Derivatives Final Document 100marks

Derivatives
A PROJECT ON DERIVATIVES
SUBMITTED BY PRIYANKA MOHAN PISAT.

ROLL NO –38
SUBMITTED TO S.K SOMAIYA COLLEGE OF
SCIENCE, ARTS AND COMMERCE.
S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 1

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Acknowledgement
I take this opportunity to express my sincere thanks and gratitude to

Mr. Gopal. I express my grateful thanks to him for the comments,
suggestion and inputs for the project.
I gratefully acknowledge the active interest and co-operation of my

project guide Gopal sir whose guidance has given me an inspiration and help
when required by me.
I also hereby express my thanks to all the sources who contributed
to the making of this project on “ Derivatives” for their help and valuable
guidance and provided assistance, without which this would have not been
possible. I am also thankful to all those who supported me in this endeavor.

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Executive Summery
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.
Derivative products initially emerged, as hedging devices against

fluctuations in commodity prices and commodity-linked derivatives
remained the sole form of such products for almost three hundred years. The
financial derivatives came into spotlight in post-1970 period due to growing
instability in the financial markets. However, since their emergence, these
products have become very popular and by 1990s, they accounted for about
two-thirds of total transactions in derivative products. In recent years, the
market for financial derivatives has grown tremendously both in terms of
variety of instruments available, their complexity and also turnover. In the

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class of equity derivatives, futures and options on stock indices have gained
more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular
indices with various portfolios and ease of use. The lower costs associated
with index derivatives vis-vis derivative products based on individual
securities is another reason for their growing use.

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INDEX
CHAPTER 1: Introduction to Derivatives

CHAPTER 2: Introduction to Commodity Markets
CHAPTER 3: Global Commodity Markets
CHAPTER 4; Indian Commodity Markets
CHAPTER 5: Commodity Future
CHAPTER 6: Regulatory Framework
CHAPTER 7: The NCDEX Platform
CHAPTER 8: Commodity versus other asset classes
CHAPTER 9: PRECIOUS metal: Gold
CHAPTER 10: Crude Oil
CHAPTER 11: Case Study
CHAPTER 12: Conclusion
CHAPTER 13: Bibliography

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Introduction to Derivatives
The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it
was sown to the time it was ready for harvest, farmers would face price
uncertainty. Through the use of simple derivative products, it was possible
for the farmer to partially or fully transfer price risks by locking-in asset
prices. These were simple contracts developed to meet the needs of farmers
and were basically a means of reducing risk.
A farmer who sowed his crop in June faced uncertainty over the
price he would receive for his harvest in September. In years of scarcity, he
would probably obtain attractive prices. However, during times of
oversupply, he would have to dispose off his harvest at a very low price.
Clearly this meant that the farmer and his family were exposed to a high risk
of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains

too would face a price risk that of having to pay exorbitant prices during
dearth, although favorable prices could be obtained during periods of
oversupply. Under such circumstances, it clearly made sense for the farmer
and the merchant to come together and enter into contract whereby the price
of the grain to be delivered in September could be decided earlier. What they

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would then negotiate happened to be futures-type contract, which would

enable both parties to eliminate the price risk.
In 1848, the Chicago Board Of Trade, or CBOT, was established to

bring farmers and merchants together. A group of traders got together and
created the ‘to-arrive’ contract that permitted farmers to lock into price
upfront and deliver the grain later. These to-arrive contracts proved useful as
a device for hedging and speculation on price charges. These were
eventually standardized, and in 1925 the first futures clearing house came
into existence.
Today derivatives contracts exist on variety of commodities such as

corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives
contracts also exist on a lot of financial underlying like stocks, interest rate,
exchange rate, etc.
Derivatives Defined
A derivative is a product whose value is derived from the value of one or

more underlying variables or assets in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset. In our earlier
discussion, we saw that wheat farmers may wish to sell their harvest at a
future date to eliminate the risk of change in price by that date. Such a
transaction is an example of a derivative. The price of this derivative is
driven by the spot price of wheat which is the “underlying” in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the

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Forward Markets Commission (FMC) continues to have jurisdiction over

commodity futures contracts. However when derivatives trading in securities
was introduced in 2001, the term “security” in the Securities Contracts
(Regulation) Act, 1956 (SCRA), was amended to include derivative
contracts in securities. Consequently, regulation of derivatives came under
the purview of Securities Exchange Board of India (SEBI). We thus have
separate regulatory authorities for securities and commodity derivative
markets.
Derivatives are securities under the SCRA and hence the trading of
derivatives is governed by the regulatory framework under the SCRA. The
Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-
• A security derived from a debt instrument, share, loan whether

secured or unsecured, risk instrument or contract differences or any other
form of security.
• A contract which derives its value from the prices, or index of prices,
of underlying securities.

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Products, Participants and Functions
Derivative contacts are of different types. The most common ones are
forwards, futures, options and swaps. Participants who trade in the
derivatives market can be classified under the following three broad
categories- hedgers, speculators, and arbitragers.
• Hedgers
The farmer’s example discussed in the introduction was a case of

hedging. Hedgers face risk associated with the price of an asset. They use
the futures or options markets to reduce or eliminate this risk.
• Speculators
Speculators are participants who wish to bet on future movements

in the price of an asset. Futures and options contracts can give them
leverage; that is, by putting in small amounts of money upfront, they can
take large positions on the market. As a result of this leveraged
speculative position, they increase the potential for large gains as well as
large losses.

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• Arbitragers
Arbitragers work at making profits by taking advantage of

discrepancy between prices of the same product across different markets.
If, for example, they see the future price of an asset getting out of line
with the cash price, they would take offsetting positions in the two
markets to lock in the profit.
Whether the underlying asset is a commodity or a financial asset, derivative

markets performs a number of economic functions.
• Prices in an organized derivatives market reflect the perception of

market participants about the future and lead the prices of underlying to
the perceived future level. The prices of derivatives converge with the
prices of the underlying at the expiration of derivative contract. Thus
derivatives help in discovery of future as well as current prices.
• The derivatives market helps to transfer risks from those who have
them but may not like them to those who have an appetite for them.
• Derivatives, due to their inherent nature, are linked to the underlying

cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more
players who would not otherwise participate for lack of an arrangement
to transfer risk.

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• Speculative traders shift to a more controlled environment of the

derivatives market. In the absence of an organized derivatives market,
speculators trade in the underlying cash markets. Margining, monitoring
and surveillance of the activities of various participants become
extremely difficult in these kinds of mixed markets.
• An important incidental benefit that flows derivatives trading is that it

acts as a catalyst for new entrepreneurial activity. Derivatives have a
history of attracting many bright, creative, well-educated people with an
entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit
of which are immense.
• Derivatives markets help increase savings and investment in the long

run. The transfer of risk enables market participants to expand their
volume of activity.
Derivative Markets
Derivative markets can broadly be classified as commodity derivative

market and financial derivative markets. As the name suggests, commodity
markets trade contracts for which the underlying asset is a commodity. It can
be agricultural commodity like wheat, soybeans, cotton, rapeseed, etc or
precious metals like gold, silver, etc. financial derivatives markets trade
contracts that have a financial asset or variable as the underlying. The more

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popular financial derivatives are those which have equity, interest rates and
exchange rates as the underlying. The most commonly used derivatives
contracts are forwards, futures and options.
Emergence Of financial derivative products
Financial derivatives came into spotlight in the post 1970 period

due to growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990’s, they
accounted for about two-thirds of total transactions in derivative products. In
recent years, the market for financial derivatives has grown tremendously in
terms of variety of instruments available, their complexity and also turnover.
In the class of equity derivatives the world over, futures and options on stock
indices have gained more popularity than on individual stocks, especially
among institutional investors, who are major users of index-linked
derivatives. Even small investors find these useful due to high correlation of
the popular indexes with various portfolios and ease of use. The lower costs
associated with index derivatives vis-à-vis derivative products based on
individual securities is another reason for their growing use.
Emergence of Commodity Derivatives

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Derivatives as a tool for managing risks first originated in the

commodities market. They were then found useful as the hedging tool in the
financial markets as well. In India trading in commodity futures has been in
existence from the 19th century with organized trading in cotton through the
establishments of Cotton Trade Association in 1875. Over a period of time,
other commodities were permitted to be traded in futures exchanges. A
regulatory constraint in 1960’s resulted in virtual dismantling of the
commodities future markets. It is only in the last decade that commodity
futures exchanges have been actively encouraged.
Commonly Used Derivatives
Here we define some of the more popularly used derivative contracts. Some
of these, namely futures and options will be discussed in more details at a
later stage.
• Forwards
A forward contract is an agreement between two entities to buy or sell the

underlying asset at a future date, at today’s pre-agreed price.
• Futures
A futures contract is an agreement between two parties to buy or sell the

underlying asset at a future date at today’s future price. Futures contracts

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differ from forward contracts in the sense that they are standardized and
exchange traded.
• Options
There are two types of options- calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at
a given price on or before a given future date. Puts give the buyer the right,
but not the obligation to sell a given quantity of the underlying asset at a
given price on or before a given date.
• Warrants
Options generally have lives of up to one year; the majority of options

traded on options exchanges having a maximum maturity of nine months.
Longer-dated options are called warrants and are generally traded over-the-
counter.
• Baskets
Basket options are options on portfolios of underlying assets. The

underlying asset is usually a weighted average of a basket of assets. Equity
index options are a form of basket options.
• Swaps

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Swaps are private agreements between two parties to exchange cash

flows in the future according to a prearranged formula. They can be regarded
as portfolios of forward contracts. The two commonly used swaps are:
• Interest rate swaps

These entail swapping only the interest related cash flows between the
parties in the same currency.
• Currency swaps
These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those
in the opposite direction.
• Swaptions
Swaptions are options to buy or sell a swap that will become operative
at the expiry of the options. Thus a swaption is an option on a forward swap.

