Commodities Market in India

1. Executive Summary
Commodities form an essential part of daily lives of all individuals. Changes in commodity prices have a direct impact on households as they can lead to a fall or rise in their cost of living. Commodities are the raw materials which form the basic input to manufacturing industry. Thus even these industries are affected by the commodity fluctuations. With the establishment of online markets, commodities now offer investment opportunities. Any person can now trade for commodities just like shares and bond market. Historical events show that India is one the most ancient countries to trade commodities and derivatives market. Agricultural commodities, Oil, Gold and silver form an integral part of Indian society. The futures commodity market has shown a constant growth ever since its restart early 2000s. The gap between the equity markets and the commodity markets in India is closing down, but still the volumes traded are less as compared to the international exchanges. Since the period recession in 2008 the growth of commodity markets outperformed the equity markets. With some further reforms in the derivatives markets, there is tremendous potential for growth of this market in the country. This project focuses on the commodities exchanges in India with respect to different exchanges and commodities for trading, available trading mechanisms, regulations, comparison on Indian commodity derivative market vis--vis equity market and future prospects.

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2. Introduction
A market is described as a platform where buyers and sellers are allowed to trade, exchange goods, services, and information. Any type of trade can take place in a market. The two major dependent factors by which a market can operate are buyers and sellers.

2.1 Types of Market in India

Currency Markets - Currency markets are among the largest traded markets in the globe, on a continual basis. Money flows are continuous around the globe governments, banks, investors and consumers - all of them are involved in buying and selling currency round the clock.

Stock Markets - Stock markets seem to be the backbone of any economy allowing investors to buy and sell shares of various companies. Majority of the Indian stock markets are operating on an electronic network. Commodity Markets - In India, the commodity markets are starting to gain attention as the prices of the essential commodities steer the economy to a desired level. Commodity markets deal in energy, soft commodities and grains, meat etc. Debt Markets There are three main segments in the debt markets in India, (1)Government Securities (2) Public Sector Units (PSU) bonds and (3)Corporate securities. Debt market is predominantly a wholesale market, with dominant institutional investor participation. The investors in the debt markets are mainly banks, financial institutions, mutual funds, provident funds, insurance companies and corporates.

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2.2 Commodity and Commodity Trading

A commodity is a product that has commercial value, which can be produced, bought, sold, and consumed. India commodity market consists of both the retail and the wholesale market in the country. The wholesale market is the one where the commodities are bought from the producers and sold to the retailers by the wholesalers while in retail markets, retailers sell the goods bought from the wholesalers are sold to the end consumers. Commodities can also be traded on different exchanges which help in discovering the price of the commodity and mitigate risks. Earlier commodity trading was much more an unorganized one as all traders were required to a common place and call out bids. In those days the buyer would study the quantity of annual produce of the commodities and the sellers would calculate the approximate demands. There was speculation and dictating of terms. This was primarily because there was no research and techniques of trading speculation.

However, commodity trading has seen a radical change with it shifting to an organized set up in the form of the commodity exchanges. Actually futures commodity trading was banned for over forty years in this country because of varied reasons. And when this ban was lifted, no one could imagine the volume of trading it has invited. Commodity markets are similar to equity markets. The commodity market basically two constituents i.e. spot market and derivative market. In case of a spot market, the commodities are bought and sold for immediate delivery. In case of a commodities derivative market, various financial instruments having commodities as underlying are traded on the exchanges.

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2.3 History of Commodity Trading in India

The history of commodity markets have their roots way back to early civilizations where people used to barter different goods as per their needs. Commodity trading was initiated in India and gradually it became popular in the other parts of the world. Long years of foreign rule, natural disasters and calamities, lack of sound government policies caused the commodity trading gradually lose it sheen in the Indian subcontinent. Major breakthroughs have witnessed an early death due to political negligence and lack of strong will. The Bombay Cotton dealers Association was formed in 1855 marked the beginning of process of formalizing cotton trade in India. Some important events that took place in the commodity market are as follows:1875 - Bombay Cotton Trade Association Ltd. Set up the first organized futures market. 1900 - Futures trading in oil started 1920 - Futures trading in bullion began in Bombay. 1939 - Cotton derivatives banned 1952 - Forward Contracts (Regulation) Act enacted. 1953 - Forwards Markets Commission (FMC) established . 1963 - Futures trading in commodities banned. 1994 Kabra Committee recommendations 2002 NMCE established 2003 MCX and NCDEX established 2003 - Futures trading in commodities allowed again.

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2.4 Commodity Exchange

A commodity exchange is defined as an association that organizes trading in commodities. Due to speculative reasons commodity trading on exchanges was banned in India for almost 40 years. However in 2003 the ban was lifted and trading began on exchanges. The traditional system of open market place was replaced by computerized system with on-line trading facilities.

The national commodity exchanges in India are:

Multi Commodity Exchange of India Ltd, Mumbai (MCX). National Commodity and Derivatives Exchange Limited, Mumbai (NCDEX) National Multi Commodity Exchange of India Ltd , Ahemadabad (NMCE) Indian Commodity Exchange Limited, New Delhi (ICEX) Ace Derivatives and Commodity Exchange Limited, Mumbai

Some Regional Exchanges in India are:

NBOT (National Board of Trade), Indore Bikaner Commodity Exchange Ltd., Bikaner Bombay Commodity Exchange Ltd., Vashi Chamber Of Commerce, Hapur Central India Commercial Exchange Ltd., Gwalior Cotton Association of India, Mumbai East India Jute & Hessian Exchange Ltd., Kolkata First Commodities Exchange of India Ltd., Kochi Haryana Commodities Ltd., Sirsa India Pepper & Spice Trade Association., Kochi Meerut Agro Commodities Exchange Co. Ltd., Meerut Rajkot Commodity Exchange Ltd., Rajkot Rajdhani Oils and Oilseeds Exchange Ltd., Delhi Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar Spices and Oilseeds Exchange Ltd. Sangli

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Vijay Beopar Chamber Ltd., Muzaffarnagar

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2.5 Multi Commodity Exchange

Headquartered in Mumbai, Multi Commodity Exchange of India Ltd (MCX) is a state-of-the-art electronic commodity futures exchange. Started operations in November 2003 MCX holds a market share of over 80%* (87.3% during the nine months ended December 31, 2011 and 82.4% in FY2011) of the Indian commodity futures market MCX offers more than 40 commodities across various segments such as bullion, ferrous and non-ferrous metals, energy, and a number of agricommodities on its platform. The Exchange introduces standardised commodity futures contracts on its platform. Some rankings of MCX o o o The Exchange is the world's largest exchange in Silver The second largest in Gold, Copper and Natural Gas and The third largest in Crude Oil futures, based on the comparison of the trading volumes of our Exchange with those of the leading global commodity futures exchanges in the world, for the calendar year 2010 and the six months ended June 30, 2011. Trade Timings at MCX Normal Session: Days Monday to Friday Monday to Friday Time 10.00am to 5.00pm 5.00 pm to 11.30pm /11.55 pm Saturday 10.00 am to 2.00pm All commodities except Agri commodities All commodities CommodiesTraded

Special Session: Monday to Saturday: 9:45 a.m. to 9:59 a.m. Special Session (order cancellation session) is held to cancel the pending orders prior to opening of market.

