comodity & future marketing

1AEM - 202

AEM 202

Agri-Business and Entrepreneurship Development(3 Credits)

Block III

Commodity and Future Marketing

Unit 1 : Commodity Markets 3-20

Unit 2 : Introduction to Commodity Exchanges 21-38

Unit 3 : Futures Exchange and Risk Management 39-54

Unit 4 : Ware house Receipts and Collateral Management 55-69

2Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Published byNational Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030, Andhra Pradesh, IndiaFirst Published: 2008 MANAGE, 2008All rights reserved . No part of this work may be reproduced in any form, by mimeograph or anyother means without permission in writing from the MANAGE.

Shri K.V. Satyanarayana, IASDirector GeneralNational Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030Andhra Pradesh, India

Program CoordinatorsDr. M.N. Reddy, Director (Agri. Extn. & Commn.) & Principal Coordinator (PGDAEM)Ph. Off: (040) 24014527, email: [email protected]

Dr. N. Balasubramani, Assistant Director (Agri. Extn.)Ph. Off: (040) 24016702-708 Extn. 275, email: [email protected]

Course CoordinatorDr. Vikram Singh, Director (OB)National Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030, Andhra Pradesh, IndiaPh. Off: (040) 24016690, email: [email protected]

ContributorsThis material was originally prepared for YASHADA, Pune. The intellectual copy right of this materialbelongs to YASHADA, Pune

3AEM - 202Agri-Business and Entrepreneurship Development

Unit 1

Commodity Markets

Structure

1.0 Objectives

1.1 Commodity markets

1.2 Classification of markets

1.3 Market players and motives

1.4 Motives of market participants

1.5 Forward and backward linkages in markets

1.6 Regulation of commodity markets

1.7 Recent innovation in commodities markets

1.8 Let us sum up

1.9 Key words

1.10 Further readings

1.11 Check your progress

1.0 Objectives

Agriculture occupies a very important place in the economic life of our country. It is the backbone

of our economic system. India is primarily an agricultural country. The fortunes of the economy are, even

now, dependent on the course of agricultural production. Commodity markets have been serving the

livelihood in the Indian economy. There were different kinds of markets based on products, nature of

competition, time etc. This Unit will help you to understand the following concepts viz:


Commodity Markets

Classification of markets,

Market motives,

Market participants and

Forward and backward linkages.

1.1. Commodity Markets

1. What are commodities?

A commodity is anything for which there is demand, but which is supplied without qualitative

differentiation across a given market.

2. Characteristics of Commodities

They are essential things that are produced and consumed in large quantities.

Physical goods that have a value attached to them and hence can be called asset classes.

They are often used as inputs in the production of other goods or services.

The prices are determined as a function of their market as a whole.

There is little differentiation between commodity coming from one producer and the same

commodity from another producer.

Generally they do not have brands, if branded they are called as products

Include physical substances, such as food, grains, and metals, which are interchangeable

with another product of the same type, and which investors buy or sell.

3. How are commodities different from other assets?

Commodities are bulky in nature

They are perishable especially agro products

Commodities are physical assets - have added storage costs

They are goods, which have logistics problem - as they are bulky and as their production and

consumption centers are far apart

They have wide variations in quality and hence certain grades are taken as standards

5AEM - 202

4. Markets

The term market means not a particular place in which things are bought and sold but the whole

of any region in which buyers and sellers are in such a free intercourse with one another that the prices

of the same goods tend to equality, easily and quickly.

1.2 Classification of Markets

There are different kinds of markets, which have been classified, based on the following aspects

Classification of markets based on:

Functioning Stage Products soldScale Time Place

1. Regulated

2. Unregulated

1. Primary

2. Secondary

1. Wholesale

2. Retail

1. Spot

2. Forwards

3. Futures

1. Physical

2. Electronic

1. Consumer

2. Industrial

Competition

1. Perfect

2. Imperfect

monopoly, duopoly and Oligopoly

The description of different kinds of markets is given below

1. Based on Functioning

Based on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categories

a. Regulated Markets: These are markets in which business is done in accordance with the

rules and regulations framed by the statuary market organization representing different sections

involved in markets. The marketing costs in such markets are standardized and marketing

practices are regulated.

Important features of regulated markets

i) Method of sale: in regulated markets, the sale of agricultural produce is undertaken either

by open auction or by the close tender method.

Commodity Markets


ii) Weighment of produce: Weighment of the produce is done by a licensed standard weights

and platform scale.

iii) Grading: the produce in the regulated markets is expected to be sold only after grading.

iv) Licensing of market functionaries: all the market functionaries , from the hamals (loaders)

to traders, working in the regulated markets have to obtain license from market committee.

b. Unregulated Markets: these are the markets in which business is conducted without any set

rules and regulations. Traders frame the rules for the conduct of the business and run the

market. These markets suffer from many ills, ranging from non-uniform charges for marketing

functions to imperfections in the determination of prices.

2. Based on the Stage of Marketing

Based on the marketing, the markets are divided into three categories

a. Primary Markets

They are markets where most of the raw materials / materials are sold without much processing.

They lie near the origin of commodities. In primary markets, the producers of goods sell their farm

products to the wholesalers and their agents.

b. Secondary Markets

These markets are mostly far away from the primary centers of production and located at the

consumption centers. This is the market where the wholesalers sell their goods to the retailers for onward

selling to the consumer. The middlemen buy goods from producers and manufacturers and sell to the

retailers.

c. Terminal Market

This is the market where goods are purchased for final use or consumption. The retailers sell

their goods to consumers. This market is one where the produce is either finally disposed of to the

consumers or processors, or assembled for exports. In these markets, merchants are well organized

and use modern methods of marketing.

The main objectives of setting up Terminal Markets are

i) To link the farmers to the markets by shortening the supply chain of perishables and enhance

their efficiency and thus increase farmers income,

ii) Provide professionally managed competitive alternative marketing structures that provide multiple

choices to farmers for sale of their agricultural produce,

7AEM - 202Commodity Markets

iii) To drive reforms in the agricultural marketing sector resulting in accelerated development of

marketing and post harvest infrastructure including cool chain infrastructure in the country

through private sector investment.

iv) To bring transparency in the market transactions and price fixation for agricultural produce and

through provision of backward linkages to enable the farmers to realise higher price and thus

higher income to the farmers.

3. Based on scale/volume of business

a. Retail Markets

These markets cater to the needs of the general public who are consumers of the products.

Largely small-scale transactions take place at retail level. Retailers are scattered all over mostly

in residential areas. In short retail refers to a market where goods are sold in small quantity

directly to the consumer.

b. Wholesale Market

This market sells primarily to traders such as caterers and small shopkeepers. Members of the

public however, are not necessarily excluded. Large-scale transactions take place. Whole sale shops are

mostly concentrated in a particular location in a town/city. It is the market where the middlemen buy the

goods in bulk from the producers and manufacturers. Wholesaling is normally characterized by a system

of delivery by the wholesaler to the customer and the extension of credit facilities against bulk purchases.

