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Commodity Market

Introduction & Overview

What is a Commodity?

Commodities are a integral part of our life.

Food we eat Clothes we wear

A basic good Interchangeable with other goods of the same type.


A generic, largely unprocessed, good that can be processed and resold.
Used as inputs in the production of other goods.
goods
Must meet specified minimum standards, for trading on an exchange.

Pulses : Chana,
Chana Urad & Tur

Spices : Pepper, Jeera, Chilli, Turmeric & Cardamom

Metals : Gold, Silver, Copper, Zinc, Lead, Nickel, Aluminum Etc.

Energy : Crude Oil, Natural Gas Etc

Others : Guar Seed, Wheat, Sugar, Mentha Oil, Potato, Kapas, Soya, Etc.

Commodity Attributes

Quality
Quantity
Q
tit
Location
Time

Quality Attributes

M
Many commodities
diti differ
diff widely
id l by
b quality
lit
Wheatyou may look at a bushel of wheat, or wheat standing in
a field,, and think it all looks the same to me
But it aint
Wheat has many potential quality attributes, including protein
content, hardness, foreign matter, toxins
Similarly, oil is a very heterogeneous commodity
A commodity

dit is
i a social
i l

The Challenges of Measurement

Trading something typically requires some sort of measurement


off quantity
tit andd quality
lit
Measurement is costly
Who measures? Who verifies?
Many commodity markets have faced daunting challenges to
create measurement systems.

Commodity Trading - An Overview

Started in 1848 at CBOT, the first standardized future contracts was introduce
in 1965 & was traded on Corn.
Corn

The Commodity futures market in India is almost as old as in the USA and UK,
Started in 1875.
1875

Large number of commodity exchanges were there during Second World War.
g was p
prohibited
In 1960s trading

Online commodity futures trading came into existence in 2003. NCDEX and
MCX.

The commodity futures trading regulated by Forward Markets Commission,


under the Forward Contracts Regulations Act, 1952

Benefits

Long Term Bench Mark Price for Price Discovery mechanism.

Real time Commodity Prices.

Increasing Bargaining Powers of Farmers.

Hedging mechanism to minimize risk.

A bit
Arbitrage
opportunities
t iti between
b t
spott andd future
f t
markets.
k t

Trade and Payment Guarantee with no Counter Party and Quality Risk.

Trading activities based on demand and supply.

Portfolio diversification

Trading Instruments

There are a variety of basic types of instruments traded in


commodity
dit marketplaces
k t l

Spot
Spot contracts
Cash market contracts
Forward contracts
Futures contracts
Options

Spot Trades

The term spot refers to a transaction for immediate delivery


That is, delivery on the spot
This involves the prompt exchange of good for money
Note that spot trades almost always involve actual delivery of the good
specified in the contract
All spot trades are generally cash trades

Cash Trades

The term cash trade or cash market is often ambiguous and


confusing
f i
It suggests the immediate exchange of cash for a good, but sometimes
cash market trades are actually trades for future delivery
Usually,
y, though
g a cash trade is a pprincipal-to-principal
p
p
p trade that
does not take place on an organized exchange
That is cash
cash market
market is to be understood as distinct from the futures
futures
market

Forward Markets

A forward
o w d co
contract
c iss oonee that spec
specifies
es thee transfer
s e oof ow
ownership
e s p oof
a commodity at a future date in time
Today the buyer and the seller agree on all contract terms, including
pprice,,
qquantity,
y,
qquality,
y,
location,,
and
the
expiration/performance/delivery date
No cash changes hands today (except, perhaps, for a performance
bond))
Contract is performed on the expiration date by the exchange of the
good for cash
Forward contracts not necessarily standardized
standardizedconsenting
consenting adults can
choose whatever terms they want

Futures Contracts

Futures contracts are a specific type of forward contract

Future Contract : An agreement between two parties to buy or sell the


underlying commodity at a future date at today's future price at the exchange.

g and surveillance
Traded on a nationwide basis with an online monitoring
mechanism.

