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Commodity market with marwadi shares & finance ltd by rohit parmar


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Commodity market with marwadi shares & finance ltd by rohit parmar

  2. 2. ACKNOWLEDGEMENT It is great pleasure for me to acknowledge the kind of help and guidance received tome during my project work. I was fortunate enough to get support from a large number ofpeople to whom I shall always remain grateful. I would like to express my sincere gratitude to Mr. Pratik Tanna and Mr. Ravi Tandonfor 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 beable to complete this project. I am very thankful to our Director Sir Dr. Sharad Joshi for giving me valuablesuggestion and encouragement to bring out good project. I am very thankful to my mentor Prof. Mr. Mahesh Halale for him inspiration and forinitiating diligent efforts and expert guidance in course of my study and completion of theproject and I am very thankful to my project guide for giving me timely and concreteguidance 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 morevaluable information for my project report. I would thank to God for their blessing and my Parents also for their valuablesuggestion and support in my project report. I would also like to thank our friends and those who have helped us during this projectdirectly or indirectly. Rohit Parmar. 2
  4. 4. 1. EXECUTIVE SUMMARY One of the interesting developments in financial market over the last 15 to 20 yearshas been the growing popularity of derivatives. In many situations, both hedgers andspeculators find it more attractive to trade a derivative on an asset, commodity than to tradeasset and commodity itself. Some commodity derivatives are traded on exchanges. In this report I have included history of commodity market. Than I have includedcommodity market in India. And after that I have discussed the mechanism of trading incommodity market in India. In this report I have taken a first look at forward, futures and options contract andother risk management instruments. Than after I have discuss the main components of futurecommodity trading like contract size, what actual margin is and delivery system etc. Thereare mainly three types of traders: hedgers, speculators and arbitrageurs. In the next section I discuss about the two major commodity exchanges in India that isMCX 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/CRatio) is a market sentiment indicator that shows the relationship between the numbers of putto calls traded. One can use put/call ratio as market indicator .Then after I have discussedabout the present scenario of commodity market in India. In the next I have tried to analyze the trading pattern and investment pattern ofcommodity 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 findingsand conclusion. And on the basis of my findings I have given suggestion andrecommendation 4
  5. 5. 2. OBJECTIVE AND SCOPE OF THE PROJECT2.1 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 andgovernment servants, I have taken data from the local area of the Rajkot city. 5
  6. 6. 3. INTRODUCTIONInstability of commodity prices has always been a major concern of the producers as well asthe consumers in an agriculture dominated country like India. Farmers’ direct exposure toprice fluctuations, for instance, makes it too risky for many farmers to invest in otherwiseprofitable activities. There are various ways to cope with this problem. Apart from increasing the stability of the market, various factors in the farm sectorcan better manage their activities in an environment of unstable prices through derivativemarkets. These markets serve a risk -shifting function, and can be used to lock -in pricesinstead 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 whoextend risk management services. (See UNCTAD, 1998 for a comprehensive survey ofinstruments) These instruments are forward, futures and option contracts, swaps andcommodity linked -bonds. While formal exchanges facilitate trade in standardized contractslike futures and options, other instruments like forwards and swaps are tailor made contractsto 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 areprimarily used for price hedging, as part of a wider marketing strategy, or for price hedging incombination with other financial deals. While forward contracts and OTC options are traderelated instruments, futures, exchange traded options and swaps between banks andcustomers are primarily price hedging instruments. In the case of swaps betweenintermediaries and producers, and commodity linked loans and bonds (CL&BS) pricehedging are combined with financial deals. Forwards contracts are mostly OTC agreements to purchase or sell a specific amountof a commodity on a predetermined future date at a predetermined price. The terms andconditions of a forward contract are rigid and both the parties are obligated to give and takephysical delivery of the commodity on the expiry of contract. The holders of forwardcontracts face spot (ready) price risk. When the prevailing spot price of the underlyingcommodity is higher than the agreed price on expiry of the contract, the buyer gains and theseller looses. The futures contracts are refined version of forwards by which the parties areinsulated from bearing spot risk and are traded in organize exchanges. A detailed discussionon the futures contracts is presented in the next chapter. 6
  7. 7. Both forwards and futures contracts have specific utility to commodity producers,merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgersand 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 ofcommodities, services or assets. Agricultural products, unlike others, have an added risk.Many of them being typically seasonal would attract only lower price during the harvestseason. The forward and futures contracts are efficient risk management tools, which insulatebuyers, and sellers from unexpected changes in future price movements. These contractsenable them to lock-in the prices of the products well in advance. Moreover, futures pricesgive necessary indications to producers and consumer s about the likely future ready priceand demand and supply conditions of the commodity traded. The cash market or readydelivery market on the other hand is a time-tested market system, which is used in all formsof business to transfer title of goods. 7
  8. 8. 4. COMPANY PROFILE4.1 NAME OF THE COMPANY MARWADI SHARES & FINANCE LTD.4.2 LOGO OF THE COMPANY4.3 VISION OF THE COMPANY “To be a world class financial services provider by arranging all conceivablefinancial services under one roof at affordable price through cost-effective deliverysystems 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 acquiredmembership of National Stock Exchange of India Ltd. That was the time when Govt. had juststarted liberalization. Capital market being at the base of every thing else was among the firstfew sectors taken up for liberalization and alignment with global benchmarks. NSE wastherefore a result of Government’s policy to modernize stock market and give our investors acost - effective trading and settlement system. They enter into the stock market coincided with Governments initiative to give amodern Stock exchange. Marwadi had then very presciently felt that this development wouldchange the very structure and content of the market. Then, when Depository system wasintroduced to automate the settlement system, we became the first Corporate DP in 1998 tobring this concept to investors doorstep in Saurashtra. Marwadi had very early on seen thatthe future lay in the ability to network and use technology to its fullest possible extent. 8
