Commodity Future Pricing

8/3/2019 Commodity Future Pricing

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COMMODITY FUTURE

PRICING

NAME: PAYAL.S.POPAT

STD: SYBFM-A

ROLL NO: 137

SUB: COMMODITIES MARKET


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INTRODUCTION & DEFINITION

Definition of 'Commodity Market'A physical or virtual marketplace for buying, selling and tradingraw or primary products. For investors' purposes there arecurrently about 50 major commodity markets worldwide that

facilitate investment trade in nearly 100 primary commodities.

Commodities are split into two types: hard and soft commodities.

Hard commodities are typically natural resources that must bemined or extracted (gold, rubber, oil, etc.), whereas softcommodities are agricultural products or livestock (corn, wheat,coffee, sugar, soybeans, pork, etc.)

Commodity Market is stated as:

There are numerous ways to invest in commodities. Aninvestor can purchase stock in corporations whose businessrelies on commodities prices, or purchase mutual funds,index funds or exchange-traded funds (ETFs) that have afocus on commodities-related companies. The most directway of investing in commodities is by buying into a futures

contract.


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ROLE OF COMMODITY MARKET:

Role of commodity Futures Exchange in Price Discovery & Price RiskManagement Unlike the physical market, a futures marketfacilitates offsetting the trades without exchanging physical goods

until the expiry of a contract. As a result, futures marketattracts hedgers for risk management, and encourages considerableexternal competition from those who possess market information

and price judgment to trade as traders in these commodities.While hedgers have long-term perspective of the market, thetraders or arbitragers, prefer an immediate view of the market.

However, all these users participate in buying and selling ofcommodities based on various domestic and global parameters suchas price, demand and supply, climatic and market relatedinformation. These factors, together, result in efficient price

discovery, allowing large number of buyers and sellers to trade onthe exchange. The Exchange is communicating these prices allacross the globe to make the market more efficient and to enhance

the utility of this price discovery function.

Price Risk ManagementHedging is the practice of off-setting the price risk inherent in

any cash market position by taking an equal but opposite position inthe futures market. This technique is very useful in case of anylong-term requirements for which the prices have to be firmed to

quote a sale price but to avoid buying the physical commodityimmediately to prevent blocking of funds and incurring large holding

costs.

Participants of a Futures marketThe Futures market participants comprise of farmers, traders,producers, processors, exporters, importers and industries

associated with commodities. The futures market is used for


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hedging the price risk and for trading or arbitrage. Brokers of theExchange, who are located all across the country, serve the

futures market users directly through their own branch offices'network or through the network of their franchisees or sub-brokers.

Trading on a Commodity ExchangeOnly exchange members and their authorized users are entitled totrade on the Exchange. Those who are not members of the

Exchange can trade through members of the Exchange or theirauthorized users. Clearing the Trades on the Exchange

All trades on the Exchange are supported by an initial margin. Atthe End-of day the Exchange does mark-to-market of all the open

positions. This activity results into final position of all members inrespect to booked losses or losses on open positions. Members makethe shortfalls good by way of pay-ins to the Exchange by next day

and the members in profit on such positions are given thenecessary credits. These payments are processed electronicallythrough a country-wide network of clearing banks, like- Bank of

India, HDFC Bank, IndusInd Bank, Union Bank of India and UTIBank wherein members maintain their accounts.

Settlement Process

A contract has a life cycle of one month or longer. At theExchange, two weeks before the expiry of a contract, the contractenters into a tender period. At the start of the tender period,

both the parties must state their intentions to give or receive

delivery, based on which the parties are supposed to act or bearthe penal charges for any failure in doing so. Those who do notexpress their intention to give or receive delivery at the beginning

of tender period are required to square-up their open positionsbefore the expiry of the contract. In case they do not theirpositions are closed out at 'due date rate'. The links to the


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physical market through the delivery process ensures maintenanceof uniformity between spot and futures prices

The Exchange has tied up with State Level WarehousingCorporations of Kerala, Gujarat, Tamil Nadu and Uttar Pradesh andis in the process of finalizing the arrangements with CWC and

other State level Warehousing Corporations.

