2. • Commodity is a product that has commercial value, which can be Produced by
companies/firms without any qualitative difference.
A derivative is a financial instrument whose value is derived from some other
financial instrument, called the underlying asset. Common examples of underlying
assets are ƒstocks, bonds, corn, pork, wheat, rainfall, etc
A commodity derivatives market (or exchange) is, in simple terms, nothing more or
less than a public market place where commodities are contracted for purchase or
sale at an agreed price for delivery at a specified date. These purchases and sales,
which must be made through a broker who is a member of an organized exchange,
are made under the terms and conditions of a standardized futures contract.
3. Aristotle (1750 BC) derivative contracts – thales- olive crop – agreement with oil
mill owners for pressing
Osaka (1730) rice futures – organised Dojima rice market
1744 – Baltic Exchange at coffee house in london
1849 – Chicago Board of International Trade - CBOT
1854 – Bolsa De Cereales -Argentina,
1877 London Metal Exchange
1898 – Chicago Butter and Egg Board – Chicago Mercantile Exchange (CME)
1990 – china 40- 1999 – 3, 1. Dalaian CE, 2.Zhengshou CE, 3.Shanghai FE.
1939 – India 300
19th – London Mercantile Exchange
Baltic Exchange
International Petroleum Exchange
Chicago Climate Exchange,
4. The Bombay Cotton trade association started future trading in 1875
In 1952 the government banned cash settlement and option trading.
In 1995 a prohibition on trading options was lifted.
In 1996, NSE sent a proposal to SEBI for listing exchange traded
derivatives.
In 1999, the Securities Contract (Regulation) Act of 1956 was
amended and derivatives could be declared “securities”.
Index future were introduced in June 2000 and Index option in 2001.
NSE started trade in future and option by 2005
5. • Forward: A forward contract is an agreement between two parties
to buy or sell the underlying asset at a future date at a today’s pre-
agreed price.
• Futures: A futures contract is an agreement for buying or selling a
commodity for a predetermined delivery price at a specific future
time. Futures are standardized contracts that are traded on organized
futures exchanges that ensure performance of the contracts and thus
remove the default risk
Ex: Suppose a farmer is expecting a crop of wheat to be ready in 2
months time, but is worried that the price of wheat may decline in
this period. In order to minimize a risk ,he can enter to futures
contract to sell his crop in 2 months time at a price determined now.
This way he is able to hedge his risk arising from a possible adverse
change in the price of his commodity
6. • Swaps: A swap is an agreement between two parties to exchange
sequences of cash flows for a set period of time. Usually, at the time the
contract is initiated, at least one of these series of cash flows is
determined by a random or uncertain variable, such as an interest rate,
foreign exchange rate, equity price or commodity price.
• Options: The commodity option holder has the right, but not the
obligation, to buy(or sell) a specific quantity of a commodity at a
specified price on or a before a specified date. The seller of the option
writes the option in favour of the buyer (holder) who pays a certain
premium to the seller as a price for the options.
Call option: It gives the buyer the right but not the obligation to buy a
given quantity of the underlying asset , at a given price on or before a
given future date
Put option: It gives the buyer the right but not the obligation to sell a
given quantity of the underlying asset , at a given price on or before a
given future date
7. Ex: Suppose a farmer buys a put option to sell 100 quintals of wheat
at price of 25dollar per quintal and pays a premium of 0.5 dollar per
quintal (or a total of 50 dollar). If the price of wheat declines to 20
dollar before expiry, the farmer will exercise his option to sell his
wheat at the agreed price of dollar 25 per quintal.However ,if the
market price of wheat increases to say 30 dollar per quintal it would
be advantageous for the farmer to sell it directly in the open market
at the spot price rather then exercise his option to sell at 25 dollar per
quintal.
