COMMODITY ASSIGNMENT

CIA II

Commodity Exchange Market

Submitted to: Dr Anirban Ghatak

Submitted by:
Kumar Aniket 1120306
Arun P 1120307
Abby Jacob 1120308
Udit David 1120313
Jithin Raju 1120314
Tanmay Das 1120317
Finance F2
CUIM, Kengeri

Introduction
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. The economic impact of the development of commodity markets is hard
to overestimate. Through the 19th century the exchanges became effective spokesmen for, and
innovators of, improvements in transportation, warehousing, and financing, which paved the way
to expanded interstate and international trade. Commodity money and commodity markets in a
crude early form are believed to have originated in Sumer where small baked clay tokens in the
shape of sheep or goats were used in trade. Sealed in clay vessels with a certain number of such
tokens, with that number written on the outside, they represented a promise to deliver that number.
This made them a form of commodity money - more than an I.O.U. but less than a guarantee by a
nation-state or bank. However, they were also known to contain promises of time and date of
delivery - this made them like a modern futures contract. Regardless of the details, it was only
possible to verify the number of tokens inside by shaking the vessel or by breaking it, at which
point the number or terms written on the outside became subject to doubt. Eventually the tokens
disappeared, but the contracts remained on flat tablets. This represented the first system of
commodity accounting.

Considering the many hazards of climate, piracy, theft and abuse

of military fiat by rulers of kingdoms along the trade routes, it was a major focus of these classical
civilizations to keep markets open and trading in these scarce commodities. Reputation and
clearing became central concerns, and the states which could handle them most effectively became
very powerful empires, trusted by many peoples to manage and mediate trade and commerce. The
trading of commodities consists of direct physical trading and derivatives trading. Exchange traded
commodities have seen an upturn in the volume of trading since the start of the decade. This was
largely a result of the growing attraction of commodities as an asset class and a proliferation of
investment options which has made it easier to access this market. According to Barclays Capital,
worldwide assets under management in pooled commodity investment products (which includes
exchange-traded products, commodity index swaps, and medium-term notes) stood at $426 billion
in November 2011, compared to $156 billion in November 2008.

What are the different segments in the commodities market?

The commodities market exists in two distinct forms, namely, the Over the Counter (OTC) market
and the exchange-based market. Also, as in equities, there exists the spot and the derivatives
segment. The spot markets are essentially over-the-counter markets and the participation is
restricted to people who are involved with that commodity, say, the farmer, processor, wholesaler,
etc. A majority of the derivative trading takes place through exchange-based markets with
standardised contracts, settlements, etc.
The OTC markets are essentially spot markets and are localised for specific commodities. Almost
all the trading that takes place in these markets is delivery based. The buyers as well as the sellers
have their set of brokers who negotiate the prices for them. This can be illustrated with the help of
the following example: A farmer, who produces castor, wishing to sell his produce would go to
the local 'Mandi.' There he would contact his broker who would in turn contact the brokers
representing the buyers. The buyers in this case would be wholesalers or refiners.
In event of a deal taking place, the goods and the money would be exchanged directly between the
buyer and the seller. Thus, it can be seen that this market is restricted to only those people who are
directly involved with the commodity. In addition to the spot transactions, forward deals also take
place in these markets. However, they too happen on a delivery basis and hence are restricted to
the participants in the spot markets.
The exchange-traded markets are essentially only derivative markets and are similar to equity
derivatives in their working. That is, everything is standardised and a person can purchase a
contract by paying only a percentage of the contract value. A person can also go short on these
exchanges. Also, even though there is a provision for delivery most of the contracts are squaredoff before expiry and are settled in cash. As a result, one can see an active participation by people
who are not associated with the commodity. Many people who participate in the exchanges are
those who are not involved with the physical trading of the commodity. Thus they would not like
receiving delivery and would not be in a position to give delivery.

What is the history of commodities markets in India?

India, being an agro-based economy, has markets for most of the agro-based commodities. India
is the largest consumer of gold in the world, which implies a huge market for the yellow metal.
India has huge spot markets for all these commodities. For instance,. Indore has a huge market for
soya, Ahmedabad for castor seeds and Surendranagar for cotton, etc. During the pre-Independence
era, India also had a thriving futures market for commodities such as gold, silver, cotton, edible
oils, etc. In mid-1960s, due to wars, natural calamities and the consequent shortages, futures
trading in most commodities was banned. Currently, the futures markets that exist in India are
localised for specific commodities. For example, Kerala has an exchange for pepper; Ahmedabad
for castor seeds, and Mumbai is the major center for gold, etc. These exchanges, however, have
only a regional presence and are dominated by people who are involved with the physical trade of
that commodity.
The government has now allowed national commodity exchanges, similar to the Bombay Stock
Exchange and the National Stock Exchange, to come up and let them deal in commodity
derivatives in an electronic trading environment. These exchanges are expected to offer a nationwide anonymous, order-driven, screen-based trading system for trading. The Forward Markets
Commission (FMC) will regulate these exchanges. Consequently four commodity exchanges have
been approved to commence business in this regard. They are:

Multi Commodity Exchange of India Ltd (MCX), located at Mumbai

National Commodity and Derivatives Exchange Ltd (NCDEX), located at Mumbai

National Board of Trade (NBOT), located at Indore

National Multi Commodity Exchange (NMCE), located at Ahmedabad.

