commodity market

1. A
PROJECT REPORT
ON
“STUDY OF COMMODITY MARKET”
For
Marwadi Shares & Finance Ltd.
SUBMITTED TO PUNE UNIVERSITY
IN PARTIAL FULFILLMENT OF 2 YEARS FULL TIME COURSE
MANAGEMENT OF BUSINESS ADMINISTRATION
(MBA)
Submitted By:
ROHIT PARMAR
(Batch 2006-08)
Guided By:-
Prof. MAHESH HALALE
BRACT’s
Vishwakarma Institute of Management,
Kondhwa Pune- 411014
1

2. ACKNOWLEDGEMENT
It is great pleasure for me to acknowledge the kind of help and guidance received to
me during my project work. I was fortunate enough to get support from a large number of
people to whom I shall always remain grateful.
I would like to express my sincere gratitude to Mr. Pratik Tanna and Mr. Ravi Tandon
for giving me this opportunity to undergo this lucrative project with Marvadi Finance Pvt.
Ltd. and also for their great guidance and advice on this project, without which I will not be
able to complete this project.
I am very thankful to our Director Sir Dr. Sharad Joshi for giving me valuable
suggestion and encouragement to bring out good project.
I am very thankful to my mentor Prof. Mr. Mahesh Halale for him inspiration and for
initiating diligent efforts and expert guidance in course of my study and completion of the
project and I am very thankful to my project guide for giving me timely and concrete
guidance for making this project successful.
I would like to thankful to customers and staff members of Marwadi Shares &
Finance Pvt. Ltd. For helped me during the project report and providing me more and more
valuable information for my project report.
I would thank to God for their blessing and my Parents also for their valuable
suggestion and support in my project report.
I would also like to thank our friends and those who have helped us during this project
directly or indirectly.
Rohit Parmar
.
2

3. CONTENT
Sr. No. Particulars Page No.
1 EXECUTIVE SUMMARY 4
2 OBJECTIVE AND SCOPE OF THE PROJECT 5
3 INTRODUCTION 6
4 COMPANY PROFILE 8
5 ABOUT THE COMMODITY 16
6 RESEARCH METHODOLOGY 62
7 DATA ANALYSIS 64
8 RESEARCH FINDING AND CONCLUSION 75
9 QUESTIONNAIRE 77
10 SUGGESTION AND RECOMMENDATION 79
11 BIBLIOGRAPHY 80
3

4. 1. EXECUTIVE SUMMARY
One of the interesting developments in financial market over the last 15 to 20 years
has been the growing popularity of derivatives. In many situations, both hedgers and
speculators find it more attractive to trade a derivative on an asset, commodity than to trade
asset and commodity itself. Some commodity derivatives are traded on exchanges.
In this report I have included history of commodity market. Than I have included
commodity market in India. And after that I have discussed the mechanism of trading in
commodity market in India.
In this report I have taken a first look at forward, futures and options contract and
other risk management instruments. Than after I have discuss the main components of future
commodity trading like contract size, what actual margin is and delivery system etc. There
are mainly three types of traders: hedgers, speculators and arbitrageurs.
In the next section I discuss about the two major commodity exchanges in India that is
MCX AND NCDEX. How they are worked for developing this commodity market in India.
And I have also given the list of other commodity exchanges in India. Put / call ratio (P/C
Ratio) is a market sentiment indicator that shows the relationship between the numbers of put
to calls traded. One can use put/call ratio as market indicator .Then after I have discussed
about the present scenario of commodity market in India.
In the next I have tried to analyze the trading pattern and investment pattern of
commodity traders and other investors. This I have done through the help of QUESTIONER,
which contains 15 questions.
On the basis of different charts prepared, I have at the end given the research findings
and conclusion. And on the basis of my findings I have given suggestion and
recommendation
4

5. 2. OBJECTIVE AND SCOPE OF THE PROJECT
2.1 OBJECTIVE OF THE PROJECT REPORT
To analyze the view of commodity traders.
To make understand the process of future commodity trading in India.
To know the investment pattern of commodity traders and people.
2.2 SCOPE OF THE PROJECT REPORT
For analyze the trading pattern and investment pattern of commodity traders and
government servants, I have taken data from the local area of the Rajkot city.
5

6. 3. INTRODUCTION
Instability of commodity prices has always been a major concern of the producers as well as
the consumers in an agriculture dominated country like India. Farmers’ direct exposure to
price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise
profitable activities. There are various ways to cope with this problem.
Apart from increasing the stability of the market, various factors in the farm sector
can better manage their activities in an environment of unstable prices through derivative
markets. These markets serve a risk -shifting function, and can be used to lock -in prices
instead of relying on uncertain price developments.
There are a number of commodity-linked financial risk management instruments,
which are used to hedge prices through formal commodity exchanges, over -the-counter
(OTC) market and through intermediation by financial and specialized institutions who
extend risk management services. (See UNCTAD, 1998 for a comprehensive survey of
instruments) These instruments are forward, futures and option contracts, swaps and
commodity linked -bonds. While formal exchanges facilitate trade in standardized contracts
like futures and options, other instruments like forwards and swaps are tailor made contracts
to suit to the requirement of buyers and sellers and are available over-the counter.
In general, these instruments are classified based on the purpose for which they are
primarily used for price hedging, as part of a wider marketing strategy, or for price hedging in
combination with other financial deals. While forward contracts and OTC options are trade
related instruments, futures, exchange traded options and swaps between banks and
customers are primarily price hedging instruments. In the case of swaps between
intermediaries and producers, and commodity linked loans and bonds (CL&BS) price
hedging are combined with financial deals.
Forwards contracts are mostly OTC agreements to purchase or sell a specific amount
of a commodity on a predetermined future date at a predetermined price. The terms and
conditions of a forward contract are rigid and both the parties are obligated to give and take
physical delivery of the commodity on the expiry of contract. The holders of forward
contracts face spot (ready) price risk. When the prevailing spot price of the underlying
commodity is higher than the agreed price on expiry of the contract, the buyer gains and the
seller looses. The futures contracts are refined version of forwards by which the parties are
insulated from bearing spot risk and are traded in organize exchanges. A detailed discussion
on the futures contracts is presented in the next chapter.
6

7. Both forwards and futures contracts have specific utility to commodity producers,
merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgers
and from hedgers to speculators, futures markets also play a major role in price discovery.
Typology of risk management instruments
The price risk refers to the probability of adverse movements in prices of
commodities, services or assets. Agricultural products, unlike others, have an added risk.
Many of them being typically seasonal would attract only lower price during the harvest
season.
The forward and futures contracts are efficient risk management tools, which insulate
buyers, and sellers from unexpected changes in future price movements. These contracts
enable them to lock-in the prices of the products well in advance. Moreover, futures prices
give necessary indications to producers and consumer s about the likely future ready price
and demand and supply conditions of the commodity traded. The cash market or ready
delivery market on the other hand is a time-tested market system, which is used in all forms
of business to transfer title of goods.
7

8. 4. COMPANY PROFILE
4.1 NAME OF THE COMPANY
MARWADI SHARES & FINANCE LTD.
4.2 LOGO OF THE COMPANY
4.3 VISION OF THE COMPANY
“To be a world class financial services provider by arranging all conceivable
financial services under one roof at affordable price through cost-effective delivery
systems and achieve organic growth in business by adding newer lines of business.”
4.4 COMPANY PROFILE:
Marwadi Sales and Finance P. Ltd. started in the year 1994 when acquired
membership of National Stock Exchange of India Ltd. That was the time when Govt. had just
started liberalization. Capital market being at the base of every thing else was among the first
few sectors taken up for liberalization and alignment with global benchmarks. NSE was
therefore a result of Government’s policy to modernize stock market and give our investors a
cost - effective trading and settlement system.
They enter into the stock market coincided with Government's initiative to give a
modern Stock exchange. Marwadi had then very presciently felt that this development would
change the very structure and content of the market. Then, when Depository system was
introduced to automate the settlement system, we became the first Corporate DP in 1998 to
bring this concept to investor's doorstep in Saurashtra. Marwadi had very early on seen that
the future lay in the ability to network and use technology to its fullest possible extent.
8