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Introduction to Commodity Markets
Rapid economic growth in recent years with more than 6 percent GDP
growth rate has made India one of the fastest growing economies of the
world. With higher income giving significant purchasing power to over a
billion strong population, demand for all kinds of goods and services is set to
grow rapidly.
With liberalization measures in place, commodity markets in India are likely

to make an overwhelming impact on the global commodity markets. Indian
corporate entities are now in a position to hedge their price risk in the
domestic and international commodity exchanges. Online trading at the three
nationwide multi-commodity futures exchanges allow domestic hedging,
while some of the established commodity-specific exchanges are gearing up
to meet the needs of the expanding market. There is no doubt that the
commodities market in India is definitely in for a big spert offering
enormous opportunities of growth to investors, speculators, arbitragers and
even big corporations in manufacturing sector. Study of commodity market
and trading mechanism and opportunities offered by them has thus become

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essential for everyone who has some interest in the Indian economy in
general and in commodity trading in particular.
Markets
Markets have existed for centuries in India and abroad for selling and buying
of good and services. The concept of market started with agricultural
products and hence it is as old as the agro products or the business of
farming itself. Traditionally, the farmers used to bring their produce to a
central place (called Mandi/Bazar) in a town/village where grain
merchant/traders would also come and buy the produce and transport,
distribute it to other markets.
In a traditional market, agriculture produce would be brought and kept in the

market and the potential buyers would come and see the quality of the
produce and negotiate with the farmers directly for a price that they would
be willing to pay and the quantity that they would like to buy. The deals
were then stuck once mutual agreement was reached on the price and the
quantity to be bought/sold.
In the system of traditional markets, shortages of a commodity in a given

season would lead to increase in price for the commodity or oversupply on
even a single day (due to heavy arrivals) could result into decline in prices
sometimes below the cost of production to the farers. Neither the farmers nor

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the food grain merchants were happy with this situation since they could not
predict what the prices would be on a given day or in a given season. As a
result, any times the farmers were required to return from the market with
their produce since it did not fetch reasonable price and since there were no
storage facilities available near the market place. It was in this context that
farmers and food grain merchants in Chicago started negotiating for future
supplies of grains in exchange of cash at a mutually agreeable price. This
type of agreement was acceptable to both parties since the farmer would
know how much he would be paid for his produce, and the dealer would
know his cost of procurement in advance. This effectively started the system
of organized commodity market and forward contracts, which subsequently
evolved the futures market.
Commodity
A Commodity is a product having commercial value, which can be

produced, bought, sold and consumed. Commodities are basically the
products of primary sector of an economy. Primary sector of an economy is
that part of the economy, which is concerned with agriculture and extraction
of raw materials. In order to qualify as a commodity, an article or a product
has to meet some basic characteristics, these are listed below:
• The product has not gone through any complicated manufacturing

activity, though simple processing (like mining, cropping, etc.) is not
ruled out. In other words, the product must be in a basic raw, unprocessed
state. (For instance wheat is a commodity; but wheat flour and bread are
not commodities).

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• The product has to be fairly standardized to facilitate writing of

contracts on products of uniform quality. (e.g. Rice is rice though
different varieties of rice can be treated as different commodities and
hence traded as separate contracts)
• Major consideration while buying a particular commodity is its

price (since there is hardly any difference in quality from seller to seller).
Prices of the products are determined by market forces, demand and
supply and they undergo rapid changes/fluctuations (price must fluctuate
enough to create uncertainty, which means both risk and potential profit /
loss for buyers and sellers)
• Product should also be available in large volume.
• Usually there should be many competing sellers and buyers of the

product in the market to facilitate price discovery.
• The product should have adequate shelf life so that delivery of a

future contract can be deferred.
Commodity Market
Market is a place where buyers and sellers meet to transact a business i.e. for
exchange of goods or services for a consideration, which is usually money.

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In today’s world, markets need not exist in physical form as long as the
exchange of goods or services takes place for a consideration.
Commodity market is therefore logically a market where commodities or

Commodity derivatives are bought or sold for a consideration. It is an
important constituent of the financial system for any country. Thus, it is a
platform where a wide range of product like precious metals (gold and
silver), base metals like aluminum, copper, zinc, crude oil, energy and other
commodities like soy oil, palm oil, coffee, food grain such as rice and wheat,
pulses, pepper are traded
Existence of a vibrant, active and liquid commodity market is normally

considered as a healthy sign of development of any economy. Commodity
markets quite often have their centers in developed countries.
Commodity futures in particular help price discovery and assist investors in

hedging their risk by taking positions in commodities and exploiting
arbitrage opportunities in the market. They also help producers to know
what price their products could fetch in future. Assured prices and
transparency are thus major hallmarks of commodity markets.
Types of commodity markets
Basically, there are three types of regulatory commodity markets:

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Over the Counter/Spot Market: Direct purchases and sales are achieved in
spot markets normally for immediate consumption. Buyers and sellers meet
“face to face” and deals are struck. This is akin to “over the counter (OTC)”
market where there is no need for an organization like commodity exchange.
These are traditional markets. Classic example of a spot market is mandi
where food grains are sold in bulk. Traders would purchase the produce “on
the spot” and settle the deal in cash.
Forward and Future Markets: in this case, the agreements are normally
made to pay now and receive the goods at a later date in future. Forwards
and futures contracts reduce the risk by allowing trader to decide a price
today for the goods to be delivered in future. Forward markets are cash
market where delivery takes place sometime in future, unlike spot markets
that call for immediate delivery. These advance sales help both buyer and
seller with long term planning. Forward contracts laid the groundwork for
futures contracts. The main difference between these two contracts is the
way in which they are negotiated.
For forward contract, terms like quantity, quality, delivery date and price
and discussed in person between the buyer and the seller. Each contract is
thus unique and not standardized since it takes into account the needs of
particular seller and a particular buyer only.
In the case of futures contracts, all terms like quantity, quality and delivery
date, are standardized except price, which is discovered through the
interaction of supply and demand in a centralized market place or exchange.
Forward contracting helped in arranging long-term transaction between

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buyers and sellers but could not deal with the financial risk that occurred
with unforeseen price changes.
Major commodities listed and traded on a given commodity exchange would

normally depend on the demand and supply situation for that commodity in
the region in which the exchange is located. For instance, commodity
exchange in Jaipur will trade ore in guar and guar products while commodity
exchanges in Indore would be predominantly dealing with soybeans or soy
as products.
There are many regulated or deregulated commodity exchanges worldwide.

They deal in many commodities. In India there are 25 commodity exchanges
and three national level commodity exchanges which deal in around 80
commodities.
Benefits of trading in Commodities
• Benefits to investor
• High financial leverage is possible in commodity market e.g. trading

in gold calls for only 3.5% initial margin. Thus if the gold contract
(1kg) is valued for 600,000/-, the investor is expected to put in margin
of only Rs. 21000/- to be able to trade. If the price of gold goes up by
even 5%, investor would make profit of Rs 30,000/- on an investment
of Rs 21000/- before the expiry of the contract.

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• Investors can effectively hedge the risk in price fluctuations of a

commodity. Investor can also hedge his risk on investment in stock
and debt markets since commodities provide a safer choice and
provide one more alternative avenue in the investment portfolio. It
may be mentioned here that the commodities are less volatile as
compared to G-sec’s.
• Commodity markets are extremely transparent in the sense that the

manipulation of prices of a Commodity is extremely difficult.
• Business involves just you and market. One does not have to
manufacture or acquire a product; allocate financial resources to
advertise market and sell the product, etc.
• With the rapid spread of derivatives trading in Commodities, this

route too has become an option for high net worth and savvy investors
to consider in their overall asset allocation.
• The fact that the stock indices and commodity indices are not
correlated implies that the commodity markets can be used as an
effective diversification tool, where investors can park their money.
• A look at the performance of the commodities markets during the last
year shows that the positive movement was witnessed during most
parts of the years.

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• Benefits to producers
• It is useful to the 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.
Farmers for instance, can get assured prices, decide on the crop that they
want to take and since there is transparency in prices, he can decide when
and where to sell.
• Benefits to consumer/user
• It is useful for consumer because he gets an idea of the price at which

the commodity would be available at a future point of time.
• Corporate entities in particular can be benefited by hedging their risk
if they are using some of the commodities as their raw material.
• Future 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.
• Benefits to economy
As the constituents of the commodity market system get benefited Indian

economy in turn is also expected to gain a lot. Growth in the commodity

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markets implies that there could be tremendous benefits to the Indian

economy in terms of business generation and employment opportunities.
Global Commodity Markets
Today Commodity markets are situated throughout the world. In many cases
the market deals in specialized commodities. There are Commodity markets
for crude oil, metals, food grain, live stock etc. notable among them are,
Chicago Board of Trade in U.S.A., London Commodity Exchange in U.K.,
Sydney Futures Exchange in Australia, Tokyo Commodity Exchange in
Japan and Singapore International Monetary Futures Exchange in Singapore.
In India we have a number of small/regional exchanges for trading in

different commodities and at national level we have three commodity
exchanges, including Multi Commodity Exchange at Mumbai. The
commodities are traded both in cash market and in futures market. It is the
futures markets that take lead in commodity trading as compared to cash
markets.
Global commodity exchanges have existed for a long time. However major
commodity exchanges/markets are situated in UK and USA. The Chicago
Board of Trade (CBOT) and the Chicago Mercantile exchange (CME) are

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two of the oldest and largest derivatives exchange in the world. London
Commodity Exchange (now merged with London Futures and Options
Exchange) is another leading commodity exchange in the world. On these
exchanges as well as similar other derivatives exchanges, a very wide range
of commodities and financial assets are traded, particularly in the form of
future contracts. The commodities traded include pork bellies, live cattle,
sugar, wool, lumber, copper, aluminium, gold and tin.
Chicago and Commodity Trading
In the 1840s, Chicago had become a commercial center since it had good
railroad and telegraph lines connecting it with the EAST. Around this sae
time, good agriculture technologies were developed in the area, which led to
higher wheat production. Midwest farmers therefore used to come to
Chicago to sell their wheat to Chicago hoping to sell it at a good price. The
city had very limited storage facilities and hence, the farmers were often left
at the mercy of the dealers. The situation changed for the better when in
1848 a central place was opened where farmers and dealers could meet to
deal in “spot” grain – that is, to exchange cash for immediate delivery of
wheat.
Farmers and food merchant/dealers slowly started entering into contract for
future exchanges of grain for cash so that farmers could avoid taking the
trouble of transporting/storing wheat, if the price was not acceptable. This
system was suitable to farmers as well as the dealers. The farmers knew how
much he would be paid for his wheat, and the dealer knew his cost of
procurement well in advance.

