Introduction to Commodity
Commodity can be defined as every kind of movable property other than actionable
claims, money and securities”. Futures’ trading is organized in such goods or commodities
as are permitted by the Central Government. At present, all goods and products of
agricultural (including plantation), mineral and fossil origin are allowed for futures
trading under the auspices of the commodity exchanges recognized under the FCRA.
Commodities are having direct relation to our everyday life. The wheat in our bread,
cotton in our clothing, Gold and silver in our jewellery or petrol in our cars all
are commodities. They are also traded in spot and futures all over the world in
form of derivates.
WORLD OF COMMODITIES
The history of commodities dates back to the times when mankind first started buying
or selling or exchanging (bartering) the goods for their daily needs. It is no doubt
worlds biggest market in itself however it comes after currency in terms of size.
This is the only market which is having a cross linkages across the countries as
one country is a producer of goods and other country is user. The size wise organized
commodity market comes among top ranking markets in the world. Exact global size
is difficult to determine as in the developing economies the markets are in transaction
phase and proper historic data are not available. Roughly fund of around $110-120bn
is likely to get invested in commodity index. In 2005 this flow was expected around
$80bn, which went up from $55 in 2004. The global commodity derivatives market is
estimated at Rs 2,53,00,000 crore as stated by Bank of International Settlements.
What is ‘Commodity Exchange’?
A Commodity Exchange is an association, or a company of any other body corporate
organizing futures trading in commodities. In a wider sense, it is taken to include
any organized market place where trade is routed through one mechanism, allowing
effective competition among buyers and among sellers – this would include auction-type
exchanges, but not wholesale markets, where trade is localized, but effectively
takes place through many non-related individual transactions between different permutations
of buyers and sellers. The emergence of the derivatives markets as the effective
risk management tools in 1970s and 1980s has resulted in the rapid creation of new
commodity exchanges and expansion of the existing ones.
In the 1840s, Chicago (U.S) had become a commercial center with railroad and telegraph
lines connecting it with the East. Midwest farmers came to Chicago to sell their
wheat to dealers who, in turn, shipped it all over the country. They brought their
wheat to Chicago hoping to sell it at a good price. The city had few storage facilities
and no established procedures either for weighing the grain or for grading it. In
short, the farmer was often at the mercy of the dealer. 1848 saw the opening of
a central place where farmers and dealers could meet to deal in "spot" grain - that
is, to exchange cash for immediate delivery of wheat. The futures contract; as we
know it today, evolved as farmers (sellers) and dealers (buyers) began to commit
to future exchanges of grain for cash. For instance, the farmer would agree with
the dealer on a price to deliver to him 5,000 bushels of wheat at the end of June.
The bargain suited both parties. The farmer knew how much he would be paid for his
wheat, and the dealer knew his costs in advance. The two parties may have exchanged
a written contract to this effect and even a small amount of money representing
a "guarantee." Such contracts became common and were even used as collateral for
bank loans. They also began to change hands before the delivery date. If the dealer
decided he didn't want the wheat, he would sell the contract to someone who did.
Or, the farmer who didn't want to deliver his wheat might pass his obligation on
to another farmer. The price would go up and down depending on what was happening
in the wheat market. If bad weather had come, the people who had contracted to sell
wheat would hold more valuable contracts because the supply would be lower; if the
harvest were bigger than expected, the seller's contract would become less valuable.
It wasn't long before people who had no intention of ever buying or selling wheat
began trading the contracts. They were speculators, hoping to buy low and sell high
or sell high and buy low. In this way the commodity futures came into existence.
- Exchanges can concentrate on the trade in futures and options contracts, or they
could primarily function as centers for facilitating physical trade.
- They act as a focal point for trade transactions, and increase the security of these
- Well-organized commodity exchanges form natural reference points for physical trade,
and in this way, they help the price discovery process.
- If a commodity exchange manages to link different warehouses in the country, this
allows trade to take place more efficiently.
Few of the principal exchanges are NYME, COMEX, LME, LIFFE, TOCOM, KLCE, CBOT etc.
Majority of the matured and high volume exchanges are based in United States.
