1.

Introduction
1.1 Brief Introduction to Commodity Markets
Commodity markets links the producers of the commodities effectively with their commercial consumers. Commodities include agricultural products, precious metals, metals, energy, others. India is agricultural based country. Agricultural sector contributes to 24% of GDP. It is multicrop country unlike other agricultural economies. It is the largest producer of pulses, tea, cashew and second largest producer of food grains, sugarcane, fruits, vegetables in the world. So, there is good future for commodity markets in India. In olden days, farmers sell their production in a market place called mandi. Farmer and trader negotiate with each other. Farmer (seller) agrees on a price to sell certain quantity of a product to the buyer. Trade goes on one to one basis. Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level.

1.2 Need for the study

The face of commodity markets is changing. In 19th century sellers and buyers meet at a place called mandi and trade goes on in that place. Now- a-days, electronic exchanges have come in. Online trading is provided by these exchanges. Futures trading help in hedging price risk.

A primary research is done on the level of awareness of people about commodity markets. Very low people are aware of commodity markets. People who are aware of financial markets lack knowledge about commodity markets. So, people (sellers, buyers, exporters, importers, Investors) who are interested in commodity markets, planning to start trading in commodities and working for brokerage companies need to know about commodity markets in India and mechanics of trading. Hedgers should know hedging mechanism. Buyers and sellers of commodities should know delivery mechanism and physical settlement process of exchanges.

1.3 Research Problem

The core research problem is lack of awareness about commodity markets. A primary research is done on the level of awareness of investors, farmers, traders, importers and exporters. Findings of research: 1. There is significant difference between the level of awareness between the investors of the share market and that of the commodity market. 2. There is a significant difference between people who trade in futures and options in the share market and that of the people who trade in commodity market. 3. Producers of agricultural products lack knowledge of commodity markets. 4. Even the investors visiting the Sharekhan office lacked knowledge of commodity markets. The details of the primary research are included at the end of the report.

1.4 Objectives of the Study

The objectives of this report are: 1. Increase the awareness of the readers about commodity markets. 2. Familiarize reader with trading mechanics.

3. Impart knowledge about hedging and risk management. 4. Build awareness about fundamental analysis of a commodity.

1.5 Methodology

Sources of data for fundamental analysis on red chilly Data is collected from ANGRAU, Hyderabad , NCDEX, Spices Board, Tamil Nadu Agricultural university and other commodity exchanges. Selection of area Andhra Pradesh is selected as it is the largest producer of red chilli in India. Guntur spot market is selected for study because it is the largest chilli market in Asia. Large volumes of trade happen in this market.

1.6 Scope and Limitations

The study of commodity markets is limited to Indian perspective. The analysis on red chilly is limited to Guntur chilli market as it is the largest market in Asia and large volumes of chilli comes to this market from different parts of India.

2. Commodity Markets
Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded.

2.1 History of Commodity Trading

Commodity futures trading has been first recorded in the 17th century in Japan. The futures trading was basically done with the seasonal agricultural products so as to ensure their continuous supply all the year around. Japanese merchants used to store rice in the warehouses for their future use and used to sell receipts against such stored rice. These receipts were called as rice tickets which then eventually became the basis for their commercial currency. The rules which were established during this time for trading these rice tickets are similar to the rules set for American futures trading. In the United States, the commodity futures trading first started in the middle of the 19th century with the help of the Chicago Board Of Trade set up in the year 1848.Gradually then about 10 commodity exchanges were set up with a wide variety of agricultural products being traded. Commodity derivative market first started in India in cotton in the 1875 and in the oilseeds in 1900 at Bombay. Forward trading in raw jute and jute goods started at Calcutta in the year 1912. But however, within few years of their establishment, the forwards trading in these commodities was banned in the year 1960. Recently, in the year 2003, such ban on trading was lifted and the trading in commodity futures was started. Permission was given to establish online multicommodity exchange in order to facilitate trading. The long period of prohibition of forward trading in major commodities like cotton and oilseeds complex has an enduring impact on the development of the commodity derivative markets in India and the futures market in commodities find themselves left far behind the derivative markets in the developed countries,

which have been functioning uninterruptedly. Thus, today the challenge before the commodity markets is to make up for the loss of growth and development during the three decades of government policies, which had the effect of restricting the growth of the derivative markets.