4. Based on Time

a. Futures Market

This is an auction market in which participants buy and sell commodity/future contracts for

delivery on a specified future date. Futures exchanges act as a platform facilitating and regulating trade.

A futures contract is an agreement between two parties to buy or sell a specified and standardized

quantity and quality of an asset at a certain time in the future at a price agreed upon. It is a market in

which the buyers and sellers make agreement for delivery of goods in future. The contract is made on a

certain date but the goods will be delivered in future. Eg: MCX

b. Forward Market

Forward contract is an agreement between two parties to buy or sell an asset at a future date for

a price agreed upon by both. Contracts are booked in advance, to mitigate risk. Contracts are signed

by the buyers and sellers and they have their own set of norms. Forward trade may not involve the

activity of an Exchange.


c. Spot Market

Commodities are physically bought and sold here so these are called physical markets. In this

market, delivery is taken immediately. Cash settlement is done within a maximum of 11 days. The spot

market is a ready market where the sellers on the spot physically hand over goods to the buyers. There is

an exchange of goods for money at the same time.

5. Based on Place

a. Electronic Market

These are markets wherein the buyers and sellers do not meet. They are also called as virtual

markets / online market place eg e-bay. In Futures exchanges also, now trading is taking place

electronically

b. Physical Markets

A market in which commodities, such as grain, gold, crude oil etc. are bought and sold for cash

and delivered immediately. This is also called cash market or spot market.

6. Based on Products sold

a. Industrial Markets

This involves the sale of goods between businesses. They are not aimed directly at the consumer.

Eg: primary market where the raw materials and inputs are obtained eg: cement.

b. Consumer Market

Here, the products and services are bought by individuals for their own or family use. Thiscan be broadly classified into:

1. Fast-Moving Consumer Goods (FMCG) - high volume, low unit value

2. Consumer durables - low volume but high unit value

3. Soft goods eg: clothes, shoes

4. Services - e.g. hairdressing, dentistry

7. Based on Competition

Based on competition the markets are classified into perfect and imperfect markets

a. Perfect Markets: A perfect market is one in which the following condition will hold good

There is a large number of buyers and sellers

9AEM - 202Commodity Markets

All the buyers and sellers in the market have perfect knowledge

Prices at any one time are uniform over a geographical area plus or minus the cost

of supplies.

b. Imperfect Markets: The markets in which the conditions of perfect completion are lacking are

characterized as imperfect markets. The following are the situations based on the imperfections:

i. Monopoly: It is a persistent situation where there is only one provider of a product or

service in a particular market. Monopolies are characterized by a lack of economic com-

petition for the good or service that they provide and a lack of viable substitute goods.

ii. Oligopoly: It is a market form in which a market or industry is dominated by a small

number of sellers (oligopolists).

i. Duopoly: This is a specific type of oligopoly where only two producers exist in one

market

1.3 Market Players and Motives

There are different kinds of participants in the markets, which are listed below. Their activities

vary slightly according to the markets they operate and they also carry different names according to the

place of operation. eg. speculators, hedgers & arbitragers in futures market.

Buyers

Sellers

Stockists

Trade facilitators / brokers

1. Buyer

A person who buys commodities or products

Buyers are classified as consumer / industrial buyer

The buying behaviour varies with time, place etc.,

2. Seller

A person who has goods to offer for willing buyers to buy.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

3. Stockist

A trader who buys goods at lower levels and stores it for some time and sells when prices

improve.

They take advantage of the price variation

4. Brokers

Intermediaries who operate between buyers and sellers

They facilitate trade and take some part of the price margin

1.4 Motives of Market Participants

The market participants have different kinds of motives to meet physical requirement. The different

kinds of motives are listed below

Investment motive

Speculative motive

Arbitrage motive

1. Investment motive

A trader who is neither a producer nor a consumer of a produce, but operates in the markets for

profit motive is an investor. He works in the market by buying goods and selling it at a later period or in

a different market and gains from the price differences. Investment may be subdivided into 1) speculative

and 2) arbitrage motive

2. Speculative motive

A speculator buys, holds and sells commodities in the market to profit from the fluctuations in the

market. Risk involved is more when a person operates with a speculative motive.

3. Arbitrage motive

Arbitrage is the practice of taking advantage of a price differential between two or more markets,

time periods etc Eg. a person buying in the spot market and selling in the futures market or vice-versa

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1.5 Forward and Backward Linkages in Markets

The markets are linked with two types of linkages namely backward and forward linkages

1. Backward linkage

a. Contract Farming

b. Corporate Farming

a. Contract Farming

Contract farming has been prevalent in various parts of the country for commercial crops like

sugarcane, cotton, tea, coffee, etc. The concept has, however, gained importance in recent times in

the wake of economic liberalization. The main feature of contract farming is that farmers grow

selected crops under a buy back agreement with an agency engaged in trading or processing.

There are many success stories on contract farming such as potato, tomato, groundnut and

chilli in Punjab, Safflower in Madhya Pradesh, oil palm in Andhra Pradesh, seed production contracts

for hybrids seed companies in Karnataka, cotton in Tamil Nadu and Maharashtra etc. which helped

the growers in realization of better returns for their produce.

In our country contract farming has considerable potential where small and marginal farmers

can no longer be competitive without access to modern technologies and support. The contractual

agreement with the farmer provides access to production services and credit as well as knowledge of

new technology. Pricing arrangements can significantly reduce the risk and uncertainty of the market

place.

Small-scale farmers are frequently reluctant to adopt new technologies because of the possible

risks and costs involved. In contract farming, private agribusiness firms normally offer improved

methods and technologies because they have a direct economic interest in improving farmers

production to meet their needs. In many instances, the larger companies provide their own extension

support to contracting farmers to ensure that production is according to the specification. The farmer

learns many skills through contract farming like record keeping, improved methods of applying

chemicals, fertilizers and knowledge of the importance of quality and of the demands of export

markets.

In view of the above, contract-farming arrangements need to be encouraged widely. This

would require arrangement for registration of sponsoring companies and recording of contract

farming agreements, in order to check unreliable and spurious companies. A dispute resolution

mechanism needs to be set up near to farmers which can quickly settle issues, if any, arising between

Commodity Markets

12


the farmers and the company under a quasi-judicial manner. The farmers while raising the contracted

crops, run the risk of incurring debt and consequent displacement from land in the event of crop failure.

Farmers need to be indemnified from such displacement by law.

Eg: PepsiCo has emerged as one of the biggest providers of high quality seeds (especially tomatoes,

chillies and potatoes) for which farmers have to pay up front. The company recently imported 15,000

citrus plants from California, which are being distributed in Punjab. The idea is to try and develop Punjab

as a major citrus exporter.

b. Corporate Farming

Corporate farming refers to direct ownership or leasing in of farmland by business organizations

in order to produce for their captive processing requirements or for the open market.