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The Commodities traded on MCX are Bullions Gold Gold guinea Metals Aluminium Aluminium Mini Gold M Copper Energy ATF Brent Crude Oil Crude Oil Oil&OilSeeds Crude Palm Oil Refined Soya Oil Kapasia Khalli Melted Menthol Flakes Gold Petal Copper Mini Electricity Monthly & Weekly Gold petal (New delhi) Iron Ore Lead Gasoline Heating Oil Cereals Barley Potato (Agra) Potato (Tarkeshwar) Platinum Lead Mini Imported Thermal Coal Maize-Feed / Industrial Grade Sugar M Soya Bean Mentha Oil Others Almond Guar Seed

Silver

Mild Steel Ingot,Billets

Natural Gas

Wheat

Spices

Silver M Silver Micro

Nickel Nickel Mini Tin Zinc

Cardamom Coriander Turmeric

Plantations Rubber

Zinc Mini

Weather Carbon(CER) Carbon(CFI)

Fiber Kapas Cotton (29mm)

Pulses Chana

Trading System and margin calculation at MCX The best five buy and sell orders for every contract available for trading are visible to the market and orders are matched based on price time priority logic. For the purpose of computing and levying the margins, MCX uses SPAN (Standard Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based approach.

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Trading Window at MCX

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2.6 NCDEX
National Commodity & Derivatives Exchange Limited (NCDEX), a national level online multi commodity exchange, commenced operations on December 15, 2003. The Exchange has received a permanent recognition from the Ministry of Consumer Affairs, Food and Public Distribution, Government of India as a national level exchange. In just over two years of operations it posted an average daily turnover of around Rs 4500- 5000 crore a day (over USD 1 billion). The major share of the volumes come from agricultural commodities and the balance from bullion, metals, energy and other products. Trading is facilitated through over 850 Members located across around 700 centers (having ~20000 trading terminals) across the country. Most of these terminals are located in the semi-urban and rural regions of the country. Trading is facilitated through VSATs, leased lines and the Internet.

Trade Timings Monday to Friday 10.00 a.m.to 5.00 p.m. for agricultural products. Monday to Friday 10.00 a.m.to 11.30 p.m for metal and energy products. On Saturdays trade in all commodities takes place from 10.00 a.m. to 2.00 p.m

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Commodities Market in India

Commodities traded on NCDEX Metals Steel Copper Zinc Aluminium Nickel Precious Metals Gold Gold (100 gms) Gold International Silver Silver (5kg) Energy Crude Oil Thermal Coal Brent Crude Oil Natural Gas Gasoline Polymers CER Polypropylene Lead Silver International Heating Oil Linear Low density Polyethylene Platinum Polyvinyl Chloride Others CER

Spices

Oil and Oilseeds

Others agri

Plantation Products

Pepper Chilli

Castor Seed Sesame Seeds

Guar Potato

Seeds Rubber Coffee-Robusta Cherry AB

Jeera Turmeric Coriander Cereals Wheat Barley

Cotton Seed Oilcake Soya Bean Rened Soya Oil Soybean meal Mustard Seed Kachhi Ghani Mustard Oil

Mentha Oil Guar Gum Gur Almond

Cashew

Pulses Chana Masoor

Maize (Yellow/Red)

Rapeseed

Yellow Peas

Crude Palm Oil RBD Palmolein Groundnut in shell Groundnut Expeller Oil

Trading Window at NCDEX

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2.7 Performance of different commodities market

Turnover million MCX NCDEX NMCE ICEX ACE Others TOTAL 98,415,030 14,106,022 2,184,109 3,777,299 300,596 706,368 119,489,425 market share 82.4 11.8 1.8 3.2 0.3 0.6 100 Turnover million 63,933,025 9,175,847 2,279,015 1,364,254 59,794 835,610 77,647,545 market share 82.3 11.8 2.9 1.8 0.1 1.1 100 Turnover million 45,880,946 5,357,070 614,566 87,810 549,176 52,489,568 market share 87.4 10.2 1.2 0.2 1 100

India has over 7,000 regulated agricultural markets, or mandis, and the majority of the nations agricultural production is consumed domestically, according to the Agricultural Marketing Information Network. India is the worlds leading producer of several agricultural commodities. There are currently 21 commodity exchanges recognised by FMC in India offering trading in over 60 commodity futures with the approval of FMC. In the fiscals 2009, 2010 and 2011, the total value of commodities traded on commodity futures exchanges in India was Rs 52,489.57 billion, Rs 77,647.54 billion and ` 119,489.42 billion, respectively. The total value of commodities traded on commodity futures exchanges in India for the first nine months ended December 31, 2011 was Rs.137,228.55 billion

2.8 Background of some commodities

2.8.1 Agricultural Commodity Markets

India has a predominantly agrarian economy and its commodity markets have a long history. Indias agricultural commodity markets were initially formed when producers and buyers met at designated locations to trade in their produces. Indias wholesale spot markets for agricultural commodities have remained relatively unchanged. Agricultural commodities are predominantly traded in government-regulated wholesale markets or mandis. Mandis are often located in or near important towns

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or centres of production, consumption or shipping where sellers, buyers and intermediaries converge to buy and sell goods. Since almost all orders flow through the mandis, they are a source of daily information about the quantity of agricultural commodities and the price at which agricultural commodities trade for the respective geographic areas in which the mandis are located.

2.8.2 Non-Agricultural Commodity Industry in India

Energy products, precious metals like gold and silver and non-ferrous metals play a significant and vital role in the growth of the Indian economy. Some of the commodities which most actively traded on the exchanges (mostly MCX) are Gold: Nations have embraced gold as a store of wealth and a medium of international exchange, and individuals buy gold as insurance against the day-to-day uncertainties of paper money. Gold is also a vital industrial metal, used in electronics and other high-tech applications. Gold occupies an important role in India. Apart from being a symbol of wealth, many social and cultural elements of Indian culture are associated with gold. However, despite being the largest consumer of gold, the Indian market has limited influence on the price of gold bullion in the world markets as it is heavily dependent on imports and its markets are scattered across the country. Crude oil: Many markets are related with the global crude oil market in various ways. Crude oil is used for the production of a wide range of products from petrol, diesel, kerosene and from liquefied petroleum gas to naphtha and other petrochemicals products. According to provisional data from the oil industry statistics for fiscal 2011 and eight months ended November 30, 2011 as published by the Petroleum Planning and Analysis Cell of the Ministry of Petroleum and Natural Gas, a total of 163.13 MMT and 112.12 million metric tonnes (MMT), respectively, of crude oil, valued at Rs 4,536.34 billion and 4,152.38 billion respectively, was imported into India. Crude oil production in the country was 37.95 MMT and 25.53 MMT during fiscal 2011 and eight months ended November 30, 2011, respectively. (Source: Official website of Petroleum Planning and Analysis Cell, Ministry of Petroleum & Natural Gas). 14

