COMMODITY MARKET

Unit-1: Introduction to Derivatives

Introduction:
It is needless to say that, most of the human beings on the earth would not like to bear risk or
uncertainty. The humans behave rationally in many situations. For example, the rational
investors in the stock market would like to bear less risk with a minimum (normal) return. These
rational investors want their principal amount should be safe with normal return.

The risk or uncertainty may expect in the future date. One should offset the loss arise out of
the uncertainty. Hence, the need to offset this uncertainty gave rise to the evolution of
contracts. Earlier contracts were verbal agreements and were not as sophisticated as the ones
today. However, they were contracts nonetheless. Derivatives are the financial instruments
(financial contracts) which play an important role in offsetting the uncertainty or loss.

RISK: Risk is a condition in which there is a possibility of an adverse deviation from a desired
outcome that is expected or hoped for.

Uncertainty: uncertainty refers to a state of mind characterized by doubt, based on a lack of

knowledge about what will or will not happen in the future. The existence of risk creates
uncertainty on the part of individuals when that risk is recognized.

Meaning of Derivatives: A derivative is a financial instrument whose value is derived from the
value of another assets, which is known as underlying. When the price of the underlying
changes, the value of the derivative also changes. A derivative is not a product. It is a contract
between two parties that derives its value from changes in the price of the underlying asset.

For example, the value of a gold futures contract is derived from the value of the underlying
asset i.e. Gold. The underlying assets can be commodities, precious metals, currency, bonds,
stocks, stocks indices, etc.

A derivative is an instrument whose value is derived from the value of one or more underlying,
which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four
most common examples of derivative instruments are Forwards, Futures, Options and Swaps.

A derivative is a financial security with a value that is reliant upon, or derived from,
an underlying asset or group of assets. The derivative itself is a contract between two or more
parties, and its price is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and market
indexes.
Derivatives can either be traded over-the-counter (OTC) or on an exchange. OTC derivatives
constitute the greater proportion of derivatives and are not standardized. Meanwhile, derivatives
traded on exchanges are standardized and more heavily regulated. OTC derivatives generally
have greater counterparty risk than standardized derivatives.

History of Derivatives:
Derivatives may have found their way into the media in very recent times. However, they have
been used by mankind for a very long time. Since the inception of time, humans have not liked
the idea of uncertainty or risk.

Ancient Examples

Derivatives are said to have existed even in cultures as ancient as Mesopotamia. It was said that
the king had passed a decree that if there was insufficient rain and therefore insufficient crop, the
lenders would have to forego their debts to the farmers. They would simply have to write it off.
Thus, the farmers had just been given a put option by the king. If certain events unfolded in a
certain way they had the right to simply walk out of their liabilities!

There have been many such examples that have been quoted during the time. Another famous
example pertains to Greek civilization when one of Aristotle’s followers who was adept (expert)
at studying meteorology predicted that there would be a bumper (abundant) crop of olives that
year. He was so sure that he went ahead and purchased the produce of all the Olive farms in and
around Athens before the crop had been harvested. In the end it did turn out to be a bumper crop
and Aristotle’s disciple made a huge profit from his way ahead of time forwards contract.

19th Century: Chicago Board Of Trade

During the nineteenth century, America was at its pinnacle of economic progress. America was
the center of innovation. One such innovation came in the field of exchange traded derivatives
when farmers realized that finding buyers for the commodities had become a problem. They
created a joint market called the “Chicago Board of Trade”. A few years later, this market
evolved into the first ever derivatives market. Instead of buyers and sellers negotiating their own
customized contracts, there were now standard contracts listed on the exchange which could be
bought and sold by anyone. This idea proved to be a big hit. Soon Chicago Board of Trade had to
create a spinoff called Chicago Mercantile Exchange to handle the growing business.

Recently Chicago Board of Trade and Chicago Mercantile Exchange have been merged to form
the CME group. It is still one of the foremost derivatives markets in the world. The massive
success witnessed by the members of the Chicago Board of Trade led to the creation of many
such exchanges across the globe. However, during the era of Chicago Board of Trade,
derivatives trading was limited to commodities only. Other financial instruments were largely
outside the realm of such trading.
Modern Day
Innovations in the modern financial market have largely been based on the idea of derivatives.
What started as a simple idea in ancient times was later developed into standard contracts during
the Chicago Board of Trade era has now become a maze of complex financial instruments and
contracts. The asset classes on which the derivative instruments were based have undergone a
rapid expansion. Nowadays, there is a derivative for pretty much everything.

We have derivatives for stocks, indices, commodities, real estate etc. We even have derivatives
that are based on other derivatives creating a Meta structure of sorts. The reason behind this
rapid expansion is that derivatives meet the needs of a large number of individuals and
businesses worldwide.

After the collapse of 2008, derivatives had to take the fall for the entire chain of events. They
were vilified by the media in general. That has come as somewhat of a setback. Barring that the
rise of derivatives in the recent years has been nothing short of extraordinary and this is expected
to continue in the future.

PRODUCTS OF DERIVATIVES/Derivatives Contracts:

The products of derivatives are broadly classified into Forwards, Futures, Options, Swaps,

Forward contracts (Foreign Exchange (FOREX) or Currency Forward

Markets): A relatively simple derivative is a forward contract. It is an agreement to buy or sell
an asset at a certain future time for a certain price. It can be contrasted with a spot contract,
which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-
counter (OTC) market-usually between two financial institutions or between a financial
institution and one of its clients.

Meaning of forwards contract: It is a contractual agreement between two parties to buy or sell
an underlying asset at a certain future date for a particular price that is predetermined on the date
of contract. This contract will be having a customized terms and conditions from varies from
locations to locations and person to person.

For example, a farmer entered into an agreement with the wholesaler to sell 10 tons of wheat
after three months for Rs. 3,00,000.

A forward contract is a customized, non-standardized contract between two parties to buy or sell
an asset at a specified price on a future date. A forward contract can be used for hedging or
speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike
standard futures contracts, a forward contract can be customized to any commodity, amount
and delivery date. A forward contract settlement can occur on a cash or delivery basis. Forward
contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter
(OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a
centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward
contracts are not as easily available to the retail investor as futures contracts.

One of the parties to a forward 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. The
terms and conditions may vary from person to person and location to location. This contract is
not regulated by any government authority.

Forward contracts on foreign exchange are very popular. Most large banks employ both spot
and forward foreign-exchange traders. Spot traders are trading a foreign currency for almost
immediate delivery. Forward traders trading for delivery at a future time. The following table
shows spot and forward quotes for the USD/GBP exchange rate, July 20, 2007 (quote is number
of USD per GBP)

Bid/buy Offer/sell
Spot 2.0558 2.0562
1-month forward 2.0547 2.0552
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
The spot indicates that, the bank is prepared to buy GBP (pound sterling) for 2.0558 dollars and
sell GBP for 2.0562 dollars (virtually immediate delivery). The 2,3, and 4th row indicate that, the
bank is prepared to buy and sell 1 month, 3 months and 6 months forward contract of USD/GBP.

Forward contracts can be used to hedge foreign currency risk. Suppose that, on July, 2007, the
treasurer of a US corporation knows that the corporation will pay 1 million GBP in 6 months (i.e.
on January, 20, 2008) and wants to hedge against exchange rate moves. Using the quotes in the
above table, the treasurer can agree to buy 1 million GBP 6 months forward at an exchange rate
of USD 2.0489/GBP. The corporation then has a long forward contract on GBP. It has agreed
that on January 20, 2008, it will buy 1 million GBP from the bank for USD 2.0489/GBP. The
bank has a short forward contract on GBP. It has agreed that on January 20, 2008, it will sell 1
million GBP for USD 2.0489/GBP. Both sides have made a binding commitment.

Payoffs from Forward Contracts:

By considering the corporation’s position’s position in the above example, the forward contract
obligates the corporation to buy 1 million GBP for $ 2, 048,900 after six months. If the spot
exchange rate rose to, say, 2.1000, at the end of the 6 months, the forward contract would be
worth $51,100 (=$21, 00,000-$2,048,900) to the corporation. It would enable 1 million pounds
to be purchased at an exchange rate of $2.0489 rather than $2.1000. Similarly, if the spot
exchange rate fell to $1.9000 at the end of the 6 months, the forward contract would have a
negative value to the corporation of $1, 48,900 because it would lead to the corporation paying
$1, 48,900 more than the market price for the sterling.

Usually, the payoff is the difference between the spot price of an underlying asset at the end of
the maturity period and the strike price (agreed price at the beginning of the contract also called
as delivery price). The payoff from long position in a forward contract on one unit of an asset is
ST – K, where K is the delivery price and ST is the spot price of the asset at the maturity of the
contract. This is because the holder of the contract is obligated to buy an asset worth ST for K.
Similarly, the payoff from a short position in a forward contract on one unit of an asset is K - ST
These payoffs can be positive or negative. It costs nothing into to enter into a forward contract;
the payoff from the contract is also the trader’s total gain or loss from the contract. For instance,
in the above example, if K = $2.0489 and the corporation has a long contract. When ST = $2.100,
the payoff is $0.511/GBP; when ST = $1.900, it is -$0.1489/GBP.

Consider a stock that pays no dividend and is worth Rs. 60. You can borrow or lend for 1 year at
5%. What should be the 1-year forward price of the stock be?

The answer is Rs. Grossed up at 5% for 1 year, or Rs. 63. If the forward price is more than this,
say Rs. 67, you could borrow Rs. 60, buy one share of the stock, and sell it forward for Rs. 67.
After paying off the loan, you would net a profit of Rs. 4 in 1 year. If the forward price is less
than Rs. 63, say Rs. 58, an investor owning the stock as part of a portfolio would sell the stock
for Rs. 60 and enter into a forward contract to buy it back for Rs. 58 in 1 year. The proceeds of
investment would be invested at 5% to earn Rs. 3. The investor would end up Rs. Better off than
if the stock were kept in the portfolio for the year.

Understanding a Forwards Contract

At its core, a forward contract is a financial instrument used for hedging purposes as part of a
risk management strategy. Forward contracts are an agreement between buyer and seller. The
seller agrees to provide a commodity at a specific price at a future date to the buyer. Farmers
usually enter into forward contracts, but investors may enter into foreign contracts on other
commodities such as oil and currencies, as in forward exchange contracts.

Characterizations

Essentially, a forward contract is an agreement to pay for a delivery of a commodity. Typically, a

forward contract also spells out the delivery method and acceptable minimum quality of the
commodity. The settlement date refers to the day when the contract must be paid. Unlike futures
contracts that involve a broker, a forward contract is an agreement between buyer and seller.

Risk Management
The principal reason to enter into a forward contract is to minimize risk, or to reduce the
probability of an adverse fluctuation in price of a commodity. By guaranteeing a price, the seller
of a forward contract establishes his price. Farmers and other commodities producers gauge
today's prices for the commodity against the "spot price," or the price at which the commodity
may sell at the delivery date in the future. A buyer of a forward contract may expect the price of
the commodity to increase by the delivery date and thus wants to lock in a lower price.

Advantages of Forwards Contract:

Forward contract is a customized agreement between two parties to buy or sell an underlying
asset at future date and for a pre-decided price. It has many advantages as mentioned below:

1. Matching against the time period and size of the cash: Forwards contracts can be
matched against the time period of exposure as well as for the cash size of the exposure.

2. Tailor made contract: Forwards contracts are customized. It can be written for any
amount or terms and conditions. It is the parties to the contract who decide and agreed the
terms. No government body is controlling this type of derivative contracts.

3. It offers complete hedge: It will give protection against the price movements in the
market in future. It provides complete protection against the adverse price movement in
an asset. The parties to the forwards contract can fully hedge or protect their assets from
unexpected changes in the market prices of the underlying asset.

4. Forwards are over-the-counter products: Forwards contracts are over-the-counter

(OTC) products. The phrase “over-the-counter” can be used to refer to stocks that trade
via a dealer network as opposed to on a centralized exchange. It also refers to debt
securities and other financial instruments, such as derivatives, which are traded through a
dealer network. Exchange is a centralized, regulated market where securities are traded in
a safe, standardized, fast and publicly transparent manner. OTC is a decentralized dealer
network and prices are not disclosed publicly until after the trade is complete. Stocks
which trade on exchange (Like BSE stock exchange in India) are called as listed stock.
Stocks which are not traded on exchange are called as unlisted stock or OTC stock.
Generally, small company’s securities and debt securities are traded in OTC. There is no
exchange fee in OTC.

5. The use of forwards provide price protect: The forward contract provide price
protection to buyer/seller. It protects the parties from the adverse movement in the market
price of an underlying asset.
 6. They are easy to understand: Forward contracts are easy to understand. It is not
centralized and has no regulation. These can be traded over the counter.

Disadvantages or Limitations of Forwards Contracts:

In spite many advantages, the forwards contracts has its own disadvantages. The following are
the limitations of forwards contracts:

i. Liquidity risk: These forwards cannot immediately liquidate. This requires tying up
capita. There are no immediate cash flows before settlement. The seller in the forwards
contracts cannot liquidate the underlying asset until the maturity date. The parties to the
contract cannot reverse the agreement. They have wait until the agreed period.

ii. Counterparty risk or default risk: Default risk is the risk in which either of the parties
failed to perform the promise. This counterparty or default risk may happen either on
seller side or buyer side. The seller may not be deliver the underlying asset to the buyer
or the buyer may make default in payment to the seller after the receiving the underlying
asset.

iii. No regulation: These forward contracts are not come under the centralized trading
system and there is no any government body which controls the forwards contracts. Lack
of regulating authority leads to many conflicts.

iv. No settlement guarantee: Settlement guarantee features presented in stock exchange.

Since no government body is controlling and it comes under decentralized dealers, no
settlement guarantee is provided. Settlement guarantee is not applicable to the forwards
contracts.

v. Contracts may be difficult to cancel: The forwards contracts are sometimes difficult to
cancel. These contracts can be cancelled by mutual consent of the parties.

vi. There may be difficult to find counter-party: Finding counter party to the forwards
contract is difficult. Since forwards market is an unorganized and uncontrolled market
where parties to the contract don’t know each other.

FUTURES CONTRACTS: Like a forwards contract, a futures is an agreement between two

parties to buy or sell an asset a t certain time in the future for a certain price. Unlike forwards
contracts, futures contracts are normally traded on an exchange. To make trading possible, the
exchange specifies certain standardized features of the contract. As the two parties to the contract
do not necessarily know each other, the exchange also provides a mechanism that gives the two
parties a guarantee that the contract will be honored. The clearing house or the clearing
corporation of the stock exchange, which is an agency designated to settle trades of investors on
the stock exchanges.

A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures
contracts also mandate the sale of commodity at a future data but at a price which is decided in
the present.

However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. Also, since these contracts are traded on the exchange they have to
follow a daily settlement procedure meaning that any gains or losses realized on this contract on
a given day have to be settled on that very day. This is done to negate the counterparty credit
risk.

An important point that needs to be mentioned is that in case of a futures contract, they buyer
and seller do not enter into an agreement with one another. Rather both of them enter into an
agreement with the exchange.

The largest exchanges on which futures contracts are traded are the Chicago Board of Trade
(CBOT) and the Chicago Mercantile Exchange (CME). On these and other exchanges
throughout the world, a very wide range of commodities and financial assets form the underlying
assets in the various contracts. The commodities include live cattle, sugar, wool, copper,
aluminum, gold and tin. The financial assets include stock indices, currencies and Treasury
bonds.

Futures contracts, while similar to forwards contracts, have certain features that make them more
useful for risk management. These include being able to extinguish contract obligations through
offsetting, rather than actual delivery of the commodity.

Characteristics of Futures/Futures Terminology

1. Two parties: There are two parties in futures contract. One party takes long position to
buy the asset/securities and another takes short position to sell the underlying asset. The
parties to the contract do not know each other.
2. Exchange traded: Futures are traded on organized exchanges (Secondary market) with
clearing association that act as intermediary between the contracting parties.
3. Spot price: The price at which an asset trades in the spot market.
4. Strike price: The agreed price a futures contract to buy or sell an underlying asset.
 5. Contract cycle: The period over which a contract trades. The index futures contracts on
NSE have 1 month, 2 months and 3 months expiry cycles which expire on the last
Thursday of the month. Thus, a January expiration contract expires on the last Thursday
of January and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following last Thursday, a new contract having 3 month expiry is
introduced for trading.
6. 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.
7. Contract size: Contract size is the deliverable quantity of commodities or financial
instruments underlying futures contracts that are traded on an exchange. The contract size
is standardized for such futures contracts so that buyers and sellers know the exact
quantity and specification of what they are buying and selling. Contract size varies
depending on the commodity or instrument that is traded. The contract size also
determines the dollar value of a unit move in the underlying commodity or instrument.
Thus, the contract size specifies the amount of the asset that has to be delivered under one
contract. For example, the contract size on NSE’s futures market is 50 Nifties.
8. Basis: The basis reflects the relationship between cash price and futures price. (In futures
trading, the term "cash" refers to the underlying product). The basis is obtained by
subtracting the futures price from the cash price. The basis can be a positive or negative
number. A positive basis is said to be "over" as the cash price is higher than the futures
price. A negative basis is said to be "under" as the cash price is lower than the futures
price.
9. Cost of carry: The relationship between futures prices and spot prices can be
summarized 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 income earned on the asset.
10. Initial margin: The amount that must deposited in the margin account at the time of a
futures contract is first entered into is known as initial margin.
11. Marking to market: 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.
12. 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.

FUTURES PRODUCTS IN INDIA

The main kinds of futures products that are available in India are as follow:
 1. Single stock futures (stock futures)
2. Equity index futures (stock index futures)
3. Interest rate futures
4. Commodity futures
5. Currency futures

Stock futures: Stock futures are derivative contracts that give you the power to buy or sell a set
of stocks at a fixed price by a certain date. Once you buy the contract, you are obligated to
uphold the terms of the agreement.
In finance, a single-stock future (SSF) is a type of futures contract between two parties to
exchange a specified number of stocks in a company for a price agreed today (the futures price
or the strike price) with delivery occurring at a specified future date, the delivery date. The
contracts are traded on a futures exchange. The party agreeing to take delivery of the underlying
stock in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
deliver the stock in the future, the "seller" of the contract, is said to be "short". The terminology
reflects the expectations of the parties - the buyer hopes or expects that the stock price is going to
increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs
nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each
party is taking (long or short)?

SSFs are usually traded in increments/lots/batches of 100. When purchased, no transmission of

share rights or dividends occurs. Being futures contracts they are traded on margin, thus offering
leverage, and they are not subject to the short selling limitations that stocks are subjected to.
They are traded in various financial markets, including those of the United States, United
Kingdom, Spain, India and others. South Africa currently hosts the largest single-stock futures
market in the world, trading on average 700,000 contracts daily. Here are some more
characteristics of futures contracts:

Lot/Contract size: In the derivatives market, contracts cannot be traded for a single share.
Instead, every stock futures contract consists of a fixed lot of the underlying share. The size of
this lot is determined by the exchange on which it is traded on. It differs from stock to stock. For
instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when
you buy one futures contract of RIL, you are actually trading 250 shares of RIL. Similarly, the
lot size for Infosys is 125 shares.*

Expiry: All three maturities are traded simultaneously on the exchange and expire on the last
Thursday of their respective contract months. If the last Thursday of the month is a holiday, they
expire on the previous business day. In this system, as near-month contracts expire, the middle-
month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month)
contracts become middle-month contracts.
Duration: Contract is an agreement for a transaction in the future. How far in the future is
decided by the contract duration. Futures contracts are available in durations of 1 month, 2
months and 3 months. These are called near month, middle month and far month, respectively.
Once the contracts expire, another contract is introduced for each of the three durations
The month in which it expires is called the contract month. New contracts are issued on the day
after expiry.

Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to
do so at the price at which the July futures contracts are currently available in the derivatives
market. Let's say that ABC Ltd July futures are trading at Rs 1,000 per share. This means, you
are agreeing to buy/sell at a fixed price of Rs 1,000 per share on the last Thursday in July.
However, it is not necessary that the price of the stock in the cash market on Thursday has to be
Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on the prevailing market
conditions. This difference in prices can be taken advantage of to make profits.

Index Futures: A stock index is used to measure changes in the prices of a group stocks over a
period of time. It is constructed by selecting stocks of similar companies in terms of an industry
or size. Some indices represent a certain segment or the overall market, thus helping track price
movements. For instance, the BSE Sensex is comprised of 30 liquid and fundamentally strong
companies. Since these stocks are market leaders, any change in the fundamentals of the
economy or industries will be reflected in this index through movements in the prices of these
stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500,
etc, which represent price movements on different exchanges or in different segments.

Futures contracts are also available on these indices. This helps traders make money on the
performance of the index.
Here are some features of index futures:

1. Contract size: Just like stock futures, these contracts are also dealt in lots. But how is
that possible when the index is simply a non-physical number. No, you do not purchase
futures of the stocks belonging to the index. Instead, stock indices points – the value of
the index – are converted into rupees.

For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that
each point is equivalent to Rs 1 , then you have to pay 100 times the index value – Rs
6,50,000 i.e. 1x6500x100. This also means each contract has a lot size of 100.

2. Expiry: Since indices are abstract market concepts, the transaction cannot be settled by
actually buying or selling the underlying asset. Physical settlement is only possible in
case of stock futures. Hence, an open position in index futures can be settled by
conducting an opposing transaction on or before the day of expiry.
 3. Duration: As in the case of stock futures, index futures too have three contract series
open for trading at any point in time – the near-month (1 month), middle-month (2
months) and far-month (3 months) index futures contracts.

Illustration of an index futures contract: If the index stands at 3550 points in the cash
market today and you decide to purchase one Nifty 50 July future, you would have to
purchase it at the price prevailing in the futures market.

This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh
(i.e., 3550*100), depending on the prevailing market conditions. Investors and traders try
to profit from the opportunity arising from this difference in prices

Interest Rate Futures: It is a contract between borrower and lender to borrow a certain money
in future at specified rate of interest. It is one of the important financial futures instruments in the
world. Important. Interest rate futures traded on various exchanges are: notional gilt-contracts,
short-term deposit futures, treasury bill futures, euro-dollar futures, treasury bond futures and
treasury notes futures. Ex. 3-month maturity instruments like treasury bills and euro-dollar time
deposits, including foreign debt instruments at Chicago Mercantile Exchange (CME), British
Govt. Bonds at London International Financial Futures Exchange (LIFFE), Japanese Govt.
Bonds at CBOT etc. are traded. Interest rate futures can be classified into two categories: Short-
term Interest Rate futures (STIRs) and long-term IRF (Bond futures).

In India, IRFs are of fairly recent origin; they commenced trading only in June 2003 and contrary
to international experience, these contracts drew a big blank on the Indian markets. In India, the
only short-term IRF contract being traded is the 91-day Treasury bill.

Commodity Futures: In commodity futures, the underlying asset will be agricultural products
(cotton, jute, coffee, oilseeds, food grains, tea, sugar, wheat, yarn etc.) Energy products (Oils),
Metal products (bullion, silver, iron and steel etc.) and Chemicals & Plastics.

