FAQ

FAQs ON COMMODITY DERIVATIVES:

What are Derivatives ?

The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

What are forward contracts ?

A forward contract is an agreement to buy or sell an asset at a certain future time for a certain price. It is traded over the counter market- usually between two financial institutions or between a financial institution and its clients. They are commonly used to hedge foreign currency risk. (Source: Options, Futures and Other Derivatives by John C.Hull)

How are forward contracts useful ?

Forward contract is very valuable in hedging and speculation. It can help a farmer to hedge himself against any unfavorable movement of the prices of his crop by forward selling his harvest at a known price. Incase of a speculator, if he has information, which forecast an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise and then take a reversing transaction. The use of forward market here supplied the leverage to the speculator. (Source: Options, Futures and Other Derivatives by John C.Hull)

What are futures contracts ?

A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. They are normally traded on the exchange. The exchange specifies certain standardized features of the contract. As the two parties do not necessarily know each other, the exchange also provides a mechanism that give the two parties a guarantee that the contract will be honored.

What is the difference between the futures contracts and forward contracts ?

Some of the basic differences between the futures and forward contracts are as follows:

What are the commodities suitable for futures trading ?

All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i.e., there should be large demand for and supply of the commodity – no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price. The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardisation and gradation.

How are futures prices determined?

Futures prices evolve from the interaction of bids and offers emanating from all over the country – which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.

How is it possible to sell, when one doesn’t own commodity?

One doesn’t need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.

What are long position?

In simple terms, long position is a net bought position.

What are short position?

Short position is net sold position.

What are short position?

Short position is net sold position.

What is bull spread (futures)?

In most commodities and financial derivatives market, the term refers to buying contracts maturing in nearby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.

What is bear spread (futures)?

In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.

What is cash settlement?

It is a process for performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt).

What is offset?

It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract

What is settlement price?

The settlement price is the price at which all the outstanding trades are settled, i.e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.

What is convergence?

This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.

Can one give delivery against futures contract?

Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.

Can a buyer demand delivery against futures contract?

The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges, particularly the northern Exchanges trading contracts in “gur”/jaggery provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position are settled at the “Due Date Rate”.

What is “Due Date Rate”?

Due Date Rate is the weighted average of both spot and futures prices of the specified number of days, as defined in the Byelaws of Associations.

What is delivery month?

It is the specified month within which a futures contract matures.

Are futures markets “satta” markets?

Participants in futures market include market intermediaries in the physical market, like, producers, processors, manufacturers, exporters, importers, bulk consumers etc., besides speculators. There is difference between speculation and gambling. Therefore futures markets are not “satta markets”.

Why do we need speculators in futures market?

Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market, therefore, it is difficult to imagine a futures market functioning without speculators.

What is the difference between a speculator and gambler?

Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market.

Does it mean that speculation need not be curbed?

Informed and speculation is good for the market. However over-speculation needs to be kerbed. There is no unanimity about what constitutes over-speculation.

How is over-speculation curbed?

In order to curb over-speculation, leading to distortion of price signals, limits are imposed on the open position held by speculators. The positions held by speculators are also subject to certain margins; many Exchanges exempt hedgers from this margins.

What are the benefits from Commodity Forward/Futures Trading?

Forward/Futures trading performs two important functions, namely, price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It enables the ‘Consumer’ in getting 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. It is very useful to the ‘exporter’ as it provides an advance indication of the price likely to prevail and thereby helps him in quoting a realistic price and secure export contract in a competitive market It ensures balance in supply and demand position throughout the year and leads to integrated price structure throughout the country. It also helps in removing risk of price uncertainty, encourages competition and acts as a price barometer to farmers and other functionaries in the economy.

What is hedging?

Hedging is a mechanism by which the participants in the physical/cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/cash markets to cover their price risk by taking opposite position in the futures market.

Illustrate hedging by a stockist by using futures market?

To illustrate the concept of hedging, let us assume that, on 1st December, 2002, a stockist purchases, say, 10 tonnes of Castorseed in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2003 contract is Rs.1750/- p.q., the stockist is able to lock in a spread/“badla” of Rs. 150/- p.q., i.e., about 9% for about 6 months. The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is Rs. 1500/- p.q.. The stockist would incur a loss of Rs. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q. to, say, Rs. 1625/- p.a. The stockist can liquidate his contract in the futures market by entering into purchase contract @ Rs. 1625/- p.q. He would end up earning a profit of Rs. 125/- in the futures segment. Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.

How does futures market benefit farmers?

World over, farmers do not directly participate in the futures market. They take advantage of the price signals emanating from a futures market. Price-signals given by long-duration new-season futures contract can help farmers to take decision about cropping pattern and the investment intensity of cultivation. Direct participation of farmers in futures market to manage price risk –either as members of an Exchange or as non-member clients of some member - can be cumbersome as it involves meeting various membership criteria and payment of daily margins etc. Options in goods would be relatively more farmer-friendly, as and when they are legally permitted.

Can the loss incurred on the futures market be set off against normal business profit?

Loss incurred in futures market by entering into contracts for hedging purposes can be set off against normal profit. The loss incurred on account of speculative transactions in futures market cannot be set off against normal business profit. This loss is however allowed to be carried forward for eight years, during which it can be set off against speculative profit

Who are the participants in forward/futures markets?

Participants in forward/futures markets are hedgers, speculators, day-traders/scalpers, market makers, and, arbitrageurs.

Who is hedger?

Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.

What is arbitrage?

Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.

Who are day-traders?

Day traders are speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.

Who is floor-trader?

A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.

Who is speculator?

A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.

Who is market maker?

A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.

What is market risk?

Market risk is the risk of loss on account of adverse movement of price.

What is liquidity risk?

Liquidity risks is the risk that unwinding of transactions may be difficult, if the market is illiquid

What are the different types of margins payable on futures?

Different margins payable on futures contracts are:
Ordinary/initial margin, mark-to-market margin, special margin, volatility margin, and delivery margin.

What is initial/ordinary margin?

It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contracts. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.

What is Mark-to-Market margin?

Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is enterned into on that day) or the previous day’s clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.

 

What is Volatility?

It is a measurement of the variability rate (but not the direction) of the change in price over a given time period.  It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.