Commodities-Mkt-Module

NCFM

NSE's CERTIFICATION IN FINANCIAL MARKETS

Commodities Market Module Work Book

NATIONAL STOCK EXCHANGE OF INDIA LIMITED

Contents 1

Introduction to derivatives................................................................................ 1.1 Derivatives defined .................................................................................... 1.2 Products, participants and functions .......................................................... 1.3 Derivatives markets ................................................................................... 1.3.1 1.3.2 1.3.3

11 11 12 13

Spot versus forward transaction .................................................... Exchange traded versus OTC derivatives ..................................... Some commonly used derivatives ..................................................

14 14 16

2

Commodity derivatives .................................................................................... 2.1 Difference between commodity and financial derivatives ......................... 2.1.1 Physical settlement ......................................................................... 2.1.2 Warehousing .................................................................................. 2.1.3 Quality of underlying assets ........................................................... 2.2 Global commodities derivatives exchanges ................................................ 2.2.1 Africa.............................................................................................. 2.2.2 Asia ............................................................................................... 2.2.3 Latin America................................................................................. 2.3 Evolution of the commodity market in India .............................................. 2.3.1 The Kabra committee report ......................................................... 2.3.2 Latest developments .......................................................................

19 19 19 21 22 22 24 24 24 24 25 27

3

The NCDEX platform ...................................................................................... 3.1 Structure of NCDEX ................................................................................... 3.1:1 Promoters ....................................................................................... 3.1.2 Governance .................................................................................... 3.2 Exchange membership ............................................................................... 3.2.1 Trading cum clearing members (TCMs) ........................................ 3.2.2 Professional clearing members (PCMs) .........................................

31 31 32 32 32 32 33

3.3 Capital requirements .................................................................................. 3.4 The NCDEX system ..................................................................................

33 34

3.4.1 3.4.2 3.4.3

Trading .......................................................................................... Clearing ......................................................................................... Settlement.......................................................................................

34 35 35

CONTENTS

4

4

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

37 37 38 40 42 43 45 46 47 49 50 54

5

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

59 59 60 60 61 62 62 63 64 65 65 65 65 67 68 68 69 69 70 71

6

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

77 77 78 80 82 83

CONTENTS

5

7

Using commodity futures ................................................................................. 7.1 Hedging ....................................................................................................... 7.1.1 Basic principles of hedging ........................................................... 7.1.2 Short hedge.................................................................................... 7.1.3 Long hedge ..................................................................................... 7.1.4 Hedge ratio .................................................................................... 7.1.5 Advantages of hedging ................................................................... 7.1.6 Limitation of hedging: basis Risk ................................................. 7.2 Speculation .................................................................................................. 7.2.1 Speculation: Bullish commodity, buy futures ............................... 7.2.2 Speculation: Bearish commodity, sell futures ............................... 7.3 Arbitrage .................................................................................................... 7.3.1 Overpriced commodity futures: buy spot, sell futures .................. 7.3.2 Underpriced commodity futures: buy futures, sell spot ................

87 87 87 88 89 91 92 93 94 94 95 95 96 97

8

Trading .............................................................................................................. 8.1 Futures trading system ............................................................................... 8.2 Entities in the trading system ..................................................................... 8.2.1 Guidelines for allotment of client code.......................................... 8.3 Contract specifications for commodity futures .......................................... 8.4 Commodity futures trading cycle............................................................... 8.5 Order types and trading parameters ........................................................... 8.5.1 Permitted lot size ............................................................................ 8.5.2 Tick size for contracts ................................................................... 8.5.3 Quantity freeze .............................................................................. 8.5.4 Base price ...................................................................................... 8.5.5 Price ranges of contracts ............................................................... 8.5.6 Order entry on the trading system .................................................. 8.6 Margins for trading in futures .................................................................... 8.7 Charges ......................................................................................................

101 101 101 102 103 103 104 108 108 109 109 109 110 112 113

9

Clearing and settlement.................................................................................... 9.1 Clearing....................................................................................................... 9.1.1. Clearing mechanism ....................................................................... 9.1.2 Clearing banks ................................................................................ 9.1.3 Depository participants ................................................................. 9.2 Settlement .................................................................................................. 9.2.1 Settlement mechanism................................................................... 9.2.2 Settlement methods ....................................................................... 9.2.3 Entities involved in physical settlement ......................................... 9.3 Risk management ........................................................................................ 9.4 Margining at NCDEX ................................................................................ 9.4.1 SPAN .............................................................................................

117 117 118 118 119 119 119 122 124 125 126 126

6

CONTENTS 9.4.2 9.4.3 9.4.4 9.4.5

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

126 126 128 130

10

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

135 135 136 136 140 144 145 146

11

Implications of sales tax ...................................................................................

149

List of Tables 2.1 The global derivatives industry............................................................................ 23

2.2 Volume on existing exchanges ...........................................................................

27

2.3 Registered commodity exchanges in India .........................................................

28

3.1 Fee / deposit structure and networth requirement: TCM ...................................... 33

3.2 Fee / deposit structure and networth requirement: PCM ..................................... 33

4.1 Country-wise share in gold production; 1968 and 1999 ......................................

51

5.1 Distinction between futures and forwards ..........................................................

61

5.2 Distinction between futures and options.............................................................. 72

6.1 NCDEX - indicative ware house charges.............................................................

82

7.1 Refined soy oil futures contract specification.....................................................

89

7.2 Silver futures contract specification ...................................................................

90

8

List of Tables

7.3 Gold futures contract specification ......................................................................

93

8.1 Commodity futures contract and their symbols ................................................... 103

8.2 Gold futures contract specification ..................................................................... 104

8.3 Long staple cotton futures contract specification ............................................... 105

8.4 Commodity futures: Quantity freeze unit ........................................................... 109

8.5 Commodity futures: Lot size another parameters ................................................ 111

9.1 MTM on along position in cotton futures ............................................................ 120

9.2 MTM on a short position in cotton futures .......................................................... 121

9.3 Calculating outstanding position at TCM level ................................................... 127

9.4 Minimum margin percentage on commodity futures contracts ........................... 127

9.5 Exposure limit as a multiple of liquid net worth.................................................. 130

9.6 Number of days for physical settlement on various commodities ....................... 131

List of Figures 5.1 Payoff for a buyer of gold ....................................................................................

66

5.2 Payoff for a seller of gold ....................................................................................

66

5.3 Payoff for a buyer of gold futures ........................................................................

67

5.4 Payoff for a seller of cotton futures .....................................................................

68

5.5 Payoff for buyer of call option on gold................................................................

69

5.6 Payoff for writer of call option on gold ...............................................................

70

5.7 Payoff for buyer of put option on long staple cotton ...........................................

71

5.8 Payoff for writer of put option on long staple cotton...........................................

72

6.1 Variation of basis overtime ...................................................................................

84

7.1 Payoff for buyer of a short hedge ........................................................................

88

7.2 Payoff for buyer of a long hedge .........................................................................

90

8.1 Contract cycle ....................................................................................................... 106

Distribution of weights Title

Chapter No.

