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In this chapter it is attempted to focus on various fundamental aspects of

commodity market such as Commodity, Market, Commodity Market, Evolution of

Commodity Market, History of Commodity Market in India, Regulatory Frame

Work, Commodity Exchanges, and Benefits of commodity exchange.

India, a commodity based economy where two-third of the one billion populations

depends on agriculture commodities. Surprisingly, it has an under-developed

commodity market. Unlike the physical market, futures market trades in

commodity are largely used as risk management (hedging) mechanism on either

commodity itself or open position in commodity stock.

1.1 COMMODITY

A commodity may be defined as an article, a product or a material that is bought

and sold. It can be classified as every kind of movable property, expect actionable

claim, money & securities. Commodities actually offer immense potential to

become separate asset class for investors, arbitragers and speculators. Retail

investors, who claim to understand the equity markets, may find commodities

difficult to understand. But commodities are easy to understand as far as

fundamentals of demand and supply are concerned. Retail investors should

understand the risks and advantages of trading in commodity future before taking

a leap. Historically, pricing in commodities futures has been less volatile

compared with equity and bonds, thus providing an efficient portfolio option.

In order to qualify as a commodity, an article or a product has to meet some basic

characteristics, which are as follows:

1. The product must be basic, raw, unprocessed state. (e.g. wheat is a commodity;

but wheat flour and bread are not commodities). There are of course some

exception to this rule e.g. in case of metal and product like sugar.

2. Major consideration while buying a particular commodity is its price.

3. The product has to be fairly standardized in the sense that there cannot any

differentiation in a product based on its quality (e.g. Rice is rice through

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different varieties of rice can be treated as different commodities and hence

traded as separate contract).

4. Price of the product are determined by market forces, demand and supply and

they undergo rapid changes/fluctuation (price must fluctuate enough to create

uncertainty, which means both risk and potential profit/loss for buyers and

sellers).

5. Usually there would be many competing seller of the product in the market.

6. The product should have adequate shelf life so that delivery of a future contract

can be differed.

1.2 MARKET

Market is a place where buyer and seller meet to transact a business i.e. for

exchange of goods and services for a consideration, which is usually money.

Markets are usually and traditionally at a place or location, where buyer and seller

could meet. However, in modern world, buyer and seller on telephone lines or on

internet can transact the business. Hence, in today’s world market need not exist in

physical form as long as the exchange of goods and services take place for a

consideration. Markets have existed for centuries in India and abroad for selling

and buying of goods and services.

1.3 COMMODITY MARKET

Commodity markets are markets where raw or primary products are exchanged.

These raw commodities are traded on regulated commodities exchanges, in which

they are bought and sold in standardized contract. It is similar to an equity market,

but instead of buying or selling shares one buys or sells commodities.

Existence of a vibrant, active and liquid commodity market is normally considered

as a healthy sign of development of any economy. Commodity markets quite often

have their centers in developed countries though the primary commodities in many

cases are produced in developing countries. Birth and growth of transparent

commodity market is thus a sign of development of an economy. This has

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particular significance in case of country like India, which produced agricultural

products as well as number of basic commodities, which are traded on commodity

exchanges world over.

Commodity future in particular help price discovery and assist investors in

hedging their risks by taking positions in commodities and exploiting arbitrage

opportunities in the market.

1.4 EVOLUTION OF COMMODITY MARKETS

Commodities futures trading have evolved from the need for ensuring continuous

supply of seasonal agricultural crops. In Japan, merchant stored rice in warehouses

for future use. In order to raise cash, warehouse holder sold receipts against the

stored rice. These were known as “rice ticket”. Eventually, such rice ticket became

accepted as a kind of general commercial currency. Rules came into being, to

standardize the trading in rice tickets.

The concept of organized trading in commodities evolved in the middle of 19th

century, in Chicago, United states. Chicago had emerged as a major commercial

hub with railroad and telegraph-lines connecting it with the rest of the world,

thereby attracting wheat producers from Mid-west to sell their produce to the

dealers and distributors. However, lack of organized storage facilities and the

absence of a uniform weighing/grading mechanism often confined them to the

mercy of dealer’s discretion. This led to inherent need to establish a common

meeting place both for farmers and dealers to transact in “spot” grain – to deliver

wheat and receive cash in return. This happened in 1848.

Gradually the farmers (sellers) and dealers (buyers) started to make commitment

to exchange the produce for cash in future. This is how the contract for future

trading evolved whereby the producer would agree to sell his produce (wheat) to

the buyer at a future delivery date at an agreed upon price. In this way the farmer

knew in advance about what he would receive for his produce and the dealer

would know about his costs involved. This arrangement was beneficial to both the

producer and the trader.

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These contracts became popular very quickly and started changing hands even

before delivery date of the product. If dealer is not interested in taking delivery of

the produce he would sell his contract to someone who needed the same. Similarly

the farmer who did not intend to deliver his crop would pass on the responsibility

to another. The price of the contract would depend on the price movement in the

wheat market.

