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A Study On Commodity Market
A Study On Commodity Market
1. Introduction…………………………………………………………………………………………. 1
1.1.Spot Vs Forward Transactions………………………………………………………………… 4
1.2.Limitations…………………………………………………………………………………...... 5
2. Company Profile……………………………………………………………………………………. 7
3. History of Commodity trading and Precious Metals……………………………………………….. 9
3.1. Commodity trading in India………………………………………………………………….... 9
3.2. Kabra committee report……………………………………………………………………...... 10
3.3. Forward Market Commission………………………………………………………………….. 12
3.4. Multi-commodity exchange of India……………………………………………………………13
3.5. National Commodity and Derivatives Exchange limited……………………………………… 15
3.6. History of Gold Market………………………………………………………………………... 19
3.6.1.Gold Trading…………………………………………………………………………….. 20
3.6.2.Production of the Gold……………………………………………………………………
20
3.6.3.Why central Banks Hold Gold……………………………………………………………
21
3.7.History of silver Market……………………………………………………………………….. 23
3.7.1.Production of silver……………………………………………………………………. ...
24
4. Pricing Commodity Futures……………………………………………………………………….. 26
4.1.Investment Vs Consumption Assets…………………………………………………………..... 26
4.2.Cost of Carry model………………………………………………………………………….... 27
4.3.Pricing Futures Contract on Investment commodities………………………………………… 29
4.4.Pricing Futures Contract on Consumption commodities……………………………………… 32
5. Clearing, Settlement and Risk Management……………………………………………………….. 35
5.1.Clearing………………………………………………………………………………………… 35
5.2.Settlement………………………………………………………………………………………. 37
5.3.Risk Management……………………………………………………………………………… 40
6. Fundamental and Technical Analysis………………………………………………………………. 42
6.1.Fundamental analysis………………………………………………………………………......
42
6.1.1.Demand and Consumption………………………………………………………………. 42
6.1.2.Consumption of gold in India……………………………………………………………..
44
6.1.3.Uses of Gold………………………………………………………………………………
44
6.2.Technical analysis……………………………………………………………………………… 46
6.2.1.Dow Theory……………………………………………………………………………… 46
6.3.2. Oscillators……………………………………………………………………………….. 68
7. References………………………………………………………………………………………….. 72
ABSTRACT
Aim: An empirical study on precious metals based on fundamental and technical analysis.
Abstract: We study the gold and silver prices based on fundamental analysis like inventories in
the entire globe, central bank reserves and currency fluctuations. We study the Inventories which
will effect due to strikes, political conditions and demand & supply mismatch. According to
central Bank policies and central agreements reserves will various. Currency trading on Dollar
verses Euro or Dollar verses sterling pound causes volatility which leads to gold/silver price
fluctuations.
the indicators used by technical analysts to study the trend of the market as a whole.
know the average prices of the commodity, and we use Oscillators to identify
analysis for predicting the future price actions based on historical data and
previous trends.
LIST OF FIGURES
1. Consumption of Gold...................................................................................................... 43
2. Primary trend and secondary reactions............................................................................. 47
3. Three Phases of bull market.............................................................................................. 48
4. Three Phases of a bear market.......................................................................................... 49
5. Line chart.......................................................................................................................... 51
6. Bar Chart of silver............................................................................................................. 52
7. Bar chart of Gold.............................................................................................................. 54
8. Bar Chart of Crude oil...................................................................................................... 55
9. Japanese candlesticks of Silver......................................................................................... 56
10. Japanese candlesticks of crude oil.................................................................................... 57
11. Japanese candlesticks of Gold.......................................................................................... 58
12. Support and resistance levels............................................................................................ 61
13.Head and shoulder formation............................................................................................... 62
14. EMA Chart.........................................................................................................................
68
15. ROC Chart..........................................................................................................................
70
LIST OF TABLES
INTRODUCTION
Trading on derivatives first started to protect farmers from the risk of their values
against fluctuations in the price of their crop. From 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
the farmers can transfer their risk (i.e. fully or partially) by locking the price of their products.
This was developed to reduce the risk of the farmers. Let’s take an example when a farmer who
sowed his crop in June which he would receive his harvest in September may face uncertainty in
prices over the period because of the oversupply they are selling at a very low cost.
In 1848, the Chicago Board of Trade (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. 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 underlying like stocks,
Due to the high volatility in Financial Market with high risk & low rate of return
had made investors to choose alternate investments such as Bullion market in Commodity
market. In India gold has traditionally played a multi-faceted role. Apart from being used for
armament purpose, it has also served as an asset of the last resort and a hedge against inflation
and currency depreciation. But most importantly, it has most often been treated as an investment.