Buyer Receiving Delivery

Buyers intending to take delivery will receive it, if there aresellers willing warehouse at the designated delivery centers on the

designated delivery days. There are commission agents who helpthe brokers with handling of the delivery, logistic support,

associated quality certification through give delivery. The Buyerwill have to make the payment within three days after the deliveryis allotted. The buyer will take actual delivery from the empanelled

agencies and associated billings due to tax implications. Thissupport is required as the buyer may be in a different city thanthe place where the delivery is being received.

Use of the Physical Delivery (in the Warehouse) by the ClientThe client of a buyer may use this delivery for his consumption inthe industry, or for exports, or he may sell in the spot market or

may sell in futures market in the subsequent contract, if he is aregular trader. Generally the commodities available in the physicalform are consumed by the industry and, rarely, commodities, are

stored in the warehouse for a longer period.

Percentage of Delivery in the Futures MarketThe percentage is fairly low. Generally, the futures markets all

over the world are used for hedging where actual deliverypercentage is about 1%. Any user in the commodities ecosystemunlike the physical spot or forward market does not use these


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markets for regular consumption.

Operating a Futures Market under FC(R)A, 1952 on CashSettlement Basis and the Position at the ExchangeThe FC(R) Act, 1952 does not permit any exchange to create amarket where settlement of contract happens only on cash basis,

without giving the seller an option to tender deliveries. TheExchange permits the sellers to tender delivery if they chose to.This has to be followed by any commodity exchange recognized

under FC(R) Act.

Quality of a Commodity given by a SellerThe Exchange has specified the deliverable grades in the contract

specifications, which are notified before commencement of tradingin a contract. The seller is required to submit the qualitycertification issued by the Exchange's empanelled quality

certification agencies, like, SGS, Geo Chem, Dr. Amins, amongothers.

Role of a Warehouse in Futures MarketIn India, vibrant spot markets, in various commodities, exists for100s of years. In these markets, there are farmers,industrialists, warehouses, consumers, dealers and traders, who

buy and sell commodities. There are warehouses, which storescommodities and there are consumers, who consume themeventually. the Exchange or, for that matter, any other Futures

Exchange do not aim to replace, replicate or substitute such spot

markets, rather the only value added service of THE EXCHANGE isto support the spot market players by developing their price riskefficiency through providing hedging tools. Therefore, a Futures

Exchange has to base its delivery process on the basis of existingphysical market practices and use existing warehouseinfrastructure, which is capable of handling billion dollars worth of


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physical market trades. So the same infrastructure can properlytake care of minuscule delivery tendered in a futures market.

Necessity of the role of WarehouseThe role of a warehouse is most necessary in the spot marketwhere a farmer after having harvested his crop sells them to

commission agents who in turn sell them to a Mandi. The Traders inMandi may then sell it to a large consumer or to a trader who inturn will sell it to some other consumer, industry, exporter or

miller at the right time and right price. The Goods during thisperiod are stored in the warehouse. It is seen that today 80% of

the warehousing capacity is used by the Government for storingvarious commodities under the Public Distribution System and for

storing fertilizers.