Commodities Market in India

India imported 81.1% and 81.5% of its crude oil requirements during this fiscal 2011 and eight months ended November 30, 2011, respectively, and was highly exposed to global crude oil price movements. Silver: Silver is sought as a valuable and practical industrial commodity, and as an appealing investment. The largest industrial users of silver in India are in the photographic, jewellery, and electronic industries. Copper: Copper is the worlds third most widely used metal, after iron and aluminium, and is primarily used in highly cyclical manufacturing industries. In India, copper is the second most consumed non-ferrous metal, after aluminium. At present, the demand for copper minerals for primary copper production is met through two sources, namely copper ore mined from indigenous mines, and imported concentrates. The production of refined copper in India has increased considerably since the fiscal 1999 after private sector manufacturers started production of refined copper, and now a considerable portion of consumption is met through domestic production. According to the estimates of the Indian Copper Development Centre, in the fiscal 2010, refined copper usage in India was approximately 550,000 MT. (Source: Annual Report of the Ministry of Mines 2010-11).

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2.9 Exchange industry Growth in India

Commodity futures trading in India has grown since the Government of India issued a notification on April 1, 2003 permitting futures trading in commodities. The total value of commodities futures traded in India in the fiscal 2011 was Rs.119,489.42 billion, representing growth of approximately 90-fold from the value of commodity futures contracts traded in the fiscal 2004, which was Rs.1,293.67 billion. Commodity futures trading volumes have risen at a compound annual growth rate of 90.9% between fiscal 2004 and fiscal 2011. There are currently over 60 commodities futures that have been approved by the FMC for trading during the calendar year 2011 with gold, silver, crude oil, copper, zinc, nickel and natural gas comprising the majority of the trading turnover for the fiscal 2011.

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2.10 Global Commodity Derivatives Exchanges

Some of the global commodity market and the commodities traded are as follows NYMEX CBOT ICE CME Shanghai Futures Exchange Dalian Commodity Exchange Zhengzhou Commodity Exchange ICE Futures LME Tokyo Commodity Exchange Crude oil, Natural Gas, Gold Corn, Soybean, Wheat, Soyabean oil US Sugar, Coffee, Cotton, Cocoa Live Cattle, Lean Hogs, Feeder Cattle Copper, Rubber, Fuel oil, Zinc, Aluminium Soy Meal, Soy oil, Polyethylene, Soybeans no 1, Palm oil Sugar, Pure Terephthalic acid (PTA), Rapeseed oil, Wheat, Cotton UK Brent Crude oil, WTI Crude, Gasoil, Natural Gas UK Aluminium, Copper, Zinc, Nickel, Lead Gold, Platinum, Rubber, Gasoline

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2.11 Objectives
To study the commodity derivative market of India. To find differences between equity and commodity market. To compare the performance of commodity derivative market vis--vis equity market.

2.12 Methodology
The information was collected through secondary data sources during the project.

Real time futures market values from websites like MCX, NCDEX were used as examples to explain the theoretical concepts.

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3. Trading in Commodity Derivatives Market

3.1 Derivatives
Derivatives are contracts which derive their value from an underlying. The most commonly traded derivative instruments are forwards, futures, swaps and options. Forward Contracts: It is a simple derivative. These are promises to buy or sell an asset at a pre-determined date in future at a predetermined price. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties. Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counterparty risk i.e. the risk that one of the parties to the contract may not fulfill his or her obligation. Futures Contracts: A futures contract is an agreement between two parties to buy or sell an underlying at a certain time in future at a certain price. These are basically exchange traded, standardized contracts. The exchange stands guarantee to all transactions and counterparty risk is largely eliminated. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets. Options Contracts: Options give the buyer (holder) a right but not an obligation to buy or sell an underlying in future. Options are of two types - calls and puts. Summary of options is as follows: Options Buyer Seller Call Right to buy Obligation to sell Put Right to sell Obligation to buy

In forwards and futures both the parties (buyer and seller) have an obligation i.e. the buyer needs to pay for the underlying to the seller and the seller needs to deliver the underlying to the buyer on the settlement date. In case of options only the seller (also called option writer) is under an obligation and not the buyer. Incase the buyer of the option does exercise his right, the seller of the option must fulfill whatever is his obligation.

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Swaps: 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.

3.2 Commodity Derivatives in India

Commodity derivatives are the products where the underlying is any commodity. As in case of equity market, the price of derivative is driven by the spot price of the underlying commodity. The exchange provides the physical facilities and exercises surveillance on trading practices. At present trading in permitted only in futures, options are not traded on any of the commodity exchange in India. Futures are standardized contract settled on predetermined fixed future date with a standard quantity and quality of the underlying (commodity). A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The main standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change ie. Tick size Delivery center

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3.3 Futures Contracts: Terminology

3.3.1 Long Position :
It basically means Profit Buying of a futures contract. eg. A person has a bullish view for gold , 27500 Gold price then he may enter into a long position by buying futures contract. The payoff for such person is as shown in Figure1. The Strike Loss
Figure 1: Long Position on gold at 27500 per 10gm

price(K) is at 27500, if at the end of the contract the spot price(S) is more than the strike price the person will be in profit of amount that equals S minus K (S K). However if the prices reduce and at the end of the contract the spot price is lower than the strike price ie. (K > S) than he suffers losses of strike minus spot (K S).

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Profit

3.3.2 Short Position :

It basically means Selling of a futures contract. eg. A person has a bearish view for chana, then he may enter into a short position by selling futures contract. The payoff for such person is as shown in Figure 2. The Strike price (K) for 20th March 2012 is at 3700 per quintal, if at the end of the contract the spot price(S) is less than the strike price the person will be in profit of amount that equals K minus S (K S) However if the prices increase and at the end of the contract the spot price is higher than the strike price ie. (K > S) than he suffers losses of strike minus spot (K S). Loss
Figure 2 Short position on Chana

3700 Chana price/quintal

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3.4 Pricing of Commodity Futures

Investment Assets Versus Consumption Assets When considering forward and futures contracts, it is important to distinguish between investment assets and consumption assets. An investment asset is an asset that is held for investment purposes by signicant numbers of investors. Stocks, bonds gold and silver are some of the examples of investment assets. A consumption asset is an asset that is held primarily for consumption. It is not usually held for investment. Examples of consumption assets are commodities such as copper, oil, and pork bellies. It is not usually held for investment. Examples of consumption assets are commodities such as copper, oil, and pork bellies. For pricing futures we use The Cost Of Carry Model which is as follows F = S*er T where

F = Futures price S = Spot price r = Risk free interest rate or cost of financing T = Time till expiration Commodities however may involve storage cost as the exchanges have to hold the commodity till the end of the contract. In absence of any cost the above equation is used to calculate the future price of the underlying commodity. If there is any storage cost involved then, F = (S + U) * e
rT

where

U = Present value of all the storage cost involved

Eg. For silver

Spot price = 55000 / kg Days to expiration T = 30 days Risk free rate = 7% Cost of storage = Rs 300 for 30 days paid in advance Hence the futures price will be F = (55000 + 300 ) * e0.07 * 30/365 F = Rs. 55619

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Scenario 1: (Cash and Carry arbitrage)

If the price of the futures contract is more than 55619 then theoretically, the futures are said to over priced and thus it creates an arbitrage opportunity.

