEX trade at Rs.605 and seem underpriced. If he happens to hold gold, he could make riskless profit by entering into the following set of transactions. 1. On day one, sell 10 kgs of gold in the spot market at Rs.60,00,000. 2. Invest the Rs.60,00,000 plus the Rs.7150 saved by way of warehouse costs for three months 6%. 3. Simultaneously, buy three–month gold futures on NCDEX at Rs.60,50,000. 4. Suppose the price of gold is Rs.615 per gram. On the futures expiration date, the spot and the futures price of gold converge. Now unwind the position. 5. The gold sales proceeds grow to Rs.60,97,936. 6. The futures position expires with a profit of Rs.1,00,000. 7. Buy back gold at Rs.61,50,000 on the spot market. 8. The result is a riskless profit of Rs.47,936.

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

Solved problems Q: A speculator thinks that the price of mustard seed will rise. He should 1. buy mustard seed futures

3. sell mustard seed futures

2. sell mustard seed

4. sell index futures

A: The correct answer is number 1. Q: A speculator thinks that the price of silver will fall. He should 1. buy silver futures

3. sell silver futures

2. buy silver

4. sell index futures


98


Q: A long hedge should be taken by a person who 1. Wants to buy the underlying asset in the future.

3. Expects to own the underlying asset in the future

2. Sell the underlying asset in the future



Q: A short hedge should be taken by a person who 1. Wants to buy the underlying asset in the future. 2. Wants to sell the underlying asset in the future.

3. Wants to sell the underlying asset today.



Q: A farmer who has just sown wheat can hedge his position by 1. buying wheat futures

3. buying index futures

2. selling wheat futures

4. selling the wheat


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

3. Selling 100 units of April futures.

2. Buying 10 units of April futures.

4. Buying 100 units of April futures.

A: The producer needs to take a short hedge to the extent of 10,000 Kgs of soy oil. One trading unit is for 1000 Kgs of soy oil. He gets the hedge by selling 10 units of April futures. The correct answer is number 1.

7.3 Arbitrage

99

Q: On the 15th of January a firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. The spot price of silver is Rs.1680 per kg and the April silver futures price is Rs.1730. A unit of trading is 5 Kgs and the delivery unit is 30 Kgs. The fabricator can hedge his position by 1. Selling 60 units of April silver futures.

3. Buying 30 units of April silver futures.

2. Buying 60 units of April silver futures.

4. Selling 30 units of April silver futures.

A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. One trading unit is for 5 Kgs of silver. He gets the hedge by selling 60 units of April silver futures. The correct answer is number 2.

Q: A company knows that it will require 33,000 bales of cotton in three months. The hedge ratio works out to be 0.85. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. The company can obtain a hedge by 1. Buying 2550 units of three–month cotton futures.

3. Buying 2550 units of three–month cotton futures.

2. Selling 2550 units of three–month cotton futures.

4. Selling 600 units of three–month cotton futures.

A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a hedge by C± BCBCB %_a² ` units of futures. The correct answer is number 3. buying ACA

Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three–month gold futures trade at Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. A speculator who expects gold prices to rise in the near future buys 10 units of gold futures. Two months later gold futures trade at Rs.6400 per 10 gms. He makes a profit/loss of 1. (+)2,500

3. (+)25,000

2. (-)2,500

4. (-)25,000

A: One unit of trading is 100 gms. He is long 10 units of futures, or 1000 grms of gold. He makes a profit \CZCB D % % % of Rs.250 per 10 gms. His total profit from the position is A4B . The correct answer is number 3.

100


Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three–month gold futures trade at Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. A speculator who expects gold prices to fall in the near future sells 10 units of gold futures. Two months later gold futures trade at Rs.6000 per 10 gms. He makes a profit/loss of 1. (+)1,500

3. (-)15,000

2. (-)1,500

4. (+)15,000

A: One unit of trading is 100 gms. He is short 10 units of futures, or 1000 grms of gold. He makes a profit A4ZCB ³D % % % of Rs.150 per 10 gms. His total profit from the position is A4B . The correct answer is number 4.

Chapter 8 Trading In this chapter we shall take a brief look at the trading system for futures on NCDEX. However, the best way to get a feel of the trading system is to actually watch the screen and observe how it operates.

8.1

Futures trading system

The trading system on the NCDEX, provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. The trade timings on the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been proposed for implementation at a later stage. The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.

8.2

Entities in the trading system

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

102

Trading

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

Box 8.10: The open outcry system of trading Each user of a TCM must be registered with the exchange and is assigned an unique user ID. The unique TCM ID functions as a reference for all orders/ trades of different users. This ID is common for all users of a particular TCM. It is the responsibility of the TCM to maintain adequate control over persons having access to the firm’s User IDs. 2. Professional clearing members: Professional clearing members are members of NSCCL. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs), both for themselves and/ or on behalf of their clients. They carry out risk management activities and confirmation/ inquiry of trades through the trading system.

8.2.1

Guidelines for allotment of client code

The trading members are recommended to follow guidelines outlined by the exchange for allotment and use of client codes at the time of order entry on the futures trading system: 1. All clients trading through a member are to be registered clients at the member’s back office. 2. A unique client code is to be allotted for each client. The client code should be alphanumeric and no special characters can be used. 3. The same client should not be allotted multiple codes.

8.3 Contract specifications for commodity futures

103

Table 8.1 Commodity futures contract and their symbols 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

8.3

Pure Gold Mumbai Pure Silver New Delhi Soybean Indore Refined Soya Oil Indore Rapeseed Mustard Seed Jaipur Expeller Rapeseed Mustard Oil Jaipur RBD Palm Olein Kakinada Crude Palm Oil Kandla J34 Medium Staple Cotton Bhatinda S06 L S Cotton Ahmedabad

GLDPURMUM SLVPURDEL SYBEANIDR SYOREFIDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD

Contract specifications for commodity futures

NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market Commission) but in a phased manner. In the first phase, under the category of bullion, it has already started trading in gold and silver, and in agri commodities, trading has commenced in cotton (long and medium staple), soybean, soya oil, rape/ mustardseed, rape/ mustard oil, crude palm oil and RBD palmolein. In the second phase NCDEX plans to offer the following commodities for trading – rice, wheat, coffee, tea. edible oil products like groundnut, sunflower, castor (seed, oil and cake), base metals (aluminium, copper, zinc and nickel) and commodity indices like agri commodity index and metal commodity index. Table 8.1 gives the list and symbols of underlying commodities on which futures contracts are available. Table 8.2 and Table 8.3 give the futures contract specifications for gold and long staple cotton.

8.4

Commodity futures trading cycle

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

104

Trading

Table 8.2 Gold futures contract specification Trading system Trading hours

NCDEX trading system Monday to Friday Normal market hours – 10:00 am to 4:00 pm Closing session – 4:15 pm to 4:30 pm Unit of trading 100 gms Delivery unit 1 Kg Quotation/ base value Rs. per 10 gms of Gold with 999.9 fineness (called “Pure Gold” in trade circles) Tick size 5 paisa Price band Limit 10%. Limits will not apply if the limit is reached during final 30 minutes of trading. Quality specification Not less than 995 fineness bearing a serial number and identifying stamp of a refiner approved by NCDEX. List of approved refiners will be available with the exchange and also on its web site: www.ncdex.com Quantity variation None No. of active contracts At any date, 3 concurrent month contracts will be active. There will be a total of twelve month contracts in a year. Delivery center Mumbai Opening date Trading in any contract month will open on the 21st day of the month, 3 months prior to the contract month i.e. January 2004 contract opens on 21st October 2003. Due date 20th day of the delivery month, if 20th happens to be a holiday then previous working day. Position limits Member–wise: Max (Rs.200 crore, 15% of open interest) Client–wise: Max (Rs.100 crore, 10% of Open interest) Premium/ Discount The discount will be given for the fineness below 999.9. The settlement price for less than 999.9 fineness will be calculated as: (Actual fineness/ 999.9) * Settlement price

8.5

Order types and trading parameters

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

8.5 Order types and trading parameters Table 8.3 Long staple cotton futures contract specification Trading system Trading hours

NCDEX trading system Monday to Friday Normal market hours – 10:00 am to 4:00 pm Closing session – 4:15 pm to 4:30 pm Unit of trading 18.7 Quintal (=11 bales) Delivery unit 93.5 Quintals (=55 bales) Quotation/ base value Rs. per Quintal Tick size 5 paisa Price band Limit 10%. Limits will not apply if the limit is reached during final 30 minutes of trading. Quality specification Main/ Base Variety: Shankar-6 Staple Length: 27-30 mm (Basis: 29 mm) Micronaire: 3.4-4.5 (Basis: 3.7-4.2) Strength, Min: 21 G/ Tex Grade: ‘Good to Fully Good’, ‘Fully Good’, ‘Fine’, ‘Superfine’, ‘Extra Superfine’, (Basis: ‘Fine’) Crop: Current Year Crop in which the delivery date falls (current year for Shankar-6 is defined as from 1st Nov of one year to 31st Oct of the subsequent year), Moisture, % Max: 8.5 No. of active contracts At any date, 3 concurrent month contracts will be active. There will be a total of twelve month contracts in a year. Delivery center Ahmedabad Opening date Trading in any contract month will open on the 21st day of the month, 3 months prior to the contract month i.e. January 2004 contract opens on 21st October 2003. Due date 20th day of the delivery month, if 20th happens to be a holiday then previous working day. Position limits Member–wise: Max (Rs.40 crore, 15% of open interest) Client–wise: Max (Rs.20 crore, 10% of Open interest) Premium/ Discount Will be given on the basis of Staple Length (at 0.5 mm intervals) & grade combinations. The exchange will communicate the premium/ discounts applicable before the settlement date.