COMMODITY VS EQUITY (Derivative markets)
- Commodities are truly global in nature, with price dynamics dependent on pure demand
& supply situation and macroeconomics.
- There is no need to study balance sheets for investing in commodities.
- Commodities, unlike equities are bulky and require special storage in warehouses.
- The qualitative grading of commodities is essential for commodities and contract
design, as the quality of commodity can vary largely.
- Commodity futures squared off before expiry is cash settled.
- Unlike equity derivatives that are cash settled upon expiry (Indian context), physical
settlement is involved in commodities. The physical delivery of the underlying commodity
takes place at the designated warehouse.
- 24 hour globally integrated markets
- Historically lower volatility leads to lower margins and more leverage than equity
derivatives but it is not the case currently, in which the volatility has increased
manifold in recent past.
- The concept of varying quality of asset does not really exist as far as financial
underlying is concerned. However in the case of commodities, the quality of the
asset underlying a contract can vary at times.
INDIAN COMMODITY MARKET
Commodity market in India is estimated at around 5 lakh crore. India is a net importer
for pulses and edible oils while it is self sufficient in food grain requirement
and a exporter of spices and many other food stuffs. It is fast emerging as largest
market for metals and energy too, in which again it is net importer. No doubt this
huge potential is now a target for the foreign investors, manufacturers, funds to
exploit particularly in liberalized economy. This pave a way for the fast emerging
futures exchanges in the country for hedging and price discovery mechanism.
Indian commodity market encompasses of lengthy value chain from the farm gate till
the actual consumer. This market is highly fragmented and unorganized. With the
advent of IT and related services and futures market, the market operations are
undergoing transaction phase. Scientific approach to gather data, interpretation,
and tailor made options has been now the featured attraction. The typical value
chain players are commission agent (adhtiya), stockist, traders, manufacturers,
distributors, dealers, consumer etc.
With the booming economy and growing middle class incomes across the country the
retail segment has grown manifold which has in turn attracted the corporates to
venture into this segment. Based on this fact the market has grown with a fast pace
across the globe thanking to the activities in producing and consuming countries.
INDIAN COMMODITY MARKET
- The first organized Futures Market in India was established in 1875, by the ‘Bombay
Cotton trade Association’ to trade in cotton.
- Before the outbreak of the Second World war, India had a thriving Futures market
for a number of commodities such as groundnut / oil, wheat, rice, raw jute, precious
metals like gold, silver etc. by 1960’s, India had the necessary legislation in
place with commodity futures considered as a reasonably successful trading market.
- In mid 1960’s due to wars, natural calamities and the consequent shortages, Futures
trading in most commodities were banned.
- It took three decades before Commodity Futures could be re-initiated into Indian
markets. This long period of hibernation for Commodity Futures in India has come
to be known as the “Lost Decades”.
- With the liberalization of the economy, emphasis was once again, to develop Commodity
Futures trading. The Kabra committee, set up in 1993 to examine Commodity Futures
trading, recommended futures trading in several commodities. Accordingly futures
trading for 16 commodities and their by-products, and international futures trading
for pepper and castor oil were permitted. By 2002 India had around 20 commodities
exchanges, trading around 42 commodities, with international contracts being traded
for pepper and castor oil.
- Forward Market Commission – the governing body for commodity trading in India in
2002, invited applications from associations / companies / consortium of organizations
(including the already recognized exchanges) to set up a Nation-wide Multi-Commodity
- The aim was to create a nation wide efficient commodity exchange, which could provide
price discovery and offer price-risk management, to all participants involved in
the commodity business cycle.
- Accordingly FMC gave approval to four entities to setup National Multi Commodity
- Out of aforesaid exchanges the NBOT has emerged as largest exchange for soyoil while
NCDEX has emerged as agri commodity specific exchange and MCX is famous for its
volumes in precious, base metals and energy products.
- The National Multi Commodity exchanges have tried to address key problems that have
plagued commodity exchanges in the country so far Primarily.
- The issue of single commodity exchanges with low liquidity has been addressed. The
modern exchanges will enable multiple commodities trading on online world standard
platforms, with nation wide reach.
