5.

ABOUT THE COMMODITY

5.1 INTRODUCTION Keeping in view the experience of even strong and developed economies of the world, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments which allow fund managers to better manage or reduce these risks. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. 5.2 COMMODITIES Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab. A three-pronged approach has been adopted to revive and revitalize the market. Firstly, on policy front many legal and administrative hurdles in the functioning of the market have been removed. Forward trading was permitted in cotton and jute goods in 1998, followed by some oilseeds and their derivatives, such as groundnut, mustard seed, sesame, cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy, issued in July, 2000 by the government that futures trading will be encouraged in increasing number of agricultural commodities was indicative of welcome change in the government policy towards forward trading. 17 Secondly, strengthening of infrastructure and institutional capabilities of the regulator and the existing exchanges received priority. Thirdly, as the existing exchanges are slow to adopt reforms due to legacy or lack of resources, new promoters with resources and professional approach were being attracted with a clear mandate to set up dematerialized, technology driven exchanges with nationwide reach and adopting best international practices. The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all the commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets. Of the country's total GDP, commodities related (and dependent) industries constitute about roughly 50-60 %, which itself cannot be ignored. Most of the existing Indian commodity exchanges are single commodity platforms;

are regional in nature, run mainly by entities which trade on them resulting in substantial conflict of interests, opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. But with the strong emergence of: National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai (NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will be addressed rapidly. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges. The current mindset of the people in India is that the Commodity exchanges are speculative (due to non delivery) and are not meant for actual users. One major reason being that the awareness is lacking amongst actual users. In India, Interest rate risks, exchange rate risks are actively managed, but the same does not hold true for the commodity risks. Some additional impediments are centered on the safety, transparency and taxation issues. 5.3 WHY COMMODITIES MARKET? India has very large agriculture production in number of agri-commodities, which needs use of futures and derivatives as price-risk management system. Fundamentally price you pay for goods and services depend greatly on how well business handle risk. By using effectively futures and derivatives, businesses can minimize risks, thus lowering cost of doing business. 18 Commodity players use it as a hedge mechanism as well as a means of making money. For e.g. in the bullion markets, players hedge their risks by using futures Euro-Dollar fluctuations and the international prices affecting it. For an agricultural country like India, with plethora of mandis, trading in over 100 crops, the issues in price dissemination, standards, certification and warehousing are bound to occur. Commodity Market will serve as a suitable alternative to tackle all these problems efficiently. 5.4 COMMODITY FUTURES: Commodity futures are simply the standard futures contracts traded through exchange. These contracts have their respective commodity as underlying asset and derive the dynamics from it. Such contracts allow the participant to buy and sell certain commodity at a certain price for future delivery. Futures trading is a natural outgrowth of the problem of maintaining a year-round supply of seasonal products like agriculture crops. The best thing about a commodity futures contract is that it is generally leveraged giving opportunity to all types of investors to participate. Characteristically, such a contract has an expiry and delivery attached with it. 5.5 WHY TRADE IN COMMODITIES? 1. Big market-diverse opportunities India, a country with a population of over one billion, has an economy based on agriculture, precious metals and base metals. Thus, trading in commodities provides lucrative market opportunities for a wider section of participants of diverse interests like investors, arbitragers, hedgers, traders, manufacturers, planters, exporters and importers. 2. Get to the sore Commodity trading has been a breakthrough in expanding the investment from investing in a metal company to trading in metal itself. 3. Huge potential Commodity exchanges see a tremendous daily turnover of more than Rs.15,000 cores. This gives a lunge potential to market participant to make profits.

4. Exploitable fundamental The fundamental for commodity trading is simple price is a function of demand and supply so is hedging, by taking appropriate contract. This makes things really easy to understand and exploit. 19 5. Portfolio diversifier Commodity futures derive their prices from the underlying commodity and commodity prices cannot become zero. Commodity has a global presence and their prices move with global economics and hence, its a good portfolio diversifier. 5.6 ADVANTAGE OF FUTURES TRADING Futures trading remove the hassles and costs of settlement and storage for traders who do not want custody. Though, the most lucrative element of futures trading is that it allows investors to participate and trade at nominal costs at a much lesser amount: No longer need to put the whole amount for trading; only the margin is required. No sales tax is applicable if the trade is required off. Sales tax is applicable only if a trade results in delivery. Traders can short sell. If a trader buys an equivalent contract back before the contract expires, he will be able to profit from a falling price. This is difficult in spot marketers because it requires the seller to borrow the commodity. It is next to impossible for retail investors in case of something like gold. All participants trade exactly the same notional right i.e. those defined on the standard contract, so the market grows deeper and more liquid in the standard futures contract than in spot bullion where different qualities of bullion exit, each of which has different prices. Greater liquidity provides a reliable real-time price something which is absolutely not available in the OTC bullion market. 5.7 CHARACTERISTICS OF FUTURES TRADING A "Futures Contract" is a highly standardized contract with certain distinct features. Some of the important features are as under: Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Bye-laws of the association. It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tenderable varieties". The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units. 20 The delivery periods are specified. The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers. In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. 5.8 COMMODITY DERIVATIVES IN INDIA Commodity derivatives have a crucial role to play in the price risk management process especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed and developing countries in the