Weights (%)

1

Introduction to derivatives

6

2

Commodity Derivatives

7

3

The NCDEX Platform

5

4

Commodities traded on the NCDEX platform

3

5

Instruments available for trading

15

6

Pricing commodity futures

16

7

Using commodity futures

14

8

Trading

16

9

Clearing and settlement

17

10

Regulatory framework

8

11

Implications of sales tax

3

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

1.1

Derivatives defined

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

12

Introduction to derivatives

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

1.2 Products, participants and functions Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories - hedgers, speculators, and arbitragers. 1. Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk. 2. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.

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

1.3 Derivatives markets

13

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use. Box 1.1: Emergence of financial derivative products

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

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

14

Introduction to derivatives

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

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

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

1.3 Derivatives markets

15

Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However "credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US, these contracts were called "futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organised futures exchanges, indeed the two largest "financial" exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Box 1.2: History of commodity derivatives markets

many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralised and located within individual institutions. 2. There are no formal centralised limits on individual positions, leverage, or margining. 3. There are no formal rules for risk and burden-sharing. 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's selfregulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

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

16

Introduction to derivatives

1.3.3 Some commonly used derivatives Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage. Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded. Options: There are two types of options - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are : • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. • Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.

Solved Problems Q: Futures trading commenced first on 1. Chicago Board of Trade 2. Chicago Mercantile Exchange A: The correct answer is number 1.

3. Chicago Board Options Exchange 4. London International Financial Futures and Options Exchange ••

1.3 Derivatives markets

17

Q: Derivatives first emerged as ------ products 1. Speculative

3. Volatility

2. Hedging

4. Risky

A: The correct answer is number 2.

••

Q: Which of the following exchanges offer commodity derivatives trading 1. National Commodity Derivatives Exchange

3. Over The Counter Exchange of India

2. Interconnected Stock Exchange

4. ICICI Securities Limited

A: The correct answer is number 1.

••

Q: OTC derivatives are considered risky because 1. There is no formal margining system.

3. They are not settled on a clearing house.

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

4. All of the

A: The correct answer is number 4.

••

Q: The first exchange traded financial derivative in India commenced with the trading of 1. Index futures

3. Stock options

2. Index options

4. Interest rate futures

A: The correct answer is number 1.

••

Q: A ____ is the simplest derivative contract 1. Option

3. Forward

2. Future

4. Swap

A: The correct answer is number 3.

••

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

3. The buyer and seller calculating the net out-standing. 4. None of the above. ••

18

Introduction to derivatives

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

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

A: The correct answer is number 3.

••

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

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

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

2.1

Difference between commodity and financial derivatives

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

2.1.1

Physical settlement

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

20

Commodity derivatives

settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities. Later on we will look into details of how physical settlement happens on the NCDEX.

Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as 'delivery notice period'. Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options market. However what is interesting and different from a typical options exercise is that in the commodities market, both positions can still be closed out before expiry of the contract. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. In the case of BMF-Brazil a seller typically has to submit the following documents: •

A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods.

•

A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.

•

A warehouse certificate showing that storage and regular insurance have been paid.

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

2.1 Difference between commodity and financial derivatives

21

Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first-in-first out basis. In some exchanges (CME), the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day.

Delivery After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts.

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

22

Commodity derivatives

The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94". The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y- is of random lengths from 8 feet to 20 feet, grade-stamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir". Box 2.3: Specifications of some commodities underlying derivatives contracts

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

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

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

2.2 Global Commodities derivatives exchanges

23

Table 2.1 The global derivatives industry Country Exchange United States of America

Chicago Board of Trade (CBOT) Chicago Mercantile Exchange Minneapolis Grain Exchange New York Cotton Exchange New York Mercantile Exchange Kansas Board of Trade New York Board of Trade Canada The Winnipeg Commodity Exchange Brazil Brazilian Futures Exchange Commodities and Futures Exchange Australia Sydney Futures Exchange Ltd. People's Republic Of China Beijing Commodity Exchange Shanghai Metal Exchange Hong Kong Hong Kong Futures Exchange Japan Tokyo International Financial Futures Exchange Kansai Agricultural Commodities Exchange Tokyo Grain Exchange Malaysia Kuala Lumpur commodity Exchange New Zealand New Zealand Futures& Options Exchange Ltd. Singapore Singapore Commodity Exchange Ltd. France Le Nouveau Marche MATIF Italy Italian Derivatives Market Netherlands Amsterdam Exchanges Option Traders Russia The Russian Exchange MICEX/ Relis Online St. Petersburg Futures Exchange Spain The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia United Kingdom The London International Financial Futures Options exchange The London Metal Exchange

exchanges in the world. The CBOT was established in 1848 to bring farmers and merchants together. Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a few years the first futures-type contract was developed. It was know as the to-arrive contract. Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges exist all over the world. On these exchanges, a wide range of commodities and financial assets form the underlying assets in

24

Commodity derivatives

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

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

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

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

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

2.3 Evolution of the commodity market in India

25

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

2.3.1

The Kabra committee report

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

6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible, particularly in commodities in which resumption of forward trading is generally demanded.

26

Commodity derivatives

The committee submitted its report in September 1994. The recommendations of the committee were as follows: • The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would need to be strengthened. • Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing. • In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further. • The FMC which regulates forward/ futures trading in the country, should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges. Amendments to the rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. • In the context of globalisation, commodity markets in India could not function effectively in an isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and castor seed, be upgraded to the level of international futures markets. • The majority of me committee recommended that futures trading be introduced in the following commodities: 1. Basmatirice 2. Cotton and kapas 3. Raw jute and jute goods 4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them. 5. Rice bran oil 6. Castor oil and its oilcake 7. Linseed 8. Silver

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

2.3 Evolution of the commodity market in India Table 2.2 Volume on existing exchanges Commodity exchange National board of trade, Indore National multicommodity exchange, Ahmedabad Ahmedabad commodity exchange Rajdhani Oil & oilseeds Vijai Beopar Chamber Ltd. Muzzaffarnagar Rajkot seeds, oil & bullion exchange IPSTA, Cochin Chamber of commerce, Hapur Bhatinda Om and oil exchange Other (mostly inactive) Total

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

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

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

• National Commodity & Derivatives Exchange of India Ltd

28

Commodity derivatives

Table 2.3 Registered commodity exchanges in India Exchange Bhatinda Om & Oil Exchange Ltd. The Bombay Commodity Exchange Ltd.

