GIK Institute of Engineering Sciences and

Technology Swabi, KPK

Financial Risk Management Time: 1 Hour
Assign 02, Date: Marks: 20
Name: Usaeed Ullah
Reg no: 2020504
Case: Tumbling Trade on the MCX: Restoring the Glory of Mentha Oil Futures

Question 01:
What distinguishes a future contract from a spot contract? How does a future contract
work on the commodity exchange? What role does a commodity exchange play in enabling
futures contract trading, settlement, and delivery?
Ans: Differences Between Future and Spot Contracts

Future Contract vs. Spot Contract:

 Spot Contract:
 Involves the immediate purchase or sale of a commodity at the current market
price.
 Settlement usually occurs within a few days.
 Example: Buying mentha oil today and receiving it within two days at today's
price.
 Future Contract:
 Agreement to buy or sell a commodity at a predetermined price on a future date.
 Contracts are standardized and traded on exchanges.
 Example: Agreeing today to buy mentha oil in three months at a price set today.
How a Future Contract Works on the Commodity Exchange:
1. Standardization: Future contracts are standardized in terms of quantity, quality, and
delivery date.
2. Trading: Traders can buy or sell future contracts on the exchange. Prices fluctuate based
on supply and demand.
3. Margin Requirements: Traders must deposit a margin (initial margin) to ensure contract
performance. This margin may vary based on volatility.
4. Daily Settlement: Mark-to-market, where gains or losses are settled daily based on the
closing price.

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 5. Closing the Position: Traders can either take delivery of the commodity or close their
position before the contract expiry by making an offsetting trade.
Role of Commodity Exchange in Futures Trading, Settlement, and Delivery:
 Trading Platform: Provides a marketplace for buying and selling futures contracts.
 Clearing House: Acts as an intermediary to guarantee contract performance, reducing
counterparty risk.
 Price Discovery: Helps in discovering prices through supply and demand dynamics.
 Regulation and Compliance: Ensures that trading follows regulatory standards to
maintain market integrity.
 Settlement and Delivery:
 Cash Settlement: Some contracts are settled in cash without physical delivery.
 Physical Delivery: On contract expiry, the physical commodity is delivered. The
exchange designates delivery locations and ensures quality specifications.

Question 02:
How should a Mentha Oil futures market breadth and depth be calculated? What are the
implications of this analysis in commodity futures contract management?
Ans: Calculating Market Breadth and Depth for Mentha Oil Futures

Market Breadth Calculation:

1. Number of Contracts Traded:
 Formula: Sum of all futures contracts traded over a specific period.
 Example: From Exhibit 4, to calculate the quarterly volume, sum the metric tons
traded in each quarter. For Q1 2017, the average quarterly volume is 667 metric
tons.
2. Open Interest:
 Formula: Total number of outstanding futures contracts (both long and short) that
have not been settled.
 Example: From Exhibit 4, for Q1 2017, the average quarterly open interest is
1,654 metric tons.
3. Number of Market Participants:
 Formula: Count of distinct traders with open positions or engaged in trading
during a specific period.

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  Data Source: Typically available through exchange records but not explicitly
provided in the given exhibits.
Market Depth Calculation:
1. Order Book Analysis:
 Depth of Market (DOM): Examines the volume of buy and sell orders at various
price levels. This requires data from the exchange's order book.
 Example: Not explicitly provided in the exhibits, but involves analyzing the order
book for buy and sell volumes at different price levels.
2. Average Daily Volume (ADV):
 Formula: Total volume traded over a period divided by the number of trading
days in that period.
 Example: From Exhibit 5, the average daily traded volume from Jan. 1, 2014 –
Nov. 4, 2020, was 815 metric tons. For the period of steep decline, it was 364
metric tons.
3. Price Impact Measure:
 Formula: Assess how much the price moves in response to a given trade size. This
requires intraday price and volume data.
 Example: Not explicitly provided in the exhibits but involves analyzing price
changes due to large trades.
Implications in Commodity Futures Contract Management:
1. Liquidity Management:
 High Breadth and Depth: Indicates a liquid market, facilitating easy entry and exit
from positions without significant price changes. This attracts more participants,
including speculators and hedgers.
 Low Breadth and Depth: Indicates potential liquidity issues, where large trades
can cause significant price fluctuations, increasing market risk.
2. Risk Management:
 Mitigating Volatility: High market depth reduces the impact of large orders on
price volatility, making the market more stable and less prone to manipulation.
 Hedging Efficiency: Adequate breadth ensures that there are enough
counterparties for hedgers to effectively manage their price risks.
3. Pricing Efficiency:

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  Accurate Price Discovery: High breadth and depth ensure that prices reflect true
supply and demand conditions, leading to more accurate and reliable pricing of
futures contracts.
 Reduced Slippage: For traders, reduced slippage in a deep and broad market leads
to lower transaction costs and better execution prices.
4. Contract Design and Regulation:
 Adjusting Specifications: Exchanges may adjust contract specifications like lot
sizes, margin requirements, and position limits based on market breadth and depth
to ensure fair and efficient trading.
 Ensuring Market Integrity: Regulatory measures to maintain sufficient breadth
and depth, such as imposing limits on speculative positions, can help ensure
market integrity and protect against excessive volatility.
5. Attracting Participation:
 Increased Confidence: High market breadth and depth attract more participants
due to the increased confidence in the market's ability to handle large trades and
maintain stability.
 Incentives for FPCs: As shown in Exhibit 10, providing incentives such as
reimbursing assaying and storage charges encourages participation from Farmer
Producer Companies (FPCs), enhancing market breadth.
In summary, analyzing market breadth and depth for Mentha Oil futures helps in understanding
liquidity, managing risk, ensuring pricing efficiency, designing effective contract specifications,
and attracting diverse market participants, all of which are crucial for robust commodity futures
contract management.