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Such contracts became common and were even used in collateral for bank
loans subsequently. The contracts slowly got standardized on quantity and
quality of wheat being traded. They also began to change hands before the
delivery date. If the dealer decided he didn’t want the wheat, he would sell
the contract someone who needed it. On the other side if the farmer who
didn’t want to deliver his wheat could also pass on his obligation to another
farmer. The price of the contract will go up and down depending on what is
happening in the wheat market. If the bad weather had come, supply of
wheat would be less and the people who had contracted to sell wheat would
hold on to more valuable contracts expecting to fetch better price; if the
harvest were bigger than expected, the seller’s contract would become less
valuable since the supply of wheat would be aplenty.
Slowly, even those individuals who had no intention of ever buying or

selling wheat began trading in these contacts expecting to make some profits
based on their knowledge of the situation an the market of wheat. They were
called speculators. They hoped to buy contracts at low price and sell them at
high price or sell the contract in advance for high price and buy them later at
a low price. This is how the futures market in commodities developed in
U.S.
Futures industry has changed a great deal over the last 20 years, including
usage of terms futures itself. The industry was never referred to as futures
but rather “commodity”. Until 1970s the agricultural market dominated the
industry, and the trading was known as “commodity trading”. Today these

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markets are known as the futures market or are referred to as the new
commodity futures market.
Africa
Africa’s most important and active commodity exchange is the South

African Futures Exchange (SAFEX). It was informally launched in 1987.
SAFEX only traded in financial futures for a long time, but the creation of
Agricultural Markets Division in the exchange led to the introduction of a
range of agriculture futures contracts for commodities. Later trading was
liberalized to merge, white and yellow maize, bread milling wheat and
sunflower seeds.
Asia
China’s first commodity exchange was established in 1990 and thereafter as

many as 40 exchanges have appeared in China by 1993. The main
commodities that were traded in these exchanges include agricultural staples
such as wheat corn and in particular soybean. In late 1994 more than half of
China’s exchanges were closed down or reverted to being wholesale
markets, while only 15 structured exchanges received government’s
approval to continue to function as recognized exchanges. At the beginning
of 1999 the China’s Securities Regulatory Committee began a nation wide
consolidation process which resulted in three commodities exchanges
emerging in China viz. the Dalian Commodity Exchange, the Zhengzhou
Commodity Exchange and the Shanghais Future Exchange.

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The Taiwan Future Exchange was launched in 1998. Malaysia and

Singapore have active commodity futures exchanges. The Singapore
exchange was formed in 1999 by the merger of two-well established
exchanges viz. the Stock Exchange of Singapore (SES) and Singapore
International Monetary Exchange (SIMEX).
Commodity Futures
The first recorded instance of futures trading occurred in rice in Japan and
China some 6000 years ago. In the United States, futures trading started in
the grain markets in the middle of the 19 th century. The Chicago Board of
Trade, a futures market in various commodities, was established in 1848.
Major development in forward trading in commodities. Work place in
middle of 18th century in Chicago in United States.
Financial future
The biggest increase in future trading activity occurred in the 1970s when
futures on financial instruments started trading in Chicago. Currency futures
began trading in the International Money Market (IMM) of the Chicago
Mercantile Exchange in 1972. Since then many other futures markets have
opened up such as London International Financial Futures Exchange
(LIFFE).

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Currencies such as the Swiss Franc and the Japanese Yen were the earliest
currencies to be traded in currency futures market. In the 1980s futures
began trading on stock market indices such as the S&P 500.
Indian and U.S. Commodity market
Commodity markets like security market and other financial markets are
regulated by governmental authorities. In India, the market regulator for
commodity futures trading is the Forward Market Commission functioning
under the Ministry of Consumer Affairs. While in U.S.A., commodity
exchanges dealing in derivatives products are regulated by Commodity
Futures Trading Commission. We give below some important differences
relating to trading, settlement, regulation etc. between the Indian commodity
market and the U.S commodity market.

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Indian Commodity Markets
The history of futures trading in commodities in India is almost as old as that

in the U.S. while the Chicago Board of Trade was setup in 1848 in the U.S,
India’s first organized futures market in cotton was setup in 1875 and was
known as the Bombay Cotton Trade Association Limited. This association,
apart from cotton, began trading in other commodities like groundnut, oil
seeds and jute. Subsequently gold futures trading started in Mumbai in 1920
and later gold and bullion markets came up in Rajkot, Jaipur, Jamnagar,
Kanpur, Delhi & Kolkata. During the first half of the 20 th century there were
several commodity futures exchanges in India trading in jute, pepper,
turmeric, potatoes, sugar etc.
Functioning of Commodity Market in India

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There are three types of regulated market in India:
• Spot market: Direct purchase for immediate consumption.
• Futures and forward Markets: Agreements now to pay and

receive/ deliver later.
Forward and futures reduce the risk by allowing the trader to decide a price
today for goods to be delivered in future.
• Derivatives market: purely financial transactions based on physical

trading.
How system works
The system includes following elements:
• Hedgers, speculators, investors, arbitragers

• Producers – farmers
• Consumers – refiners, food processing companies, jewelers, textile
mills, exporters & importers.
There are two kinds of trade in commodities. The first is the spot trade, in
which one pays cash and carries away the goods. The second is futures trade.
The underpinning for futures is the warehouse receipt. A person deposits a

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certain amount of, say; good X in a warehouse and gets a warehouse receipt
which allow him to ask for physical delivery of the good from the
warehouse.
But someone trading in commodity futures need not necessarily possess

such a receipt to strike a deal. A person can buy or sell a commodity future
on an exchange based on his expectation of where the price will go. Futures
have something called an expiry date, by when the buyer or the seller either
closes his account for all dealing parties in which the daily profit or loss due
to changes in the future price is recorded. Squaring off is done by taking an
opposite contract so that net outstanding is nil.
The biggest benefits of commodity trading will accrue to commodity traders,

farmers and companies dealing in commodity based products by allowing
them to hedge their risks. Then there are speculators, who are in the game
only to make money out of the volatility in prices. But unlike in stocks, few
retail investors are expected to trade in commodity futures since it requires a
fair bit of expertise. Even those who do will probably restrict themselves to
trading in gold and silver.
India’s share in Global Commodity Markets
At present, India’s share in the global commodity markets – both

agricultural and industrial, especially of energy products and base metals – is
not big enough to make a major impact on international prices. India
currently accounts for only around 3% of the global oil demand and 2% of

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the global copper demand. In comparison, China accounts for 8% of the

global demand for oil and as high as 22% of the global demand for copper.
However, in the gold market, India accounts fro about 20% of the world
demand and remains a key area for physical buying support on price
corrections.
In case of agricultural commodities, India’s production base is large, but

international trade volumes are still rather modest.
India is the worlds largest producer of milk, the worlds second largest
producer of rice and wheat after China and the worlds third largest producer
of cotton after China and US; though foreign trade in these commodities is
rather limited. However, in vegetable oil, India is the world’s largest
importer, as is the case with pulses also.
Despite a modest share in the industrial products market, the prospects for
growth for the industrial commodities in India are considerable. Despite a
slowdown in industrial production at times, overall the domestic economy in
India continues to grow robustly, while imports and growth in demand for
corporate borrowing also indicate a positive outlook.
In addition, large infrastructure works are being undertaken across the

country, covering rail, road, energy and ports. Port modernization and
involvement of the private sector in infrastructure development are likely to
be the key growth drivers.

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Potential of Commodity Markets in India
The following salient features of the Indian economy/commodity markets

and their related aspects would be adequate to stress the relevance of
commodity market and the great potential that they offer for future
development of India:
• India is the world’s leading producer of 17 agricultural commodities

and is also the world’s largest consumer of edible oil and gold.
• India has 30 major markets and nearly 7,500 mandies with substantial
arrivals of a variety of commodities.
• Over 27000 haats exist in country with seasonal arrivals of various

commodities.
• Nearly 5 million traders are engaged in commodity trading in India
• Commodities related (and dependent) industries constitute

approximately 58% of India’s GDP, which (at factor cost based on prices
of year 1999-2000) for the year 2004-2005 was Rs 23,93,671 Crores.
• State and central Governments have invested substantial resources to

boost production of agricultural commodities. Many of these would be
traded on the futures markets as food processing increases from the
current level of 2% to 40-50% comparable to other countries.

