DERIVATIVES

 INTRODUCTION
Keeping in view the experience of even strong and developed
economies the world over, 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.

Out of various risks, Credit Risk and Interest Rate risk are the two core risks, which are
commonly acknowledged by various categories of Financial Institutions particularly banks.
Effective management of these core risks is a critical factor in comprehensive risk management
and is essential for the long-term financial health of business organizations, especially banks.

With gradual liberalization of Indian financial system and the growing integration among
markets, the risks associated with operations of banks and All India Financial Institutions have
become increasingly complex, requiring strategic management. In keeping with spirit of the
guidelines on Asset-Liability Management (ALM) systems and on integrated risk management
systems, it is very much required to design risk management architecture, taking into
consideration the size, complexity of business, risk philosophy, market perception and the level
of capital. In addition, fine-tuning the risk management system to deal with credit and market
risk is also the need of the hour. For enabling the banks and the financial institutions, among
others, to manage their risk effectively, the concept of derivatives comes into picture. 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 locking–in 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.

 MEANING
A derivative is a financial instrument, which derives its value from some other financial price.
This “other financial price” is called the underlying. The underlying asset can be equity,
FOREX, commodity or any other asset.

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.
The most important derivatives are futures and options.
Example: -
A very simple example of derivatives is curd, which is derivative of milk. The price of curd
depends upon the price of milk, which in turn depends upon the demand, and supply of milk.
HISTORY
The derivatives markets has existed for centuries as a result of the need for
both users and producers of natural resources to hedge against price
fluctuations in the underlying commodities. 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 Desai’s 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, NSE and
BSE 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 market lots keeps on changing from
time to time. The minimum quantity you can trade in is one market lot.

 DERIVATIVES: AN INDIAN CONTEXT:

In Indian context, the intensity of derivatives usage by institutional investors (viz. Banks,
Financial Institution; Mutual Funds, Foreign Institutional Investors, Life and General Insurers)
depend on their ability and willingness to use derivatives for one or more of the following
purposes:

 Risk containment: using derivatives for hedging and risk containment purposes
 Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage;
and/or
 Covered Intermediation: On-balance-sheet derivatives intermediation for client
transaction, without retaining any net-risk on the balance sheet (except credit risks).
 TYPES OF DERIVATIVES

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 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.

Derivatives and futures are basically of 3 types:

 Futures
 Options
 Swaps
 Forwards

DERIVATIVES
DERIVATIVES

Options
Options Futures
Futures Swaps
Swaps Forwards
Forwards

Put
Put Call
Call Interest
Interest Currency
Currency
Rate
Rate
Commod
Commod
ityyyyyy
ityyyyyy Security
Security
yy
 FORWARDS:

A forward contract is the simplest mode of a derivative transaction. It is an agreement to

buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No
cash is exchanged when the contract is entered into.

Illustration: - Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it
outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will
rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a
contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What
Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward
contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three
months and Shyam in turn will pay cash equivalent to the TV price on delivery.

 FUTURES:

It is an agreement between two parties to buy or sell an asset at a certain time in

the future at a certain price through exchange traded contracts.

A Future represents the right to buy or sell a standard quantity and quality of an asset or security
at a specified date and price. Futures are similar to Forward Contracts, but are standardized and
traded on an exchange, and are valued, or "Marked to Market” daily. The Marking to Market
provides both parties with a daily accounting of their financial obligations under the terms of the
Future. Unlike Forward Contracts, the counterparty to a Futures contract is the clearing
corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents,
rather than requiring physical delivery of the underlying asset. Parties to a Futures contract may
buy or write Options on Futures.

 OPTIONS:
An option is a contract, which gives the buyer the right, but not the obligation to buy or
sell shares of the underlying security at a specific price on or before a specific date.

