commodity derivative market in india_raghav

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RAGHAV

CHHAB

RA

A3906407273/G

29

2010

COM

MODITYDER

IVATIVE

MARKET

ININDIA

This document deals with thedetails about the commodity

derivative market in India.

Amity school of business

Amity University

Submitted to: -

Mrs. Kavitha Menon


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AcknowledgementI hereby wish to acknowledge Mrs. Kavitha menon forher valuable guidance, mellow criticism and above allunflinching moral support throughout the work.I must also thank the library and other technical stafffor their assistance during the project.I must also not forget to thank my family and friendsfor their constant support during the work.Raghav ChhabraA3906407273A3906407G29Amity school of Business


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CERTIFICATEThis is to certify that Raghav Chhabra, Amity School of Business,Amity University has completed his Dissertation on the topicCOMMODITY DERIVATIVE MARKETS IN INDIA underthe Valuable Guidance of Mrs. Kavitha Menon, Faculty Guide,Amity School of Business, Amity University.

Signature SignatureRaghav Chhabra Kavitha MenonA3906407273 Faculty GuideA3906407G29 Amity School of BusinessAmity School of Business Amity University


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ABSTRACT

Derivative refers to the financial Instruments that take its price from its

underlying assets.

Underlying refers to various assets and securities like the foreign currency, equity,

government bonds, short term negotiable debt instruments like the treasury bills

commercial papers, money market indices, indexes and credit default swaps.

The derivatives include the instruments like the future contracts, forwardcontracts, options, swaps, warrants.

Future contracts include the contract to buy or sell a commodity at a future date

and a future price. This future price is known as the strike price of the contract.

Forward contract is also a contract to buy or sell an assets or a security at a future

date and a future price. The difference between future and forward lies in the

way they are traded. Forwards are the private agreements between two parties

whereas a future contract is an exchange traded contracts.

Option is a derivative contract which gives buyers/seller the right but not the

obligation to buy/sell the commodity at the certain price with respect to a certain

option premium.

A Swap is a derivative contract in which two counterparties exchange certain

benefits in order to hedge the risk against a certain transaction.


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Warrants refers to the derivative contract in which the company attaches

warrants as a sweetener with the security giving the buyer of the security a right

to buy securities of issuing company at a certain price.

There are many derivative instruments for the currency, stocks, debt instruments,

money market indexes, other indexes and the commodity derivatives.

Commodity derivatives include the derivatives instruments which take its price

from the underlying assets as the various commodities like gold, silver, crude oil.

Commodity derivative markets include the commodity markets like the Multi

commodity exchange (MCX) and National commodity derivative exchange of India

(NCDEX).


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TABLE OF CONTENTS

1. Introduction1.1 Background of the research1.2 Objectives of the research1.3 Limitations of the Project

9

10

11

2. Research Methodology 113. What Are Derivatives

Types of Derivatives

12

13

4. Risk in derivatives 155. Hedging 166. Market participants 197. Derivatives with different

UNDERYING ASSETS

23

8. Commodity DerivativesTypes of Commodity Derivatives

31

31&30

9. Comparative analysis betweencommodity and equity markets

33

10.Commodity Derivative Markets In 34


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India

11.History Of Commodity Derivativesmarkets

35

12.Top 4 Commodity DerivativeMarkets

12.1 MCX12.2 NSDEX12.3 NMCE12.4 ICEX

38

39

41

43

13.Reasons for Success of CommodityDerivatives in India

44

14.Problem with commodityexchanges

15.Risks associated with commodityexchange

45

47


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16.Conclusions17.Suggestion18.Future Prospects19.Bibliography

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INTRODUCTION

Background of the Project: -

This project deals with the commodity derivatives market in India. This will cover

the topics like derivatives, types of Derivatives, types of risks involved, the

concept of hedging, market participants in derivatives, the commodity derivative

markets, the type of commodity derivatives, difference between commodity andequity derivatives, history of commodity derivative markets, risk and problems

associated with the commodity exchange, the Regulatory framework of

commodity derivatives in India and functions of the regulatory authorities, the

developments in the commodity exchanges of India, the suggestions and the

future prospects of the project.


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Objectives of the Project: -

1. To inquire about derivatives and the types of derivatives2. To develop deep Insights about commodity Derivatives and types of

commodity Derivatives.

3. To make a comparative analysis between the commodity and equityderivatives.

4. To develop an understanding about the market participants in the commodityderivatives market.

5. To develop insights about the risks in the derivative contracts.6. To Gather Information about the commodity derivative market in India7. To acquire information about the history of commodity derivatives in India

about how do they originated.

8. To acquire knowledge about the top 3 commodity derivatives market in India.9. To know the reasons for the success of the commodity derivatives in India.10.To get information about the various risks and problems associated with the

commodity exchanges

11.To gather information about the regulatory authorities for commodityexchanges and the regulatory framework laid down by them.


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Limitations of the Project

The information is acquired from the secondary data which narrows down the

scope of this project as the practical details about the commodity derivatives

could not be obtained.

RESEARCH METHODOLOGY

The information in this report was acquired through the secondary data though

the use of Internet and Text Books.

There is no use of primary data in this project.