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• There are three national level Commodity Exchanges that trade in

approximately 100 commodities at present and the list continues to
expand.
• Indian spot market for commodities such as bullion, metals,

agriculture produce and energy is estimated at approximately Rs
11,00,000 crore annually. According to the experts in the field, global
trends indicate that the volumes in futures trading tend to be 5-7 times the
size of commodities spot trading in the country (internationally, the
multiple for physical versus derivatives is much higher at 15 to 20 times).
This implies that the potential for futures trading market in India
currently stands at a staggering Rs 55,00,000 crores to Rs 77,00,000
crore annually.
• Three nationwide electronic exchanges and 22 recognized regional or

small commodity exchanges in India had an estimated that combined
turnover of Rs 21.34 lakh crore for the year 2005-06. This translates into
a 373% growth of the previous financial year.
• Many nationalized and private sector banks have announced plans to

disburse substantial amounts to finance commodity-trading business.
(private sector giant viz. HDFC Bank alone is planning to disburse over
Rs 1,000 Crore for financing agriculture commodities in 2005-06)
• The government of India has initiated several measures to stimulate

active trading interest in commodities. Some of these measures are

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• lifting the ban on futures trading in commodities

• approving new exchanges
• developing exchanges with modern infrastructure and systems such as
online trading; and
• removing legal hurdles to attract more participants
• possibility of allowing existing stock exchanges to also deal in
commodities
As a result of the above developments, both the spot and futures market in
India are witnessing rapid growth.
Drivers of the Indian commodity prices
• Demand and Supply

The imbalance in the demand and supply position determines the
price of a commodity. When the demand outstrips supply the prices shoot
up. The supply side problems usually arise due to the bad crops, logistics,
etc.
• Imports and Exports

Government policy on imports and exports is also a factor which
affects the price. In a year of bad harvest if the government decides to
import the commodity to meet the domestic demand the prices will

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remain stable. Similarly if the policy allows export of a commodity

which fetches a better price in the international market than domestic
market, more produce will be exported. The price in the domestic market
will rise due to short supply and will tend to match the international
levels.
• Sowing and Harvesting patterns

The demand for the commodity may not exactly synchronize
with the harvesting season. Usually the prices crash immediately after the
harvest due to fresh arrivals in the mandis.
• Seasonality
Some commodities go up during certain seasons e.g. Gold prices
usually shoot up during Diwali or Marriage seasons.
• Interest rates
Any producer of the commodity whether he is a farmer or a miner
is doing his activity on borrowed capital by incurring a cost. This interest

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burden will reflect in the price of the commodity. Thus a higher interest
cost becomes a contributor to a higher commodity price.
• Currencies
In the case of commodities that are imported, if the domestic currency
has depreciated against the US $, the importer will have to pay higher in
terms of rupees per $ value of imports. This will increase the cost of
goods.
Commodity Futures
A Commodity Future contract is an agreement between two parties, to buy

or sell a specified quantity and defined quality of a commodity, at a certain
time in future, at a price agreed upon at the tie of entering into the contract
on a commodity exchange.
Features of Futures Contract
The commodity future will always have a fixed period, like one month, three
month etc. as the life of the contract may be different in different commodity
exchanges. At the end of contract period, the future contract would expire
and the concerned parties will have to give and receive delivery of the
commodity mentioned in the contract. Both the tie and the place of delivery

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are prescribed by the exchange and this will form part of the futures
contract.
There is usually a time difference between the expiry of futures contract and
the delivery period. As a result of this intervening period, the cash price for a
commodity would be different from its futures price mentioned in the
contract.
• Buyer’s Obligation:
The buyers of futures contract have two obligations. One, he has to

take delivery of the commodity purchased if the contract is allowed to run its
full life term. Second, he has to pay the purchase price. The buyer also has a
right to the facility of offsetting his existing obligation through an opposite
trade. This unique feature in the futures contract gives the buyer flexibility
with regards to delivery on expiry.
• Seller’s obligation:

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The seller’s obligation is to deliver the commodity as per standardized

quantity and quality and receive the price. He too has the facility of
offsetting the existing contract.
• Closing out position:
Closing out position means entering into a trade of opposite to the

original one to settle the contract.
• Position limit:
Some commodity exchanges prescribe position limit for speculators.

Position limit refers to the maximum number of contracts that a speculator
can hold at a particular point of time.
• Initial margin:
Let us assume that an investor contacts his Exchange Broker to buy

three November Gold futures contract. We will assume that the November
futures contract is Rs 9000 per 10 gm. The member will require the investor

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to deposit funds in the form of margin in margin account. Let us say, it is Rs

2000 per contract of 10 g. since the investor has bought three November
Gold futures, the margin amount will be Rs 6000 (3 x 2000). The investor
must deposit this sum in the margin account with the member. This margin
is known as initial margin.
• Marking to market:
At the end of every trading day, the margin account is adjusted to

reflect the investor gain or loss. Supposing, on the second day of the
contract, the November futures price for gold closes at 9100 per 10 gm. This
will result into a gain of Rs 300 (3 x 100) on the three contracts bought by
the investor and vice versa if loss. The resultant gain or loss will on day to
day basis will be taken to margin account. While the gain is credited to the
margin account and will have an impact of increasing the balance in margin
account, a loss sustained will be debited to the margin account. This daily
valuation of the account is known as marking the market.
• Margin call:
You are now aware that the daily valuation of the trader’s future
position results into a loss or gain depending upon price movements. When
such valuation results into a loss the exchange will make a margin call on
the trader. The effect of such margin call is that the trader should bring in
that much of fresh funds to be deposited in that margin account. Thus
margin calls are made by the exchanges only when the futures p[position of
a trader results into a loss as compared to its value on the previous day.

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• Maintenance margin:
Maintenance margin is that portion of the initial margin which should

be the minimum prescribed margin, which should always be available in the
margin account. In many exchanges, the maintenance margin is usually
about 75% of initial margin. The main purpose of maintenance margin is to
ensure that the margin account never becomes negative.
• Clearing margin:
Every trader is required to maintain margin account with the

broker/members. In the same way every broker of the exchange is required
to place certain money with the clearing house. Thus the margin amount
provided by the broker with the clearing house is known as clearing margin.
Objectives of Commodity Futures Contract

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• hedging with a view to transfer the price risk;
• price discovery through a large number of transaction and players;
• maintenance of buffer stock and better allocation of resources;
• reduction in inventory requirement and thereby reduction in cost of

carry;
• price stabilization through balanced demand and supply position;
• Help raise bank finance through transparency and flexibility coming

with futures contract.
Pricing Commodity Futures:
The relationship between cash price and future price can be explained in
terms of cost of carry. Cost of carry is an important element in determining
pricing relationship between spot and futures prices as well as between
prices of futures contract of different expiry months. According to the cost
of carry model, futures prices depend on the spot price of the commodity
and the cost of storing the commodity from the date of spot price to the date

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of delivery of the futures contract. Cost of storage and insurance and cost of
financing constitute cost of carry. Estimated cost of futures price is also
called ‘full carry futures price’.
Cost of Carry Model:
F=S+C
Where
F = Future price
S = Spot price
C = Cost of carry
For example: if the cost 100gm of gold in the spot market is Rs. 60,000 &
the cost of carry is 12% p.a., the fair value of a 4 month futures contract will
be
F=S+C
F = 60,000 + 2400
F = Rs 62400
The fair value of a futures contract is the theoretical value of where a futures
contract should be positioned, given the current spot price, cost of financing
and the tie for expiration.

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Fair value of a futures contract can be calculated using the following

equation:
F = S (1 + r)
Where
F = Future price
S = Spot price
R = % cost of financing (annually compounded)
n = time till expiration of the contract
if the value of ‘r’ is compounded m times in a year, the formula to calculate

the fair value will be
F = S (1 + r/m)
Where m = no. of times compounded in a year
For example
The cost of 100 gm of gold in the spot market is Rs. 60000 and the cost of
financing is 12% p.a. compounded monthly, the fair value of a 4 month
futures contract will be
F = S(1 + r/m)
F = 60,000 (1 + 0.12/12)

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F = 60,000 x 1.0406
F = 62,436
The fair value of a futures price with continuous/daily compounding can be

expressed as
F = Se
Where
F = Future price
S = Spot price
R = % COST OF FINANCING
N = time till expiration of contracts in years and
E = 2.71828
The above formula is used to calculate the futures price of a commodity

when no storage costs are involved
The futures price is equal to the sum of money ‘S’ invested at a rate of
interest ‘r’ for a period of ‘n’ years.
For example: if the cost of 100 gm of gold in the spot market is Rs 60,000 &
the cost of financing is 12% p.a. the fair value of 4 month futures contract
will be
F = se

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F = 60000 x e
F = 60000 x 1.0407
F = Rs. 62,442
Regulatory Framework
The government at different times appointed four different comities to study

this sector:
• The Shroff Committee in 1950: this committee in fact was asked to go

into details of the draft of Futures Markets (Regulation) Bill and revise it
wherever necessary. The committee was formed even before the Forward

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Contracts (regulation) Act, 1952 came into force. The findings of the
Committee are therefore no more relevant.
• The Datwala Committee in 1966: This committee remembers of

reintroduction of futures trading in major commodities.
• The Khusro Committee in 1980: Apart from the Datwala Committee,

this Committee also recommended the reintroduction of futures trading in
major commodities. The government finally brought back forward
trading in agricultural commodities that did not have a very significant
role in the economy-castor seed and castor oil, jaggery, jute, pepper,
potato and turmeric. Several localized exchanges started trading in the
same commodity, each of them with a local broker/wholesale-
merchandiser constituency. But, even after a decade, none of the market
achieved the levels of liquidity that existed prior to the ban on
commodity future trading.
• The Kabra Committee in 1993, this committee made significant

contribution to the cause of commodity trading in the country and is in a
way responsible for today’s modern system of commodity trading with
three national level and 22 other commodity exchanges/association in
operation. This committee findings and recommendations have therefore
been given more coverage not only in this book but also in training
sessions and academic circles in general.

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Once futures trading became operational, inspite of liberalization, it has been

difficult for trade to be transferred from illegal black market, which has zero
tax liability & no reporting requirements to the legal authorities as compared
to the regulated markets, where taxes & reporting are part of the legal
procedures. It was in response to this need for commodity futures in India
that the fourth committee by the name of Kabra Committee was set up in
June 1993, for assessing the scope for forwards and futures development of
futures trading in India. The committee so instituted was known as the
Kabra Committee in the name of its chairman r. Kamal Nayan Kabra, who
was a professor of Economics in the Indian Institute of Public
Administration, Delhi.
Many of the recommendation of the Kabra Committee have been

implemented. This gave an impetus to the activities of the commodity
market in the country. With the current initiatives of the regulators, these
markets have shown further revolutionary changes in the last few years, with
the national-level multi commodity exchanges in India showing tremendous
potential to tap the commodity derivatives market.
Latest Developments
Commodity markets have existed in India for long time. While the
implementations of the Kabra Committee recommendations were rather
slow, today, the commodity derivative market in India seems poised for a
transformation. National level Commodity Derivatives Exchanges seem to
be the phenomenon. The Forward Markets Commission accorded in
principle approval for the following national level commodity exchanges.

