Commodity futures have commodities as underlying assets. Futures on commodities help mitigate price risk.

Trading in forward and futures on commodities is not new. It has been in vogue for more than 100 years. BenefitFutures on commodities due to its possible use as a speculative product are often thought as unwarranted and as a disservice to society. Futures contracts on commodities result in price discovery, reducing seasonal price variations, efficient dissemination of information, reduced cost of credit, and more efficient physical markets. Commodity future and economyThe usual tools of containing the volatility in the commodity prices like buffer stocks, controlled and phased release of commodities, minimum support price etc have either failed or have proved too expensive for the economy. Commodity futures trading in developing country can contribute a lot to the stability of fiscal management, increasing the effectiveness of price protection at national level and improving the efficiency of social programmes Stability to Governments Revenue Government budget, developmental expenditure, and position of balance of payment are crucially dependent upon prices of commodities. Volatility in commodity prices causes volatility in budgetary provisions and governments developmental expenditure. Therefore at national level there is a need to reduce the volatility. Eliminating Minimum Support Price and Subsidy

Commodity futures trading helps smooth out the variability in governments revenue and transfers the price risk management from government to private participants. Commodity and financial futureFutures contracts on commodities differ significantly from those on financial assets in terms of quality specifications and delivery mechanism.The consumption value makes valuation of futures contracts on commodities difficult. Quality of underlying asset is immaterial in case of financial products, whereas there is ample scope of controversy over quality in case of commodity futures. Commodity futures are governed by seasons and perishable nature of the underlying asset. Commodities (the agricultural products) is confined to the harvesting period while the consumption is uniform throughout the year.

Long and Short PositionsWhen one holds the underlying asset he is said to be long on the asset. For example a jeweller holding gold or silver is long on the asset. The one who requires the asset in future is said to be short. For example a tea exporter needs stock of tea to execute the pending orders is short on tea.

Similarly in the futures market if one buys a futures contract he is said to be long, and if one sells the futures contract he is said to be short. Hedging principleTo execute a hedge following steps are taken:One who is long on the asset, goes short on the futures market, and the one who is short on underlying goes long in the futures market. At an appropriate time one can neutralise the position in the futures market, i.e. go long on futures if one was originally short and go short on futures if one was originally long, and receive/pay the difference of prices.

Sell or buy the underlying asset in the physical market at prevailing price Short hedgeWhen one has long position in the asset he needs to take a short position in futures to hedge. It is referred as short hedge. For example, a sugar mill would go short on the futures contract on sugar to hedge against the fall in price. If prices fall the short position in futures would yield profit compensating for the loss due to reduced realized value of sugar in the spot market. Long hedgeWhen one has short position in the asset he needs to take a long position in futures to hedge. It is referred as long hedge. For example, an importer of oil would go long on the futures contract on oil to hedge against the rise in price. If prices indeed rise the long position in futures would yield profit compensating for the loss due to increased price of oil in the spot market. Fututure hedge-Except by coincidence futures hedge is imperfect. The gains/losses in the futures do not exactly offset the loss/gains in the physical position because: the exposure in the underlying and futures market is not on the identical asset of same quality, the value of exposure in the underlying and the futures are not same because futures contract have fixed size. the time of maturity of the futures contract is not same as the time of exposure in the physical position because maturities of futures contract are specific. Speculation with commmdoty hedge futureFutures can be used for speculation if the estimate of future spot price is different than the futures price.

To speculate on the prices of commodities one has to do one of the following:If a trader expects a price fall he simply has to sell a futures contract today and buy it later; If a trader anticipates a rise in prices he simply has to buy the futures today and sell later;