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Derivatives: -

A security whose price is dependent upon or derived from one or more

underlying assets is known as a Derivative. The derivative itself is merely a

contract between two or more parties. Its value is determined by fluctuations in

the underlying asset. The most common underlying assets include stocks, bonds,

commodities, currencies, interest rates and market indexes. Most derivatives are

characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common

types of derivatives. Derivatives are contracts and can be used as an underlying

asset. There are even derivatives based on weather data, such as the amount of

rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be

used for speculative purposes. For example, a European investor purchasing

shares of an American company off of an American exchange (using U.S. dollars to

do so) would be exposed to exchange-rate risk while holding that stock. To hedge

this risk, the investor could purchase currency futures to lock in a specified

exchange rate for the future stock sale and currency conversion back into Euros.


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Types of Derivative Instruments Include: -

Forwards: A forward contract is a customized contract between two entities,

where settlement takes place on a specific date in the future at today's pre-

agreed price.

Futures: 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. Futures contracts are

special types of forward contracts in the sense that the former are standardized

exchange-traded contracts. The difference between the forward and the future

contracts lies in the way they are traded. The forward contracts are a private

agreement between two parties whereas the future contract involves an

exchange between them.

Basis of The difference Forward Future

1. Agreement Private agreementbetween two parties

They are exchange traded

contracts

2. Delivery of theassets

The delivery of the asset

usually takes place

Instead the reverse

trading takes place

3. Settlement The settlement takesplace at the maturity

period of the contact

The settlement takes

place daily that is the

marked to market

4. Settlement dates There is only onesettlement date for a

forward contract

There are a range of

dates available in a

settlement dates


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Options: Options refers to the derivative contracts in which the buyer/seller has

the right but not the obligation to buy/ sell. Options are of two types - 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.

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 cash flows in one direction being in a different currency thanthose in the opposite direction.

Warrants: warrants are a derivative contracts in which the buyer of stocks of a

company is given the rights to buy the stocks of the holding company at a certain

future date

Leaps: The acronym LEAPS means Long-Term Equity Anticipation Securities. These

are options having a maturity of up to three years longer than a general option is

available.


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Baskets: Basket options are options on portfolios of underlying assets. The

underlying asset is usually a moving average or a basket of assets. Equity index

options are a form of basket options.

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. Rather than have calls and puts, the Swaptions market has receiver

Swaptions and payer Swaptions. A receiver swaption is an option to receive fixed

and pay floating. A payer swaption is an option to pay fixed and receive floating.

Risk

Risk is that phenomenon that forces a trader to use the derivatives. It refers to a

situation or an unseen event that causes a certain loss to a person. There are two

kinds of risks that an investor could face.

1. Systematic Risk: - systematic risk refers to a portion of risk that is accordingto a specific system and cannot be controlled. This is also known as non-diversifiable risk.

2. Unsystematic risk: - Unsystematic risk refers to that portion of risk that isnot according to any system and can be controlled. Unsystematic risk is that

company or industry specific risk that is inherent in each investment one

makes.


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HEDGING

Hedging means reducing or controlling risk. This is done by taking a position in the

futures market that is opposite to the one in the physical market with theobjective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes

in price levels will be countered by changes in the value of a futures position. For

instance, a wheat farmer can sell wheat futures to protect the value of his crop

prior to harvest. If there is a fall in price, the loss in the cash market position willbe countered by a gain in futures position.

How hedging is done

In this type of transaction, the hedger tries to fix the price at a certain level with

the objective of ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take

positions based on the price movement and bet upon it. Also, there are

arbitrageurs who use this market to pocket profits whenever there are

inefficiencies in the prices. However, they ensure that the prices of spot and

futures remain correlated.

By hedging, in the general sense, we can imagine the company entering into a

transaction whose sensitivity to movements in financial prices offsets the

sensitivity of their core business to such changes. As we shall see in this article


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and the ones that follow, hedging is not a simple exercise nor is it a concept that

is easy to pin down. Hedging objectives vary widely from firm to firm, even

though it appears to be a fairly standard problem, on the face of it. And the

spectrum of hedging instruments available to the corporate Treasurer is

becoming more complex every day.

Another reason for hedging the exposure of the firm to its financial price risk is to

improve or maintain the competitiveness of the firm. Companies do not exist in

isolation. They compete with other domestic companies in their sector and with

companies located in other countries that produce similar goods for sale in theglobal marketplace. Again, a pulp-and-paper company based in Canada has

competitors located across the country and in any other country with significant

pulp-and-paper industries, such as the Scandinavian countries.

Companies that are the most sophisticated in this field recognize that the

financial risks that are produced by their businesses present a powerful

opportunity to add to their bottom line while prudently positioning the firm so

that it is not pejoratively affected by movements in these prices. This level of

sophistication depends on the firm's experience, personnel and management

approach. It will also depend on their competitors. If there are five companies in a

particular sector and three of them engage in a comprehensive financial risk

management program, then that places substantial pressure on the more passive

companies to become more advanced in risk management or face the possibility

of being priced out of some important markets. Firms that have good risk

management programs can use this stability to reduce their cost of funding or to


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lower their prices in markets that are deemed to be strategic and essential to the

future progress of their companies.

There are two types of hedge: -

1. Long Hedge/Buying: - A buying hedge is also called a long hedge. Buying hedgemeans buying a futures contract to hedge a cash position. Dealers, consumers,

fabricators, etc, who have taken or intend to take an exposure in the physical

market and want to lock- in prices, use the buying hedge strategy.

Benefits of buying hedge strategy:

To replace inventory at a lower prevailing cost. To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price

increase of a commodity in the spot market that has already been sold at a

specific price but not purchased as yet. It is very common among exporters and

importers to sell commodities at an agreed-upon price for forward delivery. If the

commodity is not yet in possession, the forward delivery is considered

uncovered.