world. The Chicago Mercantile Exchange; Chicago Board of Trade; New York Mercantile Exchange; International Petroleum Exchange, London; London Metal Exchange; London Futures and Options Exchange; Marche a Terme International de France; Sidney Futures Exchange; Singapore International Monetary Exchange; The Singapore Commodity Exchange; Kuala Lumpur Commodity Exchange ; Bolsa de Mercadorias & Futuros (in Brazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China Commodity Futures Exchange; Beijing Commodity Exchange, etc are some of the leading commodity exchanges in the world engaged in trading of derivatives in commodities. However, they have been utilized in a very limited scale in India Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity markets to control prices. The government controls the production, supply and distribution of many agricultural commodities and only forwards and futures trading are permitted in certain commodity items. Free trade in many commodity items is restricted under the Essential Commodities Ac, 195, and forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act, 1952. The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd., and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. The Gujarati Vyapari Mandali came into existence in 1900, which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures 21 trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association. Many exchanges came up in the agricultural centers in north India before world war broke out and engaged in wheat futures until it was prohibited. The exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was firs organized by IPSTA in Cochin in 1957. Futures in gold and silver began in Mumbai in 1920 and continued until the government prohibited it by mid-1950s. Later, futures trade was altogether banned by the government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities. Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until the along with futures were banned in 1939. However, the government withdrew the ban on futures with passage of Forward Contract (Regulation) Act in 1952. After the ban of futures trade many exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc. Further in 1993 the government of India appointed an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra and the report of the committee was submitted in 1994 which recommended the reintroduction of futures already banned and to introduce futures on many more commodities including silver. In tune with the ongoing economic liberalization, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk emerging from price fluctuations. In line with the proposal many more agricultural commodities are being

brought under futures trading. In India, currently there are 15 commodity exchanges actively undertaking trading in domestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association (IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recently upgraded to international exchanges to deal in international contracts in pepper and castor oil respectively. Another 8 exchanges are proposed and some of them are expected to start operation shortly. There are 4 exchanges, which are specifically approved for undertaking forward deals in cotton. More detailed account of these exchanges has been presented. 22 The proposed study is primarily based on the visit of seven leading exchanges viz., IPST Cochin, which deal in domestic and international contracts in pepper; BCE Ltd., a multy-commodity international exchange where futures in castor oil, castor seed, sunflower oil, RBD Palmolein etc are traded; The East India Cotton Association (EICA) Ltd., Bombay, which is a specialized exchange dealing in forwards and futures in cotton; South India Cotton Association (SICA , Coimbatore which deals in forward contracts in cotton; Coffee Futures Exchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading; Kanpur Commodity Exchange (KCE) which deals with futures contracts in mustard oil and gur; and The Chamber of Commerce, Hapur which undertakes futures trading in gur and potatoes. 5.9 MECHANICS OF FUTURES TRADING Futures are a segment of derivative markets. The value of a futures contract is derived from the spot (ready) price of the commodity underlying the contract. Therefore, they are called derivatives of spot market. The buying and selling of futures contracts take place in organized exchanges. The members of exchanges are authorized to carryout trading in futures. The trading members buy and sell futures contract for their own account and for the account of non-trading members and other clients. All other persons interested to trade in futures contracts, as clients must get themselves registered with the exchange as registered non-members. 5.10 WHAT IS A COMMODITY FUTURE EXCHANGE? Exchange is an association of members, which provides all organizational support for carrying out futures trading in a formal environment. These exchanges are managed by the Board of Directors, which is composed primarily of the members of the association. There are also representatives of the government and public nominated by the Forward Markets Commission. The majority of members of the Board have been chosen from among the members of the Association who have trading and business interest in the exchange. The chief executive officer and his team in day-to-day administration assist the Board. There are different classes of members who capitalize the exchange by way of participation in the form of equity, admission fee, security deposits, registration fee etc. a. Ordinary Members: They are the promoters who have the right to have own account transactions without having the right to execute transactions in the trading ring. They have to place orders with trading members or others who have the right to trade in the exchange. 23 b. Trading Members: These members execute buy and sell orders in the trading ring of the exchange on their account, on account of ordinary members and other clients. c. Trading-cum-Clearing Members: They have the right to trade and also to participate in clearing and settlement in respect of transactions carried out on their account and on account of their clients. d. Institutional Clearing Members: They have the right to participate in clearing and settlement on behalf of other members but do not have the trading rights. e. Designated Clearing Bank: It provides banking facilities in respect of pay-in, payout and

