Ppt for guest lecture

1. Introduction to Commodity Market
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2. 2 Commodity Market
 Defining a commodity:
 A Commodity is any good, merchandise or produce of the land that
can be bought or sold.
 A commodity is anything that has value, is used for commerce is
movable
 Its is Important to note that when the commodity reaches the final
hands of the consumer it ceases to be a commodity.
 Commodity Market
A Commodity market is a virtual or a physical place for trading
raw/primary products.

3.  Lack of proper price dissemination
 Fragmented and isolated
 Interstate moment of goods
 Lack of proper warehousing and transportation
 Intermediaries
 Processors are not allowed to buy from cultivators in most states
 Distress sale
 High volatility in spot prices
 Diff tax and tariff structure for diff states
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Problems With Physical Commodity Markets

4. Commodity Spot Market
 In a spot market, a physical commodity is sold or
bought at a price negotiated between the buyer
and the seller.
 Involves buying and selling of commodities in
cash with immediate delivery i.e. transfer of
ownership takes place immediately
 Eg: If one wants to buy 10 tonne of rice today,
one can buy it in the spot market.
 Delhi’s Azadpur Mandi
 Two types: Physical spot market and electronic
spot market
Derivative Market
 A commodity can be sold or bought via
derivatives contract as well
 A futures contract is a pre-determined and
standardized contract to buy or sell
commodities for a particular price and for a
certain date in the future.
 Eg:. But if one wants to buy or sell 10 tonnes
of rice at a future date, (say, after two
months), one can buy or sell rice futures
contracts at a commodity futures exchange
 In practice, most futures contracts do not
involve delivery of physical commodity as
contracts are settled in cash through an
exchange
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Commodity spot and Derivative Market

5. Over the Counter derivatives
 OTC derivatives are contracts that are
privately negotiated and traded between
two parties, without going through an
exchange.
 The market players trade with one another
through telephone, email, and proprietary
electronic trading
 Market participants are free to negotiate
any mutually attractive deal
 There is a small risk that the contract will
not be honored as are generally not
regulated by a regulatory authority.
Exchange traded derivatives
 Exchange traded derivatives contracts are
fully standardized
 Require payment of an initial deposit or
margin settled through a clearing house.
 The contract terms are specified by the
derivatives exchanges.
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Over the Counter and Exchange Traded Contracts

6.  A derivative is an instrument whose value depends on, or is derived from,
the value of more basic underlying assets
The Underlying Securities for Derivatives are:
(a) Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes
etc.)
(b) Precious Metals (Gold, Silver)
(c) Short-term Debt Securities (Treasury Bills)
(d) Interest Rate
(e) Common Shares/Stock
6 Derivatives

7. 7
Difference between Commodity and Financial derivative
Basis Commodity derivative Financial derivatives
Nature of product Commodities are physical assets and may
pronounced seasonality, which needs to be
factored in while trading in them Eg- Gold, silver,
cotton, wheat
In financial derivative the underlying
asset is a financial asset such as
equity shares, bonds, debentures,
interest rates, stock index, exchange
rate etc
Delivery Process Sequence of steps that must be completed in
specific order and at pre-determined time interval
Majority of the derivatives are cash
settled
Quality of underlying
assets
Grading plays a crucial role. Commodity
derivatives contracts specify standards and quality
assurance and certification procedures
Underlying is a financial asset and
the question of grading does not arise
Warehousing Warehousing plays a central role. Physical delivery
of commodities is effected through accredited
warehouses on maturity
Exchange of securities and cash is
effected through account transfers in
bank accounts

8. 8 Types of Derivatives
Derivatives
Forward Future Options

9. 9
Farmer- Shyam (Sell)
(Short Position)
•10 Cows in Jan 2022
•Assumes in Dec 2020 there will
be disease related to cows
•Wants to sell his cow at Rs
150/each
Broker
Farmer- Ram (Buy)
(Long Position)
•Wants to buy 10 Cows in
Dec 2022 at Rs150/each
•Assumes there would be
no disease
Price at which they agree upon- Strike Price, “K”
Example