With some more modification, such contract gradually transformed into an

instrument to protect the parties involved against adverse factors like unexpected

price movement, unfavorable climate factors etc. for example, during bad whether

people having contracts to sell wheat would be interested to hold more valuable

contracts due to supply shortage. Conversely, if there is oversupply, the seller’s

contract value would decline. This prompted the entry of traders in the future

market that had no intentions to buy or sell wheat but would purely speculate on

price movement in the market to earn profit. The hedgers (farmers) who wanted to

protect themselves from price fluctuations began to efficiently transfer risk to

dealers.

Trading in futures as a result become a very profitable mode of activity that

encourage the entry of other commodities in the future market thereby creating a

platform to set up a body that can regulate and supervise these contract. Thus,

during 1848, the Chicago board of trade was established. It was initially formed as

a common location known both to the buyers and sellers to negotiate forward

contracts. However, the popularity of the contract and the success of the CBOT in

Chicago created interest in the other local market catering to specific commodities

to establish trade bodies that would facilitate dealing in future contract.

In the early 20th

century, as communication and transportation became more

advanced, centralize warehouse were built in the principal market centers to

distribute goods more economically. Agriculture commodities were the most

commonly traded, but it led to the fact that a market can flourish for any

underlying as long as there is an active pool of buyers and sellers.

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In the 1870s and 1880s the New York coffee, cotton and produce exchange were

born. The largest commodity exchange in USA are the Chicago board of trade,

The Chicago mercantile exchange, The New York mercantile exchange, the New

York commodity exchange and the New York coffee, sugar and Cocoa Exchange.

Worldwide there are major future trading exchange in over twenty countries

including Canada, England, India, France, Singapore, Japan, Australia, and New

Zealand.

The various exchanges are constantly looking for new products in which to trade

futures. In USA, futures’ trading is regulated by an agency of the department of

agriculture called the commodity future trading commission. It regulates the future

exchange, brokerage firms, money managers and commodity advisors.

1.5 HISTORY OF THE COMMODITY MARKET IN INDIA

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized

futures market. Bombay Cotton Exchange Ltd. was established in 1893 following

the widespread discontent amongst leading cotton mill owners and merchants over

functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds

started in 1900 with the establishment of the Gujarati Vyapari Mandali, which

carried on futures trading in groundnut, castor seed and cotton. A future trading in

wheat was existent at several places in Punjab and Uttar Pradesh. But the most

notable futures exchange for wheat was chamber of commerce at Hapur set up in

1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian

Exchange Ltd. was established in 1919 for futures trading in raw jute and jute

goods. But organized futures trading in raw jute began only in 1927 with the

establishment of East Indian Jute Association Ltd. These two associations

amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct

organized trading in both Raw Jute and Jute goods. Forward Contracts

(Regulation) Act was enacted in 1952 and the Forwards Markets Commission

(FMC) was established in 1953 under the Ministry of Consumer Affairs and

Public Distribution. In due course, several other exchanges were created in the

country to trade in diverse commodities.

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1.6 REGULATORY FRAME WORK

The Forward Market Commission (FMC) headquartered at Mumbai, is the

regulatory body for commodity derivatives market in India. It is a statutory body

set up in 1953 under the forward contract regulation Act, 1952. FMC is in turn

supervised by the Ministry of Consumer affairs, Food and Public distribution,

Govt. of India.

The Act provides that the commission shall consist of not less than two but not

exceeding four members appointed by the central govt. to be the chairman thereof.

Currently the commission comprises four members among whom Shri S.

Sundeareshan, IAS, is the chairman and Dr. Kewal Ram, IES, Dr. Jayashree

Gupta, CSS, and Shri Rajeev Kumar Agarval, IRS, are the members of the

commission.

1.7 FUNCTIONS OF FORWARD MARKET COMMISSION

1. To advise the central government in respect of the recognition or the

withdrawal of recognition from any association or in respect of any other

matter arising out of the administration of the forward contract (Regulation)

Act 1952.

2. To keep forward markets under observation and to take such action in relation

to them, as it may consider necessary, in exercise of the powers assigned to it

by or under the Act.

3. To collect and Whenever the commission feels it necessary, to publish

information regarding the trading condition in respect of goods to which any of

the provisions of the act is made applicable, including information regarding

supply, demand and price, and to submit to the central govt., periodically

reports on the working of forward market relating to such goods;

4. To make recommendations generally with a view to improving the

organization and working of forward market;

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5. To undertake the inspection of the accounts and other documents of any

recognize association or registered association or any member of such

association whenever it considers it necessary.

1.8 DERIVATIVES

Derivatives are financial contracts, which derive their value from an underlying

asset. The underlying asset can be equity, commodity, foreign exchange, interest

rates, real estate or any other asset. Broadly four types of derivatives are traded,

namely forward, futures, options and swaps.

1.8.1 Need of Commodity Derivatives in India

India is among top five producers of most of the commodities, in addition to being

a major consumer of bullion and energy product. Agriculture contributes about

22% of GDP of Indian economy. It employees around 57% of the labor force on

total of 163 million hectors of land. Agriculture sector is an important factor in

achieving a GDP growth rate of 8-10%. All this indicates that India can be

promoted as a major centre for trading commodity derivatives.