Currency Futures: Futures contract is made in buying and selling of foreign currencies at
agreed exchange rate. It is also known as Exchange Rate Futures. Important Currencies of
Futures trading are: US-dollar, Pound Sterling, Yen, French Francs, Marks, Canadian dollar etc.
Normally futures currency contracts are used for hedging purpose by the exporters, importers,
bankers, financial institutions and large companies.
 Difference between Forwards and Futures

Sl. Basis of Forwards Futures

No. Difference
1 Trading Traded by telephones or telex Traded in a competitive arena
(OTC) (recognized exchange)
2 Size of contracts Decided between buyer and Standardized in each futures
seller market
3 Price of contract Remains fixed till maturity Changes every day.
4 Mark-to-market Not done Marked to market every day.
5 Margin No margin required Margins are to be paid by both
buyer and sellers
6 Counter Party There will be a chance for No counter party risk present in
Risk counter party risk. the futures market.
7 Number of There can be any number of Number of contracts in a year is
contracts in a contracts. fixed.
year
8 Frequency of 90% of all forward contracts are Very few futures contracts are
delivery settled by actual delivery. settled by actual delivery.
9 Hedging These are tailor-made for Hedging is by nearest month and
specific date and quantity. So, it quantity contracts. So, it is not
is perfect. perfect.
10 Liquidity No liquidity Highly liquid
11 Nature of Over the counter (OTC) Exchange traded
market
12 Mode of delivery Specially decided. Most of the Standardized. Most of the
contracts result in delivery. contracts are cash-settled.
13 Transaction Costs are based on bid-ask Include brokerage fees for buy and
costs spread sell orders.

OPTIONS:
Options are derivatives contracts that give the buyer the right to buy or sell an underlying asset at
a certain price within a specified time period. Selling or buying options involves two parties,
namely a buyer and a seller. The strategy of selling options is popular mostly with traders who
are capable of managing the element of risk that is inherent in such transactions.

An option is a type of contract between two parties where one person grants the other person the
right, but not the obligation, to buy a specific asset at a specific price within a specific time
period. Alternatively, the contract may grant the other party the right, but not the obligation, to
sell a specific asset at a specific price within a specific time period. The one who takes a short
position is the option writer and who takes a long position is holder of the option.
Options are traded both on exchanges and in the over-the-counter market. There are two types of
option. A call option gives the holder the right to buy the underlying asset by a certain date for a
certain price. A put option gives the holder the right to sell the underlying asset by a certain date
for certain price. The price in the contract is known as the exercise price or strike price; the
date in the contract is known as the expiration date or maturity date. American options can be
exercised at any time up to the expiration date. European options can be exercised only on the
expiration date itself.

It should be emphasized that an option gives the holder the right to do something. The holder
does not have to exercise this right. This is what distinguishes options from forwards and futures,
where the holder is obligated to buy or sell the underlying asset. whereas it costs nothing to enter
into a forward or futures contract, there is a cost of acquiring an option.

The largest exchange in the world for trading stock options is the Chicago Board Options
Exchange.

Types of Options

1. Call Option: It is a contract which gives the owner the right to buy an asset for a certain
price on or before a specified date.
2. Put Option: It is a contract which gives its owner the right to sell something for a certain
predetermined price on or before a specified date.
3. American Option: An American option can be exercised by its owner at any time on or
before the expiration date.
4. European Option: The owner can exercise his right only on the expiration date and not
before it. Most of the options traded in the world including those in Europe are American
style options.

Option Owner/Holder/Buyer of Writer/Seller of Option

Type Option
(Short Position)
(Long Position)

Call Right to buy an asset Obligation to sell an asset

Put Right to sell an asset Obligation to buy an asset

Features/Characteristics of Options:
1. Physical Delivery vs. Cash Settled Options: Option contracts are settled through either
physical delivery of the underlying asset or cash settlement. In case of cash settlement,
 the traders make/receive payments to settle any losses or gains on exercise or maturity of
the contract. Instead of making physical delivery.

2. Exercise Price or Strike Price: It is the price at which the parties with the long and short
positions buy and sell the underlying asset. It is selected by the exchange. Typically,
exercise prices are just above or below the current market price of the underlying asset.
If the price of the share becomes higher than the highest strike price, the exchange would
introduce a new series of options prices for all expiration months with a strike price just
above the old highest strike price. Similarly, if the price of the share becomes lower than
lowest strike price, a new series of options prices for various expiration months with a
strike price just below the old lowest strike price would be issued by the exchange.

For trading in Indian markets, an exchange provides for a minimum of Five strike prices
for every option type viz. Two contracts with strike prices above, two contracts with
strike prices below and one contract with strike price equal to the current price of the
security.

3. Expiration Date: The date mentioned in an options contract is called expiration date or
maturity date. After the maturity date, an option has worthless. Standardized options have
specified dates mentioned for maturity. Generally, the maximum life of an option on
stock is nine months.

4. Option Premium: One may naturally wonder as to why the seller (writer) of an option
should be always obliged to sell/buy an asset whenever the other party desires. The
writer of an option receives a consideration for the obligation he/she undertakes on
himself/herself. This is known as the price or the premium of the option. Option
contracts are created when a buyer and a seller agree on a price. The buyer pays the
premium to the seller which belongs to the seller whether the option is exercised or not.
If the owner of an option decides not to exercise the option, the option expires worthless,
the amount of premium becomes the profit of the option writer, while if the option is
exercised, the premium gets adjusted against the loss the writer incurs upon such
exercise.

5. Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts, index options contracts are also cash settled.
 6. 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.

7. 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.

8. Writer of an option: The writer of 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.

SWAPS:
An agreement between two parties to exchange one set of cash flows for another. A device or
technique adopted for obtaining the desired form of financing in an indirect way that could
otherwise be inaccessible or costly. It is an extension of the parallel loans or the back-to-back
loans emerged during 1970s. Limitation of Swap is finding a party with matched financing
requirements.

A swap is a private agreement between two parties in which both parties are ‘obligated’ to
exchange some specified cash flows at periodic intervals for a fixed period of time.

Features of Swaps
Counter Parties: All swaps involve the exchange of a series of periodic payments between at
least two parties. Ex. A firm having a loan of ten million dollar payable at 10% fixed coupon
rate for five years, wants to exchange for a floating interest rate with that party who is also
interested to exchange its liability to fixed.

Facilitators: Swap agreements are arranged mostly, (known as swap facilitators), through an
intermediary which is usually a large international financial institution / bank having network of
its operations in major countries. This institution is normally having contracts with major
international business firms who have direct link with other firms.

Types of Facilitators: Brokers – They function as agents and identify and bring the counter
parties on the table for the swap deal. The broker’s basic objective is to initiate the counter
parties to finalise the swap deal according to their respective requirements. Swap dealers-They
themselves become counter-parties and takeover the risk. Since the swap dealers are the part of
the swap deals, therefore, they face two important problems. First, how to price swap to provide
for his service. Second, the swap dealer creates a portfolio, therefore, the second problem is to
manage this portfolio.

Cash flows: In the swap deal, two different payment streams in terms of cash flows are
estimated to be identical.

Documentations: Swap transactions may be set up with great speed since their documentations
and formalities are generally much less in comparable to loan deals. Swap deals are less
complicated, less time consuming and simpler in terms of documentations and other formalities.

Transaction Cost: It has been observed that transaction costs are relatively low in swap
transactions in comparison to loan agreements. They are unlikely to exceed half percent of the
total sum involved in the swap agreement.

Benefit to Parties: Swap agreements benefit both the counter parties It enables to obtain desired
form of financing.

Termination: Swap deal cannot be terminated at one’s instance. Termination requires to be

accepted by counter parties.

Default Risk: Since most of the swap deals are bilateral agreements, the problem of potential
default by either of the counter party exist,

Types of Swaps
1. Interest Rate Swaps
2. Currency Swaps
3. Equity Swaps

Interest rate swaps: When borrower expect a rise in interest rates, they swap floating-rate loan
for a fixed-rate loan. When they expect a fall in the interest rate, they swap fixed-rate loan for
floating-rate loan.

Features of Interest Rate Swaps:

 Exchange of interest payments

 The counter-parties exchange the interest payments and feel as if they are using the loans
according to their own choice.
 Condition : Amount of loan is identical in the two cases and periodic payment of interest
takes place in the same currency.
 Synchronization of interest – one getting cheaper fixed-rate and the other getting cheaper
floating-rate funds.
 Principal amount are not exchanged (it is only notional), only interest payment is
exchanged on periodic payment dates.
  The interest payment is known as legs of swap & fixed rate is called swap coupon.

Suppose firm A needs fixed rate funds which are available to it at the rate of 10.50% to be
computed half yearly, but it has access to cheaper floating rate funds available to it at LIBOR +
0.3%. Firm B needs floating rate funds available to it at 6 month LIBOR flat, but has access to
cheaper fixed rte funds available to it at the rate of 9.5% to be computed half yearly. Both the
principles are identical in size and maturity and are in the same currency. The interest rate swap
takes place as follows

Stage-1 :

Firm A borrows floating rate loan at LIBIOR + 0.3%

Firm B borrows fixed rate loan @ 9.5%

Stage – 2

Since, both the firms have not borrowed according to their needs, they approach swap dealer .

Swap dealer and firm A

Swap dealer asks firm A to pay fixed rate interest to it as if it has borrowed fixed rate loan say
only 9.75%. In exchange, the swap dealer pays firm A the interest at 6-month LIBOR. And firm
A pays LIBOR + 0.3% to the lender on its floating rate borrowing.

Swap dealer and firm B

Swap dealer asks firm B to pay 6-month LIBOR as if it has borrowed floating rate loan.

In exchange, the swap dealer pays firm B fixed rate interest which is higher than what firm B has
to pay to the ultimate lender (i.e. 9.5%). [This is interest rate received from firm A – its
commission (i.e. 9.75% - 0.10% )]
 Chart

(10.5%) Fixed-rate loan market 9.50%

LIBOR + 0.3%
Floating-rate loan market (LIBOR)

Floating-rate loan market (LIBOR)

9.75% 9.65%
Firm - A Swap Dealer Firm - B

LIBOR LIBOR

Firm A’s Cost of Borrowing

Cost of floating-rate loan LIBOR + 0.3%

Less : floating interest rate received -LIBOR

Net cost differential +0.3%

Converting the cost differential from money-market

yield to bond equivalent yield 0.3 x 365/360 = 0.304% 0.304%

Add : Swap coupon 9.75%

Total cost of borrowing 10.054%

Firm B’s Cost of Borrowing

Cost of fixed rate borrowing 9.50%

Less : fixed rate received -9.65%

Net cost differential - 0.15%

Converting the cost differential from Bond-Equivalent Yield (BEY)

to Money-Market Yield (MMY) (-0.15 x 360/365) -0.148%

Total cost of borrowing LIBOR – 0.148%

Gain to Swap Dealer

Interest rate received 9.75%

Less : interest rate paid -9.65%

Net gain (Commission) 0.10%

CURRENCY SWAP

A currency swap is an agreement in which two parties exchange the principal amount of a loan
and the interest in one currency for the principal and interest in another currency.

At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

During the length of the swap each party pays the interest on the swapped principal loan amount.

At the end of the swap the principal amounts are swapped back at either the prevailing spot rate,
or at a pre-agreed rate such as the rate of the original exchange of principals. Using the original
rate would remove transaction risk on the swap.

Currency swaps are used to obtain foreign currency loans at a better interest rate than a company
could obtain by borrowing directly in a foreign market or as a method of hedging transaction risk
on foreign currency loans which it has already taken out.

Both the principal and interest in one currency are swapped for principal and interest in another
currency. It involves exchange of different currencies.

An American company may be able to borrow in the United States at a rate of 6%, but requires a
loan in rand for an investment in South Africa, where the relevant borrowing rate is 9%. At the
same time, a South African company wishes to finance a project in the United States, where its
direct borrowing rate is 11%, compared to a borrowing rate of 8% in South Africa. Each party
can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this case, the
American company can borrow U.S. dollars for 6%, and then it can lend the funds to the South
African company at 6%. The South African company can borrow South African rand at 8%, then
lend the funds to the U.S. company for the same amount.
EQUITY SWAPS

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are
agreed to be exchanged between two counterparties at set dates in the future. The two cash flows
are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating
rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of
the swap is based on the performance of either a share of stock or a stock market index. This leg
is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an
equity leg, although some exist with two equity legs.

Participants in Derivative Market

1. HEDGERS: Hedgers are the traders who wish to eliminate the risk of price change to
which they are already exposed. Hedging is the prime reason which led to emergence of
derivatives. Hedgers are an important constituent of the derivative markets. These are
investors with a present or anticipated exposure to the underlying asset which is subject
to price risks. Hedgers use the derivatives markets primarily for price risk management of
assets and portfolios.

Ex. Traders dealing in exports and imports are subject to fluctuations in the foreign
exchange rates, (forex risk) which can be hedged in derivatives. A steel manufacturer
can hedge price movements of iron ore which is raw material used for manufacturing
steel. A jeweler can hedge price movements of gold and silver which is used in making
jewellery. A farmer hedge against the price movements of the food grains produced

2. SPECULATORS: Hedgers wish to avoid the price risk but speculators wish to take such
risk. The speculator assumes risk my taking position in the market and makes profit from
fluctuations in the prices. These are individuals who take a view on the future direction of
the markets. They take a view whether prices would rise or fall in future and accordingly
buy or sell futures and options to try and make a profit from the future price movements
of the underlying asset. The speculators use market information, make forecasts about the
prices and put their money in market. By taking positions, they are betting that a price
would go up or they are betting that it would go down. Speculators may be day traders
or position traders.
a. Day Traders: The day traders speculate on the price movements during one trading
day, both the open and close positions are executed the same day and the position
cannot be carried to the next day.
b. Position Traders: Position traders also attempt to gain from price fluctuations but
they keep their positions for longer durations may be for a few days, weeks or even
months.
 3. ARBITRAGEURS: An arbitrageur makes riskless profits out of price differential in two
different markets. They take positions in financial markets to earn riskless profits. The
arbitrageurs take short and long positions in the same or different contracts at the same
time to create a position which can generate a riskless profit.

Arbitrage Over Space: It involves making profit by simultaneously entering into

transactions in two or more markets. Ex. If a certain share is quoted at a lower rate on the
Delhi Stock Exchange (DSE) and at a higher rate on Bombay Stock Exchange (BSE), an
arbitrageur buys the share at DSE and simultaneously sell it at BSE and makes profit.

4. Margin Traders: A margin refers to the minimum amount that you need to deposit with
the broker to participate in the derivative market. It is used to reflect your losses and
gains on a daily basis as per market movements. It enables to get a leverage in derivative
trades and maintain a large outstanding position.
Margin traders are speculators who make use of the payment mechanism, which is
peculiar to the derivative markets. When you trade in derivative products, you are not
required to pay the total value of your position up front. You are only required to deposit
a fraction (called margin) of the value of your outstanding position. This is called margin
trading and results in a high leverage factor in derivative trades, i.e., with a small deposit,
you are able to maintain a large outstanding position. This leverage factor is a multiplier,
which allows the speculator to buy three to five times the quantity that his capital
investment would otherwise have allowed him to buy in the cash market.

For example, let's say a sum of Rs 1.8 lakh fetches you 180 shares of XYZ Ltd. in the
cash market at the rate of Rs 1,000 per share. Under margin trading in the derivatives
market, if you are required to deposit a margin of say 30 per cent of the value of your
outstanding position, you would be able to purchase 600 shares of the same company at
the same price, with your capital of Rs 1.8 lakh i.e., Rs 1.8 lakh / (30 per cent of Rs 1000)
= 600 shares. So, in effect, you are allowed a leverage of 3.33 times in this case (100/30).
If the price of XYZ Ltd. rises by Rs 100, your 180 shares in the cash market will deliver a
profit of Rs 18,000, which would mean a return of 10 per cent on your investment.
However, your payoff in the derivatives market would be much higher. The same rise of
Rs 100 in the derivative market would fetch Rs 60,000, which translates into a whopping
return of over 33 per cent on your investment of Rs 1.8 lakh. This is how a margin trader,
who is basically a speculator, benefits from trading in the derivative markets.

Derivatives Market in India:

In India, derivatives markets started in the late 1890s and were futures-based markets with commodities,
primarily agricultural commodities, as the underlying assets. By 1930, a thriving futures market on
commodities existed in India. In 1952, however, to prevent speculation on the prices of agricultural
commodities, the Government of India came up with a legislation that explicitly banned any kind of
futures trading on commodities in India. As a result, until amendments to this law were made in the late
1990s and early 2000s, trading in all derivative products was banned in the market.

In the case of equity markets, an unofficial and, therefore, unregulated market existed in the form of
Badla trading, a system that had significant risks involved for the participants but was reasonably well
accepted by the market participants. However, that stopped in the wake of Harshad Mehta financial
market scam in 1992.

Exchange-Traded Markets
Derivatives trading, primarily the exchange-traded variety, in India in June 2000 with the
introduction of index futures trading on the Bombay Stock Exchange (BSE) and the National
Stock Exchange on India (NSE). This was followed up in July 2001 by the introduction of index
options, options on individual securities, and futures on individual securities (single stock
futures) on both the NSE and the BSE. The market regulator, the Securities and Exchange Board
of India (SEBI), has been on both the NSE and BSE taking active steps to increase liquidity in
the available contracts to make the market more robust (healthy) and viable for all kinds of
investors.

Interest rate futures trading was introduced on the NSE in June 2003. The underlying assets were
taken to be notional Treasury Bills or notional 10-year bonds (both zero coupons and coupon
bearing). Interest rate futures did get traded in the period immediately after the launch, but in a
few months the market became defunct (non-operational or invalid). Recently, the SEBI and the
NSE are trying to reinvigorate (strengthen) the interest rate futures.

The commodity markets have also seen the reintroduction of derivatives contracts in the form of
futures contracts. There are currently, three national exchanges and a number of regional
exchanges. The regional exchanges are generally single-product exchanges while the national
exchanges are multi-commodity exchanges. However, options based on commodity as the
underlying asset are yet to be introduced in the markets.

Currency futures were launched on the NSE in August 2008. The salient features of the contract
are that the lot size is equivalent to US $ 1,000 and that the contract will always be cash settled
in Indian currency. This way, the regulators are also able to overcome the issue of non-full
convertibility of the Indian currency. It should also be noted that currency futures are also
available for trade on BSE and Multi Commodity Exchange (MCX).

Over-the-Counter (OTC) Market

Since the late 1980s, banks were allowed to execute foreign forward contracts based on a defined
exposure and with corporate entities as counterparties. The first swap deal by any Indian
company dated as far back as 1984 when the Oil Natural Gas Corporation Limited (ONGC)
entered into a swap transaction with a foreign bank. The regulations dealing with booking and
cancellation of forward contracts have undergone several revisions since then, but the basic
contract has been in operation for over 25 years now.

Swaps were introduced in the Indian markets by the Reserve Bank of India (RBI) in the mid-
1990s on a case-by-case. However, looking at the popularity of the product, the RBI
subsequently provided blanket permission to banks to engage in swap deals provided the RBI
was kept informed on a book-value basis. In 2005, all swap transactions in the country were
legally made enforceable with retrospective effect.

Foreign currency options: In the case of foreign currency options, banks were allowed to enter
these since the early 1990s on a back-to-back basis and not run an open position. However, in
July 2003, the RBI allowed trading by banks and corporate entities (primarily for hedging
purpose) on these with the restriction that while banks could both write and hold options,
corporate could only buy (hold) options. It needs to be mentioned that currency options in India
are over-the-counter (OTC) products.

Interest rate options: Interest rate options are not allowed in the market as yet. Although the
RBI has conducted a number of studies to look at the feasibility of the introduction of interest
rate options, it is yet to take the final decision and make it available in the markets.

Further, a large number of exotic and structured products are also offered in terms of derivatives
products in Indian markets. Products such as credit derivatives, weather derivatives, and energy
derivatives, particularly options with credit options or options with weather and/or energy as the
underlying asset are still not allowed to be traded in India. The only products that are allowed in
India are futures contracts on some of them, necessarily, futures contracts on some weather-
related assets and energy underlying assets.
One can do derivatives trading in India through National stocks Exchange (the NSE), Bombay
Stocks Exchange (the BSE) in stocks. Similarly, if your interest is to trade in commodities, MCX
and NCDEX are there. The MCX stands for the Multi Commodity Exchange. While NCDEX
stands for the National Commodity and Derivatives Exchange. However, if you are willing to
trade in currency, you can do it over NSE-SX, MCX-SX. If your interest is to trade in bonds
again it’s also possible through NSE platform.

In derivatives trading, you are eligible to trade in derivatives instruments through the above-
mentioned platforms. The most common type of derivatives that you can trade in India is future
and options or f&o in short. Further, the important underlying markets for stocks, commodities,
treasury bills, foreign exchange and real estate.

The risk associated with derivatives trading in India

You should understand that derivatives trading carry an element of risk in it. The following
points are self-explanatory.

 Derivatives product requires a large number of funds. So it is not for you if you have
limited resources. Limited resources mean limited funds and low-risk appetite.
 Trading derivatives need expert knowledge. A high trading expertise and experience is
mandatory with high-risk tolerance.
 As a derivatives trader, you must therefore carefully consider its suitability depending
upon your financial position.
 You should accept the fact that you can lose profits. Even you can incur the loss with the
execution of derivatives trade.
 It is invariably desirable to refer carefully Model Risk Disclosure Document before
beginning the derivative trade. You can ask for this document from your broker. Also,
before signing it you should read and understand its implications. This document clearly
mentions all risk associated with derivatives trading.
 Read the sample SEBI Model Risk Document and also the same document for NSE
derivatives trading for having an understanding of risk.

An understanding of derivatives trading risk with examples

Situation 1 – Derivatives trading risk with the future index

Suppose you purchased 100 Nifty 50 futures @ Rs. 10724 on May 10. The expiry date is May
28. Your total Investment was INR 10,72,400. You paid the initial margin of INR 1,07,240. On
May 28, Nifty 50 index future closes at 10678.

Your loss is (1072400 – 1067800) X 100 = INR 4,60,000. In this situation your entire initial
investment (i.e. INR 1,07,240) is lost. Additionally you need to pay INR 3,52,760 (4,60,000 –
1,07,240).
Situation 2 – Derivatives trading risk with stocks future

Now suppose you purchased 100 TCS futures @ INR 1740 on May 15. The expiry date is May
28. Your total Investment is INR 1,74,000. You paid an initial margin of INR 17,400. On May
28, the price per shares of TCS was INR 1800.

You gain (1800 – 1740) X 100 = INR 6000.

Situation 3 – Derivatives trading risk with index options

Suppose you buy 100 Nifty 50 call options at a strike price of INR 10,7000 on May 10. Nifty 50
index was at 10724. Suppose you paid the premium of INR 10,000 (@INR 100 per call X 100
calls). The expiry date of the contract is May 28. On May 28, the Nifty index closes at 10678.
The call expires worthless.

You possess the entire INR 10,000 paid as premium.

Situation 4 – Derivatives trading risk with stocks option

Let us not assume that you buy 100 TCS put options at a strike price of INR 1750 on May 10.
TCS share price is at 1740. You paid the premium of INR 5,000 (@ INR 50 per put X 100 calls).
The expiry date of the contract is May 2018. On May 28, TCS shares close at INR 1800. In this
case, the put option will expire worthlessly.