9. Relying on your judgment, we used technology extensively which resulted in efficient client
servicing.
It also saw the synergy that lay in providing a bouquet of services under one roof. It is
this realization that led us in the year 2003 to go for membership of National Level
Commodity Exchanges, which were set up as part of Govt's policy to bring commodity
market on par with the capital market in terms of integrity and practices.
They bold initiatives starting with our journey from capital market up to commodities
market has given us synergies in operations, enabling us to pass on the advantage to
customers.
As an organization, have achieved a leader's position by ensuring total satisfaction of
customers through world class services.
Utilize ultra modern technology for timely, seamless and accurate data processing.
Proactively seek customer’s feedback in improving upon our service delivery modes.
Promptly respond to customer issues in order to maximize client’s satisfaction.
Products & Services offers:
Equity & Derivatives:
Can look for an easy and convenient way to invest in equity and take positions in the
futures and options market using their research and tools. To start trading in Equity, all you
need to do is open an online trading account. You can call them and they will have their
representative meet you. You can get help opening the account and get guidance on how to
trade in Equity.
Commodity:
You can enter the whole new world of commodity futures. Investors looking for a
fast-paced dynamic market with excellent liquidity can NOW trade in Commodity Futures
Market. The Commodity Exchange is a Public Market forum and anyone can play in these
vital Commodity Markets. Marwadi Commodity Broker (P) Ltd can certainly be your point
of entry to the Commodity Markets. Marwadi is a registered trading-cum-clearing member of
NCDEX and MCX.
Internet Trading:
Making the right trade at the right time! E-Broking service, which brings you
experience of online buying and selling of shares with just a click.
9

10. A detail resource like live quotes, charts, research and advice helps you take proper decisions.
Their robust risk management system and 128 bit encryption gives you a complete security
about money, shares, and transaction documents.
IPO:
An active player in the primary market with waste customer base and reaching
distribution network spread through out the lands. Then breathe Saurashtra peninsula.
Marwadi offer bidding for all booked bills IPOs being floated through NSE network.
Marwadi offer services to customer such as advises on the minimum lot to applied in
case of refer and details and data to be furnished into IPO form.
Marwadi scripts even fill up the form for related clients.
Marwadi offer bidding services at all major location in Saurashtra and Kutch there by
enabled the interline investors to subscribes qualitative IPOs.
Mutual Funds:
Transact in a wide range of Mutual Funds. Mutual Funds are an attractive means of
saving taxes and diversifying your investment portfolio. So if you are looking to invest in
mutual funds, Marwadi offers you a host of mutual fund choices under one roof; backed by
in-depth information and research to help you invest smartly.
PMS:
Can you analyze the prices of 1,500 shares every morning? Can you afford to gamble
only on the recommendations from your friends and the information overload from
magazines and financial dailies? And, of course, more importantly, if you happen to be a
High Net worth Individual, do you have the time to judge which advice is reliable, authentic
and has the least chance of failure? With Marwadi PMS, you can be assured that your
investments are in safe hands! Give your portfolio the expert edge to smoothly steer towards
wealth creation.
Cash Market Services:
Marwadi also F & O market to all clients in to entire Saurashtra and Kutch region,
which they cover through, distributed cover.
Marwadi offer cash market trading services for the both retail and in station clients at
all the certain Saurashtra and Kutch where placed either a branch or franchise or sub broker
10

11. 4.5 HIRARCHY STRUCTURE
Board of Director
General Manager
DP Front Trading Account Technology
DP Back Audit Software
(Compliance)
4.6 COMPANY INFORMATION:
Name: Marwadi Shares & Finance Ltd.
Head Office : Marwadi Financial Center
Nr. Kathiawad Gymkhana
Dr. Radhakrishnana Road
Rajkot – 360 001
C.E.O.: Mr. Jeyakumar A. S.
Directors: Mr. Ketan Marwadi
Mr. Deven Marwadi
Mr. Sandeep Marwadi
General Manager: Mr. Hareshbhai Maniar
E-Mail: smarwadi@hotmail.com
Web Site: www.marwadionline.com
11

12. 4.7 COMPANY’S MILESTONE:
1992: Marwadi Shares And Finance Pvt. Ltd. was incorporated
1996: Became a corporate member of national Stock Exchange of India.
1998: Became a member of Saurashtra Kutch Stock Exchange.
1999: Launched Depository services of Depository Participant under National Securities
Depository Ltd.
2000: Commenced Derivative Trading after obtaining registration as a Clearing and Trading
Member in NSE
2003: (MCBPL) became a corporate member of The National Commodity and Derivatives
Exchange of India Ltd.
2004: Became a corporate member of The Stock Exchange, Mumbai.
2004: Launched Depository Services of Depository Participant under Central Depository
Services (India) Ltd.
2006: MSFPL converted to Public Limited (Marwadi Shares And Finance Limited)
4.8 MEMBERSHIP:
Capital Market:
National Stock Exchange of India Ltd.
Bombay Stock Exchange Ltd.
Saurashtra-Kutch Stock Exchange Ltd.
Over-the-Counter Exchange of India Ltd.
Commodities Derivatives:
National Commodity & Derivatives Exchange Ltd.
Multi Commodity Exchange of India Ltd.
Depository Operations:
National Securities Depositories Ltd. (NSDL)
Central Depository Services (India) Ltd.
12

13. 4.9 SERVICES OF MARWADI:
Stock broking:
Cash Market
Derivatives Trading
Margin Trading
Internet Trading
Commodities Broking:
Commodities Futures
Financing Against Commodities
Depository Service:
NSDL
CDSL
IPO Subscription Services
Mutual Fund Products
Portfolio management
Insurance Services
Qualitative Research in Stock & Commodities
FUTURE SERVICES:
Private Banking Sector
Forex Market
Commodities Demat Service
Product Enhancement in commodity market
4.10 THE COMPLETE INVESTMENT DESTINATION:
It provides comprehensive range of investment services. That’s advantage of having
all the services investor need under one roof.
Stock broking:
It offers complete range of pre-trade and post-trade services on the BSE and the NSE.
Whether an investor come into its conveniently environment, or issue instruction over the
13

14. phone, its highly trained team and sophisticated equipment ensure smooth transactions and
prompt services.
E-Broking and Web-Based Services:
It is one of the offers online trading on site www.marwadionline.com, high bandwidth
leased lines, secure services and a customs-built user interface give you an international
standards trading experience. It also gives regular trading hours, and access to information,
analysis of information, and a range of monitoring tools.
Trading Terminals-Money pore Express:
It offer its sub-broker and approved/authorized user fully equipped trading terminals-
Money pore Express, at the location of investors choice. It is fully functional terminal, with a
variety of helpful features like market watch, order entry, order confirmation, charts, and
trading calls, all available in resizable windows. And it can be operated through the keyboard
using F1 for buy, F2 for sell.
Depository Participant Services:
It offers DP services mean hassle-free, speedy settlements. It is depository
participants with NSDL and CDSL.
Premium Research Services:
Its research team offers a package of fee-based services, including daily technical
analysis, research reports, and advice on clients existing investments. It is research beyond
desk and company-provider reports. If you have an equity portfolio, you know that the pace
of life in the world of stocks and shares is frantic. Managing your portfolio means you have
to take firm, informed decisions, and quickly!
4.11 BRANCHES:
Marwadi has spread throughout Gujarat state with our 28 branches and now taking on
Pan - India mantle with branches, now having come up in Hyderabad, Chennai Bangalore,
Pune, Nasik, Kolhapur and Delhi. More out-of-Gujarat branches are on the anvil in order to
be a conspicuous player at national level. As on today they are serving about 75,000 clients
spread out over 554 pin code locations through a network of about 300 intermediaries such as
sub-brokers, franchisees and authorized persons.
14

15. Also other branches of Marwadi in different cities like…..
Ahmedabad Jamnagar
Amreli Junagadh
Anand Keshod
Baroda Manavadar
Bhavnagar Mithapur
Bhuj Mumbai
Delhi Okha
Dhoraji Porbandar
Dhangadhra Surat
Gondal Surendranagar
Gandhidham Veraval
15