2.2 Evolution of the Commodity Market in India

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organised futures market. Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution.

2.2.1 The Kabra Committee Report

After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the following objectives: 1. To assess

The working of the commodity exchanges and their trading practices in India and to make suitable recommendations with a view to making them compatible with those of other countries. The role of the Forward Markets Commission and to make suitable recommendations with a view to making it compatible with similar regulatory agencies in other countries so as to see how effectively these agencies can cope up with the reality of the fast changing economic scenario. 2. To review the role that forward trading has played in the Indian commodity markets during the last 10 years. 3. To examine the extent to which forward trading has special role to play in promoting exports. 4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the recommendations, particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act. 5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be operative remains constructive and helps in maintaining prices within reasonable limits. 6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible, particularly in commodities in which resumption of forward trading is generally demanded. The committee submitted its report in September 1994. The recommendations of the committee were as follows: The Forward Markets Commission (FMC) and the Forward Contracts (Regulation) Act, 1952, would need to be strengthened. Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing.

 In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators are strengthened further. The FMC which regulates forward/ futures trading in the country should continue to act a watchdog and continue to monitor the activities and operations of the commodity exchanges. Amendments to the rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. In the context of globalisation, commodity markets in India could not function effectively in an isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and castor seed, are upgraded to the level of international futures markets. The majority of the committee recommended that futures trading be introduced in the following commodities: 1. Basmatirice 2. Cotton and kapas 3. Raw jute and jute goods 4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them. 5. Rice bran oil 6. Castor oil and its oilcake 7. Linseed 8. Silver 9. Onions The liberalised 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 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 is, however presently prohibited. 2.2.2 Latest developments

Commodity markets have existed in India for a long time. Table 1.1 gives the list of registered commodities exchanges in India. While the implementations of the Kabra committee recommendations were rather slow, today, the commodity derivative market in India seems poised for a transformation. National level commodity derivatives exchanges seem to be the new phenomenon. The Forward Markets Commission accorded in principle approval for four national level multi commodity exchanges. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game.

2.3 Size of the Commodity Market in India

The size of the commodities markets in India is quite significant. Of the country's GDP of Rs 13, 20,730 crore (Rs 13,207.3 billion), commodities related (and dependent) industries constitute about 58 per cent. The various commodities across the country clock an annual turnover of Rs 1, 40,000 crore (Rs 1,400 billion). Despite having a robust economy, India's share in the global commodity market is not as big as estimated. Except gold the share in other sectors of the commodity market is not very significant. India accounts for 3% of the global oil demands and 2% of global copper demands.

In agriculture India's contribution to international trade volume is rather less compared to the huge production base available.

2.4 Different Segments in Commodities Market

The commodities market exits in two distinct forms namely Over the Counter (OTC) market The Exchange based market Also, there exists the spot and the derivatives segment. The spot markets are essentially over the counter markets previously and the participation is restricted to people who are involved with that commodity say the farmer, processor, wholesaler etc. But, now-a-days exchange-based spot market has come into existence. National Spot Exchange provides spot trading of commodities. Derivative trading takes place through exchange-based markets with standardized contracts, settlements etc.

2.5 Commodity Exchanges in India

Commodity exchanges are places which trade in particular commodities, neglecting the trade of securities, stock index futures and options etc. Exchanges are the centralized places which provide a platform for both the buyers and the sellers to meet, set quality standards and establish the rules of businesses. Commodity exchanges in India plays an important role as it offers a tool for efficient risk management and price transparency. In India, there are about 25 recognized regional exchanges of which five are national level multicommodity exchanges. These five national level multi-commodity exchanges are, National Board of Trade National Commodity and Derivative Exchange Limited( NCDEX) Multi-Commodity Exchange Of India( MCX)

National Multi-Commodity Exchange Of India Limited ( NMCEIL) National Spot Exchange Limited(NSEL)

