2. Derivative is a contract that derives its value from the
performance of an underlying entity.
This underlying entity can be an asset, index, or
interest rate, and is often called the "underlying".
Derivatives can be used for a number of purposes,
including insuring against price movements
(hedging), increasing exposure to price movements
for speculation or getting access to otherwise hard-
to-trade assets or markets.
Some of the more common derivatives
include forwards futures options swaps and
variations of these such as synthetic collateralized
debt obligations and credit default swaps
Most derivatives are traded over-the-counter(off-
exchange) or on an exchange
3. Financial Derivatives are those assets whose
value is derived from the value of underlying
assets
Underlying assets may be equity, commodity,
or currency
Derivatives have no independent value
Derivatives are promise to convey ownership
Derivatives may be exchange traded or
privately negotiated over the counter
5. A future contract is a contract to buy or sell a
specified quantity of a commodity or financial
claim at a specified price on the specified date.
6. ‘A’ enters into a contract with ‘B’ on 1st Oct,
2012 to sell 100 shares of Reliance Industries
Ltd a price of Rs 800 on 31st Oct, 2012.
This is a future contract. In this case,
asset is specified
price is specified , and
the date on which contract will be executed is
also specified.
7. a) Why the parties entered into futures contract?
b) How do they arrive at a price of Rs 800 per
share?
c) What will happen to the contract if the actual
share price on the due date is different from
Rs 800?
8. The parties entering into the future contract may
have any one of the following objective:
Hedging of risk
Speculation
Arbitrage
9. Suppose an investor is having 100 shares of
Reliance Industries and its current market price
is Rs 780 ( say on Oct 1, 2012) and he expects
that the price of the share will be less than Rs
800 on the execution date ( ie. Oct 31,2012). He
would sell the shares in the futures market at Rs
800 ( predetermined price) to protect himself
against the probable downfall in the stock price.
10. Suppose a share of Reliance Industries is quoting at
Rs 780 in the cash market (spot market) and its price
is Rs 800 in the future market. A trader can buy
shares in the cash market and sell the same
immediately at Rs 800 in the futures market to earn
gain of Rs 20 per share through arbitrage. Arbitrage
arises when the same asset is priced differently in
two different markets at the same time. Trader buy it
in the market where it is available at low price and
sell it in the market where it is available at high
price.
11. Suppose the Reliance shares are quoted at Rs
800 as on 31/10/12 in the futures market. An
investor or a trader expects that the share will
actually trade at a price higher than this price on
31/10/12 (say at Rs 825 ) then he can purchase
the share today in the future market and sell it
later in the cash market on the same date. In
case the actual price of the share is less than Rs
800 on 31/10/12, he will have to incur loss.
12. Future price = Cash Price + Return which could
be generated on cash price during the period of
contract.
For example, an asset is available for Rs 100
today and prevailing rate of interest is 12% per
annum. Then according to the above formula,
the one month future price of the asset shall be
Rs 100 + Re 1( interest for one month) = Rs 101
13. In the above example, the interest has been
calculated using simple interest formula but in
actual practice , interest is calculated on
compounded continuously basis and risk free
rate of interest is taken into consideration for
evaluating the return during the period of
contract. Therefore ,
Future Price = Spot Price x ert
14. Future Price = Spot Price x ert
Where
F = Future price of the security
S = Spot price of the security
r = risk free rate of interest
t= time of the future contract
e = 2.71828 ( base of natural logarithm)
15. Example : The shares of R Ltd are currently
trading at Rs 90. If the risk rate is 8% p.a. , find
the 3-month future price of the share presuming
no dividend will be declared during the contract
period.
Solution : Using relationship
Future Price = Spot Price x ert
We have
Future price = 90 x e0.08 x (0.25) = Rs 91.82
rt
16. Future price = (Spot price – Present value of
dividends due to be received) x ert
Or
Future Price = (S – P) x ert
Where P = D e-rt
17. In case , dividend yield is given instead of
dividend amount, the above formula will be
given as
F= S x e(r- d)t
Where ‘d’ is the dividend yield
18. A commodity futures contract is a commitment to
make or accept delivery of a specified quantity and
quality of a commodity during a specific month in the
future date at a price agreed upon when the
commitment is made.