‘Option’, as the word suggests, is a choice given to the investor to either honor the contract; or if
he chooses not to walk away from the contract. There are two kinds of options: Call Options
and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. When
you buy a Call option, the price you pay for it, called the option premium, secures your right to
buy that certain stock at a specified price called the strike price. If you decide not to use the
option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way,
Put options are like insurance policies. With a Put Option, you can "insure" a stock by fixing a
selling price. If something happens which causes the stock price to fall, and thus, "damages"
your asset, you can exercise your option and sell it at its "insured" price level. If the price of your
stock goes up, and there is no "damage," then you do not need to use the insurance, and, once
again, your only cost is the premium.
Technically, an option is a contract between two parties. The buyer receives a privilege for
which he pays a premium. The seller accepts an obligation for which he receives a fee.

 CALL OPTIONS

Call options give the taker the right, but not the obligation, to buy the underlying shares at a
predetermined price, on or before a predetermined date.

Illustration: - Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between
the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight
a share for 100 shares).

The buyer of a call has purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option; Sam purchases a December call option
at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in
December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a
profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option
and forego the premium of Rs 15 and thus limiting his loss to Rs 15.
Call Options-Long & Short Positions
When you expect prices to rise, then you take a long position by buying calls. You are
bullish.
When you expect prices to fall, then you take a short position by selling calls. You are
bearish.

 PUT OPTIONS
A Put Option gives the holder of the right to sell a specific number of shares of an
agreed security at a fixed price for a period of time.

Illustration:- Raj is of the view that the a stock is overpriced and will fall in future, but he does
not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’. By
purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs
15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if
the stock falls below Rs 55.
Put Options-Long & Short Positions
When you expect prices to fall, then you take a long position by buying Puts. You are
bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are
bullish.

CALL OPTIONS PUT OPTIONS

If you expect a fall in
Short Long
price(Bearish)
If you expect a rise in price
Long Short
(Bullish)

IMPORTANT FACTORS IN DERIVATIVES

 HEDGING
We have seen how one can take a view on the market with the help of index futures. The other
benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order
to understand how one can protect his portfolio from value erosion let us take an example.
Illustration: Ram enters into a contract with Shyam that six months from now he will sell to
Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will
make a profit of Rs 3000 if the sale is completed.

Cost (Rs) Selling price Profit

1000 4000 3000

However, Ram fears that Shyam may not honor his contract 6 months from now. So he inserts a
new clause in the contract that if Shyam fails to honor the contract he will have to pay a penalty
of Rs 1000. And if Shyam honors the contract Ram will offer a discount of Rs 1000 as incentive.

Shyam defaults Shyam honors

1000 (Initial Investment) 3000 (Initial profit)
 1000 (penalty from Shyam) (-1000) discount given to Shyam
- (No gain/loss) 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his
initial investment. If Shyam honors the contract, Ram will still make a profit of Rs 2000. Thus,
Ram has hedged his risk against default and protected his initial investment.

The above example explains the concept of hedging.

 SPECULATION

Speculators are those who do not have any position on which they enter in futures and options
market. They only have a particular view on the market, stock, commodity etc. In short,
speculators put their money at risk in the hope of profiting from an anticipated price change.
They consider various factors such as demand supply, market positions, open interests, economic
fundamentals and other data to take their positions.

 ARBITRAGE

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless
profits. When markets are imperfect, buying in one market and simultaneously selling in other
market gives risk less profit. Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower
priced market and selling at the higher priced market. In index futures arbitrage is possible
between the spot market and the futures market.

 Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.

 The futures price of Nifty futures can be worked out by taking the interest cost of 3
months into account.
 If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs
1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs
1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at
Rs 1070.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40

These kinds of imperfections continue to exist in the markets but one has to be alert to the
opportunities as they tend to get exhausted very fast.

 MARGINS

The margining system is based on the JR Verma Committee recommendations. The actual
margining happens on a daily basis while online position monitoring is done on an intra-day
basis.
Daily margining is of two types:
 1. Initial margins
2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept of Value-at-
Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be
encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a
portfolio may stand to lose within a certain horizon time period (one day for the clearing
corporation) due to potential changes in the underlying asset market price. Initial margin amount
computed using VaR is collected up-front.