All the above exchanges have been set up under the overall control of Forward Market Commission of Government of India. National Commodity & Derivative Exchange Limited (NCDEX) National Commodity & Derivative Exchange Limited (NCDEX) located in Mumbai is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956 and had commenced its operations on December 15, 2003. This is the only commodity exchange in the country promoted by the national level institutions. It is promoted by Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange (NSE). Other shareholders are Canara Bank, Punjab National Bank (PNB), CRISIL Limited, Indian Farmers Fertiliser Cooperative Limited (IFFCO), Goldman Sachs, Intercontinental Exchange (ICE), Shree Renuka Sugars Limited and Jaypee Capital Services Limited. It is a professionally managed online multi- commodity exchange. NCDEX is regulated by Forward Market Commission and is subject to various law of land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations. The Exchange, as on May 21, 2009 when Wheat Contracts were re-launched on the Exchange platform, offered contracts in 59 commodities - comprising 39 agricultural commodities, 5 base metals, 6 precious metals, 4 energy, 3 polymers, 1 ferrous metal, and CER. The top 5 commodities, in terms of volume traded at the Exchange, were Rape/Mustard Seed, Gaur Seed, Soyabean Seeds, Turmeric and Jeera.

Multi Commodity Exchange of India Limited (MCX) Multi Commodity Exchange is headquartered in Mumbai and is an independent, de-mutualised exchange with the permanent recognition from Government of India. Key Shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India and its associates, National Bank for

Agricultural and rural Development (NABARD), National Stock Exchange of India Ltd (NSE), Fid Fund (Mauritius) Ltd. - an affiliate of Fidelity International, Union Bank of India, Corporation Bank, Bank of India, Canara Bank, HDFC Bank, SBI Life Insurance Co. Ltd., ICICI ventures, IL&FS, Merrill Lynch and New York Stock Exchange. MCX facilitates online trading, clearing and settlement operations for commodity futures market across the country.MCX started offering trade in November 2003 and has several strategic alliances with leading exchanges across the globe. It has built strategic alliances with Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors Association of India, Pulse Importers Association and Shetkari Sanghatana. The turnover of the exchange for the fiscal year 2009 was US$ 1.24 trillion. Revenue Rs 104.39 crore (20052006) .In terms of contracts traded, it was in 2009 the world's sixth largest commodity exchange. MCX offers futures trading in bullion, ferrous and non-ferrous metals, energy, and a number of agricultural commodities (mentha oil, cardamom, potatoes, palm oil and others). It is regulated by the Forward Markets Commission. MCX is India's No. 1 commodity exchange with 83% market share in 2009 The exchange's main competitor is National Commodity & Derivatives Exchange Ltd. Globally, MCX ranks no. 1 in silver, no. 2 in natural gas, no. 3 in crude oil and gold in futures trading. The highest traded item is gold. As of early 2010, the normal daily turnover of MCX was about US$ 6 to 8 billion MCX now reaches out to about 800 cities and towns in India with the help of about 126,000 trading terminals. MCX COMDEX is India's first and only composite commodity futures price index. National Multi-Commodity Exchange of India Limited (NMCEIL) National Multi-Commodity Exchange of India Limited (NMCEIL) is the first de-mutualised, electronic Multi-commodity Exchange in India. It is one and only one Commodity exchange in the world to obtain the prestigious ISO 9001:2000 certification awarded by the British Standard Institutions (BSI). NMCE not only revived futures trade electronically in the commodities in India after a gap of 41 years, but also integrated the centuries old commodity market with the latest technology. It is backed by compulsory delivery based settlement to ensure transparent and