  9. 9. Relying on your judgment, we used technology extensively which resulted in efficient clientservicing. It also saw the synergy that lay in providing a bouquet of services under one roof. It isthis realization that led us in the year 2003 to go for membership of National LevelCommodity Exchanges, which were set up as part of Govts policy to bring commoditymarket on par with the capital market in terms of integrity and practices. They bold initiatives starting with our journey from capital market up to commoditiesmarket has given us synergies in operations, enabling us to pass on the advantage tocustomers. As an organization, have achieved a leaders position by ensuring total satisfaction ofcustomers 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 thefutures and options market using their research and tools. To start trading in Equity, all youneed to do is open an online trading account. You can call them and they will have theirrepresentative meet you. You can get help opening the account and get guidance on how totrade in Equity.Commodity: You can enter the whole new world of commodity futures. Investors looking for afast-paced dynamic market with excellent liquidity can NOW trade in Commodity FuturesMarket. The Commodity Exchange is a Public Market forum and anyone can play in thesevital Commodity Markets. Marwadi Commodity Broker (P) Ltd can certainly be your pointof entry to the Commodity Markets. Marwadi is a registered trading-cum-clearing member ofNCDEX and MCX.Internet Trading: Making the right trade at the right time! E-Broking service, which brings youexperience of online buying and selling of shares with just a click. 9
  10. 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 securityabout money, shares, and transaction documents.IPO: An active player in the primary market with waste customer base and reachingdistribution 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 incase 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 byenabled the interline investors to subscribes qualitative IPOs.Mutual Funds: Transact in a wide range of Mutual Funds. Mutual Funds are an attractive means ofsaving taxes and diversifying your investment portfolio. So if you are looking to invest inmutual funds, Marwadi offers you a host of mutual fund choices under one roof; backed byin-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 gambleonly on the recommendations from your friends and the information overload frommagazines and financial dailies? And, of course, more importantly, if you happen to be aHigh Net worth Individual, do you have the time to judge which advice is reliable, authenticand has the least chance of failure? With Marwadi PMS, you can be assured that yourinvestments are in safe hands! Give your portfolio the expert edge to smoothly steer towardswealth 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 atall the certain Saurashtra and Kutch where placed either a branch or franchise or sub broker 10
  11. 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 001C.E.O.: Mr. Jeyakumar A. S.Directors: Mr. Ketan Marwadi Mr. Deven Marwadi Mr. Sandeep MarwadiGeneral Manager: Mr. Hareshbhai ManiarE-Mail: smarwadi@hotmail.comWeb Site: 11
  12. 12. 4.7 COMPANY’S MILESTONE:1992: Marwadi Shares And Finance Pvt. Ltd. was incorporated1996: 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 SecuritiesDepository Ltd.2000: Commenced Derivative Trading after obtaining registration as a Clearing and TradingMember in NSE2003: (MCBPL) became a corporate member of The National Commodity and DerivativesExchange of India Ltd.2004: Became a corporate member of The Stock Exchange, Mumbai.2004: Launched Depository Services of Depository Participant under Central DepositoryServices (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. 13. 4.9 SERVICES OF MARWADI:Stock broking: Cash Market Derivatives Trading Margin Trading Internet TradingCommodities Broking: Commodities Futures Financing Against CommoditiesDepository Service: NSDL CDSLIPO Subscription ServicesMutual Fund ProductsPortfolio managementInsurance ServicesQualitative Research in Stock & CommoditiesFUTURE SERVICES: Private Banking Sector Forex Market Commodities Demat Service Product Enhancement in commodity market4.10 THE COMPLETE INVESTMENT DESTINATION: It provides comprehensive range of investment services. That’s advantage of havingall 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. 14. phone, its highly trained team and sophisticated equipment ensure smooth transactions andprompt services.E-Broking and Web-Based Services: It is one of the offers online trading on site, high bandwidthleased lines, secure services and a customs-built user interface give you an internationalstandards 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 avariety of helpful features like market watch, order entry, order confirmation, charts, andtrading calls, all available in resizable windows. And it can be operated through the keyboardusing F1 for buy, F2 for sell.Depository Participant Services: It offers DP services mean hassle-free, speedy settlements. It is depositoryparticipants with NSDL and CDSL.Premium Research Services: Its research team offers a package of fee-based services, including daily technicalanalysis, research reports, and advice on clients existing investments. It is research beyonddesk and company-provider reports. If you have an equity portfolio, you know that the paceof life in the world of stocks and shares is frantic. Managing your portfolio means you haveto take firm, informed decisions, and quickly!4.11 BRANCHES: Marwadi has spread throughout Gujarat state with our 28 branches and now taking onPan - 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 tobe a conspicuous player at national level. As on today they are serving about 75,000 clientsspread out over 554 pin code locations through a network of about 300 intermediaries such assub-brokers, franchisees and authorized persons. 14
  15. 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. 16. 5. ABOUT THE COMMODITY5.1 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 financialmarket is not an exception to this phenomenon. The attendant risk arising out of the volatilityand complexity of the financial market is an important concern for financial analysts. As aresult, the logical need is for those financial instruments which allow fund managers to bettermanage or reduce these risks. The emergence of the market for derivative products, most notably forwards, futuresand options, can be traced back to the willingness of risk-averse economic agents to guardthemselves against uncertainties arising out of fluctuations in asset prices. By their verynature, the financial markets are marked by a very high degree of volatility. Through the useof derivative products, it is possible to partially or fully transfer price risks by locking–inasset prices. As instruments of risk management, these generally do not influence thefluctuations in the underlying asset prices. However, by locking-in asset prices, derivativeproducts minimize the impact of fluctuations in asset prices on the profitability and cash flowsituation of risk-averse investors.5.2 COMMODITIES Organized futures market evolved in India by the setting up of "Bombay Cotton TradeAssociation Ltd." in 1875. In 1893, following widespread discontent amongst leading cottonmill owners and merchants over the functioning of the Bombay Cotton Trade Association, aseparate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futurestrading in oilseeds was organized in India for the first time with the setting up of GujaratiVyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed andcotton. Before the Second World War broke out in 1939 several futures markets in oilseedswere 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 markethave 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 inJuly, 2000 by the government that futures trading will be encouraged in increasing number ofagricultural commodities was indicative of welcome change in the government policytowards forward trading. 16