- The exchanges now provide real time price and trade data dissemination.
- The new exchanges maintain capital settlement guarantee funds and have stringent
capital adequacy norms for brokers, which ensures trade guarantee to participants.
- The new exchanges enable deliveries in electronic form. Warehouse receipts exchanges
through the depository participants facilitates efficient settlement procedures
and attract participants from all key sections of the commodity business cycle.
- The institutions managing the new exchanges comprise banks and government organizations,
which bring with them institutional building experience, trust, nation wide reach,
technology and risk management skills.
- The new exchanges have rule-based management by professionals having no trade interest.
- Since 1998, Indian corporate with commodity price risk exposure on their imports
or exports can hedge their price risk, through international exchanges.
- Since the inception of this legislation, some large commodity corporates have accessed
international exchanges, converting awareness of price risk management into practice.
- Hedging has improved competitiveness for corporates in terms of pricing and improved
profitability through improved margins.
- But access has been restricted to large players, due to large margin requirements.
Hence well-managed local commodity exchanges, could attract the market segment that
was left out.
- In tune with major developments and reforms in commodity futures trading. It is
proposed to restructure the Commodity Market Regulator – Forward Market Commission
on professional lines as an autonomous organization. To develop a closer relationship
between the commodities futures regulator and equity markets regulator.
Objective & Scope
- Indias commodity related industry is valued at 5,000 billion rupees with a dependent
industry at 2,000 billion rupees. Commodities account for 58% of India’s GDP. Considering
a conservative 3 times multiple for the derivatives market, Rs 15,00,000 crore market
is waiting to be explored. The need for commodity price risk management is immense
and hence commodity risk management products should find a large audience.
- The physical markets of commodities still encounter a lot of obstacles in the shape
of various government controls and regulations, minimum support price, monopoly
procurement, varying tax structures etc.
- Efforts are being made to tackle these problems by various administrative departments.
- The objective of all the endeavors is to provide an efficient risk management mechanism
and increase the value of commodity futures trading to 10% of GDP by 2007 from 1.26%
at the end of 2002.
List Of Commodities
The commodity markets can be classified as markets trading the following types of
- Agricultural products (Pulses, Edible oil complex, spices, guar complex, cotton,
- Precious metal (Gold, Silver)
- Other metals (Copper, Aluminum, Zinc, Nickel etc )
- Energy (Crude oil, Furnance oil etc)
- Since 2003 two of the exchanges have emerged truly as a national level representative
exchanges namely NCDEX and MCX
- The combined turnover on daily basis has crossed 15000 crore which has surpassed
daily volume of BSE equity trading.
- In just two-year time MCX has reached on second position just after Comex for silver.
It has surpassed TOCOM exchange volumes.
- Few of the commodity introduced over Indian exchanges have never been traded or
listed on any other exchange of the world like Mentha oil, pulses etc
- These two exchanges have established themselves and set price discovery platform
for various commodities.
- Two of the exchanges and the commodities traded in it are having sync with other
global financial and commodity markets.
Deliveries & Settlement
In the futures commodities market there exist a mechanism of deliveries of goods.
The hedgers of the goods and other market players are free to give or take deliveries.
Ideally exchanges are not meant for deliveries or it is not encouraged but the process
and warehouses are created which can cater to the need, which could arise out of
stuck positions, arbitrage opportunities and hedging of goods.
Exchanges are having settlement of contract on any particular and pre-decided date
and on the basis of the pooling prices in spot market the prices are settled. Ideally
the spot and futures prices converge on the date of expiry. Few of the contracts
are cash settled, intention matching, seller’s option or buyer’s option etc. The
goods in warehouses are checked with the specifications specified with the exchanges
and according to the variations in the produce or goods the premium and discount
The process requirement for delivery is
- Demat account with the exchange
- Sales tax registration
- Adequate knowledge of the particularly commodity
- Knowledge of transportation cost
- Knowledge of labour charges
- Details of various taxes
- Comfort level with the physical market
- Assaying charges and agents
Participants who trade in the derivatives market can be classified under the following
four broad categories.