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The increasing volume on these exchanges suggests that commodity markets

in India seem to be a promising game.
• National Board of Trade

• Multi Commodity Exchange of India
• National Commodity and Derivatives Exchange of India Ltd
Registered commodity exchanges in India
Exchanges Product traded

Bhatinda Om & Oil Exchange Ltd. Gur
The Bombay Commodity Exchange Sunflower Oil, Cotton (seed & oil),
Ltd. Safflower (seed, oil and oil cake),
Groundnut, Castor oil, Castor Seed,
Sesamum (Oil and Oil Cake), Rice
Bran, Rice Bran Oil & Oil Cake,
Crude Palm Oil
The Kanpur Commodity Exchange Rape Seed/Mustard Seed Oil & Cake
Ltd.
Ahmedabad Commodities Exchange Cotton Seed, Castor Seed.
Ltd.
India Pepper and Spice Trade Pepper
Association, Kochi
Rajdhani Oils & Oil Seeds Exchange Gur, Rapeseed/Mustard
Ltd, Delhi
The East India Cotton Association, Cotton
Mumbai
The Central India Commercial Gur
Exchange Ltd, Gwaliar

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The East Inida Jute & Hessian Hessian, Sacking

Exchange Ltd, Kolkata
First Commodity Exchange of India Copra, Cocunut oil & Copra Cake
Ltd, Kochi
National Multi Commodity Gur, RBD, Pamolien Crude Palm
Exchange of India Ltd, Ahmedabad Oil, Copra, Rapeseed/Mustard Seed,
Soybean, Cotton, Safflower,
Groundnut (Seed, Oil, Oil Cake),
Sugar, Gram, Coconut (oil And Oil
Cake), Castor Oil, Sesamum,
Linseed, Rice Bran oil, Pepper,
Guarseed, Aluminium Ingots, Nickel,
Vanaspati, Rubber, Copper, Zinc,
Lead
The Coffee Futures Exchange India Coffee
Ltd, Bangalore
National Commodity and Derivatives Soybean, refine soy oil, Mustard
Exchange Ltd Seed, Mustard Oil, Medium Staple
Cotton, Long Staple Cotton,
Palmolien Crude Palm Oil, Gold,
Silver and many more
Multi Commodity Exchange Castor Oil, Castor Seeds, Cotton
Seeds, Crude Palm Oil, Groundnut
Oil, Cotton Long Staple, Cotton
Medium Staple, Cotton Short Staple,
Kapas, Aluminium, Copper, Nickel,
Sponge Iron, Steel Flat, Steel Long,
Tin and many more.

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The NCDEX Platform
Profile
National Commodity & Derivatives Exchange Limited (NCDEX) is a

professionally managed online multi commodity exchange promoted by
national level institutions. This unique parentage enables it to offer a
bouquet of benefits, which are currently in short supply in the commodity
markets. NCDEX is a public limited company incorporated on April 23,
2003 under the Companies Act, 1956. It obtained its Certificate for
Commencement of Business on May 9, 2003. It has commenced its
operations on December 15, 2003.
NCDEX is the youngest of the three national level multi commodity

exchanges approved by the government till date.
NCDEX is a nation-level, technology driven de-mutualized on-line
commodity exchange with an independent Board of Directors and
professionals not having any vested interest in commodity markets.
NCDEX is regulated by Forward Market Commission in respect of futures
trading in commodities. NCDEX is located in Mumbai.
NCDEX currently facilitates trading of 56 commodities - Cashew, Castor

Seed, Chana, Chilli LCA334, Coffee - Arabica, Coffee - Robusta, Cotton
Seed Oilcake, Crude Palm Oil, Groundnut (in shell), Groundnut Expeller
Oil, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Indian 28 mm

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Cotton , Indian 31 mm Cotton , Lemon Tur, Masoor Grain Bold, Medium

Staple Cotton, Mentha Oil , Mulberry Green Cocoons ,Rapeseed - Mustard
Seed ,Pepper ,Potato ,Raw Jute, Indian Parboiled Rice (IR-36/IR-64),Indian
Raw Rice(ParmalPR-106),Indian Pusa Busmati Rice, Indian Traditional
Basmati Rice,RBD Palmolein, RMSeed Oil Cake, Refined Soy Oil ,
Rubber,Sesame Seeds, Soy Bean, Sponge Iron, Expeller Mustard
Oil ,Mulberry Raw Silk,V-797 Kapas, Sugar, Turmeric, Urad, Wheat,
Yellow Peas, Yellow Red Maize, Yellow Soybean Meal, Electrolytic
Copper Cathode, Aluminium Ingot, Nickel Cathode, Zinc Metal Ingot, Mild
Steel Ingots, Gold KG, Silver, Brent Crude Oil, Furnace Oil. At subsequent
phases trading in more commodities would be facilitated. The Exchange
operates between 10 a.m. and 11.15 p.m., with 30 minutes gap between 5 -
5.30 p.m. from Mondays to Fridays and between 10 a.m. and 2.00 p.m. on
Saturdays.
Agro Products

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Cashew Castor Seed

Chana Chilli
Coffee - Arabica Coffee - Robusta
Crude Palm Oil Cotton Seed Oilcake
Expeller Mustard Oil Groundnut (in shell)
Groundnut Expeller Oil Guar gum
Guar Seeds Gur
Jeera Jute sacking bags
Lemon Tur Indian Parboiled Rice
Indian Pusa Basmati Rice Indian Traditional Basmati Rice
Indian Raw Rice Indian 28 mm Cotton
Indian 31 mm Cotton Masoor Grain Bold
Medium Staple Cotton Mentha Oil
Mulberry Green Cocoons Mulberry Raw Silk
Mustard Seed Pepper
Potato Raw Jute
Rapeseed-Mustard Seed Oilcake RBD Palmolein
Refined Soy Oil Rubber
Sesame Seeds Soyabean
Sugar Yellow Soybean Meal
Turmeric Urad
V-797 Kapas Wheat
Yellow Peas Yellow Red Maize
Metals
Electrolytic Copper Cathode
Aluminium Ingot
Nickel Cathode
Zinc Ingot
Mild Steel Ingots
Sponge Iron
Precious Metals
Gold

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Silver
NCDEX Energy
Brent Crude Oil
Furnace Oil
Promoters
The Exchange is promoted by well known national level institutions viz.

ICICI Bank Limited, National Stock Exchange of India Limited (NSE),
National Bank for Agriculture and Rural Development (NABARD) and Life
Insurance Corporation of India (LIC). Four other national level institutions –
Canara Bank, CRISIL Limited (CRISIL), Punjab National Bank (PNB) and
Indian Farmers Fertiliser Cooperative Limited (IFFCO) have subsequently
taken equity stake in the Exchange. All these shareholders bring along with
them expertise in closely related fields such as risk management (CRISIL),
rural bank network (Canara Bank in the south and PNB in the north),
technology (ICICI Bank), on-line trading technology and derivative trading
(NSE), agriculture (NABARD), market reach (IFFCO which has the largest
number of farm cooperatives) and expertise in institution building (LIC).
Besides these shareholders, there are currently requests from other banks for
taking up equity stake in NCDEX.
These promoters of NCDEX are prominent players in their respective fields
and bring with them institution building experience, trust, nation wide reach,
technology and risk management skills.

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CANARA BANK CRISIL GOLDMAN SACHS
ICICI Bank IFFCO LIC
NABARD NSE PNB
Governance
The governance of NCDEX vests with the Board of Directors. The Board
comprises 13 Directors who are persons of eminence, each an authority in
his/her own right in the areas very relevant to the Exchange. They are all
well known, highly experienced and independent. Promoters do not
participate in the day to day activities of the exchange. The directors are

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appointed in accordance with the provisions of the Articles of Association of

the company. The board is responsible for managing and regulation all the
operations of the exchange and commodities transaction. It formulates the
rules and regulation related to the operations of the exchange. Board
appoints an executive committee and other committee for the purpose of
managing activities of the exchange.
The executive committee consists of the Managing Director of the exchange

who would be acting as the Chief Executive of the exchange, and also other
members appointed by the board.
Apart from the executive committee the board has constitute committee like
Membership Committee, Audit Committee, Risk Committee, Nomination
Committee, Compensation Committee and Business Strategy Committee
which help the board in policy formulation.
Exchange Membership
Membership of NCDEX is open to any person, association of persons,

partnerships, co-operatives societies, companies etc that fulfills eligibility
criteria set by the exchange. All the members of the exchange have to
register themselves with the competent authority before commencing their

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operations. The members of NCDEX fall into two categories, trading cum
Clearing Members (TCM) & Professional Clearing Members (PCM).
Trading cum Clearing Members (TCM’s)
NCDEX invites applications for TCM from persons who fulfill the specified
eligibility criteria for trading in commodities. The TCM membership entitles
the members to trade and clear, both for themselves and/ or on behalf of
their clients. Applicants accepted for admission as TCM are required to pay
the required fees/ deposits and also maintain net worth as given in the table
below:
Fee/ Deposit structure and net worth requirement: TCM

Particulars (Rs in Lakh)
Interest free cash security deposit 15.00
Collateral security deposit 15.00
Annual subscription charges 0.50
Advance minimum transaction charges 0.50
Net worth requirement 50.00
Professional Clearing Members (PCM’s)
NCDEX also invites applications for Professional Clearing Members from

the persons who fulfill the specified eligibility criteria for trading in
commodities. The PCM membership entitles the members to clear trades
executed through Trading cum Clearing Members both for themselves and/

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or behalf of their clients. Applicants accepted for admission, as PCMs are

required to pay the following fee/ deposits and also maintain net worth as
given in the table below:
Fee/ Deposit structure and net worth requirement: TCM

Particulars (Rs in Lakh)
Interest free cash security deposit 25.00
Collateral security deposit 25.00
Annual subscription charges 1.00
Advance minimum transaction charges 1.00
Net worth requirement 5000.00
NCDEX offers trading facilities through its trading and clearing members
located across over 250 centres in the country. Presently there are around
425 members (additional 100 members are in pipeline) spread across the
country with trading taking place on over 4800 terminals. Most of their
members and their terminals are located even in smaller towns such as
Abohar, Fazilka in Punjab, Bhadurgarh, Sirsa, Fatehabad in Haryana,
Moradabad, Shyamli, Banda in Uttar Pradesh, Tonk, Newai, Churu,
Pilibenga in Rajasthan, Morena,Mandsaur, Pali in Madhya Pradesh, Gaya in
Bihar, Davengere in Karnataka, Guntur, Tenali in Andhra Pradesh, Thrissur
in Kerala, Rudrapur, Haldwani in Uttaranchal, Dahod in Gujarat, Akola,
Sangli in Maharashtra and many more similar places. This dispersal of
points of trading terminals helps people from all over the country access the
Exchange for hedging their price risks.

