Commodity Futures A Commodity futures is an agreement between two parties to buy or sell a specified and standardized quantity of a commodity

at a certain time in future at a price agreed upon at the time of entering into the contract on the commodity futures exchange. The need for a futures market arises mainly due to the hedging function that it can perform. Commodity markets, like any other financial instrument, involve risk associated with frequent price volatility. The loss due to price volatility can be attributed to the following reasons:

Consumer Preferences: - In the short-term, their influence on price volatility is small since it is a slow process permitting manufacturers, dealers and wholesalers to adjust their inventory in advance.

Changes in supply: - They are abrupt and unpredictable bringing about wild fluctuations in prices. This can especially noticed in agricultural commodities where the weather plays a major role in affecting the fortunes of people involved in this industry. The futures market has evolved to neutralize such risks through a mechanism; namely hedging.

The objectives of Commodity futures: Hedging with the objective of transferring risk related to the possession of physical assets through any adverse moments in price. Liquidity and Price discovery to ensure base minimum volume in trading of a commodity through market information and demand supply factors that facilitates a regular and authentic price discovery mechanism.

Maintaining buffer stock and better allocation of resources as it augments reduction in inventory requirement and thus the exposure to risks related with price fluctuation declines. Resources can thus be diversified for investments.

Price stabilization along with balancing demand and supply position. Futures trading leads to predictability in assessing the domestic prices, which maintains stability, thus safeguarding against any short term adverse price movements. Liquidity in Contracts of

the commodities traded also ensures in maintaining the equilibrium between demand and supply.

Flexibility, certainty and transparency in purchasing commodities facilitate bank financing. Predictability in prices of commodity would lead to stability, which in turn would eliminate the risks associated with running the business of trading commodities. This would make funding easier and less stringent for banks to commodity market players.

Participants of Commodity Derivatives For a market to succeed, it must have all three kinds of participants - hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on the market. Commodity markets give opportunity for all three kinds of participants. Hedgers Many participants in the commodity futures market are hedgers. They use the futures market to reduce a particular risk that they face. This risk might relate to the price of any commodity that the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a predetermined price. Hedging does not necessarily improve the financial outcome; indeed, it could make the outcome worse. What it does however is, that it makes the outcome more certain. Hedgers could be government institutions, private corporations like financial institutions, trading companies and even other participants in the value chain, for instance farmers, extractors, ginners, processors etc., who are influenced by the commodity prices. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. This is called a short hedge. A short hedge is a hedge that requires a short position in futures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. A long hedge is appropriate when a

company knows it will have to purchase a certain asset in the future and wants to lock in a price now. Speculators If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. These are the people who takes positions in the market & assume risks to profit from price fluctuations in fact the speculators consume market information make forecasts about the prices & put money in these forecasts. An entity having an opinion on the price movements of a given commodity can speculate using the commodity market. While the basics of speculation apply to any market, speculating in commodities is not as simple as speculating on stocks in the financial market. For a speculator who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for whatever duration he wants to. However, commodities are bulky products and come with all the costs and procedures of handling these products. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. To trade commodity futures on the NCDEX, a customer must open a futures trading account with a commodity derivatives broker. Buying futures simply involves putting in the margin money. This enables futures traders to take a position in the underlying commodity without having to actually hold that commodity. With the purchase of futures contract on a commodity, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). Arbitrage A central idea in modern economics is the law of one price. This states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price. If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. This activity termed as arbitrage. The buying cheap and selling expensive continues till prices in the two markets reach equilibrium. Hence, arbitrage helps to equalise prices and restore market efficiency. F = (S + U)erT Where: r = Cost of financing (annualised) T = Time till expiration

U = Present value of all storage costs

The cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets. The above equation gives the fair value of a futures contract on an investment commodity. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. To capture mispricings that result in overpriced futures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that result in underpriced futures, the arbitrager must sell spot and buy futures. In the case of investment commodities, mispricing would result in both, buying the spot and holding it or selling the spot and investing the proceeds. However, in the case of consumption assets which are held primarily for reasons of usage, even if there exists a mispricing, a person who holds the underlying may not want to sell it to profit from the arbitrage.