105

106

Trading

Figure 8.1 Contract cycle The figure shows the contract cycle for futures contracts on NCDEX. As can be seen, at any given point of time, three contracts are available for trading – a near-month, a middle-month and a far-month. As the January contract expires on the 20th of the month, a new three–month contract starts trading from the following day, once more making available three index futures contracts for trading.

Jan

Feb

Mar

Apr Time

Jan 20 contract Feb 20 contract March 20 contract April 20 contract May 20 contract

Jun 20 contract

following categories: Time conditions Price conditions Other conditions

Several combinations of the above are possible thereby providing enormous flexibility to users. The order types and conditions are summarised below. Of these, the order types available on the NCDEX system are regular lot order, stop loss order, immediate or cancel order, good till day order, good till cancelled order, good till date order and spread order. Time conditions – Good till day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. Example: A trader wants to go long on March 1, 2004 in refined palm oil on the commodity exchange. A day order is placed at Rs.340/ 10 kg. If the market does not reach this price the order does not get filled even if the market touches Rs.341 and closes. In other words day order is for a specific price and if the order does not get filled that day, one has to place the order again the next day. – Good till cancelled (GTC): A GTC order remains in the system until the user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the day on which the order is

8.5 Order types and trading parameters

107

placed and the order is cancelled from the system at the end of the day of the expiry period. Example: A trader wants to go long on refined palm oil when the market touches Rs.400/ 10kg. Theoritically, the order exists until it is filled up, even if it takes months for it to happen. The GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from the date of entering an order or when the contract expires, whichever is earlier. – Good till date (GTD): A GTD order allows the user to specify the date till which the order should remain in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/ date, the order is cancelled from the system. Each day/ date counted are inclusive of the day/ date on which the order is placed and the order is cancelled from the system at the end of the day/ date of the expiry period. – Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately. – All or none order: All or none order (AON) is a limit order, which is to be executed in its entirety, or not at all. Unlike a fill-or-kill order, an all-or-none order is not cancelled if it is not executed as soon as it is represented in the exchange. An all-or-none order position can be closed out with another AON order. – Fill or kill order: This order is a limit order that is placed to be executed immediately and if the order is unable to be filled immediately, it gets cancelled. Price condition – Limit order: An order to buy or sell a stated amount of a commodity at a specified price, or at a better price, if obtainable at the time of execution. The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price. – Stop–loss: A stop–loss order is an order, placed with the broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Futures traders often use stop orders in an effort to limit the amount they might lose if the futures price moves against their position. Stop orders are not executed until the price reaches the specified point. When the price reaches that point the stop order becomes a market order. Most of the time, stop orders are used to exit a trade. But, stop orders can be executed for buying/ selling positions too. A buy stop order is initiated when one wants to buy a contract or go long and a sell stop order when one wants to sell or go short. The order gets filled at the suggested stop order price or at a better price. Example: A trader has purchased crude oil futures at Rs.750 per barrel. He wishes to limit his loss to Rs.50 a barrel. A stop order would then be placed to sell an offsetting contract if the price falls to Rs 700 per barrel. When the market touches this price, stop order gets executed and the trader would exit the market. For the stop–loss sell order, the trigger price has to be greater than the limit price. Other conditions – Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price. Only the position to be taken long/ short is stated. When this kind of order is placed, it gets executed irrespective of the current market price of that particular asset.

108

Trading

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

Box 8.11: After hours electronic trading system – Market on open: The order will be executed on the market open within the opening range. This trade is used to enter a new trade, or exit an open trade. – Market on close: The order will be executed on the market close. The fill price will be within the closing range, which may, in some markets, be substantially different from the settlement price. This trade is also used to enter a new trade, or exit an open trade. – Trigger price: Price at which an order gets triggered from the stop–loss book. – Limit price: Price of the orders after triggering from stop–loss book. – Spread order: A simple spread order involves two positions, one long and one short. They are taken in the same commodity with different months (calendar spread) or in closely related commodities. Prices of the two futures contract therefore tend to go up and down together, and gains on one side of the spread are offset by losses on the other. The spreaders goal is to profit from a change in the difference between the two futures prices. The trader is virtually unconcerned whether the entire price structure moves up or down, just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold. – One cancels the other order : It is called one cancels the other order (OCO). An order placed so as to take advantage of price movement, which consists of both a stop and a limit price. Once one level is reached, one half of the order will be executed (either stop or limit) and the remaining order cancelled (either limit or stop). This type of order would close the position if the market moved to either the stop rate or the limit rate, thereby closing the trade and at the same time, cancelling the other entry order. Example: A trader has a buy position at Rs.14,000/ tonne on Soybean. He wishes to have both stop and limit orders in order to fill the order in a particular price range. A stop order is placed at Rs. 14,100/ tonne and a limit order at Rs.13,900/ tonne. If the market trades at Rs.13,900/ tonne, the limit order gets filled and the stop order is immediately gets cancelled. The trader exits the market at Rs.13,900/ tonne.

8.5.1

Permitted lot size

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

8.5.2

Tick size for contracts

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


109

Table 8.4 Commodity futures: Quantity freeze unit

8.5.3

Instrument Asset Type Asset Symbol

Quantity Freeze Unit

FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM

30,000 Grams (gm) 1,500 kilograms (Kgs) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 3,300 Bales 3,300 Bales


Quantity freeze

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

8.5.4

Base price

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

8.5.5

Price ranges of contracts

In order to prevent erroneous order entry by trading members, operating price ranges on the NCDEX are kept at +/- 10% from the base price. Orders exceeding the range specified are not executed and lie pending with the exchange as a price freeze. In respect of orders which have come under price freeze, the members are required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. The exchange can approve or

110

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

8.5.6

Order entry on the trading system

The NCDEX trading system has a set of function keys built into the trading front–end. These keys have been provided to facilitate faster operation of the system and enable quicker trading on the system. The function keys can be operated from the keyboard of the user. The set of function keys enable the following: Buy open Sell open Order cancellation Order modification Exercise/ Position liquidation Outstanding orders Quick order cancel Spread order entry Market watch setup Trade modify Trade cancel Client master maintenance Market by order Market by price Activity log Security list/ portfolio setup Portfolio offline order entry Spread market by price Previous trades Contract description Alphabetical sorting of contracts


111

Table 8.5 Commodity futures: Lot size and other parameters Instrument Asset Type Asset Symbol FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM


Spread order status Spread activity log Snap quote Online offline order entry Message log Market movement Full message display Market inquiry Spread outstanding orders Net position upload Order status Liquidity schedule Buy close Sell close

Market Quantity Price Lot Unit Unit 100 5 1 1 1 1 1 1 11 11

GM Kg MT MT MT MT MT MT Bales Bales

Rs./ 10 GM Rs./ Kg Rs./ Quintal Rs./ 10 Kg Rs./ 20 Kg Rs./ 10 Kg Rs./ 10 Kg Rs./ 10 Kg Rs./ Quintal Rs./ Quintal

Delivery Delivery Lot Unit 1 30 10 10 10 10 10 10 55 55

KG KG MT MT MT MT MT MT Bales Bales

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8.6

Trading

Margins for trading in futures

Margin is the deposit money that needs to be paid to buy or sell each contract. The margin required for a futures contract is better described as performance bond or good faith money. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract. In the futures market, there are different types of margins that a trader has to maintain. We will discuss them in more details when we talk about risk management in the next chapter. At this stage we look at the types of margins as they apply on most futures exchanges. Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. This margin is meant to cover the largest potential loss in one day. The margin is a mandatory requirement for parties who are entering into the contract. Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative, a maintenance margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account falls below the maintenance margin, the trader receives a margin call and is requested to deposit extra funds to bring it to the initial margin level within a very short period of time. The extra funds deposited are known as a variation margin. If the trader does not provide the variation margin, the broker closes out the position by offsetting the contract. Additional margin: In case of sudden higher than expected volatility, the exchange calls for an additional margin, which is a preemptive move to prevent breakdown. This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis, etc. Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted to reflect the trader’s gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day’s movement. Based on the settlement price, the value of all positions is marked–to–market each day after the official close. i.e. the accounts are either debited or credited based on how well the positions fared in that day’s trading session. If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades.

Just as a trader is required to maintain a margin account with a broker, a clearing house member is required to maintain a margin account with the clearing house. This is known as clearing margin. In the case of clearing house member, there is only an original margin and no maintenance margin. Clearing house and clearing house margins have been discussed further in detail under the chapter on clearing and settlement.