1. Hedgers 2. Speculators (Traders & Investors ) 3. Arbitragers 4. Funds
- Hedgers use futures for protection against adverse future price movements in the
underlying cash commodity. The rationale of hedging is based upon the demonstrated
tendency of cash prices and futures values moving in tandem.
- The hedgers are very often businesses or individuals who at one point or another
deal in the underlying cash commodity.
- Take, for instance, a Soya trader who buys Soya seed for oil; If Soya prices go
up he has to pay the farmer or the Soya seed dealer more. For protection against
higher Soya prices, the trader can 'hedge' his risk exposure by buying enough Soya
futures contracts to cover the amount of Soya he expects to buy.
- Alternatively, you could be a hedger.
- Let's suppose that every year during the festival season you purchase gold. You
realize that the price of gold becomes quite unpredictable during the season but
it is inconvenient for you to purchase it in advance since you typically use your
annual bonus for this purchase. Now you can hedge yourself against the vagaries
of gold prices by purchasing a contract in advance, for an upfront margin of just
5 per cent of the contract value. At the time of settlement you can pay the remainder
and have the gold transferred to your commodity demat account. When you need the
physical gold, incase you wish to convert it into jewellery, you can have the gold
- Hedgers use futures for protection against adverse future price movements in the
underlying cash commodity. The rationale of hedging is based upon the demonstrated
tendency of cash prices and futures values moving in tandem.
- Speculators are the second major group of futures players. These participants include
They benefit from price variations and serve as counter-parties to hedgers. In fact,
they accept the risk offered by the hedgers in a bid to gain from favorable price
- Independent traders and
- Let's say that you think that the price of gold nearer Diwali this year will be
lower than usual. So, you could sell a contract to a merchant at his price, which
is more or less the average price that exists around that time of the year. Nearer
the time, you can buy gold at a lower price from the market and supply it to him
or you could square off your position at the difference between the contract price
and the settlement price. This way you could make money by speculating on the price
If your surmise turns out to be correct, you could benefit but if the price in the
market around the time of settlement is higher than that contracted by the merchant,
you will have to bear a loss. So, you as a speculator have taken on the risk with
the hope of a good return.
- For speculators, futures have a number of advantages over other investments.
- They need to invest less capital in futures than in the cash market since they are
required to pay only a fraction of the value of the underlying contract (usually
between 3.5-10 per cent) as margin.
- Further, commission/brokerage charges on futures traders are small compared to what
they are in case of physical traders and other investments.
- Moreover, there are no transportation charges, no insurance costs, no storage charges
and no security concerns when someone traders in futures.
Arbitragers work at making profits by taking advantage of discrepancy between prices
of the same product across different markets. If, for example, they see the futures
price of an asset getting out of line with the cash price, they would take offsetting
positions in the two markets to lock in the profit.
There are two types of funds operating in the matured and ideal market, Hedge funds
and Trading funds. These funds help investors to make money irrespective of their
domain knowledge about the commodity itself. They take pool of funds from the investors
and trade on informed decisions in the market betting on their experience team.
THE REGULATOR AND REGULATIONS
- Commodity Futures and the Commodity Exchanges are regulated by the Central Government
under the Forward Contracts (Regulation) Act and the Forward Contract Regulation
- The Forward Market Commission (FMC), which functions under the Ministry of Consumer
Affairs, Food and Public Distribution, regulates the Futures Market in Commodities.
- The FMC deals with exchange administration and seeks to inspect the books of brokers
only if foul practices are suspected or if the exchanges themselves fail to take
- In a sense, therefore, the commodity exchanges are more self-regulating than stock
exchanges. But this could change if retail participation in commodities grows substantially.
- Unlike the equity markets, brokers don't need to register themselves with the regulator.
- They are responsible for intermediating and facilitating hedgers and speculators.
- Many established equity brokers have taken up membership of the new commodity exchanges
as the online trading platforms are similar to those used for equity.
- At the same time, some old-style commodity brokers are not yet conversant with online
screen based trading.