10. Scenario 1: When there is actually a disease
Suppose on 15th Dec price of cow in the market is Rs 40/ cow
Q1) How much does Shyam gain on each cow?
 Rs 110/cow and for 10 cows he earns profit of Rs 1100
Q2) How much does Ram lose on each cow?
 Rs 110/cow and for 10 cows he loses a sum of Rs 1100
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11. Scenario 2: No disease spread
Suppose on 15th Dec price of cow in the market is Rs 190/ cow
Q1) By selling the cows at Rs150/cow has Shyam reduced his risk?
Q2) What can be the maximum loss of Ram?
 Rs 1500, if the cows become worthless
Q3) What can be the maximum profit of Ram?
 Infinite
Q4) What can be the maximum profit of Shyam?
 Rs 1500
Q5) What can be the maximum loss of Shyam?
 Infinite
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12.  A forward contract or simply a forward is a non standardized contract between two
parties to buy or to sell an asset at a specified future time at a price agreed upon today,
making it a derivative instrument. A forward contract is traded in the over-the-counter
market
 In a forward Contract
• Terms of contract is tailored to suit the needs of the buyer and the seller
• Generally no money changes hands when the contract is first negotiated and is
settled on maturity
• Most of the contracts are held till the expiry date.
12 Forward Contract

13.  Commodity futures contracts are agreements made on a futures exchange to buy or
sell a commodity at a pre-determined price in the future.
 The buyer enters into an obligation to buy, and the seller is obliged to sell, on a specific
date.
 Commodity Futures contracts are highly uniform and are well-defined. Futures are
standardized in terms of size, quantity, grade and time, so that each contract traded on
the exchange has the same specifications and the terms of the contract are
standardized by the exchange.
 Eg: If the hotel owner wants to buy 10 tonnes of wheat for future use, he can buy
wheat future contracts at the commodity future exchange
 India has six commodity Exchanges in India-MCX, NCDEX, NMCE, ICEX DERIVATIVES,
UCX AND numerous other regional exchanges.
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Futures Contract

14.  Standardization
 Clearing house
 Margins
 Exchange based trading
 No default risk
15 Important Features of Futures Contract

15.  Example: A person has purchased a futures contract at Rs 100
Long Pay-off= St-F
Where St: spot price of the asset at the expiry of the contract
F: futures contracted price (i.e., Futures buy price)
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Spot Price at
expiry
Long future payoff
50 -50
60 -40
70 -30
80 -20
90 -10
100 0
110 10
120 20
130 30
140 40
150 50
Long Position (Buy)

16.  Example: A person sells (shorts) a futures contract at Rs 100.
Short Pay-off=F-St
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Short Position (Sell)
Spot Price at
expiry
Long future
payoff
50 50
60 40
70 30
80 20
90 10
100 0
110 -10
120 -20
130 -30
140 -40
150 -50

17. Basis Forward Contract Futures Contract
Trading Platform Forward contracts, by nature, are
over the counter (OTC) contracts.
Futures are always traded on a
recognized exchange.
Structure Forwards can be customized as per
the specific requirements of the
buyer and the seller.
Highly standardized by the exchange in terms of
quality, quality and delivery dates.
Transaction
method
Negotiated directly by the buyer and
seller
Quoted and traded on the Exchange
Market regulation Not regulated Government regulated market
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Comparison between forward and future Contracts

18. Risk High counterparty risk Low counterparty risk as exchange
becomes the central counter-party and
guarantees settlement of trade.
Guarantees No margin money therefore no guarantee
of settlement until the date of maturity
only the forward price
Both parties must deposit an initial
guarantee (margin).
Contract Maturity Forward contracts generally mature by
delivering the commodity.
Future contracts may not necessarily
mature by delivery of commodity.
Contract size Depending on the transaction and the
requirements of the contracting parties.
Standardized
Price Remains fix till maturity Changes everyday
Mode of Delivery Specifically decided. Most of
the contracts result in
delivery
Standardized. Most of the
contracts are cash-settled.
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Cont…