Product traded

Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed, oil and oil cake) Groundnut (Nut and oil) Castor oil, Castorseed Sesamum (Oil and oilcake) Rice bran, rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Groundnut oil Association, Ltd. Castorseed The Kanpur Commodity Exchange Ltd. Rapeseed/ Mustardseed oil and cake The Meerut Agro Commodities Exchange Co. Ltd. Gur The Spices and Oilseeds Exchange Ltd.Sangli Turmeric Ahmedabad Commodities Exchange Ltd. Cottonseed, Castorseed Vijay Beopar Chamber Ltd., Muzaffarnagar Gur India Pepper & Spice Trade Association, Kochi Pepper Rajdhani Oils and Oilseeds Exchange Ltd., Delhi Gur, Rapeseed/ Mustardseed Sugar Grade-M National Board of Trade, Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil, Crude Palm Oil The Chamber of Commerce, Hapur Gur, Rapeseed/ Mustardseed The East India Cotton Association, Mumbai Cotton The Central India Commercial Exchange Ltd., Gur The East India Jute & Hessian Exchange Ltd., Hessian, Sacking Kolkata First Commodity Exchange of India Ltd., Kochi Copra, Coconut oil & Copra cake The Coffee Futures Exchange India Ltd., Bangalore Coffee National Multi Commodity Exchange of India Gur, RBD Pamohen Limited, Ahmedabad Crude Palm Oil, Copra Rapeseed/ Mustardseed, Soy bean Cotton (Seed, oil, oilcake) Safflower (seed, oil, oilcake) Groundnut (seed, oil, oilcake) Sugar, Sacking, gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed,oil and oilcake) Linseed (seed, oil and oilcake) Rice Bran Oil, Pepper, Guarseed Aluminium ingots, Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead National Commodity & Derivatives Exchange Soy Bean, Refined Soy Oil Limited Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton Gold, Silver

2.3 Evolution of the commodity market in India

29

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

3. MTM settlement

2. Standardised contract size

4. Varying quality of underlying asset

A: The correct answer is number 4. •

•

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

3. the buyers requested destination

2. the exchange

4. None of the above

A: The correct answer is number 1 •

•

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

3. Undertaking

2. Warehouse receipt

4. Advance payment

A: The correct answer is number 2. •

•

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

3. The warehouse

2. The clearing corporation

4. The seller

A: The correct answer is number 2. •

•

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

3. National Board of Trade

2. Multi Commodity Exchange of India

4. National Stock Exchange

A: The correct answer is number 4.

••

30

Commodity derivatives

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

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

A: The correct answer is number 1.

••

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

3. Khusro Committee

2. Kabra Committee

4. J R Varma Committee

A: The correct answer is number 2.

••

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

3.1

Structure of NCDEX

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

32 ___________________________________________________ The NCDEX platform

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

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

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

3.2.1

Trading cum clearing members (TCMs)

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

33

3.3 Capital requirements Table 3.1 Fee/ deposit structure and networth requirement: TCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement

15.00 15.00 0.50 0.50 50.00

Table 3.2 Fee/ deposit structure and networth requirement: PCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement

25.00 25.00 1.00 1.00 5000.00

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

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

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

34

The NCDEX platform • Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. The minimum term of the bank guarantee should be 12 months. • Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period of 36 months from any of the approved banks.

• Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. The securities are valued on a daily basis and a haircut of 25% is levied.

Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in case of TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls below the minimum required level, NCDEX may initiate suitable action including withdrawal of trading facilities as given below: • If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be withdrawn with immediate effect.

• If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks' time to replenish the shortages and if the same is not done within the specified time the trading facility would be withdrawn.

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

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

3.4.1

Trading

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

3.4 The NCDEX system_________________________________________________ 35 queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. NCDEX trades commodity futures contracts having one-month, two-month and three-month expiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day. New contracts will be introduced on the trading day following the expiry of the near month contract.

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

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

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

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

3. Silver futures

2. Gold futures

4. Energy futures

A: The correct answer is number 4.

••

Q: NCDEX is regulated by 1. The Forward Markets Commission

3. Reserve Bank of India

2. SEBI

4. Controller of Capital Issues

A: The correct answer is number 1.

••

Q: The net worth requirement for a TCM is 1. Rs.5Lakh

3. Rs.500Lakh

2. Rs.50Lakh

4. Rs.5000Lakh

A: The correct answer is number 2.

••

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

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

4.1

Agricultural commodities

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

38

4.1.1

Commodities traded on the NCDEX platform

Cotton

Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17 million bales (average annual consumption, 1 bale = 170 kg) of raw cotton trade in the country. The market size of raw cotton in India is over Rs.130 billion. The average monthly fluctuation in prices of cotton traded across India has been at around 4.5% during the last three years. The maximum fluctuation has been as high as 11%. Historically, cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis. Cotton is among the most important non-food crops. It occupies a significant position, both from agricultural and manufacturing sectors' points of view. It is the major source of a basic human need clothing, apart from other fibre sources like jute, silk and synthetic. Today, cotton occupies a significant position in the Indian economy on all fronts as a commodity that forms a means of livelihood to over millions of cotton cultivating farmers at the primary agricultural sector. It is also a source of direct employment to over 35 million people in the secondary manufacturing textile industry that contributes to 14% of the country's industrial production, 27-30% of the country's export earnings and 4% of its GDP.

Cropping and Growth pattern Cotton is a tropical and sub-tropical crop. For the successful germination of its seeds, a minimum temperature of 150°C is required. The optimum temperature range for vegetative growth is 21- 270°CIt can tolerate temperatures as high as 430°C , but does not do well if the temperature falls bellow 210°C. During the period of fruiting, warm days and cool nights, with large diurnal variations are conducive to good boll and fibre development. In the case of the rain-fed cotton, which predominates and occupies nearly 75% of the area under this crop, a rainfall of 50 cm is the minimum requirement. More than the actual rainfall, a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton. Cotton is grown on a variety of soils. It requires a soil amenable to good drainage, as it does not tolerate water logging. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils. The predominant types of soils on which the crop is grown are (l)Alluvial soils predominant in the northern states of Punjab, Haryana, Rajasthan and Uttar Pradesh, (2)The black cotton soils, (3)The red sandy loams to loams - predominant in the states of Gujarat, Maharashtra, Madhya Pradesh, Andhra Pradesh, Karnataka and Tamil Nadu, and (4)Lateritic soils - found in parts of Tamil Nadu, Assam and Kerala. Cotton is a 90-120 day annual crop. In the main producing countries of USA, China, India and Pakistan, the crop is sown during the June-July period and harvested during September-October. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. Kappas are bought by ginners, who separate the seeds from the lint (cotton fibre), a process called ginning (lint recovery from kappas is 30-31%). The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in India; in USA, it is 480 pounds). Spinned cotton yarn is used by clothe manufacturers/ textile industry.

