COMMODITY MARKET AND ITS FEATURES

QUESTION : Explain the Commodity Market and its features.                       OR

            Write a note, on Commodity Market in India.

Ans. A) COMMODITY MARKET

When the value of derivative is derived from a commodity, it is known as commodity derivative. Commodity trading is one facility which investors can use for investing their funds. In India the commodity market facilitates multi commodity exchange within and outside the country. Commodity markets, particularly for agricultural commodities and primary products have been in existence for a long time all over the world. Initially goods were exchanged through cash transactions. The emergence of forward market provided a mechanism by which the prospects of future production and consumption were brought to bear. todays price in a logical way.

          In India the forward markets in commodities are regulated by Forward Markets Commission (FMC) which is a statutory body. FMC regulates forward markets in commodities through recognised associations. FMC helps to protect the interest of customers and non-members. In India, (at present) there are 22 commodity exchanges of which 3 are national level multi-commodity exchanges. These exchanges have been set up in the country to facilitate commodity trading for retail investors from anywhere in the country.

The three National exchanges in India are:—

1)    Multi Commodity Exchange (MCX), located at Mumbai.

2)    National Multi Commodity Exchange (NMCE), based at Ahmedabad.

3)    National Commodity And Derivatives Exchange (NCDEX), Mumbai based.

All the three commodity exchanges have electronic trading and settlement systems. The total value trading in commodity futures market has been increasing considerably in recent years amounting to. Rs. 50 lakh crores in 2008.

B.   AIMS OF COMMODITY EXCHANGE :-

The aim of commodity exchange is to provide a regulated forum for buyers and sellers of future contracts to meet and trade.

1)    The traders in commodity exchanges will help to raise liquidity of contracts by taking risks.

2)    They help to promote transparency in the discovery market prices for individual commodities

      based on their demand and supply.

3)    The traders in commodity exchanges carry out various hedging strategies and the commodity

      exchanges safeguard the customers against price fluctuations.

C.   FEATURES OF COMMODITY MARKETS :-

1)    Demat Account :-

The investor must have a demat account from NSDL (National Securities Depository Ltd.) to trade on NCDEX just like in stocks.

2)    Margin Requirements :-

In commodity market also margin is calculated by Value at Risk (VaR). Normally margin is between 5 to 10% of contract value: The margin keeps on changing depending on change in price and volatility.

3)    Agreement :-

The investor needs to enter into normal account agreement with the broker. This includes the procedure relating to 'know your client’ format that exist in equity trading.

4)    Circuit Filters :-

The exchanges have Circuit Filters. If the price of any commodity that fluctuates either way beyond its limit will immediately call for circuit breaker.

5)    Brokerage And Transaction Charges :-

The broker charges range from 0.10 to 0.25% of contract value. Transaction charges range between Rs. 6 to 10 per lakh / per contract.

6)    Commodities For Trading :-

Mostly all commodities are eligible for future trading. For starters exchanges have listed a few commodities. The NMCE has most major agriculture commodities and metals under its fold. The NCDEX has a large number of agriculture, metals and energy commodities.. MCX offers many commodities for future trading.

7)    Delivery Of Commodities :-

During the delivery period of commodities the margin increases to 20 to 25% of contract value. The broker may levy extra charges.

8)    Commodity Market Regulator :-

Commodity exchanges are regulated by Forward Markets Commission. The brokers don’t have to register with the regulator.. FMC will seek to inspect the books of brokers only if bad policies are suspected.

9)    Information On Commodity Market :-

Daily financial newspapers carry spot prices and relevant news and articles on most commodities. There are many magazines on agriculture commodities available for subscription. Though many websites are subscription based, a few of them offer information free of cost.

10) Effect Of Default :-

The commodity exchanges have a penalty clause in case of any default by any member.

ADVANTAGES OF FUTURE AND FORWARD CONTRACT

Q.4: Explain the advantages of forward and future contracts.                                          OR

Explain the importance of financial derivative contracts.

Ans. A. ADVANTAGES OF FORWARD AND FUTURE CONTRACTS :-

1)        Protection Against Price Fluctuations :-

Parties to contract can protect themselves against the risk of heavy fluctuations in price of underlying assets.

