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					Chapter 1

Introduction to derivatives

The origin of derivatives can be traced back to the need of farmers to protect themselves against
fluctuations in the price of their crop. From the the time it was sown to the time it was ready for
harvest, farmers would face price uncertainty. Through the use of simple derivative products, it
was possible for the farmer to partially or fully transfer price risks by locking-in asset prices.
These were simple contracts developed to meet the needs of farmers and were basically a means
of reducing risk.
    A farmer who sowed his crop in June faced uncertainty over the price he would receive for his
harvest in September. In years of scarcity, he would probably obtain attractive prices. However,
during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly
this meant that the farmer and his family were exposed to a high risk of price uncertainty.
    On the other hand, a merchant with an ongoing requirement of grains too would face a price
risk - that of having to pay exorbitant prices during dearth, although favourable prices could be
obtained during periods of oversupply. Under such circumstances, it clearly made sense for the
farmer and the merchant to come together and enter into a contract whereby the price of the grain
to be delivered in September could be decided earlier. What they would then negotiate happened
to be a futures-type contract, which would enable both parties to eliminate the price risk.
    In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and
merchants together. A group of traders got together and created the 'to-arrive' contract that
permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts
proved useful as a device for hedging and speculation on price changes. These were eventually
standardised, and in 1925 the first futures clearing house came into existence.
    Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton,
wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial
underlyings like stocks, interest rate, exchange rate, etc.


1.1     Derivatives defined
A derivative is a product whose value is derived from the value of one or more underlying
variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity
12                                                                              Introduction to derivatives

or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their
harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is
an example of a derivative. The price of this derivative is driven by the spot price of wheat which
is the "underlying" in this case.
     The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in
commodities all over India. As per this the Forward Markets Commission (FMC) continues to
have jurisdiction over commodity forward/ futures contracts. However when derivatives trading in
securities was introduced in 2001, the term "security" in the Securities Contracts (Regulation) Act,
1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation
of derivatives came under the perview of Securities Exchange Board of India (SEBI). We thus
have separate regulatory authorities for securities and commodity derivative markets.
     Derivatives are securities under the SCRA and hence the trading of derivatives is governed by
the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956
(SC(R)A) defines "derivative" to include -
     1. 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.

     2. A contract which derives its value from the prices, or index of prices, of underlying securities.


1.2 Products, participants and functions
Derivative contracts are of different types. The most common ones are forwards, futures, options
and swaps. Participants who trade in the derivatives market can be classified under the following
three broad categories - hedgers, speculators, and arbitragers.
     1. Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk
        associated with the price of an asset. They use the futures or options markets to reduce or eliminate
        this risk.

     2. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset.
        Futures and options contracts can give them leverage; that is, by putting in small amounts of money
        upfront, they can take large positions on the market. As a result of this leveraged speculative position,
        they increase the potential for large gains as well as large losses.

     3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of
        the same product across different markets. If, for example, they see the futures price of an asset getting
        out of line with the cash price, they would take offsetting positions in the two markets to lock in the
        profit.

    Whether the underlying asset is a commodity or a financial asset, derivative markets performs
a number of economic functions.
         Prices in an organised derivatives market reflect the perception of market participants
        about the future and lead the prices of underlying to the perceived future level. The prices of
        derivatives converge with the prices of the underlying at the expiration of the derivative
        contract. Thus derivatives help in discovery of future as well as current prices.
1.3 Derivatives markets                                                                                   13


 Derivative products initially emerged as hedging devices against fluctuations in commodity
 prices, and commodity-linked derivatives remained the sole form of such products for almost
 three hundred years. Financial derivatives came into spotlight in the post-1970 period due to
 growing instability in the financial markets. However, since their emergence, these products
 have become very popular and by 1990s, they accounted for about two-thirds of total
 transactions in derivative products. In recent years, the market for financial derivatives has
 grown tremendously in terms of variety of instruments available, their complexity and also
 turnover. In the class of equity derivatives the world over, futures and options on stock indices
 have gained more popularity than on individual stocks, especially among institutional investors,
 who are major users of index-linked derivatives. Even small investors find these useful due to
 high correlation of the popular indexes with various portfolios and ease of use. The lower costs
 associated with index derivatives vis-a-vis derivative products based on individual securities is
 another reason for their growing use.

                         Box 1.1: Emergence of financial derivative products


   • The derivatives market helps to transfer risks from those who have them but may not like them to those
     who have an appetite for them.

   • Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
     introduction of derivatives, the underlying market witnesses higher trading volumes because of
     participation by more players who would not otherwise participate for lack of an arrangement to
     transfer risk.

   • Speculative traders shift to a more controlled environment of the derivatives market. In the absence of
     an organised derivatives market, speculators trade in the underlying cash markets. Margining,
     monitoring and surveillance of the activities of various participants become extremely difficult in these
     kind of mixed markets.

   • An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new
     entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated
     people with an entrepreneurial attitude. They often energize others to create new businesses, new
     products and new employment opportunities, the benefit of which are immense.

   • Derivatives markets help increase savings and investment in the long run. The transfer of risk enables
     market participants to expand their volume of activity.



1.3 Derivatives markets
Derivative markets can broadly be classified as commodity derivative market and financial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts for which
the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans,
rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives markets trade
contracts that have a financial asset or variable as the underlying. The more popular financial
derivatives are those which have equity, interest rates and exchange rates as
14                                                                    Introduction to derivatives

the underlying. The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later.


1.3.1 Spot versus forward transaction
Using the example of a forward contract, let us try to understand the difference between a spot and
derivatives contract. Every transaction has three components - trading, clearing and settlement. A
buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves
finding out the net outstanding, that is exactly how much of goods and money the two should
exchange. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B. On a
net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money and goods.
    In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. "on the
spot". Consider this example. On 1st January 2004, Aditya wants to buy some gold. The goldsmith
quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 grams of gold. He
pays Rs. 12,000, takes the gold and leaves. This is a spot transaction.
    Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it a
month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the "forward" price for
20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith
Rs. 12,030 and collects his gold. This is a forward contract, a contract by which two parties
irrevocably agree to settie a trade at a future date, for a stated price and quantity. No money changes
hands when the contract is signed. The exchange of money and the underlying goods only happens
at the future date as specified in the contract. In a forward contract the process of trading, clearing
and settlement does not happen instantaneously. The trading happens today, but the clearing and
settlement happens at the end of the specified period.
    A forward is the most basic derivative contract. We call it a derivative because it derives value
from the price of the asset underlying the contract, in this case gold. If on the 1st of February, gold
trades for Rs.6,050 in the spot market, the contract becomes more valuable to Aditya because it now
enables him to buy gold at Rs.6,015. If however, the price of gold drops down to Rs.5,990, he is
worse off because as per the terms of the contract, he is bound to pay Rs.6,015 for the same gold.
The contract has now lost value from Aditya's point of view. Note that the value of the forward
contract to the goldsmith varies exactly in an opposite manner to its value for Aditya.


1.3.2 Exchange traded versus OTC derivatives
Derivatives have probably been around for as long as people have been trading with one another.
Forward contracting dates back at least to the 12th century, and may well have been around before
then. These contracts were typically OTC kind of contracts. Over the counter(OTC) derivatives are
privately negotiated contracts. Merchants entered into contracts with one another for future delivery
of specified amount of commodities at specified price. A primary motivation for prearranging a
buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility
that large swings would inhibit marketing the commodity after a harvest. Later
1.3 Derivatives markets                                                                                    15


 Early forward contracts in the US addressed merchants' concerns about ensuring that there were
 buyers and sellers for commodities. However "credit risk" remained a serious problem. To deal
 with this problem, a group of Chicago businessmen formed the Chicago Board of Trade
 (CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location known
 in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one
 step further and listed the first "exchange traded" derivatives contract in the US, these contracts
 were called "futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was
 reorganised to allow futures trading. Its name was changed to Chicago Mercantile Exchange
 (CME). The CBOT and the CME remain the two largest organised futures exchanges, indeed the
 two largest "financial" exchanges of any kind in the world today.
 The first stock index futures contract was traded at Kansas City Board of Trade. Currently the
 most popular stock index futures contract in the world is based on S&P 500 index, traded on
 Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active
 derivative instruments generating volumes many times more than the commodity futures. Index
 futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts
 traded today. Other popular international exchanges that trade derivatives are LIFFE in England,
 DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

                           Box 1.2: History of commodity derivatives markets


many of these contracts were standardised in terms of quantity and delivery dates and began to trade
on an exchange.
    The OTC derivatives markets have the following features compared to exchange-traded
derivatives:

   1. The management of counter-party (credit) risk is decentralised and located within individual institutions.

   2. There are no formal centralised limits on individual positions, leverage, or margining.

   3. There are no formal rules for risk and burden-sharing.

   4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for
      safeguarding the collective interests of market participants.

   5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-
      regulatory organisation, although they are affected indirectly by national legal systems, banking
      supervision and market surveillance.

    The OTC derivatives markets have witnessed rather sharp growth over the last few years, which
has accompanied the modernisation of commercial and investment banking and globalisation of
financial activities. The recent developments in information technology have contributed to a great
extent to these developments. While both exchange-traded and OTC derivative contracts offer many
benefits, the former have rigid structures compared to the latter.
    The largest OTC derivative market is the interbank foreign exchange market. Commodity
derivatives the world over are typically exchange-traded and not OTC in nature.
16                                                                            Introduction to derivatives

1.3.3 Some commonly used derivatives
Here we define some of the more popularly used derivative contracts. Some of these, namely futures
and options will be discussed in more details at a later stage.

 Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the
     underlying asset at a future date, at today's pre-agreed price.

 Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future
     date at today's future price. Futures contracts differ from forward contracts in the sense that they are
     standardised and exchange traded.

 Options: There are two types of options - calls and puts. Calls give the buyer the right but not the obligation to
      buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the
      buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or
      before a given date.

 Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges
     having a maximum maturity of nine months. Longer-dated options are called warrants and are generally
     traded over-the-counter.

 Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a
     weighted average of a basket of assets. Equity index options are a form of basket options.

 Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a
     prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used
     swaps are :

          • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in
            the same currency.
          • Currency swaps: These entail swapping both principal and interest between the parties, with the
            cashflows in one direction being in a different currency than those in the opposite direction.

 Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options.
     Thus a swaption is an option on a forward swap.


Solved Problems
Q: Futures trading commenced first on

     1. Chicago Board of Trade                              3. Chicago Board Options Exchange
                                                              4. London International Financial Futures and
     2. Chicago Mercantile Exchange                            Options Exchange

A: The correct answer is number 1.                                                                           ••
1.3 Derivatives markets                                                                            17

Q: Derivatives first emerged as ------ products

   1. Speculative                                    3. Volatility

   2. Hedging                                        4. Risky

A: The correct answer is number 2.                                                                 ••

Q: Which of the following exchanges offer commodity derivatives trading

   1. National Commodity Derivatives Exchange        3. Over The Counter Exchange of India

   2. Interconnected Stock Exchange                  4. ICICI Securities Limited

A: The correct answer is number 1.                                                                 ••

Q: OTC derivatives are considered risky because

   1. There is no formal margining system.           3. They are not settled on a clearing house.
   2. They do not follow any formal rules or mechanisms.        4. All of the
      above

A: The correct answer is number 4.                                                                 ••

Q: The first exchange traded financial derivative in India commenced with the trading of

   1. Index futures                                  3. Stock options

   2. Index options                                  4. Interest rate futures

A: The correct answer is number 1.                                                                 ••

Q: A ____ is the simplest derivative contract

   1. Option                                         3. Forward

   2. Future                                         4. Swap

A: The correct answer is number 3.                                                                 ••

Q: In a transaction, trading involves ___

   1. The buyer and seller agreeing upon a price.    3. The buyer and seller calculating the net
                                                        out-standing.
   2. The buyer and seller exchanging goods and
      money.                                         4. None of the above.

A: The correct answer is number 1.                                                                 ••
18                                                                    Introduction to derivatives

Q: In a transaction, clearing involves

     1. The buyer and seller agreeing upon a price.   3. The buyer and seller calculating the net out-
                                                         standing.
     2. The buyer and seller exchanging goods and
        money.                                        4. None of the above.

A: The correct answer is number 3.                                                                ••

Q: In a transaction, settlement involves __

     1. The buyer and seller agreeing upon a price.   3. The buyer and seller calculating the net out-
                                                         standing.
     2. The buyer and seller exchanging goods and
        money.                                        4. None of the above.

A: The correct answer is number 2.                                                                ••
Chapter 2

Commodity derivatives

Derivatives as a tool for managing risk first originated in the commodities markets. They were
then found useful as a hedging tool in financial markets as well. In India, trading in commodity
futures has been in existence from the nineteenth century with organised trading in cotton through
the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities
were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in
virtual dismantling of the commodities future markets. It is only in the last decade that commodity
future exchanges have been actively encouraged. However, the markets have been thin with poor
liquidity and have not grown to any significant level. In this chapter we look at how commodity
derivatives differ from financial derivatives. We also have a brief look at the global commodity
markets and the commodity markets that exist in India.


2.1     Difference between commodity and financial derivatives
The basic concept of a derivative contract remains the same whether the underlying happens to be
a commodity or a financial asset. However there are some features which are very peculiar to
commodity derivative markets. In the case of financial derivatives, most of these contracts are
cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need
special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in
commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality
of asset does not really exist as far as financial underlyings are concerned. However in the case of
commodities, the quality of the asset underlying a contract can vary largely. This becomes an
important issue to be managed. We have a brief look at these issues.


2.1.1      Physical settlement
Physical settlement involves the physical delivery of the underlying commodity, typically at an
accredited warehouse. The seller intending to make delivery would have to take the commodities
to the designated warehouse and the buyer intending to take delivery would have to go to the
designated warehouse and pick up the commodity. This may sound simple, but the physical
20                                                                                  Commodity derivatives

settlement of commodities is a complex process. The issues faced in physical settlement are
enormous. There are limits on storage facilities in different states. There are restrictions on interstate
movement of commodities. Besides state level octroi and duties have an impact on the cost of
movement of goods across locations. The process of taking physical delivery in commodities is
quite different from the process of taking physical delivery in financial assets. We take a general
overview at the process flow of physical settlement of commodities. Later on we will look into
details of how physical settlement happens on the NCDEX.

Delivery notice period
Unlike in the case of equity futures, typically a seller of commodity futures has the option to give
notice of delivery. This option is given during a period identified as 'delivery notice period'. Such
contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an
options market. However what is interesting and different from a typical options exercise is that in
the commodities market, both positions can still be closed out before expiry of the contract. The
intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of
a possible requirement to take delivery. These are required by virtue of the fact that the actual
physical settlement of commodities requires preparation from both delivering and receiving
members.
    Typically, in all commodity exchanges, delivery notice is required to be supported by a
warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities
being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In
these exchanges the seller has to produce a verification report from these laboratories along with
delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification
documents while others like BMF-Brazil have independent grading and classification agency to
verify the quality.
    In the case of BMF-Brazil a seller typically has to submit the following documents:

        A declaration verifying that the asset is free of any and all charges, including fiscal debts related to
         the stored goods.

         A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.

         A warehouse certificate showing that storage and regular insurance have been paid.


Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the
buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment
process. One approach is to display the delivery notice and allow buyers wishing to take delivery to
bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery
notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges
such as COMMEX and the Indian commodities exchanges have adopted this method.
2.1 Difference between commodity and financial derivatives                                          21

   Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to
square off positions till the market close of the day of delivery notice. After the close of trading,
exchanges assign the delivery intentions to open long positions. Assignment is done typically either
on random basis or first-in-first out basis. In some exchanges (CME), the buyer has the option to
give his preference for delivery location.
    The clearing house decides on the daily delivery order rate at which delivery will be settled.
Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality
and freight costs. The discount/ premium for quality and freight costs are published by the clearing
house before introduction of the contract. The most active spot market is normally taken as the
benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the
previous day closing rate for the contract or the closing rate for the day.

Delivery
After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The
exchange also informs the respective warehouse about the identity of the buyer. The buyer is
required to deposit a certain percentage of the contract amount with the clearing house as margin
against the warehouse receipt.
    The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer
or his authorised representative in the presence of seller or his representative takes the physical
stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the
seller to the clearing house and the invoice amount is credited to the seller's account.
    In India if a seller does not give notice of delivery then at the expiry of the contract the positions
are cash settled by price difference exactly as in cash settled equity futures contracts.


2.1.2 Warehousing
One of the main differences between financial and commodity derivative is the need for
warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled.
Cash settlement involves paying up the difference in prices between the time the contract was
entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at
Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have
to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person
who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to
do is pay up the loss of Rs.20 in cash.
    In case of commodity derivatives however, there is a possibility of physical settlement. Which
means that if the seller chooses to hand over the commodity instead of the difference in cash, the
buyer must take physical delivery of the underlying asset. This requires the exchange to make an
arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements
depends on the warehousing system available. Most international commodity exchanges used
certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are
required to provide storage facilities for participants in the commodities markets
22                                                                         Commodity derivatives


 The New York Cotton Exchange has specified the asset in its orange juice futures contract as
 "U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of
 not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37
 points or higher and 19 for defects, with a minimum score 94".
 The Chicago Mercantile Exchange in its random-length lumber futures contract has specified
 that "Each delivery unit shall consist of nominal 'i y- is of random lengths from 8 feet to 20
 feet, grade-stamped Construction Standard, Standard and Better, or #1 and #2; however, in no
 case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be
 manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or
 Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine
 fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir".

         Box 2.3: Specifications of some commodities underlying derivatives contracts


and to certify the quantity and quality of the underlying commodity. The advantage of this system
is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades
but also for other purposes too. In India, the warehousing system is not as efficient as it is in some
of the other developed markets. Central and state government controlled warehouses are the major
providers of agri-produce storage facilities. Apart from these, there are a few private warehousing
being maintained. However there is no clear regulatory oversight of warehousing services.


2.1.3 Quality of underlying assets
A derivatives contract is written on a given underlying. Variance in quality is not an issue in case
of financial derivatives as the physical attribute is missing. When the underlying asset is a
commodity, the quality of the underlying asset is of prime importance. There may be quite some
variation in the quality of what is available in the marketplace. When the asset is specified, it is
therefore important that the exchange stipulate the grade or grades of the commodity that are
acceptable. Commodity derivatives demand good standards and quality assurance/ certification
procedures. A good grading system allows commodities to be traded by specification.
    Currently there are various agencies that are responsible for specifying grades for
commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer
Affairs specifies standards for processed agricultural commodities whereas AGMARK under the
department of rural development under Ministry of Agriculture is responsible for promulgating
standards for basic agricultural commodities. Apart from these, there are other agencies like EIA,
which specify standards for export oriented commodities.