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Global and domestic demand-supply dynamics China, USA, India and Pakistan top the list of cotton producing countries. Uzbekistan, Brazil, Turkey and Australia are the other major producers. These eight countries produced over 80% of the world's cotton production during 2001-02. China, India, USA and Pakistan top the list of cotton consuming countries. These along with Turkey, Brazil, Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% of the world's annual cotton consumption. Global production of cotton during the post 1990 (till date i.e. 2002-03 forecast) has been fluctuating in the narrow range of 16.5-21 million tons. Similarly, consumption has been in the range in the 18-20.5 million tons. The global export and import trade of cotton during the post 1990 era has been in the range of 5.5 to 6.5 million tons. Production of cotton in India during the post 1990 period has been fluctuating in the range of 1217 million bales (i.e. between 2.2-2.8 million tons), constituting about 15% of the global cotton production. Currently, the country's cotton consumption stands at 17-19 million bales (2.7-2.9 million tons). India's position on the global trade front has witnessed a drastic change during the post 1995 period. The country has turned from being net exporter to net importer. The country's raw cotton exports, which stood at 1.2-1.6 million bales during the pre-1996 period have dipped to less than 100 thousand bales. Contrary to this, the imports have sharply risen from 30000-50000 bales during the pre-1995 to little over 2.2 million bales during the last three years. Among several other reasons, it is the lack of availability of desired quality cotton that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supply. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash, uniform lots, higher ginning out-turn) and better credit terms (36 months vs. 15-30 days for local). Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from Egypt, West Africa, and the CIS countries and Australia on account of lower freight and shorter delivery periods.

Price trends and factors that influence prices Cotton production and trade is influenced by various factors. Production (acreage under the crop) of cotton varies from year to year based on the climatic factors that are crucial for the productivity of crop. Cotton trade is influenced by the supply-demand scenario, production and prices of synthetic fibre (polyester, viscose and acrylic) and prices of cotton itself, etc. The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are closely watched by the trading community. The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season. The CCI is responsible for establishing the price support in all States. Typically, market prices remain well above the MSP, and CCI operations are generally limited to commercial purchases and sales (except for a few years like 2001-02 when the prices were abysmally low).

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Commodities traded on the NCDEX platform

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

4.1.2 Crude palm oil Annual edible oil trade in India is worth over Rs.440 billion, with the share of CPO being nearly 20% (Rs.80-90 billion). The country is over-dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports. There is a close inter linkage between the various vegetable oils produced, traded and consumed across the world. The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9.7% during the past two and a half years, the maximum monthly fluctuation being as high as 25% during the period. Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. One hectare of oil palm yields approximately 20 FFBs, which when crushed yields 6 tons of oil (including the kernel oil, which is used both for edible and industrial purposes). Crude palm oil (CPO), crude palmolein, RBD (refined, bleached, deodorized) palm oil, RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market.

Cropping and growth patterns Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm cultivation. Oil palm thrives well at temperatures of 22 - 33°C with at least 5 hours sunshine per day throughout the year. Oil palm can be grown on a wide range of soil. In general, the soil should be deep, well structured and well drained. However, in areas where rainfall is marginally suitable, the waterholding capacity of the soil is of greatest importance. Flat or gentle undulating land is preferred. Oil palm is sensitive to pH above 7.5 and stagnant water.

Global and domestic demand-supply dynamics CPO is used for human consumption as well as for industrial purposes. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7.37% compounded annually during the last 12 years period. While in the importing countries like China and European Union, the consumption of palm oil is growing at the rate of 5.2% and 4.8% respectively, the consumption growth rate for the worlds leading palm oil importer

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(in specific, and edible oils in general), India, stands at 25%. India, China, Pakistan and the European Union are the major importers of palm oil. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. The total imports of India, China, Pakistan and European Union amount to approximately 56% of the total global exports of palm oil annually. Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). Palm oil dominates the global vegetable oil export trade. The two producing countries viz. Malaysia and Indonesia dominate the global trade in CPO. Their share in the global exports of CPO is to the tune of 90%. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. (MDEX) could be considered as the price maker of palm oil traded world over. This exchange trades only CPO among several derivatives of palm. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Rising consumption of palm oil in India, which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports. Palm oil supports many other industries in India like refining, vanaspati and other industrial sectors apart from human consumption as RBD palmolein. The major importing and trading centres for palm in India are Chennai, Kakinada, Mumbai and Kandla. The other centers like Mundra, Kolkata, Mangalore and Karwar also play important role, but next to the four major trading centers. Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government, mainly the exportimport policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. The entire industry of CPO in India is dominated by importers, large refiners, corporate involved in wholesale and retail trade through value-addition and retail-regional level players along with a few national level players. The industry is dominated by over 200 importing companies, who are mostly refiners too. Domestic oilseed and edible oil industry is organised in the form of oilseed crushers, processors, solvent extractors, technologists, commodity-specific producers and traders.

Price trends and factors that influence prices There exists a clear trough and crest in the seasonality of CPO production, indicating a typical seasonality in the production cycle. The production bottoms down in the months of February, March and April, while the it is at its peak during the months of August, September and October. Palm oil trade is influenced by various production, market and policy related factors. Being a perennial plantation crop, acreage under palm plantation does not vary from season to season. Production is almost evenly distributed throughout the year between 0.8-1.1 million tons in a monthly. However, it exhibits seasonal highs and lows once in a year. Yield levels of the plantations are influenced by climatic conditions like rainfall, temperature, etc. Factors that influence price are market related factors viz. supply-demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. canola/ rapeseed, coconut oil, sunflower, groundnut, etc.; supply-demand status of various consuming/importing countries;

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over-all status of the edible oil industry during the immediate past; current and a short-term forecast of the future status of the industry in various producing and consuming countries. Production and trade related policies of various exporting and importing nations of palm oil at the international scene have a major bearing on the prices of palm oil.

Trade policies in India Since oilseed is one among the major crops cultivated by millions of farmers spread across the country, and is the major source of cooking oil to over one billion consuming populace of the country, like any other welfare state, Government of India (Gol) adopts a protection policy with regard to production and trade in vegetable oils, so as to protect the interests of both the producers and consumers. While the strategy of farm subsidies and minimum support price (MSP) are on the production side, the duty structure on various forms of palm oil is the major trade-related protectionist measure.

4.1.3 RBD Palmolein The RBD (refined, bleached and deodorized) palmolein is the derivative of crude palm oil (CPO), which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations. When CPO is subjected to refinement, RBD palm oil and fatty acids are obtained. Fractionation of RBD palm oil yields RBD palmolein along with stearin, which is a white solid at room temperature. While Oil is a stable derivative saturated fat, solid at room temperature), Olein is relatively unstable (unsaturated fat, liquid at room temperature, but low cholesterol). The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. Cropping of growth patterns of CPO has been already covered.

Global and domestic demand-supply dynamics The European Union, Pakistan and Middle-East countries are the major importers of RBD palmolein. Malaysia and Indonesia, which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil, export largely as CPO as is demanded by the importing nations who refine domestically and consume. RBD palmolein exports from Malaysia have increased from 3.2 million tons in 1998 to 4.5 million tons in 2002. India, which is one of the largest importer and consumer of edible oils in the world, imports nearly 3 million tons of palm oil annually (mainly from Malaysia, followed by Indonesia). This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period. At the same time, there has been a drastic change in the composition of various forms of palm oil imported owing to the differential duty structure adopted by Indian government for crude and refined palm oil imports. The import is mainly through the ports of Kandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and Chennai. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Its production grew from 5000 tons in 1991 to 35,000 tons in 2002,

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while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million tons during 2001-02, growing at the rate of 25% compounded annually during the past decade. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers.