  17. 17. Secondly, strengthening of infrastructure and institutional capabilities of the regulatorand the existing exchanges received priority. Thirdly, as the existing exchanges are slow toadopt reforms due to legacy or lack of resources, new promoters with resources andprofessional 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 commoditymarket when the government issued notifications for withdrawing all prohibitions andopening up forward trading in all the commodities. This period also witnessed other reforms,such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, whichhave reduced bottlenecks in the development and growth of commodity markets. Of thecountrys total GDP, commodities related (and dependent) industries constitute about roughly50-60 %, 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 substantialconflict of interests, opaque in their functioning and have not used technology to scale uptheir operations and reach to bring down their costs. But with the strong emergence of:National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi CommodityExchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai(NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will beaddressed rapidly. These exchanges are expected to be role model to other exchanges and arelikely 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 arespeculative (due to non delivery) and are not meant for actual users. One major reason beingthat the awareness is lacking amongst actual users. In India, Interest rate risks, exchange raterisks are actively managed, but the same does not hold true for the commodity risks. Someadditional 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, whichneeds use of futures and derivatives as price-risk management system. Fundamentally price you pay for goods and services depend greatly on how wellbusiness handle risk. By using effectively futures and derivatives, businesses can minimizerisks, thus lowering cost of doing business. 17
  18. 18. Commodity players use it as a hedge mechanism as well as a means of makingmoney. For e.g. in the bullion markets, players hedge their risks by using futures Euro-Dollarfluctuations and the international prices affecting it. For an agricultural country like India, with plethora of mandis, trading in over 100crops, the issues in price dissemination, standards, certification and warehousing are bound tooccur. Commodity Market will serve as a suitable alternative to tackle all these problemsefficiently.5.4 COMMODITY FUTURES: Commodity futures are simply the standard futures contracts traded throughexchange. These contracts have their respective commodity as underlying asset and derivethe dynamics from it. Such contracts allow the participant to buy and sell certain commodityat a certain price for future delivery. Futures trading is a natural outgrowth of the problem ofmaintaining a year-round supply of seasonal products like agriculture crops. The best thingabout a commodity futures contract is that it is generally leveraged giving opportunity to alltypes of investors to participate. Characteristically, such a contract has an expiry and deliveryattached 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 onagriculture, precious metals and base metals. Thus, trading in commodities provides lucrative market opportunities for a widersection 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 frominvesting 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 andsupply” so is hedging, by taking appropriate contract. This makes things really easy tounderstand and exploit. 18
  19. 19. 5. Portfolio diversifier Commodity futures derive their prices from the underlying commodity andcommodity prices cannot become zero. Commodity has a global presence and their pricesmove 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 whodo not want custody. Though, the most lucrative element of futures trading is that it allows investors toparticipate 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 atrade results in delivery. Traders can short sell. If a trader buys an equivalent contract back before the contractexpires, he will be able to profit from a falling price. This is difficult in spot marketersbecause it requires the seller to borrow the commodity. It is next to impossible for retailinvestors in case of something like gold. All participants trade exactly the same notional right i.e. those defined on the standardcontract, so the market grows deeper and more liquid in the standard futures contract than inspot 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 notavailable in the OTC bullion market.5.7 CHARACTERISTICS OF FUTURES TRADINGA "Futures Contract" is a highly standardized contract with certain distinct features. Some ofthe important features are as under: Futures’ trading is necessarily organized under the auspices of a market association sothat such trading is confined to or conducted through members of the association inaccordance 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" withpermission to deliver other identified varieties known as "tenderable varieties". The units of price quotation and trading are fixed in these contracts, parties to thecontracts not being capable of altering these units. 19
  20. 20. The delivery periods are specified. The seller in a futures market has the choice to decide whether to deliver goodsagainst outstanding sale contracts. In case he decides to deliver goods, he can do so not onlyat the location of the Association through which trading is organized but also at a number ofother 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 aresettled 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 managementprocess especially in any agriculture dominated economy. Derivatives like forwards, futures,options, swaps etc are extensively used in many developed and developing countries in theworld. The Chicago Mercantile Exchange; Chicago Board of Trade; New York MercantileExchange; International Petroleum Exchange, London; London Metal Exchange; LondonFutures and Options Exchange; “Marche a Terme International de France”; Sidney FuturesExchange; Singapore International Monetary Exchange; The Singapore CommodityExchange; Kuala Lumpur Commodity Exchange ; “Bolsa de Mercadorias & Futuros” (inBrazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China CommodityFutures Exchange; Beijing Commodity Exchange, etc are some of the leading commodityexchanges 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 along history of trade in commodity derivatives, this segment remained underdeveloped due togovernment intervention in many commodity markets to control prices. The governmentcontrols the production, supply and distribution of many agricultural commodities and onlyforwards and futures trading are permitted in certain commodity items. Free trade in manycommodity items is restricted under the Essential Commodities Ac, 195, and forward andfutures 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 TradeAssociation 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 invarious commodities. The Gujarati Vyapari Mandali came into existence in 1900, which hasundertaken futures trade in oilseeds first time in the country. The Calcutta Hessian ExchangeLtd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures 20