2)        Flexibility :-

Parties to forward contract can modify the agreement as per their convenience.

3)        Facilitates Planning:-

These contracts facilitates planning to buy / sell assets at the time when they are most required.

4)        Bulk Transactions :-

The forward / future contracts facilitates bulk purchase or sale of assets at short notice in advance of delivery.

5)        Portfolio Management :-

Portfolio managers can advice their clients for future contracts to avoid heavy fluctuations in prices.

6)        Development Of Financial Market :-

Future and forward contracts facilitates the growth and development of financial markets - Capital Markets as well as Money Markets.

7)        Cash Management :-

In forward contract payment is done at maturity on delivery of asset. In future contract only margin money is to be paid. So these contracts do not require payment of purchase price at the time of contract.

FUTURE CONTRACT AND ITS FEATURES

Q.3: Explain Future Contracts along with its features.                                                OR

      Write note on Future Contracts.                                                                               OR

              Distinguish between Forwards and Futures.

Ans. A) FUTURE CONTRACTS :-

A future contract is an agreement between two parties to buy or sell an asset at a certain time in future, at a certain price. Future contracts are standardised arid stock exchange traded. A future contract may be offset prior to maturity by entering into an equal and opposite transaction.

B)        FEATURES OF FUTURE CONTRACT :-

1)        Exchange Traded :-

Future Contracts are generally traded on an exchange. The exchanges provide a mechanism of guarantee to honour the contract. So there is secondary market for futures.

2)        Standardised :-

Future contracts are highly standardised and legally enforceable. There is lack of flexibility.

3)        Types Of Future :-

Future contracts can be classified into two:-

a)        Commodity future in which underlying asset is a commodity

b)        Financial future in which the underlying asset is a security or bond.

4)        Transparency :-

The contracts enjoy a fair degree of transparency. The terms and conditions are published by exchanges.

5)        Down Payment :-

In future contracts, the contracting parties have to deposit a certain percentage of contract price called as Margin Money with the exchange. It acts as a collateral to support the contract.

6)        Delivery Of Asset

In future contract the parties only exchange the difference between the future price and the spot price prevailing on the date of maturity.

7)        Settlement :-

A future contract is always settled daily, irrespective of maturity date. It is market to market on a daily basis. The difference between future price and spot price on a day constitutes either profit or loss.

FORWARD CONTRACT AND ITS FEATURE

QUESTION Explain Forward Contracts and its features.      OR

        Write note on Forward Contracts.

Ans.A) FORWARD CONTRACTS :-

Forwards are the oldest of all derivatives. It is an agreement between two parties to buy or sell an asset at a certain date in future at a predetermined price. The promised asset may be currency, commodity, instrument like shares / debentures etc.

Forward contracts are normally traded outside stock exchanges. They are popular on the over the counter market. In a forward contract, the party who promises to buy the specified asset at an agreed price at a future date is said to be in the ‘long position’ and party who promises to sell is said to be in ‘short position’. Thus, long position and short position takes the form of buy and sell in a forward contract.

For Eg :- On October 4, 2010, Mr. Naitik agrees to buy a certain asset on February 4, 2011 for Rs. 1 lakh from Mr. Aniket. This is a forward contract where Mr. Naitik has to pay Rs.1 lakh to Mr. Aniket on February 4 and Mr. Aniket has to supply the asset.

B.   FEATURES OF FORWARD CONTRACT :-

1.    Bilateral Contract :-

Forward contract is a bilateral contract between a buyer and a seller hence it is subject to counter-party risk.

2.    Over The Counter Trading (OTC)

Forward contracts are private contracts hence traded over the counter and not in exchanges. The contract can be modified as per the requirements of parties.

3.    Custom Designed :-

Forward contract is a custom designed contract between two parties. It contains features in terms of size of contract, date of expiry, type and quality of asset etc.

4.    Physical Delivery

There is no physical delivery of assets at the time of entering the contract. Physical delivery takes place only on expiry date.