- So, although they have the requisite knowledge about futures trading in commodities,
learning to use technology is a huge adjustment for them.
- Arbitrage: The simultaneous purchase and sale of similar commodities
in different markets to take advantage of a perceived price discrepancy.
- Basis: The difference between the current cash price and the futures
price of the same commodity for a given contract month.
- Bear Market: A period of declining Market prices
- Bull Market: A period of rising market prices
- Broker: A company or individual that executes futures and options
orders on behalf of financial and commercial institutions and / or the general public.
- Cash (Spot) Market: A place where people buy and sell the actual
cash commodities, i.e. grain elevator, livestock market, etc.
- Commission (Brokerage) Fee: A fee charged by a broker for executing
- Convergence: A term referring to cash and future prices tending
to come together as the futures contract nears expiration.
- Cross-hedging: Hedging a commodity using a different but related
futures contract when there is no futures contract for the cash commodity being
hedged and the cash and futures markets follow similar price trends.
- Daily Trading Limit: The maximum price change set by the exchange
each day for a contract.
- Day Traders: Speculators who take positions in futures or options
contracts and liquidate them prior to the close of the same trading day.
- Delivery: The transfer of the cash commodity from the seller of
a futures contract to the buyer of a futures contract.
- Forward (cash) contract: A cash contract in which a seller agrees
to deliver a specific cash commodity to a buyer at a specific time in the future.
- Fundamental analysis: A method of anticipating futures price movement
using supply and demand information.
- Futures contract: A legally binding agreement, made through a futures
exchange, to buy or sell a commodity or financial instrument sometime in the future.
Futures contracts are standardized according to the quality, quantity and delivery
time and location for each commodity.
- Hedger: An individual or company owing or planning to own a cash
commodity – corn, soybeans, wheat, etc. may anticipate a change in the cost of the
commodity before they intend to buy or sell it in the cash market. A hedger achieves
a protection against the price fluctuations by purchasing or selling futures contracts
of the same or the similar commodity and later squaring off their positions. The
loss (gain) in the spot (cash) market is offset by the gain (loss) in the futures
- Hedging: The practice of offsetting the price risk inherent in
the any cash market position by taking an equal but opposite position in the futures
- Initial margin: The amount of futures market anticipant must deposit
into his / her margin account at the time he / she places an order to buy or sell
a futures contract.
- Liquidate: Selling (or purchasing) futures contracts of the same
delivery month purchased (or sold) during an earlier transaction or making (or taking)
delivery of the cash commodity represented by the futures contract.
- Long: One who has bought futures contract or plans to own a cash
- Maintenance margin: A set minimum margin (per outstanding futures
contract) that a customer must maintain in his margin account.
- Nearby (delivery) month: The future contract closet to expiration.
Also referred to as spot month.
- Open interest: The total number of futures contracts of a given
commodity that has not yet been offset by an opposite futures positions nor fulfilled
by delivery of the commodity.
- Purchasing hedge (long hedge): Buying futures contracts to protect
against a possible price increase of cash commodities that will be purchased in
the future. At the time cash commodities are bought, the open futures position is
closed by selling an equal number and type of futures contract as those that were
- Selling hedge (short hedge): Selling futures contract to protect
against possible hedge declining prices of commodities that will be sold in the
future. At the time the cash commodities are sold, the open futures positions is
closed by purchasing an equal number and type of futures contracts as those that
were initially sold.
- Short position: Selling futures contracts or initiating a cash
forward contract sale.
- Speculator: A market participant who tries to profit from buying
and selling futures contracts by anticipating futures price movements. Speculators
assume market price risk and add liquidity and capital to the futures markets. They
do not hold equal and opposite cash market risks.
- Spread: The price difference between two related markets or commodities.
- Technical analysis: Anticipating future price movements using historical
prices, trading volume, open interest, and other trading data to study price patterns.
- Volatility: A measurement of the change in price over a given time
period. It is often expressed as a percentage and computed as the annualized standard
deviation of percentage change in daily price.
- Volume: The number of purchase or sales of a commodity futures
contract made during a specified period of time, often the total transactions for
one trading day.