2.2 Global commodities derivatives exchanges
Globally commodities derivatives exchanges have existed for a long time. Table 2.1 gives a list of
commodities exchanges across the world. The CBOT and CME are two of the oldest derivatives
2.2 Global Commodities derivatives exchanges                                              23
Table 2.1 The global derivatives industry
           Country                     Exchange
           United States of America   Chicago Board of Trade (CBOT)
                                      Chicago Mercantile Exchange
                                      Minneapolis Grain Exchange
                                      New York Cotton Exchange
                                      New York Mercantile Exchange
                                      Kansas Board of Trade
                                      New York Board of Trade
           Canada                     The Winnipeg Commodity Exchange
           Brazil                     Brazilian Futures Exchange Commodities
                                      and Futures Exchange
           Australia                  Sydney Futures Exchange Ltd.
           People's Republic Of China Beijing Commodity Exchange Shanghai
                                      Metal Exchange
           Hong Kong                  Hong Kong Futures Exchange
           Japan                      Tokyo International Financial Futures Exchange
                                      Kansai Agricultural Commodities Exchange
                                      Tokyo Grain Exchange
           Malaysia                   Kuala Lumpur commodity Exchange
           New Zealand                New Zealand Futures& Options Exchange Ltd.
           Singapore                  Singapore Commodity Exchange Ltd.
           France                     Le Nouveau Marche MATIF
           Italy                      Italian Derivatives Market
           Netherlands                Amsterdam Exchanges Option Traders
           Russia                     The Russian Exchange
                                      MICEX/ Relis Online St. Petersburg Futures
                                      Exchange
           Spain                      The Spanish Options Exchange
                                      Citrus Fruit and Commodity Futures Market of
                                       Valencia
            United Kingdom            The London International Financial Futures
                                      Options exchange
                                      The London Metal Exchange




exchanges in the world. The CBOT was established in 1848 to bring farmers and merchants
together. Initially its main task was to standardise the quantities and qualities of the grains that
were traded. Within a few years the first futures-type contract was developed. It was know as the
to-arrive contract. Speculators soon became interested in the contract and found trading in the
contract to be an attractive alternative to trading the underlying grain itself. In 1919, another
exchange, the CME was established. Now futures exchanges exist all over the world. On these
exchanges, a wide range of commodities and financial assets form the underlying assets in
24                                                                      Commodity derivatives

various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper,
aluminium, gold and tin. We look at commodity exchanges in some developing countries.


2.2.1 Africa
Africa's most active and important commodity exchange is the South African Futures Exchange
(SAFEX). It was informally launched in 1987. SAFEX only traded financial futures and gold futures
for a long time, but the creation of the Agricultural Markets Division (as of 2002, the Agricultural
Derivatives Division) led to the introduction of a range of agricultural futures contracts for
commodities, in which trade was liberalised, namely, white and yellow maize, bread milling wheat
and sunflower seeds.


2.2.2 Asia
China's first commodity exchange was established in 1990 and at least forty had appeared by 1993.
The main commodities traded were agricultural staples such as wheat, corn and in particularly
soybeans. In late 1994, more than half of China's exchanges were closed down or reverted to being
wholesale markets, while only 15 restructured exchanges received formal government approval. At
the beginning of 1999, the China Securities Regulatory Committee began a nationwide consolidation
process which resulted in three commodity exchanges emerging; the Dalian Commodity Exchange
(DCE), the Zhengzhou Commodity Exchange and the Shanghai futures Exchange, formed in 1999
after the merger of three exchanges: Shanghai Metal, Commodity, Cereals & Oils Exchanges. The
Taiwan Futures Exchange was launched in 1998. Malaysia and Singapore have active commodity
futures exchanges. Malaysia hosts one futures and options exchange. Singapore is home to the
Singapore Exchange (SGX), which was formed in 1999 by the merger of two well-established
exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange
(SIMEX).


2.2.3 Latin America
Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures, (BM&F) in
Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange by 2001,
with 98 million contracts traded. There are also many other commodity exchanges operating in
Brazil, spread throughout the country. Argentina's futures market Mercado a Termino de Buenos
Aires, founded in 1909, ranks as the world's 51st largest exchange. Mexico has only recently
introduced a futures exchange to its markets. The Mercado Mexicano de Derivados (Mexder) was
launched in 1998.


2.3 Evolution of the commodity market in India
Bombay Cotton Trade Association Ltd., set up in 1875, was the first organised futures market.
Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent
2.3 Evolution of the commodity market in India                                                          25

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. Futures
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 rawjute and jute goods. But organised 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 organised 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.


2.3.1      The Kabra committee report
After the introduction of economic reforms since June 1991 and the consequent gradual trade and
industry liberalisation in both the domestic and external sectors, the Government of India
appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. K.N.
Kabra. The committee was setup with the following objectives:

   1. To assess

        (a) The working of the commodity exchanges and their trading practices in India and to make
            suitable recommendations with a view to making them compatible with those of other countries
        (b) The role of the Forward Markets Commission and to make suitable recommendations with a
            view to making it compatible with similar regulatory agencies in other countries so as to see
            how effectively these agencies can cope up with the reality of the fast changing economic
            scenario.

   2. To review the role that forward trading has played in the Indian commodity markets during the last 10
      years.

   3. To examine the extent to which forward trading has special role to play in promoting exports.

   4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the
      recommendations, particularly with a view to effective enforcement of the Act to check illegal
      forward trading when such trading is prohibited under the Act.

   5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be
      operative remains constructive and helps in maintaining prices within reasonable limits.

   6. To assess the role that forward trading can play in marketing/ distribution system in the commodities
      in which forward trading is possible, particularly in commodities in which resumption of forward
      trading is generally demanded.
26                                                                             Commodity derivatives

   The committee submitted its report in September 1994. The recommendations of the
committee were as follows:

     • The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would
       need to be strengthened.

     • Due to the inadequate infrastructural facilities such as space and telecommunication facilities the
       commodities exchanges were not able to function effectively. Enlisting more members, ensuring
       capital adequacy norms and encouraging computerisation would enable these exchanges to place
       themselves on a better footing.

     • In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors
       and arbitrators be strengthened further.

     • The FMC which regulates forward/ futures trading in the country, should continue to act a watch-dog
       and continue to monitor the activities and operations of the commodity exchanges. Amendments to
       the rules, regulations and bye-laws of the commodity exchanges should require the approval of the
       FMC only.

     • In the context of globalisation, commodity markets in India could not function effectively in an
       isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper
       and castor seed, be upgraded to the level of international futures markets.

     • The majority of me committee recommended that futures trading be introduced in the following
       commodities:

          1. Basmatirice
          2. Cotton and kapas
          3. Raw jute and jute goods
          4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed,
             copra and soybean, and oils and oilcakes of all of them.
          5. Rice bran oil
          6. Castor oil and its oilcake
          7. Linseed
          8. Silver
          9. Onions

    The liberalised policy being followed by the government of India and the gradual withdrawal
of the procurement and distribution channel necessitated setting in place a market mechanism to
perform the economic functions of price discovery and risk management.
    The national agriculture policy announced in July 2000 and the announcements in the budget
speech for 2002-2003 were indicative of the governments resolve to put in place a mechanism of
futures trade/market. As a follow up, the government issued notifications on 1.4.2003 permitting
futures trading in the commodities, with the issue of these notifications futures trading is not
prohibited in any commodity. Options trading in commodity is, however presently prohibited.
2.3 Evolution of the commodity market in India                                            27
Table 2.2 Volume on existing exchanges
    Commodity exchange                               Products            Approx. annual vol
                                                                         (Rs.Crore)
    National board of trade, Indore                  Soya, mustard                   80000
   National multicommodity exchange, Ahmedabad       Multiple                        40000
    Ahmedabad commodity exchange                     Castor, cotton                   3500
    Rajdhani Oil & oilseeds                          Mustard                          3500
     Vijai Beopar Chamber Ltd. Muzzaffarnagar        Gur                              2500
    Rajkot seeds, oil & bullion exchange             Castor, groundnut                2500
    IPSTA, Cochin                                    Pepper                           2500
    Chamber of commerce, Hapur                       Gur, mustard                     2500
    Bhatinda Om and oil exchange                     Gur                              1500
    Other (mostly inactive)                                                           1500
    Total                                                                           140000


2.3.2 Latest developments
Commodity markets have existed in India for a long time. Table 2.3 gives the list of registered
commodities exchanges in India. Table 2.2 gives the total annualised volumes on various
exchanges. While the implementation of the Kabra committee recommendations were rather slow,
today, the commodity derivative market in India seems poised for a transformation. National level
commodity derivatives exchanges seem to be the new phenomenon. The Forward Markets
Commission accorded in principle approval for the following national level multi commodity
exchanges. The increasing volumes on these exchanges suggest that commodity markets in India
seem to be a promising game.

   • National Board of Trade

   • Multi Commodity Exchange of India

   • National Commodity & Derivatives Exchange of India Ltd
28                                                                      Commodity derivatives

Table 2.3 Registered commodity exchanges in India
   Exchange                                            Product traded
     Bhatinda Om & Oil Exchange Ltd.                   Gur
     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 oilcake
                                                       Crude palm oil
     The Rajkot Seeds oil & Bullion Merchants          Groundnut oil
     Association, Ltd.                                 Castorseed
     The Kanpur Commodity Exchange Ltd.                Rapeseed/ Mustardseed oil and cake
     The Meerut Agro Commodities Exchange Co. Ltd. Gur
     The Spices and Oilseeds Exchange Ltd.Sangli       Turmeric
     Ahmedabad Commodities Exchange Ltd.               Cottonseed, Castorseed
     Vijay Beopar Chamber Ltd., Muzaffarnagar          Gur
     India Pepper & Spice Trade Association, Kochi     Pepper
     Rajdhani Oils and Oilseeds Exchange Ltd., Delhi   Gur, Rapeseed/ Mustardseed
                                                       Sugar Grade-M
     National Board of Trade, Indore                   Rapeseed/ Mustard seed/ Oil/ Cake
                                                       Soybean/ Meal/ Oil, Crude Palm Oil
     The Chamber of Commerce, Hapur                    Gur, Rapeseed/ Mustardseed
     The East India Cotton Association, Mumbai         Cotton
     The Central India Commercial Exchange Ltd.,       Gur
     The East
     Gwaliar India Jute & Hessian Exchange Ltd.,       Hessian, Sacking
     Kolkata
     First Commodity Exchange of India Ltd., Kochi     Copra, Coconut oil & Copra cake
     The Coffee Futures Exchange India Ltd., Bangalore Coffee
     National Multi Commodity Exchange of India        Gur, RBD Pamohen
     Limited, Ahmedabad                                Crude Palm Oil, Copra
                                                       Rapeseed/ Mustardseed, 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, Guarseed
                                                       Aluminium ingots, Nickel, tin
                                                       Vanaspati, Rubber, Copper, Zinc, lead
     National Commodity & Derivatives Exchange         Soy Bean, Refined Soy Oil
     Limited                                           Mustard Seed
                                                       Expeller Mustard Oil
                                                       RBD Palmolein Crude Palm Oil
                                                       Medium Staple Cotton
                                                       Long Staple Cotton
                                                       Gold, Silver
2.3 Evolution of the commodity market in India                                                   29

Solved Problems
Q: Which of the following feature differentiates a commodity futures contract from a financial
futures contract?

   1. Exchange traded product                        3. MTM settlement
   2. Standardised contract size                     4. Varying quality of underlying asset

A: The correct answer is number 4.                                                               •
•



Q: Physical settlement involves the physical delivery of the underlying commodity at

   1. an accredited warehouse                        3. the buyers requested destination
   2. the exchange                                   4. None of the above

A: The correct answer is number 1                                                                •
•



Q: Typically, in all commodity exchanges, delivery notice is required to be supported by a

   1. Letter of credit                               3. Undertaking
   2. Warehouse receipt                              4. Advance payment

A: The correct answer is number 2.                                                               •
•



Q: Who identifies the buyer to whom the delivery notice is assigned?

   1. The exchange                                   3. The warehouse
   2. The clearing corporation                       4. The seller

A: The correct answer is number 2.                                                               •
•

Q: Which of the following exchanges do not offer commodity derivatives trading?

   1. National Commodity Derivative Exchange         3. National Board of Trade
   2. Multi Commodity Exchange of India              4. National Stock Exchange

A: The correct answer is number 4.                                                               ••
30                                                                      Commodity derivatives

Q: On the NCDEX ___

     1. The clearing house assigns delivery to the   3. The buyer chooses which delivery to take
        buyer
                                                     4. The warehouse assigns the delivery to the
     2. The seller assigns delivery to the buyer        buyer

A: The correct answer is number 1.                                                            ••

Q: The ____ committee recommended that the Forward Markets Commission(FMC) and the
Forward
Contracts (Regulation) Act, 1952, need to be strengthened.

     1. L C Gupta Committee                          3. Khusro Committee
     2. Kabra Committee                              4. J R Varma Committee

A: The correct answer is number 2.                                                            ••
Chapter 3
The NCDEX platform

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity
exchange. It is a public limited company registered under the Companies Act, 1956 with the
Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board
of Directors and professionals not having any vested interest in commodity markets. It has been
launched to provide a world-class commodity exchange platform for market participants to trade
in a wide spectrum of commodity derivatives driven by best global practices, professionalism and
transparency.
    NCDEX is regulated by Forward Markets Commission in respect of futures trading in
commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act,
Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations,
which impinge on its working. It is located in Mumbai and offers facilities to its members in about
91 cities throughout India at the moment.
    NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, refined soy
bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude palm
oil and cotton - medium and long staple varieties. At subsequent phases trading in more
commodities would be facilitated.


3.1     Structure of NCDEX
NCDEX has been formed with the following objectives:

    • To create a world class commodity exchange platform for the market participants.

    • To bring professionalism and transparency into commodity trading.

    • To inculcate best international practices like de-modularization, technology platforms, low cost
      solutions and information dissemination without noise etc. into the trade.

    • To provide nation wide reach and consistent offering.

    • To bring together the entities that the market can trust.
32 ___________________________________________________ The NCDEX platform

3.1.1 Promoters
NCDEX is promoted by a consortium of institutions. These include the ICICI Bank Limited
(ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and
Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). NCDEX
is the only commodity exchange in the country promoted by national level institutions. This
unique parentage enables it to offer a variety of benefits which are currently in short supply
in the commodity markets. The four institutional promoters of NCDEX are prominent players
in their respective fields and bring with them institution building experience, trust, nationwide
reach, technology and risk management skills.


3.1.2 Governance
NCDEX is run by an independent Board of Directors. Promoters do not participate in the day to day
activities of the exchange. The directors are appointed in accordance with the provisions of the
Articles of Association of the company. The board is responsible for managing and regulating all the
operations of the exchange and commodities transactions. It formulates the rules and regulations
related to the operations of the exchange. Board appoints an executive committee and other
committees for the purpose of managing activities of the exchange.
    The executive committee consists of Managing Director of the exchange who would be acting as
the Chief Executive of the exchange, and also other members appointed by the board.
    Apart from the executive committee the board has constitute committee like Membership
committee, Audit Committee, Risk Committee, Nomination Committee, Compensation Committee
and Business Strategy Committee, which, help the Board in policy formulation.


3.2 Exchange membership
Membership of NCDEX is open to any person, association of persons, partnerships, co-operative
societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of
the exchange have to register themselves with the competent authority before commencing their
operations. The members of NCDEX fall into two categories, Trading cum Clearing Members
(TCM) and Professional Clearing Members (PCM).


3.2.1      Trading cum clearing members (TCMs)
NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulfill
the specified eligibility criteria for trading in commodities. The TCM membership entitles the
members to trade and clear, both for themselves and/ or on behalf of their clients. Applicants
accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net
worth as given in Table 3.1.
3.3 Capital requirements                                                                            33

Table 3.1 Fee/ deposit structure and networth requirement: TCM
                   Particulars                             (Rupees in Lakh)
                       Interest free cash security deposit                  15.00
                       Collateral security deposit Annual                   15.00
                       subscription charges Advance                          0.50
                       minimum transaction charges Net                       0.50
                       worth requirement                                    50.00



Table 3.2 Fee/ deposit structure and networth requirement: PCM
                   Particulars                             (Rupees in Lakh)
                       Interest free cash security deposit                 25.00
                       Collateral security deposit Annual                  25.00
                       subscription charges Advance                         1.00
                       minimum transaction charges Net                      1.00
                       worth requirement                                 5000.00




3.2.2 Professional clearing members (PCMs)
NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons
who fulfill the specified eligibility criteria for trading in commodities. The PCM membership
entitles the members to clear trades executed through Trading cum Clearing Members (TCMs),
both for themselves and/ or on behalf of their clients. Applicants accepted for admission as PCMs
are required to pay the following fee/ deposits and also maintain net worth as given in Table 3.2.


3.3 Capital requirements
NCDEX has specified capital requirements for its members. On approval as a member of
NCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. Base
Minimum Capital comprises of the following:
   1. Interest free cash security deposit

   2. Collateral security deposit

    All Members have to comply with the security deposit requirement before the activation of
their trading terminal. Members can opt to meet the security deposit requirement by way of the
following:

   • Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of
     National Commodity & Derivatives Exchange Limited.
34                                                                                   The NCDEX platform

     • Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved
       banks. The minimum term of the bank guarantee should be 12 months.

     • Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR
       should be issued for a minimum period of 36 months from any of the approved banks.

     • Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the
       approved custodian for acceptance of Government of India securities. The securities are valued on a
       daily basis and a haircut of 25% is levied.

    Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in case of
TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls below the
minimum required level, NCDEX may initiate suitable action including withdrawal of trading
facilities as given below:

     • If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be
       withdrawn with immediate effect.

     • If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks'
       time to replenish the shortages and if the same is not done within the specified time the trading facility
       would be withdrawn.

   Members who wish to increase their limit can do so by bringing in additional capital in the
form of cash, bank guarantee, fixed deposit receipts or Government of India securities.