fair trade practices. NMCE offers electronic platform for future trading in plantation, spices, food grains, non-ferrous metals, oil seeds and their derivatives. On 25th July, 2001, it was granted approval by the government to organize trading in the edible oil complex. It has been operationalised from November 26, 2002. It is promoted by Central Warehousing Corporation (CWC), Punjab National Bank (PNB), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat AgroIndustries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), Neptune Overseas Limited (NOL), National Institute of Agricultural Marketing (NIAM). It has got its recognition in October 2002. National Spot Exchange Limited National Spot Exchange Ltd (NSEL) is an electronic, demutualised commodity spot market. The Exchange is promoted by Financial Technologies (India) Ltd (FTIL) and National Agricultural Cooperative Marketing Federation of India Limited (NAFED). It provides an electronic, transparent, well organized and centralized trading platform with the facility to access and participate in the market remotely. It facilitates risk free and hassle free purchase and sell of quality and quantity specified commodities to commodity market participants including farmers, traders, processors, exporters, importers, arbitrageurs, investors and the retail market participants. Exchange also offers various other services such as quality certification, warehousing, warehouse receipt financing, etc. NSEL commenced its live operations on 15th October 2008. The Exchange has started trading in Pre-certified cotton bales for Mumbai delivery, Imported Gold bar and silver bar for Ahmedabad delivery from the day one and now has added number of commodities for the spot trading. Its stated mission is to develop a Common Indian Market, by setting up a national level electronic spot market and providing a state of art trading, delivery and settlement facilities in various commodities, which can be accessed from across the country. It has created efficient spot delivery platform, helping the sellers/producers to sell commodities directly to the end buyers comprises of processors/ exporters. Currently, NSEL holds a market share of over 98% of the Indian electronic commodity Spot market, and has more than 495

registered members operating through over 3000 trader work stations, across India. Government organizations like FCI, HAFED, MMTC, PEC, NAFED, APMARKFED, RAJFED, and CCI have been actively utilizing the Exchange platform for selling various commodities. More than 33 commodities are traded on NSEL Platform having delivery locations spread across 14 states. For the first time in India, NSEL has introduced demat delivery based instrument products called e-Series, in commodities like gold, silver, copper, zinc and lead. This is a unique market segment, which is functioning just like cash segment in equities, but offering commodities in demat form in smaller denominations. Salient Features On spot exchange single day contracts are traded. It provides intra day trading with settlement of obligation on net basis. All positions outstanding at end of the day should result into compulsory delivery. Demat delivery facility is available . Fungibility of delivery between National Spot Exchange and MCX with common ICIN nos is possible. Loan facility against pledge of demate / warehouse receipt all deliverable futures contracts, including agri commodities, gold, silver, non-ferrous metals and wide number of other industrial products to be launched.

Table 2.1 Registered Commodity Exchanges in India Exchange Product traded Bhatinda Om & Oil Exchange Ltd. Gur The Bombay Commodity Exchange Ltd. Sunflower oil Cotton (Seed and oil) Safflower (Seed, oil and oil cake) Groundnut (Nut and oil) Castor oil, Castorseed Sesamum (Oil and oilcake) Rice bran, rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Groundnut oil Association, Ltd. Castorseed The Kanpur Commodity Exchange Ltd. The Meerut Agro Commodities Exchange The Ltd. Co. Spices and Oilseeds Exchange Ahmedabad Commodities Exchange Ltd. Ltd.Sangli Vijay Beopar Chamber Ltd., India Pepper & Spice Trade Association, Muzaffarnagar Rajdhani Oils and Oilseeds Exchange Ltd., Kochi Delhi National Board of Trade, Indore Rapeseed/ Mustardseed oil and Gur cake Turmeric Cottonseed, Castorseed Gur Pepper Gur, Rapeseed/ Mustardseed Sugar Grade-M Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil, Crude Palm Oil The Chamber of Commerce, Hapur The East India Cotton Association, The Central India Commercial Exchange Mumbai The East India Jute & Hessian Exchange Ltd., Gwaliar First Kolkata Ltd., Commodity Exchange of India Ltd., The Coffee Futures Exchange India Ltd., Kochi Bangalore Gur, Rapeseed/ Mustardseed Cotton Gur Hessian, Sacking Copra, Coconut oil & Copra cake Coffee

National Multi Commodity Exchange of Gur, RBD Pamohen India Limited, Ahmedabad Crude Palm Oil, Copra Rapeseed/ bean Mustardseed, Soy