You will lose the entire INR 5,000 paid as premium.

risk involved with future contracts. There is always clearing corporations behind every side of a
transaction.

At present, there are five clearing corporations operational in India, namely –

1. India International Clearing Corporation (IFSC) Limited

2. Indian Clearing Corporation Ltd
3. Metropolitan Clearing Corporation of India Ltd
4. National Securities Clearing Corporation Ltd
5. NSE IFSC Clearing Corporation Limited

The other features that differentiate future from the forward contracts are –

1. The increased time to expiration does not increase the counterparty risk in future
contracts, and
2. Future contract markets are highly liquid in comparison to forward markets.

There are various participants in the derivatives trading in India. Learn about the derivatives
market participants such as hedgers, arbitrageurs, and speculators in the blog.
Indian derivatives trading instruments and its type

In order to understand instruments for the derivatives market, let us concentrate over NSE
platform. Mainly two types of derivatives instruments, namely futures and options.

All future contracts have cash settlement over NSE. Any future contract is always made
between two persons. But Clear Corporation always takes opposite position against any order.
Thus, there is always an opposite party by default in each trade. Unlike forward contracts, in
future contract money transfer takes place during the time of entering the contract.

In general, options are of two types. Call options and put options. All options at NSE also settle
at cash.

Products of derivatives instruments at NSE

NSE has various derivatives product for the underlying stocks. You can trade on future and
options of both indices and single stocks. You can trade in Nifty 50 futures, CNX IT Index,
Bank Nifty index, CNX Nifty Junior Index, and Nifty Midcap 50 index.

But you can trade only on long-dated options contract on Nifty 50. You can also have the
option to trade in some features of individual stocks and their options. Regarding options, you
must remember, that all options on individual stocks are American type of options. While all
index-based options are European options. Under American option, you can exercise your right
any time up to the expiration date. While under European option you can exercise your right only
on the expiration date.

Exchange Traded Derivatives Versus OTC Traded Derivatives

An exchange traded product is a standardized financial instrument that is traded on an organized
exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an
exchange, the price of which is directly dependent upon the value of one or more underlying
securities, equity indices, debt instruments, commodities or any agreed upon pricing index or
arrangement.

The most common types of derivative products are interest rate swaps, caps and their offshoots.
Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb
and flow of their corporate finance and hedging activity.

The reason derivative products exist is that users often need customized products as the
standardization of exchange products can lead to hedging mismatches and gap exposures. The
distinction between OTC traded versus Exchange traded derivatives can be presented below:
 Sl. Basis of OTC Derivatives Exchange Derivatives
No. Difference
1 Trading Traded by telephones or telex Traded in a competitive arena
(OTC) (recognized exchange)
2 Size of contracts Decided between buyer and Standardized contract size decided
seller by the exchange corporation.
3 Price of contract Remains fixed till maturity Changes every day.
4 Mark-to-market Not done Marked to market every day.
5 Margin No margin required Margins are to be paid by both
buyer and sellers
6 Counter party Private transaction between two Central clearing house (CCH) acts
parties as a counterparty on both sides
7 Counter Party There will be a chance for Credit risk exposure to Central
Risk counter party risk. clearing house.
8 Number of There can be any number of Number of contracts in a year is
contracts in a contracts. fixed by the exchange.
year
9 Frequency of 90% of all OTC contracts are Very few exchange contracts are
delivery settled by actual delivery. settled by actual delivery.
10 Hedging These are tailor-made for Hedging is by nearest month and
specific date and quantity. So, it quantity contracts. So, it is not
is perfect. perfect.
11 Liquidity Simple liquidation Negotiate liquidation
12 Mode of delivery Specially decided. Most of the Standardized. Most of the
contracts result in delivery. contracts are cash-settled.
13 Transaction Costs are based on bid-ask Include brokerage fees for buy and
costs spread sell orders.
Unit-2: Commodity Derivatives
The term commodity refers to any material, which can be bought and sold. Commodities in a
market‘s context refer to any movable property other than actionable claims, money and
securities. Commodities represent the fundamental elements of utility for human beings.

Commodity market refers to markets that trade in primary rather than manufactured products.
Soft commodities are agricultural products such as wheat, coffee, cocoa and sugar. Hard
commodities are mined, such as (gold, rubber and oil).

Commodity includes every kind of movable goods excluding money and securities.
Commodities include metals (bullion and other metals), agro products, perishable/non perishable
commodities.

Precious metals (gold, silver, platinum etc.)

Other metals (tin, copper, lead, steel, nickel etc)

Agro products (coffee, wheat, pepper, cotton)

Energy products (crude oil, heating oil, natural gas)

Commodity Derivatives markets are a good source of critical information and indicator of
market sentiments. Since, commodities are frequently used as input in the production of goods or
services, uncertainty and volatility in commodity prices and raw materials makes the business
environment erratic, unpredictable and subject to unforeseeable risks.

Volatility in raw material costs affects businesses and can be significant given that commodity
prices are driven by supply and demand from domestics as well as global markets. Ability to
manage or mitigate risks by using suitable hedging in commodity derivative products, can
positively affect business performance. Futures & Options, are by far the most common
Commodity Derivatives products offered on an Exchange, that are well structured and regulated
through robust mechanisms and controls.

NSE launched the Commodities derivatives segment on October 12, 2018. Currently Futures on
Commodity derivatives are available on Bullion.

Transactions in Commodity Market

1) Spot Market

Market where commodities are bought and sold in physical form by paying cash is a spot market.
For example, if you are a farmer or dealer of Chana and you have physical holding of 10 kg of
Chana with you which you want to sell in the market. You can do so by selling your holdings in
either of the three commodities exchanges in India in spot market at the existing market or spot
price.
2) Futures Market: The market where the commodities are bought and sold by entering into
contract to settle the transaction at some future date and at a specific price is called futures
market.

3) Derivatives: Derivatives are instruments whose value is determined based on the value of an
underlying asset. Forwards, futures and options are some of the well-known derivatives
instruments widely used by the traders in commodities markets.

Types of Commodity Derivatives. Two important types of commodity derivatives are

1) Commodity futures.
2) Commodity options.

1) Commodity Futures Contracts: A futures contract is an agreement for buying or selling a

commodity for a predetermined delivery price at a specific future time. Futures are standardized
contracts that are traded on organized futures exchanges.

For example, suppose a farmer is expecting his crop of wheat to be ready in two months time,
but is worried that the price of wheat may decline in this period. In order to minimize his risk, he
can enter into a futures contract to sell his crop in two months‘ time at a price determined now.
This way he is able to hedge his risk arising from a possible adverse change in the price of his
commodity. Commodities suitable for futures trading All the commodities are not suitable for
futures trading. It must fulfill the following characteristics:

1) The commodity should have a suitable demand and supply conditions.

2) Prices should be volatile to necessitate hedging through futures price risk. As a result there
would be a demand for hedging facilities.
3) Prices should be volatile to necessitate hedging through futures trading in this case persons
with a spot market commitment face a price risk. As a result there would be a demand for
hedging facilities.
4) The commodity should be free from substantial control from Govt. regulations (or other
bodies) imposing restrictions on supply, distribution and prices of the commodity.
5) The commodity should be homogenous or, alternately it must be possible to specify a standard
is necessary for the futures exchanges to deal in standardized contracts.
6) The commodity should be storable. In the absence of this condition arbitrage would not be
possible and there would be no relationship between spot and futures.

Features of commodity Futures

a) Trading in futures is necessarily organized under the recognized association so that such
trading is conducted with the procedure laid down in the Rules and Bye-laws of the association.

b) The units of price quotation and trading are fixed contracts, parties to the contracts not being
capable of altering these units.
c) The delivery periods are specified.
d) The seller in a futures market has the choice to decide whether to deliver goods against
outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the
location of the Association through which trading is organized but also at a number of other pre-
specified delivery centres.

2) Commodity Options contracts: Like futures, options are also financial instruments used for
hedging and speculation. The commodity option holder has the right, but not the obligation, to
buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date.
Option contracts involve two parties – the seller of the option writes the option in favor of the
buyer (holder) who pays a certain premium to the seller as a price for the option.

There are two basic types of commodity options: a call option and a put option.
1) A call option gives the buyer, the right to buy the asset (commodity) at a given price. This
‗given price‘ is called ‗strike price‘.

For example: A bought a call at a strike price of Rs.500. On expiry the price of the asset is
Rs.450. A will not exercise his call. Because he can buy the same asset form the market at
Rs.450, rather than paying Rs.500 to the seller of the option.
2) A put option gives the buyer a right to sell the asset at the ‗strike price‘ to the buyer. Here the
buyer has the right to sell and the seller has the obligation to buy.

For example: B bought a put at a strike price of Rs.600. On expiry the price of the asset is
Rs.619. A will not exercise his put option. Because he can sell the same asset in the market at
Rs.619, rather than giving it to the seller of the put option for Rs.600.

Difference between Futures Options Futures

and Options in Commodity
Markets Based on
An option gives the buyer the A futures contract gives the
1) Obligations right, but not the obligation to
buyer the obligation to
buy (or sell) a certain purchase a specific
commodity at a specific price commodity, and the seller to
at any time during the life ofsell and deliver that
the contract. commodity at a specific future
date, unless the holder‘s
position is closed prior to
expiration.
Buying an options position An investor can enter into a
2) Commissions does require the payment of a futures contract with no
premium. The premium is the upfront cost.
maximum that a purchaser of
an option can lose.
- -
3) Size of the underlying
position

The gain on an option can be In contrast, gains on futures

4) The way the gains are realized in the following three positions are automatically
received by their parties ways: exercising the option ‗marked to market‘ daily.
when it is deep in the money,
going to the market and taking
the opposite position, or
waiting until expiry and
collecting the differences
between the asset price and the
strike price.

PARTICIPANTS OF COMMODITY DERIVATIVES MARKET

The commodity market needs many participants with different investment objectives and risk
profiles. This allows the market to function effectively. The participants play different roles in
the market by using the commodity futures contract. The following are the list of participants in
commodity derivatives market.

1. Hedgers
a) Exporters
b) Importers
c) Farmers
d) Merchandisers, elevators
e) Processors

2.Speculator, and

3.Arbitrageur.

HEDGERS: They use derivatives markets to reduce or eliminate the risk associated with price
of a commodity. Hedgers are commercial producers or consumers of a traded commodity.
Examples are copper smelters, oil companies, farmers, and jewellers. Hedgers are exposed to
commodity price volatility in the spot market. They use the futures market to offset (hedge) this
risk. Suppose gold prices are unstable. A jeweller would want to offset a possible risk of loss on
his monthly gold purchases due to this volatility. If he expects the price to rise next month, he
could go long on (buy) a gold futures contract with a one-month expiry period. The contract will
let him buy gold at the current price even if the prices rise in a month. But, if the prices fall
during this time, he will not profit from it. That is because he still has to buy gold at the price
specified in his futures contract.
A hedger buys or sells in the futures market to secure the future price of a commodity intended to
be sold later in the cash market. This helps protect against price risks – and can be considered an
insurance policy of sorts.

If you go long a futures contract, you try to secure as low a price as possible. Conversely, if
you sell short a contract, you want as high a price as possible (just like you would with stocks).
The futures contract, however, provides a definite price certainty for both parties, which reduces
the risks associated with price volatility. Hedging by using a futures contracts can also be used to
lock in an acceptable price margin between the cost of the raw material and the retail cost of the
final product sold.

Here’s an example. Say a silversmith needs a certain amount of silver in six months to make
jewelry that’s already been advertised in an upcoming catalog. Because the jewelry prices are
already set, any increase in the cost of silver can’t be passed on to the retail buyer – instead, the
silversmith would have to absorb that cost. The silversmith can buy a silver futures contract to
hedge against a possible price increase in silver.

They trade in the futures market to transfer their risk of movement in prices of the commodity
they are actually physically dealing. Some of the hedgers are listed below and their objective
from trading in this market:-

a) Exporters: People who need protection against higher prices of commodities contracted from
a future delivery but not yet purchased. Exporters who are contracted to deliver the commodities
at a future date, for a specific price but not yet purchased the commodities. The exporters may
use hedging technique to protect themselves against higher prices of commodities.

b) Importers: People who want to take advantage of lower prices against the commodities
contracted for future delivery but not yet received. Through hedging techniques an importer will
protect him from the adverse price movements.

c) Farmers: People who need protection against declining prices of crops still in the field or
against the rising prices of purchased inputs such as feed.

d) Merchandisers, elevators: People who need protection against lower prices between the time
of purchase or contract of purchase of commodities from the farmer and the time it is sold.
e) Processors: People who need protection against the increasing raw material cost or against
decreasing inventory values.

SPECULATORS: Speculators may not have any exposure to the spot market. To them,
commodity futures are an investment avenue, like the stock market. They try to make money by
speculating on commodity prices, just as they would by speculating on stock prices. As such,
speculators never receive delivery of the physical commodity. They take a position in
commodity futures and square it off before expiry. This means, they settle by buying or selling a
contract that is exactly the opposite of the contract they currently hold. This only involves
payment in cash and no delivery of the underlying commodities.

ARBITRAGEURS: Arbitrageurs try to profit from the difference in the prices of the same
commodity in two different markets. They take a long position (buy) in the market where the
price is lower and a short position (sell) in the market where it is higher. The difference between
the two prices is their profit. Arbitrage transactions are usually risk-free. Constant arbitrage
reduces the price in the market where it is higher and increases it in the market where it is lower.
Arbitrage stops when prices become similar in both markets.

Their varying preference for risk and return distinguishes market participants from each other.
The different categories of participants respond differently to a market development because of
their differing risk-return preferences. These differing responses determine how the market price
of a commodity will move.

Hedgers have the lowest risk appetite of the three categories. They see fluctuations in commodity
prices as a risk and use the futures contract to mitigate it. Making a profit on the trade is the least
of their concerns.

Speculators enter the market only to make a profit, without caring much for the implicit risk.
They make aggressive bets and are fine with losing money along the way.

Arbitrageurs are also driven by the profit motive. But their bets are less risky than those of
speculators. Arbitrageurs play the most important role in price discovery. That is because they
keep performing arbitrage until prices in the different markets reach parity.

EVOLUTION OF COMMODITY DERIVATIVES IN INDIA

Organized trading in commodity derivatives was initiated in India with the set up of Bombay
Cotton Trade Association Ltd in 1875. Following this, Gujarati Vyapari Mandali was set up in
1900 to carryout futures trading in groundnut, castor seed and cotton.
Forward trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the
Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up
in 1927 for organizing futures trading in Raw Jute. These two associations amalgamated in 1945
to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw
Jute and Jute goods. In case of wheat, futures markets were in existence at several centers at
Punjab and U.P. The most notable amongst them was the Chamber of Commerce at Hapur,
which was established in 1913. Futures market in Bullion began at Mumbai in 1920 and later
similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Calcutta.
 During the Second World War Futures trading was prohibited. However, after independence, the
Constitution of India brought the subject of "Stock Exchanges and futures markets" in the Union
list. As a result, the responsibility for regulation of commodity futures markets devolved on
Govt. of India and in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.
(a) An association recognized by the Government of India on the recommendation of
Forward Markets Commission,
(b) The Forward Markets Commission (it was set up in September 1953) and
(c) The Central Government.

Forward Contracts (Regulation) Rules were notified by the Central Government in July 1954.
The Act divides the commodities into 3 categories with reference to extent of regulation, viz:
(a) The commodities in which futures trading can be organized under the auspices of recognized
association.
(b) The Commodities in which futures trading is prohibited.
(c) Those commodities, which have neither been regulated for being traded under the recognized
association nor prohibited, are referred as Free Commodities and the association organized in
such free commodities is required to obtain the Certificate of Registration from the Forward
Markets Commission.

The ECA, 1955 gives powers to control production, supply, distribution, etc. of essential
commodities for maintaining or increasing g supplies and for securing their equitable distribution
and availability at fair prices. Using the powers under the ECA, 1955 various
Ministries/Departments of the Central Government have issued control orders for regulating
production/distribution/quality aspects/movement etc. pertaining to the commodities which are
essential and administered by them.

In the seventies, most of the registered associations became inactive, as futures as well as
forward trading in the commodities for which they were registered came to be either suspended
or prohibited altogether.

The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most
of the major commodities. The government, accordingly initiated futures trading in Potato during
the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. After the introduction
of economic reforms since June 1991, the government of India appointed one more committee
on Forward Markets under Chairmanship of Prof. K.N. Kabra in June 1993 and the Committee
submitted its report in September 1994.

Following this, the government of India has issued notifications on April 1, 2003 permitting
futures trading in commodities. Trading in commodity options, however, is still prohibited. The
lifting of the 30-year ban on commodity futures trading in India has opened yet another avenue
for investors.
 Forward contracts are broadly of two types:

· Specific delivery contracts

· Other than specific delivery contracts

Specific delivery contracts: Specific delivery contracts are essentially merchandising contracts,
which enable producers and consumers of commodities to market their produce and cover their
requirements respectively. These contracts are generally negotiated directly between parties
depending on availability and requirement of produce. During negotiation, terms of quality,
quantity, price, period of delivery, place of delivery, payment term, etc. are incorporated in the
contracts. Specific delivery contracts are of two types:

i) Transferable specific delivery contracts (T.S.D.)

j) Non-transferable specific delivery contracts (NTSD).

In the TSD contracts, transfer of the rights or obligations under the contract is permitted while in
NTSD it is not permitted.

Other than specific delivery contracts: Though this contract has not been specifically defined
under the act, these are called as ‘future contracts’. Futures contracts are forward contracts other
than specific delivery contracts. These contracts are usually entered into under the auspices of an
Exchange or Association. In the futures contracts, the quality and quantity of commodity, the
time of maturity of contract, place of delivery etc. are all standardized and contracting parties
have to negotiate only the rate at which contract is entered into.

Forward trading in TSD and NTSD contracts is regulated by the government. As per the section
15 of the FCRA, 1952, every forward contract in notified goods that entered into except those
between members of a recognized association or through or with any such member is treated as
illegal or void. The section 18(1) of the Act exempts the NTSD contracts from the regulatory
provisions.

However, over the years the regulatory provisions of the Act were applied to the NTSD
contracts and 79 commodity items are currently prohibited for NTSD contracts under section 17
of the Act. Moreover, another 15 commodity items are brought under the regulatory provisions
of the section 15 of the Act out of which trading in the NTSD contract has been suspended in 12
items. At present, the NTSD contracts in cotton, raw jute and jute goods are permitted only
between, through or with the members of the associations specifically recognized for the
purpose.

Commodities allowed for futures trading in India

 As per the list presented on Forward Market Commission (FMC), there are more than 25
exchanges are in operation carrying out futures trading activities in a wide variety of commodity
items under 8 major categories

1. Vegetable oilseeds, oils and meals

2. pulse
3. Cereals
4. Spices
5. Metals
6. Energy products
7. Fibres
8. Other

Factors to be considered while trading

In order to trade in commodity futures, the participants need to keep certain facts in mind. These
factors can be broadly grouped into the following categories.

Agricultural commodities

Carry over stocks: leftover stocks from the previous year’s production after meeting the
demand.

Expected demand: average level of consumption and exports during the past few years

Crop acreage: Extent of area sown under the crop

Production: Estimated output based on the acreage and weather conditions and pest infestation
etc.,

Imports and exports: in case of the commodities that have a sizeable amount of external trade
(either imports or exports) such as edible oils and pulses, the traders need to know the details of
important sources and destinations of the external trade. Further, the traders have to monitor the
crop status in the respective countries.

Government policies: any change in government policy relating to the crops such as MSP:
minimum support prices

Procurement: direct procurement by the government agencies and storage in warehouses

change in tariff and base prices of externally traded goods will have a direct impact on the
respective commodity prices.

Metals:

1. Currency effects: main source of long-term volatility

 2 .Variation in supply and demand for risk capital. Risk capital is largely provided from
established routes such as debt and equity.

3.Shocks:
o Unexpected changes in production techniques,
o Massive changes in exploration techniques,
o Changing geopolitics
o Cartel instability
o Environmental regulation with respect to production process

4. Changes in consumption trends, due in part to price elasticity

5.Inflation: change in global inflation as well as inflation in the US and the respective countries

Crude (energy) futures

 Stocks of Crude Oil and Petroleum Variance from five year average
 OPEC production variance from quota
 Strategic Petroleum Reserve (SPR) variance from target
 Demand factors
 OPEC spare capacity (Saudi Arabia)
 Refinery capacity variance
 Interest rates
 US dollar

SCOPE OF COMMODITY DERIVATIVES

India is one among the top-5 producers of most of the commodities and to being a major
consumer of bullion and energy products. Agriculture contributes about for about 22% to the
GDP of the Indian economy. It employees for about 57% of the labor force on a total of 163
million hectares of land. Agriculture sector is a significant factor in achieving a GDP growth of
8-10%. All this point out that India can be promoted as a main center for trading of commodity
derivatives.

It is regrettable that the policies of FMC during the most of 1950s to 1980s suppressed the
markets. But in fact it was supposed to encourage and nurture to grow with times. It was a
mistake and other emerging economies of the world would want to avoid such instance.
However, it is not in India alone those derivatives were suspected of creating too much
speculation that would be damaging the healthy growth of the markets and the farmers. Such
suspicions may generally arise due to a misunderstanding of the characteristics and role of
derivative product. It is significant to understand why commodity derivatives are necessary and
the role they can play in risk management. It is general knowledge that prices of commodities,
metals, shares and currencies fluctuate over time. The opportunity of adverse price changes in
future creates risk for businesses. Derivatives are used to diminish or eliminate price risk arising
from unforeseen price changes. A derivative is a financial contract whose price depends on, or is
resultant from, the price of another asset.

Commodity Futures Contracts

A futures contract is a contract for buying or selling a commodity for a predetermined delivery
price at a specific future time. Futures are standardized agreements that are traded on organized
futures exchanges that ensure performance of the contracts and therefore eliminate the default
risk. The commodity futures had existed ever since the Chicago Board of Trade (CBOT) was
established in 1848, in view to bring farmers and merchants together. The main function of
futures markets is to transfer price risk from hedgers to speculators. For instance, suppose a
farmer is expecting his crop of wheat to be ready in two months time, but is worried that the
price of wheat may turn down in this period. In order to minimize his risk, he can penetrate into a
futures contract to sell his crop in two months’ time at a price determined now. In this way he is
able to hedge his risk arising from a probable adverse change in the price of his commodity.

Commodity Options contracts

options are also financial instruments like hedges, which are used for hedging and speculation.
The commodity option holder has the right, except he don’t have the obligation, to buy (or sell) a
specific quantity of a commodity at a specified price on or before a specified date. Option
agreements involve two parties, namely the seller of the option writes the option in favor of the
buyer (holder) who pays a certain premium to the seller as a price for the option. There are two
kinds of commodity options. First one is a ‘call’ option gives the holder a right to buy a
commodity at an agreed price and the other one is ‘put’ option gives the holder a right to sell a
commodity at an agreed price on or before a specified date (called expiry date).