Eg:, Jamnagar Farms Pvt. Ltd.- a subsidiary of Reliance Industries (Mukesh Ambani group)

with 7500 acres of farm land which has mango occupying 450 acres that makes it the largest

mango orchard in Asia. The farm was originally set up as an environmental protection measure

near its refinery. Now, it is being seen as a profitable venture in itself.

2. Forward linkage

Forward linkage means the dealings with retail chains and processors. The most essential things

in forward linkages are

Quantity and consistency in supply,

Competitive pricing of the produce,

Market knowledge, and

Farmers ability to build their associations, which are very much required.

Retailers buying process

Retail buying is the recent procurement strategy adopted by major retailers, i.e. they will not

agree with any pre-agreed price with farmer, however they give the prevailing market rate through

their collection centers in villages/taluk place. They directly buy the produce on cash and cheque

payments, some retail companies buy directly from existing open markets.

Eg: Relaince Retail buying of vegetables through their collection centers for their outlets.

3. Challenges for Commodities Markets

Encourage the retail companies to evolve sourcing models and meanwhile proactively prepare

farmer group to establish linkage with retailers.

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Necessary infrastructure in order to provide, Multi commodity service, preserving quality,

enhancing agri produce shelf life etc

Improved market access for farmers both in the national and overseas markets

Increase bargaining power of farmers by building their own associations

Introduce de-intermediation process into the current marketing system

Forward linkage of farmers and backward linkage of retail chain etc.

1.6 Regulation of Commodity Markets

Commodity markets are regulated at national and international level by the following organizations.

1. India

a. APMC

b. State Marketing Board

c. Forward Markets Commission (FMC)

2. International

a) WTO

b) United Nations Conference on Trade and Development (UNCTAD)

1.a APMC (Agricultural Produce Marketing Committee) Act

The Act provides improved regulation in marketing of agricultural produce, development of an

efficient marketing system, promotion of agri-processing and agricultural export and the establishment

and proper administration of markets for agricultural produce in the States. The modified APMC Act

has been made specifically responsible for:

Ensuring complete transparency in pricing system and transactions taking place in market area

Providing market-led extension services to farmers

Ensuring payment for agricultural produce sold by farmers on the same day

Promoting agricultural processing including activities for value addition in agricultural produce

Publicizing data on arrivals and rates of agricultural produce brought into the market area for

sale.

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Setup and promote public private partnership in the management of agricultural markets

Compulsory registration of all contract farming sponsors, recording of contract farming

agreements, resolution of disputes, if any, arising out of such agreement, exemption from

levy of market fee on produce covered by contract farming agreements and to provide for

indemnity to producers title/ possession over his land from any claim arising out of the

agreement

Provision made for direct sale of farm produce to contract farming sponsor from farmers

field without the necessity of routing it through notified markets

Provision made for imposition of single point levy of market fee on the sale of notified

agricultural commodities in any market area and discretion provided to the State Government

to fix graded levy of market fee on different types of sales

Licensing of market functionaries is dispensed with and a time bound procedure for registration

is laid down. Registration for market functionaries provided to operate in one or more than

one market areas

Commission agency in any transaction relating to notified agricultural produce involving an

agriculturist is prohibited and there will be no deduction towards commission from the sale

proceeds payable to agriculturist seller

Provision made for the purchase of agricultural produce through private yards or directly

from agriculturists in one or more than one market area

Provision made for the establishment of consumers/ farmers market to facilitate direct sale

of agricultural produce to consumers

Provision made for resolving of disputes, if any, arising between private market/ consumer

market and Market Committee

Market Committee permitted to use its funds among others to create facilities like grading,

standardization and quality certification; to create infrastructure on its own or through public

private partnership for post harvest handling of agricultural produce and development of

modern marketing system

1.b State Agricultural Marketing Board

The Board acts as a liaison agency between the Market Committees and the Government for all

round development of agricultural marketing in the State. The State Agricultural Marketing Board has

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been made specifically responsible for setting up of a separate marketing extension cell in the Board to

provide market-led extension services to farmers

(i) Promoting, grading, standardization and quality certification of notified agricultural produce

and for the purpose to set up a separate Agricultural Produce Marketing Standards Bureau

(ii) Funds of the State Agricultural Marketing Board permitted to be utilized for promoting either

on its own or through public private partnership, for the following

a) Market survey, research, grading, standardization, quality certification, etc.

b) Development of quality testing and communication infrastructure

c) Development of media, cyber and long distance infrastructure relevant to marketing of

agricultural and allied commodities

1.c Forward Markets Commission

It is a regulatory authority for all Commodity Derivatives Exchanges in India, which is overseen by

the Ministry of Consumer Affairs and Public Distribution, Government of India. It is a statutory body set

up in 1953 under the Forward Contracts (Regulation) Act, 1952.

The key functions of FMC are given below

(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.

(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 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.

Commodity Markets

16


2.a United Nations Conference on Trade and Development (UNCTAD)

The United Nations Conference on Trade and Development (UNCTAD) was established in 1964

as a permanent intergovernmental body, UNCTAD is the principal organ of the United Nations General

Assembly dealing with trade, investment and development issues.

To maximizing the trade and development prospects of developing countries and economies in

transition,

Assisting them in their beneficial integration into the globalizing and liberalizing world economy

and the international trading system, and

Aims to strengthen human, institutional and policy-making capacities by formulating and

implementing national trade policy frameworks conducive to economic, human and social

development and poverty alleviation, as well as in participating effectively in multilateral,

regional and sub regional trade negotiations.

To develop Comprehensive computer-based information system on trade control measures

that uses UNCTADs database.

2.b World Trade Organization (WTO)

WTO is the only international body dealing with the rules of trade between nations.

The main functions of WTO can be described in very simple terms. These are

To oversee implementation and administering of WTO agreements

To provide a forum for negotiations

To provide a dispute settlement mechanism and

Expand the production of and trade in goods and services.

1.7 Recent Innovation in Commodities Markets

1. Safal Market

This was the initiative by NDDB, which came into existence in April 2003 with setting up of a full-

fledged trading platform for Fruits and Vegetables at Bangalore. It has been formed to establish an

alternative market set-up that operates parallel to mandis to stimulate production, raise quality standards,

reduce losses etc

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Reasons for NDDBs debut into the F&V sector could be

Dominated by small farmers, who were unable to effectively bargain in the Mandis and get

remunerative prices

APMC Act emphasises on regulation and restrictions on marketing activity which create a

situation which is disadvantageous to growers

Mandi operations were poorly designed - inefficient & lack transparency

2. E-Choupal

E-Choupal is an initiative of ITC Limited (a large diversified group in India) to link directly with

rural farmers for the procurement of agricultural/aquaculture produce like soya, coffee, and prawns.

E-Choupal was conceived to tackle the challenges posed by the unique features of Indian agriculture,

characterized by fragmented farms, weak infrastructure and the involvement of numerous

intermediaries. Traditionally, these commodities are being procured in mandis (major agricultural

marketing centres in rural areas of India), where the middleman used to make most of the profit.