The daily settlement process called "mark-to-market" provides for collection of losses that
have already occurred (historic losses) whereas initial margin seeks to safeguard against potential
losses on outstanding positions. The mark-to-market settlement is done in cash.

COMMODITIES

INTRODUCTION

Commodities Market In India

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.

There were booming activities in this market and at one time as many as 110 exchanges were
conducting forward trade in various commodities in the country. The securities market was a
poor cousin of this market as there were not many papers to be traded at that time.

The era of widespread shortages in many essential commodities resulting in inflationary

pressures and the tilt towards socialist policy, in which the role of market forces for resource
allocation got diminished, saw the decline of this market since the mid-1960s. This coupled with
the 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.

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.

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 demutualized, 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 around the safety, transparency and taxation issues.
WHY STRUCTURED COMMODITY MARKET?

Today the business is not limited to our area only. Where the production is less but, demand is
comparatively high prices of the product will go up. On the contrary where the production is
high but demand is comparatively low the prices will go down.

 If sellers and buyers come together at a place then it will create a market. Here against
one seller there will be more then one buyer. In this market buyers will come across the
country for transactions.
 In this market not only producer and seller are included but arbitrageur, speculator, and
hedger can tread. In this way the total area of market will become broad.
 In our country agricultural products form 25% of GDP. Total turnover of commodity of
market is nearly Rs.1, 10,000 corer. In which 60,000 corer comes from agriculture and
left is coming from coal, crude, etc…
 Today in our country most of the trade is done in unorganized market. In the market
current and future contracts are done. Promissory contracts have been started science
1875. But due to some restriction it was not properly worked. Presently nearly in 122
commodities tread is being done

 Transaction in the organized market:

Organized markets have structured forms of transactions. The commodity exchanges are
regulated as per rules and regulations define in The Forward Contracts (Regulation) Act, 1952
for regulating forward\future contracts. In December 2003, the National Commodity and
Derivative Exchange Ltd (NCDEX) launched futures trading in nine major commodities.

MCX To begin with contacts in gold, silver, cotton, soyabean, soya oil, mustered seed, rapeseed
oil, crude palm oil and RBD Palmolive are being offered. Now more then 40 commodity items
are included. Day by day number of commodity items is incising. The various commodities that
tread on the NCDEX and look at some commodity specific issues. In this commodity market
classified as agriculture products, precious metal, other metal and energy which we discuss
above.

COMMODITIES
  CHARACTERISTICS OF FUTURES TRADING

A "Futures Contract" is a highly standardized contract with certain distinct features. Some of
the important features are as under:

a. 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.

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.

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.
  ECONOMIC BENEFITS OF THE FUTURES TRADING

Futures contracts perform two important functions of price discovery and price risk management
with reference to the given commodity. It is useful to all segments of economy. It is useful to
producer because he can get an idea of the price likely to prevail at a future point of time and
therefore can decide between various competing commodities, the best that suits him. It enables
the consumer get an idea of the price at which the commodity would be available at a future
point of time. He can do proper costing and also cover his purchases by making forward
contracts.
The futures trading is very useful to the exporters as it provides an advance indication of the
price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure
export contract in a competitive market. Having entered into an export contract, it enables him to
hedge his risk by operating in futures market. Other benefits of futures trading are:
 Price stabilization-in times of violent price fluctuations - this mechanism dampens the
peaks and lifts up the valleys i.e. the amplititude of price variation is reduced.
 Leads to integrated price structure throughout the country.
 Facilitates lengthy and complex, production and manufacturing activities.
 Helps balance in supply and demand position throughout the year.
 Encourages competition and acts as a price barometer to farmers and other trade
functionaries.
 COMMODITIES ARE SUITABLE FOR FUTURE TRADING
The following are some of the key factors, which decide the suitability of the
commodities for future trading: -