3.4 The NCDEX system
As we saw in the first chapter, every market transaction consists of three components - trading,
clearing and settlement. This section provides a brief overview of how transactions happen on the
NCDEX's market.


3.4.1       Trading
The trading system on the NCDEX, provides a fully automated screen-based trading for futures on
commodities on a nationwide basis as well as an online monitoring and surveillance mechanism.
It supports an order driven market and provides complete transparency of trading operations. The
trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been
proposed for implementation at a later stage.
    The NCDEX system supports an order driven market, where orders match automatically.
Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity
fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery
unit for futures contracts on various commodities . The exchange notifies the regular lot size and
tick size for each of the contracts traded from time to time. When any order enters the trading
system, it is an active order. It tries to find a match on the other side of the book. If it finds a
match, a trade is generated. If it does not find a match, the order becomes passive and gets
3.4 The NCDEX system_________________________________________________ 35

queued in the respective outstanding order book in the system. Time stamping is done for each
trade and provides the possibility for a complete audit trail if required.
    NCDEX trades commodity futures contracts having one-month, two-month and three-month
expiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration
contract would expire on the 20th of January and a February expiry contract would cease trading on
the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall expire
on the previous trading day. New contracts will be introduced on the trading day following the
expiry of the near month contract.


3.4.2 Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed
on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. Only
clearing members including professional clearing members (PCMs) only are entitled to clear and
settle contracts through the clearing house. At NCDEX, after the trading hours on the expiry date,
based on the available information, the matching for deliveries takes place firstly, on the basis of
locations and then randomly, keeping in view the factors such as available capacity of the vault/
warehouse, commodities already deposited and dematerialized and offered for delivery etc.
Matching done by this process is binding on the clearing members. After completion of the
matching process, clearing members are informed of the deliverable/ receivable positions and the
unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only
for the incremental gain/ loss as determined on the basis of final settlement price.


3.4.3 Settlement
Futures contracts have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last trading
day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in
respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing
accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward,
created during the day or closed out during the day, are market to market at the daily settlement
price or the final settlement price at the close of trading hours on a day.
    On the date of expiry, the final settlement price is the spot price on the expiry day. The
responsibility of settlement is on a trading cum clearing member for all trades done on his own
account and his client's trades. A professional clearing member is responsible for settling all the
participants trades which he has confirmed to the exchange. On the expiry date of a futures
contract, members submit delivery information through delivery request window on the trader
workstations provided by NCDEX for all open positions for a commodity for all constituents
individually. NCDEX on receipt of such information, matches the information and arrives at a
delivery position for a member for a commodity.
    The seller intending to make delivery takes the commodities to the designated warehouse.
These commodities have to be assayed by the exchange specified assayer. The commodities have
to meet the contract specifications with allowed variances. If the commodities meet the
36 ________________________________________________________ The NCDEX platform

specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated
in the depository system giving a credit in the depositor's electronic account. The seller then gives
the invoice to his clearing member, who would courier the same to the buyer's clearing member.
On an appointed date, the buyer goes to the warehouse and takes physical possession of the
commodities.


Solved Problems
Q: Which of the following futures do not trade on the NCDEX?

   1. Cotton futures                                   3. Silver futures
   2. Gold futures                                    4. Energy futures

A: The correct answer is number 4.                                                                ••

Q: NCDEX is regulated by

   1. The Forward Markets Commission                   3. Reserve Bank of India
   2. SEBI                                             4. Controller of Capital Issues

A: The correct answer is number 1.                                                                ••

Q: The net worth requirement for a TCM is

   1. Rs.5Lakh                                         3. Rs.500Lakh
   2. Rs.50Lakh                                        4. Rs.5000Lakh

A: The correct answer is number 2.                                                                ••
Chapter 4
Commodities traded on the NCDEX
platform

In December 2003, the National Commodity and Derivatives Exchange Ltd (NCDEX) launched
futures trading in nine major commodities. To begin with contracts in gold, silver, cotton,
soyabean, soya oil, rape/ mustard seed, rapeseed oil, crude palm oil and RBD palmolein are being
offered.
    We have a brief look at the various commodities that trade on the NCDEX and look at some
commodity specific issues. The commodity markets can be classified as markets trading the
following types of commodities.

   1. Agricultural products

   2. Precious metal

   3. Other metals

   4. Energy

    Of these, the NCDEX has commenced trading in futures on agricultural products and precious
metals. For derivatives with a commodity as the underlying, the exchange must specify the exact
nature of the agreement between two parties who trade in the contract. In particular, it must
specify the underlying asset, the contract size stating exactly how much of the asset will be
delivered under one contract, where and when the delivery will be made. In this chapter we look at
the various underlying assets for the futures contracts traded on the NCDEX. Trading, clearing
and settlement details will be discussed later.


4.1     Agricultural commodities
The NCDEX offers futures trading in the following agricultural commodities - Refined soy oil,
mustard seed, expeller mustard oil, RBD palmolein, crude palm oil, medium staple cotton and
long staple cotton. Of these we study cotton in detail and have a quick look at the others.
38                                                Commodities traded on the NCDEX platform

4.1.1      Cotton
Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre
consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17 million bales
(average annual consumption, 1 bale = 170 kg) of raw cotton trade in the country. The market size of
raw cotton in India is over Rs.130 billion. The average monthly fluctuation in prices of cotton traded
across India has been at around 4.5% during the last three years. The maximum fluctuation has been as
high as 11%. Historically, cotton prices in India have been fluctuating in the range of 3-6% on a
monthly basis.
    Cotton is among the most important non-food crops. It occupies a significant position, both from
agricultural and manufacturing sectors' points of view. It is the major source of a basic human need -
clothing, apart from other fibre sources like jute, silk and synthetic. Today, cotton occupies a significant
position in the Indian economy on all fronts as a commodity that forms a means of livelihood to over
millions of cotton cultivating farmers at the primary agricultural sector. It is also a source of direct
employment to over 35 million people in the secondary manufacturing textile industry that contributes
to 14% of the country's industrial production, 27-30% of the country's export earnings and 4% of its
GDP.


Cropping and Growth pattern
Cotton is a tropical and sub-tropical crop. For the successful germination of its seeds, a minimum
temperature of 150°C is required. The optimum temperature range for vegetative growth is 21- 270°C-
It can tolerate temperatures as high as 430°C , but does not do well if the temperature falls bellow
210°C. During the period of fruiting, warm days and cool nights, with large diurnal variations are
conducive to good boll and fibre development. In the case of the rain-fed cotton, which predominates
and occupies nearly 75% of the area under this crop, a rainfall of 50 cm is the minimum requirement.
More than the actual rainfall, a favourable distribution is the deciding factor in obtaining good yields
from the rainfed cotton. Cotton is grown on a variety of soils. It requires a soil amenable to good
drainage, as it does not tolerate water logging. It is grown mainly as a dry crop in the black and medium
black soils and as an irrigated crop in the alluvial soils. The predominant types of soils on which the
crop is grown are (l)Alluvial soils predominant in the northern states of Punjab, Haryana, Rajasthan and
Uttar Pradesh, (2)The black cotton soils, (3)The red sandy loams to loams - predominant in the states of
Gujarat, Maharashtra, Madhya Pradesh, Andhra Pradesh, Karnataka and Tamil Nadu, and (4)Lateritic
soils - found in parts of Tamil Nadu, Assam and Kerala.
    Cotton is a 90-120 day annual crop. In the main producing countries of USA, China, India and
Pakistan, the crop is sown during the June-July period and harvested during September-October.
Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from
October-November onwards. Kappas are bought by ginners, who separate the seeds from the lint (cotton
fibre), a process called ginning (lint recovery from kappas is 30-31%). The loose cotton lint so obtained
is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in
India; in USA, it is 480 pounds). Spinned cotton yarn is used by clothe manufacturers/ textile industry.
4.1 Agricultural commodities                                                                        39

Global and domestic demand-supply dynamics
China, USA, India and Pakistan top the list of cotton producing countries. Uzbekistan, Brazil,
Turkey and Australia are the other major producers. These eight countries produced over 80% of the
world's cotton production during 2001-02.
    China, India, USA and Pakistan top the list of cotton consuming countries. These along with
Turkey, Brazil, Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% of the
world's annual cotton consumption. Global production of cotton during the post 1990 (till date i.e.
2002-03 forecast) has been fluctuating in the narrow range of 16.5-21 million tons. Similarly,
consumption has been in the range in the 18-20.5 million tons. The global export and import trade of
cotton during the post 1990 era has been in the range of 5.5 to 6.5 million tons.
    Production of cotton in India during the post 1990 period has been fluctuating in the range of 12-
17 million bales (i.e. between 2.2-2.8 million tons), constituting about 15% of the global cotton
production. Currently, the country's cotton consumption stands at 17-19 million bales (2.7-2.9
million tons). India's position on the global trade front has witnessed a drastic change during the post
1995 period. The country has turned from being net exporter to net importer. The country's raw
cotton exports, which stood at 1.2-1.6 million bales during the pre-1996 period have dipped to less
than 100 thousand bales. Contrary to this, the imports have sharply risen from 30000-50000 bales
during the pre-1995 to little over 2.2 million bales during the last three years. Among several other
reasons, it is the lack of availability of desired quality cotton that has made many Indian buyers
(particularly the export oriented units) to opt for purchases of foreign cotton despite enough
domestic supply. Most importing mills in India are ready to pay 5-10% premium for foreign cotton
due to its higher quality (less trash, uniform lots, higher ginning out-turn) and better credit terms (3-
6 months vs. 15-30 days for local). Mills using ELS (extra long staple) have been pleased with US
Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons.
Apart from US, India is also importing from Egypt, West Africa, and the CIS countries and
Australia on account of lower freight and shorter delivery periods.


Price trends and factors that influence prices
Cotton production and trade is influenced by various factors. Production (acreage under the crop) of
cotton varies from year to year based on the climatic factors that are crucial for the productivity of
crop. Cotton trade is influenced by the supply-demand scenario, production and prices of synthetic
fibre (polyester, viscose and acrylic) and prices of cotton itself, etc.
    The global supply and demand statistics released by the International Cotton Advisory
Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are
closely watched by the trading community.
    The central government establishes minimum support prices (MSP) for Kappas at the start of
each marketing season. The CCI is responsible for establishing the price support in all States.
Typically, market prices remain well above the MSP, and CCI operations are generally limited to
commercial purchases and sales (except for a few years like 2001-02 when the prices were
abysmally low).
40                                                 Commodities traded on the NCDEX platform

    Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for
cotton traded in the international market. World cotton prices fell sharply during most part of 2001,
NyBOT witnessing a sharp downfall in prices from 61.78 US Cents/ lb (as on Jan 2, 2001) to the low
of 28.20 US Cents/ lb (as on Oct 26, 2001), a sharp fall by 54.35%. Towards mid-2002, prices
recovered to 53 cents, and toward end of 2003 were currently ruling at 58.85 cents.
    Cotton prices in India are therefore influenced by various demand-supply factors operating within
the country, international raw cotton prices, demand for finished readymade garments from abroad,
prices of synthetic fibre, etc. Jute, silk, wool and khadi - the other fibre sources, are less likely to have
any major impact on cotton prices in India.


4.1.2 Crude palm oil
Annual edible oil trade in India is worth over Rs.440 billion, with the share of CPO being nearly 20%
(Rs.80-90 billion). The country is over-dependent on CPO imports to the extent of over 50% of its
annual vegetable oil imports. There is a close inter linkage between the various vegetable oils
produced, traded and consumed across the world. The average monthly fluctuation in prices of
imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9.7% during
the past two and a half years, the maximum monthly fluctuation being as high as 25% during the
period.
    Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. One
hectare of oil palm yields approximately 20 FFBs, which when crushed yields 6 tons of oil (including
the kernel oil, which is used both for edible and industrial purposes). Crude palm oil (CPO), crude
palmolein, RBD (refined, bleached, deodorized) palm oil, RBD palmolein and crude palm kernel oil
(CPKO) are the various forms of palm oil traded in the market.

Cropping and growth patterns
Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the
year. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm
cultivation. Oil palm thrives well at temperatures of 22 - 33°C with at least 5 hours sunshine per day
throughout the year. Oil palm can be grown on a wide range of soil. In general, the soil should be deep,
well structured and well drained. However, in areas where rainfall is marginally suitable, the water-
holding capacity of the soil is of greatest importance. Flat or gentle undulating land is preferred. Oil
palm is sensitive to pH above 7.5 and stagnant water.

Global and domestic demand-supply dynamics
CPO is used for human consumption as well as for industrial purposes. The consumption of palm oil
(both food and industrial consumption put together) in the world is growing at the rate of 7.37%
compounded annually during the last 12 years period. While in the importing countries like China and
European Union, the consumption of palm oil is growing at the rate of 5.2% and 4.8% respectively, the
consumption growth rate for the worlds leading palm oil importer
4.1 Agricultural commodities                                                                       41

(in specific, and edible oils in general), India, stands at 25%. India, China, Pakistan and the
European Union are the major importers of palm oil. India is the largest importer of CPO with a
share of over 15% of the total quantity traded in the international market. The total imports of
India, China, Pakistan and European Union amount to approximately 56% of the total global
exports of palm oil annually.
    Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). Palm
oil dominates the global vegetable oil export trade. The two producing countries viz. Malaysia and
Indonesia dominate the global trade in CPO. Their share in the global exports of CPO is to the tune
of 90%. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and
Rotterdam in Europe. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. (MDEX)
could be considered as the price maker of palm oil traded world over. This exchange trades only
CPO among several derivatives of palm. The domestic production of palm oil forms almost a
negligible part of the total edible oil consumption in the country.
    Rising consumption of palm oil in India, which could be mainly attributed to its price
competitiveness among several of its competing oils is being met through increasing imports. Palm
oil supports many other industries in India like refining, vanaspati and other industrial sectors apart
from human consumption as RBD palmolein. The major importing and trading centres for palm in
India are Chennai, Kakinada, Mumbai and Kandla. The other centers like Mundra, Kolkata,
Mangalore and Karwar also play important role, but next to the four major trading centers. Palm oil
trade in India is influenced by the supply-demand scene in the domestic market including the
factors influencing various oilseed production in the country, prices of various domestically
produced and imported oils, production and trade policies of the Government, mainly the export-
import policy, overall health of the economy that has a bearing on the purchasing power of ultimate
consumers, etc. The entire industry of CPO in India is dominated by importers, large refiners,
corporate involved in wholesale and retail trade through value-addition and retail-regional level
players along with a few national level players. The industry is dominated by over 200 importing
companies, who are mostly refiners too. Domestic oilseed and edible oil industry is organised in the
form of oilseed crushers, processors, solvent extractors, technologists, commodity-specific
producers and traders.

Price trends and factors that influence prices
There exists a clear trough and crest in the seasonality of CPO production, indicating a typical
seasonality in the production cycle. The production bottoms down in the months of February,
March and April, while the it is at its peak during the months of August, September and October.
Palm oil trade is influenced by various production, market and policy related factors. Being a
perennial plantation crop, acreage under palm plantation does not vary from season to season.
Production is almost evenly distributed throughout the year between 0.8-1.1 million tons in a
monthly. However, it exhibits seasonal highs and lows once in a year. Yield levels of the
plantations are influenced by climatic conditions like rainfall, temperature, etc. Factors that
influence price are market related factors viz. supply-demand scenario of palm and its competing
soy oil in the global market apart from other vegetable oil sources viz. canola/ rapeseed, coconut
oil, sunflower, groundnut, etc.; supply-demand status of various consuming/importing countries;
42                                               Commodities traded on the NCDEX platform

over-all status of the edible oil industry during the immediate past; current and a short-term forecast of
the future status of the industry in various producing and consuming countries. Production and trade
related policies of various exporting and importing nations of palm oil at the international scene have a
major bearing on the prices of palm oil.

Trade policies in India
Since oilseed is one among the major crops cultivated by millions of farmers spread across the country,
and is the major source of cooking oil to over one billion consuming populace of the country, like any
other welfare state, Government of India (Gol) adopts a protection policy with regard to production and
trade in vegetable oils, so as to protect the interests of both the producers and consumers. While the
strategy of farm subsidies and minimum support price (MSP) are on the production side, the duty
structure on various forms of palm oil is the major trade-related protectionist measure.


4.1.3 RBD Palmolein
The RBD (refined, bleached and deodorized) palmolein is the derivative of crude palm oil (CPO),
which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations.
When CPO is subjected to refinement, RBD palm oil and fatty acids are obtained. Fractionation of RBD
palm oil yields RBD palmolein along with stearin, which is a white solid at room temperature. While
Oil is a stable derivative saturated fat, solid at room temperature), Olein is relatively unstable
(unsaturated fat, liquid at room temperature, but low cholesterol).
   The whole quantity of CPO that is produced and used for human consumption is in the form of
RBD palmolein. Cropping of growth patterns of CPO has been already covered.

Global and domestic demand-supply dynamics
The European Union, Pakistan and Middle-East countries are the major importers of RBD palmolein.
Malaysia and Indonesia, which supply palm oil to the world to the extent of over 85% of the annual
global trade in palm oil, export largely as CPO as is demanded by the importing nations who refine
domestically and consume. RBD palmolein exports from Malaysia have increased from 3.2 million tons
in 1998 to 4.5 million tons in 2002.
    India, which is one of the largest importer and consumer of edible oils in the world, imports nearly 3
million tons of palm oil annually (mainly from Malaysia, followed by Indonesia). This implies that the
country is dependent on palm oil imports for over 25% of its annual edible oil consumption. There has
been a sharp rise in the imports of palm oil into the country during the post 1998 period. At the same
time, there has been a drastic change in the composition of various forms of palm oil imported owing to
the differential duty structure adopted by Indian government for crude and refined palm oil imports. The
import is mainly through the ports of Kandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and
Chennai.
    The domestic production of palm oil forms almost a negligible part of the total edible oil
consumption in the country. Its production grew from 5000 tons in 1991 to 35,000 tons in 2002,
4.1 Agricultural commodities                                                                     43

while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million
tons during 2001-02, growing at the rate of 25% compounded annually during the past decade.
Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of
the Indian edible oil consumers.


Price trends and factors that influence prices
Palm oil trade in India is influenced by the supply-demand scene in the domestic market including
the factors influencing various oilseed production in the country, prices of various domestically
produced and imported oils, production and trade policies of the Government mainly the export-
import policy, overall health of the economy that has a bearing on the purchasing power of ultimate
consumers, etc. Unlike the price of CPO imported into the country, which is largely dependent on
price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India, RBD
palmolein prices are influenced by CPO prices and the domestic consumer demand for various
edible oils at a given point of time.