The biggest advantage of having an exchange-based platform is reach. A wider reach ensures
greater participation, which results into a more efficient price discovery mechanism. In fact, it
comes to a stage where the derivative market guides the spot market in terms of pricing. This can
be well understood by looking at the following example: Imagine a soy wholesaler in Madhya
Pradesh, who having bought the crop from the farmer -- wishes to sell it to the oil refiners. To sell
his crop he has to go to the local market at Indore. The price that he will get for his crop would be
solely dependent upon the demand supply condition prevailing at that point of time at that market

place. Also as the number of players is less there are chances of the prices being biased. In contrast
the prices in the futures market are determined not only by the local demand supply conditions but
also by the global scenario. Add to that the view taken on a commodity by various sets of people
depending upon different parameters such as technical analysis, political news, exchange rates,
etc. The price that is thus quoted can be safely regarded as the most efficient price. Thus, looking
at the futures price the trader can price his crop appropriately.

What opportunities do the commodity derivatives provide for investors?

Spot trading is any transaction where delivery either takes place immediately, or with a minimum
lag between the trade and delivery due to technical constraints. Spot trading normally involves
visual inspection of the commodity or a sample of the commodity, and is carried out in markets
such as wholesale markets. Commodity markets, on the other hand, require the existence of agreed
standards so that trades can be made without visual inspection.
A forward contract is an agreement between two parties to exchange at some fixed future date a
given quantity of a commodity for a price defined today. The fixed price today is known as the
forward price. Early on these forward contracts were used as a way of getting products from
producer to the consumer. These typically were only for food and agricultural products.
A Futures contract has the same general features as a forward contract but is standardized and
transacted through a futures exchange. Although more complex today, early forward contracts for
example, were used for rice in seventeenth century Japan. Modern forward, or futures agreements,
began in Chicago in the 1840s, with the appearance of the railroads. In essence, a futures contract
is a standardized forward contract in which the buyer and the seller accept the terms in regards to
product, grade, quantity and location and are only free to negotiate the price.
Market participants can be broadly divided into hedgers, speculators and arbitrageurs.

Hedgers: They are generally the commercial producers and consumers of the traded
commodities. They participate in the market to manage their spot market price risk. Commodity
prices are volatile and their participation in the futures market allows them to hedge or protect
themselves against the risk of losses from fluctuating prices. For e.g. a copper smelter will hedge
by selling copper futures, since it is exposed to the risk of falling copper prices.

Speculators: They are traders who speculate on the direction of the futures prices with the
intention of making money. Thus, for the speculators, trading in commodity futures is an
investment option. Most Speculators do not prefer to make or accept deliveries of the actual
commodities; rather they liquidate their positions before the expiry date of the contract.

Arbitrageurs: They are traders who buy and sell to make money on price differentials across
different markets. Arbitrage involves simultaneous sale and purchase of the same commodities in
different markets. Arbitrage keeps the prices in different markets in line with each other. Usually
such transactions are risk free. The market functions because of the differing risk profiles of the
market participants. The fluctuation in commodity prices represents both, a risk and a potential for
profit. The hedgers transfer this risk by foregoing the associated profit potential. The speculators
assume this risk in the hope of realizing profits by predicting price movements. The arbitrageurs
make the process of price discovery more efficient.

India Commodity Market in the Global Scenario

Despite having a robust economy, Indias 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,
Indias contribution to international trade volume is rather less compared to the huge production
base available. With the increase in export of commodities like milk, coriander, and other food
grains a hike is seen in the market. Inflation is also a reason for the rise of commodity prices.
Indian Commodity market has gained much of its importance in recent years. With the world
getting integrated, interrelated, interdependent the commodity market is highly derived from the
market across the globe and the global happenings. The regulation of prices of commodities is
seen at large with the day to day happenings. Commodity trading in India is still at its early days
and thus requires an aggressive growth plan with innovative ideas. Liberal policies in commodity
trading will definitely boost the commodity trading and it surely has the potential to drive the
future of the economy to greater heights.