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Spot Price Discovery

NCDEX is the only organization in India which provides near real
time spot prices of commodities traded on the Exchange. NCDEX has
revolutionized the entire system of price discovery in both the spot and
futures segments. Indian spot markets particularly in respect of agricultural
products is fragmented and spread over 7,000 local market places (known as
‘mandis’). Spot prices are polled in these various principal market places
two to three times (people are stationed in these places to get a feel of the
market) a day and then statistically cleansed by a process popularly known
as 'boot-strapping.
The participants who trade on the Exchange can use these near real-time
spot prices to take decisions on the futures segment. This entire process has
been commended by the Government of India in its annual economic report
tilted, 'Economic Survey 2003-04', where the system of price discovery of
NCDEX has been credited for its robustness.
Price Dissemination
The spot prices that are collected by the Exchange are being
disseminated through its website, trader work station, news agencies such as
Doordarshan, Reuters, Telerate, Telequotes, Bloomberg, newspapers etc.
NCDEX has also tied up with ITC Ltd. (a leading corporate) which has in
place its rural electronic kiosks for purveying information through a system
called 'e-chaupals', which translated in English refers to ‘a meeting place for
people in villages'.
It is an electronic terminal/kiosk which provides the farming community

accessing e-chaupals through a networked system, important information on

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spot and futures prices traded on the Exchange. NCDEX is now in the
process of disseminating both spot and futures prices on these terminals so
that farmers can come and view them and take appropriate decisions based
on their own perceptions.
NCDEX has also tied up with the Government of India's national level call
centre initiative titled 'Kisan Call Centres' that provides on-line guidance and
handholding to farmers in the country. Under this initiative, calls made by
dialing '1551' from any place within the country lands on to a local call
centre in the state capital from where the call originated. The call is replied
to by a call operator in the local state language. The call operator, assisted by
agricultural scientists, replies to all queries relating to agriculture and
problems faced by the caller-farmers.
For replying to queries relating to agricultural commodity prices, the call

centres draw upon the NCDEX prices, both spot and futures, which are
available to them through near real-time live feeds from the Exchange. This
way, both the spot and futures prices are disseminated across a wider
spectrum of the farming community. The national television channel
‘Doordarshan’ which has by far the largest reach into the hinterland of the
country has likewise commenced carrying the spot and futures commodity
prices of NCDEX.
Farmer Pilots
NCDEX has also spearheaded pilot projects in the states of Gujarat
and Andhra Pradesh whereby farmers will be enabled to sell forward their
produce of cotton immediately after sowing/prior to harvesting through an

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aggregator who/which will be selected for this purpose. The idea is that the
farmers should be able to hedge their price risk on the NCDEX's trading
platform at any point of time prior to harvesting whenever they wish so that
they are assured of a fixed price when the crop is harvested. Many such
similar pilots are also being planned for other crops in different states.
Collateral Management Company

NCDEX has also taken an initiative in setting up a new company to
take care of the issues of warehousing, collateral management matters as
well as facilitate commodity finance by banks. This company, functioning as
a one-stop solution provider, would facilitate all related activities associated
with physical commodity delivery.
Today, a farmer who harvests his crop has to sell it in the spot market at the
prevailing price as he needs money and cannot sell forward even though he
knows that the prices would improve in future which is the typical post-
harvest tendency. Banks are not willing to lend against commodities held in
warehouses (except warehouses in the state sector) as they are not certain of
the quantity, quality, grades and longevity of the crop stored even if it is kept
in a warehouse due to the credibility factor. Now, this problem would be
overcome on account of NCDEX's initiative in setting up this collateral
management company, whose main objective would be to facilitate banks
moving away from a balance sheet lending perspective to a commodity
based lending perspective.
This is sought to be achieved by bringing under it an entire chain of

warehouses. These warehouses would be accredited, credit graded based on

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certain specific factors (like ratings for hotels) to ensure standardization in

their practices and value-addition to warehouse users. The warehouse receipt
itself would either be issued by this collateral management company or
credit enhanced by it. Once certified by this company, the warehouse receipt
would become a credible marketable lending instrument for banks. Further,
world renowned assayers/certification agencies would pre-certify the goods
kept in the warehouse and the details would be specified in the warehouse
receipt. The lending bank would now be certain about the authenticity of the
produce stored in the warehouse and would be in a position to lend money to
the farmer at better (lower) rates as the credit rating of the farmer gets
transformed automatically from a lower (say, triple B) to a higher (say,
double A) grade. Thus, the farmers would get the finance at competitive
interest rates. This would be a win-win situation for all the players
concerned. C
Holding of commodity balances in electronic form in dematerialized

accounts and delivery
NCDEX has worked successfully to network accredited
warehouses and enabled holding of commodity balances in electronic form
and dematerialized the warehouse receipt (in partnership with National
Securities Depository Limited (NSDL) and the Central Depository Services
(India) Limited (CDSL) so as to enable smooth physical commodity
settlements. The Exchange was the first to facilitate holding of commodity
balances in an electronic form very much like cash in a savings bank account
and securities in an electronic custodial account. Physical delivery in an
electronic form (demat mode) has already taken place in gold, silver, pepper,
guar seed and guar gum. Efforts are currently under way to popularize the

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idea of holding commodity balances in an electronic form by retail investors

and private banking groups/portfolio managers just as in equities which is
already in vogue today.
Working With Other Participants

In all its endeavors, the Exchange has been associating itself with
reputed domain participants to realize its goals. Towards this purpose, it has
tied up with TCS and NSE. IT for technology solutions, for networking with
members it has tied up with HCL Comnet, for leased lines with BSNL-
MTNL combine, for clearing and settlement with National Securities
Clearing Corporation Limited (NSCCL), a wholly-owned subsidiary of
NSE, for spot price polling with Centre for Monitoring Indian Economy
(CMIE) and CRISIL, for demat of warehouse receipt with NSDL and CDSL
along with Karvy Consultants who are the Registrars. NCDEX has currently
empanelled 6 clearing and settlement banks for effecting smooth payings
and pay-outs of funds on daily basis. It has also tied up with 8 depository
participants for members to open their commodity demat accounts. The
Exchange has entered into arrangements with 50 warehouses, (which are
also accredited by the Exchange) and 5 assaying and grading agencies to
facilitate efficient storage and delivery of commodity on the settlement due
dates.
Working With The Government

NCDEX has been working pro-actively with various Central and state
government departments, regulators and statutory authorities to help unlock
hurdles that are in the way of commodity trading as well as help develop the
market in a swift and secure manner.

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NCDEX Trading System

NCDEX has established reliable, time tested and transparent trading
platforms very similar to those being used by successful electronic equity
exchanges. NCDEX provides screen based trading and hence it is possible
for one to place trades on the platform without visiting the Exchange.
Clearing and Settlement System

NCDEX has a large Settlement Guarantee Fund; and guarantees the
settlement of all trades executed on its trading platform according to its
Rules, Regulations and Bye Laws. NCDEX has entered into an operational
arrangement with NSCCL for clearing and settlement of trades executed
through the NCDEX trading system.
At the Exchange, all contracts, not settled through delivery are to be cash
settled. At the end of trading hours on the expiry day (20th of every month
for most of the commodities and 7th for a few commodities or the previous
trading day if the 20th/7th happens to be a Saturday, Sunday or a holiday),
for all open positions information for delivery is sought from the members.
The Clearing and Settlement System of the Exchange matches delivery
information and the settlement will take place as per the delivery and
settlement schedule of the Exchange. Physical settlement would take place
in electronic (demat) form through the accredited warehouses and quality
certification agencies. In fact, in February 2004, within 3 months of
commencing operations, NCDEX successfully facilitated its first settlement
of delivery for gold in demat form.
Risk management

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NCDEX ensures the financial integrity of trades put through on its

platform by adopting optimal risk management practices. NCDEX as an
exchange does not have, in its governing/management team, any person who
has a vested interest in commodity trading. This enables NCDEX to take a
comprehensive, unbiased and professional approach to risk management.
The VaR/SPAN tools used for risk management stipulations and cross-
margining requirements are transparent and applied uniformly across market
participants. In commodity futures markets, margin requirements are met by
collection of deposits, which are used to cover adverse movements in futures
prices. Prudent risk management requires that margin requirements of the
Exchange should respond to changes in volatility to ensure that members are
able to meet their counter party guarantees. In the long run this ensures
financial discipline in the market and aids in the development of the market.
NCDEX has, therefore, adopted the widely accepted system for the purpose
of real-time initial margin computation. Initial margin requirements are
based on 99% daily VaR (Value at Risk). NCDEX also provides position
monitoring and margining. Position monitoring is carried out on a real-time
basis during the trading hours. Margins are re-calculated intraday at 11 a.m.,
1.00 p.m., 5.00 p.m. and 7.00 p.m. and only at 11.00 a.m. on Saturdays to
capture the intra-day volatility in the futures and spot prices.
Other risk management tools like daily price limits and exposure margins
have been adopted in line with international best practices. Margins are
netted at the level of individual client and grossed across all clients, at the
member level, without any set-offs between clients.
Differentiation factor

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The differentiating factors for the Exchange are: transparency in the

price discovery mechanism, consistency and ease in clearing and settlement
procedures and robustness of risk management systems. The Exchange
understands the business needs of its participants and will endeavour to offer
financing solutions to its members/clients in consultation with select banks
and financing agencies.
Customer education and awareness