16. 5. ABOUT THE COMMODITY
5.1 INTRODUCTION
Keeping in view the experience of even strong and developed economies of the world,
it is no denying the fact that financial market is extremely volatile by nature. Indian financial
market is not an exception to this phenomenon. The attendant risk arising out of the volatility
and complexity of the financial market is an important concern for financial analysts. As a
result, the logical need is for those financial instruments which allow fund managers to better
manage or reduce these risks.
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.
5.2 COMMODITIES
Organized futures market evolved in India by the setting up of "Bombay Cotton Trade
Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton
mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a
separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures
trading in oilseeds was organized in India for the first time with the setting up of Gujarati
Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and
cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds
were functioning in Gujarat and Punjab.
A three-pronged approach has been adopted to revive and revitalize the market.
Firstly, on policy front many legal and administrative hurdles in the functioning of the market
have been removed. Forward trading was permitted in cotton and jute goods in 1998,
followed by some oilseeds and their derivatives, such as groundnut, mustard seed, sesame,
cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy, issued in
July, 2000 by the government that futures trading will be encouraged in increasing number of
agricultural commodities was indicative of welcome change in the government policy
towards forward trading.
16

17. Secondly, strengthening of infrastructure and institutional capabilities of the regulator
and the existing exchanges received priority. Thirdly, as the existing exchanges are slow to
adopt reforms due to legacy or lack of resources, new promoters with resources and
professional approach were being attracted with a clear mandate to set up dematerialized,
technology driven exchanges with nationwide reach and adopting best international practices.
The year 2003 marked the real turning point in the policy framework for commodity
market when the government issued notifications for withdrawing all prohibitions and
opening up forward trading in all the commodities. This period also witnessed other reforms,
such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, which
have reduced bottlenecks in the development and growth of commodity markets. Of the
country's total GDP, commodities related (and dependent) industries constitute about roughly
50-60 %, which itself cannot be ignored.
Most of the existing Indian commodity exchanges are single commodity platforms;
are regional in nature, run mainly by entities which trade on them resulting in substantial
conflict of interests, opaque in their functioning and have not used technology to scale up
their operations and reach to bring down their costs. But with the strong emergence of:
National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity
Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai
(NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will be
addressed rapidly. These exchanges are expected to be role model to other exchanges and are
likely to compete for trade not only among themselves but also with the existing exchanges.
The current mindset of the people in India is that the Commodity exchanges are
speculative (due to non delivery) and are not meant for actual users. One major reason being
that the awareness is lacking amongst actual users. In India, Interest rate risks, exchange rate
risks are actively managed, but the same does not hold true for the commodity risks. Some
additional impediments are centered on the safety, transparency and taxation issues.
5.3 WHY COMMODITIES MARKET?
India has very large agriculture production in number of agri-commodities, which
needs use of futures and derivatives as price-risk management system.
Fundamentally price you pay for goods and services depend greatly on how well
business handle risk. By using effectively futures and derivatives, businesses can minimize
risks, thus lowering cost of doing business.
17

18. Commodity players use it as a hedge mechanism as well as a means of making
money. For e.g. in the bullion markets, players hedge their risks by using futures Euro-Dollar
fluctuations and the international prices affecting it.
For an agricultural country like India, with plethora of mandis, trading in over 100
crops, the issues in price dissemination, standards, certification and warehousing are bound to
occur. Commodity Market will serve as a suitable alternative to tackle all these problems
efficiently.
5.4 COMMODITY FUTURES:
Commodity futures are simply the standard futures contracts traded through
exchange. These contracts have their respective commodity as underlying asset and derive
the dynamics from it. Such contracts allow the participant to buy and sell certain commodity
at a certain price for future delivery. Futures trading is a natural outgrowth of the problem of
maintaining a year-round supply of seasonal products like agriculture crops. The best thing
about a commodity futures contract is that it is generally leveraged giving opportunity to all
types of investors to participate. Characteristically, such a contract has an expiry and delivery
attached with it.
5.5 WHY TRADE IN COMMODITIES?
1. Big market-diverse opportunities
India, a country with a population of over one billion, has an economy based on
agriculture, precious metals and base metals.
Thus, trading in commodities provides lucrative market opportunities for a wider
section of participants of diverse interests like investors, arbitragers, hedgers, traders,
manufacturers, planters, exporters and importers.
2. Get to the sore
Commodity trading has been a breakthrough in expanding the investment from
investing in a metal company to trading in metal itself.
3. Huge potential
Commodity exchanges see a tremendous daily turnover of more than Rs.15,000 cores.
This gives a lunge potential to market participant to make profits.
4. Exploitable fundamental
The fundamental for commodity trading is simple “price is a function of demand and
supply” so is hedging, by taking appropriate contract. This makes things really easy to
understand and exploit.
18

19. 5. Portfolio diversifier
Commodity futures derive their prices from the underlying commodity and
commodity prices cannot become zero. Commodity has a global presence and their prices
move with global economics and hence, it’s a good portfolio diversifier.
5.6 ADVANTAGE OF FUTURES TRADING
Futures trading remove the hassles and costs of settlement and storage for traders who
do not want custody.
Though, the most lucrative element of futures trading is that it allows investors to
participate and trade at nominal costs at a much lesser amount:
No longer need to put the whole amount for trading; only the margin is required.
No sales tax is applicable if the trade is required off. Sales tax is applicable only if a
trade results in delivery.
Traders can short sell. If a trader buys an equivalent contract back before the contract
expires, he will be able to profit from a falling price. This is difficult in spot marketers
because it requires the seller to borrow the commodity. It is next to impossible for retail
investors in case of something like gold.
All participants trade exactly the same notional right i.e. those defined on the standard
contract, so the market grows deeper and more liquid in the standard futures contract than in
spot bullion where different qualities of bullion exit, each of which has different prices.
Greater liquidity provides a reliable real-time price something which is absolutely not
available in the OTC bullion market.
5.7 CHARACTERISTICS OF FUTURES TRADING
A "Futures Contract" is a highly standardized contract with certain distinct features. Some of
the important features are as under:
Futures’ trading is necessarily organized under the auspices of a market association so
that such trading is confined to or conducted through members of the association in
accordance with the procedure laid down in the Rules & Bye-laws of the association.
It is invariably entered into for a standard variety known as the "basis variety" with
permission to deliver other identified varieties known as "tenderable varieties".
The units of price quotation and trading are fixed in these contracts, parties to the
contracts not being capable of altering these units.
19

20. The delivery periods are specified.
The seller in a futures market has the choice to decide whether to deliver goods
against outstanding sale contracts. In case he decides to deliver goods, he can do so not only
at the location of the Association through which trading is organized but also at a number of
other pre-specified delivery centers.
In futures market actual delivery of goods takes place only in a very few cases.
Transactions are mostly squared up before the due date of the contract and contracts are
settled by payment of differences without any physical delivery of goods taking place.
5.8 COMMODITY DERIVATIVES IN INDIA
Commodity derivatives have a crucial role to play in the price risk management
process especially in any agriculture dominated economy. Derivatives like forwards, futures,
options, swaps etc are extensively used in many developed and developing countries in the
world. The Chicago Mercantile Exchange; Chicago Board of Trade; New York Mercantile
Exchange; International Petroleum Exchange, London; London Metal Exchange; London
Futures and Options Exchange; “Marche a Terme International de France”; Sidney Futures
Exchange; Singapore International Monetary Exchange; The Singapore Commodity
Exchange; Kuala Lumpur Commodity Exchange ; “Bolsa de Mercadorias & Futuros” (in
Brazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China Commodity
Futures Exchange; Beijing Commodity Exchange, etc are some of the leading commodity
exchanges in the world engaged in trading of derivatives in commodities.
However, they have been utilized in a very limited scale in India Although India has a
long history of trade in commodity derivatives, this segment remained underdeveloped due to
government intervention in many commodity markets to control prices. The government
controls the production, supply and distribution of many agricultural commodities and only
forwards and futures trading are permitted in certain commodity items. Free trade in many
commodity items is restricted under the Essential Commodities Ac, 195, and forward and
futures contracts are limited to certain commodity items under the Forward Contracts
(Regulation) Act, 1952.
The first commodity exchange was set up in India by Bombay Cotton Trade
Association Ltd., and formal organized futures trading started in cotton in 1875.
Subsequently, many exchanges came up in different parts of the country for futures trade in
various commodities. The Gujarati Vyapari Mandali came into existence in 1900, which has
undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange
Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures
20

21. trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of
East India Cotton Association. Many exchanges came up in the agricultural centers in north
India before world war broke out and engaged in wheat futures until it was prohibited. The
exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this
period. The futures trade in spices was firs organized by IPSTA in Cochin in 1957.
Futures in gold and silver began in Mumbai in 1920 and continued until the
government prohibited it by mid-1950s. Later, futures trade was altogether banned by the
government in 1966 in order to have control on the movement of prices of many agricultural
and essential commodities. Options are though permitted now in stock market, they are not
allowed in commodities. The commodity options were traded during the pre-independence
period. Options on cotton were traded until the along with futures were banned in 1939.
However, the government withdrew the ban on futures with passage of Forward Contract
(Regulation) Act in 1952.
After the ban of futures trade many exchanges went out of business and many traders
started resorting to unofficial and informal trade in futures. On recommendation of the
Khusro Committee in 1980 government reintroduced futures on some selected commodities
including cotton, jute, potatoes, etc.
Further in 1993 the government of India appointed an expert committee on forward
markets under the chairmanship of Prof. K.N. Kabra and the report of the committee was
submitted in 1994 which recommended the reintroduction of futures already banned and to
introduce futures on many more commodities including silver. In tune with the ongoing
economic liberalization, the National Agricultural Policy 2000 has envisaged external and
domestic market reforms and dismantling of all controls and regulations in agricultural
commodity markets. It has also proposed to enlarge the coverage of futures markets to
minimize the wide fluctuations in commodity prices and for hedging the risk emerging from
price fluctuations. In line with the proposal many more agricultural commodities are being
brought under futures trading.
In India, currently there are 15 commodity exchanges actively undertaking trading in
domestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association
(IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recently
upgraded to international exchanges to deal in international contracts in pepper and castor oil
respectively. Another 8 exchanges are proposed and some of them are expected to start
operation shortly. There are 4 exchanges, which are specifically approved for undertaking
forward deals in cotton. More detailed account of these exchanges has been presented.
21

22. The proposed study is primarily based on the visit of seven leading exchanges viz.,
IPST Cochin, which deal in domestic and international contracts in pepper; BCE Ltd., a
multy-commodity international exchange where futures in castor oil, castor seed, sunflower
oil, RBD Palmolein etc are traded; The East India Cotton Association (EICA) Ltd., Bombay,
which is a specialized exchange dealing in forwards and futures in cotton; South India Cotton
Association (SICA , Coimbatore which deals in forward contracts in cotton; Coffee Futures
Exchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading; Kanpur
Commodity Exchange (KCE) which deals with futures contracts in mustard oil and gur; and
The Chamber of Commerce, Hapur which undertakes futures trading in gur and potatoes.
5.9 MECHANICS OF FUTURES TRADING
Futures are a segment of derivative markets. The value of a futures contract is derived
from the spot (ready) price of the commodity underlying the contract. Therefore, they are
called derivatives of spot market. The buying and selling of futures contracts take place in
organized exchanges. The members of exchanges are authorized to carryout trading in
futures. The trading members buy and sell futures contract for their own account and for the
account of non-trading members and other clients. All other persons interested to trade in
futures contracts, as clients must get themselves registered with the exchange as registered
non-members.
5.10 WHAT IS A COMMODITY FUTURE EXCHANGE?
Exchange is an association of members, which provides all organizational support for
carrying out futures trading in a formal environment. These exchanges are managed by the
Board of Directors, which is composed primarily of the members of the association. There
are also representatives of the government and public nominated by the Forward Markets
Commission. The majority of members of the Board have been chosen from among the
members of the Association who have trading and business interest in the exchange. The
chief executive officer and his team in day-to-day administration assist the Board. There are
different classes of members who capitalize the exchange by way of participation in the form
of equity, admission fee, security deposits, registration fee etc.
a. Ordinary Members: They are the promoters who have the right to have own –account
transactions without having the right to execute transactions in the trading ring. They have to
place orders with trading members or others who have the right to trade in the exchange.
22

23. b. Trading Members: These members execute buy and sell orders in the trading ring of the
exchange on their account, on account of ordinary members and other clients.
c. Trading-cum-Clearing Members: They have the right to trade and also to participate in
clearing and settlement in respect of transactions carried out on their account and on account
of their clients.
d. Institutional Clearing Members: They have the right to participate in clearing and
settlement on behalf of other members but do not have the trading rights.
e. Designated Clearing Bank: It provides banking facilities in respect of pay-in, payout and
other monetary settlements.
The composition of the members in an exchange however varies. In so me exchanges there
are exclusive clearing members, broker members and registered non -members in addition to
the above category of members.
5.11 WHAT IS COMMODITY FUTURES CONTRACT?
Futures contracts are an improved variant of forward contracts. They are agreements
to purchase or sell a given quantity of a commodity at a predetermined price, with settlement
expected to take place at a future date. While forward contracts are mainly over-the-counter
and tailor-made which physical delivery futures settlement standardized contracts whose
transactions are made in formal exchanges through clearing houses and generally closed out
before delivery. The closing out involves buying a different times of two identical contracts
for the purchase and sale o the commodity in question, with each canceling the other out. The
futures contracts are standardized in terms of quality and quantity, and place and date of
delivery of the commodity. The commodity futures contracts in India as defined by the FMC
has the following features:
(a) Trading in futures is necessarily organized under the auspices of a recognized association
so that such trading is confined to or conducted through members of the association in
accordance with the procedure laid down in the Rules and Bye-laws of the association.
(b) It is invariably entered into for a standard variety known as the “basis variety” with
permission to deliver other identified varieties known as “tender able varieties”.
(c) The units of price quotation and trading are fixed in these contracts, parties to the
contracts not being capable of altering these units.
(d) The delivery periods are specified.
23

24. (e) The seller in a futures market has the choice to decide whether to deliver goods against
outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the
location of the Association through which trading is organized but also at a number of other
pre-specified delivery centers.
(f) In futures market actual delivery of goods takes place only in a very few cases.
Transactions are mostly squared up before the due date of the contract and contracts are
settled by payment of differences without any physical delivery of goods taking place. The
terms and specifications of futures contracts vary depending on the commodity and the
exchange in which it is traded.
The major terms and conditions of contracts traded in six sample exchanges in India. These
terms are standardized and applicable across the trading community in the respective
exchanges and are framed to promote trade in the respective commodity For example, the
contract size is important for better management of risk by the customer. It has implications
for the amount of money that can be gained or lost relative to a given change in price levels. I
also affect the margins required and the commission charged. Similarly, the margin to be
deposited with the clearing house has implications for the cash position of customers because
it blocks cash for the period of the contract to which he is a party the strength and weaknesses
of contract specifications are discussed under constraints and policy options.
5.12 WHO ARE THE PARTICIPANTS IN FUTURES MARKET?
Broadly, speculators who take positions in the market in an attempt to benefit from a
correct anticipation of future price movements, and hedgers who transact in futures market
with an objective of offsetting a price risk on the physical market for a particular commodity
make the futures market in that commodity. Although it is difficult to draw a line of
distinction between hedgers and speculators, the former category consists of manufacturing
companies, merchandisers, and farmers. Manufacturing companies who use the commodity
as a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at a
predetermined price, which facilitates immunity against price fluctuations. While exporters in
addition to using the price discovery mechanism for getting better prices for their
commodities seek to hedge against their overseas exposure by way of locking-in the price by
way of buying futures contracts, the importers utilize the liquid futures market for the
purpose of hedging their outstanding position by way of selling futures contracts. Futures
market helps farmers taking informed decisions about their crop pattern on the basis of the
futures prices and reduces the risk associated with variations in their sales revenue due to
24

25. unpredictable future supply demand conditions. Above all, there are a large number of
brokers who intermediate between hedgers and speculators create the market for futures
contracts.
5.13 COMMODITY ORDERS
The buy and sell orders for commodity futures are executed on the trading floor where floor
brokers congregate during the trading hours stipulated by the exchange. The floor
brokers/trading members on receipt of orders from clients or from their office transmits the
same to others on the trading floor by hand signal and by calling out the orders (in an open
outcry system they would like to place and price. After trade is made with another floor
broker who takes the opposite side of the transaction for another customer or for his own
account, the details of transactions are passed on to the clearing house through a transaction
slip on the basis o which the clearinghouse verifies the match and adds to its records.
Following the experiences of stock exchanges with electronic screen based trading
commodity exchanges are also moving from outdated open outcry system to automated
trading system. Many leading commodity exchanges in the world including Chicago
Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International Petroleum
Exchange (IPE), London, have already computerized the trading activities. In India, coffee
futures exchange, Bangalore has already put in
place the screen based trading and many others are in the process of computerization. To add
to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for a
common electronic trading platform connecting all commodity exchanges to conduct screen
based trading. In electronic trading, trading takes place through a centralized computer
network system to which all buy and sell orders and their respective prices are keyed in from
various terminals of trading members. The deal takes place when the central computer finds
matching price quotes for buy and sell. The entire procedural steps involved in electronic
trading beginning from placing the buy/sell order to the confirmation of the transaction have
been shown in figure -2.1 below.
25