2. Short Hedge/Selling: - A selling hedge is also called a short hedge. Selling

hedge means selling a futures contract to hedge.

Uses of selling hedge strategy.


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To cover the price of finished products. To protect inventory not covered by forward sales. To cover the prices of estimated production of finished products.

Short hedgers are merchants and processors who acquire inventories of the

commodity in the spot market and who simultaneously sell an equivalent amount

or less in the futures market. The hedgers in this case are said to be long in their

spot transactions and short in the futures transactions.

MARKET PARTICIPANTS

The Market participants in a derivative contract includes: -

1.Hedgers: - Hedgers are the people who use strategies in order to minimize therisk associated with the derivative contracts. The hedgers buy and sell in orderto protect themselves from a certain risk.

Example of a hedge include: -

A stock trader believes that the stock price of Company A will rise over the next

month, due to the company's new and efficient method of producing widgets. He

wants to buy Company A shares to profit from their expected price increase. But

Company A is part of the highly volatile widget industry. If the trader simply

bought the shares based on his belief that the Company A shares were

underpriced, the trade would be a speculation.


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Since the trader is interested in the company, rather than the industry, he wants

to hedge out the industry risk by short selling an equal value (number of shares

price) of the shares of Company A's direct competitor, Company B. If the trader

was able to short sell an asset whose price had a mathematically defined relation

with Company A's stock price (for example a call option on Company A shares) the

trade might be essentially riskless. But in this case, the risk is lessened but not

removed.

The first day the trader's portfolio is:

Long 1000 shares of Company A at $1 each Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares.)

On the second day, a favorable news story about the widgets industry is

published and the value of all widgets stock goes up. Company A, however,

because it is a stronger company, goes up by 10%, while Company B goes up by

just 5%:


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Long 1000 shares of Company A at $1.10 each: $100 gain Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the

Company A position. But on the third day, an unfavorable news story is published

about the health effects of widgets, and all widgets stocks crash: 50% is wiped off

the value of the widgets industry in the course of a few hours. Nevertheless, since

Company A is the better company, it suffers less than Company B:

Value of long position (Company A):

Day 1: $1000 Day 2: $1100 Day 3: $550 => ($1000 $550) = $450 loss


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Value of short position (Company B):

Day 1: -$1000 Day 2: -$1050 Day 3: -$525 => ($1000 $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took

the $1000 he has used in short selling Company B's shares to buy Company A's

shares as well). But the hedge - the short sale of Company B - gives a profit of

$475, for a net profit of $25 during a dramatic market collapse.

2.Speculators: - The process of selecting investments with higher risk in order toprofit from an anticipated price movement. Whereas hedgers want to avoid

exposure to adverse movements in the price of an asset, speculators wish to

take a risky position in the market. The speculators bet that the price of the

asset will go up or will go down.

3.Arbitrageurs: - Arbitrageurs involves people who indulge in locking in a risklessprofit by simultaneous buying and selling of securities.

For example: -

Suppose that the exchange rates in London are 5 = $10 = 1000 and the

exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in

Tokyo and converting that $12 into 1200 in London, for a profit of 200,

would be arbitrage


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Derivatives with different underlying assets

Equity Derivative: - An equity derivative is a class of financial instruments whose

value is at least partly derived from one or more underlying equity securities.

Market participants trade equity derivatives in order to transfer or transform

certain risks associated with the underlying security. Options are by far the most

common equity derivative; however there are many other types of equity

derivatives that are actively traded. A derivative instrument with underlying

assets based on equity securities. An equity derivative's value will fluctuate with

changes in its underlying asset's equity, which is usually measured by share price.

Investors can use equity derivatives to hedge the risk associated with taking a

position in stock by setting limits to the losses incurred by either a short or long

position in a company's shares. The investor receives this insurance by paying

the cost of the derivative contract, which is referred to as a premium. If an

investor purchases a stock, he or she can protect against a loss in share value by

purchasing a put option. On the other hand, if the investor has shorted shares, he

or she can hedge against a gain in share price by purchasing a call option.

Most Common Examples of Equity Derivatives include: -

1. Equity Options: - this gives the holder right but not the obligation to buy orsell.


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2. Warrants: - Warrants are attached to securities as a sweetener giving theright to pay lower dividends making the bonds give more yields and making

it attractive for potential buyers.

3. Convertible Bonds: - These Bonds are convertible after a certain period oftime in equity

4. Equity Futures and Swaps

Credit Derivatives: -

Privately held negotiable bilateral contracts that allow users to manage their

exposure to credit risk are known as Credit Derivatives. Credit derivatives are

financial assets like forward contracts, swaps, and options for which the price is

driven by the credit risk of economic agents (private investors or governments).

Types of Credit Derivatives

Credit Derivatives includes: -

1. Credit Default Swap: - Credit default swaps allow one party to "buy"protection from another party for losses that might be incurred as a result

of default by a specified reference credit. He may need to pay a premium in

consideration to buy the protection.

2. Credit Spread Option: -A credit spread option grants the buyer the right,but not the obligation, to purchase a bond during a specified future

exercise period at the contemporaneous market price and to receive an


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amount equal to the price implied by a strike spread stated in the

contract.

3. Credit Linked Note: -A credit-linked note (CLN) is essentially a funded CDS,which transfers credit risk from the note issuer to the investor. The issuer

receives the issue price for each Credit Linked Note from the investor and

invests this in low-risk collateral.