Despite a fairly long history of derivatives trading in India, significant
education and awareness needs to be created amongst a vast majority of the
population. In order to achieve this, NCDEX has developed comprehensive
training modules on commodities and their derivatives processes in online
trading, risk management processes, etc. NCDEX has been conducting
awareness programmes across the country to highlight the opportunities in
the commodity space, which have been very well received. In the first half
of FY04, NCDEX has already conducted over 100 programmes with over
12,000 participants. The target for the financial year FY05 is to conduct 200
programmes which will cover 20,000 participants. Most of the programmes
are conducted in the vernacular medium to ensure that a better rapport is
established with the participants. With increased awareness and participation
from investors/brokers of other segments such as equity markets, the
commodity markets are expected to develop further. The Exchange has
introduced a certification course for its members analogous to the
certification courses followed in the equity segment of the capital market
and is conducted by NSE’s Certification in Financial Markets (NCFM). This
is expected to deepen the knowledge of operating staff working on
commodity desks of the Members and enable them to take appropriate

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decisions at the right time while trading on the Exchange. The Exchange
regularly brings out product brochures, which explain the products and
contracts specifications of the commodities traded on the Exchange. These
brochures are also in the process of being translated and printed in Hindi,
Guajarati, Marathi, etc. Research reports on the economy, bullion and other
commodities are also brought out in an effort to disseminate information.
These brochures are also available on the Exchange's website.
Website
The Exchange's website www.ncdex.com contains a reservoir of
information on the processes and operations of the Exchange as well as the
Rules, Regulations and Bye-laws under which the Exchange is governed.
The website disseminates near real-time spot and future prices through a
ticker. It is updated regularly so that a visitor to the site is kept abreast of the
latest developments in the field of commodities. NCDEX firmly believes
that it would achieve its chief objective when the Indian farmer would be in
a position to choose his cropping pattern based on the futures prices
disseminated by the Exchange, rather than the practice of sowing a particular
crop based on current prices. The challenge is to first reach him and
convince him of the utility of adopting the futures prices to determine the
sowing pattern of crops. The Exchange does realize that with every passing
day it is moving a step closer to achieving this objective. Easing of certain
operational and legal hurdles would further hasten this process.
Future plans

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NCDEX constantly plans to widen the menu of products available for

trading to include, besides other agricultural products, base metals, plastics,
energy products and indices (including weather). Suitable regulatory
changes would be required before the Exchange could offer contracts in
some of these, especially with regard to electricity and indices. The idea is to
make available to the people the entire range of commodities and not be
restricted to a certain category of products. In fact, NCDEX over a period of
time aspires to become a globally all-encompassing commodity exchange
and be a platform whose prices would be a point of reference to all users not
only in the country but even globally.
Thus, NCDEX is committed to provide a world-class commodity exchange

platform for market participants to trade in a wide spectrum of commodity
derivatives driven by best global practices, technology, professionalism and
transparency.
Commodities versus other asset classes

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Stock Bonds Commodities
Primary Capital gains, Income in Entirely capital gain
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Objective although it earns primary and no income at all
income in form objective while except for possible
of dividend. a capital gain is asset lending
secondary income in bullion
and other rare cases.
Claim on They are claim They are claims They are short
on long lived on long lived maturity claims on
corporations. corporations or real assets
government
Storage Easily stored in Easily stored in Difficult in storing,
demat form or a demat form or a warehousing and
physical paper. physical paper transportation.
Concept of demat
account catching in
commodity
exchanges.
Securities Securities No such act is Securities
transaction act transaction act is applicable in transaction act is
and application applicable to case of bonds. not applicable to
equity markets commodity futures
trading. trading.
Benefits to firm Stock allows firs Bonds allow firs Commodity futures
to raise resources to raise allow firms to
to invest resources to obtain insurance for
invest the future value of
their outputs.
Benefits to High returns Stable returns Portfolio
investor and safety of diversification to
principal hedge risk
Price changes Price changes Price changes Price changes are
can also be due are a result of due to change in
S.K. SOMAIYA COLLEGE
to OF ARTS, SCIENCE
corporate inflation,AND COMMERCE 72
demand and supply
actions, dividend government
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Precious Metal: Gold
Gold – rare, beautiful and unique. Treasured as a store of value for 1000’s of
years, it is an important and secure asset. Paper currencies may come and go
but gold endures. It has maintained its long term value, is not directly
affected by the economic policies of the individual countries and does not
depend on a ‘promise to pay’
Gold as a safe heaven

Gold is among only a handful of financial assets that is not matched by a
liability. It can provide 'insurance' against extreme movements on the value
of traditional asset classes that can happen in unsettled times.
A different class of asset
Most investment portfolios are invested primarily in traditional financial

assets such as stocks and bonds, as shown in the table below:
Domestic International Domestic International Real

equities equities bonds bonds Cash estate Other
(%) (%) (%) (%) (%) (%) (%)
USA 47 13 33 1 1 2 3
UK 39 28 23 1 2 7 0
Japan 29 16 26 11 11 1 6
Source: UBS Global Asset Management - Pension Fund Indicators 2005

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The reason for holding diverse investments is to protect the portfolio against
fluctuations in the value of any single asset class.
Portfolios that contain gold are generally more robust and better able to cope
with market uncertainties than those that don't.
Adding gold to a portfolio introduces an entirely different class of asset.

Gold is unusual because it is both a commodity and a monetary asset. It is an
'effective diversifier' because its performance tends to move independently
of other investments and key economic indicators.
Recent independent studies have shown that traditional diversifiers (such as

bonds and alternative assets) often fail during times of market stress or
instability. Even a small allocation of gold has been proven to significantly
improve the consistency of portfolio performance during both stable and
unstable financial periods.
Improving stability and predictability of returns
Gold improves the stability and predictability of returns. It is not correlated

with other assets because the gold price is not driven by the same factors that
drive the performance of other assets.
The chart below shows the (lack of) correlation between returns on gold and
those of a number of the world's leading stock market indices:

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Analysis of the long run shows that returns on gold have moved
independently of returns on other assets for a long time and are likely to
remain uncorrelated because the factors that drive the gold price are quite
different from those that drive most other assets.
Gold is also significantly less volatile than many equity indices and most
commodities. In this respect it tends to behave more like a currency. Simply
by reducing portfolio volatility, enhanced returns can be expected as
demonstrated in the table below:

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portfolio 1 portfolio 2
(low volatility) (high volatility)
annual annual
return return
% value % value
initial value 10,000 10,000
9 10,900 -5 9,500
year end 1
year end 2 1 12,099 25 11,875
year end 3 9 13,188 5 11,281
year end 4 11 14,629 25 14,102
year end 5 9 15,956 -5 13,396
year end 6 11 17,711 25 16,746
arithmetic av. return 10% 10%
std. deviation 1.10% 16.43%
compund return 9.996% 8.972%
Including assets with low volatility in a portfolio will also help to reduce
overall risk. Volatility, or risk, is measured here as the extent to which asset
prices fluctuate during a given period.
The chart below compares the volatility of gold with that of oil and stocks
between 2002 and February 2006. The price volatility of gold is generally
similar to that of a blue-chip stock market index like the S&P 500. Increases
in volatility are generally associated with gold price rallies.

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Data: Global Insight, WGC
Gold can be used to manage a range of other risks that concern investors,
including exposure to dollar fluctuations and unanticipated inflation. This
versatility, and its longstanding history as a safe haven asset, attracts
investors around the world.
Gold as an alternative investment
In the search for effective diversification against a background of increasing

convergence among mainstream asset classes, investors are considering a
variety of non-traditional alternative investment vehicles. Prominent among
these are hedge and private equity funds, although gold, commodities,
timber and forestry, fine art and collectibles may also come under review.

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Investors should give careful consideration to each of these alternatives in

the light of their particular requirements and may choose to invest in several
of them.
Despite its relatively low expected returns gold offers superior

diversification with high liquidity and low cost.
Gold Supply and Demand – Q2 2006

• Investment demand for gold increased 19% in tonnage terms and 75%
in value terms year on year
• Gold jewellery demand reached a quarterly record of $11.4 billion
• Q2’06 total demand in tonnage terms decreased 16% year-on-year
• Q2’06 total demand rose 23% in dollar terms reaching a record of
$16.2bn
Data on the supply and demand for gold are compiled by GFMS
Ltd. The company provides a number of tables exclusively for the
World Gold Council. The following table shows a summary of
gold demand

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Energy Commodity: Crude Oil
Crude Oil
Crude, often refered to as ‘Black Gold’ is one of the heavily traded

commodities in the International scenario. The level of consumption of
crude by a country can be used as a proxy for measuring the economic
development.
Drivers of crude prices
• Demand and supply
OPEC is the largest producer of crude in the world. They control the
supply of crude by altering the output which is at present 24 million barrels
per day. Except Saudi Arabia all other members of OPEC are working at full
capacity. So there is not much scope for increase in supply. There is also a
question of how long the supply will last before the wells go dry.
On the demand side U.S is the biggest consumer of oil. The emerging
economies such as China and India have also emerged as leading consumers
of crude.
• Inventories
U.S.A has built up huge inventories of crude to meet the winter

demand and driving season demand. They are also the biggest importers of

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crude. Whenever the crude prices move to an economic level, the country
dips into its reserves to meet the domestic demand and replenishes the same
when the prices move down. India does not have such huge storage
arrangements and hence depends completely on its imports. Crude being the
highest value elements in our imports is a big factor affecting our Balance of
Payments (BOP).
• Refining
The imported crude will have to be refined to produce the consumable

form of Gasoline, ATF, Furnace Oil, Diesel etc for this every country will
have their own refineries setup. Some of the reason why the crude oil prices
went up is because of terrorist attacks on refining installations and natural
calamities like hurricanes, cyclones and tornadoes.