Orders matches automatically on the basis of commodity, its Price, Time and
Quantity.
Commodity futures contracts are of one month, two month and three month
expiry cycles.
Futures contracts are traded on organized exchanges, such as the Multi
C
Commodity
dit Exchange
E h
(MCX)
Standardization facilitates centralized trading and market liquidity

Options

Forward, futures, and spot contracts create binding obligations on the


parties
ti
In contrast, as the name suggest, an option extends a choice to one of
the contract participants
Calloption to buy
Putoption to sell
If I buyy an option,
p
, I buyy the right
g
If I sell an option, I give somebody else the right to make me do
something
Options are beneficial to the buyer,
buyer costly to the seller
sellerhence
hence they
sell at a positive price

The Uses of Contracts

Futures and Forward contracts can be used to transfer ownership of a


commodity
These contracts can also be used to speculate
They can also be used to manage riski.e., to hedge
Hedging and speculation are the yin and yang of futures/forward
contracts

Cash Settlement vs. Delivery Settlement

Futures and forward contracts can be settled at delivery at expiration

Alternatively, buyer and seller can agree to settle in cash at expiration

Speculative
S
l ti and
d hedging
h d i uses off contracts
t t only
l requires
i that
th t settlement
ttl
t price
i
at expiration reflects underlying value of the commodity.

Main reason for settlement mechanism is to ensure that this convergence


convergence
occurs

Even futures contracts that contemplate physical delivery are usually closed
prior
i to
t expiration
i ti

Trading Mechanisms

Organized Exchangescentralized
Exchanges centralized trading of standardized instruments

Centralized trading can occur via face-to-face open outcry or computerized


markets
k t

Computerized markets now dominate

Over-the-Counter (or cash) marketsdecentralized, principal-to-principal


markets

The Functions of Markets

Price discovery
y
Resource allocation
Risk transfer
Contract enforcement

Price Discovery

Information about commodity value is highly dispersed,


dispersed and private

By buying and selling on the basis of their information, market participants


affect prices,
prices and as a result,
result market prices reflect and aggregate the
information of potentially millions of individuals

In this way, markets discover


discover prices
pricesmore
more accurately, they facilitate the
discovery and dissemination of dispersed information

Prices as a sufficient statisticonly


y need to know the p
price,, not all the
quanta of information

Resource Allocation

By discovering prices, markets facilitate the efficient allocation


of resources
Th
Thatt is,
i markets
k t facilitate
f ilit t the
th flow
fl
off a goodd to
t those
th
who
h value
l
it most highly
Centralized markets can reduce transactions costs, thereby
reducing the frictions that impede this flow

Risk Transfer

The prices of commodities (and financial instruments) fluctuate


randomly,
d l thereby
h b imposing
i
i price
i risks
i k on market
k participants
i i
Those who handle a commodity most efficiently (e.g., producers
and consumers) are not necessarily the most efficient bearers of
this price risk
Futures and other derivatives markets permit the unbundling of
price risksthose who bear price risks most efficiently can bear
them,
h
andd those
h
who
h handle
h dl the
h commodity
di most efficiently
ffi i l can
perform that function

Contract Performance

Any forward/futures trade poses risks of non-performance


non performance
As prices change, either the buyer or the seller loses money
and hence has an incentive to avoid performance
p
Even if one party wants to perform, s/he may be financially
unable to do so
Therefore, EVERY trading mechanism must have some means
of enforcing contract performance

Participation

Stock
S
Market Investors - Diversification
Commodity traders
Intermediaries from physical market
Retailers
Manufacturers
Corporate
C
Exporters and Importers
Bullion Merchants
Bullion
Speculators

Indian commodity market

FMC
Hands Behind
Commodity Market

Commodity Exchanges

National

Regional

NCDEX
MCX
NCDEX

22
Regional Exchanges

NMCE

About the exchanges

Particulars

MCX

NCDEX

Existence

Nov 2003

Dec 2003

Promoters

FT. SBI , Union Bank of India, BOI

ICICI , LIC, NABARD, NSE, ETC.