Demat Electronic Warehouse Receipt

Demat Electronic Warehouse Receipts are expected to beelectronic records created by an approved agency afterdematerialization of the physical receipt issued by a Warehouse. In

securities market the physical shares of the company aredematerialized by their Registrar and Transfer Agents using aDepository empowered under the Depositories Act. Also, the totalshares of a company are monitored by the Registrar of Companies

and the Stock Exchanges. In commodities market, there is nostandardization of monitoring of warehouse receipts issued by awarehouse by any regulatory body. Similarly, the transfer of

ownership also gets affected under a mutual agreement and not as

per any Statutory Act. It remains to be seen whether suchtransfer will be considered good transfer under NegotiableInstruments Act and whether electronic records will be good title

considering the above shortcomings. And also the fact thatcommodity is perishable and may not be a good delivery if thebuyer finds out that it has deteriorated beyond the specifications


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mentioned in the contract

Necessity of Demat Electronic Warehouse Receipts for FuturesTradingAs 99% of the trading does not result in delivery, demat electronicwarehouse receipts are not mandatory. Further, in futures market,

since this 1% delivery also happens only once in a month or perhapsonce in two months, it may not be economically viable to createsuch an elaborate system for futures market only.

In the securities market also, demat deliveries were useful only in

the spot segment where the delivery percentage is 15-20% and itoccurs on a daily basis across the country. Further, the demated

shares in securities market are perpetual in nature and, thereforeare rarely required to be used in the physical form. Whereas, inthe commodities market such an elaborate system is pointless

initially as commodities traded on the futures markets areconsumed regularly and are rarely available in abundance forextended storage.

As far as commodities are concerned, there is no law, whichregulates dematerialization of warehouse receipts. Availability of acommodity at any point of time is a direct derivative of total

production, carried forward stocks, imports and consumption.Equity shares are off the market if the issuing company buys themback. Commodities, on the other hand, are extinguished due to

consumption, the perishable nature and exports.

Currently, 80% of the warehousing in India is used primarily forwheat, rice and fertilizers, among others. The import of

commodities is spaced out at regular intervals to reduce storagecost and commodities produced seasonally are used completely, bythe next season Therefore, it may not be a feasible business


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proposition to recommend market participants to use electronicwarehouse receipts without first providing for a legal secured

framework, which guarantees the quantity, quality, title andownership of the commodities held by a genuine buyer and coversissues like sales tax concerning sale and movement of goods.


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CHARACTERISTICS

In the futures market, margin refers to the initial deposit of goodfaith made into an account in order to enter into a futures

contract. This margin is referred to as good faith because it isthis money that is used to debit any losses.

When you open a futures account, the futures exchange will statea minimum amount of money that you must deposit into your

account. This original deposit of money is called the initial margin.When your contract is liquidated, you will be refunded the initial

margin plus or minus any gains or losses that occur over the spanof the futures contract. In other words, the amount in your marginaccount changes daily as the market fluctuates in relation to your

futures contract. The minimum-level margin is determined by thefutures exchange and is usually 5% to 10% of the futurescontract. These predetermined initial margin amounts are

continuously under review: at times of high market volatility, initialmargin requirements can be raised.

The initial margin is the minimum amount required to enter into a

new futures contract, but the maintenance margin is the lowestamount an account can reach before needing to be replenished. Forexample, if your margin account drops to a certain level because of

a series of daily losses, brokers are required to make a margin call

and request that you make an additional deposit into your accountto bring the margin back up to the initial amount.

Let's say that you had to deposit an initial margin of $1,000 on acontract and the maintenance margin level is $500. A series oflosses dropped the value of your account to $400. This would then


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prompt the broker to make a margin call to you, requesting adeposit of at least an additional $600 to bring the account back up

to the initial margin level of $1,000.

Word to the wise: when a margin call is made, the funds usuallyhave to be delivered immediately. If they are not, the commodity

brokerage can have the right to liquidate your Commodity positioncompletely in order to make up for any losses it may have incurredon your behalf.

Leverage: Leverage refers to having control over large cashamounts of a commodity with comparatively small levels of capital.

In other words, with a relatively small amount of cash, you canenter into a futures contract that is worth much more than you

initially have to pay (deposit into your margin account). It is saidthat in the futures market, more than any other form ofinvestment, price changes are highly leveraged, meaning a small

change in a futures price can translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins

that are set by the exchanges are relatively small compared to thecash value of the contracts in question (which is part of the reasonwhy the futures market is useful but also very risky). The smallerthe margin in relation to the cash value of the futures contract,

the higher the leverage. So for an initial margin of $5,000, youmay be able to enter into a long position in a futures contract for30,000 pounds of coffee valued at $50,000, which would be

considered highly leveraged investments.