1.8.2 Derivatives contracts are traded either in an exchange or over the

counter

EXCHANGE

It is central marketplace for buyers and sellers of different asset classes and

financial instruments (contracts) that derive their value from these assets as the

underlying. The contracts are standardized to ensure homogeneity in the financial

instrument traded. The prices in an exchange are determined in the form of a

continuous auction. This auction provides a readily available widely accepted

reference price for the underlying. This facilitates liquidity in the derivatives

instrument being traded due to easy transferability, thereby resulting in price

discovery – The fair value is determined by market participants. For example, all

participants in the futures market are subject to the same specification of quality

(lot size of each future contract) and delivery terms. It is important to understand

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that the exchange neither takes positions in the market nor advises the market

participants on what position to take. The responsibility of the exchange is to

ensure that the market is fair and orderly. The exchange provides “Trade

guarantee” using the settlement guarantee Fund thereby minimizing counterparty

default (credit) risk. Regulatory bodies are appointed by the govt. to regulate the

functioning of all exchanges. In India, the forward market commission is the

regulatory authority for commodity future exchanges in India. Members violating

the rules of the exchange and the regulatory body can be penalized.

OVER THE COUNTER

It is an alternative trading platform linked to a network of a dealers who do not

physically meet but instead communicate through a network of telephone and

computers trades are usually transacted between financial institutions that can also

act as market-makers for the traded financial instruments. All the transactions over

telephone are recorded so that they can be authenticated in case of future disputes.

The buyer and seller can customize the contracts traded to suit their specific

requirements. Hence, the term of contract are not standardized, but customized to

meet specific requirement of the counterparties. The buyer and seller negotiate and

manually agree to the terms of the contract.

1.9 MEANING OF FORWARD, FUTURE, OPTION AND SWAPS

1.9.1 Forward Contract

A forward contract is an agreement between two parties to buy or sell an asset at a

future date for price agreed upon while signing the agreement. Forward contract is

not traded o an exchange. The terms and conditions of forward contracts are

customized based on negotiation between the counterparties. It is the oldest form

of derivative contract.

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1.9.2 Future Contract

A future contract is an agreement between two parties to buy or sell a specified

and standardized quantity and quality of an asset at a certain time in the future at a

price agreed upon at a time of entering into the contract on the future exchange.

1.9.3 Option

An option gives the right but not the obligation to the option owner, to buy or sell

an underlying asset at a specific price at a specific time period in the future.

There are two types of options:

1. A call option is an option contract that gives the owner of the option, the right,

but not the obligation to buy the underlying asset on or before a specific date

and at a specific price.

2. A put option is an option contract that gives the option owner the right, but not

the obligation to sell the underlying asset on or before a specific date and at a

specific price.

As in any other financial transaction, there are two sides to every contract. For

instance, whereas buyer of a call option has the right to buy an asset, the seller of

the same option has the obligation to sell the same asset if the option is exercised.

The option seller is virtually selling “price protection” to the buyer who pays a

certain amount of money called the premium to the option seller.

1.9.4 Swap

A swap is an agreement between two parties to exchange different streams of cash

flows in future according to predetermined terms. It is a recent innovation. The

basic idea is that the counter parties agree to swap two different types of

payments. A payment is either fixed or is designed to float according to an

underlying interest rate, exchange rate, index or the price of a security or a

commodity. When the payments are to be executed in the same currency, then

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only the net amount of payment are made. The World Bank and IBM entered into

the first ever swap contract in august 1981.

A swap rate and associated cash flow are formulated so that one series of payment

is based on a fixed interest rate and the other series is based on a floating interest

rate like LIBOR or a U.S. Treasury bill yield. A foreign exchange swap consists of

two transactions, the first involves buying a foreign currency at a specific

exchange rate and the second involves selling back that curacy at another specific

exchange rate. A foreign currency swap is structured so that one party makes a

series of payments based on an interest rate in one currency and then receives a

series of payments in another currency based on that currency’s interest rate.

1.10 DIFFERENCE BETWEEN SPOT AND FUTURE MARKETS

Commodities can be transacted in both the spot as well as in the future markets.

Although the two markets are separated, they are interrelated nevertheless. The

commodities are physically bought or sold on a negotiated basis in the spot

market, which is generally considered as the actual physical market for immediate

delivery. Most often, the contract require for the actual delivery of the commodity

traded to be made. It may also specify for immediate or forward delivery in the

future at a set time.

The future market, however, facilitates buying and selling of standardized

contractual agreements (for future delivery) of the underlying assets as the specific

commodity and not the physical commodity itself. The formulation of futures

contracts is very specific regarding the quality of the commodity, the quantity to

be delivered and the date for delivery. However, it does not involve immediate

transfer of ownership of the commodity, unless resulting in delivery. Thus, in

future markets “contractual agreements” to buy or sell the commodity at a future

date can be traded irrespective of whether the buyer or seller of this contractual

agreement has possession of the underlying commodity or not. This is because the

delivery resulting from this contractual agreement is for a future date.