 The commodity should be competitive, i.e., there should be large demand for and
supply of the commodity - no individual or group of persons acting in concert should be
in a position to influence the demand or supply, and consequently the price substantially.
 There should be fluctuations in price.
 The market for the commodity should be free from substantial government control.
 The commodity should have long shelf life and be capable of standardization and
gradation.
  THE FOLLOWING ITEMS ARE TRADED IN THE MULTI COMMODITY
EXCHANGE
Bullion: Gold, Gold M, Gold HNI, Silver, Silver M, Silver HNI
Oil & Oil Seeds : Castor Seeds, Soy Seeds, Castor Oil, Refined Soy Oil, Soymeal, RBD Palmolein, Crude
Palm Oil, Groundnut Oil, Mustard Seed, Mustard Seed Oil, Cottonseed Oilcake, Cottonseed

Spices: Pepper, Red Chilli, Jeera, Turmeric

Metal: Steel Long, Steel Flat, Copper, Nickel, Tin
Fibre: Kapas, Long Staple Cotton, Medium Staple Cotton
Pulses: Chana, Urad, Yellow Peas, Tur
Cereals: Rice, Basmati Rice, Wheat, Maize, Sarbati Rice
Energy: Crude Oil
Others: Rubber, Guar Seed, Gur, Guargum Bandhani, Guargum, Cashew Kernel, Guarseed Bandhani
  NEED FOR FUTURES TRADING IN COMMODITIES

Commodity Futures, which forms an essential component of Commodity Exchange, can be

broadly classified into precious metals, agriculture, energy and other metals. Current futures
volumes are miniscule compared to underlying spot market volumes and thus have a tremendous
potential in the near future.

Futures trading in commodities results in transparent and fair price discovery on account of
large-scale participations of entities associated with different value chains. It reflects views and
expectations of a wider section of people related to a particular commodity. It also provides
effective platform for price risk management for all segments of players ranging from producers,
traders and processors to exporters/importers and end-users of a commodity.

It also helps in improving the cropping pattern for the farmers, thus minimizing the losses to the
farmers. It acts as a smart investment choice by providing hedging, trading and arbitrage
opportunities to market players. Historically, pricing in commodities futures has been less
volatile compared with equity and bonds, thus providing an efficient portfolio diversification
option.

Raw materials form the most key element of most of the industries. The significance of raw
materials can further be strengthened by the fact that the "increase in raw material cost means
reduction in share prices". In other words "Share prices mimic the commodity price movements".

Industry in India today runs the raw material price risk; hence going forward the industry can
hedge this risk by trading in the commodities market.

 HEDGING
Hedging is a sophisticated mechanism, which provides the necessary immunity to the above
interests in the marketing of commodities from the risk of adverse price fluctuations.

A Hedge is a countervailing contract transacted in a futures market through which those who
have bought in the ready market will sell in the futures market and those who have sold in the
ready market would buy in the futures market. In each of these two cases, a purchase in the ready
market is off-set by an opposite sale in the futures market and a sale in the ready market is off-set
by purchase in the futures market.

When the purchase or sale commitment in the ready market is fulfilled, the sale or purchase
hedge contract is closed out by an offsetting reverse purchase or sale contract in the futures
market.

The practice of hedging is based on the assumption that the ready and futures prices of the
commodity move more or less parallel to each other. The ready and futures prices of a
commodity ordinarily do move together in sympathy with each other because both ready and
futures prices are basically determined by the demand and supply factors of that particular
commodity.