8.7 Charges

8.7

113

Charges

Members are liable to pay transaction charges for the trade done through the exchange during the previous month. The important provisions are listed below: The billing for the all trades done during the previous month will be raised in the succeeding month. 1. Rate of charges: The transaction charges are payable at the rate of Rs.6 per Rs.one Lakh trade done. This rate is subject to change from time to time. 2. Due date: The transaction charges are payable on the 7th day from the date of the bill every month in respect of the trade done in the previous month. 3. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to collect the transaction charges through Electronic Clearing System. 4. Registration with BJPL and their services: Members have to fill up the mandate form and submit the same to NCDEX. NCDEX then forwards the mandate form to BJPL. BJPL sends the log–in ID and password to the mailing address as mentioned in the registration form. The members can then log on through the website of BJPL and view the billing amount and the due date. Advance email intimation is also sent to the members. Besides, the billing details can be viewed on the website upto a maximum period of 12 months. 5. Adjustment against advances transaction charges: In terms of the regulations, members are required to remit Rs.50,000 as advance transaction charges on registration. The transaction charges due first will be adjusted against the advance transaction charges already paid as advance and members need to pay transaction charges only after exhausting the balance lying in advance transaction . 6. Penalty for delayed payments: If the transaction charges are not paid on or before the due date, a penal interest is levied as specified by the exchange.

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

Solved Problems Q: The trading system on the NCDEX, does not provide 1. A fully automated screen-based trading.

3. Online monitoring and surveillance mechanism.

2. Trading on a nationwide basis.

4. Trading by open–outcry


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Q: Order matching on the NCDEX happens on the basis of 1. Commodity

3. Quantity

2. Price and time

4. All of the above

A: Correct answer is number 4.

Q: COTS06ABD is the symbol for 1. Medium staple cotton Bhatinda

3. Small staple cotton Aurangabad

2. Long staple cotton Ahmedabad



Q: Initial margin is meant to cover the largest potential loss over a 1. One day horizon

3. One hour horizon

2. One week horizon

4. One month horizon


Q: NCDEX does not trade commodity futures contracts having

expiry cycles

1. One–month

3. Three–month

2. Two–month

4. Six–month


Q: Billing to members for the all trades done on the NCDEX will be raised 1. At the end of each day.

3. At the end of each week.

2. In the succeeding month.

4. Once every two weeks.


8.7 Charges

115

Q: A trader buys 10 units of gold futures at Rs.6,500 per 10 gms. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1. Rs.6,50,000

3. Rs.6,500

2. Rs.65,000

4. Rs.65,00,000

A: One trading unit is for 100 gms. He has bought 10 units. The value of his long gold futures position is ' ¯± ZCBCB 6D % % 6D %81 . The correct answer is number 1. A4B Q: A trader sells 20 units of gold futures at Rs.7,100 per 10 gms. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1. Rs.1,42,000

3. Rs.1,420

2. Rs.14,200

4. Rs.14,20,000

A: One trading unit is for 100 gms. He has bought 20 units. The value of his long gold futures position is ' ±bA4BCB 6D % % %81 . The correct answer is number 4. A4B Q: A trader requires to take a long gold futures position worth Rs.10,00,000 as part of his hedging strategy. Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg. Roughly how many units must he purchase to give him the hedge? 1. 10 units

3. 14 units

2. 20 units

4. 28 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. He has A4B± BCB± BCBCB to take a position in BCB , i.e. in 1428.57 gms of gold gms. He has to buy 14 units of gold futures contracts. The correct answer is number 3. Q: A trader requires to take a long gold futures position worth Rs.7,00,000 as part of his hedging strategy. Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg. How many units must he purchase to give him the hedge? 1. 10 units

3. 1,000 units

2. 100 units

4. 10,000 units

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

116

Trading

Q: A trader requires to take a short gold futures position worth Rs.7,00,000 as part of his hedging strategy. Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg. How many units must he sell to give him the hedge? 1. 10 units

3. 1,000 units

2. 100 units

4. 10,000 units

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

Chapter 9 Clearing and settlement Most futures contracts do not lead to the actual physical delivery of the underlying asset. The settlement is done by closing out open positions, physical delivery or cash settlement. All these settlement functions are taken care of by an entity called clearing house or clearing corporation. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX.

9.1

Clearing

Clearing of trades that take place on an exchange happens through the exchange clearing house. A clearing house is a system by which exchanges guarantee the faithful compliance of all trade commitments undertaken on the trading floor or electronically over the electronic trading systems. The main task of the clearing house is to keep track of all the transactions that take place during a day so that the net position of each of its members can be calculated. It guarantees the performance of the parties to each transaction. Typically it is responsible for the following: 1. Effecting timely settlement. 2. Trade registration and follow up. 3. Control of the evolution of open interest. 4. Financial clearing of the payment flow. 5. Physical settlement (by delivery) or financial settlement (by price difference) of contracts. 6. Administration of financial guarantees demanded by the participants.

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

118

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

9.1.1

Clearing mechanism

Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. The clearing mechanism essentially involves working out open positions and obligations of clearing members. This position is considered for exposure and daily margin purposes. The open positions of PCMs are arrived at by aggregating the open positions of all the TCMs clearing through him, in contracts in which they have traded. A TCM’s open position is arrived at by the summation of his clients’ open positions, in the contracts in which they have traded. Client positions are netted at the level of individual client and grossed across all clients, at the member level without any set–offs between clients. Proprietary positions are netted at member level without any set–offs between client and proprietary positions. At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price.

9.1.2

Clearing banks

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

9.2 Settlement

119

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

9.1.3

Depository participants

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

9.2

Settlement

Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward, created during the day or closed out during the day, are marked to market at the daily settlement price or the final settlement price at the close of trading hours on a day. Daily settlement price: Daily settlement price is the consensus closing price as arrived after closing session of the relevant futures contract for the trading day. However, in the absence of trading for a contract during closing session, daily settlement price is computed as per the methods prescribed by the exchange from time to time. Final settlement price: Final settlement price is the closing price of the underlying commodity on the last trading day of the futures contract. All open positions in a futures contract cease to exist after its expiration day.

9.2.1

Settlement mechanism

Settlement of commodity futures contracts is a little different from settlement of financial futures which are mostly cash settled. The possibility of physical settlement makes the process a little more complicated. Daily mark to market settlement Daily mark to market settlement is done till the date of the contract expiry. This is done to take care of daily price fluctuations for all trades. All the open positions of the members are marked to market at the end of the day and the profit/ loss is determined as below: On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. On any intervening days, when the member holds an open position, it is the difference between the daily settlement price for that day and the previous day’s settlement price.

120


Table 9.1 MTM on a long position in cotton futures A clearing member buys one December expiration long staple cotton futures contract at Rs.6435 per Quintal on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.

Date Dec 15,2003 Dec 16,2003 Dec 17,2003 Dec 18,2003 Dec 19,2003

Settlement price

MTM

6320 6250 6312 6310 6315

-115 -70 +62 -2 +5

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

Table 9.1 explains the MTM margins to be paid by a member who buys one unit of December expiration long staple cotton contract at Rs.6435 per Quintal (18.7 Quintals = 11 bales) on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profit/ loss per unit of trading shows at he makes a total loss of Rs.120 per Quintal of trading. So upon closing his position, he makes a total loss of Rs.2244, i.e. H: vxu ´ L on the long position taken by him. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis. Table 9.2 explains the MTM margins to be paid by a member who sells December expiration long staple cotton futures contract at Rs.6435 per Quintal on December 15. The unit of trading is 11 bales(18.7 Quintals) and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profit/ loss shows that he makes a total profit of Rs.120 per Quintal. So upon closing his position, he makes a total profit of Rs.2244 on the short position taken by him. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis. Final settlement On the date of expiry, the final settlement price is the spot price on the expiry day. The spot prices are collected from members across the country through polling. The polled bid/ ask prices are bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client’s trades. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. On the expiry date of a futures contract, members are required to submit delivery information

9.2 Settlement

121

Table 9.2 MTM on a short position in cotton futures A clearing member sells one December expiration long staple cotton futures contract at Rs.6435 on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.

Date Dec 15,2003 Dec 16,2003 Dec 17,2003 Dec 18,2003 Dec 19,2003

Settlement price

MTM

6320 6250 6312 6310 6315

+115 +70 -62 +2 -5

through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. NCDEX on receipt of such information, matches the information and arrives at a delivery position for a member for a commodity. A detailed report containing all matched and unmatched requests is provided to members through the extranet. Pursuant to regulations relating to submission of delivery information, failure to submit delivery information for open positions attracts penal charges as stipulated by NCDEX from time to time. NCDEX also adds all such open positions for a member, for which no delivery information is submitted with final settlement obligations of the member concerned and settled in cash. Non–fulfilment of either the whole or part of the settlement obligations is treated as a violation of the rules, bye–laws and regulations of NCDEX and attracts penal charges as stipulated by NCDEX from time to time. In addition NCDEX can withdraw any or all of the membership rights of clearing member including the withdrawal of trading facilities of all trading members clearing through such clearing members, without any notice. Further, the outstanding positions of such clearing member and/ or trading members and/ or constituents, clearing and settling through such clearing member, may be closed out forthwith or any time thereafter by the exchange to the extent possible, by placing at the exchange, counter orders in respect of the outstanding position of clearing member without any notice to the clearing member and/ or trading member and/ or constituent. NCDEX can also initiate such other risk containment measures as it deems appropriate with respect to the open positions of the clearing members. It can also take additional measures like, imposing penalties, collecting appropriate deposits, invoking bank guarantees or fixed deposit receipts, realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit or take further disciplinary action.