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The physical market for commodities deals in either cash or spot contract for

ready delivery and payments within 11 days, where as forward contracts for

delivery of goods and payment of price after 11 days. These contracts are

essentially party to party contracts, and are fulfilled by the seller giving delivery of

goods of a specified variety of a commodity as agreed to between the parties. In

case of uncontrolled situation which prevents buyer or seller from receiving or

giving deliveries then in such cases contract may be cash settled mutually.

The future market, unlike the physical markets, trade in future contracts primarily

for the purpose of risk management that is hedging on commodity stocks or

forward buys and sells. Most of this contract are squared off before maturity and

thus rarely end in deliveries. Speculators, who are key players in the future

markets, also use these contracts to benefit from price movement.

1.11 DIFFERENCE BETWEEN FUTURE AND FORWARD

CONTRACT

Point Future Contract Forward Contract

Meaning It is an agreement between two

parties to buy or sell a specified

& standardized quantity &

quality of asset at a certain time

on future at a certain price at

agreed at the time of entering

into the contract on the future

exchange.

It is an agreement between the

two parties to buy or sell an

asset at a future date for an

agreed price while entering in to

the forward contract. The terms

& conditions are not decided on

an exchange.

Trading place It is entered on the centralized

trading platform of the exchange.

It is traded on an OTC market.

Size It is standardized in terms of

quantity as specified by the

exchange.

Size of the forward contract is

customized as per the terms of

agreement between the buyer &

seller.

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Point Future Contract Forward Contract

Transparency

in contract

price

The price of future contract is

transparent as it is available on

the centralized trading screen of

the exchange

The price of the forward

contract is not transparent as it

is not publicly disclosed

Liquidity

Liquidity is the measure of trades

that occur in a particular

commodity future contract is

more liquid.

It is less liquid due to its

customized nature. As it is

traded on the exchange.

Counter-

party risks

In this contract, the clearing

house becomes the counterparty

to each transaction. Therefore,

counterparty risk is almost

eliminated.

In this contract, counter-party

risk is high due to the

customized & bilateral nature of

the transaction.

Regulation A regulatory authority and the

exchange regulate the future

contract.

Forward contract is not

regulated by any exchange.

Settlement Future contract is generally cash

settled but option of physical

settlement is available

Forward contract is generally

settled by physical delivery.

Delivery Delivery in future contract

should be of standard quantity &

quality as specified by the

exchange.

Delivery in forward contract is

to be carried out at delivery

centers specified in the

customized bilateral agreement.

1.12 COMMODITY FUTURE CONTRACT

A commodity future contract is an agreement between two parties to buy or sell a

specified and standardized quantity and quality of goods at a certain time in future

at price agreed upon at the time of entering into the contract on the commodity

future exchange.

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The need for future market arises mainly due to the hedging function that it can

perform. Commodity market involves risk associated with frequent price

volatility. The loss due to price volatility can be attributed to the following

reasons:

Consumer preference: in the short term, their influence on price volatility is

small since it is a slow process permitting manufacturer, dealers, and

wholesalers to adjust their inventory in advance.

Change in supply: They are unpredictable bringing about wild fluctuation in

price. This can be especially notified in agriculture commodities where the

weather plays a major role In affecting the fortunes of people involved in this

industry. The future market has evolved to neutralize such risk through a

mechanism namely, hedging.

The objectives of commodity future market areas under:

1. Hedging with the motive of transferring risk related to the possession of

physical assets through any adverse movement in price.

2. Liquidity and price discovery to ensure base minimum volume in trading of a

commodity through market information and demand supply factors that

facilitate a regular and authentic price discovery mechanism.

3. Maintaining buffer stock and better allocation of resources as it augments

reduction in inventory requirement and thus the exposure to risk related with

price fluctuations declines. Resources can thus be diversified for investment.

4. Flexibility, certainty and transparency in purchasing commodity facilitate bank

financing. Predictability in the price of commodity would lead to stability,

which in turn would eliminate the risk associated with running the business of

trading commodities. This would make funding easier and less stringent for

banks to commodity market players.

5. Price stabilization along with balancing demand and supply position. Future

trading leads to predictability in assessing the domestic prices, which maintain

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stability, thus safeguarding against any short term adverse price movements.

Liquidity in the contracts of the commodities traded also ensures in maintain

the equilibrium between demand and supply.

It is necessary to classify investment commodity and consumption commodity in

commodity future. An investment commodity is generally held for investment

purpose whereas consumption commodity is held mainly for consumption

purpose. Gold and silver can be classified as investment commodities whereas oil

and steel can be classified as consumption commodities.

1.13 MYTHS AND REALITIES ABOUT THE COMMODITY

FUTURES MARKET

The government, after prolonged prohibition, has finally approved futures trading

in all commodities. In order to activate the futures market, the government has

mandated four commodity exchanges to establish national level multi commodity

exchanges.

There have been various incorrect perceptions about the commodities market

founded on experiences in the securities market. These have hindered the

development of the commodities market and the protection of real trading

interests. Multi Commodity Exchange of India Limited (MCX) believes that the

commodities market would be successful only if the commodities' eco-system

partners use the exchange for its economic function of price discovery and price

risk management.