other monetary settlements. The composition of the members in an exchange however varies. In so me exchanges there are exclusive clearing members, broker members and registered non -members in addition to the above category of members. 5.11 WHAT IS COMMODITY FUTURES CONTRACT? Futures contracts are an improved variant of forward contracts. They are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. While forward contracts are mainly over-the-counter and tailor-made which physical delivery futures settlement standardized contracts whose transactions are made in formal exchanges through clearing houses and generally closed out before delivery. The closing out involves buying a different times of two identical contracts for the purchase and sale o the commodity in question, with each canceling the other out. The futures contracts are standardized in terms of quality and quantity, and place and date of delivery of the commodity. The commodity futures contracts in India as defined by the FMC has the following features: (a) Trading in futures is necessarily organized under the auspices of a recognized association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules and Bye-laws of the association. (b) It is invariably entered into for a standard variety known as the basis variety with permission to deliver other identified varieties known as tender able varieties. (c) The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units. (d) The delivery periods are specified. 24 (e) The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers. (f) In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. The terms and specifications of futures contracts vary depending on the commodity and the exchange in which it is traded. The major terms and conditions of contracts traded in six sample exchanges in India. These terms are standardized and applicable across the trading community in the respective exchanges and are framed to promote trade in the respective commodity For example, the contract size is important for better management of risk by the customer. It has implications for the amount of money that can be gained or lost relative to a given change in price levels. I also affect the margins required and the commission charged. Similarly, the margin to be deposited with the clearing house has implications for the cash position of customers because it blocks cash for the period of the contract to which he is a party the strength and weaknesses of contract specifications are discussed under constraints and policy options. 5.12 WHO ARE THE PARTICIPANTS IN FUTURES MARKET? Broadly, speculators who take positions in the market in an attempt to benefit from a correct anticipation of future price movements, and hedgers who transact in futures market with an objective of offsetting a price risk on the physical market for a particular commodity make the futures market in that commodity. Although it is difficult to draw a line of distinction between hedgers and speculators, the former category consists of manufacturing companies, merchandisers, and farmers. Manufacturing companies who use the commodity

as a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at a predetermined price, which facilitates immunity against price fluctuations. While exporters in addition to using the price discovery mechanism for getting better prices for their commodities seek to hedge against their overseas exposure by way of locking-in the price by way of buying futures contracts, the importers utilize the liquid futures market for the purpose of hedging their outstanding position by way of selling futures contracts. Futures market helps farmers taking informed decisions about their crop pattern on the basis of the futures prices and reduces the risk associated with variations in their sales revenue due to 25 unpredictable future supply demand conditions. Above all, there are a large number of brokers who intermediate between hedgers and speculators create the market for futures contracts. 5.13 COMMODITY ORDERS The buy and sell orders for commodity futures are executed on the trading floor where floor brokers congregate during the trading hours stipulated by the exchange. The floor brokers/trading members on receipt of orders from clients or from their office transmits the same to others on the trading floor by hand signal and by calling out the orders (in an open outcry system they would like to place and price. After trade is made with another floor broker who takes the opposite side of the transaction for another customer or for his own account, the details of transactions are passed on to the clearing house through a transaction slip on the basis o which the clearinghouse verifies the match and adds to its records. Following the experiences of stock exchanges with electronic screen based trading commodity exchanges are also moving from outdated open outcry system to automated trading system. Many leading commodity exchanges in the world including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International Petroleum Exchange (IPE), London, have already computerized the trading activities. In India, coffee futures exchange, Bangalore has already put in place the screen based trading and many others are in the process of computerization. To add to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for a common electronic trading platform connecting all commodity exchanges to conduct screen based trading. In electronic trading, trading takes place through a centralized computer network system to which all buy and sell orders and their respective prices are keyed in from various terminals of trading members. The deal takes place when the central computer finds matching price quotes for buy and sell. The entire procedural steps involved in electronic trading beginning from placing the buy/sell order to the confirmation of the transaction have been shown in figure -2.1 below.