4.1.4 Soy oil
Soy oil is among the major sources of edible oils in India. Of the annual edible oil trade worth over
Rs.440 billion in the country, soy oils share is over 20-21% at Rs.90-92 billion in terms of value.
Being an agricultural commodity, which is often subjected to various production and market-
related uncertainties, soy oil prices traded across the world are highly volatile in nature. The
average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6.6% during the
past two and a half years, the maximum monthly fluctuation being as high as 17% during the
period. Historically, soy oil prices in the major spot markets across the country have been
fluctuating in the range of 4.5-8.5%. This offers immense opportunity for the investors to profitably
deploy their funds in this sector apart from those actually associated with the value chain of the
commodity, which could use soy oil futures contract as the most effective hedging tool to minimise
price risk in the market.
    Soy oil is the derivative of soybean. On crushing mature beans, 18% oil and 78-80% meal is
obtained. While the oil is mainly used for human consumption, meal serves as the main source of
protein in animal feeds. Soy oil is the leading vegetable oil traded in the international markets, next
only to palm. Palm and soy oils together constitute around 68% of global edible oil export trade
volume, with soy oil constituting 22.85%. It accounts for nearly 25% of the world's total oils and
fats production. Increasing price competitiveness, and aggressive cultivation and promotion from
the major producing nations have given way to widespread soy oil growth both in terms of
production as well as consumption.


Cropping and growth patterns
In India, soybean is purely a Kharif crop, whose sowing begins by end-June with the arrival of
southwest monsoon. The crop, which is ready for harvest by the end of September, starts
44                                           Commodities traded on the NCDEX platform

entering the market from October beginning onwards. Crushing for oil and meal starts from
October, peaking during the subsequent two-three months.

Global and domestic demand-supply dynamics
Global consumption of soy oil during 2001-02 shot up to 29.38 million tons. It has been growing
at the rate of 5.63%. Notable upward movement in consumption of soy oil is being seen in EU,
Central Europe, Russia, Egypt, Morocco, US, Mexico, Brazil, China and India. The consumption
of soy oil in USA is to the extent of 90% of its production; growing at the rate of 2.95%, slightly
higher than the growth rate of its production (2.92%). The domestic consumption of soy oil in
Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of
soy oil.
    The current world production of soy oil stands at 29-30 million tons. It has been growing at
the rate of 5.8% compounded annually during the last decade. The production growth rate has
been the highest for Argentina at 10.8%, while that of Brazil and USA has been at 5.6% and 2.9%
respectively. United States is the major producer of soy oil in the world. It accounts to
approximately 29% of world soy oil production with an annual production of 8.5 million tons.
Brazil and Argentina with 5.1 and 4.1 million tons of production, contribute to 17% and 14% of
world production. Of the total world exports, Argentina contributes to an extent of 40.4%,
growing at the rate of 11.36% compounded annually during the past decade.
    Production of soy oil in India has been fluctuating in the range of 0.7-0.9 million tons during
the last five years, growing at the rate of 5%. In addition to domestic production, around 1.5-1.8
million tons of imports take the country's annual soy oil consumption to 2.2-2.7 million tons, with
a market value of over Rs.90 billion. Imports constitute to the extent of over 65-68% of its annual
soy oil requirement and 48% of its annual vegetable oil imports. Imports have been growing at the
rate of approximately 20% over the period of last five years. Madhya Pradesh is considered as the
soybean bowl of India, contributing 80% of the country's soybean production, followed by
Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce
in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangli in
Maharashtra are major trading centres of soybean, in and around which the crushing and solvent
extraction units are mostly located. The refining units are located at the importing ports of
Mumbai and Gujarat.

Price trends and factors the influence prices
In India, spot markets of Indore and Mumbai serve as the reference market for soy oil prices.
While the Indore price reflects the domestically crushed soybean oil (refined and solvent
extracted), Mumbai price indicates the imported soy oil price. Indian edible oil market is highly
price sensitive in nature. Hence, the quantity of soy oil imports mainly depends on the price
competitiveness of soy oil vis-a-vis its sole competitor, palm oil apart from prices of domestically
produced oils, production and trade policies of the government - mainly me export-import policy,
over-all health of the economy that has a bearing on the purchasing power of ultimate consumers,
etc. Soy oil is among the most vibrant commodities in terms of price volatility. Its
4.1 Agricultural commodities                                                                   45

exposure in the international edible trade scene (9-10 million tons), concentration of production
base in limited countries as against its widespread consumption base, its close link with several of
its substitutes and its base raw material soybean in addition to its co-derivative (soy meal), the
nature of the existing supply and value chain, etc. throw tremendous opportunity for trade in this
commodity. The opportunity is further enhanced by the expected rise in consumption base and the
consequent expected rise in imports of vegetable oils in the years to come. In addition is the
stiffening competition among substitutable oils under the WTO regime.


4.1.5 Rapeseed oil
Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world,
after soy and palm oils. On crushing rapeseed, oil and meal are obtained. The average oil recovery
from the seed is about 33%. The remaining is obtained as oil cake/ meal, which is rich in proteins
and is used as an ingredient in animal feed. Mustard oil, which is known for its pungency, is
traditionally the most favoured oils in the major production tracts world over.

Cropping and growth patterns
Rapeseed is a 90-110 day crop. In the countries of Canada, Australia and China, the rapeseed is
sown during the months of June-July and harvested by August-September. Crushing for oil begins
from October onwards. In India, rapeseed is sown in the Rabi season (November-December
sowing). China also grows partly during this season. Mustard/ Rapeseed is traditionally the most
important oil for the northern, central and eastern parts of the country. The pungency of the oil is
considered as the major quality determining factor. Therefore, traditional millers producing
unrefined oil are more favoured by the consumers. Rapeseed from the producers moves into the
hands of crushers via the regulated markets (mandies), gets crushed for oil and cake in the ghanis
or the expeller mills. It is largely consumed in the crude form in the local crushing regions. The
cake obtained from the seed crush contains some amount of oil, which is extracted by the solvent
extractors. The left over meal at the solvent extraction units forms a major portion of our oil meal
basket, part of which is consumed by the domestic animal feed industry, and the rest exported.
Refining of rapeseed oil was almost absent in the country till the end of the last century. As a
result, the sector was more unorganised when compared to the other edible oil sectors in the
country. This resulted in rampant adulteration of the oil. However, with the occurrence of dropsy
in the country, Government of India issued the edible oil packaging order in 1998, which made
refining and packing of all oils sold in the retail sector mandatory. Now, refining is present in
rapeseed oil too.

Global and domestic demand-supply dynamics
Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million
tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been
the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and
European Union at 8% each. Consumption in India and Canada has posted a negative growth
46                                            Commodities traded on the NCDEX platform

rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international
market. Hong Kong and Russia are the major importers, whose share has been declining over the
years.
    At an annual production level of 13-14 million tons, rapeseed oil accounts for about 12% of
the total world's edible oil production. Globally, rapeseed oil production has witnessed a moderate
compounded annual growth rate (over the last decade) of 4.65%. While the production growth
rates in major producing countries viz. Canada and India have posted negative values of 1.2% and
7.8% respectively during the past decade, China, France and Germany's rapeseed oil production
during the period has been growing at 10%, 6.8% and 4.7% respectively. China contributes more
than one thirds of world rapeseed oil production while that of India has gone down from 18.2% in
1997 to 11.3% in 2001.
    Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. It
forms over one-third of the country's annual edible oil production, which is substantial. The
imports of mustard oil have drastically come down in the country from around 172000 tons in
1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition
from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years
due to the differential duty structure. Unlike other oils, consumption of rapeseed oil is
concentrated in northern, north-eastern and western part of the country.
    Rapeseed oil has several industrial applications too viz. as lubricant, its erucic acid derivatives
are used in plastic industry, and it could also be transformed into a liquid biofuel. Rajasthan and
Uttar Pradesh are the major rapeseed producing states in the country. Together, they produce
about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The
other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar,
Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique
pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the
producing and trading centres.

Price trends and factors the influence prices
Various production and trade related factors influence rapeseed oil trade. Prices are largely
dependent on the domestic production of rapeseed during the year, availability of others edible
oils, and general sentiments in the overall edible oil industry within and outside the country. Being
an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The
seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide
consumption spread all through the year, the nature of the existing supply and value chain,
susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad,
influences the prices of the oil, subjecting it to frequent fluctuations.


4.1.6 Soybean
The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an
annual production of 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total
oilseed production. The average monthly fluctuation in prices of soybean traded at one of the
4.1 Agricultural commodities                                                                    47

active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two
years, the maximum monthly fluctuation being as high as 24-30% during the period. Historically,
soybean prices in the major spot markets across the country have been fluctuating in the range of
5-9%. Soybean is the single largest oilseed produced in the world. The commodity has been
commercially exploited for its utility as edible oil and animal feed. On crushing mature beans,
around 18% oil could be obtained; the rest being the oil cake/ meal, which forms the prime source
of protein in animal feeds.

Cropping and growth patterns
Soybean could be grown under rain fed conditions, provided a good amount of soil moisture is
ensured at the germination, vegetative growth and pod setting stages. The planting date of
vegetable soybean is dependent upon temperature and day length. The optimum temperature range
of soybean cultivation is 20 - 30°C with short day length (14 hours or less). However, planting
should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.0-6.5 is suitable
for its cultivation, but the field should be well drained.

Global and domestic demand-supply dynamics
About 82-85% of the global soybean production is crushed for oil and meal, while the rest is
consumed either in the form of bean itself or for value-added soybean snack foods. USA, Brazil,
Argentina, China and European Union countries constitute for the bulk of world's annual soybean
consumption. Mexico, Japan, India and Taiwan are among the other major consumers. During the
past five years period, global consumption of soybean has grown at the rate of 5.25%, higher than
the production growth rate of 5.19%.
    Of the total 310-320 million tons of oilseeds produced annually, soybean production alone
stands at 170-190 million tons, contributing to over 55% of the global oilseeds production. During
the last decade, the production of the commodity grew at the rate of 5.35% at the global level.
USA, followed by Brazil and Argentina are the major producing countries; India and China are
among the other producers.
    The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an
annual production of 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total
oilseed production. Of the total bean produced, 6-7 lakh tons goes for direct consumption in the
form of bean itself (sowing, human consumption as bean itself), leaving the rest of the quantity for
crushing for meal and oil. While the country imports soy oil, it is a leading exporter of meal in the
Asian region. Madhya Pradesh is the soybean bowl of India, contributing 65-70% of the country's
soybean production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra
Pradesh and Gujarat also produce in small quantities.


4.1.7 Rapeseed
Rapeseed/ Mustard is one of the major sources of oil and meal to India. It supplies over 1.5
million tons of oil (15-18% of India's annual edible oil requirement) and 3-3.2 million tons of
48                                                Commodities traded on the NCDEX platform

oil meal, the major protein source in animal feeds. The average monthly fluctuation in prices of
rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9.8%
during the past two years (July 2001 to July 2003), the maximum monthly fluctuation being as
high as 23.4% during the period. Rapeseed/ Mustard/ Canola is a traditionally important oilseed.
China, Canada and India are the major producers of this commodity. The other major producers
are Germany, France, Australia, Pakistan and Poland. The commodity has been commercially
exploited in the form of seeds, oil (seed to oil recovery is 39-40%) and meal. The hybrid form of
rapeseed, known as canola, is more popular internationally.

Cropping and growth patterns
Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown in
India. They are generally divided into three groups:
     1. Brown mustard, commonly called rai (raya or laha)

     2. Sarson: (i) Yellow sarson (ii) Brown sarson

     3. Toria (Lahi or Maghi Labi)

    Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require
relatively cool temperatures for satisfactory growth. In India, they are grown during the Rabi
season from September-October to February-March. Rapeseed and mustard crops grow well in
areas having 25 to 40 cm of rainfall. Sarson is preferred in low-rainfall areas, whereas Rai and
Toria are grown in medium and high rainfall areas respectively. Rapeseed and mustard thrive best
in light to heavy loams. Rai may be grown on all types of soils, but Toria does best in loam to
heavy loams. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils.

Global and domestic demand-supply dynamics
Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million
tons in 2001, growing at a rate of 4.68% compounded annually during the period. USA has been
the fastest growing market for rapeseed oil, growing at the rate of 10.3%, followed by China and
European Union at 8% each. Consumption in India and Canada has posted a negative growth rate
of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market.
Hong Kong and Russia are the major importers, whose share has been declining over the years.
    Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tons in
1999, and declined from there on to the current (2002) level of 32.5 million tons. It has been
growing at the rate of 2.2% during the last 12 years period. The major contributors to global
rapeseed production are China, India, Germany, France, Canada and Australia with a share of
32%, 12.6%, 12.1%, 10%, 9.8% and 3% respectively. Among the major contributors to world
production, Australian rapeseed production grew at the fastest rate of 21%. While China, France
and Germany are growing at a moderate rate of 2-4%, India and Canada have shown a decline
4.2 Precious metals                                                                               49

in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997
to 1.2 million tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada.
Germany follows Canada in the export of domestically produced rapeseed oil. Its exports too have
fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and China
consume most of the rapeseed oil that is produced domestically.
    Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5-4.8
million tons of rapeseed available for produced annually in the country supplies over 1.5 million
tons of oil and 3-3.2 million tons of meal on crushing. It is the largest produced edible oil in India
(groundnut oil production also stands on par with it during good years). It forms over one-third of
the country's annual edible oil production, which is substantial. The imports of mustard oil have
drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons
(of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There
have been no imports of refined rapeseed oil for the last few years due to the differential duty
structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country.
Together, they produce about 50% of the produce. The production from Rajasthan is highly
monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West
Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed
preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil
mills) spread across the producing and trading centres.


Price trends and factors the influence prices
Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/
mustard oil traded across the country. Various production and trade related factors influence
rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the
year, availability of others edible oils, and general sentiments in the overall edible oil industry
within and outside the country. Being an important source of edible oil, it is undoubtedly the focus
of Indian edible oil industry. The seasonal nature of the production of rapeseed and its
vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the
existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal
industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations.
Futures trading would also provide a right tool for hedging the market-related risk for everyone in
the value chain of the commodity- the producing farmers, processors, brokers, speculators,
mustard oil and traders of other oils.
    Import of both refined and crude rapeseed oil is permitted into the country. The import duty on
crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oil for
the last few years due to the differential duty structure.


4.2 Precious metals
The NCDEX offers futures trading in following precious metals - gold and silver. We will look
briefly at both.
50                                                    Commodities traded on the NCDEX platform


 Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November
 1972. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian
 Imperial Bank of Commerce. The gold contracts became so popular that by 1974 there was as many as
 10,00,000 contracts floating in the market. The futures trading in gold started in other countries too. This
 included the following:
     • The London gold futures exchange started operations in the early 1980s.

     • The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange
       had a relationship with the Comex where participants could take open positions in one exchange and
       liquidate them in the other.
     • The Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance
       between the Gold Exchange of Singapore and the International Monetary Market (TMM) of
       Chicago.
     • The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few
       commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked
       with seven million contracts.
     • On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago
       Mercantile Exchange and the Mid-America Commodity Exchange introduced gold futures
       contracts.
     • The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002.
     • Mumbai's first multi-commodity exchange, the National Commodities and Derivatives Exchange,
       NCDEX launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation,
       National Bank for Agriculture and Rural Development and National Stock Exchange of India
       Limited, introduces gold futures contracts.

 Gold has a very active derivative market compared with other commodities. Gold accounts for 45 per cent
 of the worlds commercial banks commodity derivatives portfolio.

                          Box 4.4: History of derivatives markets in gold



4.2.1      Gold

For centuries, gold has meant wealth, prestige, and power, and its rarity and natural beauty have
made it precious to men and women alike. Owning gold has long been a safeguard against disaster.
Many times when paper money has failed, men have turned to gold as the one true source of
monetary wealth. Today is no different. While there have been fluctuations in every market and
decided downturns in some, the expectation is that gold will hold its own. There is a limited
amount of gold in the world, so investing in gold is still a good way to plan for the future. Gold is
homogeneous, indestructible and fungible. These attributes set gold apart from other commodities
and financial assets and tend to make its returns insensitive to business cycle fluctuations. Gold is
still bought (and sold) by different people for a wide variety of reasons - as a use in jewellery, for
industrial applications, as an investment and so on.
4.2 Precious metals                                                                              51

Table 4.1 Country-wise share in gold production, 1968 and 1999
Country                    Tonnes, 1968 Share 1968 Tonnes, 1999              Share, 1999
South Africa                       972              67            437               17
Australia                                                         309               12
Canada                              87                6           154                6
USA                                 44                3           334               13
China                                                             154                6
Indonesia                                                         154                6
India                                                              51                2
Rest of the world                   87                6           463               18
Total                             1450             100           2571              100




Production
Traditionally South Africa has been the largest producers of gold in the world accounting for
almost 80% of all non-communist output in 1970. Although it retained its position as the single
largest gold producing country, its share had fallen to around 17% by 1999 because of high costs
of mining and reduced resources. Table 4.1 gives the country-wise share in gold production. In
contrast other countries like US, Australia, Canada and China have increased their output
exponentially with output from developing countries like Peru and other Latin American countries
also increasing impressively.
    Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly
from the Kolar gold mines in Karnataka) as against a total world production of about 2,272 tonnes
in 1995.

Melting & refining assaying facility in India
At present, gold is mainly refined in Bombay where a few refineries like the India Government
Mint and National refinery are active. Some private refineries are also operating elsewhere with
limited capacity. As none of the refineries is LBMA recognised, there is a need to upgrade and
also increase the refining capacity.