  21. 21. trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices ofEast India Cotton Association. Many exchanges came up in the agricultural centers in northIndia before world war broke out and engaged in wheat futures until it was prohibited. Theexchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during thisperiod. 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 thegovernment prohibited it by mid-1950s. Later, futures trade was altogether banned by thegovernment in 1966 in order to have control on the movement of prices of many agriculturaland essential commodities. Options are though permitted now in stock market, they are notallowed in commodities. The commodity options were traded during the pre-independenceperiod. 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 tradersstarted resorting to unofficial and informal trade in futures. On recommendation of theKhusro Committee in 1980 government reintroduced futures on some selected commoditiesincluding cotton, jute, potatoes, etc. Further in 1993 the government of India appointed an expert committee on forwardmarkets under the chairmanship of Prof. K.N. Kabra and the report of the committee wassubmitted in 1994 which recommended the reintroduction of futures already banned and tointroduce futures on many more commodities including silver. In tune with the ongoingeconomic liberalization, the National Agricultural Policy 2000 has envisaged external anddomestic market reforms and dismantling of all controls and regulations in agriculturalcommodity markets. It has also proposed to enlarge the coverage of futures markets tominimize the wide fluctuations in commodity prices and for hedging the risk emerging fromprice fluctuations. In line with the proposal many more agricultural commodities are beingbrought under futures trading. In India, currently there are 15 commodity exchanges actively undertaking trading indomestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association(IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recentlyupgraded to international exchanges to deal in international contracts in pepper and castor oilrespectively. Another 8 exchanges are proposed and some of them are expected to startoperation shortly. There are 4 exchanges, which are specifically approved for undertakingforward deals in cotton. More detailed account of these exchanges has been presented. 21
  22. 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., amulty-commodity international exchange where futures in castor oil, castor seed, sunfloweroil, 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 CottonAssociation (SICA , Coimbatore which deals in forward contracts in cotton; Coffee FuturesExchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading; KanpurCommodity Exchange (KCE) which deals with futures contracts in mustard oil and gur; andThe 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 derivedfrom the spot (ready) price of the commodity underlying the contract. Therefore, they arecalled derivatives of spot market. The buying and selling of futures contracts take place inorganized exchanges. The members of exchanges are authorized to carryout trading infutures. The trading members buy and sell futures contract for their own account and for theaccount of non-trading members and other clients. All other persons interested to trade infutures contracts, as clients must get themselves registered with the exchange as registerednon-members.5.10 WHAT IS A COMMODITY FUTURE EXCHANGE? Exchange is an association of members, which provides all organizational support forcarrying out futures trading in a formal environment. These exchanges are managed by theBoard of Directors, which is composed primarily of the members of the association. Thereare also representatives of the government and public nominated by the Forward MarketsCommission. The majority of members of the Board have been chosen from among themembers of the Association who have trading and business interest in the exchange. Thechief executive officer and his team in day-to-day administration assist the Board. There aredifferent classes of members who capitalize the exchange by way of participation in the formof equity, admission fee, security deposits, registration fee etc.a. Ordinary Members: They are the promoters who have the right to have own –accounttransactions without having the right to execute transactions in the trading ring. They have toplace orders with trading members or others who have the right to trade in the exchange. 22
  23. 23. b. Trading Members: These members execute buy and sell orders in the trading ring of theexchange 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 inclearing and settlement in respect of transactions carried out on their account and on accountof their clients.d. Institutional Clearing Members: They have the right to participate in clearing andsettlement 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 andother monetary settlements.The composition of the members in an exchange however varies. In so me exchanges thereare exclusive clearing members, broker members and registered non -members in addition tothe above category of members.5.11 WHAT IS COMMODITY FUTURES CONTRACT? Futures contracts are an improved variant of forward contracts. They are agreementsto purchase or sell a given quantity of a commodity at a predetermined price, with settlementexpected to take place at a future date. While forward contracts are mainly over-the-counterand tailor-made which physical delivery futures settlement standardized contracts whosetransactions are made in formal exchanges through clearing houses and generally closed outbefore delivery. The closing out involves buying a different times of two identical contractsfor the purchase and sale o the commodity in question, with each canceling the other out. Thefutures contracts are standardized in terms of quality and quantity, and place and date ofdelivery of the commodity. The commodity futures contracts in India as defined by the FMChas the following features:(a) Trading in futures is necessarily organized under the auspices of a recognized associationso that such trading is confined to or conducted through members of the association inaccordance 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” withpermission 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 thecontracts not being capable of altering these units.(d) The delivery periods are specified. 23
  24. 24. (e) The seller in a futures market has the choice to decide whether to deliver goods againstoutstanding sale contracts. In case he decides to deliver goods, he can do so not only at thelocation of the Association through which trading is organized but also at a number of otherpre-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 aresettled by payment of differences without any physical delivery of goods taking place. Theterms and specifications of futures contracts vary depending on the commodity and theexchange in which it is traded.The major terms and conditions of contracts traded in six sample exchanges in India. Theseterms are standardized and applicable across the trading community in the respectiveexchanges and are framed to promote trade in the respective commodity For example, thecontract size is important for better management of risk by the customer. It has implicationsfor the amount of money that can be gained or lost relative to a given change in price levels. Ialso affect the margins required and the commission charged. Similarly, the margin to bedeposited with the clearing house has implications for the cash position of customers becauseit blocks cash for the period of the contract to which he is a party the strength and weaknessesof 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 acorrect anticipation of future price movements, and hedgers who transact in futures marketwith an objective of offsetting a price risk on the physical market for a particular commoditymake the futures market in that commodity. Although it is difficult to draw a line ofdistinction between hedgers and speculators, the former category consists of manufacturingcompanies, merchandisers, and farmers. Manufacturing companies who use the commodityas a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at apredetermined price, which facilitates immunity against price fluctuations. While exporters inaddition to using the price discovery mechanism for getting better prices for theircommodities seek to hedge against their overseas exposure by way of locking-in the price byway of buying futures contracts, the importers utilize the liquid futures market for thepurpose of hedging their outstanding position by way of selling futures contracts. Futuresmarket helps farmers taking informed decisions about their crop pattern on the basis of thefutures prices and reduces the risk associated with variations in their sales revenue due to 24