Price trends and factors that influence prices Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country, prices of various domestically produced and imported oils, production and trade policies of the Government mainly the exportimport policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Unlike the price of CPO imported into the country, which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India, RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time.

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

Cropping and growth patterns In India, soybean is purely a Kharif crop, whose sowing begins by end-June with the arrival of southwest monsoon. The crop, which is ready for harvest by the end of September, starts

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Commodities traded on the NCDEX platform

entering the market from October beginning onwards. Crushing for oil and meal starts from October, peaking during the subsequent two-three months.

Global and domestic demand-supply dynamics Global consumption of soy oil during 2001-02 shot up to 29.38 million tons. It has been growing at the rate of 5.63%. Notable upward movement in consumption of soy oil is being seen in EU, Central Europe, Russia, Egypt, Morocco, US, Mexico, Brazil, China and India. The consumption of soy oil in USA is to the extent of 90% of its production; growing at the rate of 2.95%, slightly higher than the growth rate of its production (2.92%). The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of soy oil. The current world production of soy oil stands at 29-30 million tons. It has been growing at the rate of 5.8% compounded annually during the last decade. The production growth rate has been the highest for Argentina at 10.8%, while that of Brazil and USA has been at 5.6% and 2.9% respectively. United States is the major producer of soy oil in the world. It accounts to approximately 29% of world soy oil production with an annual production of 8.5 million tons. Brazil and Argentina with 5.1 and 4.1 million tons of production, contribute to 17% and 14% of world production. Of the total world exports, Argentina contributes to an extent of 40.4%, growing at the rate of 11.36% compounded annually during the past decade. Production of soy oil in India has been fluctuating in the range of 0.7-0.9 million tons during the last five years, growing at the rate of 5%. In addition to domestic production, around 1.5-1.8 million tons of imports take the country's annual soy oil consumption to 2.2-2.7 million tons, with a market value of over Rs.90 billion. Imports constitute to the extent of over 65-68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Imports have been growing at the rate of approximately 20% over the period of last five years. Madhya Pradesh is considered as the soybean bowl of India, contributing 80% of the country's soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangli in Maharashtra are major trading centres of soybean, in and around which the crushing and solvent extraction units are mostly located. The refining units are located at the importing ports of Mumbai and Gujarat.

Price trends and factors the influence prices In India, spot markets of Indore and Mumbai serve as the reference market for soy oil prices. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted), Mumbai price indicates the imported soy oil price. Indian edible oil market is highly price sensitive in nature. Hence, the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor, palm oil apart from prices of domestically produced oils, production and trade policies of the government - mainly me export-import policy, over-all health of the economy that has a bearing on the purchasing power of ultimate consumers, etc. Soy oil is among the most vibrant commodities in terms of price volatility. Its

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

4.1.5 Rapeseed oil Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world, after soy and palm oils. On crushing rapeseed, oil and meal are obtained. The average oil recovery from the seed is about 33%. The remaining is obtained as oil cake/ meal, which is rich in proteins and is used as an ingredient in animal feed. Mustard oil, which is known for its pungency, is traditionally the most favoured oils in the major production tracts world over.

Cropping and growth patterns Rapeseed is a 90-110 day crop. In the countries of Canada, Australia and China, the rapeseed is sown during the months of June-July and harvested by August-September. Crushing for oil begins from October onwards. In India, rapeseed is sown in the Rabi season (November-December sowing). China also grows partly during this season. Mustard/ Rapeseed is traditionally the most important oil for the northern, central and eastern parts of the country. The pungency of the oil is considered as the major quality determining factor. Therefore, traditional millers producing unrefined oil are more favoured by the consumers. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies), gets crushed for oil and cake in the ghanis or the expeller mills. It is largely consumed in the crude form in the local crushing regions. The cake obtained from the seed crush contains some amount of oil, which is extracted by the solvent extractors. The left over meal at the solvent extraction units forms a major portion of our oil meal basket, part of which is consumed by the domestic animal feed industry, and the rest exported. Refining of rapeseed oil was almost absent in the country till the end of the last century. As a result, the sector was more unorganised when compared to the other edible oil sectors in the country. This resulted in rampant adulteration of the oil. However, with the occurrence of dropsy in the country, Government of India issued the edible oil packaging order in 1998, which made refining and packing of all oils sold in the retail sector mandatory. Now, refining is present in rapeseed oil too.

Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth

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Commodities traded on the NCDEX platform

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

Price trends and factors the influence prices Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations.

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

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active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two years, the maximum monthly fluctuation being as high as 24-30% during the period. Historically, soybean prices in the major spot markets across the country have been fluctuating in the range of 5-9%. Soybean is the single largest oilseed produced in the world. The commodity has been commercially exploited for its utility as edible oil and animal feed. On crushing mature beans, around 18% oil could be obtained; the rest being the oil cake/ meal, which forms the prime source of protein in animal feeds.

Cropping and growth patterns Soybean could be grown under rain fed conditions, provided a good amount of soil moisture is ensured at the germination, vegetative growth and pod setting stages. The planting date of vegetable soybean is dependent upon temperature and day length. The optimum temperature range of soybean cultivation is 20 - 30°C with short day length (14 hours or less). However, planting should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.0-6.5 is suitable for its cultivation, but the field should be well drained.

Global and domestic demand-supply dynamics About 82-85% of the global soybean production is crushed for oil and meal, while the rest is consumed either in the form of bean itself or for value-added soybean snack foods. USA, Brazil, Argentina, China and European Union countries constitute for the bulk of world's annual soybean consumption. Mexico, Japan, India and Taiwan are among the other major consumers. During the past five years period, global consumption of soybean has grown at the rate of 5.25%, higher than the production growth rate of 5.19%. Of the total 310-320 million tons of oilseeds produced annually, soybean production alone stands at 170-190 million tons, contributing to over 55% of the global oilseeds production. During the last decade, the production of the commodity grew at the rate of 5.35% at the global level. USA, followed by Brazil and Argentina are the major producing countries; India and China are among the other producers. The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual production of 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total oilseed production. Of the total bean produced, 6-7 lakh tons goes for direct consumption in the form of bean itself (sowing, human consumption as bean itself), leaving the rest of the quantity for crushing for meal and oil. While the country imports soy oil, it is a leading exporter of meal in the Asian region. Madhya Pradesh is the soybean bowl of India, contributing 65-70% of the country's soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities.