Global and domestic demand-supply dynamics
The demand for gold may be categorised under two heads - consumption demand and investment
demand. Consumption of gold differs according to type, namely industrial applications and
jewellery. The special feature of gold used in industrial and dental applications is that some of it
cannot be salvaged and thus is truly consumed. This is unlike consumption in the form of
jewellery, which remains as stock and can reappear at future time in market in another form.
Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry
forms 89% of consumer demand.
52                                                 Commodities traded on the NCDEX platform

    In markets with poorly developed financial systems, inaccessible or insecure banks, or where
trust in the government is low, gold is attractive as a store of value. If gold is held primarily as an
investment asset, it does not need to be held in physical form. The investor could hold gold-linked
paper assets or could lend out the physical gold on the market attaining a higher return in addition
to savings on the storage costs. Japan has the highest investment demand for gold followed closely
by India. These two countries together account for over 50% of total world demand of gold for
retail investment. Investment demand can be split broadly into two, private and public sector
holdings.
    There are several ways in which investors can invest in gold either directly or through a
variety of investment products, each of which lends it to specific investor preferences:
     • Coins and small bars

     • Gold accounts: allocated and unallocated

     • Gold certificates and pool accounts

     • Gold Accumulation Plan

     • Gold backed bonds and structured notes

     • Gold futures and options

     • Gold-oriented funds

Demand
The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion
worth. More than 80% of the gold consumed is in the form of jewellery, which is generally
predominated by women. The Indian demand to the tune of 800 tonnes per year is making it the
largest market for gold followed by USA, Middle East and China. About 80% of the Physical gold
is consumed in the form of jewellery while bars and coins occupy not higher than 10% of the gold
consumed. If we include jewellery ownership, then India is the largest repository of gold in terms
of total gold within the national boundaries.
    Regarding pattern of demand, there are no authentic estimates, the available evidence shows
that about 80% is for jewellery fabrication for domestic demand, and 15% is for investor-demand
(which is relatively elastic to gold-prices, real estate prices, financial markets, tax-policies, etc.).
Barely 5% is for industrial uses. The demand for gold jewellery is rooted in societal preference for
a variety of reasons - religious, ritualistic, a preferred form of wealth for women, and as a hedge
against inflation. It will be difficult to prioritise them but it may be reasonable to conclude that it
is a combined effect, and to treat any major part as exclusively a store of value or hedging
instrument would be unrealistic. It would not be realistic to assume that it is only the affluent that
creates demand for gold. There is reason to believe that a part of investment demand for gold
assets is out of black money.
    Rural India continues to absorb more than 70% of the gold consumed in India and it has its
own role to fuel the barter economy of the agriculture community. The yellow metal used to
4.2 Precious metals                                                                                       53

play an important role in marriage and religious festivals in India. In the Hindu, Jain and Sikh
community, where women did not inherit landed property whereas gold and silver jewellery was,
and still is, a major component of the gifts given to a woman at the time of marriage. The
changeover hands of gold at the time of marriage are from few grams to kgs. The gold also
occupies a significant position in the temple system where gold is used to prepare idol and
devotees offer gold in the temple. These temples are run in trust and gold with the trust rarely
comes into re-circulation. The existing social and cultural system continues to cause net gold
buyer market and the government policies have to take note of the root cause of gold demand,
which lies in the social and cultural system of India. The annual consumption of gold, which was
estimated at 65 tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it is
likely that, with prosperity and enlightenment, there may be deceleration in demand, particularly
in urban areas, it would be made good by growing demand on account of prosperity in rural areas.
In the near future, therefore, the annual demand will continue to be over 600 tonnes per year.

Supply
Indian gold holding, which are predominantly private, is estimated to be in the range of 10000-
13000 tonnes. One fourth of world gold production is consumed in India and more than 60% of
Indian consumption is met through imports. The domestic production of the gold is very limited
which is around 9 tonnes in 2002 resulting more dependence on imported gold. The availability of
recycled gold is price sensitive and as such the dominance of the gold supply through import is in
existence. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes
in 2002. It rose almost more than 40% compared to the previous year because of rise in gold price
by more than 15%.
    The demand-supply for gold in India can be summed up thus:
   • Demand for gold has an autonomous character. Supply follows demand.
   • Demand exhibits income elasticity, particularly in the rural and semi-urban areas.

   • Price differential creates import demand, particularly illegal import prior to the commencement of
      liberalisation in 1990.


Price trends and factors that influence prices
Indian gold prices follow more or less the international price trends. However, the strong domestic
demand for gold and the restrictive policy stance are reflected in the higher price of gold in the
domestic market compared to that in the international market at the available exchange rate.
    Since the demand for gold is closely tied to the production of jewelry, gold prices tend to
increase during the time of year when demand for jewellery is greatest. Christmas, Mothers Day
and Valentine Day are all major shopping seasons and hence the demand for metals tends to be
strong a few months ahead of these holidays. Also, the summer wedding season sees a large
increase in the demand for metals, so price strength in March and April is not uncommon. On the
54                                            Commodities traded on the NCDEX platform

other hand in November, December, January and February prices tend to decline and jewellers
tend to have holiday inventory to unwind.


4.2.2 Silver
The dictionary describes it as a white metallic element, sonorous, ductile, very malleable and
capable of high degree of polish. It also has the highest thermal and electrical conductivity of any
substance. Silver is somewhat harder than gold and is second only to gold in malleability and
ductility. Silver remains one of the most prominent candidates in the metals complex as far as
futures' trading is concerned. Thanks to its unique volatility, silver has remained a hot favourite
speculative vehicle for the small time traders. Though futures trading was banned in India since
late sixties, parallel futures markets are still very active in Delhi and Indore. Speculative interest
in the white metal is so intense that it is believed that combined volume of Indian punters
represent almost 40 percent of volume traded at New York Commodity Exchange. Delhi,
Rajasthan, MP and UP are the active pockets for the silver futures. Until recently, Rajkot and
Mathura were conducting futures but now players have diverted toward comex trade.
    Most of the world's silver is mined in the US, Australia, Mexico, Peru, and Canada. Cash
markets remain highly unorganised in the silver and impurity and excessive speculation remain
key issue for the trade. Taking cue from gold, government of India is planning to introduce
hallmarking in silver which is likely to address quality and credibility of Indian silverware and
jeweller industry. The unique properties of silver restrict its substitution in most applications.

Production
Silver ore is most often found in combination with other elements, and silver has been mined and
treasured longer than any of the other precious metals. Mexico is the worlds leading producer of
silver, followed by Peru, Canada, the United States, and Australia. The main consumer countries
for silver are the United States, which is the worlds largest consumer of silver, followed by
Canada, Mexico, the United Kingdom, France, Germany, Italy, Japan and India. The main factors
affecting these countries demand for silver are macro economic factors such as GDP growth,
industrial production, income levels, and a whole host of other financial macro economic
indicators.

Demand
Demand for silver is built on three main pillars; industrial and decorative uses, photography and
jewelry & silverware. Together, these three categories represent more than 95 percent of annual
silver consumption. In recent years, the main world demand for silver is no longer monetary, but
industrial. With the growing use of silver in photography and electronics, industrial demand for
silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is the
second largest component, with more demand from the flatware industry than from the jewelry
industry in recent years. India, the largest consumer of silver, is gearing up to start hallmarking of
the white precious metal by April. India annually consumes around 4,000 tonnes of silver,
4.2 Precious metals                                                                                55


 Major markets like the London market (London Bullion Market Association), which started
 trading in the 17th century provide a vehicle for trade in silver on a spot basis, or on a forward
 basis. The London market has a fix which offers the chance to buy or sell silver at a single
 price. The fix begins at 12:15 p.m. and is a balancing exercise; the price is fixed at the point at
 which all the members of the fixing can balance their own, plus clients, buying and selling
 orders.
 Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years.
 The London Metal Exchange and the Chicago Board of Trade introduced futures trading in
 silver in 1968 and 1969, respectively. In the United States, the silver futures market functions
 under the surveillance of an official body, the Commodity Futures Trading Commission
 (CFTC). Although London remains the true center of the physical silver trade for most of the
 world, the most significant paper contracts trading market for silver in the United States is the
 COMEX division of the New York Mercantile Exchange. Spot prices for silver are determined
 by levels prevailing at the COMEX. Although there is no American equivalent to the London
 fix, Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at
 noon each working day.

                         Box 4.5: Historical background of silver markets


with the rural areas accounting for the bulk of the sales. India's demand for silver increased by 177
per cent over the past 10 years as compared to 517 tonnes in 1991. According to GFMS, India has
emerged as the third largest industrial user of silver in the world after the US and Japan.


Supply

The supply of silver is based on two facts, mine production and recycled silver scraps. Mine
production is surprisingly the largest component of silver supply. It normally accounts for a little
less than 2/3 rd of the total (last year was slightly higher at 68%). Fifteen countries produce
roughly 94 percent of the worlds silver from mines. The most notable producers are Mexico, Peru,
the United States, Canada and Australia. Mexico, the largest producer of silver from mines. Peru
is the worlds second largest producer of silver. Silver is often mined as a byproduct of other base
metal operations, which accounts for roughly four-fifths of the mined silver supply produced
annually. Known reserves, or actual mine capacity, is evenly split along the lines of production.
The mine production is not the sole source - others being scrap, disinvestments, government sales
and producers hedging. Scrap is the silver that returns to the market when recovered from existing
manufactured goods or waste. Old scrap normally makes up around a fifth of supply. Scrap supply
increased marginally last year up by 1.2%. The other major source of silver is from refining, or
scrap recycling. Because silver is used in the photography industry, as well as by the chemical
industry, the silver used in solvents and the like can be removed from the waste and recycled. The
United States recycles the most silver in the world, accounting for roughly 43.6 million ounces.
Japan is the second largest producer of silver from scrap and recycling, accounting for roughly
27.8 million troy ounces in 1997. In the United States and Japan, three-quarters of all the recycled
silver comes from the photographic scrap, mainly in the form of spent fixer solutions and old
X-ray films.
56                                                Commodities traded on the NCDEX platform

Factors influencing prices of the silver
The prices of silver, like that of other commodities, are dictated by forces of demand and supply
and consumption. Besides, a host of social, economic and political factors have powerful bearing
on silver prices. As in the case of gold prices, political tensions, the threat affects the price of
silver too. When trading and movement of silver is restricted, within or outside national
boundaries, prices move in accordance with demand and supply conditions prevalent in mat
environment Price of silver is also influenced by changes in factors such as inflation (real or
perceived), changing values of paper currencies, and fluctuations in deficits and interest rates, etc.
Although prices and incomes are important factors, they are also influenced by factors such as
tastes, technological change and market liberalisation.
    Approximately 70 percent of the silver mined in the western hemisphere is mined as a by-
product of other metal products, such as gold, copper, nickel, lead, and zinc. As such, the price of
these metals greatly affects the supply of silver mined in any year. As die price of die omer metal
products increases, die increased profit margin to mine operations stimulates greater production of
die omer metals, and as a result, die production of silver increases in tandem. Because silver is a
precious metal, its price is determined by die supply and demand ratio at any given moment. As is
the case with other precious metals, there is a limited amount of silver in the world. It is not a
product mat can be manufactured en masse, and, merefore, is subject to issues such as weamer
and politics mat may affect silver mining operations.


Solved Problems
Q: Which of the following commodities do not trade on the NCDEX?

     1. Gold                                           3. Silver
     2. Rapeseed                                       4. Energy

A: The correct answer is number 4.                                                                 ••

Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment?

     1. Wheat                                          3. Soybean
     2. Rapeseed                                       4. Soy oil

A: The correct answer is number 1.                                                                 ••

Q: In India, ___ is the most important non-food crop.

     1. Jute                                           3. Silk
     2. Cotton                                         4. None of the above.

A: The correct answer is number 2.                                                                 ••
4.2 Precious metals                                                                            57

Q: Which of the following factors do not influence the price of cotton?

   1. Demand-supply scenario                           3. Previous prices of cotton
   2. Production and prices of synthetic fibre         4. Prices of cotton products.

A: The correct answer is number 4.                                                             ••

Q: Futures prices of cotton at the __ serve as the reference price for cotton traded in the
international
market.

   1. CME                                              3. NYBOT
   2. CBOT                                             4. SGX

A: The correct answer is number 3.                                                             ••

Q: Palm oil is extracted from the __ of oil palm plantations.

   1. Mature fresh fruit bunches                       3. Stem
   2. Dry fruit bunches                                4. Leaves

A: The correct answer is number 1.                                                            ••

Q: RBD Palmolein is the derivative of

   1. Soy                                              3. CPO

   2. Rapeseed                                         4. Coconut kernel

A: The correct answer is number 3.                                                            ••

Q: Which of the following factor directly influences the price of RBD palmolein?

   1. Prices of Rapeseed oil                           3. Prices of CPO
   2. Prices of coconut oil                            4. Prices sunflower oil

A: The correct answer is number 3.                                                            ••

Q: Soy oil is the derivative of

   1. Soy                                              3. CPO
   2. Soybean                                          4. Sunflower seeds

A: The correct answer is number 2.                                                            ••
58                                             Commodities traded on the NCDEX platform

Q: The ____ market reflects the price of domestically crushed soybean

     1. Mumbai                                      3. Indore
     2. Ahmedabad                                   4. Delhi

A: The correct answer is number 3.                                                   ••

Q: The ____ market reflects the price of imported soybean

     1. Mumbai                                      3. Indore
     2. Ahmedabad                                   4. Delhi

A: The correct answer is number 1.                                                   ••
Chapter 5
Instruments available for trading

In recent years, derivatives have become increasingly popular due to their applications for
hedging, speculation and arbitrage. Before we study about the applications of commodity
derivatives, we will have a look at some basic derivative products. While futures and options are
now actively traded on many exchanges, forward contracts are popular on the OTC market. In this
chapter we shall study in detail these three derivative contracts. While at the moment only
commodity futures trade on the NCDEX, eventually, as the market grows, we also have
commodity options being traded.


5.1     Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price.
One of the parties to the contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price. Other contract details like
delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside the exchanges. The salient features of forward
contracts are:
    • They are bilateral contracts and hence exposed to counter-party risk.

    • Each contract is custom designed, and hence is unique in terms of contract size, expiration date and
      the asset type and quality.

    • The contract price is generally not available in public domain.

    • On the expiration date, the contract has to be settled by delivery of the asset.

    • If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which
      often results in high prices being charged.

    However forward contracts in certain markets have become very standardised, as in the case of
foreign exchange, thereby reducing transaction costs and increasing transactions volume. This
process of standardisation reaches its limit in the organised futures market.
60                                                           Instruments available for trading

    Forward contracts are very useful in hedging and speculation. The classic hedging application
would be that of an exporter who expects to receive payment in dollars three months later. He is
exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell
dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer
who is required to make a payment in dollars two months hence can reduce his exposure to
exchange rate fluctuations by buying dollars forward.
    If a speculator has information or analysis, which forecasts 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 to book profits.
Speculators may well be required to deposit a margin upfront. However, this is generally a
relatively small proportion of the value of the assets underlying the forward contract. The use of
forward markets here supplies leverage to the speculator.


5.1.1       Limitations of forward markets
Forward markets world-wide are afflicted by several problems:

     • Lack of centralisation of trading,

     • Illiquidity, and

     • Counterparty risk

    In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient in
that specific situation, but makes the contracts non-tradeable.
    Counterparty risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when
forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the
counterparty risk remains a very serious issue.


5.2 Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the future
at a certain price. But unlike forward contracts, the futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain
standard features of the contract. It is a standardized contract with standard underlying instrument,
a standard quantity and quality of the underlying instrument that can be delivered, (or which can
be used for reference purposes in settlement) and a standard timing of such settlement. A futures
contract may be offset prior to maturity by entering into an equal and opposite transaction. More
than 99% of futures transactions are offset this way. The standardized items in a futures contract
are:
  5.2 Introduction to futures                                                                          61

Merton Miller, the 1990 Nobel laureate had said that "financial futures represent the most significant
financial innovation of the last twenty years." The first exchange that traded financial derivatives was
launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the
International Monetary Market (EMM) and traded currency futures. The brain behind this was a man
called Leo Melamed, acknowledged as the "father of financial futures" who was then the Chairman of
the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange
sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts
traded at the Chicago Mercantile Exchange totalled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar
products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board
Options Exchange. By the 1990s, these exchanges were trading futures and options on everything
from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago
almost overnight into the risk-transfer capital of the world.
                               Box 5.6: The first financial futures market


Table 5.1 Distinction between futures and forwards
               Futures                              Forwards
               Trade on an organised exchange       OTC in nature
               Standardized contract terms          Customised contract terms
               hence more liquid                    hence less liquid
               Requires margin payments             No margin payment
               Follows daily settlement             Settlement happens at end of period



    • Quantity of the underlying

    • Quality of the underlying

    • The date and the month of delivery

    • The units of price quotation and minimum price change

    • Location of settlement


5.2.1       Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because
both serve essentially the same economic functions of allocating risk in the presence of future
price uncertainty. However futures are a significant improvement over the forward contracts as
they eliminate counterparty risk and offer more liquidity. Table 5.1 lists the distinction between
the two.
62                                                                     Instruments available for trading

5.2.2 Futures terminology
     • Spot price: The price at which an asset trades in the spot market.

     • Futures price: The price at which the futures contract trades in the futures market.

     • Contract cycle: The period over which a contract trades. The commodity futures contracts on the
       NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day
       of the delivery month. Thus a January expiration contract expires on the 20th of January and a
       February expiration contract ceases trading on the 20th of February. On the next trading day following
       the 20th, a new contract having a three-month expiry is introduced for trading.

     • Expiry date: It is the date specified in the futures contract. This is the last day on which the contract
       will be traded, at the end of which it will cease to exist.

     • Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the
       delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the
       Gold futures contract is 1 kg.

     • Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for
       each delivery month for each contract. In a normal market, basis will be positive. This reflects that
       futures prices normally exceed spot prices.

     • Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of
       what is known as the cost of carry. This measures the storage cost plus the interest that is paid to
       finance the asset less the income earned on the asset.

     ■ Initial margin: The amount that must be deposited in the margin account at the time a futures contract
        is first entered into is known as initial margin.

     • Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is
       adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called
       marking-to-market.

     • Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the
       balance in the margin account never becomes negative. If the balance in the margin account falls
       below the maintenance margin, the investor receives a margin call and is expected to top up the
       margin account to the initial margin level before trading commences on the next day.


