The document provides an overview of commodities markets and derivatives trading. It discusses: 1) The origins of commodity futures markets in addressing price risks for farmers and merchants and the establishment of the Chicago Board of Trade in 1848. 2) The definition of derivatives and how their value is derived from underlying assets, as well as the key participants in derivatives markets. 3) The cost of carry model which states that the futures price is equal to the expected future spot price plus the cost of carrying the underlying asset. 4) Features of the National Commodity & Derivatives Exchange in India and how it collects and disseminates spot price data through polling participants across commodity markets.

1. Commodities Market
Module

2. Introduction

3. Origin:
• Need of farmers to protect themselves against fluctuations in the
price of their crop.
• Need of merchant to protect themselves against fluctuations in the
price of the grains.

4. History
• In 1848, the Chicago Board of Trade (CBOT) was established to bring
farmers and merchants together.
• A group of traders got together and created the ‘to – arrive’ contract.
• In 1925 the first future clearing house was established.

5. What is a derivative?
• A derivative is a product whose value is derived from the value of one or
more underlying variables or assets in a contractual manner.
• Underlying asset could be equity, forex, commodity or any other asset.
• The forward contracts (regulation) act, 1952, regulates the forward/future
contracts in commodities all over India.
• As per this act the Forward Market Commission (FMC) continues to have
jurisdiction over commodity forward/ future contracts.

6. Securities derivative
• Derivatives trading in securities was introduced in 2001.
• The term ‘security’ in the Securities contracts (regulation) act, 1956,
was amended to include derivative contracts in securities.
• Consequently, regulations of derivatives came under the purview of
SEBI.
• Thus we have separate regulator for commodity and securities
derivative markets.

7. Derivatives as per SC(R)A:
• A security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for differences or
any other form of security.
• A contract which derives its value from the prices, or index of
prices, of underlying securities.

8. Types of Participants:
• Hedgers: Hedgers face risk associated with the price of an asset. They use
the future or options markets to reduce or eliminate this risk. For example:
Farmers or Merchants.
• Speculators: Speculators are participants who wish to bet on future
movement in the price of an asset. Futures and options contracts can give
them leverage; that is by putting in small amounts of money upfront, they
can take large positions on the market.
• Arbitragers: Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across different markets.

9. Economic Functions of derivatives
market:
• Prices in an organized derivatives market reflect the perception of market participants about the
future and lead the prices of the underlying to the perceived future level. Thus, help in discovery
of future as well as current prices
• Risk Transfer
• Higher participation in the cash market by helping participants to manage risk.
• More controlled environment for speculative traders.
• Catalyst for new entrepreneurial activity.
• Increase savings and investment in long run.

10. Types of Derivatives:
• Exchange Traded
• OTC

11. Features of OTC derivatives market:
• The management of counter party risk is decentralized and located with in individual
institutions.
• There is no formal centralized limits on individual positions, leverage, or margining.
• There are no formal rules for risk and burden sharing.
• There are no formal rules or mechanisms for ensuring market stability and integrity and
for safeguarding the collective interests of market participants.
• They are not regulated by a regulatory authority, although they are affected indirectly by
the national legal systems.

12. Some commonly used derivatives:
• Forwards
• Futures
• Options
• Warrants
• Baskets
• Swaps
Interest rate swaps
Currency swaps

13. Commodity V/S Financial Derivatives
• Most of these contacts are cash settled, also in case of physical
delivery no need of special facility for storage.
• Due to bulky nature of the underlying assets, physical settlement in
commodity derivatives creates the need for warehousing.
• Quality of asset is not a matter of concern in financial derivatives.
• In case of commodities, the quality of the asset underlying a contract
can vary largely.

14. Physical Settlement
• Physical delivery of the underlying commodity, typically at an
accredited warehouse.
• Issues faced in physical delivery:
Limited storage space in different states
Restrictions on interstate movement of commodities
State level octroi and duties have an impact on the cost of movement of
goods.

15. • Delivery notice period: A seller of commodity has the option to give
notice of delivery during a period identified as ‘delivery notice period’.
• Assignment: Exchange identifies the buyer to whom the delivery
notice may be assigned.
• Delivery: The exchange will specify the procedure of physical
settlement. The clearing house decides on the delivery order rate at
which delivery will be settled. Delivery rate depends on the spot rate
of the underlying adjusted for discount/ premium for quality and
freight cost.