These middlemen used unscientific means to judge the quality of the product, the price difference in

the payout for good quality and inferior quality was less and hence there was no incentive for the

farmers to produce good quality yield. With e-choupal, role of the middleman was restricted.

ITC Limited has now established computers and Internet access in key rural areas where the

farmers can directly negotiate the sale of their produce with ITC Limited. The PCs and Internet access

at these centers enable the farmers to obtain information on mandi prices, good farming practices

and place orders for agricultural inputs like seeds and fertilizers. This helps farmers in improving the

quality of produce, and also helps in realizing a better price. Each ITC Limited kiosk having an

access to Internet is run by a sanchalaka trained farmer. The computer housed in a farmers house

is linked to the Internet via phone lines or by a VSAT connection and serves an average of 600

farmers in 10 surrounding villages within about a 5 km radius. The sanchalak bears some operating

cost but in return gets commissions for the e-transactions done through his eChoupal. The warehouse

hub is managed by middle-men called samyojaks. The samyojak acts as a local commission agent

for ITC Limited.

The system saves procurement costs for ITC Limited. The E-Choupal model is quite different

from the other models, as the farmers do not pay for the information and knowledge they get from

E-Choupals.

Commodity Markets

18


ITC Limited has extracted value in four steps through E-Choupal

(a) Elimination of non-value adding activities

(b) Differentiating product through identity preservation

(c) Value added products traceable to farm practices

(d) E-market place and support services to future exchange.

3. Metro Cash & Carry

Cash and Carry is a new initiative in wholesaling in which services of credit and delivery are

replaced with discounts. Metros Cash & Carrys business model brings together small, medium and

large-sized producers, farmers, agricultural cooperatives and manufacturers, with the dispersed

community of hotels, restaurants, caterers, traders, retailers and small to medium business enterprises,

under one roof. They buy directly from producers and manufacturers and sell to business customers

at wholesale centers. This way, they shorten the supply chain and thereby eliminate the high costs

associated with a fragmented supply chain. They also cut costs and wastage by building modern

trade infrastructure and implementing modern IT-based systems, which improve efficiency. By

aggregating the demand of small and medium businesses, they are able to buy in bulk quantities at

lower costs, a part of which is passed on to the customers.

1.8 Let us Sum Up

The fortunes of the economy are, even now, dependent on the course of agricultural production.

Commodity markets have been serving the livelihood in the Indian economy.

A commodity is anything for which there is demand, but which is supplied without qualitative

differentiation across a given market. The markets in which the commodities are trading are called

as commodities markets. There are different kinds of commodities markets, which have been classified

based on functioning, stage, scale of business, time and nature of business transaction, place and

area, products sold and competition.

In the markets, largely there are four kinds of participants, namely buyers, sellers, stockists

and trade facilitators. The market participants have investment, speculative and arbitrage motives.

The markets are bound with forward and backward linkages. The backward linkages consist

of contract farming and corporate farming models. In contract farming the farmers grow selected

crops under a buy back agreement with an agency engaged in trading or processing. Corporate

farming involves the direct ownership or leasing in of farmland by business organizations to produce

for their captive processing requirements or for the open market. Dealing with retail chains and

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processing units are termed as forward linkages. Under the changing scenario, commodity markets are

facing many challenges such as increased infrastructure requirement, market access to farmer, improving

the bargaining power of farmers, introduction of de-intermediation process. To pace up the challenges,

market functionaries have been introducing innovations in marketing such as E-Choupal, Cash and

Carry markets and Safal market.

1.9 Key Words

Arbitrage: 1) A transaction that generates a risk-free profit; 2) a leveraged speculative transaction;

and 3) the activity of engaging in either of the above two forms of arbitrage transactions.

Auction: An auction is the process of buying and selling goods by offering them up for bid, taking bids,

and then selling the item to the winning bidder. In economic theory, an auction is a method for determining

the value of a commodity that has an undetermined or variable price.

Buyer: A buyer is any person who contracts to acquire an asset in return for some form of consideration.

Contract: Contract: Contract: Contract: Contract: It is a legally binding exchange of promises or agreement between parties that the law will

enforce. It is an agreement between two or more competent parties to do, or not to do, some legal

act for a legal consideration.

Fast moving consumer goods: Fast Moving Consumer Goods (FMCG), also known as Consumer

Packaged Goods (CPG), are products that have a quick turnover and have a relatively low cost.

Though the absolute profit made on FMCG products is relatively small, they generally sell in large

numbers and so the cumulative profit on such products can be large.

Futures contract: It is a standardized contract, traded on a futures exchange, to buy or sell a certain

underlying instrument at a certain date in the future, at a specified price. The future date is called the

delivery date or final settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price.

Investment: It is the purchase of capital equipment. i.e. the purchase of machines, equipment, factories

etc. that firms need to enable them to produce.

Liberalisation: It refers to a relaxation of previous government restrictions, usually in areas of social or

economic policy.

Price: The amount of money, or other goods, that one has to give up to buy a good or service.

Sales: Sales are the activities involved in providing products or services in return for money or other

compensation. It is an act of completion of a commercial activity.

Commodity Markets

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1.10 Further Readings

Acharya S and N.L.Agarwal, 2005 Agricultural Marketing in India, Oxford & IBH Publishing Co Pvt.

ltd, New Delhi.

Various issues of Commodityindia.com

www.wto.org

www.agmarknet.nic.in

www.dgft.gov.in

www.unctad.org

www.fmc.gov.in

1.11 Check Your Progress

1. Define commodity and markets.

2. How do you classify the commodities markets?

3. What are the kinds of markets existing under time mode?

4. What are the major primary markets for different agricultural commodities

5. Who are all the different kinds of participants in commodities markets?

6. Explain the linkages in the commodities markets?

7. What is corporate farming? Explain with an example?

8. Give a brief description about the contract farming?

9. Explain the following terms

a. Terminal markets

b. Futures markets

c. Electronic markets

10. How do you classify the markets based on competition?

11. What are the challenges faced by the commodities market?

12. Explain the recent innovations in commodities markets?

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Unit 2

Introduction to Commodity Exchanges

Structure

2.0 Objectives

2.1. Introduction to derivatives

2.2. Instruments available for trading

2.3 Commodity exchanges and futures trading

2.4 Evolution of futures trading

2.5 Commodity exchanges at global and national level

2.6 Exchange transactions

2.7 Let us sum up

2.8 Key words



2.0 Objectives

On completing this unit you will be able to

Understand the meaning of derivatives

Futures contract and exchanges

Evolution of futures trading

Commodity exchanges in India

Structure and members of commodity exchanges and

How to trade in the commodity exchanges

Agri-Business and Entrepreneurship Development

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2.1. Introduction to Derivatives

In the world of liberalization it is most indispensable to predict the future. It becomes more

requisite for agriculture, which faces more flux than other sectors. So the Government of India

introduced commodity futures trading in India through commodity exchanges.