Foreign Exchange Derivatives: -

Foreign Exchange Derivatives include derivatives whose underlying asset is the

foreign currency or its exchange rate. Foreign Exchange Derivatives are also

known as currency derivatives which are basically used for hedging International

transactions of a company in its transactions against another country.

Foreign Exchange Derivatives Include: -

1. Foreign Exchange Option: - a foreign exchange option (commonlyshortened to just FX option or currency option) is a derivative financial

instrument where the owner has the right but not the obligation to

exchange money denominated in one currency into another currency at a

pre-agreed exchange rate on a specified date. The FX options market is the

deepest, largest and most liquid market for options of any kind in the

world.


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2. Currency Swap: - A currency swap (or cross currency swap) is a foreign-exchange agreement between two parties to exchange principal and fixed-

rate interest payments on a loan in one currency for principal and fixed-

rate interest payments on an equal in net present value loan in another

currency. Currency swaps are motivated by comparative advantage. A

currency swap should be distinguished from a central bank liquidity swap.

For example, suppose a U.S.-based company needs to acquire Swiss francs

and a Swiss-based company needs to acquire U.S. dollars. These two

companies could arrange to swap currencies by establishing an interest

rate, an agreed upon amount and a common maturity date for the

exchange. Currency swap maturities are negotiable for at least 10 years,

making them a very flexible method of foreign exchange.

3. Currency Future: - Currency futures are futures markets where theunderlying commodity is a currency exchange rate, such as the Euro to US

Dollar exchange rate, or the British Pound to US Dollar exchange rate.

Currency futures are essentially the same as all other futures markets

(index and commodity futures markets), and are traded in exactly the same

way. Futures based upon currencies are similar to the actual currency

markets (often known as Forex), but there are some significant differences.

For example, currency futures are traded via exchanges, such as the CME

(Chicago Mercantile Exchange), but the currency markets are traded via

currency brokers, and are therefore not as controlled as the currency

futures.

4. Foreign Exchange Hedge: - This involves the concept of using hedging as atool to stay protected from the risk of foreign exchange fluctuations.


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Several Hedging techniques are available to hedge foreign exchange risk

like money market hedge, forward market hedge, currency risk sharing,

currency options, currency collar etc.

INTEREST RATE DERIVATIVES

An interest rate derivative is a derivative where the underlying asset is the right to

pay or receive a (usually notional) amount of money at a given interest rate. Theinterest rate derivatives market is the largest derivatives market in the world.

Types of Interest Rate Derivatives

1. Interest rate swap: - An agreement between two parties (known ascounterparties) where one stream of future interest payments is exchanged

for another based on a specified principal amount. Interest rate swaps

often exchange a fixed payment for a floating payment that is linked to an

interest rate (most often the LIBOR). A company will typically use interest

rate swaps to limit or manage exposure to fluctuations in interest rates, or

to obtain a marginally lower interest rate than it would have been able to

get without the swap. An interest rate swap is a derivative in which one

party exchanges a stream of interest payments for another party's stream

of cash flows. Interest rate swaps can be used by hedgers to manage their

fixed or floating assets and liabilities. They can also be used by speculators

to replicate unfunded bond exposures to profit from changes in interest

rates


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2. Interest rate cap: - An interest-rate cap is an OTC derivative that protectsthe holder from rises in short-term interest rates by making a payment to

the holder when an underlying interest rate (the "index" or "reference"

interest rate) exceeds a specified strike rate (the "cap rate"). Caps are

purchased for a premium and typically have expirations between 1 and 7

years. They may make payments to the holder on a monthly, quarterly or

semiannual basis, with the period generally set equal to the maturity of the

index interest rate.

3. Interest rate swaption4. Bond option5. Forward rate agreement6. Interest rate future7. Money Market Instruments

PROPERTY DERIVATIVES

A property derivative is a financial derivative whose value is derived from the

value of an underlying real estate asset. In practice, because real estate assets fall

victim to market inefficiencies and are hard to accurately price, property

derivative contracts are typically written based on a real estate property index. In

turn, the real estate property index attempts to aggregate real estate market

information to provide a more accurate representation of underlying real estate

asset performance


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Examples of Property Derivatives: -

Property Index Notes

The PINs are essentially bonds. The cash flows of these bonds are structured in a

way that is meant to be similar to a transaction in the physical property. This

means that the PIN pays the capital return on redemption of the bond and it pays

a quarterly coupon to investors.

Total Return Swaps

A property total return swap is simply an exchange of cash flows. Here, the total

return on property, as measured by the change in the relevant IPD or FTSE UK

Commercial Property Index, is exchanged for the return on cash.

Forwards/Futures

A property forward contract is based upon the property returns in any annual

period - the expected total return for example is agreed at trade, and on maturity

the difference between the realized total return and the traded price is

exchanged.


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FREIGHT DERIVATIVES

A financial instrument's value that is derived on the future levels of freight rates,

such as "dry bulk" carrying rates and oil tanker rates is a freight derivative. Freight

derivatives are used most often by end users (such as ship owners and grain-

houses) and by suppliers (such as integrated oil companies and international

trading corporations) to mitigate risk and hedge against price spikes in the supply

chain.

Forward freight agreements are the most common freight derivative present in

todays scenario.

INSURANCE DERIVATIVES

A financial instrument that derives its value from an underlying insurance index or

the characteristics of an event related to insurance. Insurance derivatives are

useful for insurance companies that want to hedge their exposure to catastrophic

losses due to exceptional events, such as earthquakes or hurricanes.