How Commodity market works? There are two kinds of trades in commodities. The first is the spot trade, in which one pays cash and carries away the goods. The second is futures trade. The underpinning for futures is the warehouse receipt. A person deposits certain amount of say, good X in a ware house and gets a warehouse receipt. Which allows him to ask for physical delivery of the good from the warehouse. But some one trading in commodity futures need not necessarily posses such a receipt to strike a deal. A person can buy or sale a commodity future on an exchange based on his expectation of where the price will go. Futures have something called an expiry date, by when the buyer or seller either closes (square off) his account or give/take delivery of the commodity. The broker maintains an account of all dealing parties in which the daily profit or loss due to changes in the futures price is recorded. Squiring off is done by taking an opposite contract so that the net outstanding is nil. For commodity futures to work, the seller should be able to deposit the commodity at warehouse nearest to him and collect the warehouse receipt. The buyer should be able to take physical delivery at a location of his choice on presenting the warehouse receipt. But at present in India very few warehouses provide delivery for specific commodities. Following diagram gives a fair idea about working of the Commodity market.

Today Commodity trading system is fully computerized. Traders need not visit a commodity market to speculate. With online commodity trading they could sit in the confines of their home or office and call the shots. The commodity trading system consists of certain prescribed steps or stages as follows: I. Trading: - At this stage the following is the system implementedOrder receiving Execution Matching Reporting Surveillance Price limits Position limits

II. Clearing: - This stage has following system in placeMatching Registration Clearing

Clearing limits Notation Margining Price limits Position limits Clearing house.

III. Settlement: - This stage has following system followed as followsMarking to market Receipts and payments Reporting Delivery upon expiration or maturity.

Current Scenario in Indian Commodity Market

Benefits of Commodity Futures Markets:The primary objectives of any futures exchange are authentic price discovery and an efficient price risk management. The beneficiaries include those who trade in the commodities being offered in the exchange as well as those who have nothing to do with futures trading. It is because of price discovery and risk management through the existence of futures exchanges that a lot of businesses and services are able to function smoothly.

1. Price Discovery:-Based on inputs regarding specific market information, the demand and supply equilibrium, weather forecasts, expert views and comments, inflation rates, Government policies, market dynamics, hopes and fears, buyers and sellers conduct trading at futures exchanges. This transforms in to continuous price discovery

mechanism. The execution of trade between buyers and sellers leads to assessment of fair value of a particular commodity that is immediately disseminated on the trading terminal.

2. Price Risk Management: - Hedging is the most common method of price risk management. It is strategy of offering price risk that is inherent in spot market by taking an equal but opposite position in the futures market. Futures markets are used as a mode by hedgers to protect their business from adverse price change. This could dent the profitability of their business. Hedging benefits who are involved in trading of commodities like farmers, processors, merchandisers, manufacturers, exporters, importers etc.

3. Import- Export competitiveness: - The exporters can hedge their price risk and improve their competitiveness by making use of futures market. A majority of traders which are involved in physical trade internationally intend to buy forwards. The purchases made from the physical market might expose them to the risk of price risk resulting to losses. The existence of futures market would allow the exporters to hedge their proposed purchase by temporarily substituting for actual purchase till the time is ripe to buy in physical market. In the absence of futures market it will be meticulous, time consuming and costly physical transactions.

4. Predictable Pricing: - The demand for certain commodities is highly price elastic. The manufacturers have to ensure that the prices should be stable in order to protect their market share with the free entry of imports. Futures contracts will enable predictability in domestic prices. The manufacturers can, as a result, smooth out the influence of changes in their input prices very easily. With no futures market, the manufacturer can be caught between severe short-term price movements of oils and necessity to maintain price stability, which could only be possible through sufficient financial reserves that could otherwise be utilized for making other profitable investments.

5. Benefits for farmers/Agriculturalists: - Price instability has a direct bearing on farmers in the absence of futures market. There would be no need to have large reserves to cover

against unfavorable price fluctuations. This would reduce the risk premiums associated with the marketing or processing margins enabling more returns on produce. Storing more and being more active in the markets. The price information accessible to the farmers determines the extent to which traders/processors increase price to them. Since one of the objectives of futures exchange is to make available these prices as far as possible, it is very likely to benefit the farmers. Also, due to the time lag between planning and production, the market-determined price information disseminated by futures exchanges would be crucial for their production decisions.