Cotton (Seed, oil, oilcake) Safflower (seed, oil, oilcake) Groundnut (seed, oil, oilcake) Sugar, Sacking, gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed,oil and oilcake) Linseed (seed, oil and oilcake) Rice Bran Oil, Pepper, Guarseed Aluminium ingots, Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead National Commodity Exchange Limited & Derivatives Soy Bean, Refined Soy Oil, Mustard Seed, Expeller Mustard Oil, RBD Palmolein, Crude Palm Oil, Medium Staple Cotton, Long Staple Cotton, Gold, Silver

Table 2.2 Commodities Traded over the Exchanges

Bullion Oil Oilseeds Spices Metals Fibre Pulses Grains Energy Others

Gold and Silver & Castor Seeds, Soya Seeds, Castor Oil, Refined Soya Oil, Soya meal, Crude Palm Oil, Groundnut Oil, Mustard Seed, Cotton Seed Oil Cake, Cottonseed. Pepper, Red Chilly, Jeera, Turmeric, Cardamom Steel Long, Steel Flat, Copper, Nickel, Zinc, Tin, Steel, Aluminum,Lead Kapas, Long Staple Cotton, Medium Staple Cotton Chana,Urad,Yellow Peas, Tur, Rice, Basmati Rice, Wheat, Maize, Sarbati Rice, Jeera Crude Oil, Natural Gas, Brent Crude, Heating oil, Gasoline Rubber, Guar Seed, Guar Gum, Cashew, Cashew Kernel, Sugar, Gur, Coffee, Silk, Almond.

3. Introduction to Commodity Derivatives

3.1 Derivatives
The term derivatives refer to financial instruments which derive their value from some underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, commodities and even indices of these various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Here , in case of commodity derivatives the underlying asset is a commodity. There are various types of derivatives traded on exchanges across India. They are Forwards Futures Options

3.1.1 Forwards A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. The price agreed upon is called the delivery price or the Forward Price. Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis. A drawback of forward contracts is that they are subject to default risk. There are chances for one party to default, i.e. not honor the contract. It could be either the buyer or the seller. This

results in the other party suffering a loss. This risk of making losses due to any of the two parties defaulting is known as counter party risk. The main reason behind such risk is the absence of any mediator between the parties, who could have undertaken the task of ensuring that both the parties fulfill their obligations arising out of the contract. Default risk is also referred to as counter party risk or credit risk. 3.1.2 Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. 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. More than 99% of 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 3.1.2.1 Futures terminology

Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th

day of the delivery month. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a new contract having a three-month expiry is introduced for trading. Expiry 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 unit: The amount of asset that has to be delivered for 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 contract is 1 kg. Basis: 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 will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarised 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 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. Marking-to-market (MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the 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.

3.1.3 Options An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the premium or price of the option. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder may or may not exercise his right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment. Call option A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. It may be noted that the person who has the right to buy the underlying asset is known as the buyer of the call option. The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (call option strike price in this case). Since the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. The buyer of the call option does not have an obligation to buy if he does not want to. Put option A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. The person who has the right to sell the

underlying asset is known as the buyer of the put option. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (put option strike price in this case). Since the buyer of the put option has the right (but not the obligation) to sell the underlying asset, he will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry date of the contract. The buyer of the put option does not have the obligation to sell if he does not want to. 3.1.3.1 Option terminology

Commodity options: Commodity options are options with a commodity as the underlying. For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract. Stock options: Stock options are options on individual stocks. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer. Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-themoney when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St - K)] which means the intrinsic value of a call is the greater of 0 or (St - K). Similarly, the intrinsic value of a put is Max [0, (K - St)], i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only

time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

3.2 Difference between Commodity and Financial Derivatives

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues. 3.2.1 Physical Settlement

Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities 3.2.1.1 Delivery Notice Period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give delivery notice. This option is given during a period identified as 'delivery notice period'. It is

usually five days before the expiry date. Such contracts are then assigned to a buyer. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. In the case of BMF-Brazil a seller typically has to submit the following documents: A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods. A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse. A warehouse certificate showing that storage and regular insurance have been paid. 3.2.1.2 Assignment

Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method. Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading,

exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first-in-first out basis. In some exchanges (CME), the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day. 3.2.1.3 Delivery

After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been affected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts. 3.2.2 Warehousing

One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not

really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person, who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. This means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.