16. • Warehouse: The efficacy of the commodities settlement depends on
the warehousing system available. Warehouse have to perform the
following functions:
Earmark separate storage areas for storing commodities.
Ensure proper grading of commodities before they are stored.
Ensure that necessary steps and precautions are taken to ensure that the
quality and grade of commodity, as certified in the warehouse receipt, are
maintained during the storage period.

17. NCDEX
• National Commodity & Derivatives Exchange Limited (NCDEX), a
national level online multi-commodity exchange, commenced
operations on December 15, 2003
• The Exchange has received a permanent recognition from the
Ministry of Consumer Affairs, Food and Public
Distribution, Government of India as a national level exchange.

18. NCDEX objectives:
• To create a world class commodity exchange platform for the market
participants.
• To bring professionalism and transparency into commodity trading.
• To inculcate best international practices like de-materialized technology
platforms, low cost solutions and information dissemination into the trade.
• To provide nation wide reach and consistent offering.
• To bring together the entities that the market can trust.

19. Benefits of SPOT price data:
• Near real time spot price information helps the trading members to
take a view on the future market and vice versa.
• The data helps the Exchange to analyze the price data concurrently to
make meaningful analysis of price movement in the futures market
and helps in the market surveillance function.
• The Exchange has to track the convergence of spot and futures prices
towards the last few days prior to the expiry of a contract.

20. • The Exchange need to know the spot prices at around closing time of
the contract for the Final Settlement Price on the expiry day.
• The Exchange needs to know the spot price at the basic center of the
underlying commodity of which the futures are being traded on the
platform.
• The near real-time spot price data when it is disseminated by the
Exchange is of great interest to the general public, especially
researchers, governmental agencies, international agencies, etc.

21. Issues with Spot price in India:
• No effective mechanism or real time spot price information of
commodities.
• ‘Agmarknet’, only government agency which collects the post trade mandi
data, but even such information is not disseminated real time.
• Prices for the same commodity differ from mandi to mandi. This is a direct
consequence of the lack of integration of markets and the lack of good
transportation facilities.
• The price differentials create a problem in the development of a unique
representative spot price for the commodity.

22. Spot Price Polling
• NCDEX has put in place a mechanism to poll spot prices prevailing at
various mandis throughout the country.
• This process is analogous to the interest rate polling conducted to find
the LIBOR rates.
• The Exchange collates spot prices for all commodities on which it
offers futures trading and disseminates the same to the market via
the trading platform.

23. • Collection and dissemination of spot prices is done by various reputed
external polling agencies which interact directly with market
participants and collect feedback on spot prices which are then
disseminated to the market.

24. Polling and Bootstrapping
• Eliciting information from a cross section of market players about the prevailing
price of the commodity in the market.
• Polling participants comprising of various user class viz. growers, traders/brokers,
processors and users.
• Considering the vital role the participants play in the process, the polling
participants are carefully chosen to ensure that they are active players in the
market.
• Spot prices is captured at the identified delivery centers which are also termed as
the primary center of a commodity by asking bid and ask quotes from the
empanelled polling participants.

25. • Spot price of a commodity from a couple of other major centers
(subject, sometimes, to adequate number of respondents) are also
captured.

26. Advantages of Multiple location polling:
• Helps estimate the price at the primary centre when the market there
is closed for some reason.
• Helps validate the primary center price when there are reasons to
believe that polled data is not reliable or justified considering the
underlying factors.
• Provide a value addition to the users.

27. Cleaning of Data
• The spot price polled from each mandi is transmitted electronically to a
central database for further process of bootstrapping to arrive at a clean
benchmark average price.
• To arrive at the bootstrapped price, all the BID & ASK quotes are sorted in
ascending order and through adaptive trimming procedure the extreme
quotes are trimmed from the total quotes.
• These values are sampled with replacement multiple numbers of times,
where software gives different mean with their respective standard
deviation.

28. • The mean with least standard deviation is the spot price that will be
uploaded by the polling agency through the polling application
provided by NCDEX.
• This price is broadcast through the Trader Work Station and also on
the NCDEX website without any human intervention.