6. Credit accessibility: - The absence of proper risk management tools would attract the marketing and processing of commodities to high-risk exposure making it risky business activity to fund. Even a small movement in prices can eat up a huge proportion of capital owned by traders, at times making it virtually impossible to pay back the loan. There is a high degree of reluctance among banks to fund commodity traders, especially those who do not manage price risks. If in case they do, the interest rate is likely to be high and terms and conditions very stringent. This posses a huge obstacle in the smooth functioning and competition of commodities market. Hedging, which is possible through futures markets, would cut down the discount rate in commodity lending.

7. Improved product quality: - The existence of warehouses for facilitating delivery with grading facilities along with other related benefits provides a very strong reason to upgrade and enhance the quality of the commodity to grade that is acceptable by the exchange. It ensures uniform standardization of commodity trade, including the terms of quality standard: the quality certificates that are issued by the exchange-certified warehouses have the potential to become the norm for physical trade.

Understanding Basis
Basis = Spot price Future price

A simple equation and the answer is a key to improving your profitability. Basis is used to determine: The best time to buy or sell. When to use the future markets to hedge a purchase or sale. The futures month is which to place a hedge. When to accept a suppliers offer or a buyers bid. Resale bids.

Basis is the difference between the local cash price of a commodity and the price of a specific futures contract of the same commodity at any given point in time. Spot price Dec futures price Basis Rs. 150 Rs. 200 - Rs. 50

In this example, the spot price is Rs.50 lower than the December futures price. In the market lingo one would say the basis is 50 under December. On the other hand, if the spot price is Rs. 50 higher than the December futures price, one would say the basis is 50 over December. Actually one can think of basis as localizing a future price. The futures market price represents the world price for commodity and is used as a benchmark in determining the value of commodity at the local level.

Because basis reflects local market conditions, its directly influenced by several factors including: Transportation costs. Local supply and demand conditions, such as grain quality, availability, need, local weather. Interest/storage costs. Handling costs and profit margins.

Basis Movement

The basis changes as the factors affecting cash or futures market change. Two terms used to describe a changing basis are strengthening and weakening. If the basis becomes more positive or less negative, the basis is said to be strengthening; and if the basis becomes less positive or more negative, the basis is said to be weakening. A strengthening basis occurs when the cash price increases relative to the futures. In the instance, the cash price is becoming strong relative to futures. A weakening basis occurs when the cash price decreases relative to the futures over time. In this instance, the cash price is becoming weak relative to the futures.

Major Commodities Exchange

National Commodities & Derivatives Exchange Limited (NCDEX) National Commodities & Derivatives Exchange Limited (NCDEX) promoted by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank of Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSC). Punjab National Bank (PNB), Credit Ratting Information Service of India Limited

(CRISIL), Indian Farmers Fertilizer Cooperative Limited (IFFCO), Canara Bank and Goldman Sachs by subscribing to the equity shares have joined the promoters as a share holder of exchange. NCDEX is the only Commodity Exchange in the country promoted by national level institutions. NCDEX is a public limited company incorporated on 23 April 2003. NCDEX is a national level technology driven on line Commodity Exchange with an independent Board of Directors and professionals 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 (FMC). NCDEX is also subjected to the various laws of land like the Companies Act, Stamp Act, Contracts Act, Forward Contracts Regulation Act and various other legislations. NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India. NCDEX currently facilitates trading of 57 commodities.