When the price of a commodity has declined in the ready market, its price in the futures market
would normally have also declined so that the loss incurred in the ready market would be
recovered by the profit made in the futures market.
Similarly, if the price rises in the ready market after the hedge sale had been entered into the
futures market, there would be a loss in the futures market, which would, however, be made up
with the profit made in the ready market. But, in certain circumstance, the ready and futures
prices may not move together or the spread between the two may increase or decrease sharply.
To the extent that they do not move together by the same extent, hedging itself may be a source
of minor gains or losses. But a dealer, manufacturer or exporter is not, per se, interested in such
speculative losses or gains. His only interest is to ensure that he gets the necessary insurance
against unforeseen fluctuation in prices. By and large, hedging in a futures market does afford
such a protection to the various functionaries.
Hedging on futures markets cannot be practiced unless there are operators willing to assume the
risk of adverse price fluctuations which the hedgers desire to transfer. These operators are called
speculators. They, thus provide the much needed breadth and liquidity to the futures markets
which in their absence would remain narrow and unstable.

A speculator operating in a futures market is the one who buys or sells futures contracts without
any countervailing commitments or transactions in the actual commodity with a view to making
profit from the fluctuations in the prices.
The basic distinction between a hedge and speculative transaction on a futures market is that
while in the case of a hedge transaction there is a corresponding opposite transaction in the ready
market, in the case of a speculative transaction, there is no corresponding transaction in the ready
market.
While the motives of the speculator in entering into futures trans actions are different from a
hedger, the form or nature of transactions entered into by both in the futures market is similar.
When a transaction takes place in a futures market, the transaction may well be between two
hedgers or two speculators or between a hedger and a speculator.
While it is possible for the individual parties to enter into futures contracts, such contracts are
generally entered under the auspices of commercial bodies known as commodity exchanges or
associations.

 REGULATORY BODY

The Forward Markets Commission (FMC) is the regulatory body for commodity futures/forward
trade in India. The commission was set up under the Forward Contracts (Regulation) Act of
1952. It is responsible for regulating and promoting futures/forward trade in commodities. The
FMC is headquartered in Mumbai while its regional office is located in Kolkata. Curbing the
illegal activities of the diehard traders who continued to trade illegally is the major role of the
Forward Markets Commission.

 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.

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.

 PROBLEMS FACED BY COMMODITIES MARKETS IN

INDIA

Institutional issues have resulted in very few deliveries so far. Currently, there are a lot of hassles
such as octroi duty, logistics. If there is a broker in Mumbai and a broker in Kolkata,
transportation costs, octroi duty, logistical problems prevent trading to take place. Exchanges are
used only to hedge price risk on spot transactions carried out in the local markets. Also multiple
restrictions exist on inter-state movement and warehousing of commodities.

 RISKS ASSOCIATED WITH COMMODITIES MARKETS

No risk can be eliminated, but the same can be transferred to someone who can handle it better
or to someone who has the appetite for risk. Commodity enterprises primarily face the following
classes of risks, namely: the price risk, the quantity risk, the yield/output risk and the political
risk. Talking about the nationwide commodity exchanges, the risk of the counter party (trading
member, client, vendors etc) not fulfilling his obligations on due date or at any time thereafter is
the most common risk.
This risk is mitigated by collection of the following margins: -

• Initial Margins
• Exposure margins
• Market to market of positions on a daily basis
• Position Limits and Intra day price limits
• Surveillance

Commodity price risks include: -

• Increase in purchase cost vis-à-vis commitment on sales price

• Change in value of inventory
• Counter party risk translating into commodity price risk

 KEY FACTORS FOR SUCCESS OF COMMODITIES

MARKET

The following are some of the key factors for the success of the commodities markets: -

• How one can make the business grow?

• How many products are covered?
• How many people participate on the platform?
  KEY FACTORS FOR SUCCESS OF COMMODITIES EXCHANGES

The following are some of the key factors for the success of the commodities exchanges: -

Strategy, method of execution, background of promoters, credibility of the institution,

transparency of platforms, scaleable technology, robustness of settlement structures, wider
participation of Hedgers, Speculators and Arbitrageurs, acceptable clearing mechanism, financial
soundness and capability, covering a wide range of commodities, size of the trade guarantee
fund, reach of the organization and adding value on the ground. In addition to this, if the Indian
Commodity Exchange needs to be competitive in the Global Market, then it should be backed
with proper "Capital Account Convertibility".