3.2.3 Quality of underlying assets

A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification.

Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.

4. Commodities Trading
4.1 Spot Trading
Earlier, commodity spot markets are essentially over the counter markets (OTC). OTC is a private market. In these markets, individuals/institutions trade through negotiations on a one to one basis. People who are in need of a commodity, buys the product from those persons (farmer, processor, wholesaler etc) who had stock with them. The buyer does the payment immediately

on the spot and the seller handovers the product. Thus, a spot market contract involves immediate payment and immediate transfer of asset. Now a days, the face of commodity spot market is changing drastically. Electronic spot exchanges have come into existence. Now, spot trading in commodities is similar to equity spot trading that is cash segment of equity market. We have only one national exchange in India where spot trading of commodities is allowed. It is National Spot Exchange Limited (NSEL) which was set up in October, 2008. It is an electronic spot exchange. It is Indias No.1 spot exchange having 99% market share, providing delivery based trading platform in commodities (CashSegment in Indian Commodity Market). Its promoters are Financial Technologies and National Agricultural Co-Operative Marketing Federation of India Limited (NAFED). The products offered by NSEL are 1. Agricultural Products Cereals: Paddy, Wheat, Bajra Pulses: Bengal gram, Green Gram, Black gram, Pigeon Peas, Yellow Peas etc. Edible Oils & Oilseeds: Soya bean, Castor Seed, Mustard Seed etc. Cotton, sugar and Black Pepper.

2. Non Agricultural Products Bullion: Gold & Silver (Bars & Coins) Steel: Ignots and Billets 3. E-Series products E-Gold E-Silver E- Copper

E-Zinc E-Lead 4.1.1 How trading goes on ..

National Spot Exchange Ltd (NSEL) introduced fully automated screen based spot trading for commodities. It uses a modern, fully computerized trading system designed to offer market participants across the length and breadth of the country a safe and easy way to trade. The NSEL trading system called 'National Exchange for Spot Trading' (NEST) is a fully automated screen based trading system, which adopts the principle of an order driven market. In spot market, single day trading contracts are traded. The contracts open every day for trading. The buyer/seller buys and sells the contracts. For buying or selling of the commodities, trader has to maintain certain amount as a margin with the broker of the exchange. If the buyer wants to hold the commodity long, he requires paying total value of the transaction. Total value of a transaction (tot) = market price of the commodity * lot size. Margin amount= tot * percentage of margin Without holding the commodity he can go for selling it. This is called short sales. In short sales investor makes profit when market goes down (bearish market). In short sales, investor first sells the commodity and then buys the commodity. According to the trading rules, if he goes for selling without holding the commodity he has to buy the commodity by the end of the trading session on that day. Let us see this. For example, the investor sells 1gm of gold for INR 2230. The market goes down and price comes down to INR 2200. He makes a profit of rupees 30(2230-2200) for 1 gm of gold if he buys at INR 2200. The buyer/seller can offset their transaction by end of that days trading session. The position open at the end of the trading session results into the compulsory delivery of the commodity traded. The electronic spot market platform is many-to-many market structure. For each contract, Exchange has identified a particular delivery location or additional warehouses where the

commodities can be delivered and lifted by the sellers and buyers respectively.

The seller willing to sell agri- commodity on the Exchange platform will be required to bring the commodity to the Exchange warehouse where weighment and quality certification is done. The quality certification is done by the quality certifying agent based at the exchange warehouse. The commodity is allowed for trading on the Exchange platform only if the quality of the commodity is as per the contract specification of the Exchange. For withdrawal of the commodity from the Exchange designated warehouse, the buyers are required to give at least 1 day prior intimation to the warehouse for necessary arrangements. Based on the intimation received from the withdrawer, delivery schedule will be intimated by the warehouse supervisor. Loading of commodities will be done on first cum first serve basis.