Many people have become very rich in commodity markets. It is one of the areas
where people can make extraordinary profits within a short span of time. For example, Richard
Dennis borrowed $1600 and turned it into a $200 million fortune in about ten years.
Definition of Derivatives: A derivative is a product whose value is derived from value of one or
more underlying assets or variables in a contractual manner. The underlying asset can be equity,
For example: A wheat farmers may wish to sell their harvest at a future date to eliminate
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures
contracts in commodities all over India. However when derivatives trading in securities was
introduced in 2001, the term security in the Securities Contracts Regulation Act, 1956 (SCRA),
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
1. Hedgers: Hedgers face risk associated with the price of an asset. They use the futures or
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.
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
Let us try to understand the difference between spot and derivatives contract.
Every transaction has three components like 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 example ‘A’ buys goods worth Rs.1000 from ‘B’ and sells goods worth Rs.400 to ‘B’.
On a net basis ‘A’ has to pay Rs.600 to ‘B’. Settlement is the actual process of exchanging
In a spot transaction, the trading, clearing and settlement happens immediately, i.e.
on the spot. For example on 1March 2009, Suman wants to buy some gold. The goldsmith quotes
Rs.15000 per 10 grams. They agree upon this price and Suman buys 20grams of gold. He pays
Rs.30000 to the goldsmith and collects his gold. This is a spot transaction.
Now suppose Suman does not want to buy the gold on the 1 March, but wants to
buy it a month later. Then the goldsmith quotes Rs.15050 per 10 grams. They agree upon the
forward price for 20 grams of gold that Suman wants to buy and Suman leaves. A month later, he
pays the goldsmith Rs.30100 and collects his gold. This is a forward contract, a contract by
which two parties permanently 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 immediately. The trading
happens today, but the clearing and settlement happens at the end of the specified period.
derives value from the price of the asset underlying the contract, in this case gold. If on the
1st of April, gold trades for Rs.15100 in the spot market, the contract becomes more valuable to
Suman because it now enables him to buy gold at Rs.15050. If however, the price of gold drops
down to Rs.15000, he is worse off because as per the terms of the contract, he is bound to pay
Rs.15050 for the same gold. The contract has now lost value from Suman’s point of view. “Note
that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its
2. This analysis will be holding good for a limited time period that is
Ranajit Kanjilal as a partnership firm in the year 1987. And in the year 1993 Mr. Ranajit Kanjilal
retired from the firm and Geojit became a proprietary concern of Mr. C.J. George. It became a
Public limited company by the name Geojit Securities Ltd. in the year 1994. The Kerala State
24% stake in the company in the year 1995. Geojit listed at The Stock Exchange, Mumbai (BSE)
in the year 2000. In 2003 the Company was renamed as Geojit Financial Services Ltd. (GFSL).
In July 2005, the company is also listed at The National Stock Exchange (NSE). Geojit is a
charter member of the Financial Planning Standards Board of India and is one of the largest DP
brokers in the country. On March 13, 2007 the formation of Geojit BNP Paribas Financial
Services Ltd., was announced in Mumbai and Paris. Through a preferential allotment, BNP
Paribas had taken 27% stake in Geojit, which will eventually increase to 34.35%. BNP Paribas
has one of the largest international banking networks with significant presence in Asia and the
United States. With presence in more than 85 countries the bank has a headcount of more than
138000. With this take over Geojit has become Geojit BNP Paribas Financial Services LTD in
April 2009. Currently Geojit BNP Paribas has more than 500 branches, 4.7 lakhs clients and
offers services in Equities, Futures and Options, Mutual Funds, Life and General Insurance,
The online trading was first introduced by the Geojit BNP Paribas to their clients
that allows the customers to track the markets by setting up their own market watch, receiving
research tips, stock alerts, real-time charts and news and many more features enable the customer
CHAPTER – 3
nineteenth century when the Cotton Trade Association started futures trading in 1875, barely
about a decade after the commodity derivatives started in Chicago. Over time the derivatives
market developed in several other commodities in India. Following cotton, derivatives trading
started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur
(1913) and in Bullion in Bombay (1920). However, many feared that derivatives lead to
unnecessary speculation in essential commodities, and were harmful to the healthy functioning
of the markets for the underlying commodities, and also to the farmers.
With a view to restricting speculative activity in cotton market, the Government of Bombay
prohibited options business in cotton in 1939. Later in 1943, forward trading was prohibited in
oilseeds and some other commodities including food-grains, spices, vegetable oils, sugar And
cloth. After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952
which Regulated forward contracts in commodities all over India. The Act applies to goods,
which are defined as any movable property other than security, currency and actionable claims.
authority.
In 1970s and 1980s the Government relaxed forward trading rules for some commodities.