  25. 25. unpredictable future supply demand conditions. Above all, there are a large number ofbrokers who intermediate between hedgers and speculators create the market for futurescontracts.5.13 COMMODITY ORDERSThe buy and sell orders for commodity futures are executed on the trading floor where floorbrokers congregate during the trading hours stipulated by the exchange. The floorbrokers/trading members on receipt of orders from clients or from their office transmits thesame to others on the trading floor by hand signal and by calling out the orders (in an openoutcry system they would like to place and price. After trade is made with another floorbroker who takes the opposite side of the transaction for another customer or for his ownaccount, the details of transactions are passed on to the clearing house through a transactionslip 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 tradingcommodity exchanges are also moving from outdated open outcry system to automatedtrading system. Many leading commodity exchanges in the world including ChicagoMercantile Exchange (CME), Chicago Board of Trade (CBOT), International PetroleumExchange (IPE), London, have already computerized the trading activities. In India, coffeefutures exchange, Bangalore has already put inplace the screen based trading and many others are in the process of computerization. To addto modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for acommon electronic trading platform connecting all commodity exchanges to conduct screenbased trading. In electronic trading, trading takes place through a centralized computernetwork system to which all buy and sell orders and their respective prices are keyed in fromvarious terminals of trading members. The deal takes place when the central computer findsmatching price quotes for buy and sell. The entire procedural steps involved in electronictrading beginning from placing the buy/sell order to the confirmation of the transaction havebeen shown in figure -2.1 below. 25
  26. 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 settlement5.14 ROLE OF CLEARING HOUSE Clearinghouse is the organizational set up adjunct to the futures exchange whichhandles 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 maturityby paying the price difference or by arranging physical delivery, etc., and assumes allcounterparty risk on behalf of buyer and seller. It is important to understand that the futuresmarket is designed to provide a proxy for the ready (spot) market and thereby acts as apricing 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 thecontract. First, the buyer (seller) may take (give) physical delivery of the commodity at thedelivery point approved by the exchange after the contract matures. The second option, whichdistinguishes futures from forward contracts is that, the buyer (seller) can offset the contract 26
  27. 27. by selling (buying) the same amount of commodity and squaring off his position. Forsquaring 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 theprocess of daily matching. As delivery time approaches, virtually all contracts are settled byoffset as those who have bought (long) sell to those who have sold (short). This offsettingreduces the open position in the account of all traders as they approach the maturity date ofthe contract. The contracts, if any, which remain unsettled by offset until maturity date aresettled by physical delivery. The clearinghouse plays a major role in the process explained above byintermediating between the buyer and seller. There is no clearinghouse in a forward marketdue to which buyers and sellers face counterparty risk. In a futures exchange all transactionsare routed through and guaranteed by the clearinghouse which automatically becomes acounterpart to each transaction. It assumes the position of counterpart to both sides of thetransaction. 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-freetransactions and provides financial guarantee on the strength of funds contributed by itsmembers and through collection of margins (discussed in section 2.3), marking-to-market alloutstanding contracts, position limits imposed on traders, fixing the daily price limits andsettlement guarantee fund. The organizational structure and membership requirements of clearinghouses varyfrom one exchange to the other. The Bombay Commodity Exchange and Cochin pepperexchange have set up separate independent corporations (namely, Prime CommoditiesClearing Corporation of India Ltd, and First Commodities Clearing Corporation of India Ltd.,respectively) for handling clearing and guarantee of all futures transactions in the respectiveexchanges. While coffee exchange has clearing house as a separate division of the exchange,many other exchanges like Chamber of Commerce, Hapur; Kanpur Commodity Exchangeand cotton exchange in Bombay run in-house clearinghouse as part of the respectiveexchanges. The clearing and guaranty are managed in these exchanges by a separatecommittee (normally called the Clearing House Committee). The membership in the clearinghouse requires capital contribution in the form ofequity, security deposit, admission fee, registration fee, guarantee fund contribution inaddition to net worth requirement depending on its organizational structure. For example, inthe Bombay Commodity Exchange the minimum capital requirement for membership in itsclearinghouse as applicable to trading-cum-clearing members is Rs.50,000 each towardequity and security deposit, Rs. 500 as annual subscription, and additionally, members are 27
  28. 28. required to have net worth of Rs.3 lakhs. Similarly, coffee exchange prescribed Rs.5 lakheach towards equity and guarantee fund contribution and Rs.40,000 towards admission feefor a trading-cum-clearing member. However, in exchanges where clearing house is a part ofthe exchange the payment requirements are lower. For example, Kanpur CommodityExchange prescribed only Rs.25,00,000 Rs.1000 and Rs.500 respectively towards securitydeposit, registration fee and annual fee for a clearing cum-trading member. For ensuring financial integrity of the exchange and for counterparty risk -free tradeposition (exposure) limits have been imposed on clearing members. These limits which arestringent 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 andsettlement guarantee fund. In Bombay Commodity Exchange the exposure limit of a clearing member is the sumof 50 times the face value of contribution to equity capital of the clearinghouse and 30 timesthe security deposit the member has maintained with the clearinghouse. While coffeeexchange prescribes the limit of 80 times the sum of member’s equity investment and thecontribution to the guarantee fund, the cotton exchange, Bombay, has stipulated a liberalexposure limit on open positions. It has a limit of 200 and 1500 units (recall that one contractunit is equivalent to 93.5 quintals respectively for composite and institutional members. TheCochin pepper exchange has fixed a net exposure limit of 60 units (equivalent to 1500quintals) for domestic contract and 90 units (equivalent to 2250 quintals) for internationalcontract. Moreover, setting up of settlement guarantee fund ensures enough financial strengthin case the clearinghouse faces default. The Kanpur Commodity Exchange maintains a trade guarantee fund with a corpus ofRs.100 lakhs while the coffee exchange in addition to a guarantee fund the exchange hassubstituted itself as party to clear all transactions. Yet another check on the possible default is through prescribing maximum pricefluctuation on any trading day, which helps limit the probable profit/loss from each unit oftransaction. The relevant data on permitted price limit has been presented. Its clear from thetable that the maximum profit/loss potential from trade in each contract unit varies from aslow as Rs. 800 for potato futures in Chamber of Commerce, Hapur to as high as Rs. 15,000 inpepper exchange, Cochin. Similarly, given the permissible open position of 200 units for atrading-cum-clearing member and maximum price fluctuation of Rs. 150 per 100 kg forcotton futures in the cotton exchange, Bombay, the maximum potential loss/profit in a tradingday works out to be Rs.28.05 lakhs! 28