122

9.2.2


Settlement methods

Settlement of futures contracts on the NCDEX can be done in three ways – by physical delivery of the underlying asset, by closing out open positions and by cash settlement. We shall look at each of these in some detail. On the NCDEX all contracts settling in cash are settled on the following day after the contract expiry date. All contracts materialising into deliveries are settled in a period 2–7 days after expiry. The exact settlement day for each commodity is specified by the exchange. Physical delivery of the underlying asset For open positions on the expiry day of the contract, the buyer and the seller can announce intentions for delivery. Deliveries take place in the electronic form. All other positions are settled in cash. When a contract comes to settlement, the exchange provides alternatives like delivery place, month and quality specifications. Trading period, delivery date etc. are all defined as per the settlement calendar. A member is bound to provide delivery information. If he fails to give information, it is closed out with penalty as decided by the exchange. A member can choose an alternative mode of settlement by providing counter party clearing member and constituent. The exchange is however not responsible for, nor guarantees settlement of such deals. The settlement price is calculated and notified by the exchange. The delivery place is very important for commodities with significant transportation costs. The exchange also specifies the precise period (date and time) during which the delivery can be made. For many commodities, the delivery period may be an entire month. The party in the short position (seller) gets the opportunity to make choices from these alternatives. The exchange collects delivery information. The price paid is normally the most recent settlement price (with a possible adjustment for the quality of the asset and the delivery location). Then the exchange selects a party with an outstanding long position to accept delivery. As mentioned above, after the trading hours on the expiry date, based on the available information, the matching for deliveries is done, firstly, on the basis of locations and then randomly keeping in view factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is done only for the incremental gain/ loss as determined on the basis of the final settlement price. Any buyer intending to take physicals has to put a request to his depository participant. The DP uploads such requests to the specified depository who in turn forwards the same to the registrar and transfer agent (R&T agent) concerned. After due verification of the authenticity, the R&T agent forwards delivery details to the warehouse which in turn arranges to release the commodities after due verification of the identity of recipient. On a specified day, the buyer would go to the warehouse and pick up the physicals. The seller intending to make delivery has to take the commodities to the designated

9.2 Settlement

123

warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouses then ensure that the receipts get updated in the depository system giving a credit in the depositor’s electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer’s clearing member. NCDEX contracts provide a standardized description for each commodity. The description is provided in terms of quality parameters specific to the commodities. At the same time, it is realized that with commodities, there could be some amount of variances in quality/ weight etc., due to natural causes, which are beyond the control of any person. Hence, NCDEX contracts also provide tolerance limits for variances. A delivery is treated as good delivery and accepted if the delivery lies within the tolerance limits. However, to allow for the difference, the concept of premium and discount has been introduced. Goods that come to the authorised warehouse for delivery are tested and graded as per the prescribed parameters. The premium and discount rates apply depending on the level of variation. The price payable by the party taking delivery is then adjusted as per the premium/ discount rates fixed by the exchange. This ensures that some amount of leeway is provided for delivery, but at the same time, the buyer taking delivery does not face windfall loss/ gain due to the quantity/ quality variation at the time of taking delivery. This, to some extent, mitigates the difficulty in delivering and receiving exact quality/ quantity of commodity Closing out by offsetting positions Most of the contracts are settled by closing out open positions. In closing out, the opposite transaction is effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is closed out by a buy. For example, an investor who took a long position in two gold futures contracts on the January 30, 2004 at 6090, can close his position by selling two gold futures contracts on February 27, 2004 at Rs.5928. In this case, over the period of holding the position, he has suffered a loss of Rs.162 per unit. This loss would have been debited from his margin account over the holding period by way of MTM at the end of each day, and finally at the price that he closes his position, that is Rs.5928 in this case. Cash settlement Contracts held till the last day of trading can be cash settled. When a contract is settled in cash, it is marked to the market at the end of the last trading day and all positions are declared closed. The settlement price on the last trading day is set equal to the closing spot price of the underlying asset ensuring the convergence of future prices and the spot prices. For example an investor took a short position in five long staple cotton futures contracts on December 15 at Rs.6950. On 20th February, the last trading day of the contract, the spot price of long staple cotton is Rs.6725. This is the settlement price for his contract. As a holder of a short position on cotton, he does not have to actually deliver the underlying cotton, but simply takes away the profit of Rs.225 per trading unit of cotton in the form of cash.

124

9.2.3


Entities involved in physical settlement

Physical settlement of commodities involves the following three entities – an accredited warehouse, registrar & transfer agent and an assayer. We will briefly look at the functions of each. Accredited warehouse NCDEX specifies accredited warehouses through which delivery of a specific commodity can be effected and which will facilitate for storage of commodities. For the services provided by them, warehouses charge a fee that constitutes storage and other charges such as insurance, assaying and handling charges or any other incidental charges. Following are the functions of an accredited warehouse: 1. Earmark separate storage area as specified by the exchange for the purpose of storing commodities to be delivered against deals made on the exchange. The warehouses are required to meet the specifications prescribed by the exchange for storage of commodities. 2. Ensure and co–ordinate the grading of the commodities received at the warehouse before they are stored. 3. Store commodities in line with their grade specifications and validity period and facilitate maintenance of identity. On expiry of such validity period of the grade for such commodities, the warehouse has to segregate such commodities and store them in a separate area so that the same are not mixed with commodities which are within the validity period as per the grade certificate issued by the approved assayers.

Approved registrar and transfer agents (R&T agents) The exchange specifies approved R&T agents through whom commodities can be dematerialized and who facilitate for dematerialization/ re–materialization of commodities in the manner prescribed by the exchange from time to time. The R&T agent performs the following functions: 1. Establishes connectivity with approved warehouses and supports them with physical infrastructure. 2. Verifies the information regarding the commodities accepted by the accredited warehouse and assigns the identification number (ISIN) allotted by the depository in line with the grade/ validity period. 3. Further processes the information, and ensures the credit of commodity holding to the demat account of the constituent. 4. Ensures that the credit of commodities goes only to the demat account of the constituents held with the exchange empanelled DPs. 5. On receiving a request for re–materialization (physical delivery) through the depository, arranges for issuance of authorisation to the relevant warehouse for the delivery of commodities.

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R&T agents also maintain proper records of beneficiary position of constituents holding dematerialized commodities in warehouses and in the depository for a period and also as on a particular date. They are required to furnish the same to the exchange as and when demanded by the exchange. R&T agents also do the job of co–ordinating with DPs and warehouses for billing of charges for services rendered on periodic intervals. They also reconcile dematerialized commodities in the depository and physical commodities at the warehouses on periodic basis and co–ordinate with all parties concerned for the same. Approved assayer The exchange specifies approved assayers through whom grading of commodities (received at approved warehouses for delivery against deals made on the exchange) can be availed by the constituents of clearing members. Assayers perform the following functions: 1. Inspect the warehouses identified by the exchange on periodic basis to verify the compliance of technical/ safety parameters detailed in the warehousing accreditation norms of the exchange. The compliance certificate so given by the assayer forms the basis of warehouse accreditation by the exchange. 2. Make available grading facilities to the constituents in respect of the specific commodities traded on the exchange at specified warehouse. The assayer ensures that the grading to be done (in a certificate format prescribed by the exchange) in respect of specific commodity is as per the norms specified by the exchange in the respective contract specifications. 3. Grading certificate so issued by the assayer specifies the grade as well as the validity period up to which the commodities would retain the original grade, and the time up to which the commodities are fit for trading subject to environment changes at the warehouses.

9.3

Risk management

NCDEX has developed a comprehensive risk containment mechanism for the its commodity futures market. The salient features of risk containment mechanism are: 1. The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent. 2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies the initial margin requirements for each futures contract on a daily basis. It also follows value-at-risk (VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively. 3. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis. 4. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation by the PCM.

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

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

9.4

Margining at NCDEX

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

9.4.1

SPAN

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

9.4.2

Initial margin

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

9.4.3

Computation of initial margin

The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose of real–time initial margin computation. Initial margin requirements are based on 99% VaR (Value at Risk) over a one–day time horizon. Initial margin requirements for a member for each contract are as under: 1. For client positions: These are netted at the level of individual client and grossed across all clients, at the member level without any set–offs between clients. 2. For proprietary positions: These are netted at member level without any set–offs between client and proprietary positions.