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
1. To assess
• The working of the commodity exchanges and their trading practices in India
2. To review the role that forward trading has played in the Indian commodity markets
3. To examine the extent to which forward trading has special role to play in promoting
exports.
reasonable limits.
The committee submitted its report in September 1994. The recommendations of the Committee
were as follows:
➢ The Forward Markets Commission (FMC) and the Forward Contracts (Regulation) Act,
facilities the commodities exchanges were not able to function effectively. Enlisting more
➢ In-built devices in commodity exchanges such as the vigilance committee and the panels
➢ 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
All the exchanges have been set up under overall control of Forward Market
at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs and
Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward
to such goods;
Commodity Exchange of India Limited (MCX), and National Multi-Commodity & Derivatives
Government of India for facilitating online trading, clearing and settlement operations for
commodity futures markets across the country. Key shareholders of MCX are Financial
Technologies (India) Ltd., State Bank of India, NABARD, NSE, HDFC Bank, State Bank of
Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union
Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank. Headquartered
in Mumbai, MCX is led by an expert management team with deep domain knowledge of the
commodity futures markets. Through the integration of dedicated resources, robust technology
and scalable infrastructure, since inception MCX has recorded many first to its credit.
Director, Reliance Industries Ltd, MCX offers futures trading in the following commodity
categories: Agri Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & Oilseeds,
Energy, Plantations, Spices and other soft commodities. MCX has built strategic alliances with
some of the largest players in commodities eco-system, namely, Bombay Bullion Association,
Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association,
Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade
Association.
cross section of the participants including Producers / Processors, Traders, Corporate, Regional
wide reach and penetration and robust infrastructure, is well placed to tap this vast potential.
professionally managed online multi commodity exchange promoted by ICICI Bank Limited
(ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and
Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Punjab
National Bank (PNB), CRISIL Limited (formerly the Credit Rating Information Services of India
Limited), Indian Farmers Fertiliser Cooperative Limited (IFFCO) and Canara Bank by
subscribing to the equity shares have joined the initial promoters as shareholders of the
Exchange. NCDEX is the only commodity exchange in the country promoted by national level
institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently
in short supply in the commodity markets. The institutional promoters of NCDEX are prominent
players in their respective fields and bring with them institutional building experience, trust,
NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act,
1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has
independent Board of Directors and professionals not having any vested interest in commodity
in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies
Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other
legislations, which impinge on its working. NCDEX is located in Mumbai and offers facilities to
its members in more than 390 centres throughout India. The reach will gradually be expanded to
more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor
Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard
Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry
Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil,
Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe),
Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal. At subsequent phases trading
Since 2002 when the first national level commodity derivatives exchange started,
the exchanges have conducted brisk business in commodities futures trading. In the last three
years, there has been a great revival of the commodities futures trading in India, both in terms of
the number of commodities allowed for futures trading as well as the value of trading. While in
year 2000, futures trading were allowed in only 8 commodities, the number jumped to 80
commodities in June 2004. The value of trading in local currency saw a quantum jump from
about INR 350 billion in 2001-02 to INR 1.3 Trillion in 2003-04. The data in the below Table
indicates that the value of commodity derivatives in India could cross the US$ 1 Trillion mark in
2006. The market regulator Forward Markets Commission (FMC) disseminates fortnightly
trading data for each of the 3 national & 21 regional exchanges that have been set up in recent
years to carry on the futures trading in commodities in the country. Exhibit presents comparative
trading data for three fortnightly periods in March, June and September 2005 and brings up some
interesting facts.
fortnightly trading data for each of the 3 national & 21 regional exchanges that have been set up
in recent years to carry on the futures trading in commodities in the country. Below Table
represents comparative trading data for three fortnightly periods in March, June and September
Ahmadabad.
3 National Commodity & $m 5,360.45 $m 7,950.49 $m 10,694.29
Derivatives
History of Gold:
In India Gold is having a history of more than 7000 years which can find in
looking at the history of world, gold is found at the Egypt at 2000B.C, which
is the first metal used by the humans value for ornament and rituals. Gold
has long been considered one of the most precious metals, and its value has
been used as the standard for many currencies in history. Gold has been
used as a symbol for purity, value, royalty, and particularly roles that
reserves because over the long period gold has an extensive history of maintaining its value.