5.3 Introduction to options
In this section, we look at another interesting derivative contract, namely options. Options are
fundamentally different from forward and futures contracts. An option gives the holder of the
option the right to do something. The holder does not have to exercise this right. In contrast, in a
forward or futures contract, the two parties have committed themselves to doing something.
Whereas it costs nothing (except margin requirements) to enter into a futures contract, the
purchase of an option requires an up-front payment.
5.3 Introduction to options                                                                                 63


 Although options have existed for a long time, they were traded OTC, without much
 knowledge of valuation. The first trading in options began in Europe and the US as early as the
 seventeenth century. It was only in the early 1900s that a group of firms set up what was known
 as the put and call Brokers and Dealers Association with the aim of providing a mechanism for
 bringing buyers and sellers together. If someone wanted to buy an option, he or she would
 contact one of the member firms. The firm would then attempt to find a seller or writer of the
 option either from its own clients or those of other member firms. If no seller could be found,
 the firm would undertake to write the option itself in return for a price.
 This market however suffered from two deficiencies. First, there was no secondary market and
 second, there was no mechanism to guarantee that the writer of the option would honour the
 contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In
 April 1973, CBOE was set up specifically for the purpose of trading options. The market for
 options developed so rapidly that by early '80s, the number of shares underlying the option
 contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then,
 there has been no looking back.

                                       Box 5.7: History of options


5.3.1      Option terminology
   ■ Commodity options: Commodity options are options with a commodity as the underlying. For instance
     a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the
     price specified in the contract.

   ■ Stock options: Stock options are options on individual stocks. Options currently trade on over 500
     stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified
     price.

   • Buyer of an option: The buyer of an option is the one who by paying the option premium buys the
     right but not the obligation to exercise his option on the seller/ writer.

   • Writer of an option: The writer of a call/ put option is the one who receives the option premium and is
     thereby obliged to sell/ buy the asset if the buyer exercises on him.

   There are two basic types of options, call options and put options.
   • Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain
     date for a certain price.

   • Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain
     date for a certain price.

   • Option price: Option price is the price which the option buyer pays to the option seller. It is also
     referred to as the option premium.

   ■ Expiration date: The date specified in the options contract is known as the expiration date, the
     exercise date, the strike date or the maturity.

   • Strike price: The price specified in the options contract is known as the strike price or the exercise
     price.
64                                                                         Instruments available for trading

     • American options: American options are options that can be exercised at any time upto the expiration
       date. Most exchange-traded options are American.

     • European options: European options are options that can be exercised only on the expiration date
       itself. European options are easier to analyse than American options, and properties of an American
       option are frequently deduced from those of its European counterpart.

     • In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive
       cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-
       money when the current index stands at a level higher than the strike price (i.e. spot price > strike
       price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a
       put, the put is ITM if the index is below the strike price.

     • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if
       it were exercised immediately. An option on the index is at-the-money when the current index equals
       the strike price (i.e. spot price = strike price).

     • Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a
       negative cashflow it it were exercised immediately. A call option on the index is out-of-the-money
       when the current index stands at a level which is less than the strike price (i.e. spot price < strike
       price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a
       put, the put is OTM if the index is above the strike price.

     • Intrinsic value of an option: The option premium can be broken down into two components - intrinsic
       value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the
       call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St
       - K)] which means the intrinsic value of a call is the greater of 0 or (St - K). Similarly, the intrinsic
       value of a put is Max [0, (K - St )],i.e. the greater of 0 or (K - St). K is the strike price and St is the spot
       price.

     • Time value of an option: The time value of an option is the difference between its premium and its
       intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time
       value. Usually, the maximum time value exists when the option is ATM. The longer the time to
       expiration, the greater is an option's time value, all else equal. At expiration, an option should have no
       time value.




5.4 Basic payoffs
A payoff is the likely profit/ loss that would accrue to a market participant with change in the
price of the underlying asset. This is generally depicted in the form of payoff diagrams which
show the price of the underlying asset on the X-axis and the profits/ losses on the Y-axis. In this
section we shall take a look at the payoffs for buyers and sellers of futures and options. But first
we look at the basic payoff for the buyer or seller of an asset. The asset could be a commodity like
gold or cotton, or it could be a financial asset like like a stock or an index.
5.5 Payoff for futures                                                                            65


 Options made their first major mark in financial history during the tulip-bulb mania in
 seventeenth-century Holland. It was one of the most spectacular get rich quick binges in
 history. The first tulip was brought into Holland by a botany professor from Vienna. Over a
 decade, the tulip became the most popular and expensive item in Dutch gardens. The more
 popular they became, the more Tulip bulb prices began rising. That was when options came
 into the picture. They were initially used for hedging. By purchasing a call option on tulip
 bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed
 number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of
 selling their bulbs at a set price by purchasing put options. Later, however, options were
 increasingly used by speculators who found that call options were an effective vehicle for
 obtaining maximum possible gains on investment. As long as tulip prices continued to
 skyrocket, a call buyer would realize returns far in excess of those that could be obtained by
 purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices
 spiralled since writers were able to keep the premiums and the options were never exercised.
 The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money.
 Hardest hit were put writers who were unable to meet their commitments to purchase Tulip
 bulbs.

                         Box 5.8: Use of options in the seventeenth-century


5.4.1 Payoff for buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, gold for instance, for Rs.6000 per 10
gms, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said
to be "long" the asset. Figure 5.1 shows the payoff for a long position on gold.


5.4.2 Payoff for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, cotton for instance, for Rs.6500 per
Quintal, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is
said to be "short" the asset. Figure 5.2 shows the payoff for a short position on cotton.


5.5 Payoff for futures
Futures contracts have linear payoff, just like the payoff of the underlying asset that we looked at
earlier. If the price of the underlying rises, the buyer makes profits. If the price of the underlying
falls, the buyer makes losses. The magnitude of profits or losses for a given upward or downward
movement is the same. The profits as well as losses for the buyer and the seller of a futures
contract are unlimited. These linear payoffs are fascinating as they can be combined with options
and the underlying to generate various complex payoffs.


5.5.1      Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who holds
an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
66.                                                                         Instruments availa ble for trading

Figure 5.1 Payoff for a buyer of gold
The figure shows the profits/losses from a long position on gold. The investor brought gold at Rs. 6000 per 10 gms.
If the price of gold rises, he profits. If price of gold falls he looses.




Figure 5.2 Payoff for a seller of gold
The figure shows the profits/losses from a short position on cotton. The investor sold long staple cotton at Rs. 65000
per Quintal. If the price of cotton falls, he profits. If the price of cotton rises, he looses.
5.5 Payoff for futures                                                                                         67

Figure 5.3 Payoff for a buyer of gold futures
The figure shows the profits/ losses for a long futures position.The investor bought futures when gold futures
were trading at Rs.6000 per 10 gms. If the price of the underlying gold goes up, the gold futures price too
would go up and his futures position starts making profit. If the price of gold falls, the futures price falls too
and his futures position starts showing losses.




Take the case of a speculator who buys a two-month gold futures contract on the NCDEX when it
sells for Rs.6000 per 10 gms. The underlying asset in this case is gold. When the prices of gold in
the spot market goes up, the futures price too moves up and the long futures position starts making
profits. Similarly when the prices of gold in the spot market goes down, the futures prices too
move down and the long futures position starts making losses. Figure 5.3 shows the payoff
diagram for the buyer of a gold futures contract.




5.5.2 Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts
an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take
the case of a speculator who sells a two-month cotton futures contract when the contract sells
Rs.6500 per Quintal. The underlying asset in this case is long staple cotton. When the prices of
long staple cotton move down, the cotton futures prices also move down and the short futures
position starts making profits. When the prices of long staple cotton move up, the cotton futures
price also moves up and the short futures position starts making losses. Figure 5.4 shows the
payoff diagram for the seller of a futures contract.
68                                                                     Instruments available for trading

Figure 5.4 Payoff for a seller of cotton futures
The figure shows the profits/ losses for a short futures position. The investor sold cotton futures at Rs.6500
per Quintal. If the price of the underlying long staple cotton goes down, the futures price also falls, and the
short futures position starts making profit. If the price of the underlying long staple cotton rises, the futures
too rise, and the short futures position starts showing losses.




5.6 Payoff for options
The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited, however the profits are
potentially unlimited. The writer of an option gets paid the premium. The payoff from the option
written is exactly the opposite to that of the option buyer. His profits are limited to the option
premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as
they lend themselves to be used for generating various complex payoffs using combinations of
options and the underlying asset. We look here at the four basic payoffs.


5.6.1       Payoff for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. The profit/ loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher
the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike
price, he lets his option expire un-exercised. His loss in this case is the premium he paid for
buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option on gold
(often referred to as long call) with a strike of Rs.7000 per 10 gms, bought at a premium of
Rs.500.
5.6 Payoff for options                                                                                       69

Figure 5.5 Payoff for buyer of call option on gold
The figure shows the profits/ losses for the buyer of a three-month call option on gold at a strike of Rs.7000
per 10 gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes in-the-
money. If upon expiration, gold trades above the strike of Rs.7000, the buyer would exercise his option and
profit to the extent of the difference between the spot gold-close and the strike price. The profits possible on
this option are potentially unlimited. However if the price of gold falls below the strike of Rs.7000, he lets
the option expire. His losses are limited to the extent of the premium he paid for buying the option.




5.6.2 Payoff for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/ loss that
the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's
profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will
exercise the option on the writer. Hence as the spot price increases the writer of the option starts
making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price
of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the
writer gets to keep the premium. Figure 5.6 gives the payoff for the writer of a three month call
option on gold (often referred to as short call) with a strike of Rs.7000 per 10 gms, sold at a
premium of Rs.500.


5.6.3 Payoff for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in the
option. The profit/ loss that the buyer makes on the option depends on the spot price of the
70                                                                    Instruments available for trading

Figure 5.6 Payoff for writer of call option on gold
The figure shows the profits/ losses for the seller of a three-month call option on gold with a strike price of
Rs.7000 per 10 gms. As the price of gold in the spot market rises, the call option becomes in-the-money and
the writer starts making losses. If upon expiration, gold price is above the strike of Rs.7000, the buyer would
exercise his option on the writer who would suffer a loss to the extent of the difference between the spot
gold-close and the strike price. The loss that can be incurred by the writer of the option is potentially
unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.500
charged by him.




underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower
the spot price, more is the profit he makes. If the spot price of the underlying is higher than the
strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for
buying the option. Figure 5.7 gives the payoff for the buyer of a three month put option on cotton
(often referred to as long put) with a strike of Rs.6000 per Quintal, bought at a premium ofRs.400.


5.6.4 Payoff for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in the
option. For selling the option, the writer of the option charges a premium. The profit/ loss that the
buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's
profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the
buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is
more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep
the premium. Figure 5.8 gives the payoff for the writer of a three month put option on long staple
cotton (often referred to as short put) with a strike of Rs.6000 per Quintal,
5.7 Using futures versus using options                                                                     71

Figure 5.7 Payoff for buyer of put option on long staple cotton
The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. As can
be seen, as the price of cotton in the spot market falls, the put option becomes in-the-money. If at expiration,
cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and profit to
the extent of the difference between the strike price and spot cotton-close. The profits possible on this option
can be as high as the strike price. However if spot price of cotton on the day of expiration of the contract is
above the strike of Rs.6000, he lets the option expire. His losses are limited to the extent of the premium he
paid for buying the option, Rs.400 in this case.




sold at a premium of Rs.400.


5.7 Using futures versus using options
An interesting question to ask at this stage is - when would one use options instead of futures?
Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After
this, he only has an upside. There is no possibility of the options position generating any further
losses to him (other than the funds already paid for the option). This is different from futures,
which is free to enter into, but can generate very large losses. This characteristic makes options
attractive to many occasional market participants, who cannot put in the time to closely monitor
their futures positions.
    More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs".
By combining futures and options, a wide variety of innovative and useful payoff structures can
72                                                                 Instruments available for trading

Figure 5.8 Payoff for writer of put option on long staple cotton
The figure shows the profits/ losses for the seller of a three-month put option on long staple cotton. As the
price of cotton in the spot market falls, the put option becomes in-the-money and the writer starts making
losses. If upon expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise
his option on the writer who would suffer a loss to the extent of the difference between the strike price and
spot cotton-close. The profit that can be made by the writer of the option is limited to extent of the premium
received by him, i.e. Rs.400, whereas the losses are unlimited (actually they are limited to the strike price
since the worst that can happen is that the price of the underlying asset falls to zero.




Table 5.2 Distinction between futures and options
            Futures                            Options
              Exchange traded, with novation          Same as futures.
              Exchange defines the product            Same as futures.
              Price is zero, strike price moves       Strike price is fixed, price moves.
              Price is zero                           Price is always positive.
              Linear payoff                           Nonlinear payoff.
              Both long and short at risk             Only short at risk.




be created.
5.7 Using futures versus using options                                                                73

Solved Problems
Q: Which of the following cannot be an underlying asset for a financial derivative contract?

   1. Equity index                                    3. Interest rate
   2. Commodities                                     4. Foreign exchange

A: The correct answer is 2                                                                             ••



Q: Which of the following cannot be an underlying asset for a commodity derivative contract?

   1. Wheat                                           3. Cotton
   2. Gold                                            4. Stocks

A: The correct answer is 4                                                                            ••



Q: Which of the following exchanges was the first to start trading commodity futures?

   1. Chicago Board of Trade                           3. Chicago Board Options Exchange
                                                      4. London International Financial Futures and
   2. Chicago Mercantile Exchange                         Options Exchange

A: The correct answer is 3.                                                                           ••



Q: In an options contract, the option lies with the

   1. Buyer                                            3. Both
   2. Seller                                          4. Exchange

A: The option to exercise lies with the buyer. The correct answer is number 1.                        ••



Q: The potential returns on a futures position are:

   1. Limited                                          3. a function of the volatility of the index
   2. Unlimited                                       4. None of the above

A: The correct answer is number 2.                                                                    ••
74                                                                 Instruments available for trading

Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an
example of a

     1. Futures contract                                3. Spot contract
     2. Forward contract                                4. None of the above

A: The correct answer is number 2.                                                                   ••

Q: Typically option premium is

     1. Less than the sum of intrinsic value and time   3. Equal to the sum of intrinsic value and
        time value                                      value
     2. Greater than the sum of intrinsic value and
        time value                                      4. Independent of intrinsic value and time
        value

A: The correct answer is number 3.                                                                   ••

Q: An asset currently sells at 120. The put option to sell the asset at Rs.134 costs Rs.18. The time
value of the option is

     1. Rs.18                                           3. Rs.14
     2. Rs.4                                            4. Rs.12

A: The correct answer is number 2.                                                                   ••

Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an
example of a

     1. OTC contract                                    3. Spot contract
     2. Exchange traded contract                        4. None of the above

A: The correct answer is number 1.                                                                   ••

Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader
buys futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1550/Quintal. How much profit/loss has he made on his position?

     1. (+)5000                                         3. (+)50,000
     2. (-)5000                                         4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position 100 Quintals. He
makes
a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is number 1. • •
5.7 Using futures versus using options                                                                     75

Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader
buys futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1450/Quintal. How much profit/loss has he made on his position?

   1. (+)5000                                               3. (+)50,000
   2. (-)5000                                               4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals.
He
makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. • •


Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader
sells futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1550/Quintal. How much profit/loss has he made on his position?

   1. (+)5000                                               3. (+)50,000
   2. (-)5000                                               4. (-)50,000

A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals.
He
makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2. • •


Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader
sells futures on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1450/Quintal. How much profit/loss has he made on his position?

   1. (+)5000                                               3. (+)50,000
   2. (-)5000                                               4. (-)50,000

A: Each unit is for 10 Quintals. He sells 10 units which means a futures position in 100 Quintals.
He makes a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is
number 1. • •


Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.7000/10 gms at a
premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is
Rs.7080/10 gms. What is his net payoff?

   1. (+) 10,000                                            3. (-) 10,000
   2. (+) 1,000                                             4. (-) 1,000

A: Per 10 gms he makes a net profit of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000 gms. So
                                                        100      
he makes a net profit of Rs. 1000 on his position            10  The correct answer is number 2. • •
                                                        10       
76                                                             Instruments available for trading

Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.7000/10 gms at a
premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is
Rs.6080/10 gms. What is his net payoff?

     1. (-)7000                                       3. (-)700
     2. (+) 1,000                                     4. (-) 1,000

A: The option is OTM. Unit of trading is 100 gms and he has bought 10 units. So he has a
position in 1000 gms of gold. He pays an option premium of Rs.70 per 10 gms. He losses the
premium amount of Rs.7000 on his position. The correct answer is number 1.             ••


Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms
at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold
is Rs.7080/10 gms. What is his net payoff?

     1. (+) 10,000                                    3. (-) 10,000
     2. (+) 1,000                                     4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is
the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short
                                                                                100      
position in 1000 gms. So he makes a net loss of Rs.1000 on his position              10  . The
                                                                                10       
correct answer is number 4.


Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms
at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold
is Rs.6080/10 gms. What is his net payoff?

     1. (-)7000                                       3. (-)700
     2. (+) 1,000                                     4. (-) 1,000

A: The option is OTM. The buyer does not exercise so the seller gets to keep the premium. Unit
of trading is 100 gms and he has sold 10 units. So he has a position in 1000 gms of gold. He
receives an option premium of Rs.70 per 10 gms. He earns the premium amount of Rs.7000 on
his position. The correct answer is number 1.                                             ••
Chapter 6
Pricing commodity futures

Commodity futures began trading on the NCDEX from the 14th December 2003. The market is
still in its nascent phase, however the volumes and open interest on the various contracts trading
in this market have been steadily growing.
     The process of arriving at a figure at which a person buys and another sells a futures contract
for a specific expiration date is called price discovery. In an active futures market, the process of
price discovery continues from the market's opening until its close. The prices are freely and
competitively derived. Future prices are therefore considered to be superior to the administered
prices or the prices that are determined privately. Further, the low transaction costs and frequent
trading encourages wide participation in futures markets lessening the opportunity for control by a
few buyers and sellers.
     In an active futures markets the free flow of information is vital. Futures exchanges act as a
focal point for the collection and dissemination of statistics on supplies, transportation, storage,
purchases, exports, imports, currency values, interest rates and other pertinent information. Any
significant change in this data is immediately reflected in the trading pits as traders digest the new
information and adjust their bids and offers accordingly. As a result of this free flow of
information, the market determines the best estimate of today and tomorrow's prices and it is
considered to be the accurate reflection of the supply and demand for the underlying commodity.
Price discovery facilitates this free flow of information, which is vital to the effective functioning
of futures market.
     In this chapter we try to understand the pricing of commodity futures contracts and look at
how the futures price is related to the spot price of the underlying asset. We study the cost-of-carry
model to understand the dynamics of pricing that constitute the estimation of fair value of futures.