How does futures contract facilitate hedging against price risk? The futures contracts are designed to deal directly with the credit risk involved in locking-in prices and obtaining forward cover. These contracts can be used for hedging price risk and discovering future prices. For commodities that compete in world or national markets, such as coffee, there are many relatively small producers scattered over a wide geographic area. These widely dispersed producers find it difficult to know what prices are available, and the opportunity for producer, processor, and merchandiser to ascertain their likely cost for coffee and develop long range plans is limited. Futures trading, used in the Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955, provides the industry with a guide to what coffee is worth now as well as todays best estimate for the future. Moreover, since all transactions are guaranteed through a central body, clearing house, which is the counter party to each buyer and seller ensuring zero default risk, market participants need not worry about their counterparts creditworthiness. Hedge is a purchase or sale on a futures market intended to offset a price risk on the physical (ready) market. It involves establishing a position in the futures market again ones position or firm commitments in the physical market. The producers who seek to protect themselves from an expected decline in prices of their commodity in future go for short hedge (also called sell hedge). He undertakes the following operations in the market to lockin the price in advance which he is going to receive after the product. I ready for physical sale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2 units of contracts in Cochin pepper exchange) of pepper in March, the futures price for March delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and the prevailing (say, October) ready market price is Rs.8100 per quintal. a) In October, the producer goes short (sells) in the futures market selling 2 March futures contracts at Rs.8400 per quintal. This is called price fixing. 31 b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sells pepper in the ready market for Rs.8200. c) Simultaneously, he closes out his short position in futures by buying (long position) 2 March futures contracts at Rs.8200 per quintal. The result is that the producer sold futures contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a net gain of Rs.200 per quintal or Rs.5000 per contract. For the physical sale, the producer received the market price of Rs.8200 prevailing on the day of the sale and the gain of Rs.200 per quintal from closing-out of futures contracts makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the price realized in the ready market is lower than the price in future contract, the loss on the physical market is compensated by the higher price realized on the future contract. On the other hand, if the price in the ready market is higher than in futures contract, the gain in the ready market is offset by the loss on the repurchase of the futures contract. Since futures market prices move in tandem with the ready market prices over the course of time tending to converge as the contract matures, a gain in the futures market in a developed commodity market under normal conditions, will be offset by a loss in the ready market, or vice versa. However, market imperfections will lead to the basis risk emerging from the mismatch between the gain/loss from the futures market not compensated by loss/gain in the ready market. Meaning of Derivatives The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived". A derivative is a financial instrument, which derives its value from some other financial price. This other financial price is called underlying. The most common

underlying assets include stocks, bonds, commodities, currencies, livestock, interest rates and market indexes. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying. The terms derivative contract, derivative product, or derivative are used interchangeably. 32 Examples of Derivatives Consider how the value of mutual fund units changes on a day-to-day basis. Dont mutual fund units draw their value from the value of the portfolio of securities under the schemes? A very simple example of derivatives is cloth, which is derivative of cotton. The price of cloth depends upon the price of cotton, which in turn depends upon the demand, and supply of cotton... Arent these examples of derivatives? Yes, these are. And you know what, these examples prove that derivatives are not so new to us. There are two broad types of derivatives: Financial derivatives: - Here the underlying includes treasuries, bonds, stocks, stock index, foreign exchange etc. Commodity derivatives: Here the underlying is a commodity such as wheat, cotton, peppers, turmeric, corn, soybeans, rice crude oil etc. 5.15 HISTORY The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago board of trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralized location to negotiate forward contracts, where forward contracts on various commodities were standardized around 1865.The primary market intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial 33 exchanges of any kind in the world today. From then on, futures contracts have remained more or less in the same form, as we know them today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S & P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France etc.

However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments - such as bond, currencies, stocks and stock indiceshas now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desais government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities was allowed to trade on exchanges. In June 2000, National Stock Exchange and Bombay Stock Exchange started trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005 34 5.16 TYPES OF DERIVATIVES A derivative as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few smart finance professionals. In reality it is not so. In fact, a derivative transaction helps to cover risk, which would arise on the trading of securities on which the derivative is based and a small investor, can benefit immensely. A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. An example of a simple derivative contract: Rohan buys a futures contract. He will make a profit of Rs. 1200 if the price of Infosys rises by Rs. 1200. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs. 1000 he will lose Rs. 1000. As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty.