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 or any other

asset.

Derivative markets can broadly be classified as commodity derivative market and financial

derivatives markets. As the name suggests, 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 main types of derivatives are

futures, forwards, options, and swaps.

a.a.a.a.a. FFFFFuturesuturesuturesuturesutures: A futures contract is an agreement between two parties to buy or sell the underlying

asset at a future date at a future price. Futures contracts differ from forward contracts in the

sense that they are standardized and exchange traded.

b.b.b.b.b. OptionsOptionsOptionsOptionsOptions: 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.

c.c.c.c.c. WWWWWarrantsarrantsarrantsarrantsarrants: Options generally have lives of up to 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.

d.d.d.d.d. SwapsSwapsSwapsSwapsSwaps: 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.

2.2. 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. There are three derivative contracts namely

forward, futures and options trading.

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a. 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 counter party,

which often results in high prices being charged.

b. Futures contract

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. Majority of the futures transactions are

offset this way.

The standardized items in a futures contract are:

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


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Distinction between futures and forwards

OTC in nature

Customized contract terms hence less liquid

No margin payment

Settlement happens at end of period

Futures Forwards

Trade on an organized exchange

Standardized contract terms hence more liquid

Requires margin payments

Follows daily settlement

Futures Terminology

Spot priceSpot priceSpot priceSpot priceSpot price: The price at which an asset trades in the spot market.

FFFFFutures priceutures priceutures priceutures priceutures price: The price at which the futures contract trades in the futures market.

Contract cycleContract cycleContract cycleContract cycleContract cycle: The period over which a contract trades. The commodity futures contracts on the

exchanges have one-month, two-months and three-months expiry cycles.

Expiry dateExpiry dateExpiry dateExpiry dateExpiry 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 unitDelivery unitDelivery unitDelivery unitDelivery 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 in MCX contract is 1 kg.

BasisBasisBasisBasisBasis: 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 is positive. This reflects that futures

prices normally exceed spot prices.

Cost of carryCost of carryCost of carryCost of carryCost of carry: The relationship between futures prices and spot prices can be summarized in terms of

what is known as the cost of carry. This measures the storage cost plus the interest that is paid to

finance the asset less the income earned on the asset.

Initial marginInitial marginInitial marginInitial marginInitial 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.

MarkingMarkingMarkingMarkingMarking-to-to-to-to-to-market (MTM):-market (MTM):-market (MTM):-market (MTM):-market (MTM): In the futures market, at the end of each trading day, the margin account

is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is

called marking to market.

Maintenance margin:Maintenance margin:Maintenance margin:Maintenance margin:Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the

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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.

Short position:Short position:Short position:Short position:Short position: The sale of a security or commodities futures not owned by the seller at the time of the

trade. Short sales are usually made in anticipation of a decline in the price.

LLLLLong Pong Pong Pong Pong Position: osition: osition: osition: osition: Owning a commodity with an anticipation of increase in prices.

c. Options trading

An option gives the holder of the option the right to do something but the holder does not have

the obligation to exercise this right. In contrast, in a forward or futures contract, the two parties have

committed themselves to the act of buying and selling. Whereas it costs nothing (except margin

requirements) to enter into a futures contract, the purchase of an option requires an up front payment.

2.3 Commodity Exchanges and Futures Trading

A commodity exchange is an association or a company or any other body corporate that is

organizing futures trading in commodities.

A commodity futures contract is a contractual agreement between two parties to buy or sell a

specified quantity and quality of commodity at a certain time in future at a certain price agreed at the

time of entering into the contract on the commodity futures exchange.

1. Structure of Commodities exchange

A Commodities Exchange is formed with the following objectives

To create a 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

2. Exchange membership

Membership of exchanges is open to any person, association of persons, partnerships, cooperative

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.


26


The members of Exchanges fall into two categories, Trading cum Clearing Members (TCM) and Professional

Clearing Members (PCM).

a.a.a.a.a. TTTTTrading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member - An individual or corporate can be admitted by the

Commodity Exchange as a Trading-Cum-Clearing Member (TCM) conferring upon them a right

to trade and clear through the clearing house of the Commodity Exchange. Moreover, the member

may be allowed to make deals for themselves (proprietary positions) besides trading on

behalf of registered approved / authorized users and to clear/ settle them.

b.b.b.b.b. PPPPProfessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) - Any Financial Institution or Bank, which is registered

as PCM is conferred the right only to clear and settle trades through the clearing-house of the

exchange. They may clear and settle trades of such members of the exchange who choose to

do so through that PCM.

3. Participants in the futures trading

There are three types of participants in futures trading namely hedgers, speculators, and

arbitragers.

a.a.a.a.a. HedgersHedgersHedgersHedgersHedgers: a person who makes investment in order to reduce the risk of adverse price

movements in a commodity, by taking an offsetting position in a related commodity, such as

long and short position is called as hedger. Hedgers could be government institutions, private

corporations like financial institutions, trading companies and even other participants in the

value chain, for instance farmers, extractors, ginners, processors etc., who are influenced by

the commodity prices.

b.b.b.b.b. SpeculatorsSpeculatorsSpeculatorsSpeculatorsSpeculators: 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.

c.c.c.c.c. Arbitragers:Arbitragers:Arbitragers:Arbitragers: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.

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2.4 Evolution of Futures Trading

History of modern futures trading begins in 1848, the Chicago Board of Trade (CBOT) the

worlds first modern futures exchange was formed. Trading was originally in forward contracts; the

first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contracts were

introduced. Today, the futures markets have far outgrown their agricultural origins.

Organized futures market evolved in India by the setting up of Bombay Cotton Trade

Association Ltd. in 1875. Futures trading in Raw Jute and Jute Goods began in Calcutta with the

establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd

was set up in 1927 for organizing futures trading in Raw Jute. The most notable amongst them was

the Chamber of Commerce at Hapur, which was established in 1913. Futures market in Bullion

began at Mumbai in 1920 and later similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur,

Delhi and Kolkata.

After independence, the Constitution of India brought the subject of Stock Exchanges and

futures markets in the Union list. As a result, the responsibility for regulation of commodity futures

markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee

headed by Prof. A.D.Shroff and Select Committees of two successive Parliaments and finally in

December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.

After the introduction of economic reforms since June 1991 and the consequent gradual

trade and industry liberalization in both the domestic and external sectors, the Govt. of India appointed

in June 1993 one more committee on Forward Markets und Chairmanship of Prof. K.N. Kabra. The

Committee recommended that futures trading be introduced in Basmati Rice, cotton, Jute, oilseeds,

silver and onions.

The liberalized 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 of Honble

Finance Minister 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 are, however

presently prohibited.


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FFFFForward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC) is a regulatory authority for all Commodity Derivatives

Exchanges in India, which is overseen by the Ministry of Consumer Affairs and Public Distribution,

Government of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation)

Act, 1952.