The option holder will exercise the option only if it is advantageous to him; or else he will let the
option lapse. For instance, presume a farmer buys a put option to sell 100 Quintals of wheat at a
price of Rs 1250 per quintal and pays a ‘premium’ of Rs. 25 per quintal (or a total of Rs. 2500).
If the price of wheat reduces to say Rs. 1000 before expiry, the farmer will exercise his option
and sell his wheat at the agreed price of rs. 1250 per quintal. Nevertheless, if the market price of
wheat amplifies to say rs. 1500 per quintal, it would be beneficial for the farmer to sell it directly
in the open market at the spot price, instead of exercise his option to sell at rs. 1250 per quintal.
Futures and options trading for that reason helps in hedging the price risk and also provide
investment opportunity to speculators who are keen to assume risk for a possible return. In
addition to this, futures trading and the ensuing discovery of price can help farmers in deciding
which crops to cultivate. They can also help in building a competitive edge and enable
businesses to smoothen their earnings since non- hedging of the risk would boost the volatility of
their quarterly earnings. Thus futures and options markets perform essential functions that can
not be ignored in modern business environment. At the same time, it is factual that too much
speculative activity in vital commodities would destabilize the markets and hence, these markets
are normally regulated as per the laws of the country.

DIFFERENCE BETWEEN COMMODITY DERIVATIVES 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. Since financial assets are not bulky, they do not need special facility for storage,
transport even in case of physical settlement. On the other hand, due to the bulky nature and
physically existence 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 underlying 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. 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. 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 procedure for buyer and seller regarding the physical settlement for different types
of contracts is clearly specified by the Exchange. The period available for the buyer to take
physical delivery is stipulated by the Exchange.
Basis of difference Financial derivatives Commodity derivatives
Settlement Most of these contracts are cash Some contracts may be settled
settled. through physical delivery of
commodities.

Storage and Even in the case of physical Due to the bulky nature of the
transportation settlement, financial assets are not underlying assets, physical
facility bulky and do not need special settlement in commodity derivatives
facility for storage, transportation creates the need for warehousing and
etc. transportation.

Varying of quality Concept of varying quality of asset The quality of the asset underlying a
of asset does not really exist. contract can vary at times.

Derivative Forwards, Futures, Options and Futures and Options are most
techniques used Swaps are used in contracting of suitable techniques used in
financial derivatives. Commodity market.
Underlying Assets Stocks, bonds, Index, currency, Agriculture commodities, precious
used interest rates metals, other metals, energy
products.
Place of delivery Clearing system or exchange The buyer and the seller should go to
delivers the assets the designated wareshouse to receive
the physical delivery of goods.
Excise duty and Mostly the participants used pay Since movement of commodities
customs transaction cost. happened between states. The
participants has to pay excise duy
and customers.
Restrictions on No restrictions on transfer of There is a restriction on movement
movement of financial assets. of commodities from one state to
commodities. other state.
UNIT-3: NCDEX PLATFORM
National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed
on-line multi commodity exchange. The shareholders of NCDEX comprises of large national
level institutions, large public sector bank and companies.

NCDEX offers a bouquet of benefits, which are currently in short supply in the commodity
markets. The shareholders of NCDEX are prominent players in their respective fields and bring
with them institutional building experience, trust, nationwide reach, technology and risk
management skills.

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 commenced
its operations on December 15, 2003. Corporate Identity No. is U51909MH2003PLC140116.

NCDEX is a nation-level, technology driven de-mutualised on-line commodity exchange with an

independent Board of Directors and professional management - both not having any vested
interest in commodity markets. It is committed 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 Securities and Exchange Board of India. NCDEX is subjected to various
laws of the land like the Securities Contracts (Regulation) Act, 1956, Companies Act, Stamp
Act, Contract Act and various other legislations.

NCDEX headquarters are located in Mumbai and offers facilities to its members from the centers
located throughout India.

As of March 31, 2018, the Exchange offered trading in 27 commodity contracts, which includes
25 agricultural commodity contracts, 1 bullion commodity contract and 1 metal commodity
contract.

The National Commodities and Derivatives Exchange (NCDEX) is a commodities exchange

dealing primarily in agricultural commodities in India. The National Commodities and
Derivatives Exchange was established in 2003. The exchange was founded by some of India's
leading financial institutions such as ICICI Bank Limited, the National Stock Exchange of
India and the National Bank for Agricultural and Rural Development, among others.

The National Commodities and Derivatives Exchange (NCDEX) is one of the top commodity
exchanges in India based on value and the number of contracts, second only to the Multi
Commodity Exchange (MCX) with its focus on energy and precious metals. The National
Commodities and Derivatives Exchange is located in Mumbai, but has offices across the country
to facilitate trade. Trading is done on 27 commodity contracts as of March, 2018. These include
25 contracts for agricultural products. NCDEX is run by an independent board of directors with
no direct interest in agriculture.

In establishing and maintaining an online futures market for crops, NCDEX has helped increase
the market transparency. This has resulted in farmers in India conduct price discovery, helping
them price their goods more accurately even if they are not active in the futures
market. Middlemen called commission agents previously controlled much of the market
information in India, so the introduction of online commodity exchanges like NCDEX has
greatly improved the information asymmetry.

STRUCTURE OF NCDEX
National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in
Mumbai on April 23,2003.

OBJECTIVES OF NCDEX

1. To create a world class commodity exchange platform for the market participants.
2. To bring professionalism and transparency in to the commodity trading.

3. To inculcate international best practices like demutualization, technology platforms, low

cost solutions and information dissemination without noise etc. into our trade.

4. To provide nationwide reach and consistent offering.

5. To bring together the names that market can trust.

Ministry of Finance

Forward Market Commission

Commodity Exchanges

National Exchanges Regional Exchanges

NCDEX

Managing Director and CEO

 Directors of Public and Shareholders
interest and various committees

PROMOTERS OF NCDEX OR (SHAREHOLDERS)

Total no. of % of total

Sr.No.Name of the shareholder
shares capital
1. National Stock Exchange of India Limited (NSE) 76,01,377 15.00%
2. Life Insurance Corporation of India (LIC) 5,625,000 11.10%
National Bank for Agriculture and Rural
3. 5,625,000 11.10%
Development (NABARD)
Indian Farmers Fertiliser Cooperative Limited
4. 50,68,000 10.00%
(IFFCO)
5. Oman India Joint Investment Fund 5,067,600 10.00%
6. Punjab National Bank (PNB) 3,694,446 7.29%
7. Build India Capital Advisors LLP 3,091,236 6.10%
8. Canara Bank 3,055,519 6.03%
9. IDFC Private Equity Fund III 25,33,800 5.00%
10. Shree Renuka Sugars Limited 25,33,700 5.00%
11. CRISIL Limited 1,875,000 3.70%
12. InterContinental Exchange (ICE) 1,500,000 2.96%
13. Goldman Sachs Investments (Mauritius) I Limited 1,500,000 2.96%
14. Jaypee Capital Services Limited 1,204,800 2.38%
Star Agriwarehousing and Collateral Management
15. 7,00,500 1.38%
Ltd.
16. Individuals 22 0.00%
Total 50,676,000 100.00%

GOVERNANCE OF NCDEX

The governance of NCDEX vests with the Board of Directors. The Board comprises persons of
eminence, each an authority in his own right, in the areas very relevant to the Exchange.

Our Board of Directors comprises of 12 Directors who are well known and highly experienced.
There are 6 Public Interest Directors and 6 Shareholder Directors and One Managing Director
and CEO. 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 Executive
committee and other committees for the purpose of managing activities of the exchange.

Executive Committee

The executive committee consists of Managing Director of the exchange who would be acting as
the Chief Executive of the Exchange, and also other members appointed by the board. Other
Committees Apart from the executive committee the board has constitute committee like
Membership committee, Audit Committee, Risk Committee, Nomination Committee,
Compensation Committee and Business Strategy Committee which help the Board in policy
formulation.

The following are the other committees formed for the Governance of
NCDEX.
1. Audit Committee (re-constituted w.e.f. February 13, 2019)
2. Nomination and Remuneration Committee (re-constituted w.e.f. February 13, 2019)
3. Risk Management Committee (reconstituted w.e.f. February 13, 2019)
4. Technology Standing Committee (reconstituted w.e.f. February 13, 2019)
5. Public Interest Directors’ Committee (reconstituted w.e.f. February 13, 2019)
6. Corporate Social Responsibility Committee (re-constituted w.e.f. April 24, 2018)
7. Regulatory Oversight Committee (constituted w.e.f. February 13, 2019)
8. Stakeholders Relationship Committee (re-constituted w.e.f. February 13, 2019)
9. Membership Selection Committee (re-constituted w.e.f. February 13, 2019)
10. Advisory Committee (re-constituted w.e.f. February 13, 2019)

Proposed Systems and Regulations at NCDEX pertaining to Accredited warehouse,

Registrar and Transfer Agent and Assayer

ACCREDITED WAREHOUSE

The Exchange shall specify accredited warehouse(s) through which delivery of a specific
commodity shall be affected and which shall facilitate for storage of commodities.

PROCESS AND PROCEDURES FOR ACCREDITED WAREHOUSE

The Exchange shall specify from time to time the processes, procedures, and operations that
every accredited Warehouse, Constituents, Depository Participants and R & T Agents shall be
required to follow for the participation, functioning and operations of the accredited warehouse.

FUNCTIONS OF ACCREDITED WAREHOUSE

(a) Earmark separate storage area as specified by the Exchange for the purpose of storing
commodities to be delivered against deals made on the Exchange. The Warehouse(s) shall also
meet the specifications prescribed by the Exchange for storage of commodities.

(b)Ensure and co-ordinate for grading of the commodities received at the Warehouse before they
are being stored.
(c) Store commodities in line with their grade specifications and validity period and shall
facilitate maintenance of identity. On expiry of such validity period of the grade for such
commodities, the Warehouse(s) shall segregate such commodities and store them in a separate
area so that the same are not mixed with commodities which are within the validity period as per
the grade certificate issued by the approved Assayers

DUTIES OF ACCREDITED WAREHOUSE

(a) Shall use uniform and standard description of commodities and units of measurement in
respect of the commodities stored pertaining to the Constituent of the Exchange.

(b) Shall strictly adhere to the Warehousing norms stipulated for a commodity in particular or
group of commodities in general by the Exchange.

(c) Shall ensure that necessary steps and precautions are taken to ensure that the quantity and the
grade of the commodity are maintained during the storage period.

(d) Shall maintain the records for the commodities deposited with it by the Constituents, in
electronic form in the manner and in the system as prescribed by specified Depository.
Warehouse(s) shall avail the services of a Registrar & Transfer (R&T) agent approved and
appointed by the Exchange for the above purpose. The Warehouse shall facilitate the uploading
of instructions by the R&T agent using the system connected to the depository for the creation of
electronic records of the Commodities received by the Warehouse in the Depository Clearing
System. The Warehouse shall execute and complete necessary documentation with the R&T
agent and the Depository in this regard.

(e) Unless and until expressly consented by the Exchange, the Warehouse shall not assign, shift,
transfer and relocate the commodities held by it pertaining to the Constituents of the Exchange.
The warehouse (s), however is/are entitled to move the commodities within the area earmarked
in the warehouse for storing the commodities pertaining to the constituents of the exchange.

VERIFICATION OF COMMODITIES STORED IN WAREHOUSE

The Exchange will verify itself or through any agencies/experts, at any time, the commodities
deposited by the Constituents and/or warehouse facilities in general or for compliance of the
warehousing norms stipulated by the Exchange for the specific commodities.

RELEASE OF COMMODITIES STORED IN WAREHOUSE

As and when the Buyers intend to take physical delivery of the commodities held by them in
their respective Demat Account, they would make such requests to their respective depository
participant (DP) with whom they hold the Demat account. The DP will upload such requests to
the specified Depository who will in turn forward the same to the Registrar and Transfer Agent
(R & T Agent) concerned. After due verification of the authenticity, the R & T Agent will
forward delivery details to the warehouse who in turn will arrange to release the commodities
after due verification of the identity of recipient.

CHARGES FOR WAREHOUSE SERVICES

Warehouses shall charge from the constituents of the exchange, storage and other charge as may
be mutually agreed in advance between the exchange and warehouses from time to time. For the
purpose operational convenience, the DPs who will be opening the Demat account for the
constituent will arrange to collect the storage charges from them and pay the same to the
warehouse at agreed periodic intervals. The warehouses are entitled to levy all incidental charges
such as insurance; assaying, handling charges or any such charges directly from the constituent
depositing the commodities as may be applicable. The exchange shall not be responsible in any
manner for payment of any of the charges of warehouse.

The exchange may also explore the possibility of availing the services of Collateral Management
Agent (CMA), who can offer the warehousing facilities for the constituent of the exchange. In
such a case the constituent shall be required to shift their holding in the warehouses
approved/identified by such CMA.

REGISTRAR AND TRANSFER AGENT (R & T AGENT)

Approved R & T Agent

The exchange shall specify approved R & T Agents through which commodities shall be
dematerialized and which shall facilitate for dematerialization/re-materialization of commodities
in the manner as prescribed by the exchange from time to time.

Process and Procedure for R & T Agent

The exchange shall specify from time to time the processes, procedures, and operations that
every accredited warehouse, Depository Participants and Constituents shall be required to follow
for the participation, functioning and operations of the R & T Agent. The regulations relating to
the R & T Agent shall be deemed to form a part of any settlement process so provided.

FUNCTIONS OF R&T AGENT

(a)Establish connectivity with approved warehouse(s) and support them with physical
infrastructure.
(b)Verify the information regarding the commodities accepted by the accredited warehouse and
assign the identification number (ISIN) allotted by the Depository in line with the grade/validity
period.
(c)Further process the information, and ensure the credit of commodity holding to the Demat
account of the Constituent.
(d)Ensure that the credit of commodities goes only to the Demat account of the Constituents held
with the Exchange empanelled DPs
(e)On receiving request for Re-materialization (physical delivery) through the depository, R&T
Agent(s) shall arrange for issuance of authorization to the relevant warehouse for the delivery of
commodities.
MAINTENANCE OF RECORDS AND CO-ORDINATION ACTIVITIES
R&T Agent(s) shall maintain proper records of beneficiary position of Constituents holding
dematerialized commodities in Warehouse(s) and in the Depository for a period and also as on a
particular date. R&T Agent(s) shall furnish the same to the Exchange as and when demanded by
the Exchange. R&T Agent(s) shall also co-ordinate with DPs and Warehouse(s) for billing of
charges for services rendered on periodic intervals. R&T Agent(s) shall also reconcile
Dematerialized commodities in the Depository and Physical commodities at the Warehouse(s) on
periodic basis and co-ordinate with all parties concerned for the same.

ASSAYERAPPROVED ASSAYER

The Exchange shall specify Approved Assayer(s) through which grading of commodities
received at approved warehouse(s) for delivery against deals made on the Exchange can be
availed by the Constituents of Clearing Members.

PROCESS AND PROCEDURES FOR ASSAYER

The Exchange shall specify from time to time the processes, procedures, and operations that
every Warehouse, Constituents and R&T Agent shall be required to follow for the participation,
functioning and operations of the Assayer. The Regulations relating to the approved Assayer
shall be deemed to form a part of any settlement process so provided.

FUNCTIONS OF ASSAYERS
(a) Inspect the Warehouse(s) identified by the Exchange on periodic basis to verify the
compliance of technical / safety parameters detailed in the Warehousing Accreditation norms of
the Exchange by the Warehouse(s). The compliance certificate so given by the Assayer would
form the basis of Warehouse accreditation by the Exchange.

(b) Make available grading facilities to the Constituents in respect of the specific commodities
traded on the Exchange at specified warehouse. The Assayer shall ensure that the grading to be
done, in a certificate format prescribed by the Exchange from time to time, in respect of specific
commodity shall be as per the norms specified by the Exchange in the respective Contract
specifications

(c) Grading certificate so issued by the Assayer would specify the grade as well as the validity
period up to which the commodities would retain the original grade, and the time up to which the
commodities are fit for trading subject to environment changes at the warehouses.

DUTIES OF ASSAYER(S)
(a) The issuance of the certificate of compliance by the Assayer would imply that in the event of
deterioration of quality of the commodity before the expiry of the validity period assigned by the
Assayer, the Assayer would make good the losses that may be incurred. However, the Exchange
shall not liable for any losses arising out of such cases.

(b) Assayer(s) shall not allow to store any commodity that does not meet the grading norms and
parameters specified by the Exchange and that the Assayer(s) shall make available to the
Constituents the grading certificate when the commodities are allowed to be stored in the
warehouses.

(c) Assayer(s) shall ensure that it shall at all given times maintain properly records in respect of
grading of specific commodities and validity period of the commodity in electronic form along
with the details with regard to the certificate issued by them from time to time.

INSPECTION OF GRADING FACILITIES

The Exchange reserves the right to physically verify / inspect itself or through any agencies /
experts, at any time, the grading facilities and processes of the approved Assayers as and when
felt necessary.

Committee set up for the purpose.

Clearing bankers
Following banks have agreed to act as clearing bankers:Canara BankHDFC BankICICI BankUTI
Bank

Depository participants
NCDEX has approached

Bank of Baroda
Canara Bank
Global Trust Bank
HDFC Bank
ICICI Bank
IDBI Bank
Indusind Bank
UTI Bank

CLEARING AND SETTLEMENT AT NCDEX IN A NUTSHELL

NCDEX has tied-up with NSCCL National Securities Clearing Corporation Limited) for clearing the trades Settlement
guarantee fund would be maintained and managed by NCDEX.

Contracts settlement
All open contracts not intended for delivery and non-deliverable positions at client level would
be cash settled.

Settlement period
All contracts settling in cash would be settled on the following day after the contract expiry date.
All contracts materializing into deliveries would settle in a period of 2-7 days after the expiry.
The exact settlement day would be specified for each commodity.

Are deliveries compulsory?

No. The buyer and the seller have to give delivery information. Deliveries would be matched
randomly at client level. Contracts not assigned delivery would be settled in cash

Would additional margins be levied for deliverable positions?

Yes

Settlement in commodity futures market

For open positions on the expiry day of the contract, the buyer and the seller can give intentions
for delivery. Deliveries would take place in electronic form. All other positions would be settled
in cash.

Taking physical delivery

Any buyer intending to take physicals would have to put a request to its Depository Participant,
who would pass on the same to the registrar and the warehouse. On a specified day, the buyer
would go to the warehouse and pick up the physicals.

Getting the electronic balance for the physical holdings

The seller intending to make delivery would have to take the commodities to the designated
warehouse. These commodities would have to be assayed by the Exchange specified assayer.
The commodities would have to meet the contract specifications with allowed variances. If the
commodities meet the specifications, the warehouse would accept them. Warehouses would then
ensure updating the receipt in the depository system giving a credit in the depositor's electronic
account.
Seller giving an invoice to the buyer
The seller would give the invoice to its clearing member, who would courier, the same to the
buyer's clearing member.

Accrediting warehouses
NCDEX would prescribe the accreditation norms, comprising of financial and technical
parameters, which would have to be met by the warehouses. NCDEX would take
assayer's/Structural Engineer's certificate confirming the compliance of the technical norms by
the warehouses.

Whether the accredited warehouses would be dedicated warehouses?

In case of grains/seeds, warehouses would earmark a definite storage capacity within the
warehouse premises for members of NCDEX, while in case of oils, specified tankers would be
earmarked for NCDEX participants.

Warehousing charges
The warehouse concerned would decide the warehousing charges. However, the warehouse
charges would be made available on NCDEX website

Health checks and inventory verification

The assayers and or other experts on behalf of NCDEX would carry out surprise health checks
and inventory verification.
Sales tax
Prices quoted for the futures contracts would be basis warehouse and exclusive of sales tax
applicable at the delivery center. For contracts materializing into deliveries, sales tax would be
added to the settlement amount. The sales tax would be settled on the specified day after the
payout.

How would the buyer give a declaration for re-sale in case of last point collection of tax?
The buyer intending to take delivery would give declaration for re-sale at the time of giving
intention for delivery. Accordingly the seller would issue the invoice, exclusive of sales tax. The
declaration form duly signed by the buyer would be forwarded through the buyer's clearing
member to the seller's clearing member within a specified time after pay-in and payout.

Uniformity in delivered grades / varieties

The exchange will specify, in its contract description, the particular grade / variety of a
commodity that is being offered for trade. A range will be specified for all the properties and
only those grades / varieties, which fall within the range, will be accepted for delivery. In case
the properties fall within the range, but differ from the benchmark specifications, the Exchange
will specify a premium / rebate

Premium / rebates for the difference in quality

These would be pre-defined and made available on the website. The settlement obligation would
be impacted on account of the premium / rebates in case of deliverable positions. The parameters
which would be considered for premium / rebate computation as well as the methodology would
be specified by NCDEX

Certifying / assaying agencies.

NCDEX is looking at following assayers: SGS India Pvt. Limited, Geo-Chem Laboratories, Dr.
Amin Superintendents & Surveyors Pvt Ltd., Calib Brett and Stewart. Only certificates given by
specified assayers by NCDEX will be accepted. All the certificates issued will have time validity

What happens when the commodities reach the validity date?

Those commodities will not be available for delivery on the clearing corporation. Hence the
deliverable electronic balance would be automatically reduced. Warehouse would place the
commodities in a separate area, indicating that they are not available for electronic trading.

Would commodities be accepted without assayer's certificate?

No

Can commodities be re-deposited in the warehouse after the validity period of the assayer's
certificate?
Yes, provided they are re-validated by the assayer.

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

Procedure for handling bad delivery / part delivery?

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

How would disputes be resolved?

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

COMMODITIES TRADED ON THE NCDEX PLATFORM

COMMODITIES THAT ARE TRADED ON NCDEX

NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market
Commission) but in a phased manner. Commodities traded in 1st phase.

NCDEX has approval from FMC to trade in the following commodities in the first phase

1. Bullion- Gold, Silver

2. Agricultural commodities-
3. Cotton (long and medium staple),
4. Soybean,
5. Soya oil,
6. Rape/Mustard seed,
7. Rape/Mustard oil,
8. Crude Palm Oil and RBD Palmolein.

Commodities planned to be offered for trading in 2nd phase

1. Rice,
2. Wheat,
3. Coffee,
4. Tea.
5. Edible oil products like Groundnut, Sunflower, Castor (Seed, Oil and cake)
6. Base metals (Aluminium, Copper, Zinc and Nickel)
7. Commodity indices-Agri commodity index, Metal commodity index.

THE FOLLOWING ARE THE AGRICULTURAL PRODUCTS PRESENTLY TRADING

IN NCDEX:

I. CEREALS AND PULSES

1. Barley
2. Chana
3. Maize kharif/south
 4. Maize rabi
5. Wheat

II. FIBERS
1. Kapas (Cotton)
2. 29 MM Cotton

III. GUAR COMPLEX

1. Guar seed 1 MT
2. Guar seed 10 MT
3. Guar Gum

IV. OIL AND OIL SEEDS

1. Castor seed
2. Cotton seed oilcake
3. Soy bean
4. Refined soy oil
5. Mustard oil
6. Crude oil
7. Crude palm oil

V. SOFT
1. Sugar M

VI. SPICES
1. Pepper
2. Turmeric
3. Jeera
4. Coriander

VII. GOLD: India is one of the largest importers of gold in the world with 90% of
country’s physical demand for the metal is being met from imported gold bars.
Despite being the largest consumer and biggest exporter of gold jewellery, India
remains a price taker and follows international market for its pricing in domestic
market. Domestic price of gold in India is, thus, derived from the international gold
price, rupee-dollar exchange rate and domestic market conditions, which includes
customs duty, domestic premium, etc. For physical market players with considerable
exposure to international price risks, the single most important factor that ensures
their ability to effectively hedge the risks by trading in domestic pricing. However,
since 2013, domestic market conditions and government policy interventions have
distorted the rupee price of gold resulting in drastic de-coupling of domestic market
 from international gold market, resulting in non-transparent price discovery and
imperfect hedging.