1.13.1 Some of the Myths about the Commodities Market

Myth: Commodities markets are very complex to understand.

Reality: The markets are not complex as the products are natural and therefore

cannot be artificially manipulated. The demand and supply also depends on

economic factors. It is easier to understand commodities, as in our everyday life

we are familiar with commodities, we know the ruling prices of these commodities

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in the market, while in the stock market, we are not fully aware about the internal

affairs of a company.

Myth: Only farmers are interested in trading and only they should be trading.

Reality: It is incorrect to say that only the farmers would use this market.

Actually, the farmers only use the commodity futures prices as a tool to decide

which crop to grow and some large farmers would use this market to hedge their

price risk through an intermediary. These intermediaries would normally be the

same commission agents who help the farmers to sell their crop in the cash

market.

Myth: These markets are not really required and they only serve the need of

speculators.

Reality: Commodities markets are needed for the most important economic

function of price discovery and price risk management, Speculators constitute only

one dimension of the market. They can work only because someone is hedging

their risk in the market.

Myth: The economy does not need futures market.

Reality: A Futures Exchange provides price signals to producers and consumers

based on which they meet their long terms requirements. These price signals are

not available to the user unless there is a commodity futures exchange and in its

absence, the markets have large price fluctuations. This is not in the interest of the

producers and consumers. Price stabilization comes from the price discovery

process when market participants react positively to the information available to

decide a price.

Myth: A Commodity Futures Exchange must have large capital.

Reality: A Commodity Futures Exchange has to be run and managed efficiently

with optimal costs as the commodities markets does not provide listing fees as in

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the securities market and therefore all costs have to be recovered from revenues

earned through transactions. Large infrastructure costs may translate into large

costs to traders and which would have direct implications on hedging making it

expensive. If real users of the commodities market use this market as insurance

and discover that the cost of hedging is considerably high, they would prefer not to

hedge but bear the risk instead.

Myth: A Commodity Futures Exchange is represented by the size of its real estate.

Reality: No, it's not true that the Commodity Futures Exchange is known by the

size of its real estate. The new order Commodity Futures Exchanges may not

necessarily require large conventional real estate. In fact in the new era the real

estate is defined by the power of processors deployed to handle system driven

trading and post trading operations. Further, the Exchanges need an efficient team

of professionals who thoroughly understand the intricacies of the commodities

market, state of the art technology support partners and dynamic members.

Myth: A Commodity Futures Exchange must have large number of members to be

successful.

Reality: A Commodity Futures Exchange must have large number of members to

be successful. The Commodity Futures Exchange should focus on good and well-

spread brokerage houses to penetrate the market. The market would soon move

over to many intermediaries with separate trading rights and have few members

with clearing rights like banks.

Myth: An Exchange must have cash settled contracts to avoid the pains of

delivery handling process.

Reality: Cash settled market would be no different than an online lottery system.

In such markets, the price of the commodity futures will have no bearing on the

spot market as delivery is not required and therefore money will be the only factor

that determines prices. At MCX, there is a complete understanding of the

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commodities market and it has a large talent pool to handle deliveries to keep the

link pulsating between the futures market and physical cash market. The

commodities market has to be kept as real as possible.

Myth: The Depository system of electronic transfer of commodities is covered in

the Depositories Act.

Reality: It is incorrect.

Myth: The regulatory framework covers agencies in the chain of the Demat

Process for commodities.

Reality: No, it is merely an understanding being reached within the trade and

industry.

Myth: The Depository/Warehouse guarantees the quality.

Reality: Quality of delivery is not guaranteed by anyone. Until the standards in

ware housing management improves to ensure preservation of the quality of goods

stored no exchange or depository will be able to guarantee quality of the

commodity in warehouse. If the quality is not assured no benefit accrues to the

actual user. Therefore, the Exchange should provide a system, Where by the

sellers must ensure quality certification before tendering delivery and the buyers

must have option to recheck the quality at the time of collecting delivery and in

case of any discrepancies compared to the contract specifications, they should

have an option to reject it. Worldwide there is no Demat delivery operational in

commodities.

Myth: There is no guarantee of quality in a physical settlement between member

to member through a ware house.

Reality: The seller guarantees the quality to the buyer and therefore he takes care

of storing the commodity, as it may be rejected by the buyer. He keeps it in a

warehouse where he ensures preservation of quality and quantity of the

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commodity. Further, the buyer also has the option to recheck the quality at the

time of delivery. For performing all such checks, there are professional firms of

international repute, which are experts in certification. India is exporting a large

number of agro-based commodities to Europe and America on the basis of such

certification. Therefore, a commodity Exchange has to educate the members about

the effective prevailing systems and to implement a settlement process based on a

similar infrastructure.

Myth: The operators can manipulate commodity futures prices and so it is not safe

to operate in this system.