The functions of the FThe functions of the FThe functions of the FThe functions of the FThe functions of the Forward Markets Commission are as follows:orward Markets Commission are as follows:orward Markets Commission are as follows:orward Markets Commission are as follows:orward 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.

(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 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.

2.5 Commodity Exchanges at Global and National level

1. Commodity Exchanges at National level

The Government, in order to make the commodities market more transparent and efficient,

accorded approval for setting up of national level multi commodity exchanges. Accordingly three

national level exchanges are there which deal in a wide variety of commodities and which allow

nation-wide trading. They are

a. National Commodities Derivatives Exchange (NCDEX)

b. Multi Commodity Exchange (MCX)

c. National Multi Commodity Exchange (NMCE)

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Today commodity exchanges are offering spectacular growth opportunities and advantages to a

large cross section of the participants including Producers / Processors, Traders, Corporate, Regional

Trading Centers, Importers, Exporters, Cooperatives and Associations.

a. National Commodities Derivatives Exchange (NCDEX)

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

independent Board of Directors and professionals. It is a professionally managed by ICICI Bank, LIC,

NABARD and (NSE). NCDEX is a public limited company incorporated on April 23, 2003 under the

Companies Act, 1956.

Important Commodities traded at NCDEX

Commodity Unit of price

quotation

Unit of trading Yield/Re.

Movement

Precious metals

Gold

Kilo gold

Silver

Agricultural products

Soya oil

Cotton-l

Mustard

Mustard oil

Palmolein oil RBD

Pepper

Chana

Guar seeds

Rubber

10gm

10gm

1kg

10KG

1 T

20KG

10KG

10KG

1 T

1 T

1 T

1 T

100gm

1000gm

5KG

1000kg

11 bales

1000kg

1000kg

1000kg

1000kg

10000kg

10000kg

1000kg

10.00

100.00

5.00

100.00

18.70

50.00

100.00

100.00

10.00

100.00

100.00

10.00


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b. Multi Commodity Exchange (MCX)

MCX an independent and de-mutulised multi commodity exchange established on November

2003. It has permanent recognition from Government of India for facilitating online trading, clearing

and settlement operations for commodity futures markets across the country. Key shareholders of

MCX include Financial Technologies (I) Ltd., State Bank of India & associates, Fidelity International,

National Stock Exchange of India Ltd. (NSE) and National Bank for Agriculture and Rural Development

(NABARD).

Important Commodities traded at MCX

Commodity Unit of price

quotation

Unit of trading Yield/Re.

MovementPrecious metals

Gold-m

Gold

Silver-m

Silver

Agricultural products

Soya

Soya oil

Crude palm oil

Rbd palmolein

Castor seed

Castor oil

Ground nut oil

Gaur seed

Black pepper

Rubber

Kapas

Industrial metals

Steel long

Steel flat

Copper

Nickel

Tin

10gm

10gm

1kg

1kg

1 t

10kg

10kg

10kg

100kg

10kg

10kg

100kg

100kg

100kg

20kg

1 t

1 t

1kg

1kg

1kg

100gm

1000gm

5kg

30kg

10 t

1000kg

1000kg

1000kg

1 t

1 t

1 t

5 t

1 t

25 t

4 t

25 t

25 t

1 t

250kg

500kg

10.00

100.00

5.00

30.00

10.00

100.00

100.00

100.00

10.00

100.00

100.00

50.00

10.00

250.00

200.00

25.00

25.00

1000.00

250.00

500.00

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c. National Multi Commodity Exchange of India Limited

National Multi Commodity Exchange of India Limited (NMCEIL) is the first de-mutualized,

Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was granted approval by the

Government to organize trading in the edible oil complex. It has operationalized from November

26, 2002. It is being supported by Central Warehousing Corporation Ltd., Gujarat State Agricultural

Marketing Board and Neptune Overseas Limited. It got its recognition in October 2002.

Apart from these national exchanges there are other regional commodities exchanges in

India, which are listed below. Most of these commodity exchanges are offline and commodity specific.

Registered commodity exchanges in India

Bhatinda Om & Oil Exchange Ltd.

The Bombay Commodity Exchange Ltd.

The Rajkot Seeds oil & Bullion Merchants Association, Ltd. Castorseed

The Kanpur Commodity Exchange Ltd.

The Meerut Agro Commodities Exchange Co. Ltd.

The Spices and Oilseeds Exchange Ltd.Sangli

Ahmedabad Commodities Exchange Ltd.

Vijay Beopar Chamber Ltd., Muzaffarnagar

India Pepper & Spice Trade Association, Kochi

Rajdhani Oils and Oilseeds Exchange Ltd., Delhi

National Board of Trade, Indore

The Chamber of Commerce, Hapur

The East India Cotton Association, Mumbai

The Central India Commercial Exchange Ltd., Gwaliar

The East India Jute & Hessian Exchange Ltd., Kolkata

First Commodity Exchange of India Ltd., Kochi

The Coffee Futures Exchange India Ltd., Bangalore


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2. Global Commodities Exchanges

a.a.a.a.a. Chicago Board of TChicago Board of TChicago Board of TChicago Board of TChicago Board of Traderaderaderaderade

Chicago Board of Trade was established in 1948 and has been trading in agricultural produce,

interests, metals and US treasuries, soya complex, wheat and corn prices across the world are

referenced here. It has both electronic as well as open cry system of trading. It trades both in futures

as well as options.

b.b.b.b.b. New YNew YNew YNew YNew York Board of Tork Board of Tork Board of Tork Board of Tork Board of Trade (NYBOrade (NYBOrade (NYBOrade (NYBOrade (NYBOT)T)T)T)T)

New York Board of Trade (NYBOT) is the worlds largest commodities exchange for Coffee,

Sugar, Cotton and Frozen Concentrated Orange Juice. The exchange was founded as the New York

Cotton Exchange in 1870. NYBOT also facilitates trades in foreign currencies and derivative indices

for equities.

c.c.c.c.c. Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)

Chicago Mercantile Exchange (CME) is the largest futures exchange in US. The exchange

trades in interest rates, equities, foreign exchange and agricultural commodities. It has both open cry

as well as electronic trading systems. Agricultural commodities traded on the exchange include dairy

products (butter, milk cheese) and live stock futures.

d.d.d.d.d. LLLLLondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)

London Metal Exchange trades in Metals and non-ferrous metals like aluminum, copper,

lead, nickel, tin and zinc. Consumers as well as producers of metals use the official prices of LME for

their long-term contracts pricing. There are over 400 LME approved warehouse in some 32 locations

covering USA, Europe, the middle & the Far East. (At the moment there is none in India)., The

exchange has both open outcries as well as electronic system for trade.

e.e.e.e.e. New YNew YNew YNew YNew York Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)

New York Mercantile Exchange in its current form was created in 1994 by the merger of the

former New York Mercantile Exchange and the Commodity Exchange of New York (COMEX). Together

they represent one of worlds largest exchanges for precious metals and energy.

fffff..... TTTTTokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (TOCOM)OCOM)OCOM)OCOM)OCOM)

Tokyo Commodity Exchange (TOCOM) is the largest exchange in Japan and second largest

commodity exchange in the world for futures and options. Crude oil, gasoline, kerosene, gas oil,

gold, silver, aluminum, platinum and rubber are the commodities that are actively traded.