Commodities Traded at NCDEX:

Bullion: Gold KG, Silver, Brent. Minerals: Electrolytic Copper Cathode, Aluminum Ingot, Nickel Cathode, Zinc Metal Ingot, Mild steel Ingots. Oil and Oil seeds: Cotton seed, Oil cake, Crude Palm Oil, Groundnut (in shell),Groundnut expeller Oil, Cotton, Mentha oil, RBD Pamolein, RM seed oil cake, Refined soya oil, Rape seeds, Mustard seeds, Caster seed, Yellow soybean, Meal

Pulses: Urad, Yellow peas, Chana, Tur, Masoor, Grain: Wheat, Indian Pusa Basmati Rice, Indian parboiled Rice (IR-36/IR-64), Indian raw Rice (ParmalPR-106), Barley, Yellow red maize Spices: Jeera, Turmeric, Pepper Plantation: Cashew, Coffee Arabica, Coffee Robusta

Fibers and other: Guar Gum, Guar seeds, Guar, Jute sacking bags, Indian 28 mm cotton, Indian 31mm cotton, Lemon, Grain Bold, Medium Staple, Mulberry, Green Cottons, , , Potato, Raw Jute, Mulberry raw Silk, V-797 Kapas, Sugar, Chilli LCA334

Energy: Crude Oil, Furnace oil

Multi Commodity Exchange of India Limited (MCX)

Multi Commodity Exchange of India Limited (MCX) is an independent and de-mutulized exchange with permanent reorganization from Government of India, having Head Quarter in Mumbai. Key share holders of MCX are Financial Technologies (India) Limited, State Bank of India, Union Bank of India, Corporation Bank of India, Bank of India and Cnnara Bank. MCX facilitates online trading, clearing and settlement operations for commodity futures market across the country. MCX started of trade in Nov 2003 and has built strategic alliance with Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors Association of India, pulses Importers Association and Shetkari Sanghatana.

MCX deals with about 100 commodities.

Commodities Traded at MCX: Bullion:-

Gold, Silver, Silver Coins, Minerals:-

Aluminum, Copper, Nickel, Iron/steel, Tin, Zinc, Lead. Oil and Oil seeds:-

Castor oil/castor seeds, Crude Palm oil/ RBD Pamolein, Groundnut oil, Mustard/ Rapeseed oil, Soy seeds/Soy meal/Refined Soy Oil, Coconut Oil Cake, Copra, Sunflower oil, Sunflower Oil cake, Tamarind seed oil. Pulses:-

Chana, Masur, Tur, Urad, Yellow peas. Grains:-

Rice/ Basmati Rice, Wheat, Maize, Bajara, Barley, Spices:-

Pepper, Red Chili, Jeera, Cardamom, Cinnamon, Clove, Ginger. Plantation:-

Cashew Kernel, Rubber, Areca nut, Betel nuts, Coconut, Coffee, Fiber and others:-

Kapas, Kapas Khalli, Cotton (long staple, medium staple, short staple), Cotton Cloth, Cotton Yarn, Gaur seed and Guargum, Gur and Sugar, Khandsari, Mentha Oil, Potato, Art Silk Yarn, Chara or Berseem, Raw Jute, Jute Goods, JuteSacking, Petrochemicals:-

High Density Polyethylene (HDPE), Polypropylene (PP), Poly Vinyl Chloride (PVC) Energy:-

Brent Crude Oil, Crude Oil, Furnace Oil, Middle East Sour Crude Oil, Natural Gas

The New York Mercantile Exchange (NYMEX):The New York Mercantile Exchange is the worlds biggest exchange for trading in physical commodity futures. It is a primary trading forum for energy products and precious metals. The exchange is in existence since last 132 years and performs trades trough two divisions, the NYMEX division, which deals in energy and platinum and the COMEX division, which trades in all the other metals.

Commodities traded: - Light sweet crude oil, Natural Gas, Heating Oil, Gasoline, RBOB Gasoline, Electricity Propane, Gold, Silver, Copper, Aluminum, Platinum, Palladium, etc.

London Metal Exchange:The London Metal Exchange (LME) is the worlds premier non-ferrous market, with highly liquid contracts. The exchange was formed in 1877 as a direct consequence of the industrial revolution witnessed in the 19th century. The primary focus of LME is in providing a market for participants from non-ferrous based metals related industry to safeguard against risk due to movement in base metal prices and also arrive at a price that sets the benchmark globally. The exchange trades 24 hours a day through an inter office telephone market and also through a electronic trading platform. It is famous for its open-outcry trading between ring dealing members that takes place on the market floor. Commodities traded:- Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy, North American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density Polyethylene, etc.