NCDEX GOLDHEDGE, launched in January 2014, marked the beginning of

country’s endeavor towards transparent price discovery in gold and re-established its
link with the international market GOLDHEDGE offered a simple and transparent
mechanism for calculating price of gold in the country based on international price of
gold and RBI reference rate irrespective of domestic market conditions. This clarity
and transparency in traded prices ensured that domestic prices continuously moved in
tandem (cycle) with international prices, with little scope for manipulation and made
GOLDHEDGE the perfect and most efficient risk management tool for hedgers in the
country. GOLDHEDGE was, however, introduced as an intention matching contract.

PRECIOUS METALS
Gold: Gold's importance in world markets and responsiveness to world events make gold futures
and options an important risk management tool and exciting, potentially rewarding opportunity
for investors who seek to profit by correctly anticipating price changes. Perhaps no other market
in the world has the universal appeal of the gold market.

Gold futures and options provide an important alternative to traditional means of investing in
gold such as bullion, coins, and mining stocks. Gold futures contracts are also valuable trading
tools for commercial producers and users of the metal. Furthermore, gold has traditionally had a
role in investment strategies, and gold futures and options can be found in investors' portfolios.
Gold is a vital industrial commodity. It is an excellent conductor of electricity, is extremely
resistant to corrosion, and is one of the most chemically stable of the elements, making it
critically important in electronics and other high-tech applications. India is the world's largest
gold consumer with an annual demand of 800 tons.

The principal gold producing countries include South Africa, the United States, Australia,
Canada, China, Indonesia, and Russia.. Gold prices float freely in accordance with supply and
demand, responding quickly to political and economic events.

Silver: Silver, pleasing to the eye and easy to work with, has attracted man's interest for
thousands of years. Today, silver is sought as a valuable and practical industrial commodity, and
as an appealing investment. The largest industrial users of silver are the photographic, jewelry,
and electronic industries. As a precious metal, silver also plays a role in investment portfolios.
Mining companies, fabricators of finished products, and users of silver-content industrial
materials can use the silver futures and options contracts to manage their price risk. Just over half
of mined silver comes from Mexico, Peru and United States, respectively, the first, second and
fourth largest producing countries. The third largest is Australia.

EXPLANATION FOR AGRICULTURAL PRODUCTS TADED IN NCDEX

COTTON: Cotton refers to the ginned fibrous substance extracted from the cotton plant (cotton
bolls), which covers the underlying seed. Cotton crop is known to the world for at least 7000
years and enjoys a prime place among all agricultural commodities for multiplicity of its uses as
a fiber, protein and oil. Cotton I one of the most important textile fibers in the world, accounting
for around 35% of total world fiber use. While some 80 countries from around the globe produce
cotton, the United States, China, and India together provide two-thirds of the world’s cotton.
India, the leading producer of cotton for last 2 years, followed by China and USA, has the largest
area under cotton cultivation, accounting for 1/3 of global area under raw cotton. Cotton is the
most important raw material for the textiles industry as a whole. The Indian textiles industry,
currently estimated at around $108 billion, is expected reach $223 billion by 2021. The industry
is the second largest employer after agricultural, providing employment to over 45 million
people directly and 60 million people indirectly. The Indian textile industry contributes
approximately 5% to India’s Gross Domestic Product (GDP), and 14% to overall Index of
Industrial Production (IIP).

Raw cotton is majorly grown in Gujarat followed by Maharashtra, Telangana, Andhra Pradesh,
Karnataka, Haryana, MP and Punjab.
Settlement of a contract depends on the delivery logic of a particular commodity. Delivery logic
is specified as a part of contract specification and list of contracts expiring in the particular
month are informed to the market vide a circular pertaining to Settlement Calendar and
submission of delivery Intentions giving details about the delivery logic. Delivery logic defines
the method of physical settlement, penalties for delivery default, timelines for submission of
delivery intentions etc. Before trading in a particular commodity market participants are advised
to take note of the delivery logic of a commodity. Following are different types of delivery logic
applicable for commodities traded on our Exchange. 1. Compulsory with Staggered Delivery 2.
Sellers Option with Staggered Delivery 3. Sellers Option 4. Intention Matching

Intention matching: In these types of commodities option is given to both, the seller as well as
the buyer to give their intention to give/take physical delivery. In case of intention is received
from both the seller and the buyer and their intentions are matching for quantity, delivery
location etc. their open position would result in physical delivery. In case of open positions for
which either intentions are received from both the parties or which remains unmatched, these
position would be cash settled.

Sellers & Buyers having open positions are required to give their intention/notice to deliver to
the extent of their open position.

The matching for deliveries would take place firstly, on the basis of locations and then randomly
keeping in view the factors such as available capacity of the vault/warehouse, commodities
already deposited and dematerialized and offered for delivery and any other factor as may be
specified by the Exchange from time to time. Buyer’s defaults are not permitted in any of the
contracts. The amount due from the buyers shall be recovered as Pay in shortage along with the
prescribed charges. Exchange shall have right to sell the goods on account of such Buyer to
recover the dues and if the sale proceeds are insufficient, the Buyer would be liable to pay the
balance. A seller who has got requisite stocks in the Exchange approved warehouses is not
allowed to default and any such delivery default by seller would be viewed seriously and the
Exchange shall take suitable penal / disciplinary action against such members over and above the
prescribed penalty as enumerated above. - refer circular 161 & 203 of 2012 Further, any delivery
default after marking an intention during staggered delivery period by seller would be viewed
seriously and the Exchange may take suitable penal / disciplinary action against such members in
addition to the penalty prescribed for delivery defaults - Refer circular no. 237 of 2012
Settlement calendar issued every month specify the exact timelines and other details pertaining
to settlement of all contracts expiring in that month. Market participants are requested to refer to
product note of respective commodity as well as physical delivery guide available on our website
for further details.

SILVER: India imports its entire silver requirements. Rajasthan, Gujarat and Jharkhand are the
three silver producing states. Production ranges from 15 MT to 55 MT. Annual demand for silver
in India is close to 2500MT -3200MT comprising 50% demand from Industry, 39% from
Jewelry and silverware, 9% from coins and 1% each from photography and net implied
investment. 77.1% of the total demand is met through imports, 18.8% from secondary silver and
2.5% from Hindstan Zinc which is the largest producer of silver in India. India is world’s largest
immport of silver. Most of the import close to 50% is from China.
UNIT-4: TRADING PARAMETERS
Trading parameter in commodities market refers to constraints which indicates contract
specifications to the members and clients of commodity exchange. Members and clients should
follow the contract specifications. The following are the generally used contract specifications:

Order types: One of the most important pieces of information you need to indicate in a
commodity transaction is the order type. This indicates how you want your order to be placed
and executed.

Order Type What It Means

Fill or kill (FOK) Use this order if you want your order to be filled right away
at a specific price. If a matching offer isn’t found within
three attempts, your order is cancelled, or
“killed.”

Limit (LMT) A limit order is placed when you want your order to be filled
only at a specified price or better. If you’re on the buy
side of a transaction, you want your limit buy order placed at or
below the market price. Conversely, if you’re on the sell
side, you want your limit sell order at or above market price.

Market (MKT) A market order is perhaps the simplest type of order. When you
choose a market order, you’re saying you want your order
filled at the current market price.

Market if touched (MIT)
A market if touched order sounds intimidating, but it’s
not. When you place an MIT, you specify the price at which you want
to buy or sell a commodity. When that price is reached (or
“touched”), your order is automatically filled at the
current market price. A buy MIT order is placed below the market; a
sell MIT order is placed above the market. In other words, you buy
low and sell high.

Market on close (MOC) When you place a market on close order, you’re selecting
not a specific price, but a specific time to execute your order.
Your order is executed at whatever price that particular commodity
happens to close at the end of the trading session.
Stop (STP) A stop order is a lot like a market if touched order because
your order is placed when trading occurs at or through a specified
price. However, unlike an MIT order, a buy stop order is placed
above the market, and a sell stop order is placed below market
levels.

Stop close only (SCO) If you choose a stop close only order, your stop order is
executed only at the closing of trading and only if the closing
trading range is at or through your designated stop price.

Stop limit (STL) A stop limit order combines both a stop order and a limit
order. When the stop price is reached, the order becomes a limit
order and the transaction is executed only if the specified price
at which you want the order to go through has been reached.

“Buy ten June 2011 CME/COMEX Gold at $1,380 Limit Day Order.” This means you’re
buying ten contracts for gold on the CME/COMEX (the metals complex of the CME), with a
delivery date of June 2011. You’re willing to pay $1,380 per troy ounce per contract or better.
Because this is a day order, if your order isn’t filled by the end of the trading day, it will expire.

LOT SIZE: Lot size refers to the quantity of an item ordered for delivery on a specific date. In
financial markets, lot size is a measure or quantity increment suitable to or précised by the party
which is offering to buy or sell it. A simple example of lot size is: when we buy a pack of six
chocolates, it refers to buying a single lot of chocolate.

In the stock market, lot size refers to the number of shares you buy in one transaction. In options
trading, lot size represents the total number of contracts contained in one derivative security. The
theory of lot size allows financial markets to regulate price quotes. It basically refers to the size
of the trade that you make in the financial market. With the regulation of prices, investors are
always aware of exactly how many units they are buying of an individual contract and can easily
assess what is the price they are paying for each unit.

Number of base/quotation price of commodities comprises one lot or number of contracts forms
one lot size. For example,

Trading unit of gold = 1 kilograms = 1000 grams

Quotation/base value = 10 grams
Then, lot size = 1000 grams/10 grams = 100
MCX NCDEX Lots size
Commodity Quotation/base Symbol Tick size Trading Unit Lot size Delivery center

Metal futures- Mega

Gold 10gm GOLD 1.00 1Kg 100 Mumbai/ Ahm’bad

Silver 1Kg SILVER 1.00 30Kg 30 Ahmedabad

Copper 1Kg COPPER 0.05 1MT 1000 Mumbai

Nickel 1Kg NICKEL 0.10 250Kg 250 Bhiwandi

Lead 1Kg LEAD 0.05 5MT 5000 Bhiwandi

Aluminium 1Kg ALUMINUM 0.05 5MT 5000 Bhiwandi

Zinc 1Kg ZINC 0.05 5MT 5000 Bhiwandi

Metal Futures-Mini

Gold Mini 10gm GOLDM 1.00 100gm 10 Ahmedabad

Gold Guinea 8gm GOLD GUINEA 1.00 8gm 1 Ahmedabad

Gold PETAL 1gm GOLD Petal 1.00 1gm 1 Mumbai

Silver Mini 1Kg SILVERM 1.00 5Kg 5 Ahmedabad

Silver Micro 1Kg SILVERMIC 1.00 1Kg 1 Ahmedabad

Copper Mini 1Kg COPPER 0.05 250Kg 250 Ahmedabad

Nickel Mini 1Kg NICKEL 0.10 100Kg 100 Bhiwandi

Lead Mini 1Kg LEAD 0.05 1MT 1000 Bhiwandi

Zinc Mini 1Kg ZINC 0.05 1MT 1000 Bhiwandi

Aluminium Mini 1Kg ALUMINI 0.05 1MT 1000 Bhiwandi

Energy Futures-MCX

Crude Oil 1BBl CRUDEOLL 1.00 100BBl 100 Mumbai

Natural Gas 1 mmBtu NATURAL GAS 0.10 1250mmbtu 1250 Hazira

Agriculture Futures -Cereals & Pulses & soft

Barley (NCDEX) 1Quintal BARLEYJPR 0.50 10MT 100 Jaipur

Chana (NCDEX) 1Quintal CHARJDDEL 1.00 10MT 100 Delhi

Maize (NCDEX) 1Quintal MAIZYRNZM 1.00 10MT 100 Nizamabad

Wheat (NCDEX) 1Quintal WHTSMQDELI 1.00 10MT 100 Delhi

Sugar-M200(NCDEX) 1Quintal SUGARM200 1.00 10MT 100 Kolhapur

Gur (NCDEX) 40Kg GURCHMUZR 0.50 10MT 250 Muzaffarnagar

Agriculture Futures – Spices

Cardomom (MCX) 1Kg CARDOMOM 0.10 100Kg 100 Vandanmedu

Pepper (NCDEX) 1Quintal PPRMLGKOC 5.00 1MT 10 Kochi

Chilli (NCDEX) 1Quintal CHLL334GTR 2.00 5MT 50 Guntur

Coriander (NCDEX) 1Quintal DHANIYA 1.00 10MT 100 Kota

Turmeric (NCDEX) 1Quintal TMCFGRNZM 2.00 5MT 50 Nizamabad

Jeera (NCDEX) 1Quintal JEERAUNJHA 2.50 3MT 30 Unjha

Agriculture Futures -Oil & Oil seeds

CrudePalmOil (MCX) 10Kg CPO 0.10 10MT 1000 Kandla

Ref. Soya Oil (NCDEX) 10Kg REFSOYOIL 0.05 10MT 1000 Indore

Soybean (NCDEX) 1Quintal SYBEANIDR 0.50 10MT 100 Indore

Mustard seed (NCDEX) 1 Quintal RMSEED 1.00 10MT 100 Jaipur

Castor seed (NCDEX) 1Quintal CASTORDSA 1.00 10MT 100 Deesa

Agriculture Futures -Industrial commodities

Guargum (NCDEX) 1Quintal GARGUMJDR 0.10 1MT 100 Jodhpur

Guarseed (NCDEX) 1Quintal GARSEDJDR 1.00 1MT 100 Jodhpur

Kapas (MCX) 20Kg KAPAS 0.10 4MT 200 Surendranagar

Cotton (MCX) 1Bale COTTON 1.00 25 bales 25 Rajkot

Mentha Oil (MCX) 1Kg MENTHAOIL 0.10 360Kg 360 Chandausi

KapasKhali (NCDEX) 1Quintal COCUDAKL 1.00 10MT 100 Akola

Rubber (NMCE) 1 Quintal RUBBERF 1.00 1MT 10 Kochi

Coffee (NMCE) 1 Quintal COFERF 0.50 1.5MT 15 Kushalnagar

Agriculture Futures – Others

Potato (NCDEX) 1Quintal POTATO 0.10 15MT 150 Agra

Potato (MCX) 1Quintal POTATO 0.10 30MT 300 Agra

TICK SIZE: The price of a financial instrument may vary based on the supply and demand
for that financial instrument. In trading, tick size (tick movement, tick data) is the smallest
amount of price can change when the market trend is up or down. For example if the tick size is
Re.1 per 10 grams of gold means, there will be a increase or decrease Rs. 1 per 10 grams of gold
depending upon the up or down in the market. This is the price difference between buy price and
sell price. If the buy price and sell price is Rs. 1500 and 1512 respectively and if the tick size is
Rs. 1, then the tick price of a commodity would be Either Rs. 1499 or Rs. 1501.

When trading commodities we calculate their price moves using a measurement called ticks. A
tick is, therefore, the smallest possible price change for any commodity-based instrument and the
size of a tick will be unique to each instrument in question.

For example, if 10 grams of gold is trading at Rs. 18,000 and moves to Rs. 18,001 , we say the
market moved one tick. If a barrel of crude oil is trading at Rs. 6,300 and moves to Rs. 6,301,
again we say it moved one tick. Therefore for these markets, a one tick movement simply refers
to a one cent movement in price.

However, other instruments do not move in 1c movements. For example, soft commodities such
as wheat, corn and soybeans all move in 25c increments. So let’s say wheat moved from $690.50
per (100) bushel to $690.75 we say it has moved 1 tick. If soybeans moved from 1541.50 to
1542.00, we say it moved two ticks and so on.

Calculating the value of 1 Tick Movement

So to calculate the value of a tick move we simply multiply our position size by one tick. So let’s
take crude oil as an example. If we buy 100 barrels of crude oil and the price per barrel rises by
Rs. 2 then our position profits by Rs. 200 (100 * 2). If we buy 500 barrels of crude oil that means
every time the price rises by Rs. 2 we make Rs. 1000. Therefore the size of our position dictates
the monetary value for each tick move.

Tick size is the minimum price change between different bid and offer prices of an asset traded
on an exchange platform. It is the minimum price difference that must exist at all times between
consecutive bid and offer prices. In other words, it is the minimum increment in which prices can
change. For example, if a stock has a tick size of Rs 0.05 and if the last traded price (LTP) was
Rs 100, then the next five best bid prices for the stock shall be Rs 99.95, Rs 99.90, Rs 99.85, Rs
99.80 and Rs 99.75. In this instance, the bid price cannot be Rs 99.87, say, as it does not meet the
tick size of Rs 0.05.

Description: Suppose the LTP of a stock is Rs 100, i.e. last time the stock traded at Rs 100 on a
particular exchange, say the National Stock Exchange or NSE, and the tick size is Rs 0.05.

At the LTP of Rs 100, the bid-offer window of the stock shall look something like this:
In the above table we can see that the best bid price is Rs 99.90, instead of Rs 99.95, even though
the LTP is Rs 100. This is because there is no bid at Rs 99.95, i.e. the quantity bid at Rs 99.95 is
zero. Similarly, there is no offer price at Rs 100.15 after Rs 100.10, instead the next best offer
price is Rs 100.10, i.e. again the quantity offered at Rs 100.15 is zero.

Thus, whenever there is no quantity bid at a particular price, that particular price is not shown in
the bid column, instead the price at the next tick (i.e. 0.05) is shown. This goes on till a
maximum of five bid prices are visible in the column. A similar logic applies to the offer price
column.

QUANTITY FREEZE: Stock exchanges around the world introduce rules and regulations
from time to time in order to protect and sustain the market activity in the long-run. One such
rule is Quantity Freeze. It helps to regulate the flow of orders within a certain specified quantity
and avoid flash moves in either direction. Any order size above the pre-defined limits will be
automatically canceled by NSE and the limits available in the client ID will be blocked for the
rest of the day to ensure that such breaches do not occur.

Logic of Quantity Freeze:

In a busy marketplace in which transactions are happening every split second, things can go
haywire if the flow is disrupted by disproportionately large buy/sell orders. Whether these orders
are placed by large non-institutional players, rogue traders or it happens by accident, it can affect
the short-term prices of the underlying derivative contract. For instance, assume that a trader
sends an order to sell/short 25,000 Nifty Bank futures by mistake instead of 250. Let’s also
assume that he has the limits in his account to fulfill the margin for that trade. By mistake, he
would’ve put himself at huge risk and in the process disrupted the order flow for other traders.
This is referred to as a fat finger trade and we’ve seen such errors happen in the markets before.
A quantity freeze ensures that such mishaps do not happen and trading activity goes on as usual.
If traders want to buy or sell large quantities beyond the freeze limits, then they will have to slice
it into smaller orders.
Benefits of Quantity Freeze:
• Smooth order flow.
• Better liquidity (Large orders will have to be sent in smaller quantities).
• Better execution
• Avoids accidents (Fat finger trades)
• Discourages the formation of dark pools (As institutions don’t have the incentive to hide from
large HFT to some extent).

Information on Quantity freeze limits:

From time to time when there are revisions in the quantity freeze limits, NSE publishes these
revisions via circulars This information is available to you and you can access them at any time.
Here is a sample. Often, this is received on short notice and the limits can change based on the
exchange’s internal checks. Below is a screenshot of the above circular for your reference.

BASE PRICE: The price which market offers you to buy the commodity is called bases price
or quotation price. This price will quote on the base/quotation value of a commodity. For
example, Rs. Per 10 grams of gold, Rs. Per quintal, Rs. Per ton, Rs. Per 1 k.g. etc.

The base value is also called as agreed or strike price which is predetermined based on the
current market conditions. The future price of a commodity may vary. The profit or loss from
trading a commodity may come to know by taking the difference between base price and future
spot price. The future price may more than the base price or less than base price (current market
price).

The spot price or base is the current market price at which an asset is bought or sold for
immediate payment and delivery. It is differentiated from the forward price or the futures price,
which are prices at which an asset can be bought or sold for delivery in the future.
How it works (Example):

On November 29, 2010, the spot price of gold was $1,367.40 per ounce on the New York
Commodities Exchange (COMEX). That was the price at which one ounce of gold could be
purchased at that particular moment in time. The spot price for a bushel of wheat was about
$648 on the same day.

On November 29, 2010, the futures price for an ounce of gold to be delivered in December 2011
was $1,373.20. The futures price for December 2011 delivery of a bushel of wheat was about
$764.

Large differences between the spot price and the futures price can exist because the market is
always trying to look ahead to predict what prices will be. Futures prices can be either higher or
lower than spot prices, depending on the outlook for supply and demand of the asset in the
future.

Why it Matters:

The spot price is important in and of itself because it is the price at which buyers and sellers
agree to value an asset. But spot price becomes an even more important concept when it's viewed
through the eyes of the $3 trillion derivatives market.

Spot prices are continually changing -- they fluctuate according to varying supply and demand.
To mitigate the risk of continuously changing prices, investors created derivatives. Derivatives
such as forwards, futures and options allow buyers and sellers to "lock in" the price at which they
buy or sell an asset in the future. Locking in prices with derivatives is one of the most common
ways investors reduce risk.

PRICE RANGES: Where the price of a commodity or financial assets like shares and
debentures are not mentioned or not disclosed or not yet decided but their price ranges are given.
The price of a of a commodity is discovered through a certain mechanism. In book building
mechanism the price of a commodity or financial asset is decided through auction within price
ranges.

For example, the price range of a barrel of crude oil is Rs. 6,500 – 6,800.
ORDER ENTRY: The members or clients in commodity market can place an order through
proper channel. To place an order the participant should visit the website of a authorized
commodity brokers’ website and should fill the order by providing necessary information.

New order (commodity)

To place an order in Commodity segment, select 'Commodity Market' in Order Entry drop-down
field given in Order Entry section. The various fields given in Order Entry for Commodity
Market are as follows:

1. Exchange - Choose the exchange where you want to place the current order. You may
select 'MCX' and 'NCDEX'.

2. Symbol - Enter the internal symbol of the commodity underlying in which you would
like to trade. You need to first use "Magnifier" icon to find and update the internal
symbol of the desired scrip. Note! Fields related to underlying like Weight Unit, Price
Unit, Expiry Date etc will only be populated once you search the underlying and update it
in Symbol field. To know on how to search the desired commodity underlying, click
here...

3. Expiry Date - Expiry Date is non-editable field and displays the respective expiry dates
of the commodity underlying selected by you in 'Symbol' field.

4. Buy / Sell - Now, select whether you like to place the Buy / Sell order.

5. Product Type - You need to select the product in which you wish to place this order.
Currently only 'Carry Forward' option is available.