  29. 29. Margins Margins (also called clearing margins) are good -faith deposits kept with aclearinghouse usually in the form of cash. There are two types of margins to be maintainedby 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 thecommodity traded. Margins are deposited with the clearing house in advance against theexpected exposure of the trading member on his account and on account of the clients. Themember 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 ishigher, multiplied by the current price of the contract) on account of trades executed throughhim 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 arenot required. The margin is refundable after the client liquidates his position or after thematurity of the contract. Maintenance margin which usually ranges from 60 to 80 per cent of initial margin isalso required by the exchange. Variation margin is to compensate the risk borne by theclearinghouse on account of price volatility of the commodity underlying the contract towhich it is a counterparty. A debit in the margin account due to adverse market conditionsand consequent change in the value of contract would lead to initial margin falling below themaintenance level. The clearinghouse restores initial margin through margin calls to theclient 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 theinitial contract value and its change over the lifetime of the contract on the basis of its dailyprice movements. If the member is not able to pay the variation margin, he is bound to squareoff 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 tradingentity gets blocked to that extent. While a higher margin requirement prevents traders fromparticipating in trading, a lower margin makes the clearinghouse vulnerable to any defaultdue to its weak financial strength otherwise. Internationally, many developed exchangesmaintain a low margin on positions due to their better financial strength along with massivevolume of trade resulting in large income accruing to them. However, this has not been the case with many exchanges in India. For example, asshown in table 2.2 the initial margin liability for transacting the minimum lot size in pepper is 29
  30. 30. Rs.30, 000 for domestic contracts and US$ 312.50 for international contracts .Similarly, thevolume of transactions. These clearinghouses deal in many exchanges in India is abysmallylow making their existence financially unviable.Most of the exchanges in additions to keeping mandatory margins maintain a settlementguarantee fund. The fund set up with the contribution from members of clearing house is usedfor guaranteeing financial performance of all members. This fund absorbs losses not coveredby margin deposits of the defaulted member. The clearinghouse ensures this by settling thedefault transactions by properly compensating the traders paying the amount of difference atthe 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 inlocking-in prices and obtaining forward cover. These contracts can be used for hedging pricerisk and discovering future prices. For commodities that compete in world or nationalmarkets, such as coffee, there are many relatively small producers scattered over a widegeographic area. These widely dispersed producers find it difficult to know what prices areavailable, and the opportunity for producer, processor, and merchandiser to ascertain theirlikely cost for coffee and develop long range plans is limited. Futures trading, used in theMidwest 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 bestestimate for the future. Moreover, since all transactions are guaranteed through a centralbody, clearing house, which is the counter party to each buyer and seller ensuring zerodefault 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 thephysical (ready) market. It involves establishing a position in the futures market again one’sposition or firm commitments in the physical market. The producers who seek to protectthemselves from an expected decline in prices of their commodity in future go for shorthedge (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 physicalsale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2units of contracts in Cochin pepper exchange) of pepper in March, the futures price for Marchdelivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and theprevailing (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 futurescontracts at Rs.8400 per quintal. This is called “price fixing”. 30
  31. 31. b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sellspepper in the ready market for Rs.8200.c) Simultaneously, he closes out his short position in futures by buying (long position) 2March futures contracts at Rs.8200 per quintal. The result is that the producer sold futurescontract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a netgain of Rs.200 per quintal or Rs.5000 per contract. For the physical sale, the producer received the market price of Rs.8200 prevailing onthe day of the sale and the gain of Rs.200 per quintal from closing-out of futures contractsmakes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the pricerealized in the ready market is lower than the price in future contract, the loss on the physicalmarket 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 marketis offset by the loss on the repurchase of the futures contract. Since futures market prices move in tandem with the ready market prices over thecourse of time tending to converge as the contract matures, a gain in the futures market in adeveloped commodity market under normal conditions, will be offset by a loss in the readymarket, or vice versa. However, market imperfections will lead to the basis risk emergingfrom the mismatch between the gain/loss from the futures market not compensated byloss/gain in the ready market.Meaning of Derivatives The term "Derivative" indicates that it has no independent value, i.e. its value isentirely "derived". A derivative is a financial instrument, which derives its value from someother financial price. This “other financial price” is called underlying. The most commonunderlying assets include stocks, bonds, commodities, currencies, livestock, interest rates andmarket indexes. A wheat farmer may wish to contract to sell his harvest at a future date to eliminatethe risk of a change in prices by that date. The price for such a contract would obviouslydepend upon the current spot price of wheat. Such a transaction could take place on a wheatforward 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” areused interchangeably. 31
  32. 32. Examples of Derivatives Consider how the value of mutual fund units changes on a day-to-day basis. Don’tmutual fund units draw their value from the value of the portfolio of securities under theschemes? A very simple example of derivatives is cloth, which is derivative of cotton. The priceof cloth depends upon the price of cotton, which in turn depends upon the demand, andsupply of cotton... Aren’t these examples of derivatives? Yes, these are. And you know what, theseexamples 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. Sometexts even find the existence of the characteristics of derivative contracts in incidents ofMahabharata. Traces of derivative contracts can even be found in incidents that date back tothe ages before Jesus Christ. The first organized commodity exchange came into existence in the early 1700s inJapan. The first formal commodities exchange, the Chicago board of trade (CBOT), wasformed in 1848 in the US to deal with the problem of credit risk and to provide centralizedlocation to negotiate forward contracts, where forward contracts on various commoditieswere standardized around 1865.The primary market intention of the CBOT was to provide acentralized 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 CMEremain the two largest organized futures exchanges, indeed the two largest “financial” 32