INFLATION DERIVATIVES

A subclass of derivative that is used by individuals to mitigate the effects of

potentially large levels of inflation IS known as inflation derivatives. The most

common type of inflation derivatives are swaps, in which counterpartys cash

flows are linked to a price index and the other counterparty is linked to a

conventional fixed or floating cash flow.


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COMMODITY DERIVATIVES

Commodity derivatives include derivatives for the underlying assets i.e. the

commodities.

Commodity derivatives include the general commodity options, futures, swaps in

order to hedge the risks associated with fluctuating prices of the commodities

traded on the commodity exchange.

Commodity derivatives include the derivative instruments with commodities like:

-

1. WTI crude oil futures2. Commodity swaps3. Iron ore forward contract4. Gold option5. Weather Derivatives

The main Commodity derivatives comprise of the basic derivatives contracts: -

1. Commodity future: - an agreement to buy/sell a certain commodity at acertain date and at a certain price.

2. Commodity option: - an agreement which entitles the buyer/seller of theright but not the obligation to buy/ sell a certain commodity at a future

price in consideration for a certain premium.


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3. Commodity Swaps: - these are the types of derivative contracts in whichtwo parties agree to swaps their beneficial positions in order to save

themselves from risk.


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Comparative Analysis of Commodity And Equity Markets

Factors Commodity Markets Equity Markets

Percentage

Returns

Gold gives 10-15 % returns

on the conservative basis.

Returns in the range of 15-

20 % on annual basis.

Initial MarginsLower in the range of 4-5-

6%

Higher in the range of 25-

40%

Arbitrage

Opportunities

Exists on 1-2 monthcontracts. There is a small

difference in prices, but in

case of commodities, which

it is in large tonnage makes

a huge difference.

Significant Arbitrage

Opportunities exists.

Price

Movements

Price movements are

purely based on the supply

and demand.

Prices movements based on

the expectation of future

performance.

Price Changes

Price changes are due to

policy changes, changes in

tariff and duties.

Price changes can also be

due to Corporate actions,

Dividend announcements,

Bonus shares / Stock splits.

Future

Predictability

Predictability of future

prices is not in the control

due to factors like Failure of

Predictability of futures

performance is reasonably

high, which is


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Monsoon and Formation of

El-ninos at Pacific.

supplemented by the

History of management

performance.

Volatility Lower Volatility Higher Volatility

Securities

Transaction Act

Application

Securities Transaction Act is

not applicable to

commodity futures trading.

Securities Transaction Act is

applicable to equity

markets trading.

Commodity derivatives markets

There are 3 top commodity derivatives market: -

1. Multi Commodity exchange (MCX)2. National commodity derivatives exchange of India3. National multi commodity exchange (NMCE)

Top 5 commodity derivatives exchanges include: -

NYME (New York Mercantile Exchange) TCE (Tokyo Commodity Exchange) NYSE Euronext DCE (Dalian Commodity Exchange) MCX (Multi Commodity Exchange)


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History of Derivatives Markets in India

Historically, dating from ancient Sumerian use of sheep or goats, or other peoples

using pigs, rare seashells, or other items as commodity money, people have

sought ways to standardize and trade contracts in the delivery of such items, to

render trade itself more smooth and predictable.

Commodity money and commodity markets in a crude early form are believed tohave originated in Sumer where small baked clay tokens in the shape of sheep or

goats were used in trade. Sealed in clay vessels with a certain number of such

tokens, with that number written on the outside, they represented a promise to

deliver that number. This made them a form of commodity money - more than an

"I.O.U." but less than a guarantee by a nation-state or bank. However, they were

also known to contain promises of time and date of delivery - this made them likea modern futures contract. Regardless of the details, it was only possible to verify

the number of tokens inside by shaking the vessel or by breaking it, at which point

the number or terms written on the outside became subject to doubt. Eventually

the tokens disappeared, but the contracts remained on flat tablets. This

represented the first system of commodity accounting.

However, the Commodity status of living things is always subject to doubt - it was

hard to validate the health or existence of sheep or goats. Excuses for non-

delivery were not unknown, and there are recovered Sumerian letters that

complain of sickly goats, sheep that had already been fleeced, etc.


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If a seller's reputation was good, individual "backers" or "bankers" could decide to

take the risk of "clearing" a trade. The observation that trust is always required

between market participants later led to credit money. But until relatively

modern times, communication and credit were primitive.

Classical civilizations built complex global markets trading gold or silver for spices,

cloth, wood and weapons, most of which had standards of quality and timeliness.

Considering the many hazards of climate, piracy, theft and abuse of military fiat

by rulers of kingdoms along the trade routes, it was a major focus of these

civilizations to keep markets open and trading in these scarce commodities.

Reputation and clearing became central concerns, and the states which could

handle them most effectively became very powerful empires, trusted by many

peoples to manage and mediate trade and commerce.

The modern commodity markets have their roots in the trading of agricultural

products. While wheat and corn, cattle and pigs, were widely traded using

standard instruments in the 19th century in the United States, other basic

foodstuffs such as soybeans were only added quite recently in most markets. For

a commodity market to be established there must be very broad consensus on

the variations in the product that make it acceptable for one purpose or another.

The economic impact of the development of commodity markets is hard to

overestimate. Through the 19th century "the exchanges became effective

spokesmen for, and innovators of, improvements in transportation, warehousing,

and financing, which paved the way to expanded interstate and international

trade."