26. Order and Execution flows in electronic future trade
Confirmation Comfirmation
BUYER SELLER
Order Output Order Input
COMPUTER COMPUTER
Verifaction of
Verifaction of Order Order
CREDIT RISK CREDIT RISK
Legitimitate Order Legitimate
Are Trasferred ELECTRONIC Order are
TRADING Transferred
Orders are matched
EXECUTION
Transfer of Position
CLEARING HOUSE
CLEARING MEMBER CLEARING MEMBER
Position
and margin settlement
5.14 ROLE OF CLEARING HOUSE
Clearinghouse is the organizational set up adjunct to the futures exchange which
handles all back-office operations including matching up of each buy and sell transactions,
execution, clearing and reporting of all transactions, settlement of all transactions on maturity
by paying the price difference or by arranging physical delivery, etc., and assumes all
counterparty risk on behalf of buyer and seller. It is important to understand that the futures
market is designed to provide a proxy for the ready (spot) market and thereby acts as a
pricing mechanism and not as part of, or as a substitute for, the ready market.
The buyer or seller of futures contracts has two options before the maturity of the
contract. First, the buyer (seller) may take (give) physical delivery of the commodity at the
delivery point approved by the exchange after the contract matures. The second option, which
distinguishes futures from forward contracts is that, the buyer (seller) can offset the contract
26

27. by selling (buying) the same amount of commodity and squaring off his position. For
squaring of a position, the buyer (seller) is not obligated to sell (buy) the original contract.
Instead, the clearinghouse may substitute any contract of the same specifications in the
process of daily matching. As delivery time approaches, virtually all contracts are settled by
offset as those who have bought (long) sell to those who have sold (short). This offsetting
reduces the open position in the account of all traders as they approach the maturity date of
the contract. The contracts, if any, which remain unsettled by offset until maturity date are
settled by physical delivery.
The clearinghouse plays a major role in the process explained above by
intermediating between the buyer and seller. There is no clearinghouse in a forward market
due to which buyers and sellers face counterparty risk. In a futures exchange all transactions
are routed through and guaranteed by the clearinghouse which automatically becomes a
counterpart to each transaction. It assumes the position of counterpart to both sides of the
transaction. It sells contract to the buyer and buys the identical contract from the seller.
Therefore, traders obtain a position vis -à-vis the clearing house. It ensures default risk-free
transactions and provides financial guarantee on the strength of funds contributed by its
members and through collection of margins (discussed in section 2.3), marking-to-market all
outstanding contracts, position limits imposed on traders, fixing the daily price limits and
settlement guarantee fund.
The organizational structure and membership requirements of clearinghouses vary
from one exchange to the other. The Bombay Commodity Exchange and Cochin pepper
exchange have set up separate independent corporations (namely, Prime Commodities
Clearing Corporation of India Ltd, and First Commodities Clearing Corporation of India Ltd.,
respectively) for handling clearing and guarantee of all futures transactions in the respective
exchanges. While coffee exchange has clearing house as a separate division of the exchange,
many other exchanges like Chamber of Commerce, Hapur; Kanpur Commodity Exchange
and cotton exchange in Bombay run in-house clearinghouse as part of the respective
exchanges. The clearing and guaranty are managed in these exchanges by a separate
committee (normally called the Clearing House Committee).
The membership in the clearinghouse requires capital contribution in the form of
equity, security deposit, admission fee, registration fee, guarantee fund contribution in
addition to net worth requirement depending on its organizational structure. For example, in
the Bombay Commodity Exchange the minimum capital requirement for membership in its
clearinghouse as applicable to trading-cum-clearing members is Rs.50,000 each toward
equity and security deposit, Rs. 500 as annual subscription, and additionally, members are
27

28. required to have net worth of Rs.3 lakhs. Similarly, coffee exchange prescribed Rs.5 lakh
each towards equity and guarantee fund contribution and Rs.40,000 towards admission fee
for a trading-cum-clearing member. However, in exchanges where clearing house is a part of
the exchange the payment requirements are lower. For example, Kanpur Commodity
Exchange prescribed only Rs.25,00,000 Rs.1000 and Rs.500 respectively towards security
deposit, registration fee and annual fee for a clearing cum-trading member.
For ensuring financial integrity of the exchange and for counterparty risk -free trade
position (exposure) limits have been imposed on clearing members. These limits which are
stringent in some cases and are liberal in other cases are normally linked to the members’
contribution towards equity capital or security deposit or a combination of both and
settlement guarantee fund.
In Bombay Commodity Exchange the exposure limit of a clearing member is the sum
of 50 times the face value of contribution to equity capital of the clearinghouse and 30 times
the security deposit the member has maintained with the clearinghouse. While coffee
exchange prescribes the limit of 80 times the sum of member’s equity investment and the
contribution to the guarantee fund, the cotton exchange, Bombay, has stipulated a liberal
exposure limit on open positions. It has a limit of 200 and 1500 units (recall that one contract
unit is equivalent to 93.5 quintals respectively for composite and institutional members. The
Cochin pepper exchange has fixed a net exposure limit of 60 units (equivalent to 1500
quintals) for domestic contract and 90 units (equivalent to 2250 quintals) for international
contract. Moreover, setting up of settlement guarantee fund ensures enough financial strength
in case the clearinghouse faces default.
The Kanpur Commodity Exchange maintains a trade guarantee fund with a corpus of
Rs.100 lakhs while the coffee exchange in addition to a guarantee fund the exchange has
substituted itself as party to clear all transactions.
Yet another check on the possible default is through prescribing maximum price
fluctuation on any trading day, which helps limit the probable profit/loss from each unit of
transaction. The relevant data on permitted price limit has been presented. Its clear from the
table that the maximum profit/loss potential from trade in each contract unit varies from as
low as Rs. 800 for potato futures in Chamber of Commerce, Hapur to as high as Rs. 15,000 in
pepper exchange, Cochin. Similarly, given the permissible open position of 200 units for a
trading-cum-clearing member and maximum price fluctuation of Rs. 150 per 100 kg for
cotton futures in the cotton exchange, Bombay, the maximum potential loss/profit in a trading
day works out to be Rs.28.05 lakhs!
28

29. Margins
Margins (also called clearing margins) are good -faith deposits kept with a
clearinghouse usually in the form of cash. There are two types of margins to be maintained
by the trader with the clearinghouse: initial margin and maintenance or variation margins.
Initial margin is a fixed amount per contract and does not vary with the current value of the
commodity traded. Margins are deposited with the clearing house in advance against the
expected exposure of the trading member on his account and on account of the clients. The
member who executes trade for them in turn collects this amount from the clients. Generally,
the margin is payable on the net exposure of the member.
Net exposure is the sum of gross exposure (buy quantity or sale quantity, whichever is
higher, multiplied by the current price of the contract) on account of trades executed through
him for each of his clients and gross exposure of trades carried out on his own account.
However, for squaring-off transactions carried out only at the clients’ level, fresh margins are
not required. The margin is refundable after the client liquidates his position or after the
maturity of the contract.
Maintenance margin which usually ranges from 60 to 80 per cent of initial margin is
also required by the exchange. Variation margin is to compensate the risk borne by the
clearinghouse on account of price volatility of the commodity underlying the contract to
which it is a counterparty. A debit in the margin account due to adverse market conditions
and consequent change in the value of contract would lead to initial margin falling below the
maintenance level. The clearinghouse restores initial margin through margin calls to the
client for collecting variation margin. In case of an increase in value of the contract, marking-
to-market ensures that the holder gets the payment equivalent to the difference between the
initial contract value and its change over the lifetime of the contract on the basis of its daily
price movements. If the member is not able to pay the variation margin, he is bound to square
off his position or else the clearinghouse will be liquidating the position.
The margins have important bearing on the success of futures. As they are non-
interest bearing deposits payable to the clearinghouse up-front working capital of any trading
entity gets blocked to that extent. While a higher margin requirement prevents traders from
participating in trading, a lower margin makes the clearinghouse vulnerable to any default
due to its weak financial strength otherwise. Internationally, many developed exchanges
maintain a low margin on positions due to their better financial strength along with massive
volume of trade resulting in large income accruing to them.
However, this has not been the case with many exchanges in India. For example, as
shown in table 2.2 the initial margin liability for transacting the minimum lot size in pepper is
29