Suppose Futures are trading at 55700 then one can earn riskless profit as follows: 1) Borrow an amount of S+U at risk free interest rate and Buy in spot market 2) Sell the futures

If contract closes at 55650 Cost = 55000 + 300 = 55300 Futures = 55700 Profit in spot = 350 Profit in futures = 50 Net profit = Rs. 400 Sell in spot at 55650 and return the borrowed amount If contract closes at 55800 Cost = 55000 + 300 = 55300 Futures = 55700 Profit in spot = 500 Loss in futures = 100 Net profit = Rs. 400 Sell in spot at 55800 and return the borrowed amount If contract closes at 55100 Cost = 55000 + 300 = 55300 Futures = 55700 Loss in spot = 200 Profit in futures = 600 Net profit = Rs. 400 Sell in spot at 55100 and return the borrowed amount

Scenario 2: (Reverse Cash and Carry arbitrage)

If the price of the futures contract is less than 55619 then theoretically, the futures are said to under priced and it creates an arbitrage opportunity.

Suppose Futures are trading at 55200 then one can earn riskless profit as follows: 1) Sell in spot market saving storage cost and invest the amount in risk free asset 2) Buy the futures

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If contract closes at 55550 Cost = 55000 + 300 = 55300 Futures = 55200 loss in spot = 250 Profit in futures = 350 Net profit = Rs. 100 Buy in spot at 55550 if required.

If contract closes at 56000 Cost = 55000 + 300 = 55300 Futures = 55200 Loss in spot = 700 Profit in futures = 800 Net profit = Rs. 100 Buy in spot at 56000 if required.

If contract closes at 49500 Cost = 55000 + 300 = 55300 Futures = 55200 Profit in spot = 5800 Loss in futures = 5700 Net profit = Rs. 100 Buy in spot at 49500 if required.

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3.5 Pricing Futures Contracts on Consumption Commodities

We used the arbitrage argument to price futures on investment commodities. For commodities that are consumption commodities rather than investment assets, the arbitrage arguments used to determine futures prices need to be reviewed carefully. Suppose we have F > (S + U) * e
rT

To take advantage of this opportunity, an arbitrager can implement the following strategy: 1. Borrow an amount S+U at the risk-free interest rate and use it to purchase one unit of the commodity and pay storage costs. 2. Short a forward contract on one unit of the commodity. If we regard the futures contract as a forward contract, this strategy leads to a profit of F-(S+U) * erT at the expiration of the futures contract. As arbitragers exploit this

opportunity, the spot price will increase and the futures price will decrease until the equation does not hold good. Suppose next that F < (S + U) * erT In case of investment assets such as gold and silver, many investors hold the commodity purely for investment. When they observe the inequality , they will find it profitable to trade in the following manner: 1. Sell the commodity, save the storage costs, and invest the proceeds at the riskfree interest rate. 2. Take a long position in a forward contract. This would result in a profit at maturity of (S + U) * erT - F relative to the position that the investors would have been in had they held the underlying commodity. As arbitragers exploit this opportunity, the spot price will decrease and the futures price will increase until equation does not hold good. This means that for investment assets, equation holds good. However, for commodities like cotton or wheat that are held for consumption purpose, this argument cannot be used. Individuals and companies, who keep such a commodity in inventory, do so, because of its consumption value - not because of its value as an investment. They are reluctant to sell these commodities and buy

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forward or futures contracts because these contracts cannot be consumed. Therefore, there is unlikely to be arbitrage when equation holds good. In short, for a consumption commodity therefore, F <= (S + U) * e
rT

That is the futures price is less than or equal to the spot price plus the cost of carry.If storage costs are expressed as a proportion u of the spot price, the equivalent result is F <= S * e(r+u)* T

3.6 Convenience Yields

We do not necessarily have equality in the above equations because users of a consumption commodity may feel that ownership of the physical commodity provides benets that are not obtained by holders of futures contracts. For example, an oil rener is unlikely to regard a futures contract on crude oil in the same way as crude oil held in inventory. The crude oil in inventory can be an input to the rening process, whereas a futures contract cannot be used for this purpose. In general, ownership of the physical asset enables a manufacturer to keep a production process running and perhaps prot from temporary local shortages. A futures contract does not do the same. The benets from holding the physical asset are sometimes referred to as the convenience yield provided by the commodity. If the amount of storage costs is known and has a present value U, then the convenience yield y is dened such that F * eyT = (S + U) * erT If the storage costs per unit are a constant proportion, u of the spot price, then y is dened so that . F * eyT F
= =

S * e(r+u)* T
(r+u-y)* T

OR

S*e

For investment assets the convenience yield must be zero; otherwise, there are arbitrage opportunities. The convenience yield reects the markets expectations concerning the future availability of the commodity. The greater the possibility that shortages will occur, the higher the convenience yield. If users of the commodity have high inventories, there is very little chance of shortages in the near future and the convenience yield tends to be low. 27

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On the other hand, low inventories tend to lead to high convenience yields. The Futures Basis The cost-of-carry model defines the relationship between the futures price and the related spot price. The difference between the spot price and the futures price is called the basis. As a futures contract nears expiration, the basis reduces to zero. This means that there is a convergence of the futures price to the price of the underlying asset. If the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage opportunity for traders. This will lead to a profit equal to the difference between the futures price and spot price. Traders start using this arbitrage opportunity, demand for the contract in spot will increase ie. Spot price will increase & he will short futures and prices will fall leading to the convergence of the future price with the spot price. If the futures price is below the spot price during the delivery period all parties interested in buying the asset will take a long position. The trader would buy the contract and sell the asset in the spot market making a profit equal to the difference between the future price and the spot price. As more traders take a long position the demand for the particular asset would increase and the futures price would rise nullifying the arbitrage opportunity. Contango refers to a situation where the future price of a commodity is higher than the spot price. A contango is normal for investment asset which has cost of carry. A contango should equal the cost of carry because the producers and consumers compare the futures price against the spot price plus storage cost.

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3.7 Participants in Futures market

There are 3 types of participants in futures markets namely 1) Hedgers. 2) Speculators 3) Arbitragers

3.7.1 Hedgers
These are people with a present or anticipated exposure to a commodity which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management . Hedger tries to avert the unfavorable risk he may face in the future. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.