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Need For Futures Trading In Commodities

Commodity Futures, which forms an essential component of Commodity

Exchange, can be broadly classified into precious metals, agriculture, energy andother metals. Current futures volumes are miniscule compared to underlying spot

market volumes and thus have a tremendous potential in the near future.

Futures trading in commodities results in transparent and fair price discovery on

account of large-scale participations of entities associated with different value

chains. It reflects views and expectations of a wider section of people related to a

particular commodity. It also provides effective platform for price risk

management for all segments of players ranging from producers, traders and

processors to exporters/importers and end-users of a commodity.

It also helps in improving the cropping pattern for the farmers, thus minimizing

the losses to the farmers. It acts as a smart investment choice by providing

hedging, trading and arbitrage opportunities to market players. Historically,

pricing in commodities futures has been less volatile compared with equity and

bonds, thus providing an efficient portfolio diversification option.


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Multi Commodity Exchange of India (MCX)

Multi Commodity Exchange is among the top 5 largest commodity exchanges of

World.

Headquartered in the financial capital of India, Mumbai, Multi Commodity

Exchange of India Ltd (www.mcxindia.com) is a demutualised nationwide

electronic commodity futures exchange set up by Financial Technologies (India)

Ltd. with permanent recognition from Government of India for facilitating online

trading, clearing & settlement operations for futures market across the country.

The exchange started operations in November 2003.

MCX has achieved three ISO certifications including ISO 9001:2000 for quality

management, ISO 27001:2005 - for information security management systems

and ISO 14001:2004 for environment management systems. MCX offers futures

trading in more than 40 commodities from various market segments including

bullion, energy, ferrous and non-ferrous metals, oil and oil seeds, cereal, pulses,

plantation, spices, plastic and fiber. The exchange strives to be at the forefront of

developments in the commodities futures industry and has forged strategic

alliances with various leading International Exchanges, including Tokyo

Commodity Exchange, Chicago Climate Exchange, London Metal Exchange, New

York Mercantile Exchange, Bursa Malaysia Derivatives, Berhad and others.


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National Commodity Derivatives Exchange of India (NCDEX)

India's largest and most recognized commodities exchange, which was

established in 2003. The exchange was founded by some of India's leading

financial institutions such as ICICI Bank Limited, the National Stock Exchange of

India and the National Bank for Agricultural and Rural Development, among

others.

The exchange is located in Mumbai, but has offices across the country to facilitate

trade. Trading is done on 45 commodities that are integral to India's economy.

These include gold, silver, Brent Crude oil, and rice, along with other agricultural

products and base metals.

National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally

managed on-line multi commodity exchange. The shareholders of NCDEX

comprises of large national level institutions, large public sector bank and

companies.

Promoter shareholders: ICICI Bank Limited (ICICI)*, Life Insurance Corporation of

India (LIC), National Bank for Agriculture and Rural Development (NABARD) and

National Stock Exchange of India Limited (NSE).

Other shareholders: Canara Bank, Punjab National Bank (PNB), CRISIL Limited,

Indian Farmers Fertilizer Cooperative Limited (IFFCO), Goldman Sachs,

Intercontinental Exchange (ICE) and Shree Renuka Sugars Limited


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NCDEX is the only commodity exchange in the country promoted by national level

institutions. This unique parentage enables it to offer a bouquet of benefits,

which are currently in short supply in the commodity markets. The institutional

promoters and shareholders of NCDEX are prominent players in their respective

fields and bring with them institutional building experience, trust, nationwide

reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23, 2003 under the

Companies Act, 1956. It obtained its Certificate for Commencement of Business

on May 9, 2003. It commenced its operations on December 15, 2003.

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

exchange with an independent Board of Directors and professional management -

both not having any vested interest in commodity markets. It is committed to

provide a world-class commodity exchange platform for market participants to

trade in a wide spectrum of commodity derivatives driven by best global

practices, professionalism and transparency.

NCDEX is regulated by Forward Markets Commission. NCDEX is subjected to

various laws of the land like the Forward Contracts (Regulation) Act, Companies

Act, Stamp Act, Contract Act and various other legislations.

NCDEX headquarters are located in Mumbai and offers facilities to its members

from the centers located throughout India.

The Exchange, as on May 21, 2009 when Wheat Contracts were re-launched on

the Exchange platform, offered contracts in 59 commodities - comprising 39


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agricultural commodities, 5 base metals, 6 precious metals, 4 energy, 3 polymers,

1 ferrous metal, and CER. The top 5 commodities, in terms of volume traded at

the Exchange, were Rape/Mustard Seed, Gaur Seed, Soya bean Seeds, Turmeric

and Jeera.

National Multi Commodity Exchange of India (NMCE)

The Indian experience in commodity futures market dates back to thousands of

years. References to such markets in India appear in Kautialyas Arthasastra. The

words, Teji, Mandi, Gali, and Phatak have been commonly heard in Indian

markets for centuries.

The first organized futures market was however established in 1875 under the

aegis of the Bombay Cotton Trade Association to trade in cotton contracts.

Derivatives trading were then spread to oilseeds, jute and food grains. The

derivatives trading in India however did not have uninterrupted legal approval. By

the Second World War, i.e., between the 1920s &1940s, futures trading in

organized form had commenced in a number of commodities such as cotton,

groundnut, groundnut oil, raw jute, jute goods, castor seed, wheat, rice, sugar,

precious metals like gold and silver. During the Second World War futures trading

was prohibited under Defense of India Rules.