19.  Options provides additional flexibility in managing price risk.
 An options contact is an agreement between a buyer and a seller that gives
the purchaser of the option the right to buy or sell a particular asset at a
later date at an agreed upon price.
 Can be standarized or customized. Options are traded both on exchanges
and in the over-the-counter market
Call: An option to buy`
Put: An option to sell
20 Options Contract

20.  In the option transaction, the purchaser pays the seller (writer of an
option), an amount for the right to buy (in case of “call” option) or for the
right to sell (in case of “put option). This amount is known as “Option
Premium”.
 Buyer of an Option- Is the one who has a right but no obligation in the
contract. He pays a price to the seller called Option Premium
 Writer of an option- Is the one who receives the option premium and is
thereby obliged to sell/buy the asset if the buyer exercises his rights
 Long call –Buying an option to buy
 Long put –Buying an option to sell
 Short call -selling an option to buy / From me
 Short put-Selling an option to sell/ to me
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21. 22 Long Call (Buying an option to buy)
Sham
Wants to sell A phone for
100$ after 2 months (1st Oct
2022)
Ram
Wants to buy a phone worth
100 $ after 2 months (1st Oct
2022)
He pays option premium of 5$
to sham
Q1) If the spot price is 0 will Ram enter into the contract?
Q2) What will be the loss of Ram?
Q3) If the spot price is 90, 100 will Ram enter into the contract?
Q4) Till what price will Ram not buy the phone from Sham?
Q5) If the spot price is 102 will Ram enter into the contract?
Q6) If the spot price is 105 and 110 will Ram enter into the contract?
Q7) What will be maximum gain of Ram?
If the spot price 102 $,
Ram will buy the phone
from sham at 100 $ and
sell in the market at 102$
and earn 2$ but as he had
paid an option premium
of 5$ he will incur at loss
of 3$

22. 23
Long Call (Buying an option to buy)
Market
Price
Strike
price
Premiu
m
Enter/exit Profit/Loss
0 100 5 Exit -5
70 100 5 Exit -5
80 100 5 Exit -5
90 100 5 Exit -5
100 100 5 Indifferent -5
102 100 5 Enter -3
105 100 5 Enter 0
110 100 5 Enter 5

23. Q1) If the spot price is 0, then what will be the Profit/loss of Sham?
Q3) What will happen If the spot price is 90$ and 100$ and what would
be the Profit/loss of Sham?
Q4) What will happen If the spot price is 102$ and 105$ and what would
be the Profit/loss of Sham?
Q5) What would be the maximum loss of Sham?
24 Short Call (selling an option to buy) (From me)

24. Profit from writing one call option: Option price = $5, strike price = $100
25 Short Call (selling an option to buy) (from me )
Market
Price
Strike
price
Premium Enter/exit Profit/Loss
0 100 5 Exit 5
70 100 5 Exit 5
80 100 5 Exit 5
90 100 5 Exit 5
100 100 5 Indifferent 5
102 100 5 Enter 3
105 100 5 Enter 0
110 100 5 Enter -5

25. 26 Long Put (Buying an option to sell)
Ram
Wants to sell the phone at
$ 70 and he pays Option
premium of 7 $ to sham
to sell after 2 months say
1st Oct 2022
Sham
Wants to buy the phone at $
70
Q1) Will Ram enter the contract if the spot price is 100$
Q2) What will be the maximum loss of Ram?
Q3) Will Ram enter the contract if the spot price is 70$
Q4) Will Ram enter the contract if the spot price is 65? How much will he gain or lose?
Q4)What will happen if the spot price is 63$
Q5) What will happen if the spot price is 0 or what would be the maximum profit of Ram?