Reality: it is incorrect that commodities prices can be manipulated because all

these commodities are under OGL and in case somebody tries to corner s tocks of

a commodity to manipulate price, some importer will import that commodity from

any other country and deliver in India nullifying the attempt to manipulate the

price. In the stock markets , the floating s tocks are limited so if an operator buys a

large number of shares , prices will rise, which is not the case in commodities ,

because supply and floating s tocks are virtually unlimited. In terms of

fundamentals and technical analysis commodity prices follow the trends with more

accuracy than as compared to scrip, because the commodity markets truly reflect

the demand and supply factors.

Myth: Commodity futures markets are more risky and so it is not advisable to

trade in commodities.

Reality: While a scrip price can go down even by 30-40 percent in a single trading

session, it cannot happen in commodity futures as the commodity futures price is

based on the intrinsic value of the commodity. For instance, a scrip future can go

down fromRs.4000 to Rs. 2800 in a single trading session, but Gold Feb 2004

contract would never come down from Rs. 6100 to Rs. 4100 in a single trading

session, because the inherent value of gold would never fall so drastically.

Therefore, it is always safe to operate in the commodity futures market as against

the stock futures market. It is only an issue of in depth understanding of the real

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market and anticipating and delivering what the commodity industry actually

requires.

1.14 ECONOMIC PERSPECTIVE OF COMMODITY FUTURE

MARKET

Price Discovery

Price risk management

Import-Export management

Predictable pricing

Benefits for farmers & agriculturalist

Credit accessibility

Improved product quality

The buyer and seller at the future exchange conduct trading based on their

assessment of input regarding specific market information, expert’s view and

comments, the demand & supply equilibrium, government policies, inflation rates,

Whether forecasts, market dynamics, hopes and fears which transforms into a

continuous price discovery mechanism. The execution of trades between buyers

and sellers leads to assessment of the fair value of a particular commodity that is

immediately disseminated on the trading terminal.

Hedging is the most common method of price risk management. It is the strategy

of offsetting price risk that is inherent in a spot market by taking an equal but

opposite position in the future market. Future markets are used as a mode by

hedgers to protect their business from adverse price changes, which could dent

profitability of their business. Hedging benefits all participants who are involved

in trading of commodities i.e. manufacturer, exporters, importers, farmers etc.

The exporters can hedge their price risk and improved their competitiveness with

the help of future market. Most of the buyers intend to buy forwards if they are

involved in physical trade internationally. For example, The Indian textile mills

exports three months forwards since their buyer needs this security. Also in the

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oilseed sector the international buyer prefer to buy at least one year forward.

Normally, exporters who enter into such forward contract do not possess the entire

stock required. The purchases would have to be made from the physical market,

which would expose them to the risk of price risk resulting to losses. To safeguard

against such risk, the exporters might have to refuse demand for long period

contracts thereby hurting their own competitive position or hold inventory that is

more than required. The existence of a future market would allow the exporters to

hedge their propose purchase by temporarily substituting for an actual purchase till

the time is ripe to buy in the physical market. Without future market this can only

be possible by a meticulous, time consuming and costly timing of their physical

transactions. A future market would allow the processor & oilseeds crushers to cut

down the marketing and processing margin thus enabling them to compete

effectively with the now free imports of edible oils. Similarly, reduced margins

will enable the crushers to offer high prices to oilseed growers.

The demand for certain commodities like edible oils is highly price elastic. The

manufacturers thus have to ensure that the prices are stable in order to protect their

market share with the free entry of imports. Future contract will enable

predictability in domestic prices. As a result, the manufacturer can smooth out the

influence of change in their input prices very easily. With no future market, the

manufacturer can be caught between sever short term price movement of oil and

the necessity to maintain price stability, which could only be possible through

sufficient financial reserves that could otherwise be utilize for making other

profitable investments.

Future market would be beneficial for the farmers as well as to those who do not

use them directly. Price instability has a direct bearing on farmers in the absence

of future market. There would be no need to have large reserves to cover against

unfavorable price fluctuations. This would reduce the risk premium associated

with the marketing or processing margins enabling more return on the produce

storing more and being more active in the market. The price information

accessible to the farmers determines the extent to which traders or processor

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increase prices to them. Since one of the objectives of the future exchange is to

make available these prices as far as possible, it is very likely to benefits the

farmers.

Due to the time lag between planning & production, the market determined price

information disseminated by the future exchanges would be crucial for their

production decision.

The absences of proper risk management tool would attract the marketing and

processing of commodities to high risk exposure making it a risky business

activity to fund. Even a small movement in prices can eat up a huge proportion of

capital own by trader, at times making it virtually impossible to pay back the loan.

There is a high degree of reluctance among banks to fund commodity traders,

especially those who do not manage price risks. If in case they do, the interest rate

is likely to be high and the terms and conditions very stringent. This poses a huge

obstacle in the smooth functioning and competition of the commodities market.

Hedging, which is possible through future markets, would cut down the discount

rate in commodity lending.

The existence of warehouses for facilitating delivery with grading facilities along

with other delivery related Benefits provides a very strong reason to upgrade and

enhance the quality of the commodity to a grade that is acceptable by the

exchange. It ensures uniform standardization of commodity trade, including the

terms of quality standard. The quality certificates that are issued by the exchange-

certified warehouses have the potential to become the norms for physical trade.