29. Outsourcing of Polling
• It is prohibitively expensive for the Exchange to post personnel at various mandis
to poll prices especially in the initial stages when there is no scope to recover any
fee from the sale of price data.
• Further it is advisable that the spot prices are polled by an agency independently
rather than by the Exchange itself for reasons of corporate governance.
• Thirdly, the agencies chosen will have some expertise and experience in this field
which the Exchange can leverage upon.
• NCDEX has outsourced the processes of polling and bootstrapping to external
reputed entities.

30. • The Product Managers for the various commodities are asked to
identify through interactions at the mandis the participants who
would form a part of the polling community for a given commodity.

31. Validation & Checks on the Polling
Processes
• Exchange routinely makes daily calls to the polling participants randomly in
various commodities and speak to them about the prices quoted to cross
check the raw quotes sent by the polling agency.
• The exchange officials also talk to them about the demand and supply
conditions, mandi arrivals, imports/exports activities, impact of state
procurement and agricultural policies, weather conditions impacting the
crop, etc.
• Necessary precaution/checks are maintained at the Exchange so that any
spot price which deviates from the previous day's spot price by +/- 4% is
reviewed before uploading.

32. • Exchange reviews the raw prices as quoted by respondents available with
the polling agency and tries independently to ascertain the reason for
deviation through interaction with the participants.
• If the price rise/fall is justified with the feedback received from the
participants, the price is uploaded in the system after obtaining necessary
approval.
• If the price rise/fall is not justified with the feedback received from the
participants, the polling agency is asked to re-poll the prices and the new
bootstrapped price is allowed to be uploaded.
• Two days prior to the expiry of the contract, the above price limit of 4% will
be re-set to 2%. This is done as a precaution in view of the impending
expiry and the high risk of accepting what may be an incorrect spot price as
the FSP.

33. Cost of Carry Model

34. Introduction
• Cost-of-carry model is an arbitrage-free pricing model.
• Its central theme is that futures contract is so priced as to preclude
arbitrage profit.
• Investors will be indifferent to spot and futures market to execute
their buying and selling of underlying asset because the prices they
obtain are effectively the same.

35. Contd…
• The basis for the cost of carry model where the price of the future
contract is:
F= S+C
Where, F = Future price
S= Spot Price
C = Holding costs or carry costs
• Carry cost (CC) is the interest cost of holding the underlying asset
(purchased in spot market) until the maturity of futures contract.

36. Contd…
• The equation can also be written as:
Where,
r = Cost of financing (using continuously
interest rate)
t = Time till expiration
e = 2.71828
compounded

37. Pricing Future Contracts : Investment
Commodities
• In Investment Commodities , Storage Costs add to the cost of carry.
F = (S + U)e rt
Where,
U = Present value of all storage costs

38. Pricing Future Contracts : Consumption
Commodities
• For commodities that are consumption commodities , the arbitrage
arguments used to determine future prices need to be reviewed, i.e.


F > (S + U)e rt
F < (S + U)e rt

39. Contd…
• To take advantage of this opportunity, an arbitrager can borrow the
amount to take long position in the commodity at the risk free rate
and can take short position in the forward contract.
• To take advantage of this opportunity, an arbitrager can sell the
commodity to take short position in the commodity at the risk free
rate and can take long position in the forward contract.

40. Contd…
• When F > (S + CC): Sell the (overpriced) futures contract, buy the
underlying asset in spot market and carry it until the maturity of
futures contract. This is called "cash-and-carry" arbitrage.
• When F < (S + CC ):Buy the (under priced) futures contract, short-sell
the underlying asset in spot market and invest the proceeds of shortsale until the maturity of futures contract. This is called "reverse cashand-carry" arbitrage

41. Contd…
• Individuals and companies, who keep such a
commodity in inventory, do so, because of its
consumption value not because of its value as an
investment. They are reluctant to sell these
commodities and buy future or forward contracts
because these contracts cannot be consumed.

42. CONTD…
• Therefore, there is unlikely to be arbitrage when
F > (S + U)e rt
In short, for a consumption commodity :
F < = (S + U)e rt

43. Future Basis
• The basis reflects the relationship between cash price and futures
price. (In futures trading, the term "cash" refers to the underlying
product). The basis is obtained by subtracting the futures price from
the cash price.
• The basis can be a positive or negative number. A positive basis is said
to be "over" as the cash price is higher than the futures price. A
negative basis is said to be "under" as the cash price is lower than the
futures price.

44. Contd…
• As the future contract nears expiration, the basis
reduces to zero.
• There is a convergence of the future price to the price
of the underlying asset.