30. Rs.30, 000 for domestic contracts and US$ 312.50 for international contracts .Similarly, the
volume of transactions. These clearinghouses deal in many exchanges in India is abysmally
low making their existence financially unviable.
Most of the exchanges in additions to keeping mandatory margins maintain a settlement
guarantee fund. The fund set up with the contribution from members of clearing house is used
for guaranteeing financial performance of all members. This fund absorbs losses not covered
by margin deposits of the defaulted member. The clearinghouse ensures this by settling the
default transactions by properly compensating the traders paying the amount of difference at
the closing out rate.
How does futures contract facilitate hedging against price risk?
The futures contracts are designed to deal directly with the credit risk involved in
locking-in prices and obtaining forward cover. These contracts can be used for hedging price
risk and discovering future prices. For commodities that compete in world or national
markets, such as coffee, there are many relatively small producers scattered over a wide
geographic area. These widely dispersed producers find it difficult to know what prices are
available, and the opportunity for producer, processor, and merchandiser to ascertain their
likely cost for coffee and develop long range plans is limited. Futures trading, used in the
Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955,
provides the industry with a guide to what coffee is worth now as well as today’s best
estimate for the future. Moreover, since all transactions are guaranteed through a central
body, clearing house, which is the counter party to each buyer and seller ensuring zero
default risk, market participants need not worry about their counterpart’s creditworthiness.
Hedge is a purchase or sale on a futures market intended to offset a price risk on the
physical (ready) market. It involves establishing a position in the futures market again one’s
position or firm commitments in the physical market. The producers who seek to protect
themselves from an expected decline in prices of their commodity in future go for short
hedge (also called sell hedge). He undertakes the following operations in the market to lock-
in the price in advance which he is going to receive after the product. I ready for physical
sale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2
units of contracts in Cochin pepper exchange) of pepper in March, the futures price for March
delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and the
prevailing (say, October) ready market price is Rs.8100 per quintal.
a) In October, the producer goes short (sells) in the futures market selling 2 March futures
contracts at Rs.8400 per quintal. This is called “price fixing”.
30

31. b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sells
pepper in the ready market for Rs.8200.
c) Simultaneously, he closes out his short position in futures by buying (long position) 2
March futures contracts at Rs.8200 per quintal. The result is that the producer sold futures
contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a net
gain of Rs.200 per quintal or Rs.5000 per contract.
For the physical sale, the producer received the market price of Rs.8200 prevailing on
the day of the sale and the gain of Rs.200 per quintal from closing-out of futures contracts
makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the price
realized in the ready market is lower than the price in future contract, the loss on the physical
market is compensated by the higher price realized on the future contract. On the other hand,
if the price in the ready market is higher than in futures contract, the gain in the ready market
is offset by the loss on the repurchase of the futures contract.
Since futures market prices move in tandem with the ready market prices over the
course of time tending to converge as the contract matures, a gain in the futures market in a
developed commodity market under normal conditions, will be offset by a loss in the ready
market, or vice versa. However, market imperfections will lead to the basis risk emerging
from the mismatch between the gain/loss from the futures market not compensated by
loss/gain in the ready market.
Meaning of Derivatives
The term "Derivative" indicates that it has no independent value, i.e. its value is
entirely "derived". A derivative is a financial instrument, which derives its value from some
other financial price. This “other financial price” is called underlying. The most common
underlying assets include stocks, bonds, commodities, currencies, livestock, interest rates and
market indexes.
A wheat farmer may wish to contract to sell his harvest at a future date to eliminate
the risk of a change in prices by that date. The price for such a contract would obviously
depend upon the current spot price of wheat. Such a transaction could take place on a wheat
forward market. Here, the wheat forward is the “derivative” and wheat on the spot market is
“the underlying”. The terms “derivative contract”, “derivative product”, or “derivative” are
used interchangeably.
31

32. Examples of Derivatives
Consider how the value of mutual fund units changes on a day-to-day basis. Don’t
mutual fund units draw their value from the value of the portfolio of securities under the
schemes?
A very simple example of derivatives is cloth, which is derivative of cotton. The price
of cloth depends upon the price of cotton, which in turn depends upon the demand, and
supply of cotton...
Aren’t these examples of derivatives? Yes, these are. And you know what, these
examples prove that derivatives are not so new to us.
There are two broad types of derivatives:
Financial derivatives: - Here the underlying includes treasuries, bonds, stocks, stock index,
foreign exchange etc.
Commodity derivatives: – Here the underlying is a commodity such as wheat, cotton,
peppers, turmeric, corn, soybeans, rice crude oil etc.
5.15 HISTORY
The history of derivatives is surprisingly longer than what most people think. Some
texts even find the existence of the characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in incidents that date back to
the ages before Jesus Christ.
The first organized commodity exchange came into existence in the early 1700s in
Japan. The first formal commodities exchange, the Chicago board of trade (CBOT), was
formed in 1848 in the US to deal with the problem of credit risk and to provide centralized
location to negotiate forward contracts, where forward contracts on various commodities
were standardized around 1865.The primary market intention of the CBOT was to provide a
centralized location known in advance for buyers and sellers to negotiate forward contracts.
In 1865, the CBOT went one step further and listed the first “futures contracts”. In 1919,
Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow futures trading.
Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME
remain the two largest organized futures exchanges, indeed the two largest “financial”
32

33. exchanges of any kind in the world today. From then on, futures contracts have remained
more or less in the same form, as we know them today.
The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular stock index futures contract in the world is based on S & P 500
index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures
became the most active derivative instruments generating volumes many times more than the
commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three
most popular futures contracts traded today. Other popular international exchanges that trade
derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan,
MATIF in France etc.
However, the advent of modern day derivative contracts is attributed to the need for
farmers to protect themselves from any decline in the price of their crops due to delayed
monsoon, or overproduction. Although trading in agricultural and other commodities has
been the driving force behind the development of derivatives exchanges, the demand for
products based on financial instruments - such as bond, currencies, stocks and stock
indices—has now far outstripped that for the commodities contracts.
India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and
oil etc for decades in the gray market. Trading derivatives contracts in organized market was
legal before Morarji Desai’s government banned forward contracts. Derivatives on stocks
were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract
in various commodities was allowed to trade on exchanges.
In June 2000, National Stock Exchange and Bombay Stock Exchange started trading
in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June
2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the
month of July and November respectively. The derivatives market in India has grown
exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE
accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005
33

34. 5.16 TYPES OF DERIVATIVES
A derivative as a term conjures up visions of complex numeric calculations, speculative
dealings and comes across as an instrument which is the prerogative of a few ‘smart finance
professionals’. In reality it is not so. In fact, a derivative transaction helps to cover risk,
which would arise on the trading of securities on which the derivative is based and a small
investor, can benefit immensely.
A derivative security can be defined as a security whose value depends on the values of other
underlying variables. Very often, the variables underlying the derivative securities are the
prices of traded securities.
An example of a simple derivative contract:
Rohan buys a futures contract.
He will make a profit of Rs. 1200 if the price of Infosys rises by Rs. 1200.
If the price is unchanged Ram will receive nothing.
If the stock price of Infosys falls by Rs. 1000 he will lose Rs. 1000.
As we can see, the above contract depends upon the price of the Infosys scrip, which
is the underlying security. Similarly, futures trading has already started in Sensex futures and
Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty.
There are basically of 3 types of Derivatives and Futures:
Forwards and Futures
Options
Swaps
DERIVATIVES
Options Swaps Futures Forwards
Put Call Commodity Securities
Interest Rate Currency
34

35. FORWARD CONTRACT
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees to buy
the underlying assed on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to dell the asset on the same date for the same
price. Other contract details like delivery date, price and quantity are negotiated bilaterally by
the parties to the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
• They are bilateral contracts hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• it has to compulsorily go to the same counter party, which often results in high price
being charged.
Limitation of forward market:
Forward market world-wide are afflicted by several problems:
Lack of centralization
Illiquidity
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and
generality. The forward market is like a real estate market in that any two consenting adults
can form contracts against each other. This often makes them design terms of the deal which
are very convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the other
suffers. Even when forward market trade standardized contracts, and hence avoids the
problem of illiquidity, still the counterparty risk remains very serious issue.
Illustration
Sahil wants to buy a Laptop, which costs Rs 30,000 but he has no cash to buy it
outright. He can only buy it 3 months hence. He, however, fears that prices of laptop will rise
35