The holders of the long position in futures contracts (buyers of the commodity), are trying to secure as low a price as possible eg. A manufacturer who might need raw materials after 3 months finds them trading at a low price will enter into a long position. This is called as long hedge. Cotton in spot market is trading at Rs.782 per 20 kg cotton April 2012 Futures is trading at Rs.857 per 20 kg cotton

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Company will require cotton in April and fears prices will rise further. Hence it can lock the buy price. The company buys 1 future contract of 1 lot @ 857*200 = Rs.171400. Profit Long in futures 857 Cotton price

Short position to close long position

Loss

Case1: Spot on the last day is 860. Futures will the same ie. Company closes contract at 860. Company buys in spot at 860 . Total Cost =Rs.172000 and receives profits from futures of Rs. 3 (860-857). Total receipt =Rs 600. Net Cost = Rs.171400 Case2: Spot on the last day is 840. Futures will the same ie. Company closes contract at 840. Company buys in spot at 840 .Total Cost =Rs.168000 and suffers losses from futures of Rs. 17 (840-857). Losses = Rs 3400. Net Cost = Rs.171400

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The short holders of the contract (sellers of the commodity) will want to secure as high a price as possible. eg. A farmer who produces a crop that is currently trading at a higher price and has a view that in coming months due to increased supply of the crop , the prices might Profit reduce will enter into a Long position to close short position short hedge. Pepper in spot market is trading at Rs.37610 per quintal 37835 Pepper price June 2012 Futures is trading at Rs.37835 per quintal The farmer fears prices
Short position

might fall further. Hence he short hedges.

Loss Short 1 Futures contract @ 37835

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Case1: Spot on the last day is 37800. Futures will the same ie. farmer closes contract at 37835. Farmer sells in spot at 37800 .Total sell value = Rs.378000 and receives profits from futures of Rs. 35 (37835 - 37800). Total receipt =Rs 350. Net receipt = Rs.378350

Case2: Spot on the last day is 38840. Futures will the same ie. Farmer closes contract at 38840. Farmer sells in spot at 38840 .Total sell value =Rs.388400 and suffers losses from futures of Rs. 1005 (37835 - 38840). Losses = Rs 10050. Net receipt = Rs.378350

The commodity contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. By means of futures contracts, Hedging can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold. A Hedger can be Farmers, manufacturers, importers and exporter.

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3.7.2 Speculator
These persons are basically high risk takers. They have a view on the direction of the market and buy or sell in futures / option market to try and make profits of the market movement. Speculation of commodities is different from that of speculation of equity speculation. A person can speculate a direction of companys movement , buy the shares and keep it with him as long as wants. But commodities involve various storage costs associated with them. With availability of derivatives any person can speculate the prices of commodities, even if he doesnot hold the commodity as some derivatives are available with option of cash settlement rather than physical delivery. Entry into the futures market will only involve the person to deposit margin money with corresponding exchange. The speculation logic may be of demand supply logic of the commodities.

Eg1. Due to political tensions between the western world and Iran, one can speculate Crude oil prices can move up in near future. A speculator thus being bullish on Crude oil can buy the futures contract. This strategy is Bullish security, buy futures. Spot price of Crude oil on MCX 5266 / barrel March Futures Trading at 5321 / barrel

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Commodities Market in India

The speculator buys one contract ie. 100 barrels of crude oil, he pays an initial margin for entering into the contract.

Profit

Long futures At the end of contract the spot and futures close at 5355 / barrel. 5321 Speculators profit = Crude price 5355 * 100 - 5321 * 100

Speculators profit = Rs 3400 Loss

This profit is exclusive of other transaction costs involved in carrying out the trade.

Eg2 If a speculator feels that that due excessive production or reduction in demand of a particular commodity , the prices may fall in the near future than he can sell the future contract of the commodity and earn profits

Spot price of gur = 1031 March futures trading at 1066

Speculator belives that due to excessive supply the prices may fall in the near future.

Even though he does produce Gur, because of futures market availability he can just sell the futures trading at 1066.

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The speculator sell 1 futures contract worth of Rs.266500 (1066*10000/40). In futures market he Profit Short futures only has to pay an initial margin to enter into a futures contract. If he gets his bet correct 1066 Gur price and the value of gur falls to 1050, the profit he earns will be = (1066-1050) * (10000/40) = Rs. 4000 Loss

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3.7.3 Arbitrageurs
They take positions in markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit.

The arbitrage condition is possible if:1) If the price of the same commodity is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. 2) The futures price of a commodity is theoretically different from the calculated spot price plus the carry cost compounded using risk free interest rate. This activity termed as arbitrage, involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices.

The buying cheap and selling expensive continues till prices in the two markets reach an equilibrium. Hence, arbitrage helps to equalize prices and restore market efficiency. The arbitrageur can make the use of cash and carry arbitrage and reverse cash and carry arbitrage explained earlier in pricing of futures, to earn riskless profits. The summary of them is as follows: Cash and carry 1)Borrow an amount at risk free interest rate and Buy in spot market 2)Sell the futures Reverse Cash and carry 1)Sell in spot market saving storage cost and invest the amount in risk free asset 2)Buy the futures

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3.8 Trading in Futures

3.8.1 Trading methods
Trading on exchange takes place in following manner 1) Open out cry 2) Electronic trading Open Out Cry system While most exchanges the world over are moving towards the electronic form of trading, some still follow the open outcry method. Open outcry trading is a face-to-face and highly activate form of trading used on the floors of the exchanges. In open outcry system the futures contracts are traded in pits. A pit is a raised platform in octagonal shape with descending steps on the inside that permit buyers and sellers to see each other. Normally only one type of contract is traded in each pit like a Eurodollar pit, Live Cattle pit etc. Each side of the octagon forms a pie slice in the pit. All the traders dealing with a certain delivery month trade in the same slice. The brokers, who work for institutions or the general public stand on the edges of the pit so that they can easily see other traders and have easy access to their runners who bring orders. Chicago Mercentile Exchange follows open cry system as well as electronic trading system.

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Electronic Trading Electronic trading offers significant advantages like: a) Easy accessibility to remote investors in real time. b) Improved efficiency. c) Low transaction cost. d) Greater transparency. e) Automated transaction. The orders are placed in the system by the broker. The host computer matches bids with offers according to the pre-determined rules. In a simplest case if a trader places a buy order equal to or higher than the sell order matching occurs and the host computer automatically executes the order. Trading at MCX The Trader Work Station (TWS) is the application through which members access the trading platform, place orders and execute trades. The TWS offers a multitude of user friendly trading features which include commodity price ticker, market watch screen displaying best buy, best sell, last traded price, volume for the day, open interest etc,top gainer and loser contracts, net position, on-line back up facility etc Trading System The best five buy and sell orders for every contract available for trading are visible to the market and orders are matched based on price time priority logic. Orders can be placed with time conditions and/ or price conditions Trading at NCDEX The trading system on the NCDEX, provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The Exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities. The Exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. 38

Commodities Market in India

When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.