1.15 COMMODITY EXCHANGES

A commodity exchange is an association or a company where various

commodities and derivatives products are traded for which license has been

granted by regulating authority. Most commodity markets across the world trade

in agricultural products and other raw materials like wheat, barley, sugar, maize,

cotton, cocoa, coffee, milk product, pork bellies, oil, metal, etc. and contract based

on them. These contracts can include spot forward, future etc.

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A big difference between a typical auction, where a single auctioneer announces

the bids and the exchange is that people are not only competing to buy but also to

sell. By exchange rules and by law, no one can bid under a higher bid, no one can

offer to sell higher than someone else’s lower offer. This keeps the market as

efficient as possible, and keeps the traders on their toes to make sure no one gets

the purchase or sell before they do.

1.15.1 Definition

A commodity exchange refers to the market place where buying and selling of

commodities for future delivery takes place.

1.15.2 List of exchanges in India

1. Bhatinda Om & Oil Exchange Ltd., Batinda

2. The Bombay Commodity Exchange Ltd. Mumbai

3. The Rajkot Seeds Oil & Bullion Merchants’ Association Ltd.

4. The Kanpur Commodity Exchange Ltd., Kanpur

5. The Meerut Agro Commodities Exchange Co. Ltd., Meerut

6. The Spices and Oilseeds Exchange Ltd.

7. Ahmedabad Commodity Exchange Ltd.

8. Vijay Beopar Chamber Ltd., Muzaffarnagar

9. India Pepper & Spice Trade Association. Kochi

10. Rajdhani Oils and Oilseeds Exchange Ltd., Delhi

11. National Board of Trade, Indore

12. The Chamber of Commerce, Hapur

13. The East India Cotton Association, Mumbai

14. The Central India Commercial Exchange Ltd., Gwaliar

15. The East India Jute & Hessian Exchange Ltd.

16. First Commodity Exchange of India Ltd., Kochi

17. Bikaner Commodity Exchange Ltd., Bikaner

18. The Coffee Futures Exchange India Ltd., Bangalore

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19. Esugarindia Ltd.

20. National Multi Commodity Exchange of India Ltd. (NMCE)

21. Surendranagar Cotton Oil & Oilseeds Association Ltd.

22. Multi Commodity Exchange of India Ltd. (MCX)

23. National Commodity & Derivatives Exchange Ltd. (NCDEX)

24. Haryana Commodities Ltd., Hissar

25. e-Commodities Ltd.

Out of these 25 commodity Exchanges the MCX, NCDEX and NMCE are large

exchanges and MCX is the biggest among them.

1.15.3 Registered Commodity Exchanges and Commodities Traded

No. Name of the Exchange Product traded

1. 1. MCX Gold, silver, Copper, Nickel, Sponge,

Iron, Steel Flat, Steel Long, Tin,

Castor oil, Castor seeds, Cotton seed,

Crude palm oil, Groundnut oil,

Kapasia khalli, Mustard seed,

Rapessed oil, RBD palmolein, Refined

soy oil, Sesame seed, Soymeal, Soy

seed, Chana, Masur, Tur, Urad,

Yellow peas, Rice, Wheat, Maize,

Black pepper, Red chilli, Jeera,

Turmeric, Cashewkermal, Rubber,

Coffee, Kapas, Cotton long staple,

Medium staple, Short staple, Gaur

seed, Gaur gum, Gur, Mentha oil,

Sugar, High density polyethylene,

Brent crude oil, Natural gas, etc.

2. 2. Bhatinda Om & Oil Exchange

Ltd.

Gur

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No. Name of the Exchange Product traded

3. 3. The Bombay Commodity

Exchange Ltd.

Sunflower oil

Cotton (Seed and oil)

Safflower (Seed, oil and oil cake)

Groundnut (Nut and oil)

Castor oil, Castorseed

Sesamum (Oil and oilcake)

Rice bran, rice bran oil and oil cake

Crude palm oil

4. The Rajkot Seeds Oil & Bullion

Merchants Association, Ltd.

Groundnut oil

Castor seed

5. The Kanpur Commodity

Exchange Ltd.

Rapeseed/ Mustard seed oil and cake

6. The Meerut Agro Commodities

Exchange Co. Ltd.

Gur

7. The Spices and Oilseeds

Exchange Ltd. Sangli

Turmeric

8. Ahmedabad Commodities

Exchange Ltd.