  33. 33. exchanges of any kind in the world today. From then on, futures contracts have remainedmore 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 500index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futuresbecame the most active derivative instruments generating volumes many times more than thecommodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the threemost popular futures contracts traded today. Other popular international exchanges that tradederivatives 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 forfarmers to protect themselves from any decline in the price of their crops due to delayedmonsoon, or overproduction. Although trading in agricultural and other commodities hasbeen the driving force behind the development of derivatives exchanges, the demand forproducts based on financial instruments - such as bond, currencies, stocks and stockindices—has now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton andoil etc for decades in the gray market. Trading derivatives contracts in organized market waslegal before Morarji Desai’s government banned forward contracts. Derivatives on stockswere traded in the form of Teji and Mandi in unorganized markets. Recently futures contractin various commodities was allowed to trade on exchanges. In June 2000, National Stock Exchange and Bombay Stock Exchange started tradingin futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in themonth of July and November respectively. The derivatives market in India has grownexponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSEaccounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005 33
  34. 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 ForwardsPut Call Commodity Securities Interest Rate Currency 34
  35. 35. FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset on a specified date for aspecified price. One of the parties to the contract assumes a long position and agrees to buythe underlying assed on a certain specified future date for a certain specified price. The otherparty assumes a short position and agrees to dell the asset on the same date for the sameprice. Other contract details like delivery date, price and quantity are negotiated bilaterally bythe 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 andgenerality. The forward market is like a real estate market in that any two consenting adultscan form contracts against each other. This often makes them design terms of the deal whichare 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 thetransaction. When one of the two sides to the transaction declares bankruptcy, the othersuffers. Even when forward market trade standardized contracts, and hence avoids theproblem 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 itoutright. He can only buy it 3 months hence. He, however, fears that prices of laptop will rise 35
  36. 36. 3 months from now. So in order to protect himself from the rise in prices Sahil enters into acontract 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 forwardcontract. The forward contract is settled at maturity. The dealer will deliver the asset to Sahilat the end of three months and Sahil in turn will pay cash equivalent to the LAPTOP price ondelivery.FUTURES CONTRACT Futures markets were designed to solve the problems that exist in forward market. Afutures contract is an agreement between two parties to buy or sell an asset at a certain time inthe future at a certain price. But unlike forward contracts, the futures contracts arestandardized and exchange traded. So, the counter party to a future contract is the clearingcorporation of the appropriate exchange. To facilitate liquidity in the futures contracts, theexchange specifies certain standard features of the contract. It is a standardized contract withstandard underlying instrument, a standard quantity and quality of the underlying instrumentthat can be delivered, (or which can be used for reference purposes in settlement) and astandard timing of such settlement. Future contracts are often settled in cash or cashequivalents, rather than requiring physical delivery of the underlying asset. A futures contractmay be offset prior to maturity by entering into an equal and opposite transaction. More than99% 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 isprimarily because both serve essentially the same economic functions of allocating risk in thepresence of future price uncertainty. However futures are a significant improvement over theforward contracts as they eliminate counterparty risk and offer more liquidity. The distinctionbetween futures and forwards are summarized below: 36
  37. 37. Futures Forwards1.Trade on an organized exchange 1.OTC in nature2.Standardized contract terms 2.Customized contract terms3.Hence more liquid 3.Hence less liquid4.Requires margin payments 4.No margin payment 5.Settlement happens at the end of5.follows daily settlement period.OPTIONS CONTRACT Option means several things to different people. It may refer to choice or alternativeor 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 provideprotection against unwanted, uncertain happenings. They provide alternatives to bail out froma 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 anexplicit option that will protect you in the event there is a fire or a theft in your house. If youown shares of a company, your liability is limited. Limited liability is an implicit option todefault on the payment of debt. Options have assumed considerable significance in finance. They can be written onany asset, including shares, bonds, portfolios, stock indices currencies, etc. They are quiteuseful 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 orsell an underlying asset at a specific price on or before a certain date. An option, just like astock or bond, is a security. It is also a binding contract with strictly defined terms andproperties.For example, that Rohit discover a bungalow that Rohit love to purchase. Unfortunately,Rohit wont have the cash to buy it for another three months. Rohit talk to the owner andnegotiate a deal that gives Rohit an option to buy the bunglow in three months for a price ofRs.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, themarket value of the bunglow increases to Rs. 50,00,000. Because the owner sold Rohit the 37
  38. 38. option, he is obligated to sell Rohit the bunglow for Rs.20,00,000. In the end, Rohit stand tomake 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 ofasbestos, but also that it is a home place of numerous rats. Though Rohit originally thoughtRohit had found the bunglow of Rohit dreams, Rohit now consider it worthless. On theupside, because Rohit bought an option, Rohit are under no obligation to go through with thesale. Of course, Rohit still lose the Rs.50,000 price of the option. This example demonstrates two very important points. First, when Rohit buy anoption, Rohit have a right but not an obligation to do something. Rohit can always let theexpiration date go by, at which point the option becomes worthless. If this happens, Rohitlose 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 arecalled derivatives; means an option derives its value from something else. In our example, thebunglow is the underlying asset. Most of the time, the underlying asset is a stock or an index.Types of OptionsThere are two types of options:Call Options: - It gives the holder the right to buy an asset at a certain price within a specificperiod of time. Calls are similar to having a long position on a stock. Buyers of calls hopethat 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 specificperiod of time. Puts are very similar to having a short position on a stock. Buyers of putshope that the price of the stock will fall before the option expires.Participants in the Options MarketThere are four types of participants in options markets depending on the position they take:1. Buyers of calls2. Sellers of calls3. Buyers of puts4. Sellers of put 38