At the time of lifting the delivery from the exchange warehouse the buyer member needs to submit the Letter of Authority requesting the Warehouse manager to issue the delivery of Commodity to the bearer of the Authority Letter along with original Copy of the Warehouse Receipt. The buyer has to instruct their representative to carry some identity Proof (ID proof of his representative such as Voter ID / PAN/ Passport to enable the Exchange) along with the Authority Letter and Original Warehouse Receipt for lifting the stock from the accredited warehouse. For spot trading in the bullions, the same procedure is followed as in the Agricommodity. The Exchange accredited vaults are the delivery centres for the bullions. 4.1.2 Physical Settlement 1. Trade Matching Finding the sellers and buyers and assigning sellers to buyers. 2. Delivery marking & Obligation to Members through FTP 3. Commodity Deposited by Seller at W-H/Vault 4. Confirmation by WH to Delivery dept. after certification 5. Commodity Pay-In confirmation by Delivery dept to Clearing Dept.

6. Funds Pay-in by Buyer (thru Settlement A/C) 7. Funds pay-out to seller. 8. Buyer detail to the Exchange. 9. DO issued to warehouse. 10. Commodity pay-out confirmation to the Buyer 11. Lifting of commodity. 12. Invoice by the seller.

Gold reserves
1. United States Value of reserves: $418.39 billion Holdings total: 8,965.6 tons The United States Bullion Depository in Kentuckyotherwise known as Fort Knoxis the most famous gold stockpile in the world. It holds the majority of the nations gold reserves, the remainder of which is held at the Philadelphia Mint, the Denver Mint, the West Point Bullion Depository and the San Francisco Assay Office. Altogether, the total gold reserves of the U.S. equal 8,965.6 tons and would be valued at approximately $418.39 billion in today's market. Who Has the Most Gold? The price of gold hovered around $1,600 per ounce at the end of of 2011, rising over 15% in 2011, following uncertainty in the equity markets and the global economy as a whole. The biggest individual holders of goldcentral banks, international organizations and governmentsare believed to account for approximately 16.5 percent of the world's gold, holding about 30,700 tons. The numbers are taken from the monthly report produced by the World Gold Council, which is the gold industry's key market development body. The holdings presented here are as of WGC's December 2011 report, unless otherwise noted

2. Germany Value of reserves: $174.7 billion Holdings total: 3,743.7 tons The Deutsche Bundesbank, Germany's central bank, has 3,743.7 tons of gold reserves, which are valued at about $174.7 billion. According to the World Gold Council, Germanys gold coffers account for 73.7 percent of total foreign reserves.

3. The International Monetary Fund Value of reserves: $144.76 billion Holdings total: 3,101 tons The International Monetary Fund (IMF) oversees international economic operations of 185 member countries. Its gold policies have changed in the last 25 years, but the reserves remain to stabilize international markets and aid national economies. In one such instance, the IMF sold a portion of its reserves in December 1999 to aid the Heavily Indebted Poor Countries Initiative. The 3,101 tons of IMF Gold would fetch roughly $144.76 billion in the open market.

4. Italy Value of reserves: $126.12 billion Holdings total: 2,702.6 tons The Banca D'Italia manages Italy's foreign reserves, which have been reported at 2,702.6 tons by the World Gold Council and comprise the fourth largest gold reserve in the world. These holdings are worth $126.12 billion in the open market and account for 73.4 percent of the country's foreign reserves.

5. France Value of reserves: $125.28 billion Holdings total: 2,684.6 tons The French National Bank, Banque De France, is home to the country's gold holdings, which

comprise 71.8 percent of its foreign reserves. With 2,684.6 tons of gold in reserve, France's holdings are worth approximately $125.28 billion.