6. Lot - You need to enter the number of lots that you wish to buy. Note! In equities, you
need to enter the quantity in multiple of lot size. But in commodities, you only need to
enter the number of lots. The system automatically converts the lots into quantity. For
ex., if you wish to place an Order in MCX Gold contract whose price unit is 10 grams
and delivery unit is 1 Kg. Thus the lot size becomes (1000 grams / 10 grams= 100). So
 instead of entering 100, you need to enter '1' if you intend to place order for one lot.

7. Total Wt (Delivery Unit)- This is a non-editable field which will display the total weight
of your order. For ex., if you are placing order for 1 lot of Gold contract in MCX, the
system will display weight as 1 Kg. The unit of weight is shown in the caption.

8. Order Type - Next, you need to select whether you like to place the order at the desired
price or wish to trade at the current market price. To trade at the current market price,
choose 'Market' option from the drop-down box. Alternatively, you can
choose 'Limit' option and enter the price in the text box displayed to place the order at the
pre-decided price.

9. Disc Lot- This option is very useful in case you are placing a bulk quantity and do not
wish to disclose the same in the Order Book. To place such order, enter the quantity that
you wish to disclose to the counterparties and the same will be visible in the order book.
For example: if you place an order of 100 lots and put the disclosed quantity as 10, then
the order book will show 10 as quantity while 90 lots remain undisclosed. Once these 10
lots are traded, the next tranche of 10 lots will be displayed at the same price and so on...

10. Disc Wt (Unit) - This is a non-editable field which will display the weight of the
Disclosed Lot.

11. Trigger Price (Stop Loss) -Trigger Price is the price at which you wish to trigger a
particular order into the market. This field is also used to place Stop-loss order to limit
your losses in the existing positions. Below are the examples of Stop Loss Sell and Stop
Loss Buy orders for better understanding:

a) Stop Loss Sell Order - Mr. X has previously purchased Gold MCX @ Rs.19000 in
expectation that the price will rise. However, in case of price fall, 'Mr. X' would like to
limit his losses by selling the contract. Thus, he may place a Stop Loss Sell Order
specifying a trigger price of Rs. 18900 and a limit price of Rs. 18880. Do remember that
the Stop Loss Trigger Price has to be between the Limit Price and the Last Traded Price
at the time of placing the Stop Loss Sell Order. As soon as Gold contract's Last Traded
Price falls below 18900, a limit sell order for Gold @ Rs.18880 will get activated.

b) Stop Loss Buy order - Mr. X has sold Gold MCX contract @ Rs.19000 during the day
in expectation that the price will fall. However, in case of price increase, 'Mr. X' would
like to limit his losses by buying back the contract. Thus, he may place a Stop Loss Buy
Order specifying a trigger price of Rs. 19100 and a limit price of Rs. 19120. Do
remember that the trigger price has to be between the last Traded Price and Buy Limit
Price at the time of placing Stop Loss Buy Order. As soon as Gold last traded price rises
above Rs. 19100, a limit order for Gold @ Rs. 19120 will get activated.

12. Order Term - In this field, you can choose the time duration for which you wish to place
the order in the market. You can choose – 'Day' to place the order that will remain valid
till End of Day. Alternatively, you can choose 'IOC' to place order that will either get
 confirmed Immediately or else will be cancelled.

13. Confirm - Once you enter all the transaction details, click on “Confirm” button to
execute the order.

14. Reconfirm - The system asks you to reconfirm the transaction details to ensure you only
give the correct order. When you click on 'Confirm' button,

CONTRACT SIZE: Contract size is the deliverable quantity of commodities or financial

instruments underlying futures and options contracts that are traded on an exchange. These
contracts trade with margin requirements and daily settlement. The contract size is standardized
for such futures and options contracts so that buyers and sellers know the exact quantity and
specification of what they are buying and selling. Contract size varies depending on the
commodity or instrument that is traded. The contract size also determines the dollar value of a
unit move in the underlying commodity or instrument.

There are many different ways to trade commodities and financial instruments. The most popular
way is between banks themselves in a practice called over-the-counter (OTC) trading, wherein
the transaction occurs between the institutions directly and not on a regulated exchange. These
same commodities and financial instruments can also be traded on a regulated exchange.
Exchange houses use contracts as a way to standardize the instruments being traded. This
reduces costs and improves trading efficiencies. Part of the standardization process includes
specifying a contract size.

For example, the contract size of most equity option contracts is 100 shares. However, in case
crude oil dealt in MCX, the contract size may be 100 barrels. Cotton bales dealt in NCDEX, the
contract size is 25 bales.

Specifying the contract size has both advantages and disadvantages for traders. One key
advantage is that the users are clear about their obligations. If a farmer sells three soybean
contracts, for example, then she understands that she needs to supply 15,000 bushels and will be
paid the exact dollar amount that is specified by the contact size. One key disadvantage of the
contract size is that it is not amendable. These contracts are standardized. So if a food producer
needs 7,000 bushels of soybeans, he will either have to buy one contract for 5,000 (leaving him
2,000 short) or buy two contracts for 10,000 bushels (leaving him a surplus of 3,000). It is not
possible to modify the contract size in the same way as in the over-the-counter market. In the
OTC market, the amount of product being traded is much more flexible, which can come at a
higher cost for the same product.

EXERCIE PRICE: The exercise price is the price at which an underlying security can be
purchased or sold when trading a call or put option, respectively. The exercise price is the same
as the strike price of an option, which is known when an investor takes a trade. An option gets its
value from the difference between the fixed exercise price and the market price of the underlying
security

"Exercise price" is a term used in derivatives trading. A derivative is a financial instrument based
on an underlying asset. Options are derivatives, while the stock, for example, refers to the
underlying. In options trading, there are calls and puts.

In finance, the strike price (or exercise price) of an option is the fixed price at which the owner
of the option can buy (in the case of a call), or sell (in the case of a put), the
underlying security or commodity. The strike price may be set by reference to the spot
price (market price) of the underlying security or commodity on the day an option is taken out,
or it may be fixed at a discount or at a premium.

The strike price is a key variable in a derivatives contract between two parties. Where the
contract requires delivery of the underlying instrument, the trade will be at the strike price,
regardless of the market price of the underlying instrument at that time.

Order types: IOC, SL, SLM, GTC, Regular, Limit)

EXPIRATION PRICE: contracts specify the expiration date as part of the contract
specifications. An expiration date in derivatives is the last day that a derivative, such
as options or futures, is valid. On or before this day, investors will have already decided what to
do with their expiring position.

Before an option expires, its owners can choose to exercise the option, close the position to
realize their profit or loss, or let the contract expire worthless.

Futures traders holding the expiring contract must close it on or before expiration, often called
the "final trading day," to realize their profit or loss. Alternatively, they can hold the contract and
ask their broker to buy/sell the underlying asset that the contract represents. Retail traders don't
typically do this, but businesses do. For example, an oil producer using futures contracts to sell
oil can choose to sell their tanker. Futures traders can also "roll" their position. This is a closing
of their current trade, and an immediate reinstitution of the trade in a contract that is further out
from expiry.

Expiration Date (Derivatives): Expiration dates, and what they represent, vary based on the
derivative being traded.

The expiration date for listed stock options in the United States is normally the third Friday of
the contract month or the month that the contract expires. On months that the Friday falls on a
holiday, the expiration date is on the Thursday immediately before the third Friday. Once an
options or futures contract passes its expiration date, the contract is invalid. The last day to trade
equity options is the Friday prior to expiry. Therefore, traders must decide what to do with their
options by this last trading day.

Some options have an automatic exercise provision. These options are automatically exercised if
they are in the money (OTM) at the time of expiry. If a trader doesn't want the option to be
exercised, they must close out or roll the position by the last trading day.

Index options also expire on the third Friday of the month, and this is also the last trading day
for American style index options. For European style index options, the last trading is typically
the day before expiration.

POSITION LIMITS: A position limit is a preset level of ownership, or control, of derivative

contracts – like options or futures – that a trader, or affiliated group of traders, may not exceed.
Position limits are established by the U.S. Commodity Futures Trading Commission (CFTC) to
ensure that no single trader, or group of traders, can exert outsized control on any one financial
asset using derivatives.

Purpose of Position Limits

Position limits are ownership restrictions that most individual traders are never going to need to
worry about breaching. Most position limits are simply set too high for an individual trader to
reach. However, individual traders should be grateful these limits are in place because they
provide a level of stability in the financial markets by preventing large traders, or groups of
traders, from manipulating market prices using derivatives.

For instance, by buying call options or futures contracts, large investors, or funds, can build
controlling positions in certain stocks or commodities without having to buy actual assets
themselves. If these positions are large enough, the exercise of them can change the balance of
power in corporate voting blocks or commodities markets, creating increased volatility in those
markets.
How Position Limits are Determined

Position limits are determined on a net equivalent basis by contract. This means that a trader who
owns one options contract that controls 100 futures contracts is viewed the same as a trader who
owns 100 individual futures contracts. It's all about measuring the control a trader can exert over
a market.

Position limits are applied on an intraday basis. While some financial rules apply to the number
of holdings, or exposure, a trader has at the end of the trading day, position limits are applicable
throughout the trading day. If at any time during the trading day, a trader surpasses the position
limit, she will be in violation of the limit.
UNIT-5: HEDGING TECHNIQUES
Hedging is a trading operation that allows a person to transform a less acceptable risk into
a more acceptable one. Commodity trading gives opportunity to the traders for investment and
risk management through different strategies like hedging, speculation and arbitrage. Most of
those who participate in the futures or options markets can be categorized broadly into one of
two groups hedgers and speculators depending on whether they are trying to transfer or accept
risk. Brokers are intermediaries who carry out buying and selling instructions from hedgers or
speculators.

Hedging is often considered an advanced investing strategy, but the principles of hedging are
fairly simple. With the popularity – and accompanying criticism – of hedge funds, the practice of
hedging became more widespread. Despite this, it is still not widely understood.

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a
hedge consists of taking an offsetting position in a related security.

HEDGING

Commodity trading involves sizable price risks (due to volatile prices in the cash markets),
which may affect the value of the underlying commodity. Hedging is a strategy used in the
futures markets to protect one’s asset from adverse price changes and minimize risks.
Hedging does not necessarily improve the financial outcome; indeed it could make the outcome
worse. What it does however is, that it makes the outcome more certain. Hedgers could be
Government institutions, private corporations like financial institutions, trading companies and
even other participants in the value chain for instance farmers, extractors, ginners, processors
etc., who are influenced by the commodity prices. Example: A company orders a commodity at a
price of USD 300 per tonne. The commodity will be delivered after 8 weeks to the receiving
port. If the price, during the period, increases to USD 310 per tonne, the company would have
made a gain. However, if the price falls to USD280 per tonne, the company would incur a loss.
The company hedges its position by taking a put option on the same commodity at say, USD 300
per tonne for the same date.

If the price indeed falls to USD 280, the company exercises its option and offsets its losses (The
company buys an equivalent amount in the spot market and gains USD 20 per tonne. This offsets
the losses due to fall in price during the delivery period). If the prices, on the other hand go up to
say, USD 310 per tonne, the company will choose not to exercise the option and will lose only
the premium. The option premium is thus an insurance against losses. A company that wants to
sell an asset at a particular time in the future can hedge by taking short futures position. This is
known as futures hedge. If the price of the asset goes down, the company does not fare well on
the sale of the asset but makes a gain on the short futures position. If the price of the asset goes
up, the company gains from the sale of the asset but takes a loss on the futures position.
Similarly, a company that knows that it is due to buy an asset in the futures can hedge by taking
long futures position. This is known as long hedge Example:

A poultry farmer’s objective is to raise and sell broiler birds at a price that would give him the
most profit. His risk is declining broiler prices. To offset (minimize) this risk, he could sell
futures contracts. If broiler prices fall, he could then buy back the futures contracts at a price
lower than he previously sold them. The subsequent gain on this futures transaction would help
offset his cash loss, thus minimizing his risk. (In this case, if he sold futures and prices rose, he
would lose money on the futures transaction, but gain on the spot transaction).Whereas the
broiler farmer is the futures seller in this example, the futures buyer could be a risk taker
— a speculator who thinks that broiler prices are going to rise, or a commercial user
—such as a poultry processor, who needs broiler birds and would be adversely affected by higher
prices. A speculator is willing to accept risk in hopes of generating a profit. The commercial user
is using futures to offset the risk of possible higher bird prices.

Hedging strategies
The hedging strategies are short and long. A hedger takes a closed position where he has an asset
and liability on the same maturity date. Selling Hedge (Short)–Selling futures contracts to protect
against possible declining prices of commodities that will be sold in the future. At the time the
cash commodities are sold, the open futures position is closed by purchasing an ―equal number
and type of futures contracts as those that were initially sold. Example. If a company knows that
it is due to sell an asset at a particular time in the future, it hedges by taking a short futures
position. If the price of the asset goes down the sale results in a loss to the company but it makes
a gain on the short futures market. If the price of the asset goes up the company gains from the
sale of the asset but makes a loss on the short futures position. Purchasing (Long) Hedge
–
Buying futures contracts to protect against a possible increase in the price of cash commodities
that will be purchased in the future. At the time the physical commodities are bought, the open
futures position is closed by selling an ―equal number and type‖ of futures contracts as those
that were initially purchased. This is also referred to as a buying hedge.

Hedge Ratio
The Hedge Ratio is defined as the ratio of the size of the position taken in futures contract o the
size of the exposure. Let,

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

∆F be the change in futures price, P during the life of the hedge
σS be the standard deviation of ∆S
σF be the standard deviation of ∆F
ρ be the coefficient of correlation between ∆S and ∆F
h be the hedge ratio
When the hedger is long on the assets and short on futures (short hedge), the change in value of
the hedger’s position during the life of the hedge is

∆S – h ∆F

For a long hedge, it is h ∆F-∆S

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

V = (σS)2 + (h)2 (σF)2 – 2 h ρ (σS) (σF)

The variance is minimized when

h = ρ (σS) (σF)

If these two are perfectly correlated, ie., ρ=1, ρ (σS) (σF)

When the futures price mirrors the spot price perfectly, σS= σF and h = 1.0

Example: A company will buy 100,000 tons of soy-bean in three months. The standard deviation
of the change in price per ton over a three- month period has been calculated as 0.072. The
company hedges by buying futures contracts. The standard deviation of the change in futures
price is 0.08 over a three-month period. The coefficient of correlation between the three month
change in spot prices and futures prices is 0.9. The optimal hedge ratio will be

h = 0.9 x 0.072/ 0.08 = 0.81

If one futures contract is for 1000 tons, the company needs to buy0.81 x 100,000/ 1000 = 81
contracts.

Roll Over
Hedges can be rolled forward. When the expiration date of the hedge is later than the delivery
dates of the future contracts, the hedger closes out the futures contracts entered into and takes the
same position in futures contracts with a later delivery date. Hedges can be rolled forward many
times. However, multiple rollovers could lead to short-term cash flow problems.
Basis Risk
The limitations of hedging give rise to basis risk. The basis in a hedging situation is defined as
the difference between the current cash price and the futures price of the same commodity.
Unless otherwise specified, the price of the nearby futures contract month is used to calculate the
basis.Basis = Spot price of asset to be hedged less futures price of contract. When the spot price
increases by more than the futures price, the basis increases which is referred to as strengthening
of the basis. When the futures price increases by more than the spot price the basis declines. This
is referred as weakening of the basis. Example of Hedging A farmer intends to plant 10 acres of
Soybean in June and is willing to forward sell 50 percent of his anticipated production before
planting (expected yield is 400 kgs/acre and estimated total production is 4 tons). Only a portion
of the expected crop is hedged due to production uncertainty. Delivery is expected in mid-
September. The farmer estimates basis to be Rs. 25/ton under the November contract price in
mid-September. The farmer places an order to sell 2 November futures contracts (2 ton) on June
15. This is referred to as a forward pricing hedge. The farmer delivers and sells the harvested
soybean crop on September 15. Also on September 15, the farmer buys back the 2 November
soybean futures contracts at the current price of Rs.14, 250/ton, offsetting his/her position in the
futures market.

Date Market price November Basis

June 15 Implied Rs. Rs. 14,025/ton Anticipated Rs.
14,000/ton 25/ton

Forward Price Hedge: Soya bean seed

Date Action Cash Position Futures Position basis
June 15 Plant Soya Expected 4 Sell 2 November Anticipated Rs. 25/ton
bean sell tons Futures contract @
50% of production. Rs. 14,025/ton
expected Hedge 2 tons at
production expected price
on of Rs.
November 14,000/ton (Rs.
Futures 14,025-bases
Rs. 25/ton)
September Sell cash Sell 2 tons @ Buy 2 November Rs. 25/ton
15 Soya bean Rs. 13,700/ton soya bean @ Rs.
seed offset 13,700/ton
futures
position
Gains/losses Loss: Rs. Gain Rs. 300/ton No change
300/ton
(relative to
expectation)

Final Outcome: The net price received on the 4 ton of Soybean hedged is Rs.14,000/t.
(Rs.13,700/ton from the cash sale plus a Rs. 300/ton gain on the futures position).If all 4 ton of
production are sold on September 15, the average price for the total crop is Rs.13,850/t. (average
of Rs.14,000/t for the hedged portion and Rs.13,700/t for the un-hedged portion)

LONG HEDGE: A long hedge refers to a futures position that is entered into for the purpose of
price stability on a purchase. Long hedges are often used by manufacturers and processors to
remove price volatility from the purchase of required inputs. These input-dependent companies
know they will require materials several times a year, so they enter futures positions to stabilize
the purchase price throughout the year. For this reason, a long hedge may also be referred to as
an input hedge, a buyers hedge, a buy hedge, a purchasers hedge or a purchasing hedge.

A long hedge represents a smart cost control strategy for a company that knows it needs to
purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is
quite simple, with the purchaser of a commodity simply entering a long futures position. A long
position means the buyer of the commodity is making a bet that the price of the commodity will
rise in the future. If the good rises in price, the profit from the futures position helps to offset the
greater cost of the commodity.

Example of a Long Hedge

For a simplified example of a long hedge, assume it is January and an aluminum manufacturer
needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The
current spot price is $2.50 per pound, but the May futures price is $2.40 per pound. In January
the aluminum manufacturer would take a long position in a May futures contract on copper.

This futures contract can be sized to cover part or all of the expected order. Sizing the position
sets the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the
hedge ratio is 50%. If the May spot price of copper is over $2.40 per pound, then the
manufacturer has benefited from taking the long position. This is because the overall profit from
the futures contract helps offset the higher purchasing cost paid for copper in May. If the May
spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures
position while saving overall thanks to a lower-than-anticipated purchasing price.

SHORT HEDGE: A short hedge is an investment strategy utilized to protect against the risk of
a declining asset price at some time in the future. It is typically focused on mitigating the risk of
a current asset held by a company. The strategy involves shorting an asset with
a derivative contract that hedges against potential losses in an owned investment by selling at a
specified price.

A short hedge can be used to protect against losses and potentially earn a profit in the future.
Short hedges are often used in the agriculture business where “anticipatory hedging” is often
prevalent.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities
producing a commodity can hedge by taking a short position. Entities in need of
the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to prudently manage their inventory. Entities may
also seek to add additional profit through anticipatory hedging. In a short hedged position, the
entity is seeking to sell a commodity in the future at a specified price. The entity seeking to buy
the commodity takes the opposite position on the contract known as the long hedged position.
Hedging is used in all types of commodity markets including copper, silver, gold, oil, natural
gas, corn and wheat.

Commodity Price Hedging

Commodity producers can seek to lock in a preferred rate of sale in the future by taking the short
position. In this case a company would enter into a derivative contract to sell a commodity at a
specified price in the future. The company would determine the derivative contract price at
which they seek to sell and the detailed contract terms. The company is typically required to
monitor this position throughout the duration of the holding for daily requirements.

Assume that an energy company would like to take a short position on the future value of oil.
They would need to short the oil at a specified price. If the current price of oil is $30 per barrel
and they want to hedge against any future losses, they may want to take a short position at $35
per barrel. Contracts are often structured to offer the price for multiple barrels. Therefore, the
company would be selling 1,000 barrels at the price of $35 per barrel in one contract. If the
contract is executed, the oil producer succeeds in mitigating losses and earns a targeted profit.

ADVANTAGES AND DISADVANTAGES OF HEDGING

Hedging is the term used in the context of the stock market, many people use this term when
they talk about the financial market but few people take care to explain this term to people who
are new to stock market. Hedging does not help you in earning money but it helps you in
lessening the potential loss and that is the reason why it is used by mutual funds, institutional
investors, venture capitalist and sophisticated investors who are not looking for earning profit
from hedging but looking to earn a constant return by reducing risk. In order to understand
hedging better let’s look at some of the advantages and disadvantages of hedging –

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

2. Hedging protects inventory values: Example. A merchandiser with a large, unsold

inventory can sell futures contracts that will protect the value of the inventory, even if the price
of the commodity drops.

3. Hedging permits forward pricing of products: Example A jewelry manufacturer can

determine the cost for gold, silver or platinum by buying a futures contract, translate that to a
price for the finished products, and make forward sales to stores at firm prices. Having made the
forward sales, the manufacturer can use its capital to acquire only as much gold, silver, or
platinum as maybe needed to make the products that will fill its orders
4. Risk management tool: It is a risk management tool used by long-term traders and investors.
No one wants to lose their money in trading activities. Hedging will not bring the participants
any profits rather it will protect them from financial loss due to adverse price movements of
commodities. Uncertainties are common in day to day trading. Large manufactures, traders and
investors want to manage the risk arising out of the adverse conditions in the commodity or
financial markets. Hedging acts as a risk management tool, it protects the participants from loss
due to adverse movements of prices of commodities or financial securities.

5. Assists traders during poor market periods: Hedging protects and assists traders during
poor market conditions. If the prices of commodities are highly volatile in the market during a
particular period, then the traders can use hedging technique either to take long or short position
to protect them. Hedging protects against commodity price changes, due to inflation, currency
exchange rate changes and interest rate change.

6. Lock in a profit: Hedging locks in profits and losses in one investment by taking an offsetting
position in a similar tradable investment. You can exit from the position by selling full or part of
the holdings.

7. Saves time: Hedging saves time by requiring less maintenance on portfolio/files due to daily
market volatility.

8. Complex trading options: It allows traders to practice complex options trading approaches to
maximize returns.

LIMITATIONS OF HEDGING/DISADVANTAGES OF HEDING

Hedging-using futures does not work perfectly in practice. The limitations are:

Hedging can only minimize the risk but cannot fully eliminate it. For Example. The loss made
during selling of an asset is not equal to the profits made by going short. This is because the
underlying value of the asset and the future contract vary

The hedge may require the futures contract to be closed out well before its expiration date Hedge
ratio, hh*Variance of position Dependence of variance of hedger’s position on hedge ratio.

Limitation also exists that the underlying hedged product and the contract specification might not
be exactly the same grade

1. The cost of hedging can minimize overall profits.

2. Reducing the risk can reduce profits.
3. It is a difficult strategy to understand and is not commonly used by the short-term trader.
4. When markets are moving positive, hedging proposes little benefits.
 5. It requires an increase in account balance.
6. It requires excellent trading skills and experience.