8. features Advantages Disadvantages
Counter party risk •Offers complete hedge •Default risk
Underlying Assrt •Over the counter
products
•Difficult to cancel the
contracts
Flexibility •Price protection • Not standardized
Settlement •Easy to understand •Not transparent
Contract Price • Difficult to find counter
parties
Unique •No intermediate
cashflows before
settlement
9. Features Advantages Disadvantages
Organised Exchanges •Commission charges are
less
•High risk
Standardisation • leverage •Partial hedge
Clearing House • Can open short as well
as long positions
•Basis risk
Margins •High liquidity •Complex for new
investors
Marking to Market
10. Forwards Futures
•Are not traded on an exchange •Are traded on an exchange
•Are private, and are negotiated between
parties, with no exchange guarantees
•With the help of clearing house it
provides protection for both parties
•Involve no margin payments as mutual
goodwill is the basis for contracting
•Requires a margin to be paid as good-
faith money
•Are used for hedging and physical
delivery
•Are used for hedging and speculating
•Terms of the contract are dependent on
the negotiated contract
•Terms of the contract are standardised
and published by the exchange
•Contracts are settled by physical delivery •Most contracts (almost98%) are cash
settled against delivery
•Are not transparent as they are private
deals
•Are transparent and are reported by the
exchange
11. Features Advantages Disadvantages
High Flexible •standardized • high spread
•Down Payment • limited loses • complexity
Settlement • enhances portfolio
return
• not available for all
stocks
• hedge against risk • diversification cannot
eliminate systematic risk
• terms of listed options
are regulated
• less capital requirement
12. Futures Options
•Both the buyer and the seller are under
an obligation to fulfil the contract
•It is one-dimensional as its price
depends on the on the underlying only.
•The buyer and seller are subject to
unlimited risk of losing
•Seller – unlimited risk & buyer has
limited (premium)
•The buyer and seller have unlimited
potential to gain
•The seller has limited potential to gain
than buyer
•It is one-dimensional as its price
depends on the on the underlying only
•It is multidimensional price depends on
spot, strike, time to maturity, implied
volatility and risk free interest rate
13. By organisation – OTC: are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other
intermediary.
By trading system
Futures
Options
By settlement
Delivery
Cash
Termination of contract
By complexity
14. Bid price: The highest price at which a dealer is willing to buy
commodities
Ask price: The ask price represents the lowest priced sell order
that is currently available, or the lowest price someone is
willing to go short or sell at
Arbitrage:Arbitrage is the simultaneous purchase and sale of
an asset to profit from a difference in the price. It is a trade that
profits by exploiting the price differences of identical or similar
financial instruments on different markets or in different forms.
15. Hedgers: These are investors with a present or anticipated exposure
to the underlying asset which is subject to price risks. Hedgers use
the derivatives markets primarily for price risk management of assets
and portfolios
Stockiest (protection against lower prices from the time they
purchase till they sold)
Exporters (protection against higher prices for the goods contracted
for future delivery but not yet purchased)
Producers (protection against increasing raw material costs or to
avoid decrease in the values of inventories.
Farmers (protection against declining prices)
16. Advantages Disadvantages
• Risk management tool • Minimizes overall profits
• To lock in profits •Reducing the risk can reduce profits
• Protection against price changes,
inflation, interest rate changes, etc…
•Not commonly used by the short-term
trader
• Maximizes returns •requires an increase in account balances
• Minimizes time • requires excellent trading skills and
experience
17. Speculators: These are individuals who take a view on the future
direction of the markets. They take a view whether prices would rise
or fall in future and accordingly buy or sell futures and options to try
and make a profit from the future price movements of the underlying
asset
Speculators are interested in favourable price fluctuations
They are prepared to accept the risk being transferred by hedgers.
Speculators provide liquidity to the market
18. Arbitrageurs: They take positions in financial markets to earn
riskless profits. The arbitrageurs take short and long positions in the
same or different contracts at the same time to create a position
which can generate a riskless profit.
They simultaneously sell and purchase in two markets to avail
benefit of price fluctuation
Their behaviour will help removing price imperfections in different
markets
19. Help in discovery of future as well as current prices.
Helps to transfer risks from those who have them but do
not like them to those who have an appetite for them.
With the introduction of derivatives, the underlying
market witnesses higher trading volumes.
Speculative trades shift to a more controlled environment
in derivatives market. In the absence of an organized
derivatives market, speculators trade in the underlying
cash markets.
The derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial
attitude. They often energize others to create new
businesses, new products and new employment
opportunities, the benefit of which are immense.