Commodities traded in the commodity exchanges are
required to be delivered at the contracted price,
ignoring all the changes in the market prices. Both the
participants (Buyers & Sellers) are allowed to liquidate
their respective positions by way of cash settlement of
price between the contracted and liquidated price, no
later than the last trading session of the specified
expiry date.
19. It was in the year 1875, with the setting up of
the Bombay Cotton Trade Association Ltd.,
the evolution of the organized futures market
in India commenced. A separate association,
Bombay Cotton Exchange Ltd., was
constituted in 1983 following widespread
discontent among leading cotton mill owners
and merchants over the functioning of the
Bombay Cotton Trade Association.
20. With the setting up of the Gujrati Vyapari Mandali in 1900, futures
trading in oilseeds originated, which carried out futures trading in
ground nuts, castor seeds and cotton. For futures trade in raw jute,
the Calcutta Hessian Exchange Ltd. and the East India Jute
Association Ltd. were set up in 1919 and 1927 respectively. Futures
in cotton were organized in Mumbai under the auspices of the East
India Cotton Association (EICA) in 1921. Several futures markets in
oilseeds were functioning in the states of Gujarat and Punjab before
the Second World War in 1939. Several other exchanges were
established in the country in due course, alleviating trade in diverse
commodities such as pepper, turmeric, potato, sugar and jaggery.
The Indian constitution listed the subject of ―Stock Exchanges and
Future Markets‖ under the union list after independence. Solely as
the responsibility of the central government, the regulation and
development of the commodities futures markets were defined.
21. In December 1952, the Forward Contracts (Regulation) Act was enacted .An
expert committee headed by Prof. A.D. Shroff and selected committees of two
successive parliaments. The central government in 1954 notified the Forward
Contracts (Regulation) rules. The India Pepper and Spices Trade Association
(IPSTA) in Cochin in 1957 first organised the futures trade in spices. Futures trade
was completely banned by the government in 1966 in order to monitor the price
movements of several agricultural and essential commodities. Many traders
resorted to unofficial and informal trade in futures subsequent to the ban of futures
trade. The government reintroduced futures on selected commodities as per the
June 1980 Khusro committee‘s recommendations. Expanding its coverage of
agricultural commodities, along with silver, the committee submitted its report in
September 1994, championing the reintroduction of futures, which are banned in
1966. The Government of India appointed an expert committee on forward
markets under the chairmanship of Prof. K.N. Kabra in June 1993 following the
introduction of economic reforms in 1991. The National Agricultural Policy 2000
conceived of external and domestic market reforms and disassembling of all
controls and regulations in the agricultural commodity markets in order to
encourage the agricultural sector. To minimize the wide fluctuations in commodity
prices and for hedging the risk arising from extreme price volatilities it also
proposed an expansion of the coverage of futures markets. The commodity trading
experience various regulatory decisions during the post independence period.
22. Under the ministry of consumer affairs, the forward contract (Regulation)
Act was enacted in 1952 and the FMC or the forward market commission
was established in 1953. FMC acts as a regulatory body, which governs the
commodity markets in India. During the mid-1960s, it was witnessed that
an unprecedented rise in the prices of major oils and oilseeds as an
outcome of a sharp fall in output. Futures trade was banned in most
commodities to certain speculation, which the government attributed to
rising inflation. 2.4 REGULATORY FRAMEWORK: FORWARD
MARKETS COMMISSION (FMC) Forward Markets Commission (FMC)
acts as a regulatory authority, which is a statutory body set up under the
Forward Contracts (Regulation) Act 1952 (FC(R) Act.
23. A commodity futures market is a public
market where commodities are contracted for
purchase or sale at an agreed price for
delivery on a specified date. This process of
purchase or sale of commodities must be
made through an organized exchange broker
and the purchase should be made under the
terms and conditions of a standardized
futures contract.
24. A commodity exchange is defined as a market in which multiple buyers
and sellers trade commodity associated contracts on the foundation of
rules and procedures established by the commodity exchange
The commodity market that is mentioned today pertains to the derivative
market in the country for various commodities that are controlled by the
commodity exchanges. The difference between futures price and spot
prices is known as the cost of carry. This comprises of interest rate, cost
of transport, and warehousing. Preferably, as the interest cost becomes
negligible for say three months, the futures prices should come closer to
the spot price at the time of delivery.