Average Volume

20000 - 25000 Cr. Per day

3000 - 5000 Cr Per day

Active Commodities
Traded

Metals, Energy, Soya oil, Mentha


Oil, Kapas

Pulses, Spices, Grains, Guar Seed,


Soya

Contracts

Different for each contracts

Normally Monthly

Timings

Agri : 10 AM - 5 PM

Agri : 10 AM - 5 PM

Metals & Energy: 10 AM - 11.55


PM

Metals & Energy: 10 AM - 11.55


PM

Varies from commodity to


commodity

20th of the Month

Expiry Date

Major Commodities
COMMODITIES

Metals

Gold
Silver
Steel
Copper
Zinc
Aluminium
Nickel

Edible Oils

Crude Palm Oil


Soy Oil
Mustard Oil
Caster oil

Energy

Softs

Brent crude

Cotton

Sweet Crude oil Sugar


Natural Gas

Gur

Agriculture

Mentha Oil
Guar Seed
Soy Beans
Jeera
Mustard
Chilli
Chana Etc..

Comparative Returns

Trading strategies

Trading
High leverage / higher returns ( Intraday & Positional strategies )
Hedging
Protection against Rising Prices locking in a predetermine buying prices.
Protection against decreasing inventory values locking in a predetermined selling
prices.

Arbitrage
Physical V/S Futures Based on actual consumption
Future V/S Future Based on actual consumption

Spreads
Calendar Spread - Buy in one contract & Sell in other
Inter Commodity Spread - Buy in one commodity & Sell in other
Inter Exchange Spread - Buy in one exchange & Sell in other

Market Influencing Factors

Global & Domestic Demand / Supply


Weather Watch
Government policies and regulations.
Import and Export policy.
Acreages & arrivals in mandis. Year ending stocks
Geopolitical Tensions
Economic Indicators
Global Inflation & Interest rates
Currency Fluctuations

Delivery Process

Pre Requisite for Delivery


Open a commodity Demat account
Mandatory to open an Demat account with both the depositories i.e. NSDL &
CDSL.
CDSL
Sales Tax Registration
g
Both seller & buyer should have sales tax registration at the location of the
warehouse. In case the client does not have a sales tax registration he has to
appoint a Clearing and Forwarding agent for the same.
5 Days advance intimation to our delivery team.

Sellers Option
During Delivery notice period ,If a Seller with open position desires to give
delivery of commodities at delivery location, then Buyer with open position
has an obligation to settle in physical deliveries.

Mutual intention
Unless both the parties to the contract gives intention for taking/giving
g The contract is otherwise settled in cash.
deliveries at exchange.

Compulsory delivery
A seller/ buyer with open position on expiry of the contract have obligation
t settle
to
ttl contract
t t by
b deliveries
d li i only.penalty
l
lt would
ld be
b imposed
i
d on longs
l
and
d
shorts if they fail to meet their delivery obligation.

Trading Margins
Initial Margin :- The up front money must be deposited by a customer at the
time of entering into a contract is called initial margin.
Exposure Margin:- Margin Money charged by the Exchange to ensure that
initial margin does not go below a particular level.
level
Additional Margin:- In case of sudden higher than expected volatility, the
exchange calls for an additional margin, which is a preemptive move to prevent
breakdown.
Mark-to-Market (MTM):- At the end of each trading day, the margin account
is adjusted to reflect the trader's gain or loss. This is known as marking to
market the account of each trader.

Caution in Trading

Always limit your losses i.e. keep Stoploss


Avoid trading on punters calls
Take view of advisors & analysts before trading
T di should
Trading
h ld be
b done
d
through
th
h professional
f i l organization
i ti
Trail your Stoploss if you are in profit
Act on information rather than news.
Emotion
Hope
Greed
Fear