6.1     Investment assets versus consumption assets
When studying futures contracts, it is essential to distinguish between investment assets and
consumption assets. An investment asset is an asset that is held for investment purposes by most
investors. Stocks and bonds are examples of investment assets. Gold and silver are also
78                                                                       Pricing commodity futures

examples of investment assets. Note however that investment assets do not always have to be held
exclusively for investment. As we saw earlier, silver, for example, has a number of industrial
uses. However, to classify as investment assets, these assets do have to satisfy the requirement
that they are held by a large number of investors solely for investment. A consumption asset is an
asset that is held primarily for consumption. It is not usually held for investment. Examples of
consumption assets are commodities such as copper, oil, and pork bellies.
    As we will learn, we can use arbitrage arguments to determine the futures prices of an
investment asset from its spot price and other observable market variables. For pricing
consumption assets, we need to review the arbitrage arguments a little differently. To begin with,
we look at the cost-of-carry model and try to understand the pricing of futures contracts on
investment assets.


6.2 The cost of carry model
We use arbitrage arguments to arrive at the fair value of futures. For pricing purposes, we treat the
forward and the futures market as one and the same. A futures contract is nothing but a forward
contract that is exchange traded and that is settled at the end of each day. The buyer who needs
an asset in the future has the choice between buying the underlying asset today in the spot market
and holding it, or buying it in the forward market. If he buys it in the spot market today, it
involves opportunity costs. He incurs the cash outlay for buying the asset and he also incurs costs
for storing it. If instead he buys the asset in the forward market, he does not incur an initial outlay.
However the costs of holding the asset are now incurred by the seller of the forward contract who
charges the buyer a price that is higher than the price of the asset in the spot market. This forms
the basis for the cost-of-carry model where the price of the futures contract is defined as:



                                            F = S-C                                                (6.1)

     where:
     F Futures price
     S Spot price
     C Holding costs or carry costs
     The fair value of a futures contract can also be expressed as:


                                           F = S(l + r)T                                           (6.2)

     where:

     r Percent cost of financing
6.2 The cost of carry model                                                                                         79

   T Time till expiration

    Whenever the futures price moves away from the fair value, there would be opportunities for
arbitrage. If F < S(1 + r)T or F > S(1 + r)T, arbitrage would exist. We know what are the spot and
futures prices, but what are the components of holding costs? The components of holding cost
vary with contracts on different assets. At times the holding cost may even be negative. In the case
of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance
purchased. In the case of equity futures, the holding cost is the cost of financing minus the
dividends returns.
    Equation 6.2 uses the concept of discrete compounding, where interest rates are compounded
at discrete intervals, for example, annually or semiannually. Pricing of options and other complex
derivative securities requires the use of continuously compounded interest rates. Most books on
derivatives use continuous compounding for pricing futures too. When we use continuous com-
pounding, equation 6.2 is expressed as:


                                                  F - SerT                                                       (6.3)

   where:

   r Cost of financing (using continuously compounded interest

   rate)

   T Time till expiration

   e 2.71828

    So far we were talking about pricing futures in general. To understand the pricing of
commodity futures, let us start with the simplest derivative contract - a forward contract. We use
examples of forward contracts to explain pricing concepts because forward contracts are easier to
understand. However, the logic for pricing a futures contract is exactly the same as the logic for
pricing a forward contract. We begin with a forward contract on an asset that provides the holder
with no income and has no storage or other costs. Then we introduce real world factors as they
apply to investment commodities and later to consumption commodities.
    Consider a three-month forward contract on a stock that does not pay dividend. Assume that
the price of the underlying stock is Rs.40 and the three-month interest rate is 5% per annum. We
consider the strategies open to an arbitrager in two extreme situations.

   1. Suppose that the forward price is relatively high at Rs.43. An arbitrager can borrow Rs.40 from the
      market at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in the
      forward market at Rs.43. At the end of three months, the arbitrager delivers the share and receives
                                                                             0.05  0.25
      Rs.43. The sum of money required to pay off the loan is 40e                            40.50. By following this
      strategy, the arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at the end of the three month period.
80                                                                             Pricing commodity futures

     2. Suppose that the forward price is relatively low at Rs.39. An arbitrager can short one share for Rs.40,
        invest the proceeds of the short sale at 5% per annum for three months, and take a long position in a
                                                                                        0.05  0.25
        three-month forward contract. The proceeds of the short sale grow to 40 e                    40 .50 in
        three months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share
        under the terms of the forward contract and uses it to close his short position, in the process making a
        net gain of Rs. 1.50 at the end of three months.

    We see that if the forward price is greater than Rs.40.50, there exists arbitrage. Under such a
situation, arbitragers will sell the asset in the forward market, eventually driving the forward price
down to Rs.40.50. Similarly if the forward price is less than Rs.40.50, there exists arbitrage.
Arbitragers will buy the asset in the forward market, eventually pushing the forward price up to
Rs.40.50. At a forward price of Rs.40.50 there will be no arbitrage. This is the fair value of the
forward contract. The same arguments hold good for a futures contract on an investment asset.
    Now let us try to extend this logic to a futures contract on a commodity. Let us take the
example of a futures contract on a commodity and work out the price of the contract. The spot
price of gold is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be the
futures price of 10 gms of gold one month down the line ? Let us assume that we're on 1st January
2004. How would we compute the price of a gold futures contract expiring on 30th January? From
the discussion above we know that the futures price is nothing but the spot price plus the cost-of-
carry. Let us first try to work out the components of the cost-of-carry model.

     1. What is the spot price of gold? The spot price of gold, S= Rs.7000/ 10 gms.
                                                                30
                                                       0.15 
     2. What is the cost of financing for a month? e            365


     3. What are the holding costs? Let us assume that the storage cost = 0.

     In this case the fair value of the futures, works out to be = Rs.7086.80

                                                                      30
                                                          0.15 
                               F  Se rT  7000e       365  Rs. 7086.80

 If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing
                                                                                                       90
                                                                                              0.15 
would increase the futures price. Therefore, the futures price would be F  7000e                      365   
Rs.7263.75

6.2.1        Pricing futures contracts on investment commodities
In the example above we saw how a futures contract on gold could be priced using arbitrage
arguments and the cost-of-carry model. In the example we considered, the gold contract was for
10 grams of gold. Hence we ignored the storage costs. However, if the one-month contract was for
a 100 kgs of gold instead of 10 gms, then it would involve non-zero holding costs which would
include storage and insurance costs. The price of the futures contract would then be Rs.7086.80
plus the holding costs.
    Table 6.1 gives the indicative warehouse charges for accredited warehouses/ vaults that will
function as delivery centres for contracts that trade on the NCDEX. Warehouse charges include
6.2 The cost of carry model
                                                                                                    8
1


    Under normal market conditions, F, the futures price is very close to S(X + r)T. However, on
    October 19,1987, the US market saw a breakdown in this classic relationship between spot and
    futures prices. It was the day the markets fell by over 20% and the volume of shares traded on
    the New York Stock Exchange far exceeded all previous records. For most of the day, futures
    traded at significant discount to the underlying index. This was largely because delays in
    processing orders to sell equity made index arbitrage too risky. On the next day, October
    20,1987, the New York Stock Exchange placed temporary restrictions on the way in which
    program trading could be done. The result was that the breakdown of the traditional linkages
    between stock indexes and stock futures continued. At one point, the futures price for the
    December contract was 18% less than the S&P 500 index which was the underlying index for
    these futures contracts! However, the highlight of the whole episode was the fact that inspite of
    huge losses, there were no defaults by futures traders. It was the ultimate test of the efficiency
    of the margining system in the futures market.

                               Box 6.9: The market crash of October 19,1987


a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The
per unit charges include storage costs and insurance charges.
    We saw that in the absence of storage costs, the futures price of a commodity that is an
investment asset is given by F = SerT Storage costs add to the cost of carry. If U is the present
value of all the storage costs that will be incurred during the life of a futures contract, it follows
that the futures price will be equal to

                                            F =   (S + U)erT                                    (6.4)

      where:
      r Cost of financing (annualised)
      T Time till expiration
     U Present value of all storage costs

    For ease of understanding let us consider a one-year futures contract on gold. Suppose the
fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week,
it costs Rs.3170 to store one kg of gold for a year(52 weeks). Assume that the payment is made at
the beginning of the year. Assume further that the spot gold price is Rs.6000 per 10 grams and the
risk-free rate is 7% per annum. What would the price of one year gold futures be if the delivery
unit is one kg?


                                  F = (S+ U)erT
                                    = (600000 + 310 + 2860)e0.07 x 1
                                    = 646904.76
82                                                                     Pricing commodity futures

Table 6.1 NCDEX - indicative warehouse charges
                  Commodity         Fixed charges Warehouse charges per unit per week (Rs.)
                                             (Rs.)
                 Gold                          310                      55 per kg
                 Silver                        610                       1 per kg
                 Soy Bean                      110                     13 per MT
                 Soya oil                      110                     30 per MT
                 Mustard seed                  110                      18perMT
                 Mustard oil                   110                     42 per MT
                 RBD Palmolein                 110                     26 per MT
                 CPO                           110                     25 per MT
                 Cotton - long                 110                     6 per Bale
                 Cotton - medium               110                     6 per Bale



    We see that the one-year futures price of a kg of gold would be Rs.6,46,904.76. The one-year
futures price for 10 grams of gold would be about Rs.6469.
    Now let us consider a three-month futures contract on gold. We make the same assumptions -
the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per
week. It costs Rs.1025 to store one kg of gold for three months(13 weeks). Assume that the
storage costs are paid at the time of deposit. Assume further that the spot gold price is Rs.6000 per
10 grams and the risk-free rate is 7% per annum. What would the price of three month gold
futures if the delivery unit is one kg?


                               F = (S + U)erT
                                 = (600000 + 310 + 715)e0.07 x
                                   0.25

                                   = 611635.50


  We see that the three-month futures price of a kg of gold would be Rs.6,11,635.50. The three-
month futures price for 10 grams of gold would be about Rs.6116.


6.2.2 Pricing futures contracts on consumption commodities
We used the arbitrage argument to price futures on investment commodities. For commodities mat
are consumption commodities rather than investment assets, the arbitrage arguments used to
determine futures prices need to be reviewed carefully. Suppose we have


                                          F   > (S+U)erT                                          (6.5)
     To take advantage of this opportunity, an arbitrager can implement the following strategy:
6.3 The futures basis                                                                                          83

   1. Borrow an amount S+ U at the risk-free interest rate and use it to purchase one unit of the commodity
      and pay storage costs.

   2. Short a forward contract on one unit of the commodity.

    If we regard the futures contract as a forward contract, this strategy leads to a profit of
F - (S + U) erT at the expiration of the futures contract. As arbitragers exploit this opportunity, the
spot price will increase and the futures price will decrease until Equation 6.5 does not hold good.
    Suppose next that


                                             F <     (S+U)erT                                               (6.6)

    In case of investment assets such as gold and silver, many investors hold the commodity
purely for investment. When they observe the inequality in equation 6.6, they will find it
profitable to trade in the following manner:

   1. Sell the commodity, save the storage costs, and invest the proceeds at the risk-free interest rate.

   2. Take a long position in a forward contract.

    This would result in a profit at maturity of (S + U) erT - F relative to the position that the
investors would have been in had they held the underlying commodity. As arbitragers exploit this
opportunity, the spot price will decrease and the futures price will increase until equation 6.6 does
not hold good. This means that for investment assets, equation 6.4 holds good. However, for
commodities like cotton or wheat that are held for consumption purpose, this argument cannot be
used. Individuals and companies who keep such a commodity in inventory, do so, because of its
consumption value - not because of its value as an investment. They are reluctant to sell these
commodities and buy forward or futures contracts because these contracts cannot be consumed.
Therefore there is unlikely to be arbitrage when equation 6.6 holds good. In short, for a
consumption commodity therefore,


                                              F<=(S+U) erT                                                  (67)


   That is the futures price is less than or equal to the spot price plus the cost of carry.


6.3 The futures basis
The cost-of-carry model explicitly defines the relationship between the futures price and the
related spot price. The difference between the spot price and the futures price is called the basis.
We see that as a futures contract nears expiration, the basis reduces to zero. This means that there
is a convergence of the futures price to the price of the underlying asset. This happens because if
the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage
84                                                                               Pricing commodity futures

Figure 6.1 Variation of basis over time
The figure shows how basis changes over time. As the time to expiration of a contract reduces, the basis
reduces. Towards the close of trading on the day of settlement, the futures price and the spot price converge.
The closing price for the April gold futures contract is the closing value of gold in the spot market on that
day.




opportunity for traders. In case of such arbitrage the trader can short his futures contract, buy the
asset from the spot market and make the delivery. This will lead to a profit equal to the difference
between the futures price and spot price. As traders start exploiting this arbitrage opportunity the
demand for the contract will increase and futures prices will fall leading to the convergence of the
future price with the spot price. If the futures price is below the spot price during the delivery
period all parties interested in buying the asset will take a long position. The trader would buy the
contract and sell the asset in the spot market making a profit equal to the difference between the
future price and the spot price. As more traders take a long position the demand for the particular
asset would increase and the futures price would rise nullifying the arbitrage opportunity.

Nuances
     • As the date of expiration comes near, the basis reduces - there is a convergence of the futures price
       towards the spot price(Figure 6.1). On the date of expiration, the basis is zero. If it is not, then there is
       an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between
       spot and futures price) or the spreads (difference between prices of two futures contracts) during the
       life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can
       be exploited.

     • There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price in the
       case of investment assets. In the case of consumption assets, we need to factor in the benefit provided
       by holding the physical commodity.

     • Transactions costs are very important in the business of arbitrage.
6.3 The futures basis                                                                           85

    Note: The pricing models discussed in this chapter give an approximate idea about the true
future price. However the price observed in the market is the outcome of the price-discovery
mechanism (demand-supply principle) and may differ from the so-called true price.


Solved problems
Q: The _______ model is used for pricing futures contracts.

   1. Black & Scholes                                  3. Miller
   2. Cost-of-carry                                    4. Time-value

A: The correct answer is number 2.                                                              ••

Q: What is the fair value of one month futures if the spot value of gold is Rs.6000 per 10 grams?
The money can be invested at 10% p.a. and warehousing cost are Rs.25

   1. 6025.00                                          3. 6090.00
   2. 6075.40                                          4. 6050.30

A: The fair value is 6025e01x00833 = 6075.40. The correct answer is number 2.                   .•

Q: As the a futures contract nears expiration, the basis

   1. Increases                                        3. Remains unchanged
   2. Reduces                                          4. Reduces to half

A: The correct answer is number 2.                                                              ••

Q: An investment asset is an asset that is held for investment purposes by

   1. Large investors                                  3. Most investors
   2. Some investors                                   4. All investors

A: The correct answer is number 3.                                                              ••

Q: An investment asset is an asset that is held for consumption purposes by

   1. Large investors                                  3. Most investors
   2. Some investors                                   4. All investors

A: The correct answer is number 3.                                                              ••
86                                                                     Pricing commodity futures

Q: When the futures price happens to be higher than the fair value of the futures contract,
arbitragers profit by

     1. Selling futures                                   set
     2. Buying the underlying asset                     4. Selling the underlying asset and buying
                                                           futures
     3. Selling futures and buying the underlying as-

A: The correct answer is number 3.                                                               ••

Q: When the futures price happens to be lower than the fair value of the futures contract,
arbitragers profit by

     1. Selling futures                                   set
     2. Buying the underlying asset                       4. Selling the underlying asset and
                                                             buying futures

     3. Selling futures and buying the underlying as-

A: The correct answer is number 4.                                                                   ••
Chapter 7
Using commodity futures

For a market to succeed, it must have all three kinds of participants - hedgers, speculators and
arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on
the market. Commodity markets give opportunity for all three kinds of participants. In this chapter
we look at the use of commodity derivatives for hedging, speculation and arbitrage.


7.1     Hedging
Many participants in the commodity futures market are hedgers. They use the futures market to
reduce a particular risk that they face. This risk might relate to the price of wheat or oil or any
other commodity that the person deals in. The classic hedging example is that of wheat farmer
who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is
ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a
predetermined price. Hedging does not necessarily improve the financial outcome; indeed, it could
make the outcome worse. What it does however is, that it makes the outcome more certain.
Hedgers could be government institutions, private corporations like financial institutions, trading
companies and even other participants in the value chain, for instance farmers, extractors, ginners,
processors etc., who are influenced by the commodity prices.


7.1.1      Basic principles of hedging
When an individual or a company decides to use the futures markets to hedge a risk, the objective
is to take a position that neutralises the risk as much as possible. Take the case of a company that
knows that it will gain Rs. 1,00,000 for each 1 rupee increase in the price of a commodity over the
next three months and will lose Rs. 1,00,000 for each 1 rupee decrease in the price of a commodity
over the same period. To hedge, the company should take a short futures position that is designed
to offset this risk. The futures position should lead to a loss of Rs. 1,00,000 for each 1 rupee
increase in the price of the commodity over the next three months and a gain of Rs. 1,00,000 for
each 1 rupee decrease in the price during this period. If the price of the commodity goes down, the
gain on the futures position offsets the loss on the commodity. If
88                                                                     Using commodity futures

Figure 7.1 Payoff for buyer of a short hedge
The figure shows the payoff for a soy oil producer who takes a short hedge. Irrespective of what the spot
price of soy oil is three months later, by going in for a short hedge he locks on to a price of Rs.450 per MT.




the price of the commodity goes up, the loss on the futures position is offset by the gain on the
commodity.
    There are basically two kinds of hedges that can be taken. A company that wants to sell an
asset at a particular time in the future can hedge by taking short futures position. This is called a
short hedge. Similarly, a company that knows that it is due to buy an asset in the future can hedge
by taking long futures position. This is known as long hedge. We will study these two hedges in
detail.