36. 3 months from now. So in order to protect himself from the rise in prices Sahil enters into a
contract with the laptop dealer that 3 months from now he will buy the laptop for Rs 30,000.
What Sahil is doing is that he is locking the current price of a LAPTOP for a forward
contract. The forward contract is settled at maturity. The dealer will deliver the asset to Sahil
at the end of three months and Sahil in turn will pay cash equivalent to the LAPTOP price on
delivery.
FUTURES CONTRACT
Futures markets were designed to solve the problems that exist in forward market. A
futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. But unlike forward contracts, the futures contracts are
standardized and exchange traded. So, the counter party to a future contract is the clearing
corporation of the appropriate exchange. To facilitate liquidity in the futures contracts, the
exchange specifies certain standard features of the contract. It is a standardized contract with
standard underlying instrument, a standard quantity and quality of the underlying instrument
that can be delivered, (or which can be used for reference purposes in settlement) and a
standard timing of such settlement. Future contracts are often settled in cash or cash
equivalents, rather than requiring physical delivery of the underlying asset. A futures contract
may be offset prior to maturity by entering into an equal and opposite transaction. More than
99% of futures transaction is offset this way.
The standardized items in a futures contract are:
Quantity of the Underlying.
Quality of the Underlying.
The date and month of delivery.
The units of price quotation and minimum price change.
Location of settlement.
Distinction between futures and forwards contracts:
Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of allocating risk in the
presence of future price uncertainty. However futures are a significant improvement over the
forward contracts as they eliminate counterparty risk and offer more liquidity. The distinction
between futures and forwards are summarized below:
36

37. Futures Forwards
1.Trade on an organized exchange 1.OTC in nature
2.Standardized contract terms 2.Customized contract terms
3.Hence more liquid 3.Hence less liquid
4.Requires margin payments 4.No margin payment
5.Settlement happens at the end of
5.follows daily settlement period.
OPTIONS CONTRACT
Option means several things to different people. It may refer to choice or alternative
or privilege or opportunity or preference or right. To have option is normally regarded good.
One is considered unfortunate without any options. Options are valuable since they provide
protection against unwanted, uncertain happenings. They provide alternatives to bail out from
a difficult situation. Options can be exercised on the happening of certain events.
Options may be explicit or implicit. When you buy insurance on your house, it is an
explicit option that will protect you in the event there is a fire or a theft in your house. If you
own shares of a company, your liability is limited. Limited liability is an implicit option to
default on the payment of debt.
Options have assumed considerable significance in finance. They can be written on
any asset, including shares, bonds, portfolios, stock indices currencies, etc. They are quite
useful in risk management. How are options defined in finance? What gives value to options?
How are they valued?
An option is a contract that gives the buyer the right, but not the obligation, to buy or
sell an underlying asset at a specific price on or before a certain date. An option, just like a
stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties.
For example, that Rohit discover a bungalow that Rohit love to purchase. Unfortunately,
Rohit won't have the cash to buy it for another three months. Rohit talk to the owner and
negotiate a deal that gives Rohit an option to buy the bunglow in three months for a price of
Rs.20,00,000. The owner agrees, but for this option, Rohit pay a price of Rs.50,000.
Now, consider two theoretical situations that might arise:
1. It is discovered that the bunglow is actually having a historical importance! As a result, the
market value of the bunglow increases to Rs. 50,00,000. Because the owner sold Rohit the
37

38. option, he is obligated to sell Rohit the bunglow for Rs.20,00,000. In the end, Rohit stand to
make a profit of Rs.29, 50,000.
(Rs.50,00,000–Rs.20,00,000–Rs.50,000).
2. While touring the bunglow, Rohit discover not only that the walls are chock-full of
asbestos, but also that it is a home place of numerous rats. Though Rohit originally thought
Rohit had found the bunglow of Rohit dreams, Rohit now consider it worthless. On the
upside, because Rohit bought an option, Rohit are under no obligation to go through with the
sale. Of course, Rohit still lose the Rs.50,000 price of the option.
This example demonstrates two very important points. First, when Rohit buy an
option, Rohit have a right but not an obligation to do something. Rohit can always let the
expiration date go by, at which point the option becomes worthless. If this happens, Rohit
lose 100% of Rohit investment, which is the money Rohit used to pay for the option. Second,
an option is merely a contract that deals with an underlying asset. For this reason, options are
called derivatives; means an option derives its value from something else. In our example, the
bunglow is the underlying asset. Most of the time, the underlying asset is a stock or an index.
Types of Options
There are two types of options:
Call Options: - It gives the holder the right to buy an asset at a certain price within a specific
period of time. Calls are similar to having a long position on a stock. Buyers of calls hope
that the stock will increase substantially before the option expires.
Put Option: - It gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on a stock. Buyers of puts
hope that the price of the stock will fall before the option expires.
Participants in the Options Market
There are four types of participants in options markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of put
38

39. People who buy options are called holders and those who sell options are called writers;
furthermore, buyers are said to have long positions, and sellers are said to have short
positions.
Here is the important distinction between buyers and sellers:
Call holders and put holders (buyers) are not obligated to buy or sell. They have the
choice to exercise their rights if they choose.
Call writers and put writers (sellers), however, are obligated to buy or sell. This
means that a seller may be required to make good on a promise to buy or sell.
Terminology Associated With The Options Market.
Option Price: - Option price is the price, which the option buyer pays to the option
seller. It is also referred to as the option premium.
Expiration Date: - The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike Price: - The price specified in the options contract is known as the strike price
or the exercise price.
Listed Options: - An option that is traded on a national options exchange such as
the National Stock Exchange is known as a listed option. These have fixed strike prices and
expiration dates. Each listed option represents a predetermined number of shares of company
stock (known as a contract).
In-the-money Option: - An in-the-money (ITM) option is an option that would lead
to a positive cashflow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level higher than the
strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the
call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike
price.
At-the-money Option: - An at-the-money (ATM) option is an option that would lead
to zero cashflow if it were exercised immediately. An option on the index is at-the-money
when the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money Option:- An out-of-the-money (OTM) option is an option that
would lead to a negative cash flow when exercised immediately. A call option on the index is
out-of-the-money when the current index stands at a level, which is less than the strike price
(i.e. spot price < strike price). If the index is much lower than the strike price, the call is said
to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
Depending on when an option can be exercised, it is classified in on of the following two
categories:
39

40. American Options: - American options are options that can be exercised at any time
upto the expiration date. Most exchange-traded options are American.
European Options: - European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options, and
properties of an American option are frequently deduced from those of its European
counterpart.
TRADING IN OPTIONS
If one buys an option contract he is buying the option, or "right" to trade a particular
underlying instrument at a stated price.
An option that gives you the right to eventually make a purchase at a predetermined
price is called a "call" option. If you buy that right it is called a long call; if you sell that right
it is called a short call.
An option that gives you the right to eventually make a sale at a predetermined price
is called a "put" option. If you buy that right it is called a long put; if you sell that right it is
called a short put.
Trading in Call
Suppose a call option with an exercise/strike price equal to the price of the underlying (100)
is bought today for premium Re.1.
Profit/ Loss for a Long Call.
At expiry, if the security’s price has fallen below the strike price, the option will be allowed
to expire worthless and the position has lost Re.1. This is the maximum amount that you can
40

41. lose because an option only involves the right to buy or sell, not the obligation. In other
words, if it is not in your interest to exercise the option you don’t have to and so if you are an
option buyer your maximum loss is the premium you have paid for the right.
If, on the other hand, the security’s price rises, the value of the option will increase by
Re.1 for every Re.1 increase in the security’s price above the strike price (less the initial Re.1
cost of the option).
Note that if the price of the underlying increases by Re.1, the option purchaser breaks even -
breakeven is reached when the value of the option at expiry is equal to the initial purchase
price. For our call option, the breakeven price is 101. If the price of the security is greater
than 101, the call buyer makes money.
Profit/Loss for a short call.
Here profit is limited to the premium received for selling the right to buy at the exercise price
- again Re.1. For every Re.1 rise in the price of the underlying security above the exercise
price the option falls in value by Re.1. Here again, the breakeven point is 101.
Trading in Put:
Consider that a put option with an exercise/strike price equal to the price of the underlying
(100) is bought today for premium Re.1.
41