3.9 Orders in Futures Market

Customers can place different type of orders with brokers. The instructions given by the clients should be clearly specified in terms of a) Buy or sell b) Number of contracts. c) Type of commodity d) Month of contract. e) Price. f) Period of validity.

g) Validity of order. Some important orders used in futures market are 1) Market Order 2) Limit Order 3) Stop - loss order 4) Time Order 5) Spread order 6) Exchange for physicals Orders used at MCX 1) Time related Conditions a. DAY order b. GTC - A Good Till Cancelled (GTC) order c. GTD - A Good Till Date (GTD) order d. IOC - An Immediate or Cancel (IOC)

2) Price Conditions a. Limit Order b. Market Order 39

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Orders used at NCDEX 1) Time conditions a. Good till day order b. Good till cancelled (GTC): c. Good till date (GTD) d. Immediate or Cancel (IOC) e. All or none order 2) Price conditions a. Limit order b. Stop-loss 3) Other conditions a. Market price b. Trigger price c. Spread order Note : Meanings of all the orders are mentioned in appendix

3.10 Margin requirement for futures.

To enter in to a futures contract every member has to deposit a particular amount. This amount is called as margin. It has to be deposited by both buyer and sellers of futures contract. Margin in futures is not a complete down payment value as in securities spot market but it is kind of bond. The margin varies from one contract to another and they are set by the respective exchanges depending on the volatility of the commodity. Kinds of margin in general: 1) Initial margin: This amount is deposited by the customer while entering into a contract. Initial margin is collected by the clearing agency for

allowing members to take positions on their own behalf or on behalf of their clients. In a rough sense, a clearing agency assumes that everyone in the market is going to default on his/ her position at the end of the day. 2) Maintenance margin: Maintenance margin is lower than initial margin and is minimum amount that must be present in the account of the customer who has entered into a futures contract .If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level.

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3) Additional margin: It is a precautionary step taken by the exchange if it fears that market has become very volatile and there might payment crisis. 4) Mark-to-Market margin: At the end of each trading day, the margin account is adjusted to reflect the trader's gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day's movement. Based on the settlement price, the value of all positions is marked-to-market each day after the official close. i.e. the accounts are either debited or credited based on how well the positions fared in that day's trading session. If the account falls below the required margin level the clearing member needs to replenish the account by giving additional funds or closing positions either partially/ fully. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades. 5) Margin for Calendar Spread positions: Calendar spread is defined as the purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity by a client/ member. Since price moves across contract months do not generally exhibit perfect correlation, calendar spread margin is imposed to cover the calendar basis risk that may exist for portfolios containing contracts with different expirations.

These margins and some other margins are levied by both MCX and NCDEX.

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3.11 Clearing and Settlement of futures contract

3.11.1 Clearing
Clearing of trades that take place on an Exchange happens through the Exchange clearing house. A clearing house is a system by which Exchanges guarantee the faithful compliance of all trade commitments undertaken on the trading floor or electronically over the electronic trading systems. The main task of the clearing house is to keep track of all the transactions that take place during a day so that the net position of each of its members can be calculated. It guarantees the performance of the parties to each transaction. Typically it is responsible for the following: 1. Effecting timely settlement. 2. Trade registration and follow up. 3. Control of the open interest. 4. Financial clearing of the payment flow. 5. Physical settlement or financial settlement of contracts. 6. Administration of financial guarantees demanded by the participants. The clearing house is a guarantor for all transactions that take place in the exchange and it stipulates margins to manage the default risk. Depending on a day's transactions and price movement, the members either need to add funds or can withdraw funds from their margin accounts at the end of the day as calculated by the clearing house. Thus clearing house will never have any open position in the market. National Commodity Clearing Limited (NCCL) undertakes clearing of trades executed on the NCDEX. After the trading hours on the expiry date, based on the 42

Commodities Market in India

available information, the matching for deliveries takes place firstly, on the basis of locations and men randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. MCX has an in house clearing house which monitors and performs all activities relating to delivery, fund settlement, margining and managing the settlement guarantee funds. It operates a well-defined settlement cycle to ensure no deviations or deferments from this cycle.

3.11.2 Settlement
Futures contracts have two types of settlement, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX daily mtm settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respecting clearing bank. All position of a CM, either brought forward, created during the day or closed out during the day, are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. On the date of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement is on a trading cum clearing members for all the trades done on own account and his clients trades. A professional clearing member is responsible for settling all the participant trades which he has confirmed to the exchange. On the expiry date of a futures contract, member submits delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. NCDEX on receipt of such information and arrives at a delivery position for a member for a commodity. 43

Commodities Market in India

The seller intending to make delivery takes the commodity to the designated warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contracts specification with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouse ensures that the recipes get updated in the depository system giving a credit in the depositors electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyers clearing member. On an appointed date, the buyer goes to the warehouse and takes physical possession of the commodities.

3.11.2.1 Settlement Mechanism

Settlement of commodity futures contracts is a little different from settlement of financial future which are mostly cash settled. The possibility of physical settlement makes the process a little more complicated. Daily mark to market settlement Example of calculation of mark to market Spot Price of Sugar = Rs.2903 / 100 kg Futures price for 15/03/2012 contract = Rs. 2855 /100 kg Trading unit = 10 metric tonne

long 10-Mar-12 11-Mar-12 12-Mar-12 13-Mar-12 14-Mar-12 15-Mar-12

2855 2857 2858 2864 2861 2866 2859 Total

MTM +2 +1 +6 -3 +5 -7 +4

Total profit = 4 * 100 = Rs 400 44

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short 10-Feb-12 11-Feb-12 12-Feb-12 13-Feb-12 14-Feb-12 15-Feb-12

2855 2852 2857 2860 2855 2856 2850 Total

MTM +3 -5 -3 +5 -1 +6 +5

Total profit = 5 * 100 = 500

Final settlement On the date of expiry, the final settlement price is the spot price on the expiry day. It is final price at which the contract is closed down. All open positions in a futures contract cease to exist after its expiration day. The settlement price may be varied by the exchange if it finds the trading of commodity was volatile in the last trading days.

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3.11.2.2 Settlement Methods

Settlement of futures contracts can be done in three ways:

1) Physical delivery of the underlying commodity For open position on the expiry date of the contract, the buyer and the seller can announce intention for delivery. Deliveries take place in the electronic form. All the other position are settled in cash. When a contract comes to settlement, the exchange provides alternatives like delivery place, month and quality specifications. Trading period, delivery date etc. are all defined as per the settlement calendar. A member is bound to provide delivery information. If he fails to give information, it is closed out with penalty as decided by the exchange. The delivery place is very important for commodities with significant transportation costs. The exchange also specifies the precise period (date and time) during which the delivery can be made. For many commodities, the delivery period may be an entire month. The party in the short position (seller) gets the opportunity to make choices from the above alternatives. The exchange collects delivery information. Then the exchange selects a party with an outstanding long position to accept delivery. After the trading hours on the expiry date, based on the available information, the matching for deliveries is done, firstly, on the basis of locations and then randomly keeping in view factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time.

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2) Closing out by offsetting positions Most of the contracts are settled by closing out open position. In closing out, the opposite transaction is effected to close out the original future position. A buy contract is closed out by a sale and a sale contract is closed out by a buy. For example, Spot for almond is Rs.365 an investor who takes a long position in one

almond futures contract for 30/4/2012 at 364.5, can close his position by selling one almond futures contracts on 27/04/2012 suppose that Rs.370 is the futures price on that date. Trading unit for almond at MCX is 500 kg. Futures contract value = 364.5 * 500 = 182250 Close out price = 370 * 500 = 185000 Profit = 2750 This profit will be credited in his margin account by way of MTM at the end of each day, and finally at the price that he closes his position, that is Rs.370 in this case.