However, gold does become particularly desirable in times of extremely weak confidence and
during hyperinflation because gold maintains its value even as fiat money becomes worthless
for ornamental value on all social functions, festivals and celebrations. It is the popular
form of investment in rural areas between the farmers after having bumper crop or after
harvesting, this all factor makes India as largest consumer (18.7% of world total demand
in 2004) and importer of gold due to its low production, which is negligible, and
untapped gold reserves. This is due to lack of new technology in finding gold reserves
Gold future trading debuted first at Winnipeg Commodity Exchange (know is Comex) in Canada
in 1972. The gold contract gain popularity among traders, led to many countries had too started
gold future trading. Which include London gold future, Sydney future exchange, Singapore
Mercantile Exchange, Chicago Board of Trade (CBOT), Shanghai Gold Exchange, Dubai Gold
and Commodity Exchange are some of the world Top recognized exchange, and in India,
(MCX), and National Board of Trade (NBOT) are some Indian exchanges where Gold are traded.
History of gold trading in India is dates back to 1948 with Bombay Bullion Association, which is
PRODUCTION OF GOLD
Till now the total gold is extracted from the mines is about $1 trillion dollar, which is
Annual gold production worldwide is about US$35 billion and by far the one of
the largest-trading world commodity. Worldwide, gold mines produce about 2,464 tonnes in the
year 2004 from total supply of 3328 tonnes but unable to meet identifiable demand of 3497
tonnes. Gold is mined in more than 118 countries around the world, with the large number of
development projects in these countries expected to keep production growing well into the next
century. Currently, South Africa is the largest gold producing country, followed by the United
States, Australia, Canada, Indonesia, Russia and others, some of these countries also account for
Monetary authorities have long held gold in their reserves. Today their stocks amount to some
30,000 tonnes - similar to their holdings 60 years ago. It is sometimes suggested that maintaining
such holdings is inefficient in comparison to foreign exchange. However, there are good reasons
for countries continuing to hold gold as part of their reserves. These are recognized by central
banks themselves although different central banks would emphasize different factors.
Diversification: In any asset portfolio, it rarely makes sense to have all your eggs in one
basket. Obviously the price of gold can fluctuate - but so too do the exchange and interest rates
of currencies held in reserves. A strategy of reserve diversification will normally provide a less
Gold has good diversification properties in a currency portfolio. These stem from the fact that its
value is determined by supply and demand in the world gold markets, whereas currencies and
government securities depend on government promises and the variations in central banks’
monetary policies. The price of gold therefore behaves in a completely different way from the
Physical Security: Countries have in the past imposed exchange controls or, at the worst,
total asset freezes. Reserves held in the form of foreign securities are vulnerable to such
measures. Where appropriately located, gold is much less vulnerable. Reserves are for using
when you need to. Total and incontrovertible liquidity is therefore essential. Gold provides this.
Unexpected needs: If there is one thing of which we can be certain, it is that today’s status quo
will not last forever. Economic developments both at home and in the rest of the world can upset
countries’ plans, while global shocks can affect the whole international monetary system.
insurance against some improbable but, if it occurs, highly damaging event. Such events might
foreign debts by major sovereign borrowers, a regression to a world of currency or trading blocs
universally acceptable as a means of payment. It can also serve as collateral for borrowing.
Confidence: The public takes confidence from knowing that it’s Government holds gold - an
indestructible asset and one not prone to the inflationary worries overhanging paper money.
Some countries give explicit recognition to its support for the domestic currency. And rating
agencies will take comfort from the presence of gold in a country's reserves.
The IMF's Executive Board, representing the world's governments, has recognized that the
Fund's own holdings of gold give a "fundamental strength" to its balance sheet. The same applies
Income: Gold is sometimes described as a non income-earning asset. This is untrue. There is a
gold lending market and gold can also be traded to generate profits. There may be an
"opportunity cost" of holding gold but, in a world of low interest rates, this is less than is often
thought. The other advantages of gold may well offset any such costs.
Insurance: The opportunity cost of holding gold may be viewed as comparable to an insurance
premium. It is the price deliberately paid to provide protection against a highly improbable but
highly damaging event. Such an event might be war, an unexpected surge of inflation, a
generalized debt crisis involving the repudiation of foreign debts by major sovereign borrowers,
a regression to a world of currency and trading blocs, or the international isolation of a country.
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
Production of Silver
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 world’s
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 world’s 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
macroeconomic indicators.
CHAPTER – 3
The process of arriving a figure at which a person buys and another sells a futures
contract for a specific expiration date is called price discovery. The process of price discovery
continues from the market's opening until its close and also free flow of information is also very
important in an active future market. Futures exchanges act as a focal point for the collection and
currency values, interest rates and other relevant formation. 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 essential to the effective
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.
When we are 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, bonds, Gold and silver are examples of investment assets. However
investment assets do not always have to be held entirely for investment. As we saw earlier silver
for example, have a number of industrial uses. However to classify as investment assets, these
assets 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,
asset from its spot price and other observable market variables. For pricing consumption assets,
we need to review the arbitrage arguments a little differently. We look at the cost – of – carry
model and try to understand the pricing of futures contracts on investment assets.