SPECULATION
The price of any commodity in the market is a function of the demand and supply. If supplies fall
short, prices tend to increase and vice versa. Often the estimation of demand and supply is the
major challenge faced by the market. The traders who speculate are called Speculators.
Speculation is the process of buying or selling something now based on anticipations of future
price changes. Speculators buy (or sell) futures at a time when its price is low (or high) and sell
later (or buy) when the price is higher (or lower). Speculators are risk takers and they add
liquidity and capital to the futures markets. If the price changes are temporary, speculation
reduces fluctuations, reduces risk and enhances efficiency. The main objective of speculators is
to make profit in the trade and not to minimize risk unlike Hedgers.

In the world of commodities, a speculator is a party who typically does not handle the actual
physical commodity but takes a financial position (long or short) with the expectation of profit
from a move in the price of the asset. Speculators tend to do their homework. They constantly
monitor and analyze the fundamental and technical factors affecting the markets in which they
trade.

There are various forms of speculation. A market maker, a party who shows a bid and offer price
at all times, is a speculator who assumes that making a two-way price will offer the opportunity
to profit or make the spread between the buy price and the sell price. An investor in commodity
production is a speculator. Consider the case of a gold miner who sinks millions into a mine with
the hope of extracting gold at a cost that is lower than the market price. That investor is certainly
a speculator, speculating that the investment will yield a positive return.

Finally, a proprietary trader who was the likely target of the Delta CEO's wrath looks to buy at
low prices and sell at high prices in a myriad of assets including commodities.

Positions
Speculators take open positions- i.e. they will have either an asset or liability. Long position: Buy
futures, expecting higher futures price at later date Short Position: Sell futures, expecting lower
futures price at later date.
Speculative Trading (with reference to futures contract)

Speculative trading is the trading of futures contracts, without the intention of actually obtaining
the underlying commodity. These traders buy or sell futures contracts with the intention of re-
selling these contracts before the maturity date. They expect the price of a futures contract to
move in their favor, which will grant them a profit when selling these contracts. Speculative
trading is however very risky, because there is no guarantee prices will move in their favor.
When prices move against their position, this can result in substantial losses. They fulfill a
number of roles which are of vital importance to the commodity market.

Liquidity and Efficiency: Speculative traders maintain a liquidity which is vital to the
effectiveness of the commodity market. The level of liquidity is determined by the ability of an
asset to be sold rapidly and with minimal loss of value. This requires a large amount of sellers
and buyers to be active on a market. On the futures market there are numerous traders and thus
there is virtually a buyer and seller willing to obtain a futures contract at any moment. It can be
very time-consuming for a producer and an end-user to agree on a contract for the delivery of
a commodity. There is always a trader willing to buy a contract, because he believes he will be
able to sell it at a later date with a profit. Therefore it is easier for producers and end-users to sell
their contracts on an exchange, where traders will buy the contracts and then trade these
contracts with other traders or an end-user.

Risks: Speculative traders are both a liability as well as an essential when considering risks. First
off al they reduce the price risks for producers because they are willing to buy a contract at a
fixed price. Due to this fixed price, producers are insured of an acceptable price for their product
and thus will be motivated to increase their supply. Therefore traders take over the price risks of
producers and simultaneously stimulate an increase in supply.
Traders themselves can however also generate additional risks. Because of their speculative
trading they will sometimes rise prices in such a manner that they are no longer in accordance
with the underlying asset. In such a situation this so-called economic bubble will eventually burst
and result in a rapid decrease of the price.

Speculation arises only in those markets in which demand and supply conditions are
unpredictable and the prices are highly fluctuating. Speculators purchase or sell in anticipation of
price changes and attempt to profit thereby.

Places where speculative transactions takes place

1. Produce Exchanges: - Markets for agricultural commodities like wheat, coffee, oil, cotton
etc.

2. Stock Exchanges: - Markets for invested capital, namely stocks and shares; and

3. Bullion Exchange: - Markets for precious metals like gold and silver.
Example of Speculation Transaction

Suppose, the spot price (i.e., price prevailing in the market at a point of time when we want to
buy the commodity actually) of raw cotton is Rs.1,000 per bale. The supply of raw cotton in the
market may not be uniform and it may go up or down depending on climatic conditions and the
harvest of cotton.

Suppose a speculator anticipates a fall in the supply of cotton in the market in three months time
and believes that in all probabilities the price of cotton would go up after three months due to
reduced supply.

On this calculation, the speculator will buy now at current prices (Rs. 1,000 per bale) a certain
specified quantity of cotton, say 100 bales and the seller will be asked to deliver the commodity
after three months. This means actual delivery of the commodity will not take place immediately.
The price will be settled at the prevailing rate and the seller is given three months time.

Suppose after three months, at the due date, the price of cotton has increased from Rs.1,000 to
Rs.1,020 per bale, the speculator will gain Rs.20 per bale and in the transaction he will profit
Rs.2,000.

Suppose on the due date of delivery, the price of cotton is lower than the original price settled,
the speculator will lose in the transaction. In practice, the accounts between the buyer and the
seller will be settled only by paying the difference of amount between the agreed price and the
prevailing price.

Kinds of Speculation

Speculative activity undertaken with genuine intention of dealing with markets as they are, may
be called simple speculation. The simple speculator does not consider himself to have any
influence on the market price and believes that the prices are changing quite independently of his
own activities. He either buys or sells in an attempt to make profit depending on the prevailing
prices and anticipated prices. This type of speculation is a constructive one and this is also
called productive speculation by Lerner. Taussig calls this as mercantile speculation.

But there are other types of speculators who are called by Lerner as aggressive speculators. This
speculation is done by a few rich and powerful operators who organize themselves into
monopolistic combination in order to tilt the price in their favour.

In a sense, all businessmen and traders are simple speculators as their production activities
include speculation. Simple and mercantile speculation is essential and also beneficial to the
market.
Genesis of Speculation

There are different stages through which a commodity has to pass from the point where it is
produced to the point where it is finally consumed.

Assembling, grading, standardizing, storing, transporting, wholesaling, etc., all play their part
and specialized agencies have come into existence to perform these services in marketing. While
these services are more conspicuous because of the significant push they give to the goods in
their movement from producer to consumer, there are two important services which go rather
unnoticed and which are perhaps more important.

The first one is the finance for marketing. Banks and investment houses come forward for
financing the wheels of marketing. But risk-bearing is a special problem in marketing
and forward markets undertake the risk-bearing through the operation of the speculators.

Risks that can be insured against, in the marketing process, are not risks at all. The pattern of
economy and the element of time present certain risks in the marketing process which cannot be
insured. Goods have to be produced, stored and transported before they are sold to consumers
and it is the element of time between production and consumption which renders risk bearing
indispensable.

Assuming the goods have to be stored for a longer time, somebody has to bear the risk arising
out of a possible change in the price between the two points of time covering the process. Since
certain type of goods take a long time to produce, the production cannot be started until an
assurance is forthcoming that the goods would be sold profitably after they are produced.

Supposing there are wide fluctuations in the price of a commodity, the products are not likely to
produce the commodity, fearing fall in the price and the consequent loss. This would lead to
uneven flow of the goods. In order that all gains and losses may be evened out over a period of
time and to ensure smooth and uninterrupted flow of goods, the service of risk-bearing has
become essential and this is done by speculators in their forward contracts.

Risk-bearing and ensuring smooth flow of goods should be the objective of speculative
transaction taking place in forward markets

Speculation Proper

Speculation is to be met within markets where there are possibilities of price fluctuations. In
commodities like cotton, wheat or gold, dealers legitimately speculate on the probability of rise
or fall in the prices of commodities. If they anticipate a rise in price in the future they buy long.
If they anticipate fall in price in the future, they sell short. These dealers are experts and they
posses specialized knowledge of the market conditions. They forecast demand and supply and
thus perform a useful function to the market.
The transactions in stock exchanges are highly risky and there are great chances for making huge
profits or heavy losses. Generally, it is only the speculation in stock exchange market, which has
come to be called the speculation proper.

There are special classes of speculators in the speculative market. They are called BULLS and
BEARS. Bulls always buy long and they will be interested in rising or tossing up price. By their
hectic activity in buying at a premium would set the market force to demand more and more and
the price will be increased.

BULLISH COMMODITY

A bull market is the condition of a financial market of a group of securities in which prices are
rising or are expected to rise. The term "bull market" is most often used to refer to the stock
market but can be applied to anything that is traded, such as bonds, real estate, currencies and
commodities. Because prices of securities rise and fall essentially continuously during trading,
the term "bull market" is typically reserved for extended periods in which a large portion of
security prices are rising. Bull markets tend to last for months or even years.

If being long or buying are actions related to a belief that an asset will rise in value, then being
bullish is the belief. To say "I'm bullish gold" means that I believe the price of gold will rise.

Being a bull can represent an opinion/belief, or an action. Someone who's bullish may actually
go long the assets they're bullish in, or they may simply have an opinion that the price will rise,
but not make a trade based on that opinion.

The term "bull" or "bullish" comes from the bull, who strikes upwards with its horns, thus
pushing prices higher.

A bull market is when an asset's price is rising—called an uptrend—typically over a sustained

time period, such as months or years.

Bullish, bull and long are used interchangeably. For example, instead of saying "I am long" a
trader may simply say "I am bullish." Both statements indicate this person believes prices will
rise.

Long is like "buy." If you're "going long" in a stock, it means you're buying it. If you're already
long, then you bought the stock and now own it.

In trading, you buy or go long something if you believe its value will increase. This way, you can
sell it for a higher value than you paid for and reap a profit.

Assume Suzy goes long 100 shares of ZYZY stock at $10.00, costing her $1,000. Several hours
later she sells the stock for $10.40 per share, collecting $1,040 and making a $40 profit. If the
price moves down to $9.50, she has a loss of $50 ($0.50 x 100 shares).
Bear or Bearish Commodity

Being bearish is the belief that the price of an asset will fall. A person with this belief may
choose to act on it or not.
If the trader does act, they may sell shares they currently own, or they may go short.

To say "I'm bearish on stocks" means I believe the price of stocks will decline in value.
The term "bear" or "bearish" comes from the bear, who strikes downward with its paws, thus
pushing prices down.
Acting on a bearish or bullish opinion should only be done based on a well defined and
tested trading strategy.
A bear market is when an asset's price is falling—called a downtrend—typically over a sustained
period of time such as months or years.
Most people think of trading as buying at a lower price and selling at a higher price. Traders can
also sell at a high price and buy back at a lower price. Being short, or shorting, is when you
sell first in the hopes of being able to buy the asset back at a lower price later.

It is a strange concept for many people to grasp, but in the financial markets you can buy then
sell, or sell then buy. If you've done the latter, then you're short the asset.

You'll also hear the term short-selling. This is the same as shorting.

In the futures and forex market, you can short any time you wish. In the stock market, there are
more restrictions on what stocks can be shorted and when. When you hear someone say they are
shorting something, it means they believe the price will go down.

Assume Suzy shorts 100 shares of ZYZYZ stock at $10.00. Since she sold first,
she'll receive $1,000 into her trading account, but her account will show negative 100 shares.
The negative share balance must be brought back to zero at some point by buying back the 100
shares.

An hour later she buys the stock back at a price of $9.60 per share at the cost of $960. Since she
initially received $1,000, buying the shares back for only $960 gives her a $40 profit. If the price
moves up to $10.50, she is losing $50 ($0.50 x 100 shares).
ARBITRAGE
Arbitrage is the process of buying something at a place where its price is low and selling it where
its price is high. Arbitragers try to profit from difference in prices of identical goods in different
locations. Example: The shares of a particular stock are trading at Rs.410 and Rs 420 in
Ahmedabad and Mumbai stock exchanges simultaneously. An arbitrager will purchase the scrip
in Ahmedabad and sell it in Mumbai to generate a riskless profit of Rs 10 per share. In arbitrage
as both the trades are done simultaneously there is no investment. But in an efficient market,
arbitrage opportunities would not exist. Even though they exist they cannot last long as arbitrage
itself reduces the price differentials. As arbitrageurs start buying goods from the low price
locations it raises the prices of goods and as they sell the scrip in a high price location it lowers
the price of goods thereby nullifying any arbitrage opportunities. In reality, if such arbitrage
opportunities do exist (at first glance), the prospective arbitrageur would do well to check the
hidden transaction costs. In most cases he would find that such hidden costs nullify the apparent
arbitrage opportunity.

Cost-of-carry
This is the cost to carry a storable good forward in time. The carrying charges are of four basic
kinds

 Cost of warehousing
 Cost of insurance
 Transportation costs (moving the goods from origin to the appropriate destination for
delivery).
 Financing cost

Cash and carry arbitrage

A trader can buy goods for cash and carry it through to the expiration of the futures contract. Let
us see an example to understand this: Example Spot price of gold per 10 gms– Rs 5,100/-Future
price of gold per 10 gms (for delivery in one year)– Rs 5,500/-Interest rate per annum–6.5%The
trader borrows Rs 5,100 for 1 year at 6.5%. He buys 10 gms of gold in the spot market for Rs
5,100 and sells a futures contract for delivery one year hence. At the end of 1 year, he delivers 10
gms of gold against the futures and realizes Rs 5,500/-.He also repays the loan of Rs 5,100/- and
the interest amount of Rs 331/- (total Rs 5431/-).Thus, he gets a total profit of Rs 69/-In the
above example, we have assumed that there is only financing charge applicable. When
attempting arbitrage at significant volumes of goods, the trader would have to worry about
storage costs and insurance. The arbitrage opportunity may still exist. However, as discussed
earlier, the market would react to changes in interest rates, insurance premiums and storage costs
and the gaps would close very quickly.
Example of Cash-and-Carry Arbitrage

Consider the following example of cash-and-carry-arbitrage. Assume an asset currently trades at

$100, while the one-month futures contract is priced at $104. In addition, monthly carrying costs
such as storage, insurance, and financing costs for this asset amount to $3. In this case, the trader
or arbitrageur would buy the asset (or open a long position in it) at $100, and simultaneously sell
the one-month futures contract (i.e. initiate a short position in it) at $104. The trader would then
hold or carry the asset until the expiration date of the futures contract and deliver the asset
against the contract, thereby ensuring an arbitrage or riskless profit of $1.

Reverse cash and carry arbitrage

This happens when the spot price is too high. In the above example, let us suppose that the spot
price was Rs 5,200/- instead of Rs 5,100/-.The trader would now sell 10 gms of gold short, lend
Rs 5,200/- for 1 year and buy one gold future for delivery of 10 gms one year hence.

At the end of 1 year, he collects the proceeds from the loan (Rs 5,200/- + interest Rs338/-),
accepts delivery on the futures contract of 10 gms gold (pays out Rs 5,500/-) and uses the gold
from futures delivery to repay the short sale. He thus profits by Rs 38/-In the end the market
ensures that the future price equals the spot price and the cost of carry to close out the arbitrage
opportunities.

Example of Cash-and-Carry Arbitrage

Consider the following example of a reverse cash-and-carry-arbitrage. Assume an asset currently
trades at $104, while the one-month futures contract is priced at $100. In addition,
monthly carrying costs on the short position (for example, dividends are payable by the short
seller) amount to $2. In this case, the trader or arbitrageur would initiate a short position in the
asset at $104, and simultaneously buy the one-month futures contract at $100. Upon maturity of
the futures contract, the trader accepts delivery of the asset and uses it to cover the short position
in the asset, thereby ensuring an arbitrage or riskless profit of $2.

The term "riskless" is not 100% correct as there are still risks that carrying costs can increase,
such as the brokerage firm raising its margin rates. However, the risk of any market movement,
which is the major component in any regular long or short trade, is mitigated by the fact that
once the trade is set in motion, the only event is the delivery of the asset against the futures
contract. There is no need to access either side of the trade in the open market at expiration.

OVERPRICED OR OVERVALUED COMMODITY FUTURES

When the price of a commodity is bought or sold more than its true value is called overpricing of
commodity. There are many reasons which leads overpricing of a commodity or financial asset.
The overpricing of a commodity in its trading may happen due to lack of information or
imperfect market (market is said to be inefficient). In arbitrating process a trader may take short
position to sell the particular underlying assets which overpriced. He may take long position to
buy the asset in order to sell it in the market where the same or similar asset is underpriced or
fairly priced.

UNDERPRICED OR UNDERVALUED COMMODITY FUTURES

When the price of a commodity is bought or sold more less than its true value (intrinsic value) is
called underpriced or undervalued. In this case also the commodity market is inefficient. The
traders are unable to get the every information which have taken place in the market. Under
arbitraging the arbitrageur may take long position to buy an underpriced asset in order to sell it in
the market where the same or similar asset is fairly or overpriced.
UNIT-6: INSTRUMENTS FOR TRADING
Forward contracts (Foreign Exchange (FOREX) or Currency Forward
Markets): A relatively simple derivative is a forward contract. It is an agreement to buy or sell
an asset at a certain future time for a certain price. It can be contrasted with a spot contract,
which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-
counter (OTC) market-usually between two financial institutions or between a financial
institution and one of its clients.

Meaning of forwards contract: It is a contractual agreement between two parties to buy or sell
an underlying asset at a certain future date for a particular price that is predetermined on the date
of contract. This contract will be having a customized terms and conditions from varies from
locations to locations and person to person.

For example, a farmer entered into an agreement with the wholesaler to sell 10 tons of wheat
after three months for Rs. 3,00,000.

A forward contract is a customized, non-standardized contract between two parties to buy or sell
an asset at a specified price on a future date. A forward contract can be used for hedging or
speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike
standard futures contracts, a forward contract can be customized to any commodity, amount
and delivery date. A forward contract settlement can occur on a cash or delivery basis. Forward
contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter
(OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a
centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward
contracts are not as easily available to the retail investor as futures contracts.

One of the parties to a forward 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. The
terms and conditions may vary from person to person and location to location. This contract is
not regulated by any government authority.

Forward contracts on foreign exchange are very popular. Most large banks employ both spot
and forward foreign-exchange traders. Spot traders are trading a foreign currency for almost
immediate delivery. Forward traders trading for delivery at a future time. The following table
shows spot and forward quotes for the USD/GBP exchange rate, July 20, 2007 (quote is number
of USD per GBP)

Bid/buy Offer/sell
Spot 2.0558 2.0562
1-month forward 2.0547 2.0552
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
The spot indicates that, the bank is prepared to buy GBP (pound sterling) for 2.0558 dollars and
sell GBP for 2.0562 dollars (virtually immediate delivery). The 2,3, and 4th row indicate that, the
bank is prepared to buy and sell 1 month, 3 months and 6 months forward contract of USD/GBP.

Forward contracts can be used to hedge foreign currency risk. Suppose that, on July, 2007, the
treasurer of a US corporation knows that the corporation will pay 1 million GBP in 6 months (i.e.
on January, 20, 2008) and wants to hedge against exchange rate moves. Using the quotes in the
above table, the treasurer can agree to buy 1 million GBP 6 months forward at an exchange rate
of USD 2.0489/GBP. The corporation then has a long forward contract on GBP. It has agreed
that on January 20, 2008, it will buy 1 million GBP from the bank for USD 2.0489/GBP. The
bank has a short forward contract on GBP. It has agreed that on January 20, 2008, it will sell 1
million GBP for USD 2.0489/GBP. Both sides have made a binding commitment.

Payoffs from Forward Contracts:

By considering the corporation’s position’s position in the above example, the forward contract
obligates the corporation to buy 1 million GBP for $ 2, 048,900 after six months. If the spot
exchange rate rose to, say, 2.1000, at the end of the 6 months, the forward contract would be
worth $51,100 (=$21, 00,000-$2,048,900) to the corporation. It would enable 1 million pounds
to be purchased at an exchange rate of $2.0489 rather than $2.1000. Similarly, if the spot
exchange rate fell to $1.9000 at the end of the 6 months, the forward contract would have a
negative value to the corporation of $1, 48,900 because it would lead to the corporation paying
$1, 48,900 more than the market price for the sterling.

Usually, the payoff is the difference between the spot price of an underlying asset at the end of
the maturity period and the strike price (agreed price at the beginning of the contract also called
as delivery price). The payoff from long position in a forward contract on one unit of an asset is
ST – K, where K is the delivery price and ST is the spot price of the asset at the maturity of the
contract. This is because the holder of the contract is obligated to buy an asset worth ST for K.
Similarly, the payoff from a short position in a forward contract on one unit of an asset is K - ST
These payoffs can be positive or negative. It costs nothing into to enter into a forward contract;
the payoff from the contract is also the trader’s total gain or loss from the contract. For instance,
in the above example, if K = $2.0489 and the corporation has a long contract. When ST = $2.100,
the payoff is $0.511/GBP; when ST = $1.900, it is -$0.1489/GBP.

Forward Prices and Spot Prices:

Forward price is the predetermined delivery price for an underlying commodity, currency, or
financial asset as decided by the buyer and the seller of the forward contract, to be paid at a
predetermined date in the future. At the inception of a forward contract, the forward price makes
the value of the contract zero, but changes in the price of the underlying will cause the forward to
take on a positive or negative value.

Forward price is based on the current spot price of the underlying asset, plus any carrying costs
such as interest, storage costs, foregone interest or other costs or opportunity costs.

Although the contract has no intrinsic value at the inception, over time, a contract may gain or
lose value. Offsetting positions in a forward contract are equivalent to a zero-sum game. For
example, if one investor takes a long position in a pork belly forward agreement and another
investor takes the short position, any gains in the long position equals the losses that the second
investor incurs from the short position. By initially setting the value of the contract to zero, both
parties are on equal ground at the inception of the contract.

The spot price: The spot price is the current price in the marketplace at which a given asset—
such as a security, commodity, or currency—can be bought or sold for immediate delivery.
While spot prices are specific to both time and place, in a global economy the spot price of most
securities or commodities tends to be fairly uniform worldwide when accounting for exchange
rates. In contrast to the spot price, a futures price is an agreed upon price for future delivery of
the asset.

Consider a stock that pays no dividend and is worth Rs. 60. You can borrow or lend for 1 year at
5%. What should be the 1-year forward price of the stock be?

The answer is Rs. Grossed up at 5% for 1 year, or Rs. 63. If the forward price is more than this,
say Rs. 67, you could borrow Rs. 60, buy one share of the stock, and sell it forward for Rs. 67.
After paying off the loan, you would net a profit of Rs. 4 in 1 year. If the forward price is less
than Rs. 63, say Rs. 58, an investor owning the stock as part of a portfolio would sell the stock
for Rs. 60 and enter into a forward contract to buy it back for Rs. 58 in 1 year. The proceeds of
investment would be invested at 5% to earn Rs. 3. The investor would end up Rs. Better off than
if the stock were kept in the portfolio for the year.

Understanding a Forwards Contract

At its core, a forward contract is a financial instrument used for hedging purposes as part of a
risk management strategy. Forward contracts are an agreement between buyer and seller. The
seller agrees to provide a commodity at a specific price at a future date to the buyer. Farmers
usually enter into forward contracts, but investors may enter into foreign contracts on other
commodities such as oil and currencies, as in forward exchange contracts.