The interests of Indian consumers, households and producers are most important, as these are the
people who are exposed to risk and price fluctuations.

 KEY EXPECTATIONS OF COMMODITIES EXCHANGES

The following are some of the key expectations of the investor's w.r.t. any commodity exchange:
-

• To get in place the right regulatory structure to even out the differences that may exist in
various fields.
• Proper Product Conceptualization and Design.
• Fair and Transparent Price Discovery & Dissemination.
• Robust Trading & Settlement systems.
• Effective Management of Counter party Credit Risk.
• Self-Regulation to ensure: Overview of Trading and Surveillance, Audit and review of
Members, Enforcement of Exchange rules.
  FUTUREPROSPECTS

With the gradual withdrawal of the government from various sectors in the post-liberalization
era, the need has been felt that various operators in the commodities market be provided with a
mechanism to hedge and transfer their risks. India's obligation under WTO to open agriculture
sector to world trade would require futures trade in a wide variety of primary commodities and
their products to enable diverse market functionaries to cope with the price volatility prevailing
in the world markets. Government subsidy may go down as a result of WTO. The MSP
programme will not be sustainable in such a scenario. The farmer will have to look at ways of
being in a position to trade on commodity exchanges in future. Also, corporate will feel the
pressure to hedge their price risk once the frontiers open up for free trade.

Indian markets have recently thrown open a new avenue for retail investors and traders to
participate: commodity derivatives. For those who want to diversify their portfolios beyond
shares, bonds and real estate, commodities are the best option.

Following are some of the applications, which can utilize the power of the commodity markets
and create a win-win situation for all the involved parties: -

 REGULATORY APPROVAL / PERMISSION TO FII'S FOR

TRADING IN THE COMMODITY MARKETS

FII's are currently not allowed nor disallowed under any law. As, they have added depth to the
equity markets; they will add depth to the commodities markets, since they globally know the
commodities.

 ACTIVE INVOLVEMENT OF MUTUAL FUND INDUSTRY IN INDIA

Currently Mutual Funds are prohibited from not using derivatives apart from hedging. Mutual
Funds as investors can invest in gold and get returns as they get from debt instruments, equity
markets. AMFI & SEBI need to collectively work towards the same. Launch of the "Commodity
Funds", by the Mutual Funds in India, can serve as a newer investment avenue for investors.
  ONLINE COMMODITY TRADING

Online commodity trading offers a way for an open, many-to-many system, where every user has
equal access to price quotes and trading functionality. It provides a level playing field for all,
without favoritism or control by a chosen few, where any user can view all quotes posted by
other users in real time, act or trade on quotes posted by others, post their own prices and
quantities for others to trade

The Online commodity trading site usually lists a large number of unique products covering a
variety of commodities, structures, and settlement terms ranging from Oil, Natural Gas, Electric
Power, Precious Metals, Emissions and Weather. It provides for various media ranging from
Physical Delivery and Financial Cash Settlement. There are further derivative options available
ranging from Forwards, Swaps, Options, Spreads, Differentials, Complex Derivatives.

Liquidity, or trade activity, is perhaps the best measure of success of an online trading
commodity trading system. With most online commodity trading systems, traders can be sure of
finding an interesting market development or trading opportunity almost every time they log on.

All quotes posted by users on any online commodity trading systems are live and firm. They can
be acted on with full assurance of a completed transaction. The greatest advantage of an online
system for trading is that just a click can be used to hit a bid or lift an offer.

The Online trading system operates almost continuously around the clock, 24 hours a day, seven
days a week. This allows any user to extend the trading day, and easily pass the trading
objectives to others in companies in different times zones.
The online commodity trading system in India is only an emerging segment yet. This is because
the Internet boom in Indian is on the rise only now. The Internet charges are becoming minimal
and the Internet is soon becoming a way of life in India. It is in this scenario that online trading is
becoming more the way of trading in India.