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. The basis for the cost – of – carry model
F=S+C
……………………………… Eq (1)
Where
Where:
Whenever the futures price moves away from the fair value, there would be
opportunities for arbitrage. If F > S (1+r) t or F < S (1+r) t arbitrage would exit. We know that
what is Spot price and what are future price. We should know that what are the components of
the holding cost? The components of holding cost vary with contracts on different assets.
Sometimes holding cost may even be negative. In case of commodity futures, the holding cost is
the cost of financing plus cost of storage and insurance purchased. In case of equity futures, the
Equation – (2) uses the concept of discrete compounding, i.e. where interest rates
are compounded at discrete intervals like annually or semiannually. Pricing of options and other
complex derivative securities requires the use of continuously compounded interest rates. Most
books on derivatives use continuous compounding for pricing futures too. When we use
Where:
e = 2.71828
Let us take an example of a future contract on commodity and we work out the
price of the contract. Let the spot price of gold is RS. 13763÷10gms. If the cost of financing is
15% annually, then what should be the future price of 10gms of gold one month later? Let us
assume that we are on 1 Jan 2009. How would we compute the price of gold future contract
expiring on 30 January? Let us first try to work out the components of cost – of – carry model.
e0.15 ×30/365
3. What are the holding costs?
In the example above we saw how a futures contract on gold could be raised
using 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
100kgs of gold instead of 10gms, 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.14281.58
function as delivery centers for contracts that trade on the NCDEX. Warehouse charges include a
fixed charge per deposit of commodity into the warehouse, and as per unit per week charge. Per
unit charges include storage costs and insurance charges. We saw that in the absence of storage
costs, the futures price of a commodity that is an investment asset is given by F = S erT Storage
Costs add to the cost of carry. If U is the present value of all the storage costs that will be
incurred during the life of a futures contract, it follows that the futures price will be equal to
F = (S+U) erT
………………………………Eq (4)
Where:
For understanding the above formula let us consider a one – year future contract of
gold. Suppose the fixed charge is Rs.310 per deposit up to 500kgs 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.13763 per 10 grams and the risk – free rate is 7% per annum. What would the price of one
F = (S+U) erT
= (1376300 + 310 + 2860) e0.07 × 1
= 1379470 × e0.07 × 1
= 1379470 × 1.072508
= 1479493
We see that the one year futures price of a kg of gold would be Rs.1479493. The one year futures
Now let us consider a three – month futures contract on gold. We make the same
assumptions that the fixed charge is Rs.310 per deposit up to 500kgs, 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 13763per 10 grams and the risk free rate is 7% per annum. What would the price of
F = (S+U) erT
= (1376300 + 310 + 715) e0.07 × 0.25
= 1377325 × 1.017654
= 1401640.30
We see that the three – month futures price of a kg of gold would be Rs. 1401640.30. The three –
month futures price for 10 grams of gold would be about Rs. 14016.40
Pricing futures contracts on consumption commodities
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
To take advantage of this opportunity, an arbitrager can implement the following strategy:
If we regard the futures contract as a forward contract, this strategy leads to a profit of
F - (S+U) erT at the expiration of the futures contract. As arbitragers exploit this opportunity, the
spot price will increase and the futures price will decrease until Equation (5) does not hold good.
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, they will find it profitable to
interest rate.
This would result in a profit at maturity of (S+U) erT – F relative to the position that the investors
would have been in had they held the underlying commodity. As arbitragers exploit this
opportunity, the spot price will decrease and the futures price will increase until equation 6 does
not hold well. This means that for investment assets, equation 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 holds good. In short, for a
F ≤ (S+U) erT
………………………………………. Eq (7)
That is the futures price is less than or equal to the spot price plus the cost of carry.
CHAPTER – 4
CLEARING, SETTLEMENT AND RISK
MANAGEMENT
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
trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by
NCDEX.
1. Clearing
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
difference) of contracts.
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 not maintenance margin),
Every day 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
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 authorize 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 as clearing banks. ICICI Bank Limited,
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
2. Settlement
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
• 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
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
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 accurate
period (date and time) during which the delivery can be made.
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, 2009 at 14402 can close his
position by selling two gold futures contracts on February 27, 2004 at Rs.15445. In this case,
over the period of holding the position, he has gained an amount of Rs.1043 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. 15445 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.
Risk management
NCDEX has developed a comprehensive risk containment mechanism for its commodity
✔ NCDEX charges an open initial margin for all the open positions of a
margining through SPAN. The PCMs and TCMs in turn collect the
PCM.