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e.e.e.e.e. Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)

Dubai Gold & Commodity Exchange (DGCX) was formed in Dubai by joint participation of

Dubai government as well as MCX and FTIL. Dubai has an advantage of its location of serving all

time zones.

fffff..... Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)

Dubai Mercantile Exchange (DME) is a joint venture between a Dubai holding, the New York

Mercantile Exchange (NYMEX) and the Oman Investment Fund (OIF). It is a premier international

energy futures and commodities exchange in the Middle East.

2.6 Exchange Transactions

There are three components in exchanges transaction viz: trading, clearing and settlement.

1. Trading

The trading system on the electronic exchanges provide a fully automated screen based trading

for futures on commodities on a nationwide basis as well as an online monitoring and surveillance

mechanism, which is called as terminal. It supports an order driven market and provides complete

transparency of trading operations. The 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 specified 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 queued in the

respective outstanding order book in the system. Electronic recording is done for each trade and this

provides the possibility for a complete audit trail if required.

a.a.a.a.a. How to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchange

The following diagram should give an investor/trader clear understanding of how to go about

investing/trading in commodities market. The prerequisite for trading in commodities markets are

a.1a.1a.1a.1a.1 Client codeClient codeClient codeClient codeClient code: The client who is interested to trade in commodity exchanges has to open a

trading account with a commodity broker by signing the client agreement form. The broker

in turn submits the details to the TCM and PCM of the exchanges. The validity of client

agreement will be verified in the exchanges and specific client code is allotted to trade in the

exchanges.


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a.2. Depositing initial margin

An initial amount has to be deposited by a customer at the time of entering into a contract, which

is termed as initial margin. The initial margin will differs based on the commodities. The exchanges fix the

margin for each commodity and it is a small percentage (5-6%) of the value of the lot.

Procedure for opening client-trading account

a.3a.3a.3a.3a.3 TTTTTrading processrading processrading processrading processrading process

The next step is trading in the exchange terminal. The client has to place his trade with broker

through NCDEX/MCX terminals. The trade placed at brokers terminal is submitted to the exchange

terminal. 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. From the exchange terminal the trade

confirmation is sent to the broker and broker in turn gives the trade confirmation to the client.

a.4a.4a.4a.4a.4 PPPPPayayayayay-in / P-in / P-in / P-in / P-in / Payayayayay-----outoutoutoutout

NCDEX/MCX

BROKER BROKER BROKER

CLIENT CLIENT CLIENT CLIENT CLIENT CLIENT

Client opens trading account, by signing Client Agreement with the Broker

Commodity Broker, TCM/PCM Member of the Exchange

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PAY-IN PAY-OUT

NCDEX/MCX

BROKER

CLIENT

Daily exchanges calculate the difference of the entry value and closing price of the particular

date. If the difference is positive the exchanges credit that particular amount into the client account.

In case the difference is negative, the exchanges deduct that particular amount from the credit

account. If the account does not have balance then pay in request is sent to the clients.

2. Clearing

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed

on the exchanges. The settlement guarantee fund is maintained and managed by exchanges. Only

clearing members including Professional Clearing Members (PCMs) are entitled to clear and settle contracts

through the clearinghouse. At exchanges, 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. 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 Exchanges, 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 CM (Clearing Member) with the respective clearing bank. All positions of a CM, either

brought forward created during the day or closed out during the day, are marked to market at the

daily settlement price or the final 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


36


is on a trading cum clearing member for all trades done on his own account and his clients 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 the exchanges for all open positions for

a commodity for all constituents individually. Exchanges on receipt of such information match the

information and arrive 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 specifications, the warehouse

accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a

credit in the depositors electronic account. The seller then gives the invoice to his clearing member, who

would courier the same to the buyers clearing member. On an appointed date, the buyer goes to the

warehouse and takes physical possession of the commodities.

2.7 Let us Sum Up

The agricultural sector in India is facing more flux in prices than other sector. So the government

of India introduced commodity futures trading in India through commodity exchanges. A commodity

exchange is an association or a company or any other body corporate that is organizing futures

trading in commodities. The members of Exchanges are Trading cum Clearing Members (TCM) and

Professional Clearing Members (PCM). While the participants of futures trading are hedgers,

speculators, and arbitragers.

Organized futures market evolved in India by the setting up of Bombay Cotton Trade

Association Ltd. in 1875. The consequent gradual trade and industry liberalization in both the

domestic and external sectors emphasized the need for futures trading and on 1.4.2003 the

Government permitted futures trading in the commodities. The national commodity exchanges in

India are National Commodities Derivatives Exchange (NCDEX), Multi Commodity Exchange (MCX)

and National Multi Commodity Exchange (NMCE)

Globally, the major commodity exchanges are New York Mercantile Exchange, Chicago

Board of Trade, New York Board of Trade, Chicago Mercantile Exchange and London Metal Exchange.

Exchange transactions involve trading, clearing and settlement. To start trading the participant has to

create trading account in exchange and has to place the trades at broker terminals. The exchanges

undertake the pay in and pay out of trades executed. National Securities Clearing Corporation

Limited (NSCCL) undertakes clearing of trades executed on the exchanges. At last the contracts are

settled.

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2.8 Key Words

Contract expiration: Derivatives contracts expire on a predetermined date and time up to which the

contract is available for trading. This is notified by the exchange in advance. The contract expiration

period will not exceed twelve months or as the exchange may specify from time to time.

Contract Specification - Contract specification is a document, which provides detailed guidelines

and parameters of any relevant commodity traded on the exchange. The contract ensures the standards

of commodity futures through various parameters such as trading details, contract duration or expiry

date, quality parameters, delivery mode and its details. It includes every possible detail for the successful

execution of the trade conducted on the exchange. These include trading lot, price quote, order size,

tick size, limits of daily price, margin and open positions, delivery centers, settlement price and

procedure, tender / delivery period, taxation, legal obligation, etc.

Delivery - The tender and receipt of the actual commodity, the cash value of the commodity or of

a delivery instrument covering the commodity (e.g., warehouse receipts) used to settle a futures

contract.

Lot size: The permitted trading lot size for the futures contracts on individual commodities is stipulated

by the exchange from time to time. The lot size currently applicable on individual commodity contracts.

Mark-to-Market (MTM)- At the end of every trading day, the margin account of the trader / client

is adjusted to reflect the participants gain or loss. The price changes on the close of every trading

day may result in some gain or loss as compared to the previous days closing price. These price

variations are netted into the daily margin account. This process is known as marking to the market.