There are basically of 3 types of Derivatives and Futures: Forwards and Futures Options Swaps FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying assed on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to dell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. it has to compulsorily go to the same counter party, which often results in high price being charged. Limitation of forward market: Forward market world-wide are afflicted by several problems: Lack of centralization Illiquidity Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward market trade standardized contracts, and hence avoids the problem of illiquidity, still the counterparty risk remains very serious issue. Illustration Sahil wants to buy a Laptop, which costs Rs 30,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of laptop will rise 36 3 months from now. So in order to protect himself from the rise in prices Sahil enters into a contract with the laptop dealer that 3 months from now he will buy the laptop for Rs 30,000. What Sahil is doing is that he is locking the current price of a LAPTOP for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Sahil at the end of three months and Sahil in turn will pay cash equivalent to the LAPTOP price on delivery. FUTURES CONTRACT Futures markets were designed to solve the problems that exist in forward market. 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. So, the counter party to a future contract is the clearing

corporation of the appropriate exchange. 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. Future contracts are often settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transaction is offset this way. The standardized items in a futures contract are: Quantity of the Underlying. Quality of the Underlying. The date and month of delivery. The units of price quotation and minimum price change. Location of settlement. Distinction between futures and forwards contracts: Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. OPTIONS CONTRACT Option means several things to different people. It may refer to choice or alternative or privilege or opportunity or preference or right. To have option is normally regarded good. One is considered unfortunate without any options. Options are valuable since they provide protection against unwanted, uncertain happenings. They provide alternatives to bail out from a difficult situation. Options can be exercised on the happening of certain events. Options may be explicit or implicit. When you buy insurance on your house, it is an explicit option that will protect you in the event there is a fire or a theft in your house. If you own shares of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt. Options have assumed considerable significance in finance. They can be written on any asset, including shares, bonds, portfolios, stock indices currencies, etc. They are quite useful in risk management. How are options defined in finance? What gives value to options? How are they valued? An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. For example, that Rohit discover a bungalow that Rohit love to purchase. Unfortunately, Rohit won't have the cash to buy it for another three months. Rohit talk to the owner and negotiate a deal that gives Rohit an option to buy the bunglow in three months for a price of Rs.20,00,000. The owner agrees, but for this option, Rohit pay a price of Rs.50,000. Now, consider two theoretical situations that might arise: 1. It is discovered that the bunglow is actually having a historical importance! As a result, the market value of the bunglow increases to Rs. 50,00,000. Because the owner sold Rohit the 38 option, he is obligated to sell Rohit the bunglow for Rs.20,00,000. In the end, Rohit stand to make a profit of Rs.29, 50,000. (Rs.50,00,000Rs.20,00,000Rs.50,000).

2. While touring the bunglow, Rohit discover not only that the walls are chock-full of asbestos, but also that it is a home place of numerous rats. Though Rohit originally thought Rohit had found the bunglow of Rohit dreams, Rohit now consider it worthless. On the upside, because Rohit bought an option, Rohit are under no obligation to go through with the sale. Of course, Rohit still lose the Rs.50,000 price of the option. This example demonstrates two very important points. First, when Rohit buy an option, Rohit have a right but not an obligation to do something. Rohit can always let the expiration date go by, at which point the option becomes worthless. If this happens, Rohit lose 100% of Rohit investment, which is the money Rohit used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives; means an option derives its value from something else. In our example, the bunglow is the underlying asset. Most of the time, the underlying asset is a stock or an index. Types of Options There are two types of options: Call Options: - It gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. Put Option: - It gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. Participants in the Options Market There are four types of participants in options markets depending on the position they take: 1. Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of put 39 People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. Here is the important distinction between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. Terminology Associated With The Options Market. 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. Listed Options: - An option that is traded on a national options exchange such as the National Stock Exchange is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents a predetermined number of shares of company stock (known as a contract). 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 cash flow when exercised immediately. A call option on the index is out-of-the-money 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. Depending on when an option can be exercised, it is classified in on of the following two categories: 40 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 analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. TRADING IN OPTIONS If one buys an option contract he is buying the option, or "right" to trade a particular underlying instrument at a stated price. An option that gives you the right to eventually make a purchase at a predetermined price is called a "call" option. If you buy that right it is called a long call; if you sell that right it is called a short call. An option that gives you the right to eventually make a sale at a predetermined price is called a "put" option. If you buy that right it is called a long put; if you sell that right it is called a short put. Trading in Call Suppose a call option with an exercise/strike price equal to the price of the underlying (100) is bought today for premium Re.1.

http://mcx-ncdex-commodity-trading-tips.blogspot.in/