✔ A separate settlement guarantee fund for this segment has been created
CHAPTER – 5
Gold produced from different sources and demanded for consumption in form of
Jewellery, Industrial applications, Government & Central bank Investment and Private investor,
which has been worth US$ 38 billion on average over the past five years in world.
Total of world gold produced is mostly consumed by different sectors are Jewelers
80%, Industrial application 11.5% and rest of gold is used as investment purpose 8.5%.
Considering the situation in India, the demand for Gold consumption is far more ahead than its
availability through production, scrap or recycled gold. Where gold production in India is only
2tonnes, where demand is 18.7% of world gold consumption, which make India a leading
consumer of gold followed by Italy, Turkey, USA, China, Japan. According to Countries wise
demand, the following graph shows the demand in each country. Large part constitute by Jewelry
consumption with 85.56% during 2004 by Indian consumers, who seem to spend a
Gold fabrication for domestic and international market, also formed large part of
business in India with 527 tonnes of gold fabricated in India in 2004, making world largest
fabricator which is 60% more than its closest competitor Italy, Turkey, USA. But this Jeweler
Fabrication is unable to generate much revenue, as most of its consumed in India (479 tonnes).
18.70%
In dia
Italy
42.20% 11.10% Turkey
US
China
Japan
Rest of world
8.50%
5.30% 7.30%
Consumption of Gold
6.90%
GOLD CONSUMPTION IN INDIA
India consumed around 18% of world Gold produced. Even though it only contribute 1.6% of
Global GDP.
“Traditionally, Gold has been a good safety net for Indian households. However, the
sharp rise in gold imports over the last three years when the rupee has started appreciating,
inflation is relatively low, banking facilities are improving And economic can confidence has
picked up, is surprising” say Market watchers.(Source: -Economic Times, Article, “ Forget
The demand is much that it consumed more than 1.5 times of US consumption of
gold. Increasing by nearly 60% in 2003-04, but during this fiscal Gold imports increased by
another 58%, with Import of gold and silver account around $11 billion consumption increased
Uses of Gold
new years, demand from the jewelry industry alone has exceeded Western mine production. This
shortfall has been bridged by supplies from reclaimed jewelry and other industrial scrap, as well
as the release of official sector reserves. Gold's workability, unique beauty, and universal appeal
make this rare precious metal the favorite of jewelers all over the world.
India is the world's foremost gold jewellery fabricator and consumer with fabricator
and consumption annually of over 600 tons according to GFMS. Measures of consumption and
fabrication are made more difficult because Indian jewellery often involves the re-making by
goldsmiths of old family ornaments into lighter or fashionable designs and the amount of gold
thus recycled is impossible to gauge. Estimates for this recycled jewellery vary between 80 tons
and 300 tons a year. GFMS estimates are that official gold bullion imports in 2001 were 654
tons. Exports have increased dramatically since 1996, and in 2001 stood at over 60 tons. The US
accounted for about one third of total official exports. Manufacturers located in Special Export
Zones can import gold tax-free through various registered banks under an Export Replenishment
scheme.
industry needs gold for the manufacture of computers, telephones, televisions, and other
equipment. Gold's unique properties provide superior electrical conducting qualities and
circuitry. In dentistry, gold alloys are popular because they are highly resistant to corrosion
and tarnish. For this reason gold alloys are used for crowns, bridges, gold inlays, and partial
debenture.
3. Governments and central banks: The third source of gold demand is governments
and central banks that buy gold to increase their official reserves. Central banks holds 28,225.4
tons, the holdings of Reserve Bank of India are only a modest 397.5 tons.
4. Private investors: Finally, there are private investors. Depending upon market
circumstances, the investment component of demand can vary substantially from year to year.
TECHNICAL ANALYSIS
Prices of the commodities in the commodity market fluctuate daily because of the continuous
buying and selling of the commodities. Prices of the commodity prices move in trends and
cycles and are never stable. An investor in the commodity market is interested in buying
commodities at a low price and sells them at a high price, so that he can get good return on his
investment. He therefore tries to analyze the movement of the share prices in market. There are
two approaches that we use for analyze the price of the commodities. One of these is the
fundamental analysis wherein the analyst tries to determine the true worth or intrinsic value of
the commodity when its market price is below its intrinsic value. The second approach to analyze
the commodity is technical analysis. It is an alternative approach to study the commodity price
behavior.