6. SPDR Gold ETF (GLD) Value of holdings: $64.53 billion Holdings total: 1,213.9 tons Unlike other major gold holdings, this is one that investors can actually buy in to. As the price of gold fluctuates, so does the value of SPDR Gold Trust, also known the GLD. The fund held 38,845,889 ounces, or 1,213.9 tons of gold as of its 10-Q filing on June 30, 2011. Although gold is off its all time highs, during the week of August 22, 2011, the SPDR Gold Trust surpassed the heavily-traded S&P 500 SPDR (SPY) for the first time. Like many investors, the ETF has indicated they have increased their holdings of gold since their most recent filing.

7. China Value of reserves: $54.22 billion Holdings total: 1,161.9 tons At 1,161.9 tons, the world's most populated country has the world's seventh largest gold reserve. Expect it to be higher on the list? Well, bear in mind that China's gold only accounts for 1.8 percent of its foreign reserves. With a population of 1.34 billion, the country holds about $40.46 worth of gold per person, totaling $54.22 billion.

8. Switzerland Value of reserves: $53.5 billion Holdings total: 1,146.5 tons The Swiss National Bank conducts Switzerland's monetary policy and manages the country's 1,146.5 tons of gold. With the world's eighth largest reserve of the precious metal, Switzerland's supply is worth approximately $53.5 billion in today's gold market. It accounts for 15.8 percent of the country's foreign reserves, though this proportion has dropped in the past year.

9. Russia Value of reserves: $44.8 billion Holdings total: 960.1 tons The Central Bank of the Russian Federation is in charge of the countrys 960.1 tons of gold, which are valued at $44.8 billion and comprise 9.2 percent of the countrys foreign reserves.

In 2009, Russia increased its gold production by 21 percent, due in part to the launch of several new mines. In 2010, the country overtook Japan in total holdings, adding more than 140 tons to its stockpile in that year alone. Russia's buying of gold continued in 2011, purchasing 4.9 tons in July, according to the IMF's August report. 10. Japan Value of reserves: $39.36 billion Holdings total: 843.5 tons Although Japan is ninth on the list, its 843.5 tons of gold account for only 3.5 percent of total foreign reserves. On the open market, Japan's gold reserves would be worth around $39.36 billion, and are overseen by the Bank of Japan. 11. The Netherlands Value of reserves: $31.5 billion Holdings total: 675.2 tons The Netherlands has the 11th largest reserve on the list, with 675.2 tons of gold. De Nederlandsche Bank manages the countrys national finances, including the gold reserves, which amount to approximately $31.5 billion and account for 61.9 percent of the country's foreign reserves. 12. India Value of reserves: $28.69 billion Holdings total: 614.75 tons Shooting up in the rankings in the past few years is India. The second most populous nation in the world maintains the 12th largest gold reserves. The size of India's holdings were bolstered in November 2009 by a $6.9 billion purchase of 200 tons of gold from the International Monetary Fund.

The Reserve Bank of India currently oversees the countrys 614.75 tons of gold, which are valued at $28.69 billion, comprising 9.6% of its foreign reserves. Indias current ranking may also continue to move upwards, as the government has asked the Geological Survey of India to mine previously untapped gold reserves in many of its states. 13. The European Central Bank Value of reserves: $25.8 billion Holdings total: 553.4 tons Established in 1998 by the European Union, the European Central Bank (ECB) is responsible for the monetary policy of the member nations of the euro zone and is headquartered in Frankfurt. The ECB's 553.3 tons of gold accounts for 35 percent of the bank's foreign reserves and would be worth $25.8 billion in today's market 14. Taiwan Value of reserves: $21.7 billion Holdings total: 465.6 tons Renowned for its technology industry and robust economic growth, Taiwan also boasts one of the largest gold reserves in the world. The Central Bank of the Republic of China (Taiwan) manages the island nations foreign reserves, which are reported at 465.6 tons. These holdings are worth $21.7 billion at today's prices and comprise approximately 5.9 percent of the country's foreign reserves.

15. Portugal Value of reserves: $19.7 billion Holdings total: 421.6 tons The westernmost nation in mainland Europe is home to the 15th largest gold reserve in the world. At 421.6 tons, Portugals holdings are overseen by Banco de Portugal and are valued at roughly $19.7 billion, accounting for 89.2 percent of the countrys foreign reserves.