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Table 9.3 Calculating outstanding position at TCM level Account Proprietary Client A Client B

Number of Number of Outstanding units bought units sold position 3000 2000

1000 1500 1000

Long 2000 Long 500 Short 1000

Net outstanding position

3500

Table 9.4 Minimum margin percentage on commodity futures contracts Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada

Minimum margin percentage 4 4 3 3 4 4 4 4 4 4

Consider the case of a trading member who has proprietary and client–level positions in a April 2004 gold futures contract. On his proprietary account, he bought 3000 trading units and sold 1000 trading units within the day. On account of client A, he bought 2000 trading units at the beginning of the day and sold 1500 units an hour later. And on account of client B, he sold 1000 trading units. Table 9.3 gives the total outstanding position for which the TCM would be margined. For the purpose of SPAN margin, various parameters as given below will be specified from time to time: 1. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR purpose for the prices of futures contracts. The minimum margin percentages for various commodities are given in Table 9.4. These may change from time to time as specified by the exchange. 2. Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may be specified by the exchange from time to time. 3. Calendar spread charge: Calendar spread is defined as the purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity on the same

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Clearing and settlement exchange. Margins are charged on all open calendar spread positions at 2% on the higher value of the near month or the far month position, or at such rate as may be specified by the exchange from time to time. The near month position is the buy/ sell position on the calendar–spread position that expires first. The far month position is the buy/ sell position on the calendar–spread position that expires next. A calendar spread position is treated as non–spread (naked) positions in the far month contract, 3 trading days prior to expiration of the near month contract. However, calendar spread A position is reduced gradually at the rate of µ µ % per day for three days or at such rate as may be prescribed by the exchange from time to time. The reduction of the spread position starts five days before the date of expiry of the near month contract.

9.4.4

Implementation aspects of margining and risk management

We look here at some implementation aspects of the margining and risk management system for trading on NCDEX. 1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateral security deposits in the form of bank guarantees, fixed deposits receipts and approved Government of India securities. 2. Payment of initial margin: The initial margin is payable upfront by members. 3. Effect of failure to pay initial margins: Non–fulfilment of either the whole or part of the initial margin obligations is treated as a violation of the rules, bye–laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX from time to time. In addition, the exchange can withdraw any or all of the membership rights of a member including the withdrawal of trading facilities of the members clearing through such clearing members, without any notice. The outstanding positions of such members and/ or constituents clearing and settling through such members, can be closed out forthwith or any time thereafter at the discretion of the Exchange, to the extent possible, by placing counter orders in respect of the outstanding position of members. Such action is final and binding on the members and/ or constituents. The exchange can also initiate such other risk containment measures as it deems fit with respect to the open positions of the members and/ or constituents. The exchange can take additional measures like imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit. 4. Exposure limits: This is defined as the maximum open positions that a member can take across all contracts and is linked to the liquid net worth of the member available with the exchange. The member is not allowed to trade once the exposure limits have been exceeded on the exchange. The trader workstation of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of additional capital. (a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at any point in time. The liquid networth maintained by the members at any point in time cannot be less than Rs.25 lakh (referred to as minimum liquid net worth) or such other amount, as may be specified by the exchange from time to time.


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(b) Effective deposits: This includes all deposits made by the members in the form of cash or cash equivalents form the effective deposits. For the purpose of computing effective deposits, cash equivalents mean bank guarantees, fixed deposit receipts and Government of Indian securities. (c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the ! liquid net worth. i.e. a member can have an exposure limit of times his liquid net worth. The multiple is as specified in Table 9.5 or as may be prescribed by the exchange from time. (d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures, contracts are treated as open position of one third of the value of the far month futures contract. However the spread positions is treated as a naked position in far month contract three trading days prior to expiry of the near month contract. 5. Imposition of additional margins and close out of open positions: As a risk containment measure, the exchange may require the members to make payment of additional margins as may be decided from time to time. This is in addition to the initial margin, which are or may have been imposed. The exchange may also require the members to reduce/ close out open positions to such levels and for such contracts as may be decided by it from time to time. 6. Failure to pay additional margins: Non–fulfilment of either the whole or part of the additional margin obligations is treated as a violation of the rules, bye-Laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX. The exchange may withdraw any or all of the membership rights of the members including the withdrawal of trading facilities of trading members clearing through such members, without any notice. In addition, the outstanding positions of such members and/ or constituents, clearing and settling through such members, can be closed out forthwith or any time thereafter, at the discretion of the exchange, to the extent possible, by placing counter orders in respect of their outstanding positions. 7. Return of excess deposit: Members can request the exchange to release excess deposits held by it or by a specified agent on behalf of the exchange. Such requests may be considered by the exchange subject to the bye–laws, rules and regulations. 8. Initial margin deposit or additional deposit or additional base capital: Members who wish to make a margin deposit (additional base capital) with the exchange and/ or wish to retain deposits and/ or such amounts which are receivable by them from the exchange, at any point of time, over and above their deposit requirement towards initial margin and/ or other obligations, must inform the exchange as per the procedure. 9. Position limits: Position wise limits are the maximum open positions that a member or his constituents can have in any commodity at any point of time. This is calculated as the higher of a specified percentage of the total open interest in the commodity or a specified value. Open interest is the total number of open positions in that futures contract multiplied by its last available traded price or closing price, as the case may be. 10. Intra–day price limit: The maximum price movement during a day can be +/- 10% of the previous day’s settlement price prescribed for each commodity. If the price hits the intra day price limit (at upper side or lower side), there will be a cooling period of 15 minutes. During the cooling period, trading in that particular contract will be suspended and normal trading will resume after the cooling period. The base price when trading resumes after cooling period will be the last traded price before the commencement of cooling period. There would be no cooling period if the price hits the intra day limit during the last 30 minutes of trading.

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Table 9.5 Exposure limit as a multiple of liquid net worth Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada

Multiple 25 25 40 40 25 25 25 25 25 25

(a) Daily settlement price: The daily profit/ losses of the members are settled using the daily settlement price. The daily settlement price notified by the exchange is binding on all members and their constituents. (b) Mark–to–market settlement: All the open positions of the members are marked to market at the end of the day and the profit/ loss determined as below: (a) On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. (b) On any intervening days, when the member holds an open position, it is the difference between the daily settlement value for that day and the previous day’s settlement price. (c) On the expiry date if the member has an open position, it is the difference between the final settlement price and the previous day’s settlement price. 11. Intra–day margin call: The exchange at its discretion can make intra day margin calls as risk containment measure if, in its opinion, the market price changes sufficiently. For example, it can make an intra–day margin call if the intra day price limit has been reached, or any other situation has arisen, which in the opinion of the exchange could result in an enhanced risk. The exchange at its discretion may make selective margin calls, for example, only for those members whose variation losses or initial margin deficits exceed a threshold value prescribed by the exchange. 12. Delivery margin: In case of positions materialising into physical delivery, delivery margins are calculated as ¶ days VaR margins plus additional margins. ¶ days refer to the number of days for completing the physical delivery settlement. The number of days are commodity specific, as described hereunder or as may be prescribed by the exchange from time to time. There is a mark up on the VaR based delivery margin to cover for default. Table 9.6 gives the number of days for physical settlement on various commodities.

9.4.5

Effect of violation

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


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Table 9.6 Number of days for physical settlement on various commodities Commodity

Number of days for physical settlement

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

2 4 10 10 7 7 7 7 7 7

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

Solved Problems Q: The settlement of futures contracts cannot be done by 1. Closing out open positions.

3. Cash settlement.

2. Physical delivery.

4. Carrying forward the position.

A: The correct answer is number 4. Q:

undertakes clearing and settlement of all trades executed on the NCDEX 1. NSE

3. NSDL

2. NSCCL

4. NCDEX


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Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by 1. NSE

3. NSDL

2. NSCCL

4. NCDEX


Q: The clearing house of an exchange is responsible for 1. Effecting timely settlement.

3. Financial clearing of the payment flow.

2. Control of the evolution of open interest.

4. All of the above.


Q: On expiry of a commodity futures contract, the settlement price is the 1. Spot price of the underlying asset

3. Spot price plus cost-of-carry

2. Futures close price

4. None of the above.


Q: The clearing house of an exchange is not responsible for 1. Effecting timely settlement.

3. Control of the evolution of open interest.

2. Ensuring that the buyer and seller get the best price.

4. Financial clearing of the payment flow.


Q: The exposure limit for each member is linked to the

of the member available with the exchange.

1. Liquid net worth.

3. Bank guarantees.

2. Security deposits.

4. Base capital.



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Q: A cotton trader bought ten one–month, long staple cotton futures contracts at Rs.6020 per Quintal at the beginning of the day. The unit of trading is 11 bales and each contract is for delivery of 55 bales. The settlement price at the end of the day was Rs.6050 per Quintal. The trader’s MTM account will show 1. A profit of Rs.5610

3. A profit of Rs.1500

2. A loss of Rs.5610


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

Q: A gold merchant bought two units of one–month gold futures contracts at Rs.6000 per 10 gms at the beginning of the day. The unit of trading is 100 gms and each contract is for delivery of one kg of gold. The settlement price at the end of the day was Rs.6025 per 10 gms. The trader’s MTM account will show 1. A profit of Rs.500

3. A profit of Rs.5000

2. A loss of Rs.500


A: Each unit of trading is 100 gms. He has bought two units. This means he has a long position in 200 gms of gold. He makes a profit of Rs.25 per 10 gms on his futures position. So he makes a profit of \CZ ® % % Rs.500, i.e. A4B = Rs.500. The correct answer is number 1.