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Case Study
Sumitomo Corporation – its background
Sumitomo Corporation was originally established as Sumitomo Merchant

House in Kyoto in Japan in the 16th century. The fir was engaged in
smelting silver and copper. Three generations later, the fir had expanded into
banking by opening a money changing store in Osaka. The firm became a
prominent organization when it discovered copper mines in 1690. After few
centuries of successful business, the firm was incorporated as Sumitomo
Corporation in 1919.
Hamanaka Yasuo – the trader
Mr. Hamanaka Yasuo, local Japanese, joined Sumitomo Corporation in

April 1970 at its Tokyo head quarters as a clerk. By that time, the company
was engaged in large scale copper business activity. In 1973 or so, Mr
Hamanaka Yasuo was asked to help the marketing and hedging of the
company’s copper business. Five years later in 1978 he had become the head
of copper hedging trader.
Mr. 5 percent and Mr. Hammer – the nick names

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During this period, Hamanaka rose to fame through his clever market
dealings. He had earned a nick name “Mr. 5%”, reflective of the share of the
world copper market that he supposedly controlled on behalf of his
company, Sumitomo Corporation. He also had another nick name “Mr.
Hammer” to portray his ability to hammer the copper market. Obviously, the
corporation was very proud of his employee and his stature in the copper
market. Like our Harshad Mehta, in his hey days, Mr. Hamanaka also
featured in the cover page of various magazines and annual reports of the
company only to fall into disgrace soon.
The team – Mr. Shimizu Saburo and Mr. Hamanaka:
His trading success in copper market earned him a visit to London Metals
Exchange (LME) in late 1970’s to learn the metals trading through
exchanges. After learning the trading aspects of these metals he returned to
Japan, again to continue with his copper trading. By 1984, the copper
division of the company was headed by Mr. Shimizu Sarbro. R Hamanaka
joined the copper trading team headed by Shimizu. The team, by then, was
making unauthorized speculative futures contracts in copper. Unfortunately,
many of the deals were not successful and incurred losses. Naturally the
dealers were finding ways to hide their trading losses. To conceal the losses
and to protect their jobs, the duo entered into off-the-book deals.
Hamanaka – now Head of Trading
In 1987, Mr. Shimizu Saburo quit and Hamanaka took full control over
copper trading section. By then the losses had climbed to about US$58mn.

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The losses continued to grow further because he used to trade beyond limits
and also carrying huge positions on (LME), despite of the warnings from the
exchange due to his over trading. Simultaneously he started opening up fresh
windows for raising funds and for trading. Thu8s he started dealings with
Merrill Lynch, who advanced him US$150mn. This fund was not enough to
carry on his trade and hide his losses from huge positions. He had to find out
fresh avenues and methods to raise additional funds.
Unauthorized Funding
Accordingly in 1990, he began borrowing money against Sumitomo’s

copper stock to fund his trading positions. Also to create an impression of
trading success in management’s eyes he began to put through fictitious
options trade. By writing fictitious options, one can show income by way of
premiums and by way of buyer of options; you can show profits when your
strike price is shown to be advantageous compared to market rate. So, the
technique suitable to him was utilized to show fictitious profits through
options trade and this helped him to create better impression at the
management level and also to garner further independence from close watch,
while the losses were also hidden from head office. However actual cash
was not generated since most of the deals were fictitious. Hence he needed
actual funds to carry on his trade. Further he needed documents to support
his deals. However there were no documents to support his profit making
deals since they were all fictitious.
Backdated Fictitious deals

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Hence, Hamanaka used his London contracts and arranged backdated

fictitious invoices of trade for as much as US$350mn. From a U.S. metal
broker in London. The broker however notified the fictitious deals to LME,
which, in turn informed the Sumitomo Corporation about the wrong doing of
their employee, Mr. Hamanaka. By that time Hamanaka managed his
contacts with his bosses well. Sumitomo Corporation, instead of verifying
and ascertaining the true nature of the deals, merely replied the LME that
Hamanaka needed the invoice only tax reasons and not for any other
purpose.
Illegal trading/ borrowing and secret amount
Mean while during early 1990s, copper prices started sliding down in the
global market. As he was maintaining large long position in copper, his
losses continued to mount with the plunge in copper prices. He needed
additional funds to carry on his trade and to hide existing losses. He
therefore approached a Dutch bank viz. ING Bank and raised upto
US$100mn on the strength of forged signatures of his senior managers.
Simultaneously he started writing unauthorized put options to Morgan
Guaranty Trust, possibly in the hope of earning premium. But the sale of put
options in falling market conditions, without proper assessment of risk and
premium, had resulted into additional loss of $ 393mn. Also in 1994
Hamanaka entered into further unauthorized sale of puts and calls via
Morgan to raise US$150n and this deal lost him US$253mn.
To cover these losses, he managed to obtain funds from his Hong Kong
branch. Further he had put through unauthorized deals and earned premium.

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For hiding his trading losses, Hamanaka established several highly unusual
accounts, called B account, at a number of broking houses.
Commodities Futures Trading Commission & Securities Investment

Board
In 1995, Sumitomo owned and controlled up to 100% of LME warehouse

stock. As a result, the prices of copper futures contracts, copper spread price
differentials, and the prices of physical copper – both in the United States
and abroad – reached artificially high levels. This enabled Sumitomo to
capture large profits by allowing it to liquidate, lend or roll forward its large
position at a higher price or price differential. The high fluctuation in copper
prices led the US Commodities Future Trading Commission (CFTC) and the
securities Investment Board (SIB) of Britain to launch investigations into
usual fluctuation in copper prices. Now, you remember the power of an
uncontrolled individual or a single organization to manipulate the price of a
commodity at the global level. This type of trading pattern is not usual in
any market. Given the power of manipulation or financial muscle, a single
trader can move the market. It is particularly true, from past experience, in
cases of stock.
Discrepant bank statement – the clue & detection of fraud
Finally certain clue comes to light. In March 1996, Sumitomo discovered

that certain transactions shown in the bank statement received from a foreign
bank did not match the records in its treasury department. The discrepancy
in the statement related to credit of funds to its account from an unknown

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transaction. This possibly raised doubts about the happenings in domain of

Hamanaka.
His employer thereafter relieved Hamanaka of his trading duties and within
a month he confessed his every wrong doing. Six month after his sacking
from trading duties, Sumitomo Corporation announced that it had lost a total
of US$2.6 billion in unauthorized trading and hiding of losses by Hamanaka
The Loss
Enquiries and investigations revealed that Hamanaka forged signatures of

his seniors, maintained secret record of his off-the-books trading and
swindled about US$770mn through Sumitomo’s Hong Kong branch. Net
effect of all these wrong doings resulted in the loss of his position and 8
years in jail. The effect on the company was that it lost a cool US $ 2.6
billion
Penalty and Fine
At the same, the US Commodity and Futures Trading Commission and

Britain’s Securities Investment Board charged Sumitomo Corporation for
manipulation of copper prices through various trading methods and levied a
fine running upto $ 160mn. Like a drowning person dragging the helper
under the water, these regulatory bodies also charged Merrill Lynch in
helping Sumitomo carrying out illegal trade. This resulted into the former
paying $25mn fine to both the regulators in U.S and in Britain

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After the announcement of removal of Sumitomo’s copper trader

Sumitomo’s market dominance began to decline and also led to drop in
copper prices from $2800 to $2000 per metric ton levels.
Conclusion
What we see in India now is only the beginning as far as

commodity futures market goes. Internationally the commodity
markets are much bigger than the bond, equity and currency
markets. Days are not far off when the volumes in our domestic
commodity exchanges will outstrip the volumes in the other
markets. The government is pushing agricultural reforms at a fast
pace. Some of the reforms like VAT will rationalize the sales tax
across the country and will help build a unified market.
Against the backdrop of the dynamic economic scenario in the

country, in my opinion the topic chosen for this project is both
appropriate and timely.

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Bibliography
Books referred to
• ‘Options, Futures and Other Derivatives’ – John Hull
• ‘Introduction to Futures and Options Markets’ – John Kolb
• ‘Hot Commodities’ – Jim Rogers
• ‘Commodity Futures and Options’ – George Kleinman
Newspapers
• Economic Times
• Business Standard
Websites
• www.ncdex.com
• www.gold.org

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• www.nseindia.com
• www.bloomberg.com
• www.financialsense.com
• www.reuters.com

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SUBMITTED BY PRIYANKA MOHAN PISAT.

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 1

I take this opportunity to express my sincere thanks and gratitude to

I gratefully acknowledge the active interest and co-operation of my

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 2

Derivative products initially emerged, as hedging devices against

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 3

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 4

CHAPTER 1: Introduction to Derivatives

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 5

On the other hand, a merchant with an ongoing requirement of grains

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 6

would then negotiate happened to be futures-type contract, which would

In 1848, the Chicago Board Of Trade, or CBOT, was established to

Today derivatives contracts exist on variety of commodities such as

A derivative is a product whose value is derived from the value of one or

The Forwards Contracts (Regulation) Act, 1952, regulates the

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 7

Forward Markets Commission (FMC) continues to have jurisdiction over

• A security derived from a debt instrument, share, loan whether

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 8

Products, Participants and Functions

The farmer’s example discussed in the introduction was a case of

Speculators are participants who wish to bet on future movements

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 9

Arbitragers work at making profits by taking advantage of

Whether the underlying asset is a commodity or a financial asset, derivative

• Prices in an organized derivatives market reflect the perception of

• Derivatives, due to their inherent nature, are linked to the underlying

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 10

• Speculative traders shift to a more controlled environment of the

• An important incidental benefit that flows derivatives trading is that it

• Derivatives markets help increase savings and investment in the long

Derivative markets can broadly be classified as commodity derivative

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE AND COMMERCE 11

Emergence Of financial derivative products

Financial derivatives came into spotlight in the post 1970 period

Emergence of Commodity Derivatives

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Derivatives as a tool for managing risks first originated in the

Commonly Used Derivatives

A forward contract is an agreement between two entities to buy or sell the

A futures contract is an agreement between two parties to buy or sell the

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Options generally have lives of up to one year; the majority of options

Basket options are options on portfolios of underlying assets. The

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Swaps are private agreements between two parties to exchange cash

• Interest rate swaps

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Introduction to Commodity Markets

With liberalization measures in place, commodity markets in India are likely

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In a traditional market, agriculture produce would be brought and kept in the

In the system of traditional markets, shortages of a commodity in a given

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A Commodity is a product having commercial value, which can be

• The product has not gone through any complicated manufacturing

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• The product has to be fairly standardized to facilitate writing of

• Major consideration while buying a particular commodity is its

• Product should also be available in large volume.