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

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Commodities traded on the NCDEX platform

oil meal, the major protein source in animal feeds. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9.8% during the past two years (July 2001 to July 2003), the maximum monthly fluctuation being as high as 23.4% during the period. Rapeseed/ Mustard/ Canola is a traditionally important oilseed. China, Canada and India are the major producers of this commodity. The other major producers are Germany, France, Australia, Pakistan and Poland. The commodity has been commercially exploited in the form of seeds, oil (seed to oil recovery is 39-40%) and meal. The hybrid form of rapeseed, known as canola, is more popular internationally.

Cropping and growth patterns Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown in India. They are generally divided into three groups: 1. Brown mustard, commonly called rai (raya or laha) 2. Sarson: (i) Yellow sarson (ii) Brown sarson

3. Toria (Lahi or Maghi Labi) Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool temperatures for satisfactory growth. In India, they are grown during the Rabi season from September-October to February-March. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. Sarson is preferred in low-rainfall areas, whereas Rai and Toria are grown in medium and high rainfall areas respectively. Rapeseed and mustard thrive best in light to heavy loams. Rai may be grown on all types of soils, but Toria does best in loam to heavy loams. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils.

Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each. Consumption in India and Canada has posted a negative growth rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major importers, whose share has been declining over the years. Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tons in 1999, and declined from there on to the current (2002) level of 32.5 million tons. It has been growing at the rate of 2.2% during the last 12 years period. The major contributors to global rapeseed production are China, India, Germany, France, Canada and Australia with a share of 32%, 12.6%, 12.1%, 10%, 9.8% and 3% respectively. Among the major contributors to world production, Australian rapeseed production grew at the fastest rate of 21%. While China, France and Germany are growing at a moderate rate of 2-4%, India and Canada have shown a decline

4.2 Precious metals

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in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997 to 1.2 million tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada. Germany follows Canada in the export of domestically produced rapeseed oil. Its exports too have fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and China consume most of the rapeseed oil that is produced domestically. Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5-4.8 million tons of rapeseed available for produced annually in the country supplies over 1.5 million tons of oil and 3-3.2 million tons of meal on crushing. It is the largest produced edible oil in India (groundnut oil production also stands on par with it during good years). It forms over one-third of the country's annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres.

Price trends and factors the influence prices Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil traded across the country. Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations. Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value chain of the commodity- the producing farmers, processors, brokers, speculators, mustard oil and traders of other oils. Import of both refined and crude rapeseed oil is permitted into the country. The import duty on crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oil for the last few years due to the differential duty structure.

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

50

Commodities traded on the NCDEX platform

Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November 1972. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. The gold contracts became so popular that by 1974 there was as many as 10,00,000 contracts floating in the market. The futures trading in gold started in other countries too. This included the following: • The London gold futures exchange started operations in the early 1980s. • The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange had a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other. • The Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance between the Gold Exchange of Singapore and the International Monetary Market (TMM) of Chicago. • The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with seven million contracts. • On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange and the Mid-America Commodity Exchange introduced gold futures contracts. • The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002. • Mumbai's first multi-commodity exchange, the National Commodities and Derivatives Exchange, NCDEX launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation, National Bank for Agriculture and Rural Development and National Stock Exchange of India Limited, introduces gold futures contracts. Gold has a very active derivative market compared with other commodities. Gold accounts for 45 per cent of the worlds commercial banks commodity derivatives portfolio.

Box 4.4: History of derivatives markets in gold

4.2.1

Gold

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

51

4.2 Precious metals Table 4.1 Country-wise share in gold production, 1968 and 1999 Country Tonnes, 1968 Share 1968 Tonnes, 1999 South Africa Australia Canada USA China Indonesia India Rest of the world Total

972

67

87 44

6 3

87 1450

Share, 1999

6

437 309 154 334 154 154 51 463

17 12 6 13 6 6 2 18

100

2571

100

Production Traditionally South Africa has been the largest producers of gold in the world accounting for almost 80% of all non-communist output in 1970. Although it retained its position as the single largest gold producing country, its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Table 4.1 gives the country-wise share in gold production. In contrast other countries like US, Australia, Canada and China have increased their output exponentially with output from developing countries like Peru and other Latin American countries also increasing impressively. Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly from the Kolar gold mines in Karnataka) as against a total world production of about 2,272 tonnes in 1995.

Melting & refining assaying facility in India At present, gold is mainly refined in Bombay where a few refineries like the India Government Mint and National refinery are active. Some private refineries are also operating elsewhere with limited capacity. As none of the refineries is LBMA recognised, there is a need to upgrade and also increase the refining capacity.

Global and domestic demand-supply dynamics The demand for gold may be categorised under two heads - consumption demand and investment demand. Consumption of gold differs according to type, namely industrial applications and jewellery. The special feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly consumed. This is unlike consumption in the form of jewellery, which remains as stock and can reappear at future time in market in another form. Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry forms 89% of consumer demand.

52

Commodities traded on the NCDEX platform

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

• Gold-oriented funds

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

4.2 Precious metals

53

play an important role in marriage and religious festivals in India. In the Hindu, Jain and Sikh community, where women did not inherit landed property whereas gold and silver jewellery was, and still is, a major component of the gifts given to a woman at the time of marriage. The changeover hands of gold at the time of marriage are from few grams to kgs. The gold also occupies a significant position in the temple system where gold is used to prepare idol and devotees offer gold in the temple. These temples are run in trust and gold with the trust rarely comes into re-circulation. The existing social and cultural system continues to cause net gold buyer market and the government policies have to take note of the root cause of gold demand, which lies in the social and cultural system of India. The annual consumption of gold, which was estimated at 65 tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it is likely that, with prosperity and enlightenment, there may be deceleration in demand, particularly in urban areas, it would be made good by growing demand on account of prosperity in rural areas. In the near future, therefore, the annual demand will continue to be over 600 tonnes per year.

Supply Indian gold holding, which are predominantly private, is estimated to be in the range of 1000013000 tonnes. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%. The demand-supply for gold in India can be summed up thus: • Demand for gold has an autonomous character. Supply follows demand. • Demand exhibits income elasticity, particularly in the rural and semi-urban areas.

• Price differential creates import demand, particularly illegal import prior to the commencement of liberalisation in 1990.

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

54

Commodities traded on the NCDEX platform

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

4.2.2 Silver The dictionary describes it as a white metallic element, sonorous, ductile, very malleable and capable of high degree of polish. It also has the highest thermal and electrical conductivity of any substance. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. Silver remains one of the most prominent candidates in the metals complex as far as futures' trading is concerned. Thanks to its unique volatility, silver has remained a hot favourite speculative vehicle for the small time traders. Though futures trading was banned in India since late sixties, parallel futures markets are still very active in Delhi and Indore. Speculative interest in the white metal is so intense that it is believed that combined volume of Indian punters represent almost 40 percent of volume traded at New York Commodity Exchange. Delhi, Rajasthan, MP and UP are the active pockets for the silver futures. Until recently, Rajkot and Mathura were conducting futures but now players have diverted toward comex trade. Most of the world's silver is mined in the US, Australia, Mexico, Peru, and Canada. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. Taking cue from gold, government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry. The unique properties of silver restrict its substitution in most applications.