Q: A trading member took proprietary positions in a March 2004 cotton futures contract. He bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per Quintal. What is the outstanding position on which he would be margined? 1. Long 3000 units

3. Long 5400 units

2. Short 2400 units

4. Long 600 units

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

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Q: A trading member has proprietary and client positions in a March cotton futures contract. On his proprietary account, he bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per Quintal. On account of client A, he bought 2000 trading units at Rs.6012 per Quintal, and on account of client B, he sold 1000 trading units at Rs.5990 per Quintal. What is the outstanding position on which he would be margined? 1. Long 3000 units

3. Long 3600 units

2. Short 8400 units

4. Long 1600 units

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

Q: A trading member has proprietary and client positions in a April 2004 gold futures contract. On his proprietary account, he bought 3000 trading units at Rs.6000 per 10 gms. On account of client A, he bought 2000 trading units at Rs.6012 per 10 gms and sold 1500 units at Rs.6020 per 10 gms, and on account of client B, he sold 1000 trading units at Rs.5990 per 10 gms. What is the outstanding position on which he would be margined? 1. Long 3000 units

3. Long 3600 units

2. Short 4500 units

4. Long 7500 units

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

Chapter 10 Regulatory framework At present, there are three tiers of regulations of forward/futures trading system in India, namely, government of India, Forward Markets Commission(FMC) and commodity exchanges. The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. Proper regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous participants could use these leveraged contracts for manipulating prices. This could have undesirable influence on the spot prices, thereby affecting interests of society at large.. Regulation is also needed to ensure that the market has appropriate risk management system. In the absence of such a system, a major default could create a chain reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and management of the exchange so as to protect and promote the interest of various stakeholders, particularly non–member users of the market.

10.1

Rules governing commodity derivatives exchanges

The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission(FMC). Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the exchanges, which are granted recognition by the central government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution). All the exchanges, which deal with forward contracts, are required to obtain certificate of registration from the FMC. Besides, they are subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on their working. Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i.e. to prevent systematic risk of default by one major operator or group of operators), market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect and promote interest of customers/ non–members. It prescribes the following regulatory measures:

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Regulatory framework

1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on intra–day net open position. The limit is imposed operator–wise, and in some cases, also member– wise. 2. Circuit–filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices. 3. Special margin deposit to be collected on outstanding purchases or sales when price moves up or down sharply above or below the previous day closing price. By making further purchases/sales relatively costly, the price rise or fall is sobered down. This measure is imposed only on the request of the exchange. 4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. This measure is also imposed on the request of the exchanges. 5. Skipping trading in certain derivatives of the contract, closing the market for a specified period and even closing out the contract: These extreme measures are taken only in emergency situations.

Besides these regulatory measures, the F.C(R) Act provides that a client’s position cannot be appropriated by the member of the exchange, except when a written consent is taken within three days time. The FMC is persuading increasing number of exchanges to switch over to electronic trading, clearing and settlement, which is more customer–friendly. The FMC has also prescribed simultaneous reporting system for the exchanges following open out–cry system. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like trading ahead of clients, etc. The FMC has also mandated all the exchanges following open outcry system to display at a prominent place in exchange premises, the name, address, telephone number of the officer of the commission who can be contacted for any grievance. The website of the commission also has a provision for the customers to make complaint and send comments and suggestions to the FMC. Officers of the FMC have been instructed to meet the members and clients on a random basis, whenever they visit exchanges, to ascertain the situation on the ground, instead of merely attending meetings of the board of directors and holding discussions with the office–bearers.

10.2

Rules governing intermediaries

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

10.2.1

Trading

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

10.2 Rules governing intermediaries

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approved workstation(s) located at locations for the office(s) of a trading member as approved by the exchange. If LAN or any other way to other workstations at any place connects an approved workstation of a trading Member it shall require an approval of the exchange. Each trading member is required to have a unique identification number which is provided by the exchange and which will be used to log on (sign on) to the trading system. A trading member has a non–exclusive permission to use the trading system as provided by the exchange in the ordinary course of business as trading member. He does not have any title rights or interest whatsoever with respect to trading system, its facilities, software and the information provided by the trading system. For the purpose of accessing the trading system, the member will install and use equipment and software as specified by the exchange at his own cost. The exchange has the right to inspect equipment and software used for the purposes of accessing the trading system at any time. The cost of the equipment and software supplied by the exchange, installation and maintenance of the equipment is borne by the trading member. Trading members and users Trading members are entitled to appoint, (subject to such terms and conditions, as may be specified by the relevant authority) from time to time Authorised persons Approved users

Trading members have to pass a certification program, which has been prescribed by the exchange. In case of trading members, other than individuals or sole proprietorships, such certification program has to be passed by at least one of their directors/ employees/ partners / members of governing body. Each trading member is permitted to appoint a certain number of approved users as notified from time to time by the exchange. The appointment of approved users is subject to the terms and conditions prescribed by the exchange. Each approved user is given a unique identification number through which he will have access to the trading system. An approved user can access the trading system through a password and can change the password from time to time. The trading member or its approved users are required to maintain complete secrecy of its password. Any trade or transaction done by use of password of any approved user of the trading member, will be binding on such trading member. Approved user shall be required to change his password at the end of the password expiry period. Trading days The exchange operates on all days except Saturday and Sunday and on holidays that it declares from time to time. Other than the regular trading hours, trading members are provided a facility to place orders off–line i.e. outside trading hours. These are stored by the system but get traded only once the market opens for trading on the following working day.

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The types of order books, trade books, price limits, matching rules and other parameters pertaining to each or all of these sessions is specified by the exchange to the members via its circulars or notices issued from time to time. Members can place orders on the trading system during these sessions, within the regulations prescribed by the exchange as per these bye laws, rules and regulations, from time to time. Trading hours and trading cycle The exchange announces the normal trading hours/ open period in advance from time to time. In case necessary, the exchange can extend or reduce the trading hours by notifying the members. Trading cycle for each commodity/ derivative contract has a standard period, during which it will be available for trading. Contract expiration Derivatives contracts expire on a pre–determined date and time up to which the contract is available for trading. This is notified by the exchange in advance. The contract expiration period will not exceed twelve months or as the exchange may specify from time to time. Trading parameters The exchange from time to time specifies various trading parameters relating to the trading system. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. The exchange also prescribes different order books that shall be maintained on the trading system and also specifies various conditions on the order that will make it eligible to place it in those books. The exchange specifies the minimum disclosed quantity for orders that will be allowed for each commodity/ derivatives contract. It also prescribes the number of days after which Good Till Cancelled orders will be cancelled by the system. It specifies parameters like lot size in which orders can be placed, price steps in which orders shall be entered on the trading system, position limits in respect of each commodity etc. Failure of trading member terminal In the event of failure of trading members workstation and/ or the loss of access to the trading system, the exchange can at its discretion undertake to carry out on behalf of the trading member the necessary functions which the trading member is eligible for. Only requests made in writing in a clear and precise manner by the trading member would be considered. The trading member is accountable for the functions executed by the exchange on its behalf and has to indemnity the exchange against any losses or costs incurred by the exchange.


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Trade operations Trading members have to ensure that appropriate confirmed order instructions are obtained from the constituents before placement of an order on the system. They have to keep relevant records or documents concerning the order and trading system order number and copies of the order confirmation slip/ modification slip must be made available to the constituents. The trading member has to disclose to the exchange at the time of order entry whether the order is on his own account or on behalf of constituents and also specify orders for buy or sell as open or close orders. Trading members are solely responsible for the accuracy of details of orders entered into the trading system including orders entered on behalf of their constituents. Trades generated on the system are irrevocable and ‘locked in’. The exchange specifies from time to time the market types and the manner if any, in which trade cancellation can be effected. Where a trade cancellation is permitted and trading member wishes to cancel a trade, it can be done only with the approval of the exchange. Margin requirements Subject to the provisions as contained in the exchange bye–laws and such other regulations as may be in force, every clearing member, in respect of the trades in which he is party to, has to deposit a margin with exchange authorities. The exchange prescribes from time to time the commodities/ derivative contracts, the settlement periods and trade types for which margin would be attracted. The exchange levies initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as the exchange may decide from time to time. The margin is charged so as to cover one–day loss that can be encountered on the position on 99% of the days. Additional margins may be levied for deliverable positions, on the basis of VaR from the expiry of the contract till the actual settlement date plus a mark–up for default. The margin has to be deposited with the exchange within the time notified by the exchange. The exchange also prescribes categories of securities that would be eligible for a margin deposit, as well as the method of valuation and amount of securities that would be required to be deposited against the margin amount. The procedure for refund/ adjustment of margins is also specified by the exchange from time to time. The exchange can impose upon any particular trading member or category of trading member any special or other margin requirement. On failure to deposit margin/s as required under this clause, the exchange/clearing house can withdraw the trading facility of the trading member. After the pay-out, the clearing house releases all margins. Unfair trading practices No trading member should buy, sell, deal in derivatives contracts in a fraudulent manner, or indulge in any unfair trade practices including market manipulation. This includes the following: Effect, take part either directly or indirectly in transactions, which are likely to have effect of artificially, raising or depressing the prices of spot/ derivatives contracts.

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Regulatory framework Indulge in any act, which is calculated to create a false or misleading appearance of trading, resulting in reflection of prices, which are not genuine. Buy, sell commodities/ contracts on his own behalf or on behalf of a person associated with him pending the execution of the order of his constituent or of his company or director for the same contract. Delay the transfer of commodities in the name of the transferee. Indulge in falsification of his books, accounts and records for the purpose of market manipulation. When acting as an agent, execute a transaction with a constituent at a price other than the price at which it was executed on the exchange. Either take opposite position to an order of a constituent or execute opposite orders which he is holding in respect of two constituents except in the manner laid down by the exchange.