26. 27 Long Put (Buying an option to sell)
Market
Price
Strike
price
Premium Enter/exit Profit/Loss
100 70 7 Exit -7
90 70 7 Exit -7
80 70 7 Exit -7
70 70 7 Indifferent -7
65 70 7 Enter -2
63 70 7 Enter 0
50 70 7 Enter 13
0 70 7 Enter 63

27. As sham has already sold his options to Ram, so Ram will be a decision
maker
Q1) What will happen if Spot price is $100, 90, 80? What will be the
maximum profit/loss of sham?
Q2) What will happen if Spot price is $70?
Q3) What will happen if Spot price is $68?
Q4) What will happen if Spot price is $63?
Q5) What will be the maximum loss of Sham?
28 Short Put (Selling an option to sell) (TO ME)

28. 29 Short Put (Selling an option to sell)
Market
Price
Strike
price
Premium Enter/exit Profit/Loss
100 70 7 Exit 7
90 70 7 Exit 7
80 70 7 Exit 7
70 70 7 Indifferent 7
65 70 7 Enter 2
63 70 7 Enter 0
50 70 7 Enter -13
0 70 7 Enter -63

29.  Hedgers: A person who invests in financial markets to reduce the risk of price volatility in exchange markets,
i.e., eliminate the risk of future price movements. Hedging means taking a position in the derivatives market that
is opposite of a position in the physical market with the objective of reducing or limiting risks associated with the
price changes.
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PARTICIPANTS IN DERIVATIVE MARKET
Date Spot Market Future market
1st June A jeweler needs to buy 1 kg of gold
at end-July at Rs 50,000 per 10
grams to make desired profit and
make a provision for INR 50.00 lakhs
to buy 1 kg of Gold.
August Futures is trading at Rs
50,400 per 10 grams. He buys
one August gold futures contract at
the rate of Rs 50,400 per 10 grams.
(1 contract = 1 kg)
31st July At end of July, gold is trading at Rs
51,600 per 10 grams in the spot
market. The jeweler pays Rs 51.60
lakhs to buy one kg gold.
August futures is trading at Rs 52,000
per 10 grams. He sells the futures at
Rs 52,000 and squares off his
position in August month futures and
makes a profit of Rs 1,60,000.
Result Loss in the spot market= 1,60,000 Gain in the future market= 1,60,000

30. Speculators: Are traders who speculate on the direction of future prices with the
goal of making profit. They are not end users of the underlying commodity and do not take
physical delivery of the commodity and instead liquidate their position prior to or upon
expiry of the contract.
 Long Speculator: Those who buy first and expect the price to increase from current level.
 Short Speculator: Those who sell first and expect the price to decrease from current level.
Arbitragers: A profit-making activity in financial markets that comes into effect by
taking advantage of or profiting from the price volatility of the market. These situation are
very rare and they remain for shorter duration
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31. An Arbitrage Opportunity ?
Suppose Spot price of gold is US $1400
The one year forward price of gold is US$1500
The one year interest rate is 5%
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Step 1: Go to the bank and take a loan of US $1400 at interest rate of 5% for 1 year
Step 2: Buy gold of US $1400
Step 3: (Short) Sell gold in the market as one year forward price of gold is US$1500 .
You will earn US$1500
Step 4: Return US$ 1470 to the bank and profit received is US $30

32. Price discovery
Transfer of Risk
Liquidity and trading volume
Trading catalyst
33 Uses of derivatives

33.  Large demand for and supply of the physical commodity
 There should be fluctuations in prices of that commodity
 The commodity should have long shelf life
 The commodity should be capable of standardization and gradation
 The delivery points where farmers need to physically deliver the underlying commodity
should not be too far away from the harvest place.
34 Which commodities are suitable for futures trading?

34. Thank You
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