You already know that the futures market can be extremely risky,and therefore not for the faint of heart. This should become more

obvious once you understand the arithmetic of leverage. Highlyleveraged investments can produce two results: great profits oreven greater losses.


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Due to leverage, if the price of the futures contract moves up

even slightly, the profit gain will be large in comparison to theinitial margin. However, if the price just inches downwards, thatsame high leverage will yield huge losses in comparison to the initialmargin deposit. For example, say that in anticipation of a rise in

stock prices across the board, you buy a futures contract with amargin deposit of $10,000, for an index currently standing at1300. The value of the contract is worth $250 times the index

(e.g. $250 x 1300 = $325,000), meaning that for every point gainor loss, $250 will be gained or lost.

If after a couple of months, the index realized a gain of 5%, this

would mean the index gained 65 points to stand at 1365. In termsof money, this would mean that you as an investor earned a profitof $16,250 (65 points x $250); a profit of 162%!

On the other hand, if the index declined 5%, it would result in amonetary loss of $16,250--a huge amount compared to the initial

margin deposit made to obtain the contract. This means you stillhave to pay $6,250 out of your pocket to cover your losses. Thefact that a small change of 5% to the index could result in such alarge profit or loss to the investor (sometimes even more than the

initial investment made) is the risky arithmetic of leverage.Consequently, while the value of a commodity or a financialinstrument may not exhibit very much price volatility, the same

percentage gains and losses are much more dramatic in futures

contracts due to low margins and high leverage.Pricing and LimitsAs we mentioned before, contracts in the Commodity futures

market are a result of competitive price discovery. Prices arequoted as they would be in the cash market: in dollars and cents orper unit (gold ounces, bushels, barrels, index points, percentages


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and so on).

Prices on futures contracts, however, have a minimum amount thatthey can move. These minimums are established by the futuresexchanges and are known as ticks. For example, the minimum sumthat a bushel of grain can move upwards or downwards in a day is a

quarter of one U.S. cent. For futures investors, it's important tounderstand how the minimum price movement for each commoditywill affect the size of the contract in question. If you had a grain

contract for 3,000 bushels, a minimum of $7.50 (0.25 cents x3,000) could be gained or lost on that particular contract in one

day.

Futures prices also have a price change limit that determines theprices between which the contracts can trade on a daily basis. Theprice change limit is added to and subtracted from the previous

day's close, and the results remain the upper and lower priceboundary for the day.

Say that the price change limit on silver per ounce is $0.25.Yesterday, the price per ounce closed at $5. Today's upper priceboundary for silver would be $5.25 and the lower boundary wouldbe $4.75. If at any moment during the day the price of futures

contracts for silver reaches either boundary, the exchange shutsdown all trading of silver futures for the day. The next day, thenew boundaries are again calculated by adding and subtracting

$0.25 to the previous day's close. Each day the silver ounce could

increase or decrease by $0.25 until an equilibrium price is found.Because trading shuts down if prices reach their daily limits, theremay be occasions when it is NOT possible to liquidate an existing

futures position at will.

The exchange can revise this price limit if it feels it's necessary.


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It's not uncommon for the exchange to abolish daily price limits inthe month that the contract expires (delivery or spot month). This

is because trading is often volatile during this month, as sellers andbuyers try to obtain the best price possible before the expirationof the contract.

In order to avoid any unfair advantages, the CTFC and theCommodity futures exchanges impose limits on the total amount ofcontracts or units of a commodity in which any single person can

invest. These are known as position limits and they ensure that noone person can control the market price for a particular commodity


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The Trading Process

Here are some typical steps in the process of making a commodity

trade including the trader's decision-making process and theprocedures involved in actually placing the trade.