Outcry: Open outcry trading is a face to face and highly activate form of trading used on the floors

of the exchanges.

Over-the-Counter (OTC): Trading is to trade financial instruments such as stocks, bonds,

commodities or derivatives directly between two parties. It is contrasted with exchange trading, which

occurs via corporate-owned facilities constructed for the purpose of trading

Pay in - It refers to the transfer of funds from the buyer-members settlement account to the exchange

before he takes delivery of the commodity from the exchange specified warehouse.

Payout - It refers to the transfer of funds to the selling-members settlement account from the

exchange, after the buyer lifts the commodity.

Tic Size: It is the minimum jump in the price.

Trading cycle: Trading cycle for each commodity/ derivative contract has a standard period,

during which it will be available for trading.


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Trading hours: The exchange announces the normal trading hours/ open period in advance from time

to time. In case necessary, the exchange can extend or reduce the trading hours by notifying the members.

Unit of price quotation: Unit of price quotation is the price shown on the trading screen.

Unit of trading: Unit of trading or lot size or contract size is all unanimous. Lot size is the minimum size

of the derivatives, futures or options contract.

Yield / Rupee = Lot Size (Unit of Trading)/ Unit of price quotation.

2.9 Further Readings

Derivatives FAQ by Ajay Shah and Susan Thomas

Options, futures and other derivatives by John Hull.

http://www.ncdex.com

http://fmc.gov.in

2.10 Check Your Progress

1. What are commodity futures?

2. Who is the watchdog of futures trading?

3. Define TCM

4. What are the benefits of commodity exchanges?

5. Brief the structure of commodity exchanges?

6. Explain the exchange transactions in brief?

7. How commodity exchanges evolved into India?

8. What are the commodities identified for trading?

9. What are the benefits in futures trading in commodities?

10. How would contracts settle?

11. What happens when the commodities reach the validity date?

12. Explain pay in and pay out in the commodity futures?

13. What is NMCEIL and who are the promoters of NMCEIL ?

14. What are the key commodity exchanges in India

15. What do you mean by lot size?

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Unit 3

Futures Exchange and Risk Management

Structure

3.0 Objectives

3.1. Price risk

3.2 Causes of price risk

3.3. Methods of tackling price risks

3.4. Evaluation of methods for their efficiency and limitation

3.5. Hedging

3.6. Advantages of hedging

3.7 Basic principles of hedging

3.8. Limitation of hedging

3.9 Types of hedging

3.10 Hedge ratio

3.11 Let us sum up

3.12 Key words



3.0 Objectives

This unit has been designed to help you to understand

Price risk, causes of price risks

Methods of handling price risk

Hedging, advantages and limitations of hedging

Agri-Business and Entrepreneurship Development

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Types of hedging-long hedge

Short hedge and cross hedge and hedge ratio

3.1 Price Risk

Risk has always been a part of agriculture. The rate of price volatility in agricultural produce

would create uncertainty and risks, which could hamper the performance of the agricultural sector

and negatively impact the income and welfare of the farmers. Besides, it will have a negative impact

on overall economic growth, income distribution and poverty alleviation. Therefore understanding

agricultural risks and the ways for managing it becomes important. Price volatility is perhaps the

most pressing issue facing the producers of primary commodities.

Agricultural production implies an expected outcome or yield to achieve the expected returns.

Variability in outcomes from those, which are expected, poses risks to the ability to achieve financial

goals. In this context Price risk is basically the risk that returns from the investment in physical

agricultural goods or commodities will be reduced or lost due to a fall in the future market price of

the commodity owned. Here it is important to understand the difference between risk and variability.

It is well known that agricultural prices vary from month to month and year to year. However, if the

variation were predictable, farmers would face no price risk. There are many numbers of risks that

are associated with the agricultural commodities, especially at the production, storage, transport,

marketing and processing stages. Hence it becomes important to identify the cause for price risks

and manage them.

3.2 Causes of Price Risks

a. Production Risks

As the demand for agricultural products is inelastic, supply shocks caused due to production

variations are magnified in price variations. Agricultural production risks may be due to those arising

out of weather related factors, pests or diseases, farm and management practices, genetics, machinery

efficiency, quality of inputs and also due to risks from variable prices.

b. Financial or Credit Risk

Farm credit has always been an important factor in improving agricultural productivity and

strengthening the rural economy. However, complicated operational mechanism of farm credit services,

high transaction costs, uncomfortable repayment schedules, higher interest rates, lower access to

credit, heavy reliance on money lenders, insolvency problems etc have increased the associated

price risks of the commodities.

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c. Institutional Risks

If Government policy framework may come unwarranted that would create a profound impact

on the prices. The government intervention sometimes instead of protecting may result in distortion

of trade, as it does not let the natural market forces of supply and demand in identifying the prices.

Eg. Reform measures like restriction on storage and movement of produces, direct price support

measures, subsidies etc.

d. Market linked Risks

In a developing economy like India, wild swings in market prices due to supply and demand

factors arise due to nascent nature of such markets. Lack of participation, non-availability or low

dissemination of market information, infrastructure bottlenecks, market structure etc tend to increase

the price risks.

3.3 Methods of Tackling Price Risks

a. Handling price risks

Price risks may be handled in any one of the following ways. They may be

1) Retained holding the risk, that is taking no protection for the downside risk

2) Avoided Risks can be avoided fully by going for a totally new venture

3) Reduced risks can be reduced or mitigated by different possible ways in order to get someassured income.

b. Self-insurance

Here the farmers use the previous periods accumulated savings to protect themselvesagainst uncertainties that they cannot control.

c. Crop storage It is a means of avoiding seasonally low prices when there is expectation of

price fall in the season and adequate price rise later. However financial resources and storagespace are required which may limit the scope of this kind of risk management.

d. Diversification It is the combining of different production processes so that low income in

one will be offset by higher income from other enterprises. It can include growing of differentcrops or different types of the same crop, mixed farming with combining crops and livestocketc.

e. Taking credit The farmers may lean on to credit given by government banks, co-operative

societies, commercial banks, etc as well as money lenders. If collateral is insisted on advancingof the loan then this measure may not be feasible for poor farmers.

Futures Exchange and Risk Management

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f. Contract farming Contract farming is normally associated with vertical integration, where

an agribusiness firm coordinates all aspects of a producer from production to obtaining the

end produce. Here a stable market or price is guaranteed.

g. Crop Insurance Insuring a crop against the risks basically gives protection against the

losses and also sometimes offers opportunity for gains.

h. Hedging in futures

With the advent of futures, the use of futures and other derivative products to manage risk

has turned out to be one of the most important and practical innovations in evolving market economies.

Of all the measures intended to reduce risk in futures, hedging is a concept that gains utmost

importance and is used as a financial offset to cash market risks, prevalently. Here the risk averse

producers can buy protection from the risk taking speculators looking for profit.

Hedging is defined as, the establishing of a position in the futures market that is equal and

opposite the po

comodity & future marketing

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