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3) Cash settlement Contracts held till the last day of trading can be cash settled. When a contract is settled in cash, it is marked to market at the end of the last trading day and all positions are declared closed. The settlement price on the last trading day is the price closing spot price of the underlying commodity ensuring the convergence of future prices and the spot prices. For example On MCX Spot price of Cardamom = Rs.845 and an investor takes a short position in one cardamom futures contracts expiring on 15/03/2012 at Rs.968 / kg. On 15/03/12 the last trading day of the contract, suppose the spot price is Rs.970/ kg. This is the settlement price for his contract. Trading unit for cardamom is 100 kg. As a holder of a short position on cardamom, he does not have to actually deliver the same, but he suffers a loss of Rs.200 (968 * 100 970 *100).This amount is debited from his account

Settlement dates at MCX and NCDEX Daily Mark to Market settlement where 'T' is the trading day Mark to Market Pay-in (Payment): T+1 working day. Mark to Market Pay-out (Receipt): T+1 working day. Final settlement for Futures Contracts The settlement schedule for Final settlement for futures contracts is given by the Exchange in detail for each commodity. Timings for Funds settlement: Pay-in: On Scheduled day as per settlement calendars. Pay-out: On Scheduled day as per settlement calendars.

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3.12 Regulation of commodity exchanges

The Forward Contracts (Regulation) Act, 1952 (FCRA) is the principal legislation for the commodity futures market in India. The FCRA and the Forward Contracts (Regulation) Rules, 1954 (FCRR) provide for the regulation of commodity futures trading under a three-tier system, which consists of the following governing bodies: the Department of Consumer Affairs, Ministry of Consumer Affairs Food and Public Distribution FMC and an Exchange or Association recognised by the Central Government on the recommendation of FMC. FCRA exercises overall regulatory supervision over the commodity exchanges, and also has the authority to grant or withdraw recognition of any commodity exchange. The FMC (Forwards Market Commission) was set up in 1953. Most of the regulatory powers of the Central Government were delegated to the FMC. The FCRA categorizes commodities into 3 categories for purposes of regulation: commodities in which forward trading can be undertaken through a recognized association commodities in which forward trading is prohibited and commodities which have neither been regulated for being traded under the recognized association nor prohibited. Such commodities are referred to as free commodities and the associations dealing in such free commodities are required to obtain a certificate of registration from the FMC for trading thereof.

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3.12.1 Forward Markets Commission

Establishment of the FMC The FMC has its headquarters at Mumbai and a regional office at Kolkata. Under the FCRA, it is stipulated that the FMC shall consist of A Chairman Two members from amongst the officials of the Ministries or Departments of the Central Government dealing with Consumer Affairs, Commodity Derivatives, Food and Public Distribution, Agriculture or Finance One member from amongst the officials of the Reserve Bank, Five other members of whom at least three shall be the whole- time members

Functions of the FMC: To advise the Central Government in respect of matters arising out of the administration of the FCRA To grant or withdraw recognition of any association To keep forward markets under observation and to take such action in relation to them as it may consider necessary, in exercise of the powers assigned to it by or under the FCRA To collect and publish information regarding the trading conditions in respect of goods including information regarding supply, demand and prices,etc To make recommendations generally with a view to improving the organisation and working of forward markets Impose circuit filters on commodities and keep a watch on volatility To regulate the functioning of members of the associations, clearing houses, warehouses and intermediaries To levy fees for carrying out the purposes of the FCRA To conduct research for the purpose of development and regulation of commodity derivatives market To protect the interests of the market participants in commodity derivatives markets To prohibit fraudulent and unfair trade practices relating to commodity derivatives markets

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To prohibit insider trading in commodity derivative

Supervision The FMC has powers to conduct inspection of accounts of the exchanges and their members and to inquire into the affairs of the exchanges. In addition, the FMC shall have the power to suspend member of recognised association or to prohibit him from trading; supercede governing body of recognised association and power to suspend business of recognised associations.

Penal Provisions The FCRA provides for penal provisions in relation to offences involving contravention of the FCRA and most offences under the FCRA constitute cognizable offences. The powers of search, seizure and investigation are with the respective state police authorities.

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3.13 Difference Between Commodity And Financial Derivatives

There are some features which are very peculiar to commodity derivative markets. Those are as follows Physical Settlement Financial derivatives are cash settled but commodity derivative may be cash settled or may involve a physical settlement. The seller will have to deliver the goods to the warehouse and the buyer has to collect it from the there. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations.

Warehousing As the case of physical settlement arises, the exchange requires to make an arrangement with warehouses to handle the settlements. Such warehouses must have requisite infrastructure and take all precautionary measures for storing the commodities.

Quality of Underlying Assets When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the Exchange stipulate the grade or grades of the commodity that are acceptable. Trading in commodity derivatives also requires quality assurance and certifications from specialized agencies. In India, for example, the Bureau of Indian Standards (BIS) under the Department of Consumer Affairs specifies standards for processed agricultural commodities. AGMARK, another certifying body under the Department of Agriculture and Cooperation, specifies standards for basic agricultural commodities.

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Importance of offsetting positions In equity derivatives if the member has open positions at the end of the contract, the difference will be settled in cash. But in commodity futures contract if the contract is of compulsory delivery type and the member does not reverse his position before the end of the contract than he will have to deliver or collect the goods.

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3.14 Commodity v/s Equity derivatives

Ever since the first national level commodity exchange was introduced in 2003, commodity exchanges have seen an exponential growth. In the last fiscal, that is, 2010-11 the total turnover of the Indian commodity markets was approximately Rs.112.52 trillion, an increase of more than 50% as compared to the year 2009-10. Following the sharp surge in turnover and trade volumes in recent years, the stakes in commodity trading are higher than ever before. Investment and trading in commodities is now considered a good alternative investment in the country.

Growth in the commodity market as compared to the equity market The Indian commodity futures volumes have grown 5.5 times from Rs.20.53 trillion in 2005-06 to Rs.112.52 trillion in 2010-11. Currently, the average monthly volume on the Indian commodity exchanges is Rs.6 trillion. MCX leads the industry, followed by NCDEX. MCX is not only number one in India but has achieved some global milestones too. It was the largest exchange in silver (in terms of number of futures contracts traded in 2010), number two in gold, copper and natural gas and number three in crude oil. When we say India is the largest exchange in silver, it is a great achievement for the Multi Commodity Exchange. The Indian agricultural commodities market has futures contracts of commodities such as black pepper, cumin seed, mentha oil and many more which are internationally traded but only listed in India, internationally traders tend to consider these as benchmark rates. For example, exporters from Vietnam, the largest producer of black pepper, are keeping a close watch on Indian pepper futures. Slowly but steadily the Indian commodity market is laying a strong foundation for a takeoff in the near future.