5.    Settlement At Maturity

Money is exchanged only on the maturity as stated in the contract. The asset must be delivered on maturity date on receipt of payment.

6.    Need For Intermediary

Mostly parties enter into a forward contract with the help of some intermediary. It can be a bank or financial institution or any other party.

C.   LIMITATIONS QF FORWARD CONTRACTS

1.    Since these contracts are customised, they are non-tradable.

2.     There is counter party risk. Default by any one party puts another party in trouble.               

DERIVATIVE MARKET, ITS PARTICIPANTS AND TYPES

Q1: What is a Derivative Market? Explain its Participants and Types.                              OR   

             Write note on Derivative Market.

Ans. A)  DERIVATIVE MARKET :-

A derivative is an instrument which derives its value from an underlying asset. They have no independent value, so its value depends on the underlying asset. The underlying asset may be a commodity or a security. When a person buys derivative, he buys only a contract and not assets. If it is a commodity it is called commodity derivative, if it is a security it is called financial derivative.

According to The Security Contracts (Regulation) Act derivative is defined as follows “A derivative includes

a)    a security derived from a debt instrument, share loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security

b)    a contract which derives its value from the prices or index of prices of underlying securities”.

B.   PARTICIPANTS OF DERIVATIVE MARKET :-

The participants of Derivative Market are broadly classified into three

Groups:-

1.    Hedgers :-

They participate in derivative market to lock the prices at which they will be able to do a buy or sell transaction in future. The transaction they undergo is known as Hedging. They try to reduce or avoid price risk by dealing in derivatives.

2.    Speculators :-

Speculators are risk takers who want to take advantage of future price movement of an asset. They are ready to face what hedgers want to avoid. They use derivatives to get extra leverage.

3.    Arbitrageurs :-

They watch the spot and future markets. They are interested in taking advantage of discrepancy between the prices in two different markets Whenever they see a mismatch in prices of two markets, they enter into a buy transaction in one and a sell transaction in other market so as to enjoy profitarising out of differences in prices.

C.   TYPES OF DERIVATIVES / DERIVATIVE INSTRUMENTS :-

1.    Forwards :-

Forward contracts are private bilateral contracts to settle them at some future date. It is an over-the-counter agreement. Forward contract is a contract in which the seller agree to sell and settle the deal on a specific date in future at a predetermined price. At the time of agreement there is no exchange of assets. Physical delivery of assets takes place only on the day of final settlement.

2.    Futures :-

Future contract is a legally binding agreement. It is an agreement between two parties to exchange commodity or asset for a specific price at a certain future date. Future contracts are transferable legal agreements and their terms cannot be changed during the life of the contract. They are traded in an organised exchange. The important types of futures are stock index futures like Nifty futures, interest rate futures and currency futures.

3.    Options :-

Options are contracts between the option writers (sellers) and buyers. Options grant the buyer or the holder the right but not the obligation to* buy or sell an underlying asset at predetermined price on or before any time to the specific date.

4.    Swaps :-

Swaps are generally customised transactions. They are agreements between two parties to exchange one set of financial obligations for another as per the terms of agreement.. Some of the important types of swaps are currency swaps, interest rate swaps, bond swaps and debt equity swaps.

5.    Warrants :-

It is a contract made by issuing company giving the holder the right to purchase or subscribe to the stated number of equity shares of that company within specified period of time at a predetermined price.

6.    Credit Derivates :-

They reduce credit risk. They help the banks, finance companies and other investors to manage credit risk by insuring against adverse changes in quality of borrowers. If borrowers default, the loss can be offset by gains from credit derivatives.

D.   IMPORTANCE I BENEFITS OF DERIVATIVES

1.    Derivatives reduce risk and increases liquidity in the market for underlying assets.

2.    Derivatives help to find out the future as well as current prices of underlying instrument.    ‘

3.    Derivatives act as catalysts to the growth of stock markets. They attract young investors to securities market.

4.    Derivatives provide information about the direction in which various market indices are expected to move.

5.    Derivative trading helps to transfer the risk from risk averser to risk takers.

6.    Derivatives by increasing the volume of trading, increases savings.