10.2.2

Clearing

As mentioned earlier, National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. All deals executed on the Exchange are cleared and settled by the trading members on the settlement date by the trading members themselves as clearing members or through other professional clearing members in accordance with these regulations, bye laws and rules of the exchange. Last day of trading Last trading day for a derivative contract in any commodity is the date as specified in the respective commodity contract. If the last trading day as specified in the respective commodity contract is a holiday, the last trading day is taken to be the previous working day of exchange. On the expiry date of contracts, the trading members/ clearing members have to give delivery information as prescribed by the exchange from time to time. If a trading member/ clearing member fails to submit such information during the trading hours on the expiry date for the contract, the deals have to be settled as per the settlement calendar applicable for such deals, in cash together with penalty as stipulated by the exchange. Delivery Delivery can be done either through the clearing house or outside the clearing house. On the expiry date, during the trading hours, the exchange provides a window on the trading system to submit delivery information for all open positions. After the trading hours on the expiry date, based on the available information, the matching for deliveries takes place – firstly, on the basis of locations and then randomly keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time. Matching done is binding on the clearing members. After completion of the


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matching process, clearing members are informed of the deliverable / receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of the final settlement price. All matched and unmatched positions are settled in accordance with the applicable settlement calendar. The exchange may allow an alternate mode of settlement between the constituents directly provided that both the constituents through their respective clearing members notify the exchange before the closing of trading hours on the expiry date. They have to mention their preferred identified counter–party and the deliverable quantity, along with other details required by the exchange. The exchange however, is not be responsible or liable for such settlements or any consequence of such alternate mode of settlements. If the information provided by the buyer/ seller clearing members fails to match, then the open position would be settled in cash together with penalty as may be stipulated by the exchange. The clearing members are allowed to deliver their obligations before the pay in date as per applicable settlement calendar, whereby the clearing house can reduce the margin requirement to that extent. The exchange specifies the parameters and methodology for premium/ discount, as the case may be, from time to time for the quality/ quantity differential, sales tax, taxes, government levies/ fees if any. Pay in/ Pay out for such additional obligations is settled on the supplemental settlement date as specified in the settlement calendar. Procedure for payment of sales tax/VAT The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/central tax/fee applicable to the deals culminating into sale with physical delivery of commodities. All members have to ensure that their respective constituents, who intend to take or give delivery of commodity, are registered with sales tax authorities of all such states in which the exchange has a delivery center for a particular commodity in which constituent has or is expected to have open positions. Members have to maintain records/details of sales tax registration of each of such constituent and furnish the same to the exchange as and when required. The seller is responsible for payment of sales tax/VAT, however the seller is entitled to recover from the buyer, the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. In no event is the exchange/ clearing house liable for payment of sales tax/ VAT or any other local tax, fees, levies etc. Penalties for defaults In the event of a default by the seller or the buyer in delivery of commodities or payment of the price, the exchange closes out the derivatives contracts and imposes penalties on the defaulting buyer or seller, as the case may be. It can also use the margins deposited by such clearing member to recover the loss. The settlement for the defaults in delivery is to be done in cash within the period as prescribed by the exchange at the highest price from the last trading date till the final settlement date with a mark up thereon as may be decided from time to time.

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Process of dematerialization Dematerialization refers to issue of an electronic credit, instead of a vault/ warehouse receipt, to the depositor against the deposit of commodity. Any person (a constituent) seeking to dematerialize a commodity has to open an account with an approved depository participant (DP). The exchange provides the list of approved DPs from time to time. In case of commodities (other than precious metals) the constituent delivers the commodity to the exchange–approved warehouses. The commodity brought by the constituent is checked for the quality by the exchange–approved assayers before the deposit of the same is accepted by the warehouse. If the quality of the commodity is as per the norms defined and notified by the exchange from time to time, the warehouse accepts the commodity and sends confirmation in the requisite format to the R & T agent who upon verification, confirms the deposit of such commodity to the depository for giving credit to the demat account of the said constituent. In case of precious metals, the commodity must be accompanied with the assayers’ certificate. The vault accepts the precious metal, after verifying the contents of assayers certificate with the precious metal being deposited. On acceptance, the vault issues an acknowledgement to the constituent and sends confirmation in the requisite format to the R & T agent who upon verification, confirms the deposit of such precious metal to the depository for giving credit to the demat account of the said constituent. Validity date In case of commodities having validity date assigned to it by the approved assayer, the delivery of the commodity upon expiry of validity date is not considered as a good delivery. The clearing member has to ensure that his concerned constituent removes the commodities on or before the expiry of validity date for such commodities. For the depository, commodities, which have reached the trading validity date, are moved out of the electronic deliverable quantity. Such commodities are suspended from delivery. The constituent has to rematerialize such quantity and remove the same from the warehouse. Failure to remove deliveries after the validity date from warehouse is levied with penalty as specified by the relevant authority from time to time. Process of rematerialisation Re–materialization refers to issue of physical delivery against the credit in the demat account of the constituent. The constituent seeking to rematerialize his commodity holding has to make a request to his DP in the prescribed format and the DP then routes his request through the depository system to the R & T agent issues the authorisation addressed to the vault/ warehouse to release physical delivery to the constituent. The vault/warehouse on receipt of such authorisation releases the commodity to the constituent or constituent’s authorised person upon verifying the identity.


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Delivery through the depository clearing system Delivery in respect of all deals for the clearing in commodities happens through the depository clearing system. The delivery through the depository clearing system into the account of the buyer with the depository participant is deemed to be delivery, notwithstanding that the commodities are located in the warehouse along with the commodities of other constituents. Payment through the clearing bank Payment in respect of all deals for the clearing has to be made through the clearing bank(s); Provided however that the deals of sales and purchase executed between different constituents of the same clearing member in the same settlement, shall be offset by process of netting to arrive at net obligations. Clearing and settlement process The relevant authority from time to time fixes the various clearing days, the pay–in and pay– out days and the scheduled time to be observed in connection with the clearing and settlement operations of deals in commodities/ futures contracts. 1. Settlement obligations statements for TCMs: The exchange generates and provides to each trading clearing member, settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him in his capacity as clearing member and by professional clearing member for deals made by him for which the clearing Member has confirmed acceptance to settle. The obligations statement is deemed to be confirmed by the trading member for which deliveries are to be given and/ or taken and funds to be debited and/ or credited to his account as specified in the obligations statements and deemed instructions to the clearing banks/ institutions for the same. 2. Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to each professional clearing member, settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him. The settlement obligation statement is deemed to have been confirmed by the said clearing member in respect of every and all obligations enlisted therein.

Delivery of commodities Based on the settlement obligations statements, the exchange generates delivery statement and receipt statement for each clearing member. The delivery and receipt statement contains details of commodities to be delivered to and received from other clearing members, the details of the corresponding buying/ selling constituent and such other details. The delivery and receipt statements are deemed to be confirmed by respective member to deliver and receive on account of his constituent, commodities as specified in the delivery and receipt statements. On respective pay–in day, clearing members effect depository delivery in the depository clearing system as per delivery statement in respect of depository deals. Delivery has to be made in terms of the delivery units notified by the exchange.

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Commodities, which are to be received by a clearing member, are delivered to him in the depository clearing system in respect of depository deals on the respective pay–out day as per instructions of the exchange/ clearing house. Delivery units The exchange specifies from time to time the delivery units for all commodities admitted to dealings on the exchange. Electronic delivery is available for trading before expiry of the validity date. The exchange also specifies from time to time the variations permissible in delivery units as per those stated in contract specifications. Depository clearing system The exchange specifies depository(ies) through which depository delivery can be effected and which shall act as agents for settlement of depository deals, for the collection of margins by way of securities for all deals entered into through the exchange, for any other commodities movement and transfer in a depository(ies) between clearing members and the exchange and between clearing member to clearing member as may be directed by the relevant authority from time to time. Every clearing member must have a clearing account with any of the Depository Participants of specified depositories. Clearing Members operate the clearing account only for the purpose of settlement of depository deals entered through the exchange, for the collection of margins by way of commodities for deals entered into through the exchange. The clearing member cannot operate the clearing account for any other purpose. Clearing members are required to authorise the specified depositories and depository participants with whom they have a clearing account to access their clearing account for debiting and crediting their accounts as per instructions received from the exchange and to report balances and other credit information to the exchange.

10.3

Rules governing investor grievances, arbitration

In matters where the exchange is a party to the dispute, the civil courts at Mumbai have exclusive jurisdiction and in all other matters, proper courts within the area covered under the respective regional arbitration center have jurisdiction in respect of the arbitration proceedings falling/ conducted in that regional arbitration center. For the purpose of clarity, we define the following: Arbitrator means a sole arbitrator or a panel of arbitrators. Applicant means the person who makes the application for initiating arbitral proceedings. Respondent means the person against whom the applicant lodges an arbitration application, whether or not there is a claim against such person.