  39. 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 shortpositions.Here is the important distinction between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or sell. They have thechoice to exercise their rights if they choose. Call writers and put writers (sellers), however, are obligated to buy or sell. Thismeans 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 optionseller. It is also referred to as the option premium. Expiration Date: - The date specified in the options contract is known as theexpiration date, the exercise date, the strike date or the maturity. Strike Price: - The price specified in the options contract is known as the strike priceor the exercise price. Listed Options: - An option that is traded on a national options exchange such asthe National Stock Exchange is known as a listed option. These have fixed strike prices andexpiration dates. Each listed option represents a predetermined number of shares of companystock (known as a contract). In-the-money Option: - An in-the-money (ITM) option is an option that would leadto a positive cashflow to the holder if it were exercised immediately. A call option on theindex is said to be in-the-money when the current index stands at a level higher than thestrike price (i.e. spot price > strike price). If the index is much higher than the strike price, thecall is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strikeprice. At-the-money Option: - An at-the-money (ATM) option is an option that would leadto zero cashflow if it were exercised immediately. An option on the index is at-the-moneywhen 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 thatwould lead to a negative cash flow when exercised immediately. A call option on the index isout-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 saidto 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 twocategories: 39
  40. 40. American Options: - American options are options that can be exercised at any timeupto the expiration date. Most exchange-traded options are American. European Options: - European options are options that can be exercised only on theexpiration date itself. European options are easier to analyze than American options, andproperties of an American option are frequently deduced from those of its Europeancounterpart.TRADING IN OPTIONS If one buys an option contract he is buying the option, or "right" to trade a particularunderlying instrument at a stated price. An option that gives you the right to eventually make a purchase at a predeterminedprice is called a "call" option. If you buy that right it is called a long call; if you sell that rightit is called a short call. An option that gives you the right to eventually make a sale at a predetermined priceis called a "put" option. If you buy that right it is called a long put; if you sell that right it iscalled a short put. Trading in CallSuppose 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 allowedto expire worthless and the position has lost Re.1. This is the maximum amount that you can 40
  41. 41. lose because an option only involves the right to buy or sell, not the obligation. In otherwords, if it is not in your interest to exercise the option you don’t have to and so if you are anoption 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 byRe.1 for every Re.1 increase in the security’s price above the strike price (less the initial Re.1cost 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 purchaseprice. For our call option, the breakeven price is 101. If the price of the security is greaterthan 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 exerciseprice 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. 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 theoption 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 underlyingsecurity 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 optionfalls in value by Re.1. Here again, the breakeven point is 99. 42
  43. 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 riskSWAP CONTRACT: Swaps are similar to futures and forwards contracts in providing hedge againstfinancial risk. A swap is an agreement between two parties, called counter parties, to tradecash flows over a period of time. Swaps arrangements are quite flexible and are useful inmany financial situation. Two most popular swaps are currency swaps and interest-rateswaps. These two swaps can be combined when interest on loans in two currencies are 43
  44. 44. swapped. The development of swaps in the eighties is a significant development. The interestrate and currency swap markets enable firms to arbitrage are differences between capitalmarkets. They make use of their comparative advantage of borrowing in their domesticmarket 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 betweenthe 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 oppositedirection. COMMODITY FUTURES EXCHANGES – THE PROFILE AND REGULATORY ENVIRONMENTThe Profile of Futures Exchanges (mcx and ncdex)5.17 Overview of MCX MCX an independent and de-mutulised multi commodity exchange has permanentrecognition from Government of India for facilitating online trading, clearing and settlementoperations for commodity futures markets across the country. Key shareholders of MCXinclude Financial Technologies (I) Ltd., State Bank of India (India’s largest commercialbank) & associates, Fidelity International, National Stock Exchange of India Ltd. (NSE),National Bank for Agriculture and Rural Development (NABARD), HDFC Bank, SBI Life 44
  45. 45. Insurance Co. Ltd., Union Bank of India, Canara Bank, Bank of India, Bank of Baroda andCorporation Bank. Headquartered in Mumbai, MCX is led by an expert management team with deepdomain knowledge of the commodity futures markets. Through the integration of dedicatedresources, robust technology and scalable infrastructure, since inception MCX has recordedmany first to its credit. Inaugurated in November 2003 by Shri Mukesh Ambani, Chairman & ManagingDirector, Reliance Industries Ltd, MCX offers futures trading in the following commoditycategories: 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 commoditieseco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, SolventExtractors Association of India, Pulses Importers Association, Shetkari Sanghatana, UnitedPlanters Association of India and India Pepper and Spice Trade Association. Today MCX is offering spectacular growth opportunities and advantages to a largecross 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 multiplecommodities for trading with wide reach and penetration and robust infrastructure, is wellplaced to tap this vast potential.5.18 Vision and Mission The vision of MCX is to revolutionize the Indian commodity markets by empoweringthe market participants through innovative product offerings and business rules so that thebenefits of futures markets can be fully realized .Offering unparalleled efficiencies,unlimited growth and infinite opportunities to all the market participants. 45
  46. 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. 47. 5.19 Benefits to ParticipantsThe mark of a true exchange market is that it provides equal opportunities to all participantswithout any bias. This is the central belief of MCX and towards that it shall be our endeavorto provide all our participants with equally rewarding opportunities. MCX wouldharmoniously meet the requirements of all the stakeholders in the commodity ecosystem inthe 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