Characterizations

Essentially, a forward contract is an agreement to pay for a delivery of a commodity. Typically, a

forward contract also spells out the delivery method and acceptable minimum quality of the
commodity. The settlement date refers to the day when the contract must be paid. Unlike futures
contracts that involve a broker, a forward contract is an agreement between buyer and seller.

Risk Management

The principal reason to enter into a forward contract is to minimize risk, or to reduce the
probability of an adverse fluctuation in price of a commodity. By guaranteeing a price, the seller
of a forward contract establishes his price. Farmers and other commodities producers gauge
today's prices for the commodity against the "spot price," or the price at which the commodity
may sell at the delivery date in the future. A buyer of a forward contract may expect the price of
the commodity to increase by the delivery date and thus wants to lock in a lower price.

Advantages of Forwards Contract:

Forward contract is a customized agreement between two parties to buy or sell an underlying
asset at future date and for a pre-decided price. It has many advantages as mentioned below:

1. Matching against the time period and size of the cash: Forwards contracts can be matched
against the time period of exposure as well as for the cash size of the exposure.

2. Tailor made contract: Forwards contracts are customized. It can be written for any amount
or terms and conditions. It is the parties to the contract who decide and agreed the terms. No
government body is controlling this type of derivative contracts.

3. It offers complete hedge: It will give protection against the price movements in the market in
future. It provides complete protection against the adverse price movement in an asset. The
parties to the forwards contract can fully hedge or protect their assets from unexpected changes
in the market prices of the underlying asset.

4. Forwards are over-the-counter products: Forwards contracts are over-the-counter (OTC)

products. The phrase “over-the-counter” can be used to refer to stocks that trade via a dealer
network as opposed to on a centralized exchange. It also refers to debt securities and other
financial instruments, such as derivatives, which are traded through a dealer network. Exchange
is a centralized, regulated market where securities are traded in a safe, standardized, fast and
publicly transparent manner. OTC is a decentralized dealer network and prices are not disclosed
publicly until after the trade is complete. Stocks which trade on exchange (Like BSE stock
exchange in India) are called as listed stock. Stocks which are not traded on exchange are called
as unlisted stock or OTC stock. Generally, small company’s securities and debt securities are
traded in OTC. There is no exchange fee in OTC.
5. The use of forwards provide price protect: The forward contract provide price protection to
buyer/seller. It protects the parties from the adverse movement in the market price of an
underlying asset.

6. They are easy to understand: Forward contracts are easy to understand. It is not centralized
and has no regulation. These can be traded over the counter.

Disadvantages or Limitations of Forwards Contracts:

In spite many advantages, the forwards contracts has its own disadvantages. The following are
the limitations of forwards contracts:

1. Liquidity risk: These forwards cannot immediately liquidate. This requires tying up capita.
There are no immediate cash flows before settlement. The seller in the forwards contracts cannot
liquidate the underlying asset until the maturity date. The parties to the contract cannot reverse
the agreement. They have wait until the agreed period.

2. Counterparty risk or default risk: Default risk is the risk in which either of the parties failed
to perform the promise. This counterparty or default risk may happen either on seller side or
buyer side. The seller may not be deliver the underlying asset to the buyer or the buyer may
make default in payment to the seller after the receiving the underlying asset.

3. No regulation: These forward contracts are not come under the centralized trading system and
there is no any government body which controls the forwards contracts. Lack of regulating
authority leads to many conflicts.

4. No settlement guarantee: Settlement guarantee features presented in stock exchange. Since

no government body is controlling and it comes under decentralized dealers, no settlement
guarantee is provided. Settlement guarantee is not applicable to the forwards contracts.

5. Contracts may be difficult to cancel: The forwards contracts are sometimes difficult to
cancel. These contracts can be cancelled by mutual consent of the parties.

6. There may be difficult to find counter-party: Finding counter party to the forwards contract
is difficult. Since forwards market is an unorganized and uncontrolled market where parties to
the contract don’t know each other.

FUTURES CONTRACTS: Like a forwards contract, a futures is an agreement between two

parties to buy or sell an asset a t certain time in the future for a certain price. Unlike forwards
contracts, futures contracts are normally traded on an exchange. To make trading possible, the
exchange specifies certain standardized features of the contract. As the two parties to the contract
do not necessarily know each other, the exchange also provides a mechanism that gives the two
parties a guarantee that the contract will be honored. The clearing house or the clearing
corporation of the stock exchange, which is an agency designated to settle trades of investors on
the stock exchanges.

A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures
contracts also mandate the sale of commodity at a future data but at a price which is decided in
the present.

However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. Also, since these contracts are traded on the exchange they have to
follow a daily settlement procedure meaning that any gains or losses realized on this contract on
a given day have to be settled on that very day. This is done to negate the counterparty credit
risk.

An important point that needs to be mentioned is that in case of a futures contract, they buyer
and seller do not enter into an agreement with one another. Rather both of them enter into an
agreement with the exchange.

The largest exchanges on which futures contracts are traded are the Chicago Board of Trade
(CBOT) and the Chicago Mercantile Exchange (CME). On these and other exchanges
throughout the world, a very wide range of commodities and financial assets form the underlying
assets in the various contracts. The commodities include live cattle, sugar, wool, copper,
aluminum, gold and tin. The financial assets include stock indices, currencies and Treasury
bonds.

Futures contracts, while similar to forwards contracts, have certain features that make them more
useful for risk management. These include being able to extinguish contract obligations through
offsetting, rather than actual delivery of the commodity.

Characteristics of Futures/Futures Terminology

1. Two parties: There are two parties in futures contract. One party takes long position to buy
the asset/securities and another takes short position to sell the underlying asset. The parties to the
contract do not know each other.

2. Exchange traded: Futures are traded on organized exchanges (Secondary market) with
clearing association that act as intermediary between the contracting parties.
3. Spot price: The price at which an asset trades in the spot market.

4. Strike price: The agreed price a futures contract to buy or sell an underlying asset.

5. Contract cycle: The period over which a contract trades. The index futures contracts on NSE
have 1 month, 2 months and 3 months expiry cycles which expire on the last Thursday of the
month. Thus, a January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On the Friday
following last Thursday, a new contract having 3 month expiry is introduced for trading.

6. 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.

7. Contract size: Contract size is the deliverable quantity of commodities or financial

instruments underlying futures contracts that are traded on an exchange. The contract size is
standardized for such futures contracts so that buyers and sellers know the exact quantity and
specification of what they are buying and selling. Contract size varies depending on the
commodity or instrument that is traded. The contract size also determines the dollar value of a
unit move in the underlying commodity or instrument. Thus, the contract size specifies the
amount of the asset that has to be delivered under one contract. For example, the contract size on
NSE’s futures market is 50 Nifties.

8. Basis: The basis reflects the relationship between cash price and futures price. (In futures
trading, the term "cash" refers to the underlying product). The basis is obtained by subtracting
the futures price from the cash price. The basis can be a positive or negative number. A positive
basis is said to be "over" as the cash price is higher than the futures price. A negative basis is
said to be "under" as the cash price is lower than the futures price.

9. Cost of carry: The relationship between futures prices and spot prices can be summarized 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 income earned on the asset.

10. Initial margin: The amount that must deposited in the margin account at the time of a
futures contract is first entered into is known as initial margin.

11. Marking to market: 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.

12. 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.
FUTURES PRODUCTS IN INDIA
The main kinds of futures products that are available in India are as follow:

1. Single stock futures (stock futures)

2. Equity index futures (stock index futures)
3. Interest rate futures
4. Commodity futures
5. Currency futures

Stock futures: Stock futures are derivative contracts that give you the power to buy or sell a set
of stocks at a fixed price by a certain date. Once you buy the contract, you are obligated to
uphold the terms of the agreement.
In finance, a single-stock future (SSF) is a type of futures contract between two parties to
exchange a specified number of stocks in a company for a price agreed today (the futures price
or the strike price) with delivery occurring at a specified future date, the delivery date. The
contracts are traded on a futures exchange. The party agreeing to take delivery of the underlying
stock in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
deliver the stock in the future, the "seller" of the contract, is said to be "short". The terminology
reflects the expectations of the parties - the buyer hopes or expects that the stock price is going to
increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs
nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each
party is taking (long or short)?

SSFs are usually traded in increments/lots/batches of 100. When purchased, no transmission of

share rights or dividends occurs. Being futures contracts they are traded on margin, thus offering
leverage, and they are not subject to the short selling limitations that stocks are subjected to.
They are traded in various financial markets, including those of the United States, United
Kingdom, Spain, India and others. South Africa currently hosts the largest single-stock futures
market in the world, trading on average 700,000 contracts daily. Here are some more
characteristics of futures contracts:

Lot/Contract size: In the derivatives market, contracts cannot be traded for a single share.
Instead, every stock futures contract consists of a fixed lot of the underlying share. The size of
this lot is determined by the exchange on which it is traded on. It differs from stock to stock. For
instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when
you buy one futures contract of RIL, you are actually trading 250 shares of RIL. Similarly, the
lot size for Infosys is 125 shares.*

Expiry: All three maturities are traded simultaneously on the exchange and expire on the last
Thursday of their respective contract months. If the last Thursday of the month is a holiday, they
expire on the previous business day. In this system, as near-month contracts expire, the middle-
month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month)
contracts become middle-month contracts.

Duration: Contract is an agreement for a transaction in the future. How far in the future is
decided by the contract duration. Futures contracts are available in durations of 1 month, 2
months and 3 months. These are called near month, middle month and far month, respectively.
Once the contracts expire, another contract is introduced for each of the three durations
The month in which it expires is called the contract month. New contracts are issued on the day
after expiry.

Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to
do so at the price at which the July futures contracts are currently available in the derivatives
market. Let's say that ABC Ltd July futures are trading at Rs 1,000 per share. This means, you
are agreeing to buy/sell at a fixed price of Rs 1,000 per share on the last Thursday in July.
However, it is not necessary that the price of the stock in the cash market on Thursday has to be
Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on the prevailing market
conditions. This difference in prices can be taken advantage of to make profits.

Index Futures: A stock index is used to measure changes in the prices of a group stocks over a
period of time. It is constructed by selecting stocks of similar companies in terms of an industry
or size. Some indices represent a certain segment or the overall market, thus helping track price
movements. For instance, the BSE Sensex is comprised of 30 liquid and fundamentally strong
companies. Since these stocks are market leaders, any change in the fundamentals of the
economy or industries will be reflected in this index through movements in the prices of these
stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500,
etc, which represent price movements on different exchanges or in different segments.

Futures contracts are also available on these indices. This helps traders make money on the
performance of the index.
Here are some features of index futures:

1. Contract size: Just like stock futures, these contracts are also dealt in lots. But how is
that possible when the index is simply a non-physical number. No, you do not purchase
futures of the stocks belonging to the index. Instead, stock indices points – the value of
the index – are converted into rupees.

For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that
each point is equivalent to Rs 1 , then you have to pay 100 times the index value – Rs
6,50,000 i.e. 1x6500x100. This also means each contract has a lot size of 100.
 2. Expiry: Since indices are abstract market concepts, the transaction cannot be settled by
actually buying or selling the underlying asset. Physical settlement is only possible in
case of stock futures. Hence, an open position in index futures can be settled by
conducting an opposing transaction on or before the day of expiry.

3. Duration: As in the case of stock futures, index futures too have three contract series
open for trading at any point in time – the near-month (1 month), middle-month (2
months) and far-month (3 months) index futures contracts.

Illustration of an index futures contract: If the index stands at 3550 points in the cash
market today and you decide to purchase one Nifty 50 July future, you would have to
purchase it at the price prevailing in the futures market.

This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh
(i.e., 3550*100), depending on the prevailing market conditions. Investors and traders try
to profit from the opportunity arising from this difference in prices

Interest Rate Futures: It is a contract between borrower and lender to borrow a certain money
in future at specified rate of interest. It is one of the important financial futures instruments in the
world. Important. Interest rate futures traded on various exchanges are: notional gilt-contracts,
short-term deposit futures, treasury bill futures, euro-dollar futures, treasury bond futures and
treasury notes futures. Ex. 3-month maturity instruments like treasury bills and euro-dollar time
deposits, including foreign debt instruments at Chicago Mercantile Exchange (CME), British
Govt. Bonds at London International Financial Futures Exchange (LIFFE), Japanese Govt.
Bonds at CBOT etc. are traded. Interest rate futures can be classified into two categories: Short-
term Interest Rate futures (STIRs) and long-term IRF (Bond futures).

In India, IRFs are of fairly recent origin; they commenced trading only in June 2003 and contrary
to international experience, these contracts drew a big blank on the Indian markets. In India, the
only short-term IRF contract being traded is the 91-day Treasury bill.

Commodity Futures: In commodity futures, the underlying asset will be agricultural products
(cotton, jute, coffee, oilseeds, food grains, tea, sugar, wheat, yarn etc.) Energy products (Oils),
Metal products (bullion, silver, iron and steel etc.) and Chemicals & Plastics.

Currency Futures: Futures contract is made in buying and selling of foreign currencies at
agreed exchange rate. It is also known as Exchange Rate Futures. Important Currencies of
Futures trading are: US-dollar, Pound Sterling, Yen, French Francs, Marks, Canadian dollar etc.
Normally futures currency contracts are used for hedging purpose by the exporters, importers,
bankers, financial institutions and large companies.
OPTIONS:
Options are derivatives contracts that give the buyer the right to buy or sell an underlying asset at
a certain price within a specified time period. Selling or buying options involves two parties,
namely a buyer and a seller. The strategy of selling options is popular mostly with traders who
are capable of managing the element of risk that is inherent in such transactions.

An option is a type of contract between two parties where one person grants the other person the
right, but not the obligation, to buy a specific asset at a specific price within a specific time
period. Alternatively, the contract may grant the other party the right, but not the obligation, to
sell a specific asset at a specific price within a specific time period. The one who takes a short
position is the option writer and who takes a long position is holder of the option.

Options are traded both on exchanges and in the over-the-counter market. There are two types of
option. A call option gives the holder the right to buy the underlying asset by a certain date for a
certain price. A put option gives the holder the right to sell the underlying asset by a certain date
for certain price. The price in the contract is known as the exercise price or strike price; the
date in the contract is known as the expiration date or maturity date. American options can be
exercised at any time up to the expiration date. European options can be exercised only on the
expiration date itself.

It should be emphasized that an option gives the holder the right to do something. The holder
does not have to exercise this right. This is what distinguishes options from forwards and futures,
where the holder is obligated to buy or sell the underlying asset. whereas it costs nothing to enter
into a forward or futures contract, there is a cost of acquiring an option.

The largest exchange in the world for trading stock options is the Chicago Board Options
Exchange.

Types of Options

1. Call Option: It is a contract which gives the owner the right to buy an asset for a certain
price on or before a specified date.
2. Put Option: It is a contract which gives its owner the right to sell something for a certain
predetermined price on or before a specified date.
3. American Option: An American option can be exercised by its owner at any time on or
before the expiration date.
4. European Option: The owner can exercise his right only on the expiration date and not
before it. Most of the options traded in the world including those in Europe are American
style options.
 Option Owner/Holder/Buyer of Writer/Seller of Option
Type Option
(Short Position)
(Long Position)

Call Right to buy an asset Obligation to sell an asset

Put Right to sell an asset Obligation to buy an asset

Features/Characteristics of Options:
1. Physical Delivery vs. Cash Settled Options: Option contracts are settled through either
physical delivery of the underlying asset or cash settlement. In case of cash settlement,
the traders make/receive payments to settle any losses or gains on exercise or maturity of
the contract. Instead of making physical delivery.

2. Exercise Price or Strike Price: It is the price at which the parties with the long and short
positions buy and sell the underlying asset. It is selected by the exchange. Typically,
exercise prices are just above or below the current market price of the underlying asset.
If the price of the share becomes higher than the highest strike price, the exchange would
introduce a new series of options prices for all expiration months with a strike price just
above the old highest strike price. Similarly, if the price of the share becomes lower than
lowest strike price, a new series of options prices for various expiration months with a
strike price just below the old lowest strike price would be issued by the exchange.

For trading in Indian markets, an exchange provides for a minimum of Five strike prices
for every option type viz. Two contracts with strike prices above, two contracts with
strike prices below and one contract with strike price equal to the current price of the
security.

3. Expiration Date: The date mentioned in an options contract is called expiration date or
maturity date. After the maturity date, an option has worthless. Standardized options have
specified dates mentioned for maturity. Generally, the maximum life of an option on
stock is nine months.

4. Option Premium: One may naturally wonder as to why the seller (writer) of an option
should be always obliged to sell/buy an asset whenever the other party desires. The
writer of an option receives a consideration for the obligation he/she undertakes on
himself/herself. This is known as the price or the premium of the option. Option
 contracts are created when a buyer and a seller agree on a price. The buyer pays the
premium to the seller which belongs to the seller whether the option is exercised or not.
If the owner of an option decides not to exercise the option, the option expires worthless,
the amount of premium becomes the profit of the option writer, while if the option is
exercised, the premium gets adjusted against the loss the writer incurs upon such
exercise.

5. Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts, index options contracts are also cash settled.

6. 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.

7. 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.

8. Writer of an option: The writer of 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.

CALL OPTION: Call options are an agreement that give the option buyer the right, but not the
obligation, to buy a stock, bond, commodity or other instrument at a specified price within a
specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer
profits when the underlying asset increases in price.

Call options give the holder the right to buy 100 shares of an underlying stock at a specific price,
known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple
stock at $100 up until the expiry date in three months. There are many expiration dates and strike
prices for traders to choose from. As the value of Apple stock goes up, the price of the
option contract goes up, and vice versa. The call option buyer may hold the contract until the
expiration date, at which point they can take delivery of the 100 shares of stock or sell the
options contract at any point before the expiration date at the market price of the contract at that
time.

The market price of the call option is called the premium. It is the price paid for the rights that
the call option provides. If at expiry the underlying asset is below the strike price, the call buyer
loses the premium paid. This is the maximum loss.
If the underlying's price is above the strike price at expiry, the profit is the current stock price,
minus the strike price and the premium. This is then multiplied by how many shares the option
buyer controls.

For example, if Apple is trading at $110 at expiry, the strike price is $100, and the options
cost the buyer $2, the profit is $110 - ($100 +$2) = $8. If the buyer bought one contract that
equates to $800 ($8 x 100 shares), or $1,600 if they bought two contracts ($8 x 200).

If at expiry Apple is below $100, then the option buyer loses $200 ($2 x 100 shares) for each
contract they bought.

Call options are typically used for three primary purposes. These are tax management, income
generation, and speculation.

Using Options for Tax Management

Investors sometimes use options to change portfolio allocations without actually buying or
selling the underlying security.

For example, an investor may own 100 shares of XYZ stock and may be liable for a large
unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to
reduce the exposure to the underlying security without actually selling it. While gains from call
and put options are also taxable, their treatment by the IRS is more complex because of the
multiple types and varieties of options. In the case above, the only cost to the shareholder for
engaging in this strategy is the cost of the options contract itself.

Using Options for Income

Some investors use call options to generate income through a covered call strategy. This strategy
involves owning an underlying stock while at the same time writing a call option, or giving
someone else the right to buy your stock. The investor collects the option premium and hopes the
option expires worthless (below strike price). This strategy generates additional income for the
investor but can also limit profit potential if the underlying stock price rises sharply. This is
because if the stock rises above the strike price, the option buyer will exercise their right to buy
the stock at the lower strike price. This means the option writer doesn't profit on the stock's
movement above the strike price. The options writer's maximum profit on the option is the
premium received.

Using Options for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a
relatively small price. Used in isolation, they can provide significant gains if a stock rises. But
they can also result in a 100% loss of premium, if the call option expires worthless due to the
underlying stock price failing to move above the strike price. The benefit of buying call options
is that risk is always capped at the premium paid for the option.

Real World Example of a Call Option

Suppose that Microsoft shares are trading at $108 per share. You own 100 shares of the stock
and want to generate an income above and beyond the stock's dividend. You also believe that
shares are unlikely to rise above $115.00 per share over the next month.

You take a look at the call options for the following month and see that there's a 115.00 call
trading at $0.37 per contract. So, you sell one call option and collect the $37 premium ($0.37 x
100 shares), representing a roughly four percent annualized income.

If the stock rises above $115.00, the option buyer will exercise the option and you will have to
deliver the 100 shares of stock at $115.00 per share. You still generated a profit of $7.00 per
share, but you will have missed out on any upside above $115.00. If the stock doesn't rise above
$115.00, you keep the shares and the $37 in premium income.

PUT OPTION: A put option is an option contract giving the owner the right, but not the
obligation, to sell a specified amount of an underlying security at a specified price within a
specified time frame. This is the opposite of a call option, which gives the holder the right to buy
an underlying security at a specified price, before the option expires

How Do Put Options Work?

Put options are traded on various underlying assets, including stocks, currencies, commodities,
and indexes. The specified price the put option buyer can sell at is called the strike price.

A put option becomes more valuable as the price of the underlying stock depreciates relative to
the strike price. Conversely, a put option loses its value as the underlying stock increases. It also
decreases in value as the expiration date approaches.

Time Decay

The value of a put option decreases due to time decay, because the probability of the stock
falling below the specified strike price decreases. When an option loses its time value,
the intrinsic value is left over, which is equivalent to the difference between the strike price less
the underlying stock price. If an option has intrinsic value, it is in the money (ITM).

Out of the money (OTM) and at the money put options have no intrinsic value because there
would be no benefit of exercising the option. Investors could short sell the stock at the current
higher market price, rather than exercising an out of the money put option at an undesirable
strike price.
Real World Examples of Put Options

Assume an investor owns one put option on the SPDR S&P 500 ETF (SPY)—currently trading
at $277.00—with a strike price of $260 expiring in one month. For this option they paid a
premium of $0.72, or $72 ($0.72 x 100 shares).

The investor has the right to sell 100 shares of XYZ at a price of $260 until the expiration date in
one month, which is usually the third Friday of the month, though it can be weekly.

If shares of SPY fall to $250 and the investor exercises the option, the investor could purchase
100 shares of SPY for $250 in the market and sell the shares to the option's writer for $260 each.
Consequently, the investor would make $1,000 (100 x ($260-$250)) on the put option, less the
$72 cost they paid for the option. Net profit is $1,000 - $72 = $928, less any commission
costs. The maximum loss on the trade is limited to the premium paid, or $72. The maximum
profit is attained if SPY falls to $0.

Contrary to a long put option, a short or written put option obligates an investor to take delivery,
or purchase shares, of the underlying stock.

Assume an investor is bullish on SPY, which is currently trading at $277, and does not believe it
will fall below $260 over the next two months. The investor could collect a premium of $0.72 (x
100 shares) by writing one put option on SPY with a strike price of $260.

The option writer would collect a total of $72 ($0.72 x 100). If SPY stays above the $260 strike
price, the investor would keep the premium collected since the options would expire out of the
money and be worthless. This is the maximum profit on the trade: $72, or the premium collected.

Conversely, if SPY moves below $260, the investor is on on the hook for purchasing 100 shares
at $260, even if the stock falls to $250, or $200, or lower. No matter how far the stock falls, the
put option writer is liable for purchasing shares at $260, meaning they face theoretical risk of
$260 per share, or $26,000 per contract ($260 x 100 shares) if the underlying stock falls to zero.