After independence, the subject of futures trading was placed in the Union list,

and Forward Contracts (Regulation) Act, 1952 was enacted. Futures trading in

commodities particularly, cotton, oilseeds and bullion, was at its peak during this

period. However following the scarcity in various commodities, futures trading in

most commodities were prohibited in mid-sixties. There was a time when trading

was permitted only two minor commodities, viz., pepper and turmeric.


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Deregulation and liberalization following the Forex crisis in early 1990s, also

triggered policy changes leading to re-introduction of futures trading in

commodities in India. The growing realization of imminent globalization under the

WTO regime and non-sustainability of the Government support to commodity

sector led the Government to explore the alternative of market-based

mechanism, viz., futures markets, to protect the commodity sector from price-

volatility. In April, 1999 the Government took a landmark decision to remove all

the commodities from the restrictive list. Food-grains, pulses and bullion were not

exceptions.

The long spell of prohibition had stunted growth and modernization of the

surviving traditional commodity exchanges. Therefore, along with liberalization of

commodity futures, the Government initiated steps to cajole and incentives the

existing Exchanges to modernize their systems and structures. Faced with the

grudging reluctance to modernize and slow pace of introduction of fair and

transparent structures by the existing Exchanges, Government allowed setting up

of new modern, demutualised Nation-wide Multi-commodity Exchanges with

investment support by public and private institutions. National Multi Commodity

Exchange of India Ltd. (NMCE) was the first such exchange to be granted

permanent recognition by the Government.


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ICEX (Indian Commodity Exchange Ltd.)

Indian Commodity Exchange Limited is a screen based on-line derivatives

exchange for commodities and has established a reliable, time tested, and a

transparent trading platform. It is also in the process of putting in place robust

assaying and warehousing facilities in order to facilitate deliveries. ICEX is latest

commodity exchange of India Started Function from 27 Nov, 09. It is jointly

promote by Indiabulls Financial Services Ltd. and MMTC Ltd. and has Indian

Potash Ltd. KRIBHCO and IFC among others, as its partners having its head office

located at Gurgaon (Haryana). BSE is also planning to set up a Commodity

exchange.

Why Commodities Market?

India has very large agriculture production in number of agri-commodities,which needs use of futures and derivatives as price-risk management

system.

Fundamentally price you pay for goods and services depend greatly on howwell business handle risk. By using effectively futures and derivatives,

businesses can minimize risks, thus lowering cost of doing business.

Commodity players use it as a hedge mechanism as well as a means ofmaking money. For e.g. in the bullion markets, players hedge their risks by

using futures Euro-Dollar fluctuations and the international prices affecting

it.

For an agricultural country like India, with plethora of mandis, trading inover 100 crops, the issues in price dissemination, standards, certification


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and warehousing are bound to occur. Commodity Market will serve as a

suitable alternative to tackle all these problems efficiently.

Reasons for the success of commodity derivatives in India

Strategy, method of execution, background of promoters, credibility of the

Institution, transparency of platforms, scalable technology, robustness of

Settlement structure wider participation of Hedgers; speculators and arbitragers,

acceptable clearing mechanism, financial soundness and capability, covering a

wide range of commodity, reach of the organization and adding value on the

ground.

In addition to his, if the Indian Commodity exchanges need to be competitive in

the Global Market, then it should be backed with proper capital account

convertibility.

The performance of the commodity derivatives exchange has been significantly

growing. The rising affection for gold and silver has led to a 3 times increase of

the use of commodity derivatives in India.

The Volume traded today is 3 times what was used during the past years.


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Key Expectations from Commodities Exchanges

The following are some of the key expectations of the investor's from any

commodity exchange: -

To get in place the right regulatory structure to even out the differencesthat may exist in various fields.

Proper Product Conceptualization and Design. Fair and Transparent Price Discovery & Dissemination. Robust Trading & Settlement systems. Effective Management of Counter party Credit Risk.

Regulatory body of Commodity exchanges:-

FMCL forward Market commission headquarter in Mumbai, is regulation authority

which is overseen by the minister of consumer affairs, food and publicdistribution Govt. of India, It is station body set up in 1953 under the forward

contract (Regulation) Act 1952.

The functions of the Forward Markets Commission are as follows:

(a) To advise the Central Government in respect of the recognition or the

withdrawal of recognition from any association or in respect of any other matter

arising out of the administration of the Forward Contracts (Regulation) Act 1952.


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(b) To keep forward markets under observation and to take such action in relation

to them, as it may consider necessary, in exercise of the powers assigned to it by

or under the Act.

(c) To collect and whenever the Commission thinks it necessary, to publish

information regarding the trading conditions in respect of goods to which any of

the provisions of the act is made applicable, including information regarding

supply, demand and prices, and to submit to the Central Government, periodical

reports on the working of forward markets relating to such goods;

(d) To make recommendations generally with a view to improving the

organization and working of forward markets;

(e) To undertake the inspection of the accounts and other documents of any

recognized association or registered association or any member of such

association whenever it considerers it necessary.

Problems faced by Commodities Markets in India

Institutional issues have resulted in very few deliveries so far. Currently, there are

a lot of hassles such as octroi duty, logistics. If there is a broker in Mumbai and a

broker in Kolkata, transportation costs, octroi duty, logistical problems prevent

trading to take place. Exchanges are used only to hedge price risk on spot

transactions carried out in the local markets. Also multiple restrictions exist on

inter-state movement and warehousing of commodities.


