Commodities

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.

COMMODITY EXCHANGES

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.

Evolution
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.

Role

• 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 transactions.
• 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.

Global Exchanges
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

History

• 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.

Developments

• 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 Exchange.
• 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 Exchanges.
  • NCMSL
  • NBOT
  • MCX
  • NCDEX
• 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.

Other Developments

• 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

• India’s 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 commodities.

• Agricultural products (Pulses, Edible oil complex, spices, guar complex, cotton, sugar etc)
• Precious metal (Gold, Silver)
• Other metals (Copper, Aluminum, Zinc, Nickel etc )
• Energy (Crude oil, Furnance oil etc)

Performance

• 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 are decided.

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

MARKET PARTICIPANTS

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:

• 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 rematerialized.

Speculators:

• 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
  • Independent traders and
  • Investors.
  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 changes.
• 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 of gold.
  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:
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.

Funds:
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 Rules.
• 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 action.
• 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.

Glossary

• 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 a transaction
• 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 market.
• 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 market.
• 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 commodity.
• 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 initially bought.
• 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.