Cottonseed, Castor seed

9. Vijay Beopar Chamber Ltd.,

Muzaffarnagar

Gur

10. India Pepper & Spice Trade

Association, Kochi

Pepper

11. Rajdhani Oils and Oilseeds

Exchange Ltd., Delhi

Gur, Rapeseed / Mustard seed

Sugar Grade-M

12. National Board of Trade, Indore Rapeseed / Mustard Seed / Oil / Cake

Soybean / Meal / Oil, Crude Palm Oil

13. The Chamber of Commerce,

Hapur

Gur, Rapeseed / Mustard seed

14. The East India Cotton

Association, Mumbai

Cotton

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No. Name of the Exchange Product traded

15. The Central India Commercial

Exchange Ltd., Gwaliar

Gur

16. The East India Jute & Hessian

Exchange Ltd., Kolkata

Hessian, Sacking

17. First Commodity Exchange of

India Ltd., Kochi

Copra, Coconut oil & Copra cake

18. The Coffee Futures Exchange

India Ltd., Bangalore

Coffee

19. National Multi Commodity

Exchange of India Limited,

Ahmedabad

Gur, RBD Pamohen

Crude Palm Oil, Copra

Rapeseed / Mustard seed, Soy bean

Cotton (Seed, oil, oilcake)

Safflower (seed, oil, oilcake)

Groundnut (seed, oil, oilcake)

Sugar, Sacking, gram

Coconut (oil and oilcake)

Castor (oil and oilcake)

Sesamum (Seed, oil and oilcake)

Linseed (seed, oil and oilcake)

Rice Bran Oil, Pepper, Guar seed

Aluminum ingots, Nickel, tin

Vanaspati, Rubber, Copper, Zinc, lead

20. National Commodity &

Derivatives Exchange Limited

Soy Bean, Refined Soy Oil

Mustard Seed

Expeller Mustard Oil

RBD Palmolein Crude Palm Oil

Medium Staple Cotton

Long Staple Cotton

Gold, Silver

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1.16 BENEFITS OF COMMODITY EXCHANGE

BENEFITS TO CONSUMERS AND USERS

a) It is useful for the consumer because he gets an idea of the price at which the

commodity would be available at a future point of time. He can do proper

costing and also cover his purchases by making forward contracts. Predictable

pricing and transparency is an added advantage.

b) Hedging their risks if they are using some of the commodities as their raw

materials in particular can benefit corporate entities. They can hedge the risk

even if the commodity traded does not meet their requirements of exact

quality/technical specifications.

c) Futures’ trading is very useful to the exporters as it provides an advance

indication of the price likely to prevail and thereby help the exporter in quoting

a realistic price and thereby secure export contract in a competitive market.

BENEFITS TO PRODUCERS

It is useful to the producer because he can get an idea of the price likely to prevail

at a future point of time and therefore can decide between various competing

commodities. The best that suits him farmers for instance, can get assured prices,

decided on the crop that they want to take and since there is transparency in prices,

he can decide when and where to sell.

BENEFITS TO INVESTORS

a) High financial leverage is possible in commodity markets. In case of stocks, an

investor needs to put up the full amount of the stock value to buy the stock.

With commodities, you control commodity futures contacts with a margin,

which varies from 2% to 10% of the value of the commodity .Investor can

effectively hedge the risk in price fluctuation of a commodity.

b) Investors can also hedge his risk on investments in stocks and debt markets

since commodities provide a choice and provide one more alternative avenue

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in the investment port for. It may be mentioned here that the Commodities are

less volatile compare to equity market, through more volatile as compare to

Government security.

c) Commodity markets are extremely transparent in the sense that the

manipulation of prices of a commodity is extremely difficult. Given the

knowledge of the commodity, the investor can be thus clear about what he can

expect in foreseeable future.

d) Business involves just the investor and the market.

e) With the rapid spread of derivatives trading in commodities, this rout too has

become an option for high net worth and savvy investors to consider in their

overall asset allocation.

f) The fact that the stock indices and commodity indices are not correlated

implies that the commodity markets can be used as an effective diversification

tool, where investor can park their money.

g) A look at the performance of the commodities markets during the last year

shows that the positive movement was witnessed during most parts of the year.

BENEFITS TO EXCHANGE MEMBERS

a) Access to a huge potential market much greater than the securities and cash

market in commodities.

b) Robust, scalable, state-of-art technology deployment.

c) Member can trade in multiple commodities from a single point, on real time

basis.

d) Traders would be trained to be Rural Advisors and commodity specialists and

through them multiple rural needs would be met, like bank credit, information

dissemination, etc.

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GENERAL BENEFITS AND OTHER ADVANTAGES FOR ALL

PLAYERS

A) Improved Product Quality: since the contracts for commodities are

standardized, it becomes essential for the producers/sellers to ensure that the

quality of the commodity is specified in the contract.

B) Credit Accessibility: buyers and sellers can avail of the bank finances for

trading in commodities. As mentioned here, some nationalized banks and some

banks in the private sector have come forward to offer credit facilities for

commodity trading. More and more banks are likely to fall in line looking at

the huge potential that commodity market offers in India.

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References

1. Chandra, Prasan, (2002), Financial Management, 5th

Edition, pp. 1052-1061.

2. Chitaliya, Jayesh, (2012), Future and Options, Parichay Trust, Mumbai, 1st

Edition.

3. Hull, John C., (2008), Options, Futures and Other Derivatives, Dorling

Kindersley (India) Pvt. Ltd., Delhi, 7th

Edition, pp.1-43.

4. Shah Jignesh (2007), Reference Material for MCCP, MCX, pp. 1-30.

5. Kabra, Pooja R., (2009), Commodity Market, Project Report of T.Y.B.B.A.

Student, Sardar Patel University.