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Risks associated with Commodities Markets

No risk can be eliminated, but the same can be transferred to someone who can

handle it better or to someone who has the appetite for risk. Commodityenterprises primarily face the following classes of risks, namely: the price risk, the

quantity risk, the yield/output risk and the political risk. Talking about the

nationwide commodity exchanges, the risk of the counter party (trading member,

client, vendors etc) not fulfilling his obligations on due date or at any time

thereafter is the most common risk.

This risk is mitigated by collection of the following margins: -

Initial Margins Exposure margins Market to market of positions on a daily basis Position Limits and Intraday price limits Surveillance

Commodity price risks include: -

Increase in purchase cost vis--vis commitment on sales price Change in value of inventory Counter party risk translating into commodity price risk


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Some Interesting Facts about commodity exchanges

Commodities in which future contracts are successful are commodities

those are not protected through government policies; (Example: Gold/Silver/ Cotton/ Jute) and trade constituents of these commodities are not

complaining too. This should act as an eye-opener to the policy makers to

leave pricing and price risk management to the market forces rather than

to administered mechanisms alone. Any economy grows when the

constituents willingly accept the risk for better returns; if risks are not

compensated with adequate or more returns, economic activity will comeinto a standstill.

Worldwide, Derivatives volumes of non-US exchanges in the last decade,has been increasing as compared to the US Exchanges.

Commodities are less volatile compared to equity market, but more volatileas compared to G-Sec's.

The basic idea of Commodity markets is to encourage farmers to choosecropping pattern based on future and not past prices.

Industry in India runs the raw material price risk, going forward they canhedge this risk.

Commodities Exchanges are working with banks to provide liquidity toretail investors against holdings such as bullion, cotton or any edible oil,

much like loan against shares.


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CONCLUSIONS and SUGGESTIONS

Conclusions

A derivative contract refers to a contract which takes its price from the underlying

asset. Underlying assets could be equity, debt, short term negotiable debt

instruments, spot foreign exchange, money market indices, credit risk and other

indices. A derivative contract are of different types like future contract, forward

contract, options contract, swaps, basket, warrants, LEAPS, Swaptions. The

derivative contract covers the systematic i.e. non-diversifiable risk and the non

systematic i.e. diversifiable risk.

Hedging refers to buying and selling in order to protect him/her from the

different risk attached to a buying contract. Hedging is of two types long Hedge

and a Short Hedge.

The main Participants in derivatives contract include: -

1. Hedgers2. Speculators3. Arbitrageurs

Commodity derivatives refers to the derivative contracts with the underlying

assets as different commodities like gold, silver, chana, brass. The commodities in

the commodity are of different types that include 39 agricultural commodities, 5

base metals, 6 precious metals, 4 energy, 3 polymers, 1 ferrous metal, and CER.


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Commodity derivatives include commodity futures, commodity options,

commodity forwards, commodity swaps, and commodity Swaptions.

The top 3 commodity derivative exchanges of India are the Multi commodityexchange (MCX), National Commodity and Derivatives exchange of India (NCDEX)

and National Multi Commodity exchange (NMCE).

There is one commodity exchange which has recently come into force i.e. The

Indian Commodity exchange ltd (ICEX) which is currently on the no.4 spot.

These Commodity exchange are regulated by the FMC i.e. the Forwards Market

Commission which has laid down certain rules and regulations for the operations

of Commodity exchanges in India.

The risks associated with commodity exchanges include the price risk, quantity

risk, yield/output risk and the political risk.

Finally there are a lot of problems faced by the different commodity exchanges

like the octroi duty, logistics etc.


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Suggestions

The following steps need to be taken by the exchanges, regulator and the

government in order that this market develops in a robust manner and thebenefits flow to the ultimate beneficiaries like the consumers, processors,

exporters and farmers etc. -

To mount a massive awareness programme among the potentialbeneficiaries about the benefits and risks of futures trading.

Disseminate futures prices widely so that stakeholders can take informeddecisions.

Develop other allied activities such as warehousing, standardization andgradation; collateral financing linked to futures markets.

Reforms in physical market to develop efficient and integrated nationalmarket.

Make necessary amendments in the FC(R) Act for permitting futures inintangible commodities and options trading, which are at present

prohibited.

Allow participation of mutual funds and financial institutions in thecommodity market.

Coordination with other segments of the financial market such as banking,debt and capital market.


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Future Prospects

With the gradual withdrawal of the Govt. from various sectors in the post

liberalization era, the need has been left that various operators in thecommodities market be provided with a mechanism to hedge and transfer their

risk. Indias obligation under WTO to open agriculture sector to world trade

require future trade in a wide variety of primary commodities and their product

to enable diverse market functionaries to cope with the price volatility prevailing

n the world markets.

Following are some of applications, which can utilize the power of the commodity

market and create a win-win situation for all the involved parties:-

Commodity Market in India:

Regulatory approval/permission to FIIS to trading in the commodity market.

Active Involvement of mutual fund industry of India. Permission to Banks for acting as Aggregators and traders. Active involvement of small Regional stock exchanges. Newer Avenues for trading in Foreign Derivatives Exchanges. Convergence of variance market. Amendment of the commodities Act and Implementers of VAT.


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Bibliography

1. Internet: -www.wikipedia.org

www.Investopedia.com

www.investorwords.com

www.ncdex.comwww.mcxindia.com

www.nmce.co.in

www.Fmc.gov.in

www.icexindia.com

2. Books: -Hull, John C Options, Futures, and Other derivative sixth edition, 2007

3. Online Journals: -www.eurojournals.com

commodity derivative market in india_raghav

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