10.3 Rules governing investor grievances, arbitration

145

If the value of claim, difference or dispute is more than Rs.25 Lakh on the date of application, then such claim, difference or dispute are to be referred to a panel of three arbitrators. If the value of the claim, difference or dispute is up to Rs.25 Lakh, then they are to be referred to a sole arbitrator. Where any claim, difference or dispute arises between agent of the member and client of the agent of the member, in such claim, difference or dispute, the member, to whom such agent of the member is affiliated, is impeded as a party. In case the warehouse refuses or fails to communicate to the constituent the transfer of commodities, the date of dispute is deemed to have arisen on 1. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of the constituent. 2. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for transfer with the seller, whichever is later.

10.3.1

Procedure for arbitration

The applicant has to submit to the exchange application for arbitration in the specified form (Form No. I/IA) along with the following enclosures: 1. The statement of case (containing all the relevant facts about the dispute and relief sought). 2. The statement of accounts. 3. Copies of member – constituent agreement. 4. Copies of the relevant contract notes, invoice and delivery challan.

The Applicant has to also submit to the exchange the following along with the arbitration form: 1. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited. 2. Form No. II/IIA containing list of names of the persons eligible to act as arbitrators.

If any deficiency/ defect in the application is found, the exchange calls upon the applicant to rectify the deficiency/ defect and the applicant must rectify the deficiency/ defect within 15 days of receipt of intimation from the exchange. If the applicant fails to rectify the deficiency/ defect within the prescribed period, the exchange returns the deficient/ defective application to the applicant. However, the applicant has the right to file a revised application, which will be considered as a fresh application for all purposes and dealt with accordingly. Upon receipt of Form No.I/IA, the exchange forwards a copy of the statement of case and related documents to the respondent. The respondent then has to submit Form II/IIA to the exchange within 7 days from the date of receipt. If the respondent fails to submit Form II/IIA within the time period prescribed by the exchange, then the arbitrator is appointed in the manner as specified in the regulation. The respondent(s) should within 15 days from the date of receipt

146


of Form No. I/IA from the exchange, submit to the exchange in Form No. III/IIIA three copies in case of sole arbitrator and five copies in case of panel of arbitrators along with the following enclosures: The statement of reply (containing all available defences to the claim) The statement of accounts Copies of the member constituent agreement. Copies of the relevant contract notes, invoice and delivery challan Statement of the set–off or counter claim along with statements of accounts and copies of relevant contract notes and bills

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

10.3.2

Hearings and arbitral award

No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs.25,000 or less. In such a case the arbitrator proceeds to decide the matter on the basis of documents submitted by both the parties provided. However the arbitrator for reasons to be recorded in writing may hear both the parties to the dispute. If the value of claim, difference or dispute is more than Rs.25,000, the arbitrator offers to hear the parties to the dispute unless both parties waive their right for such hearing in writing. The exchange in consultation with the arbitrator determines the date, the time and place of the first hearing. Notice for the first hearing is given at least ten days in advance, unless the parties, by their mutual consent, waive the notice. The arbitrator determines the date, the time and place of subsequent hearings of which the exchange gives a notice to the parties concerned. If after the appointment of an arbitrator, the parties settle the dispute, then the arbitrator records the settlement in the form of an arbitral award on agreed terms. All fees and charges relating to the appointment of the arbitrator and conduct of arbitration proceedings are to borne by the parties to the reference equally or in such proportions as may be decided by the arbitrator. The costs, if any, are awarded to either of the party in addition to the fees and charges, as decided by the arbitrator.

10.3 Rules governing investor grievances, arbitration

147

Solved Problems Q: Which of the following is not involved in regulating forward/futures trading system in India? 1. Government of India

3. Commodity exchanges

2. Forward Markets Commission(FMC)

4. Commodity board of trading


Q: All the exchanges, which deal with forward contracts, are required to obtain certificate of registration from the 1. Government of India

3. Commodity exchanges

2. Forward Markets Commission(FMC)

4. Commodity board of trading


Q: To ensure financial integrity and market integrity, the FMC prescribes certain regulatory measures. Which of the following is not a measure prescribed? 1. Limit on net open positions.

3. Special margin deposits.

2. Circuit–filters or limit on price fluctuations.

4. Price determination


Q: Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. 1. Open order or close order

3. take order or give order

2. call order or put order

4. bid order or ask order

A: The correct answer is number 1. Q: In matters where the NCDEX is a party to the dispute, the civil courts at

have exclusive

jurisdiction. 1. Delhi

3. Ahmedabad

2. Mumbai

4. Calcutta


148


Q: No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs.25,000 or less. 1. Rs.25,000

3. Rs.1,00,000

2. Rs.50,000

4. Rs.10,000

A: The correct answer is number 1. Q: In the case of an arbitration, the exchange in consultation with the and place of the first hearing. 1. Respondent

3. Arbitrator

2. Applicant

4. Warehouse


determines the date, the time

Chapter 11 Implications of sales tax The physical settlement in the case of commodities futures contracts involves issues concerned with sales tax. The fact that delivery could happen across various states, and these states have different sales tax rules, makes the issue a little complicated. In the case of settlements culminating into delivery, sales tax at the rates applicable in the state where the delivery center is located will be payable. In many states, the sales tax laws, also provide for levy of additional tax, turnover tax, resale tax, etc. which may or may not be recoverable from the buyer depending on the provisions of the local state sales tax law. The NCDEX has examined the implications of trading on NCDEX system under the relevant state sales tax laws and has also sought opinion from independent tax advisors on the matter. The present understanding of the implications are given below for reference. Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liable for payment of sales tax. If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodities, there is no liability for payment of sales tax. When the futures contract fructifies into a sale and culminates into delivery, there would be liability for payment of sales tax. This liability will arise in the state in which the warehouse (into which the goods are lodged by the constituent) is situated when the commodities are delivered to the buyer. It is the responsibility of the selling constituent to comply with the relevant local state sales tax laws and other local enactments. The selling constituent will be responsible for the following: 1. Obtaining registration under the relevant state sales tax laws, filing of returns, payment of taxes and due compliance of laws. 2. Payment of entry tax, octroi, etc., when the commodities are brought into the designated local area for lodging the same with the warehouse. 3. Complying with any check–post regulations prescribed under the local sales tax, entry tax or other municipal laws and ensuring that the prescribed documents accompany the goods. 4. Liability for central sales tax if the commodities are moved from outside the state pursuant to a transaction of sale.

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Implications of sales tax 5. The selling constituent may move the commodities into the warehouse well in advance and ensure compliance of provisions of law. 6. Furnishing of duly completed sales invoices, declaration forms and certificates prescribed under the local sales tax, entry tax or other municipal laws to enable the buyer to avail of exemption or deduction as provided in the relevant laws. It is the responsibility of the buying constituent to comply with the applicable local state sales tax laws and other local enactments. The buying constituent will be responsible for the following: 1. Obtaining registration under the relevant state sales tax laws based on the purchase of commodities, filing of returns, payment of taxes and due compliance of laws. 2. Furnishing of duly completed declaration forms and certificates prescribed under the local sales tax, entry tax or other municipal laws to enable the seller to avail of exemption or deduction as provided in the relevant laws.

Solved Problems Q: When the futures contract fructifies into a sale and culminates into delivery, the payment of sales tax is situated. is to be done in the state in which the 1. Clearing corporation

3. Buyer

2. Warehouse

4. Seller

A: The correct answer is number 2. Q: It is the responsibility of the

to comply with the relevant local state sales tax laws and other local

enactments. 1. Warehouse

3. Seller

2. Buyer

4. Buyer and seller


Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and culminates into of the underlying. 1. Payment

3. Delivery

2. Sale

4. Exchange


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Sources/references/suggested readings The readings suggested here are supplementary in nature and would prove to be helpful for those interested in learning more about derivatives. Derivatives FAQ by Ajay Shah and Susan Thomas Escape to the futures by Leo Melamed Futures and options by Hans R.Stoll and Robert E. Whaley. Futures and options in risk management by Terry J. Watsham. Options, futures and other derivatives by John Hull. Futures, options and swaps by Robert W. Kolb. Introduction to futures and options markets by John Kolb Options and financial future: Valuation and uses by David A. Dubofsky. Rubinstein on derivatives by Mark Rubinstein. Derivative markets in India 2003 edited by Susan Thomas. http://www.ncdex.com http://fmc.gov.in

Index arbitragers, 10 assignment, 18 basis, 60 baskets, 14 cost of carry, 60 cost-of-carry, 76 delivery, 19 derivatives exchange traded, 13 OTC, 13 forwards, 57 futures, 14 commodity, 77 hedge long, 87 short, 86 hedgers, 10 long call, 66 put, 68 margin initial, 60 maintenance, 60 MTM, 60 option american, 61 at-the-money, 61 buyer, 61 call, 61 european, 61

in-the-money, 61 index, 61 intrinsic value, 62 out-of-money, 61 premium, 61 put, 61 stock, 61 time value, 62 writer, 61 order day, 104 GTC, 105 GTD, 105 IOC, 105 stop–loss, 105 price limit, 106 trigger, 106 settlement physical, 17 short call, 67 put, 69 speculators, 10 spot price, 60 swaps, 14 currency, 14 interest rate, 14 swaptions, 14 transaction forward, 12 spot, 12 warrants, 14

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