Commodity Markets
It should be noted that following are some of the differences between commodity and financial derivatives:
1. Storage Cost: Commodities especially agricultural commodities are perishable in nature and they require storage. Due to this reason, the buyer has to bear the cost of storage and transportation charges. In case if location of goods is not in the same state then, the buyer
also has to borne taxes, octroi etc.
1. Complexity: Compare to Financial Market, there is low volumes of transactions and transparency in commodity market, and thus often relationship between future and spot get distorted. Further delivery in financial market is quite less cumbersome.
2. Higher Cost: While in financial market, only cost in the form of interest cost and exchange rate loss are involved, while in commodity market a lot of costs are involved such as transportation, delivery, storage etc.
3. Physical Delivery: Since the quality of goods commodities even in two different batches cannot be same the delivery of commodities becomes a challenging task. Stating otherwise, this can be the principal distinguishing feature of commodity derivatives.
Pre-requisites for Futures trading on a Commodity Exchange
For a future to be traded on a Commodity Exchange, following are the prerequisites:
(1) Durability: - Commodity should be storable and durable.
(2) Homogeneity: - The commodity should be homogeneous in nature.
(3) Free from Control: - The trading in commodity should be free from any type of price or regulatory control.
(4) Frequent Trading: - The demand and supply should be large leading to daily fluctuation in prices. Practically, it has been seen that despite the fact that same commodities possess above characteristics it still required to be traded successfully.
Trading and Settlement Process
Broadly, commodity trading involves following three mechanisms:
(i) Order Matching Mechanism: - First any trader places his/her order with any registered broker who in turn enter the same into online terminal. In case order matches with opposite order (one party buys and other party sells) the trade is said to be complete.
(ii) Trade Clearing Mechanism: - For matched order clearing takes place through a Registered Clearing House. The function of these clearing houses is as follows: -
(a) Follow up with parties
(b) Timely Settlement
(c) Delivery versus payment (DVP) of commodity traded.
(d) In case of non-delivery settlement through fund transfer.
(iii) Processing of Delivery: - The main issues to be considered in the delivery processes are as
follows:
(a) Availability of warehouse
(b) Location of order
(c) Quantity of Commodity deposited and dematerialized. Further, delivery process involves following steps:
(i) Buyer request Depository Participant (DP) to deliver the commodity.
(ii) DP forward this requests to the Registrar and then to Transfer Agent.
(iii) Transfer Agent after verifying authenticity of request passes the details of delivery to the warehouse.
(iv) After thorough identification check warehouses arranges the delivery of the concerned goods to the designated buyer.
SEBI’s Approval for Option in Commodities
Recently, SEBI allowed for the option trading in Commodity Future market. On expiry date, if option ends in Out The Money (OTM) position it will be squared off at loss (premium) and the holder of In The Money (ITM) position will have a choice either to square it off at profit or get converted into a Future Contract. Once it is converted into future contract it will be subject to margin requirement as other future contracts.
Critical Terms to be understood (A Revisit)
a) Short position in a contract: The party who agrees to deliver (sell) the contracted commodity.
b) Long position in a contract: The party who agrees to receive (purchase) the contracted commodity.
c) Futures Contract: The formal agreement where one party agrees to take a short position and another party assumes the long position on contracted commodity. The contract will specify the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. Please remember that futures is a derivative contract.
d) Settlement: The close out day of the futures contract. The positions get wound and the resulting profit / loss of either party gets settled in cash.
e) Margin: This is perhaps the most important term in commodity futures – the parties entering into a contract must furnish a margin equal to a % (usually 5 to 15 percent) of the contract value. Traders are required to keep margin monies usually based on the traded
volumes.
a) Open: This is the opening price of the trade
b) High: The highest price in the trading session / day
c) Low: The lowest price in the trading session / day
d) Open Interest (Volume): The number of open positions of contracts
e) Expiry Date: The closure date of the contract
f) LTP: Last traded price
g) Unit traded: The unit of measurement (For eg: Cotton will be measured in ‘bales’)
The Role of Derivatives
1. Forward Contract: This is a the simplest of all contracts, which states that there would be an exchange of an agreed quantity of given commodity at a particular price (the forward price).
2. Futures Contract: These are standardized forward contracts that are done through an exchange, for a particular quantity of commodity at a particular future date and location, the price is left undetermined.
3. ETCs: Exchange traded commodities are the commodities that are contracted at based on ETFs. They track the performance of an underlying commodity index including total return indices based on a single commodity.
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