In order to make decisions about when to trade commodity futures,

you must have a source of price data. Many daily newspapers carrysome commodity prices in their financial sections. The Wall StreetJournal has comprehensive commodity price listings. Investor's

Business Daily has both price tables and numerous price charts

All experienced commodity traders prefer to look at price activityon a chart rather than trying to interpret tables of numbers. In

financial analysis, charts are indispensable for quickly grasping theessence of historical and recent price action.

The typical commodity chart depicts daily price action as a thinvertical bar which indicates the day's high and low by the top and

bottom of the bar. The opening and closing prices are shown astiny dots attached to the left and right side of the bar. A typicaldaily price chart can show up to six months of price action thisway.

It is easy to change the bar's time frame from days to weeks ormonths and thus show from two to twenty years of historical priceaction in the same format. For short-term trading you can change

the bar's time frame to hours or even minutes.

Looking at such bar charts enables a trader to see the recenttrend of prices--whether up, down or sideways--in whatever time

frame he chooses. Following the current trend of prices is a


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cornerstone of successful trading.

There are a number of ways to obtain the price charts a traderneeds to analyze the markets. You can make your own using graphpaper. This sounds rather primitive, but some experts recommendit as a good way to put yourself in close touch with price activity

and monitor risk.

Another source of charts is the printed chart service. There are

about half a dozen of these. They typically mail a booklet ofnumerous charts covering all the tradeable markets after the

markets close on Friday. There is space on the charts to updatethem daily during the following week until next chart book arrives.

These printed chart books normally have a number of indicatorsplotted along with the price action and contain a wealth ofadditional information.

For computer owners there are many software programs thatcreate fancy charts on the computer screen. You can input the

price data manually or, via telephone modem, downloadcomprehensive data after the markets close for the day. Thosewith larger budgets can install a small satellite dish and watchprice changes in all the markets nearly instantaneously as they

occur. The software creates charts dynamically on the computerscreen as each trade takes place on the exchanges. You can putmany different charts on the screen and thus watch numerous

markets all around the world in real time. The cost can range from

a few hundred to $1,000 a month depending on the software andthe number of exchanges you subscribe to.

It is easy to believe that computers can make a big difference intrading success. Vendors of expensive software will tell you thatsince other traders, who are your competition, have expensive


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computer setups, you need one too. This isn't really true.

Those who can't trade profitably without a computer probablywon't be helped too much by using a computer. It may actually bedetrimental by causing an increase in trading frequency. While acomputer will not make a bad trader into good one, they are fun to

use, and they do make a trader's life easier.

There are two primary analytic methods for deciding when to take

a futures position: fundamental analysis and technical analysis.Fundamental analysis involves using economic data relating to supply

and demand to forecast likely future price action. Technicalanalysis involves analyzing past price action of the market itself to

forecast the likely future price action.

While there are differences of opinion about the relative merits of

the two approaches, almost all successful traders emphasizetechnical analysis. There are a number of reasons for this. Firstand foremost is the difficulty of obtaining accurate fundamental

data. While various governments and private companies publishstatistics concerning crop sizes and demand levels, these numbersare gross estimates at best. With the current global marketplace,even if you could obtain accurate current information, it would still

be impossible to predict future supply and demand with enoughaccuracy to make commodity trading decisions.

Technical analysts argue that since the most knowledgeable

commercial participants are actively trading in the markets, thecurrent price trend is the most accurate assessment of futuresupply and demand. If someone is correct that for fundamental

reasons, prices will likely move up strongly in the future, thecommercial participants who have the greatest knowledge andinfluence on the markets should certainly be moving the price


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upward right now. If price instead is moving down, a lot of veryknowledgeable people must think price in the future will likely be

down, not up.