Production Silver ore is most often found in combination with other elements, and silver has been mined and treasured longer than any of the other precious metals. Mexico is the worlds leading producer of silver, followed by Peru, Canada, the United States, and Australia. The main consumer countries for silver are the United States, which is the worlds largest consumer of silver, followed by Canada, Mexico, the United Kingdom, France, Germany, Italy, Japan and India. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth, industrial production, income levels, and a whole host of other financial macro economic indicators.

Demand Demand for silver is built on three main pillars; industrial and decorative uses, photography and jewelry & silverware. Together, these three categories represent more than 95 percent of annual silver consumption. In recent years, the main world demand for silver is no longer monetary, but industrial. With the growing use of silver in photography and electronics, industrial demand for silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is the second largest component, with more demand from the flatware industry than from the jewelry industry in recent years. India, the largest consumer of silver, is gearing up to start hallmarking of the white precious metal by April. India annually consumes around 4,000 tonnes of silver,

4.2 Precious metals

55

Major markets like the London market (London Bullion Market Association), which started trading in the 17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The London market has a fix which offers the chance to buy or sell silver at a single price. The fix begins at 12:15 p.m. and is a balancing exercise; the price is fixed at the point at which all the members of the fixing can balance their own, plus clients, buying and selling orders. Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969, respectively. In the United States, the silver futures market functions under the surveillance of an official body, the Commodity Futures Trading Commission (CFTC). Although London remains the true center of the physical silver trade for most of the world, the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. Spot prices for silver are determined by levels prevailing at the COMEX. Although there is no American equivalent to the London fix, Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at noon each working day. Box 4.5: Historical background of silver markets

with the rural areas accounting for the bulk of the sales. India's demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. According to GFMS, India has emerged as the third largest industrial user of silver in the world after the US and Japan.

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

56

Commodities traded on the NCDEX platform

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

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

3. Silver

2. Rapeseed

4. Energy

A: The correct answer is number 4.

••

Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment? 1. Wheat

3. Soybean

2. Rapeseed

4. Soy oil

A: The correct answer is number 1.

••

Q: In India, ___ is the most important non-food crop. 1. Jute

3. Silk

2. Cotton

4. None of the above.

A: The correct answer is number 2.

••

4.2 Precious metals

57

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

3. Previous prices of cotton

2. Production and prices of synthetic fibre

4. Prices of cotton products.

A: The correct answer is number 4.

••

Q: Futures prices of cotton at the __ serve as the reference price for cotton traded in the international market. 1. CME

3. NYBOT

2. CBOT

4. SGX

A: The correct answer is number 3.

••

Q: Palm oil is extracted from the __ of oil palm plantations. 1. Mature fresh fruit bunches

3. Stem

2. Dry fruit bunches

4. Leaves

A: The correct answer is number 1.

••

Q: RBD Palmolein is the derivative of 1. Soy

3. CPO

2. Rapeseed

4. Coconut kernel

A: The correct answer is number 3.

••

Q: Which of the following factor directly influences the price of RBD palmolein? 1. Prices of Rapeseed oil

3. Prices of CPO

2. Prices of coconut oil

4. Prices sunflower oil

A: The correct answer is number 3.

••

Q: Soy oil is the derivative of 1. Soy

3. CPO

2. Soybean

4. Sunflower seeds

A: The correct answer is number 2.

••

58

Commodities traded on the NCDEX platform

Q: The ____ market reflects the price of domestically crushed soybean 1. Mumbai

3. Indore

2. Ahmedabad

4. Delhi

A: The correct answer is number 3.

••

Q: The ____ market reflects the price of imported soybean 1. Mumbai

3. Indore

2. Ahmedabad

4. Delhi

A: The correct answer is number 1.

••

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

5.1

Forward contracts

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

• If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

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

60

Instruments available for trading

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

5.1.1

Limitations of forward markets

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

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

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

5.2 Introduction to futures

61

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

Box 5.6: The first financial futures market

Table 5.1 Distinction between futures and forwards Futures

Forwards

Trade on an organised exchange

OTC in nature

Standardized contract terms hence more liquid Requires margin payments Follows daily settlement

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

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

• Location of settlement

5.2.1

Distinction between futures and forwards contracts

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

62

Instruments available for trading

5.2.2 Futures terminology • Spot price: The price at which an asset trades in the spot market. • Futures price: The price at which the futures contract trades in the futures market. • Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day of the delivery month. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a new contract having a three-month expiry is introduced for trading. • Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. • Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the Gold futures contract is 1 kg. • Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. • Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. ■ Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. • Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

• Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

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

5.3 Introduction to options

63

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honour the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early '80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back. Box 5.7: History of options

5.3.1

Option terminology

■ Commodity options: Commodity options are options with a commodity as the underlying. For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract. ■ Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. • Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer. • Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. • Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. • Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. • Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. ■ Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. • Strike price: The price specified in the options contract is known as the strike price or the exercise price.

64

Instruments available for trading • American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. • European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart. • In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-themoney when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). • Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. • Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St - K)] which means the intrinsic value of a call is the greater of 0 or (St - K). Similarly, the intrinsic value of a put is Max [0, (K - St )],i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price.

• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

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

5.5 Payoff for futures

65

Options made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiralled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs. Box 5.8: Use of options in the seventeenth-century

5.4.1 Payoff for buyer of asset: Long asset In this basic position, an investor buys the underlying asset, gold for instance, for Rs.6000 per 10 gms, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be "long" the asset. Figure 5.1 shows the payoff for a long position on gold.

5.4.2 Payoff for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, cotton for instance, for Rs.6500 per Quintal, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be "short" the asset. Figure 5.2 shows the payoff for a short position on cotton.

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

5.5.1

Payoff for buyer of futures: Long futures

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

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Instruments available for trading

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

Figure 5.2 Payoff for a seller of gold The figure shows the profits/losses from a short position on cotton. The investor sold long staple cotton at Rs. 65000 per Quintal. If the price of cotton falls, he profits. If the price of cotton rises, he looses.

5.5 Payoff for futures

67

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

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

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

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Instruments available for trading

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

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

5.6.1

Payoff for buyer of call options: Long call

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

5.6 Payoff for options

69

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

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

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

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Instruments available for trading

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

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

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

5.7 Using futures versus using options

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

sold at a premium of Rs.400.

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

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Instruments available for trading

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

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

be created.

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

5.7 Using futures versus using options

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

3. Interest rate

2. Commodities

4. Foreign exchange

A: The correct answer is 2

••

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

3. Cotton

2. Gold

4. Stocks

A: The correct answer is 4

••

Q: Which of the following exchanges was the first to start trading commodity futures? 1. Chicago Board of Trade 2. Chicago Mercantile Exchange

3. Chicago Board Options Exchange 4. London International Financial Futures and Options Exchange

A: The correct answer is 3.

••

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

3. Both

2. Seller

4. Exchange

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

••

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

3. a function of the volatility of the index

2. Unlimited

4. None of the above

A: The correct answer is number 2.