42. Profit/Loss graph for a Long Put.
At expiry the put is worth nothing if the security’s price is more than the strike price of the
option but, as with the long call, the option buyer’s loss is limited to the premium paid.
The breakeven for this option is 99, so the put purchaser makes money if the underlying
security is priced below 99 at expiry.
Profit/Loss graph for a short put.
Here profit is limited to the premium received for selling the right to sell at the strike price.
For every Re.1 fall in the price of the underlying security below the strike price the option
falls in value by Re.1. Here again, the breakeven point is 99.
42

43. Difference between Future and Options
Futures Options
Obligation Both the buyer and the seller are The buyer of the option has the
under obligation to fulfill the right and not the obligation
contract. whereas the seller is under
obligation to fulfill the contract.
Risk The buyer and seller are subject to The seller is subject to unlimited
unlimited risk of losing. risk of losing whereas the buyer
has a limited potential to lose.
Profit The buyer and seller have unlimited The seller has limited potential
potential to gain. to gain while the buyer has
unlimited potential to gain.
Price It is one-dimensional as its price It is bi-dimensional as its price
Behavior depends on the price of the depends upon both the price and
underlying only. the volatility of the underlying.
Payoff Linear payoff Nonlinear payoff
Price and Price is zero and strike price moves Strike price is fixed and price
Strike price moves
Price Price is always zero Price is always positive
Risk Both long and short at risk Only short at risk
SWAP CONTRACT:
Swaps are similar to futures and forwards contracts in providing hedge against
financial risk. A swap is an agreement between two parties, called counter parties, to trade
cash flows over a period of time. Swaps arrangements are quite flexible and are useful in
many financial situation. Two most popular swaps are currency swaps and interest-rate
swaps. These two swaps can be combined when interest on loans in two currencies are
43

44. swapped. The development of swaps in the eighties is a significant development. The interest
rate and currency swap markets enable firms to arbitrage are differences between capital
markets. They make use of their comparative advantage of borrowing in their domestic
market and arranging swaps for interest rates or currencies that they cannot easily access.
1. 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.
COMMODITY FUTURES EXCHANGES –
THE PROFILE AND REGULATORY ENVIRONMENT
The Profile of Futures Exchanges (mcx and ncdex)
5.17 Overview of MCX
MCX an independent and de-mutulised multi commodity exchange has permanent
recognition from Government of India for facilitating online trading, clearing and settlement
operations for commodity futures markets across the country. Key shareholders of MCX
include Financial Technologies (I) Ltd., State Bank of India (India’s largest commercial
bank) & associates, Fidelity International, National Stock Exchange of India Ltd. (NSE),
National Bank for Agriculture and Rural Development (NABARD), HDFC Bank, SBI Life
44

45. Insurance Co. Ltd., Union Bank of India, Canara Bank, Bank of India, Bank of Baroda and
Corporation Bank.
Headquartered in Mumbai, MCX is led by an expert management team with deep
domain knowledge of the commodity futures markets. Through the integration of dedicated
resources, robust technology and scalable infrastructure, since inception MCX has recorded
many first to its credit.
Inaugurated in November 2003 by Shri Mukesh Ambani, Chairman & Managing
Director, Reliance Industries Ltd, MCX offers futures trading in the following commodity
categories: Agri Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils &
Oilseeds, Energy, Plantations, Spices and other soft commodities.
MCX has built strategic alliances with some of the largest players in commodities
eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent
Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United
Planters Association of India and India Pepper and Spice Trade Association.
Today MCX is offering spectacular growth opportunities and advantages to a large
cross section of the participants including Producers / Processors, Traders, Corporate,
Regional Trading Centers, Importers, Exporters, Cooperatives, Industry Associations,
amongst others MCX being nation-wide commodity exchange, offering multiple
commodities for trading with wide reach and penetration and robust infrastructure, is well
placed to tap this vast potential.
5.18 Vision and Mission
The vision of MCX is to revolutionize the Indian commodity markets by empowering
the market participants through innovative product offerings and business rules so that the
benefits of futures markets can be fully realized .Offering 'unparalleled efficiencies',
'unlimited growth' and 'infinite opportunities' to all the market participants.
45

46. Commodities
Gold, Gold HNI, Gold M, I-Gold, Silver, Silver HNI, Silver M
Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cottonseed,
Crude Palm Oil, Groundnut Oil,
Kapasia Khalli (Cottonseed Oilcake), Mustard /Rapeseed Oil,
Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined
Sunflower Oil, Sesame Seed, Soymeal, Soy Seeds
Cardamom, Jeera, Pepper, Red Chilli
Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Flat, Steel
Long (Bhavnagar),
Steel Long (Gobindgarh), Tin, Zinc
Cotton Long Staple ,
Cotton Medium Staple,
Cotton Short Staple, Cotton Yarn, Kapasii
Chana, Masur, Tur, Urad, Yellow Peas,
Basmati Rice, Maize, Rice, Sarbati Rice, Wheat
Brent Crude Oil, Crude Oil, Furnace Oil Middle East Sour Crude
Oil
Arecanut, Cashew Kernel, Rubber
High Density Polyethylene (HDPE),
Polypropylene (PP), PVC
Guar Seed, Guar gum, Gurchaku, Mentha Oil, Potato, Sugar M-30,
46

47. 5.19 Benefits to Participants
The mark of a true exchange market is that it provides equal opportunities to all participants
without any bias. This is the central belief of MCX and towards that it shall be our endeavor
to provide all our participants with equally rewarding opportunities. MCX would
harmoniously meet the requirements of all the stakeholders in the commodity ecosystem in
the most impartial manner.
Benefits to Industry
• Hedging the price risk associated with futures contractual commitments.
• Spaced out purchases possible rather than large cash purchases and its storage.
• Efficient price discovery prevents seasonal price volatility.
• Greater flexibility, certainty and transparency in procuring commodities would aid
bank lending.
• Facilitate Informed lending
• Hedged positions of producers and processors would reduce the risk of default faced
by banks
• Lending for agricultural sector would go up with greater transparency in pricing and
storage.
• Commodity Exchanges to act as distribution network to retail agri-finance from
Banks to rural households.
• Provide trading limit finance to Traders in commodities Exchanges.
Benefits to Exchange Members
• Access to a huge potential market much greater than the securities and cash market in
commodities.
• MCX would leverage on the vast experience of NSE in the capital markets and
NABARD for its strong presence in the rural agricultural markets
• Robust, scalable, state-of-art technology deployment.
• Member can trade in multiple commodities from a single point, on real time basis.
• Traders would be trained to be Rural Advisors and Commodity Specialists and
through them multiple rural needs would be met, like bank credit, information
dissemination, etc.
47

48. 5.20 WINNING EDGE
Value Proposition - MCX's most important differentiator and strength is that it is an
independent and a de-mutualized exchange since inception. This is further strengthened by
participation from different constituents of the market, such as banks, financial institutions,
warehousing companies and other stakeholders of the marketplace. Moreover, experienced
professionals with deep knowledge of the commodity markets as well as exchange
management experience manage MCX.
Neutral Image - MCX has de-mutualized status from inception that allows formation
of a broad, collaborative business partnership.
Strategic Equity Partnerships - MCX has consolidated it base by entering into
strategic equity partnership with leading nationalized banks like State Bank of India, HDFC
Bank, National Stock Exchange (NSE), National Bank for Agriculture and Rural
Development (NABARD), State Bank of Indore, State Bank of Hyderabad, State Bank of
Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Of India, Bank Of
Baroda, Canara Bank, Corporation Bank.
Trade Support - MCX has already tied up exclusively with some of the largest
players in this eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange,
Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana,
United Planters Association of India and India Pepper and Spice Trade Association.
FTIL: Technology Partner - It is here that MCX gets the strategic advantage of
having Financial Technologies (India) Ltd. as its technology partner for delivering
technologically advanced solutions to market participants. FTIL's proven class of end-to-end
Exchange Trading technologies addressing Trading / Surveillance / Clearing and Settlement
operations would deliver a cutting-edge to the MCX Trade Life Cycle i.e. Pre-Trade, Trade
and Post-Trade operations. In addition to its (technology) technological capabilities, FTIL
also brings to MCX its deep engagements with technology giants such as Microsoft / Intel
and HP which would be used to gain the competitive edge in gaining foothold in global
markets.
48