For this reason, almost all successful speculators learn to followprice action and not try futilely to predict turning points in

advance. They seek to trade in tune with the large participantswho move the markets.

In his classic book, Technical Analysis of the Futures Markets,famous analyst John Murphy summarizes the rationale for technical

analysis: "The technician believes that anything that can possiblyaffect the market price of a commodity futures contract--

fundamental, political, psychological or otherwise--is actuallyreflected in the price of that commodity. It follows, therefore,that a study of price action is all that is required. By studying

price charts and supporting technical indicators, the technician letsthe market tell him which way it is most likely to go. The chartistknows there are reasons why markets go up and down. He just

doesn't believe that knowing what those reasons are is necessary."


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Using Commodity Futures as a Price Forecasting Tool

Joe Parcell and Vern Pierce, Department of Agricultural EconomicsCommodity futures prices can serve as a mechanism for pricediscovery either for the present price or for determining expected

future prices. A market is defined as an efficient market if themarket accounts for all public and non-public information indetermining an equilibrium price in the market. Commodity futures

markets are often referred to as efficient in the price discoveryprocess. That is, the price quoted for a commodity on the futures

market is thought to be the best measure of the actual price,either current or in the future. Therefore, if you would like a good

predictor of what prices will be four months from now, the closestdeferred (four month out) futures price quote for that commoditymay be the best and easiest aggregate price forecast.

Tables 1 and 2 provide closing future price quotes for corn and livecattle, respectively, for December 18, 1998. On December 18,

1998 these price quotes for corn and live cattle could be thoughtof as a forecasted price for the months listed on the left-handside of the tables. For example, if you wanted a forecast of whatcorn price was going to be for the U.S. in March of 1999, you

could use the March 1999 CBOT futures closing price of$2.19/bushel as a forecasted price. Similarly, if you wereinterested in a forecast of live cattle prices for December 1999,you could use the December 1999 CME live cattle futures price

quote of $64.85/cwt.

Why does someone care about forecasting price? Knowing what the

grain price will be in March 1999 is helpful in evaluating storagedecisions. Knowing what the live cattle price will be in December of


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1999 is helpful in making retained ownership decisions. Also,knowing expected prices can help in making forward pricing

decisions. That is, if you could forward price corn for March 1999at $2.24/bushel, you would know that the offered price is abovethe expected price (typically this will not be the case in forwardpricing agreements because the entity offering the forward price

contract requires a price discount to assume your price risk).Expected prices can help grain producers decide which croppingalternative to plant in the spring. Lastly, expected prices can be

useful in planning annual cash flows and loan requests.

What about Determining a Local Price?

Agriculture producers and agribusinesses face a diverse array ofmarketing and production alternatives. Each time a marketing orproduction decision is made, farmers or agribusinesses must

estimate what impact this decision will have on their riskmanagement plan. None of these are more difficult to answer than,"What price can I expect?" No matter the time of year, this

question always looms in a farmers or agribusinesses decisionprocess. With changes in the domestic farm program, producersmust now ask themselves, which crop will I plant given my knowninput costs and expected harvest time prices? During this same

time and into crop maturity, producers then must ask themselves,should I forward price a portion of my crop? Finally, in the fallproducers must ask themselves, should I store my crop? Or for the

cow-calf producer, should I retain ownership on a portion of my

heard beyond weaning? Similarly, agribusinesses must determineprice expectations to know what forward price to offer.

Commodity futures exchange markets provide a mechanism for pricediscovery on an aggregate level through arbitrage between multiplebuyers and sellers. However, price discovery at a given location is


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not nearly as clearly defined because local supply and demandrelationships are not as well known. However, historical basis

provides a linkage between these two markets (see An Introductionto Basis). Therefore, a simple, low cost, and relatively goodpredictor of the local cash price is the futures contract [month]price of interest adjusted for a multiple year average basis for

that time. An expected price, where E denotes an expectation.


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THANK YOU


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Commodity Future Pricing

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