A financial contract whose value is derived from the value of
a stock price, a commodity price, an exchange rate, an
interest rate, or even an index of prices is known as the
derivative security. There are various reasons for a
commodities derivatives to be traded in a market.
25. The benefits of the commodity futures
market are as follows: Price Discovery
Price Risk Management
Import and Export competitiveness
Predictable Pricing
Control over unfavorable price fluctuations
for farmers/Agriculturalists
Credit accessibility Improved product
quality
26. Market participants can be typically divided in
to hedgers, speculators and arbitrageurs.
Hedgers Hedgers are the commercial
producers and consumers of the traded
commodities. They enter into the market to
manage their spot market price risk.
Commodity prices are volatile and their
participation in the futures market allows
them to hedge or protect themselves against
the risk of losses from fluctuating prices.
27. Speculators are the traders who speculate on
the direction of the futures prices with the
intention of making money. Trading in
commodity futures is an investment option
for the speculators. Most speculators do not
prefer to make or accept deliveries of the
actual commodities; rather they liquidate
their positions before the expiry date of the
contract.
28. Arbitrageurs The traders who buy and sell to
make money on price differentials across
different markets are the arbitrageurs.
Arbitrage demands the simultaneous sale and
purchase of the same commodities in
different markets. Arbitrage continues to the
prices in different markets in line with each
other.
29. This study being on commodity futures, it has considered one of the leading
player, namely, Multi Commodity Exchange of India Limited (MCX), for
the purpose of collection of data.MCX is the India‘s first listed commodity
futures exchange that facilitates online trading, and clearing and settlement
of commodity futures transactions in India.Thus it offers a platform for risk
management. The MCX started operations in November 2003 that operates
within the regulatory framework of the Forward Contracts (Regulation) Act,
1952. MCX offers trading in altered commodity futures contracts across
segments, including bullion, ferrous and non-ferrous metals, energy, Agri-
based and agricultural
30. The Exchange concentrates on rendering commodity value chain participants with
neutral, secure and transparent trade mechanisms, and formulating quality
parameters and trade regulations, in accordance with the regulatory framework. The
Exchange has an extensive national reach, with over 2100 members, operations
through more than 400,000 trading terminals, spanning over 1900 cities and towns
across India. MCX is India‘s leading commodity futures exchange with a market
share of about 86 per cent in terms of the value of commodity futures contracts
traded in 2013-14.
31. In 2002, the Government of India allowed
commodity futures in India. Three screen
based,nation-wide multi-commodity
exchanges were permitted to be set up with
the approval of the Forward Markets
Commission. These are
32. •National Commodity & Derivative Exchange
•Multi Commodity Exchange
•National Multi Commodity Exchange of India
33. In terms of market share, MCX is today the
largest commodity futures exchange in India,
with a market share of close to 70%. NCDEX
follows with a market share of around 25%,
leaving the balance 5% for NMCE.
34. Features of commodity futures
1. Organized :
Commodity Futures contracts always trade on an organized
exchange, e.g. NCDEX, MCX, etc in India and NYMEX, LME, COMEX
etc. internationally.
2. Standardized :
Commodity Futures contracts are highly standardized with the
quality, quantity, and delivery date, being predetermined.
3. Eliminates Counterparty Risk :
Commodity Futures exchanges use clearing houses to guarantee
that the terms of the futures contract are fulfilled. The Clearing
House guarantees that the contract will be fulfilled, eliminating
the risk of any default by the other party.
35. Features of commodity futures
4. Facilitates Margin Trading :
Commodity Futures traders do not have to put up the
entire value of a contract. Rather, they are required to post
a margin that is roughly 4 to 8% of the total value of the
contract (this margin varies across exchanges and
commodities). This facilitates taking of leveraged positions.
5. Closing a Position :
Futures markets are closely regulated by government
agencies, e.g. Forward Markets Commission (FMC) in India,
Commodity Futures Trading Commission in (CFTC) USA,
etc. This ensures fair practices in these markets.
36. Features of commodity futures
6. Regulated Markets Environment :
Commodity Futures contracts are highly
standardized with the quality, quantity, and
delivery date, being predetermined.
7. Physical Delivery :
Actual delivery of the commodity can be made or
taken on expiry of the contract. Physical delivery
requires the member to provide the exchange
with prior delivery information and completion of
all the delivery related formalities as specified by
the exchange.