Dow Theory
Whatever is generally being accepted today as technical analysis has its roots in
the Dow theory. The theory is so called because it was formulated by Charles H. Dow who was
the editor of the wall street journal in U.S.A. Charles Dow formulated a hypothesis that the
commodity market does not move on a random basis but is influenced by three distinct cyclical
trends that guides its direction. According t this theory, the market has three movements and
these movements are simultaneous in nature. These movements are primary movements,
The primary movements are a long range cycle that carries the entire market up or
down. This is the long – term trend in the market. The secondary reactions act as a restraining
force on the primary movement. These are in the opposite direction to the primary movement
and last only for a short while. These are also known as correction. For example, when the
downward movements of short durations. These are called secondary reactions. The third
movement in the market is the minor movements which are the day – to – day fluctuations in the
market. The three movements of the market have been compared to the tides, the waves and the
According to Dow theory, the prices of the commodities can be identified by the
means of a line chart. In this chart, the closing prices of the commodities may be plotted against
the corresponding trading days. The below diagram shows a line chart of closing prices of the
commodity in the market, The primary trend is said to have three phases in it, each of which be
interrupted by a counter move or secondary reaction which would retrace about 33 – 66 % of the
Bullish Trend
During a bull market (upward moving market), in the first phase the prices
would advance with the revival of confidence in the future of business. The future prospects of
business in general would be perceived to be promising. This would prompt the investors to buy
the commodities. During the second phase, prices would advance due to inflation and
speculation. Thus during the bull market the line chart would exhibit the formation of three
peaks. Each peak would be followed by a bottom formed by the secondary reaction. According
to Dow theory, the formation of higher bottoms and higher tops indicates a bullish trend.
Bearish Trend
The bear market is also characterized by three phases. In the first phase the
prices begin to fall due to abandonment of hopes. Investors begin to sell their commodities. In
the second phase, the prices fall due to increased selling pressure. In the final phase, prices fall
hypotheses of the theory. The first hypothesis states that the primary trend cannot be
institutions can exert influence on major trend of the market. The second hypothesis states that
averages discount everything. The third hypothesis states that the theory is not perfect. The
theory is concerned with the trend of market and has no forecasting value as regards the duration
or the likely price targets for the peak or bottom of the bull and bear markets.
1. The market value of the commodity is related to demand and supply factors operating
in the market.
2. There are both rational and irrational factors which surrounded the supply and demand
factors of a security.
4. Trends in a commodity prices have been seen to change when there is a shift in the
5. The shift in demand and supply can be detected through charts prepared specifically to
Line Chart
It is the simplest price chart. In this chart the closing prices of the share are plotted
on the XY graph on a day to day basis. The closing price of each day would be represented by a
point on the XY graph. All these points would be concerned by straight line which would
Bar Chart
It is perhaps the most popular chart used by technical analysts. In this chart the highest price and
the lowest price and the closing price of each day are plotted on a day – to – day basis. A bar is
formed by joining the highest price and the lowest price of a particular day by a vertical line. The
top of the bar represents the highest price and the bottom of the bar represents the lower price
and the small horizontal hash on the right of the bar is used to represents the closing price of the
day. Sometimes the opening price of the day is marked as a hash on left side of the bar. This can
Bar Chart
Bar Chart
The Japanese candlestick chart shows the highest price, the lowest price, the
opening price and the closing price of the commodities on day – to – day basis. The highest price
and the lowest price of a day are joining by a vertical bar. There are mainly three types of
candlesticks, like the white, the black and the doji or neutral candlestick. A white candlestick is
used to represents a situation where the closing price of the day is higher than the opening price.
A Black candlestick is used to represents a situation where the closing price of the day is lower
than the opening price. A White candlestick indicates a bullish trend while a black candlestick
indicates a bearish trend. A doji candlestick is the one where the opening price and the closing
price of the day are the same. This can be expressed below by taking prices of silver, Gold &
Japanese candlesticks
CHART PATTERNS:
When the price bar charts of several days are drawn close together, certain
patterns emerge. These patterns are used by technical analysts to identify trend reversal and
predict the future movement of prices. The chart patterns may be classified as support and
Support and resistance are the price levels at which the downtrend or
uptrend in price movements is reversed. Support occurs when price is falling but bounces back or
reverses direction every time it reaches a particular level. When all these low points are
connected by a horizontal line, it forms the support line. In other words, support level is the price
level at which sufficient buying pressure is exerted to stop the fall in prices.
Resistance occurs when the commodity price moves upwards. The price may fall
back every time it reaches a particular level. A horizontal line joining these tops forms the
resistance level. Thus, resistance level is the price level where sufficient selling pressure is
If the scrip were to break the support level and move downwards it has bearish
implications signaling the possibility of a future fall in prices. Similarly, if the scrip were to
penetrate the resistance level it would be indicative of a bullish trend or a future rise in prices.
2. Reversal patterns:
The trends reverse direction after a period of time. These reversal can be
identified with the help of certain chart formations that typically occur during these trend
revaesals. Thus reversal patterns are chart formations that trend to signal a change in direction of
Head and shoulder Formation: The most popular reversal pattern is Head and Shoulder
formation which usually occurs at the end of a long uptrend. This formation resembles the head
and two shoulders of a man and hence the name head and shoulder formation.