••

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Instruments available for trading

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

3. Spot contract

2. Forward contract

4. None of the above

A: The correct answer is number 2.

••

Q: Typically option premium is 1. Less than the sum of intrinsic value and time time value

3. Equal to the sum of intrinsic value and value

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

4. Independent of intrinsic value and time

A: The correct answer is number 3.

••

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

3. Rs.14

2. Rs.4

4. Rs.12

A: The correct answer is number 2.

••

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

3. Spot contract

2. Exchange traded contract

4. None of the above

A: The correct answer is number 1.

••

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

3. (+)50,000

2. (-)5000

4. (-)50,000

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

5.7 Using futures versus using options

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

3. (+)50,000

2. (-)5000

4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. • •

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

3. (+)50,000

2. (-)5000

4. (-)50,000

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

3. (+)50,000

2. (-)5000

4. (-)50,000

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

3. (-) 10,000

2. (+) 1,000

4. (-) 1,000

A: Per 10 gms he makes a net profit of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000 gms. So

 100  × 10  The correct answer is number 2. • •  10 

he makes a net profit of Rs. 1000 on his position 

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Instruments available for trading

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

3. (-)700

2. (+) 1,000

4. (-) 1,000

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

3. (-) 10,000

2. (+) 1,000

4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short

 100  × 10  . The  10 

position in 1000 gms. So he makes a net loss of Rs.1000 on his position  correct answer is number 4.

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

3. (-)700

2. (+) 1,000

4. (-) 1,000

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

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

6.1

Investment assets versus consumption assets

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

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Pricing commodity futures

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

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

F = S-C

(6.1)

where: F Futures price S Spot price C Holding costs or carry costs The fair value of a futures contract can also be expressed as: F = S(l + r)T where: r Percent cost of financing

(6.2)

6.2 The cost of carry model

79

T Time till expiration Whenever the futures price moves away from the fair value, there would be opportunities for arbitrage. If F < S(1 + r)T or F > S(1 + r)T, arbitrage would exist. We know what are the spot and futures prices, but what are the components of holding costs? The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased. In the case of equity futures, the holding cost is the cost of financing minus the dividends returns. Equation 6.2 uses the concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. Most books on derivatives use continuous compounding for pricing futures too. When we use continuous compounding, equation 6.2 is expressed as:

F - SerT

(6.3)

where: r Cost of financing (using continuously compounded interest rate) T Time till expiration e 2.71828 So far we were talking about pricing futures in general. To understand the pricing of commodity futures, let us start with the simplest derivative contract - a forward contract. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. However, the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs. Then we introduce real world factors as they apply to investment commodities and later to consumption commodities. Consider a three-month forward contract on a stock that does not pay dividend. Assume that the price of the underlying stock is Rs.40 and the three-month interest rate is 5% per annum. We consider the strategies open to an arbitrager in two extreme situations. 1. Suppose that the forward price is relatively high at Rs.43. An arbitrager can borrow Rs.40 from the market at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in the forward market at Rs.43. At the end of three months, the arbitrager delivers the share and receives Rs.43. The sum of money required to pay off the loan is 40e 0.05 × 0.25 − 40.50. By following this strategy, the arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at the end of the three month period.

80

Pricing commodity futures 2. Suppose that the forward price is relatively low at Rs.39. An arbitrager can short one share for Rs.40, invest the proceeds of the short sale at 5% per annum for three months, and take a long position in a 0.05 × 0.25

three-month forward contract. The proceeds of the short sale grow to 40e − 40.50 in three months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share under the terms of the forward contract and uses it to close his short position, in the process making a net gain of Rs. 1.50 at the end of three months.

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

0.15 ×

30 365

3. What are the holding costs? Let us assume that the storage cost = 0. In this case the fair value of the futures, works out to be = Rs.7086.80 0.15 ×

30

365 = Rs. 7086.80 F = Se rT = 7000e If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing

would increase the futures price. Therefore, the futures price would be F = 7000e Rs.7263.75

6.2.1

0.15 ×

90 365

=

Pricing futures contracts on investment commodities

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

6.2 The cost of carry model 8 1 Under normal market conditions, F, the futures price is very close to S(X + r)T. However, on October 19,1987, the US market saw a breakdown in this classic relationship between spot and futures prices. It was the day the markets fell by over 20% and the volume of shares traded on the New York Stock Exchange far exceeded all previous records. For most of the day, futures traded at significant discount to the underlying index. This was largely because delays in processing orders to sell equity made index arbitrage too risky. On the next day, October 20,1987, the New York Stock Exchange placed temporary restrictions on the way in which program trading could be done. The result was that the breakdown of the traditional linkages between stock indexes and stock futures continued. At one point, the futures price for the December contract was 18% less than the S&P 500 index which was the underlying index for these futures contracts! However, the highlight of the whole episode was the fact that inspite of huge losses, there were no defaults by futures traders. It was the ultimate test of the efficiency of the margining system in the futures market. Box 6.9: The market crash of October 19,1987

a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The per unit charges include storage costs and insurance charges. We saw that in the absence of storage costs, the futures price of a commodity that is an investment asset is given by F = SerT Storage costs add to the cost of carry. If U is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to F =

(S + U)erT

(6.4)

where: r Cost of financing (annualised) T Time till expiration U Present value of all storage costs For ease of understanding let us consider a one-year futures contract on gold. Suppose the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week, it costs Rs.3170 to store one kg of gold for a year(52 weeks). Assume that the payment is made at the beginning of the year. Assume further that the spot gold price is Rs.6000 per 10 grams and the risk-free rate is 7% per annum. What would the price of one year gold futures be if the delivery unit is one kg? F = (S+ U)erT = (600000 + 310 + 2860)e0.07 x 1 = 646904.76

82

Pricing commodity futures

Table 6.1 NCDEX - indicative warehouse charges Commodity Fixed charges Warehouse charges per unit per week (Rs.) (Rs.) Gold Silver Soy Bean Soya oil Mustard seed Mustard oil RBD Palmolein CPO Cotton - long Cotton - medium

310 610 110 110 110 110 110 110 110 110

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

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

F = (S + U)erT = (600000 + 310 + 715)e0.07 x 0.25

= 611635.50 We see that the three-month futures price of a kg of gold would be Rs.6,11,635.50. The threemonth futures price for 10 grams of gold would be about Rs.6116.

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

> (S+U)erT

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

(6.5)

6.3 The futures basis

83

1. Borrow an amount S+ U at the risk-free interest rate and use it to purchase one unit of the commodity and pay storage costs. 2. Short a forward contract on one unit of the commodity.

If we regard the futures contract as a forward contract, this strategy leads to a profit of F - (S + U) erT at the expiration of the futures contract. As arbitragers exploit this opportunity, the spot price will increase and the futures price will decrease until Equation 6.5 does not hold good. Suppose next that

F <

(S+U)erT

(6.6)

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

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