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Turnover Growth of Indian commodity Exchanges

in Rs Trillions

120 112.52 100

80

73.3

60 39.01

52.21

40 20.53 20

34.6

0 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

From Rs.20 trillion, the volumes have reached Rs.112.52 trillion in FY10-11and it has been a futures market, without Options. Foreign institutional investors, domestic institutions, banks and insurance companies are not allowed to trade on the Indian commodity bourses and a majority of volumes come from jobbers, arbitrageurs, retail traders and small scale enterprises and corporates (for hedging). Even portfolio management services are not permitted. Globally, commodity derivatives volumes are 35x-40x of the physical market but in India it is just 4x. As the number of participants is increasing by the day and the overall interest in commodity futures market among traders and investors is increasing rapidly, the growth potential of this market is immense.

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Turnover Growth of Indian Equity Exchanges

in Rs Trillions

350 300 250 200 150 100 50 0 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 48.24 74.15 133.52 110.22 176.63 292.48

Comparison of equity and commodity markets.

100.00% 80.00% 60.00% 40.00% 20.00% 0.00% 2006-07 2007-08 2008-09 2009-10 2010-11 -20.00% -40.00% Commodity Equity

While the turnover in the equity derivatives segment has grown at a CAGR of 21.70% since FY08, the turnover in the commodity futures market has grown at a CAGR of 30.32% in the same period.

Over the last few years, the equity market has seen turbulent times due to the meltdown in the global financial markets. In FY09, the equity derivatives turnover 56

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had fallen from Rs.133.32 trillion in 2007-08 to Rs.110.22 trillion in 2008-09, a fall of 21%. On the other hand, the commodities market has seen a steady growth rate over the years. Being in a nascent stage, the commodities futures market is catching up rapidly with equities and in the coming years, it has the potential to equal or surpass the equity turnover.

Reasons for growth of commodities volumes

The reason for the rising trade volumes on the Indian commodity futures exchanges are: They provide an efficient platform for hedging against price uncertainty and global volatility. The exchanges provide transparent price discovery and hedging platform for trading futures contracts of different commodities. On these exchanges, the fair value prices are determined through active participation of a large number of stakeholders of the commodity value chain, who have access to information on the demand and supply conditions.

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3.15 Future Prospects of Indian Commodity exchange.

Introduction of option contracts: Option contracts are currently not allowed on the Indian exchanges. If these contracts are introduced, the trading volumes will definitely increase. Allowing for institutional investors participation: FIIs are not allowed to participate in commodity exchanges, with their participation there will be benefits like more liquidity, better practices, global experiences etc. But they also have some risks involved like concentration and control over crucial commodities, withdrawal from markets etc. Mutual funds in the market: With commodities like gold providing interesting returns, the mutual funds can invest in such commodities like they do in equity market and thus indirectly the retail investors in mutual funds will get the benefit. Index Trading: This will give small investors a diversified investment option that can be easily tracked with an overall knowledge of the commodity market. Amendment in Banking Regulations Act: According to the Banking Regulations Act, banks are not allowed to trade in the commodity derivatives. But banks have a big role to play in the development of the commodity market. As they have exposure to agriculture, they would be better off in case they were able to hedge their positions. Imposition of Commodity transaction tax: There is a buzz around the market that the Finance Minster might introduce a Commodity Transaction Tax(CTT) in the union budget of 2012-13. A CTT of 0.017 per cent, or Rs 17 for every lakh of transactions, on commodity derivatives was announced in the 2008-09 Budget. However, it was never put to practice, as there were apprehensions from then the Prime Ministers Economic Advisory Council (PMEAC). Impact of CTT The commodity markets are relatively new and the tax would impact the volume and liquidity of commodity exchanges. Though the Agricultural Produce Marketing Committee (APMC) Act has a provision that says no tax, cess or mandi fee is payable by the farmers, they will have to pay CTT as it is proposed to be levied on sellers. 58

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It implies that a farmer, who sells a futures contract to protect himself against price risk, will be required to pay CTT. Due to higher volume requirements, exchange charges etc. the participation of farmers is lower and with this kind of tax, the participation will reduce further.

The commodity, before it comes for trading on the exchange platforms, is already taxed to the tune of almost 12%, with taxes such as mandi tax, cess, handling costs and warehousing charges, hence the prices will increase futher if CTT is introduced.

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4. Conclusion
Due to increasing demand from the developing countries like India and China the period from 2000 has been a boom for the commodities market. With India being susceptible to oil prices which drives the overall inflation, investing in commodities helps in hedging against it and also diversify the investors portfolio.

Since the restart of futures market, the commodity has not seen a backward step and there is a lot of scope for growth. The government now has to play an active role to get the farmers educated about the market so that they receive the worth of their efforts. Banks and NGOs which have their presence in rural India can provide a helping hand for this purpose.

The infrastructure facilities like warehouses, transportation etc. should be improved so that the genuine buyers can take physical delivery of goods instead of settling transaction in cash.

Amendments of FCRA to make FMC autonomous and permitting new derivative products like options are the need of the future. This introduction will further help deepen the market & would help in increasing the popularity of such exchanges and lead to a wider investor base & lesser power in the hands of ruthless traders & speculators.

With these kinds of reforms there is no doubt that Indian commodity market will outperform the Indian equity markets.

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5. Bibliography
John C Hull, Options Futures and other derivatives 8th Edition, TMH publications. IIBF. Commodity Derivatives Published in 2007. MACMILLAN Publications. Madhoo Pavaskar, Readings in Commodity Derivative Markets,2010. Takshashila Academia of Economic Research Publishers. Magazines Articleso Websites www.mcxindia.com www.ncdex.com www.fmc.gov.in www.business.mapsofindia.com Commodity as Asset Class - Commodity Vision, Aug 2011 Edition

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6. Appendix

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DAY order- A Day order is valid for the day on which it is entered. If the order is not matched during the day, the order gets cancelled automatically at the end of the trading day. GTC - A Good Till Cancelled (GTC) order is an order that remains in the system until the expiry of the respective contract in which it is entered or until when the same is cancelled by the member. GTD - A Good Till Date (GTD) order is valid till the date specified by the member. After the specified date the unexecuted orders get automatically cancelled by the system. IOC - An Immediate or Cancel (IOC) order allows a member to execute the orders as soon as the same is placed in the market, failing which the order will get cancelled immediately Limit Order The order wherein the price is to be specified while placing the same. Market Order The order at the best available price at the time of placing the same. All or none order - All or none order (AON) is a limit order, which is to be executed in its entirety, or not at all. Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price. Only the position to be taken long/ short is stated. When this kind of order is placed, it gets executed irrespective of the current market price of that particular commodity. Trigger price: Price at which an order gets triggered from the stop-loss book.

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Commodities Market in India

Spread order: A simple spread order involves two positions, one long and one short. They are taken in the same commodity with different months (calendar spread) or in closely related commodities. Prices of the two futures contract therefore tend to go up and down together, and gains on one side of the spread are offset by losses on the other. The spreaders goal is to profit from a change in the difference between the two futures prices. The trader is virtually unconcerned whether the entire price structure moves up or down, just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold.

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