The first hump known as the left shoulder is formed when the prices reach the top
under a strong buying impulse. Then trading volume becomes less and there is a short downward
swing. This is followed by another high volume advance which takes the price to a higher top
known as the head. This is followed by another reaction on less volume which takes the price
down to a bottom near to the earlier downswing. A third rally now occurs taking the price to a
height the head but comparable to the left shoulder. This rally results in the formation of the right
shoulder. A horizontal line joining the bottoms of this formation is known as the neckline. This
head and shoulder formation usually occurs at the end of the bull phase and is indicative of a
reversal of trend. After breaking the neckline the price is expected to decline sharply.
Commodity prices do not rise or fall in a straight line. The movements are
unpredictable. This makes the investors difficult for the analyst to measure the underlying trend.
We can use the mathematical tool of moving averages to smoothen the unpredictable movements
price movement. There are two types of moving averages (MA) are commonly used by
the analyst.
The closing prices of the shares are generally used for the calculation of moving averages.
Commodity for a specified number of days divided by the number of days, in a simple moving
average, a set of averages are calculated for a specified number of days, each average being
In the below table the first total of 67022 in column 3 is obtained by adding the prices
of the first five days, i.e. (13611+13124+13124+13433+13730). The next Total of 67448 in
column 3 is obtained by adding 6th day and deleting first day price from the first total i.e.
Following formula: EMA = (Current closing price – Previous EMA) × Factor + Previous EMA
Where Factor = 2/n+1 and n = number of days for which the average is to be calculated.
The EMA for the first day is taken as the closing price of that day itself. The EMA for the second
day is calculated as
If we are calculating the five day exponential moving average, the correct five day EMA will be
available from the sixth day onwards. A moving average represents the underlying trend in
commodity price movement. The period of the average indicates the type of trend being
identified. For example, Five day or Ten day average would represent the short – term trend; a 50
day average would indicate the medium term trend and a 200 day average indicates the long term
trend.
The moving averages are plotted on the price charts. The curved line joining these moving
averages represent the trend line. When the price of the commodity intersects and moves below
or above this trendline, it may be taken as the first sign of trend reversal. Sometimes, two moving
averages – one short-term and the other long term are used in combination. In this case, trend
Oscillators:
Oscillators are the mathematical indicators calculated with the help of the closing
price data. They help to identify overbought and oversold conditions and also the possibility of
trend reversals. These indicators are called oscillators because they move across a reference
point.
Rate of change Indicators (ROC): It is a very popular oscillator which measures the rate of
change of current price as compared to the price a certain number of days or weeks back. To
calculate a 7 day rate of change, each day’s price is divided by the price which prevailed 7 days
where the X – axis represents the time and the Y – axis represents the values of the ROC. The
ROC values oscillate across the zero line. When the ROC line is above the zero line, the price is
rising and when it below the zero line, the price is falling.
Ideally, one should buy a commodity that is oversold and sell a commodity that is
overbought. In the ROC chart, the overbought zone is above the zero line and the oversold zone
is below the zero line. Many analysts use the zero line for identifying buying and selling
opportunities. Upside crossing (from below to above the zero line) indicates a buying
opportunity, while a downside crossing (from above to below the zero line) indicates a selling
opportunity.
The ROC has to be used along with the price chart. The buying and selling signals
MARKET INDICATORS:
Technical analysis focuses its attention not only on individual commodity price behaviour, but
also on the general trend of market, Indicators used by technical analysts to study the trend of the
intrinsic value of a commodity by evaluating the fundamental factors affecting the economy,
industry and company. This is a tedios process and takes a rather long time to complete the
process.
Thecnical analysis studies the price and volume movements in the market and by careful
examining the pattern of these movements, the future price of the commodity is predicted. Since
the whole process involves much less timeand data analysis, compared to fundamental analysis,
technical analysis helps in identifying the best timing of an investment, i.e. the best time to buy
technical analysis may be used as a supplement to fundamental analysis rather thanas a substitute
to it. The two approaches, however, differ in terms of their databases and tools of analysis.
Fudamental analysis and technical analysis are two alternative approaches to predicting stock
offen difficult to identify the patterns underlying commodity price movements. Moreover, it is
not easy to interpret the meaning of patterns and their likely impact on future price movements.
REFERENCES
Books:
- S.kevin
E – Books:
• Nair C.K.G. (2004): Commodity Futures Markets in India: Ready for Take
Off”? www.nseindia.com
Websites:
• www.geojit.com
• www.bseindia.com
• www.mcx.com
• www.kitco.com
• www.ncdex.com