7.1.2 Short hedge
A short hedge is a hedge that requires a short position in futures contracts. As we said, a short
hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and
expects to sell it at some time in the future. For example, a short hedge could be used by a cotton
farmer who expects the cotton crop to be ready for sale in the next two months. A short hedge can
also be used when the asset is not owned at the moment but is likely to be owned in the future. For
example, an exporter who knows that he or she will receive a dollar payment three months later.
He makes a gain if die dollar increases in value relative to the rupee and makes a loss if the dollar
decreases in value relative to the rupee. A short futures position will give him the hedge he
desires.
    Let a look at a more detailed example to illustrate a short hedge. We assume that today is the
7.1 Hedging                                                                                        89

Table 7.1 Refined soy oil futures contract specification
              Trading system          NCDEX trading system
               Trading hours         Monday to Friday
                                     Normal market hours - 10:00 am to 4:00 pm
                                     Closing session - 4:15 pm to 4:30 pm
               Unit of trading       1000 Kgs (=1 MT)
               Delivery unit         10000 Kgs (=10 MT)
               Quotation/ base value Rs. per 10 Kgs
              Tick size              5paisa



15th of January and that a refined soy oil producer has just negotiated a contract to sell 10,000
Kgs of soy oil. It has been agreed that the price that will apply in the contract is the market price
on the 15th April. The oil producer is therefore in a position where he will gain Rs. 10000 for each
1 rupee increase in the price of oil over the next three months and lose Rs. 10000 for each one
rupee decrease in the price of oil during this period. Suppose the spot price for soy oil on January
15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465 per 10 Kgs.
Table 7.1 gives the soy oil futures contract specification. The producer can hedge his exposure by
selling 10,000 Kgs worth of April futures contracts (10 units). If the oil producers closes his
position on April 15, the effect of the strategy would be to lock in a price close to Rs.465 per 10
Kgs. Figure 7.1 gives the payoff for a short hedge. Let us look at how this works. On April 15, the
spot price can either be above Rs.465 or below Rs.465.
   1. Case 1: The spot price is Rs.455 per 10 Kgs. The company realises Rs.4,55,000 under its
      sales contract. Because April is the delivery month for the futures contract, the futures price
      on April 15 should be very close to the spot price of Rs.455 on that date. The company
      closes its short futures position at Rs.455, making a gain of Rs.465 - Rs.455 = Rs.10 per 10
      Kgs, or Rs. 10,000 on its short futures position. The total amount realised from both the
      futures position and the sales contract is therefore about Rs.465 per 10 Kgs, Rs.4,65,000 in
      total.
   2. Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its
      sales contract. Because April is the delivery month for the futures contract, the futures price
      on April 15 should be very close to the spot price of Rs.475 on that date. The company
      closes its short futures position at Rs.475, making a loss of Rs.475 - Rs.465 = Rs.10 per 10
      Kgs, or Rs.10,000 on its short futures position. The total amount realised from both the
      futures position and the sales contract is therefore about Rs.465 per 10 Kgs, Rs.4,65,000 in
      total.


7.1.3 Long hedge
Hedges that involve taking a long position in a futures contract are known as long hedges. A long
hedge is appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now.
    Suppose that it is now January 15. A firm involved in industrial fabrication knows that it will
require 300 kgs of silver on April 15 to meet a certain contract. The spot price of silver is Rs. 1680
90                                                                              Using commodity futures

Figure 7.2 Payoff for buyer of a long hedge
The figure shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what the spot
price of silver is three months later, by going in for a long hedge he locks on to a price of Rs.1730 per kg.




Table 7.2 Silver futures contract specification
               Trading system         NCDEX trading system
                 Trading hours         Monday to Friday
                                       Normal market hours - 10:00 am to 4:00 pm
                                       Closing session - 4:15 pm to 4:30 pm
                 Unit of trading       5Kgs
                 Delivery unit         30Kgs
                 Quotation/ base value Rs.per kg of Silver with 999 fineness
                Tick size              5 paisa



per kg and the April silver futures price is Rs.1730. Table 7.2 gives the contract specification for
silver. A unit of trading is 5 Kgs. The fabricator can hedge his position by taking a long position in
sixty units of futures on the NCDEX. If the fabricator closes his position on April 15, the effect of
the strategy would be to lock in a price close to Rs.1730 per kg. Figure 7.2 gives the payoff for the
buyer of a long hedge. Let us look at how this works. On April 15, the spot price can either be
above Rs.1730 or below Rs.1730.

     1. Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver from the
       spot market. Because April is the delivery month for the futures contract, the futures price on April 15
       should be very close to the spot price of Rs.1780 on that date. The company closes its long
7.1 Hedging                                                                                              91

      futures position at Rs.1780, making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000 on its
      long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT,
      orRs.5,19,000intotal.

   2. Case 2: The spot price is Rs.1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver from the
      spot market. Because April is the delivery month for the futures contract, the futures price on April 15
      should be very close to the spot price of Rs.1690 on that date. The company closes its long futures
      position at Rs.1690, making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on its long
      futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT,
      orRs.5,19,000intotal.

    Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in
the future upfront. In the industrial fabricator example, since prices of silver rose in three months,
on hind sight it would seem that the company would have been better off buying the silver in
January and holding it. But this would involve incurring interest cost and warehousing costs.
Besides, if the prices of silver fell in April, the company would have not only incurred interest and
storage costs, but would also have ended up buying silver at a much higher price.
    In the examples above we assume that the futures position is closed out in the delivery month.
The hedge has the same basic effect if delivery is allowed to happen. However, making or taking
delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps
the futures contract until the delivery month. Hedgers with long positions usually avoid any
possibility of having to take delivery by closing out their positions before the delivery period.


7.1.4 Hedge ratio
Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the
exposure in the underlying asset. So far in the examples we used, we assumed that the hedger
would take exactly the same amount of exposure in the futures contract as in the underlying asset.
For example, if the hedgers exposure in the underlying was to the extent of 11 bales of cotton, the
futures contracts entered into were exactly for this amount of cotton. We were assuming here that
the optimal hedge ratio is one. In situations where the underlying asset in which the hedger has an
exposure is exactly the same as the asset underlying the futures contract he uses, and the spot and
futures market are perfectly correlated, a hedge ratio of one could be assumed. In all other cases, a
hedge ratio of one may not be optimal. Equation 7.1 gives the optimal hedge ratio, one that
minimizes the variance of the hedger's position.


                                                       S
                                                h                                                   (7.1)
                                                       F

   where:

    •  S: Change in spot price, S, during a period of time equal to the life of the hedge
    •  F: Change in futures price, F, during a period of time equal to the life of the hedge
    •  S : Standard deviation of  S
92                                                                              Using commodity futures

     •  R : Standard deviation of  F
     •  : Coefficient of correlation between  S and  F
     • h : Hedge ratio

    Let us consider an example. A company knows that it will require 11,000 bales of cotton in
three months. Suppose the standard deviation of the change in the price per Quintal of cotton over
a three-month period is calculated as 0.032. The company chooses to hedge by buying futures
contracts on cotton. The standard deviation of the change in the cotton futures price over a three-
month period is 0.040 and the coefficient of correlation between the change in price of cotton and
the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit
for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures
contracts should it buy?
    If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, as
shown in Equation 7.3, the hedger would have to buy 1000 units (one unit of trading =11 bales of
cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.


                                                                  11,000
                                    Number of contracts                                                 (7.2)
                                                                    11
                                                      N p 1    1000                                    (7.3)

    However, in this case as shown in Equation 7.5, the hedge ratio works out to be 0.64. The
company will hence require to take a long position in 140 units of cotton futures to get an
effective hedge (Equation 7.7).

                                                                    0.032
                                  Optimal hedge ratio  0.8                                             (7.4)
                                                                    0.040
                                                       h = 640                                           (7.5)

                                                                     11,000
                                Number of contracts        0.64                                        (7.6)
                                                                       11

                                                N p  0.64  640                                         (7.7)


7.1.5 Advantages of hedging
Besides the basic advantage of risk management, hedging also has other advantages:
     1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his
        cattle are ready to market before he can sell them. The futures market permits him to sell futures
        contracts to establish the approximate sale price at any time between the time he buys his calves for
        feeding and the time the fed cattle are ready to market, some four to six months later. He can take
        advantage of good prices even though the cattle are not ready for market.
7.1 Hedging                                                                                                  93

   2. Hedging protects inventory values. For example, a merchandiser with a large, unsold inventory can
      sell futures contracts that will protect the value of the inventory, even if the price of the commodity
      drops.

   3. Hedging permits forward pricing of products. For example, a jewelry manufacturer can determine the
      cost for gold, silver or platinum by buying a futures contract, translate that to a price for the finished
      products, and make forward sales to stores at firm prices. Having made the forward sales, the
      manufacturer can use his capital to acquire only as much gold, silver, or platinum as may be needed to
      make the products that will fill its orders.



7.1.6 Limitation of hedging: basis Risk
In the examples we used above, the hedges considered were perfect. The hedger was able to
identify the precise date in the future when an asset would be bought or sold. The hedger was then
able to use the futures contract to remove almost all the risk arising out of price of the asset on that
date. In reality, hedging is not quite this simple and straightforward. Hedging can only minimise
the risk but cannot fully eliminate it. The loss made during selling of an asset may not always be
equal to the profits made by taking a short futures position. This is because the value of the asset
sold in die spot market and the value of the asset underlying the future contract may not be the
same. This is called the basis risk. In our examples, the hedger was able to identify the precise
date in the future when an asset would be bought or sold. The hedger was then able to use the
perfect futures contract to remove almost all the risk arising out of price of the asset on that date.
In reality, this may not always be possible for a various reasons.


    • The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures
      contract. For example, in India we have a large number of varieties of cotton being cultivated. It is
      impractical for an exchange to have futures contracts with all these varieties of cotton as an
      underlying. The NCDEX has futures contracts on two varieties of cotton, long staple cotton and
      medium staple cotton. If a hedger has an underlying asset that is exactly the same as the one that
      underlies the futures contract, he would get a better hedge. But in many cases, farmers producing
      small staple cotton could use the futures contract on medium staple cotton for hedging. While this
      would still provide the farmer with a hedge, since the price of the farmers cotton and the price of the
      cotton underlying the futures contract do match perfectly, the hedge would not be perfect.

    • The hedger may be uncertain as to the exact date when the asset will be bought or sold. Often the
      hedge may require the futures contract to be closed out well before its expiration date. This could
      result in an imperfect hedge.

    • The expiration date of the hedge may be later than the delivery date of the futures contract. When this
      happens, the hedger would be required to close out the futures contracts entered into and take the same
      position in futures contracts with a later delivery date. This is called a rollover. Hedges can be rolled
      forward many times. However, multiple rollovers could lead to short-term cash flow problems.
94                                                                    Using commodity futures

Table 7.3 Gold futures contract specification
             Trading system           NCDEX trading system
             Trading hours            Monday to Friday
                                      Normal market hours - 10:00 am to 4:00 pm
                                      Closing session - 4:15 pm to 4:30 pm
             Unit of trading          100 gm
             Delivery unit            1kg
             Quotation/ base value    Rs.per 10 gms of gold with 999 fineness
             Tick size                5paisa


7.2 Speculation
An entity having an opinion on the price movements of a given commodity can speculate using
the commodity market. While the basics of speculation apply to any market, speculating in
commodities is not as simple as speculating on stocks in the financial market. For a speculator
who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for
whatever duration he wants to. However, commodities are bulky products and come with all the
costs and procedures of handling these products. The commodities futures markets provide
speculators with an easy mechanism to speculate on the price of underlying commodities.
    To trade commodity futures on the NCDEX, a customer must open a futures trading account
with a commodity derivatives broker. Buying futures simply involves putting in the margin
money. This enables futures traders to take a position in the underlying commodity without having
to to actually hold that commodity. With the purchase of futures contract on a commodity, the
holder essentially makes a legally binding promise or obligation to buy the underlying security at
some point in the future (the expiration date of the contract).
    We look here at how the commodity futures markets can be used for speculation.


7.2.1      Speculation: Bullish commodity, buy futures
Take the case of a speculator who has a view on the direction of the price movements of gold.
Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding
season, the prices of gold are likely to rise. He would like to trade based on this view. Gold trades
for Rs.6000 per 10 gms in the spot market and he expects its price to go up in the next two-three
months. How can he trade based on this belief? In the absence of a deferral product, he would
have to buy gold and hold on to it. Suppose he buys a 1 kg of gold which costs him Rs.6,00,000.
Suppose further that his hunch proves correct and three months later gold trades at Rs.6400 per 10
grms. He makes a profit of Rs.40,000 on an investment of Rs.6,00,000 for a period of three
months. This works out to an annual return of about 26 percent.
    Today a speculator can take exactly the same position on gold by using gold futures contracts.
Let us see how this works. Gold trades at Rs.6000 per 10 gms and three-month gold futures trades
at Rs.6150. Table 7.3 gives the contract specifications for gold futures. The unit of trading
7.3 Arbitrage                                                                                    95

is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. He buys one
kg of gold futures which have a value of Rs.6,15,000. Buying an asset in the futures market only
require making margin payments. To take this position, he pays a margin of Rs.1,20,000. Three
months later gold trades at Rs.6400 per 10 gms. As we know, on the day of expiration, the futures
price converges to the spot price (else there would be a risk-free arbitrage opportunity). He closes
his long futures position at Rs.6400 in the process making a profit of Rs.25,000 on an initial
margin investment of Rs.1,20,000. This works out to an annual return of 83 percent. Because of
the leverage they provide, commodity futures form an attractive tool for speculators.


7.2.2 Speculation: Bearish commodity, sell futures
Commodity futures can also be used by a speculator who believes that there is likely to be excess
supply of a particular commodity in the near future and hence the prices are likely to see a fall.
How can he trade based on this opinion? In the absence of a deferral product, there wasn't much
he could do to profit from his opinion. Today all he needs to do is sell commodity futures.
    Let us understand how this works. Simple arbitrage ensures that the price of a futures contract
on a commodity moves correspondingly with the price of the underlying commodity. If the
commodity price rises, so will the futures price. If the commodity price falls, so will the futures
price. Now take the case of the trader who expects to see a fall in the price of cotton. He sells ten
two-month cotton futures contract which is for delivery of 550 bales of cotton. The value of the
contract is Rs.4,00,000. He pays a small margin on the same. Three months later, if his hunch
were correct the price of cotton falls. So does the price of cotton futures. He close out his short
futures position at Rs.3,50,000, making a profit of Rs.50,000.


7.3 Arbitrage
A central idea in modern economics is the law of one price. This states that in a competitive
market, if two assets are equivalent from the point of view of risk and return, they should sell at
the same price. If the price of the same asset is different in two markets, there will be operators
who will buy in the market where the asset sells cheap and sell in the market where it is costly.
This activity termed as arbitrage, involves the simultaneous purchase and sale of the same or
essentially similar security in two different markets for advantageously different prices. The
buying cheap and selling expensive continues till prices in the two markets reach an equilibrium.
Hence, arbitrage helps to equalise prices and restore market efficiency.


                                        F = (S+U)erT                                           (7.8)

   where:
   r Cost of financing (annualised)

   T Time till expiration
96                                                                               Using commodity futures

     U Present value of all storage costs

    In the chapter on pricing, we discussed that the cost-of-carry ensures that futures prices stay in
tune with the spot prices of the underlying assets. Equation 7.8 gives the fair value of a futures
contract on an investment commodity. Whenever the futures price deviates substantially from its
fair value, arbitrage opportunities arise. To capture mispricings that result in overpriced futures,
the arbitrager must sell futures and buy spot, whereas to capture mispricings that result in
underpriced futures, the arbitrager must sell spot and buy futures. In the case of investment
commodities, mispricing would result in both, buying the spot and holding it or selling the spot
and investing the proceeds. However, in the case of consumption assets which are held primarily
for reasons of usage, even if there exists a mispricing, a person who holds the underlying may not
want to sell it to profit from the arbitrage.


7.3.1        Overpriced commodity futures: buy spot, sell futures
An arbitrager notices that gold futures seem overpriced. How can he cash in on this opportunity to
earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market. Three
month gold futures on the NCDEX trade at Rs.625 and seem overpriced. He could make riskless
profit by entering into the following set of transactions.

     1. On day one, borrow Rs.60,07,460 at 6% per annum to cover the cost of buying and holding gold. Buy
        10 kgs of gold on the cash/ spot market at Rs.60,00,000. Pay (310 + 7150) as warehouse costs. (We
        assume that fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55
        per kg per week for 13 weeks).

     2. Simultaneously, sell 10 gold futures contract at Rs.62,50,000.

     3. Take delivery of the gold purchased and hold it for three months.

     4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

     5. Say gold closes at Rs.615 in the spot market. Sell the gold for Rs.61,50,000.

     6. Futures position expires with profit of Rs. 1,00,000.

     7. From the Rs.62,50,000 held in hand, return the borrowed amount plus interest of Rs.60,98,251.

     8. The result is a riskless profit of Rs.1,51,749.

    When does it make sense to enter into this arbitrage? If the cost of borrowing funds to buy the
commodity is less than the arbitrage profit possible, it makes sense to arbitrage. This is termed as
cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves
trading on the spot and futures market. In the real world, one has to build in the transactions costs
into the arbitrage strategy.
7.3 Arbitrage                                                                                              97

7.3.2 Underpriced commodity futures: buy futures, sell spot
An arbitrager notices that gold futures seem underpriced. How can he cash in on this opportunity
to earn riskless profits? Say for instance, gold trades for Rs.600 per gram in the spot market.
Three month gold futures on the NCDEX trade at Rs.605 and seem underpriced. If he happens to
hold gold, he could make riskless profit by entering into the following set of transactions.
   1. On day one, sell 10 kgs of gold in the spot market at Rs.60,00,000.

   2. Invest the Rs.60,00,000 plus the Rs.7150 saved by way of warehouse costs for three months 6%.

   3. Simultaneously, buy three-month gold futures on NCDEX at Rs.60,50,000.

   4. Suppose the price of gold is Rs.615 per gram. On the futures expiration date, the spot and the futures
      price of gold converge. Now unwind the position.

   5. The gold sales proceeds grow to Rs.60,97,936.

   6. The futures position expires with a profit of Rs. 1,00,000.

   7. Buy back gold at Rs.61,50,000 on the spot market.

   8. The result is a riskless profit of Rs.47,936.

    If the returns you get by investing in riskless instruments is more than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and-carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash-and-carry and
reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well
as the derivatives market.


Solved problems
Q: A speculator thinks that the price of mustard seed will rise. He should _

   1. buy mustard seed futures                              3. sell mustard seed futures

   2. sell mustard seed                                     4. sell index futures

A: The correct answer is number 1.                                                                         ••

Q: A speculator thinks that the price of silver will fall. He should _

   1. buy silver futures                                    3. sell silver futures
   2. buy silver                                            4. sell index futures

A: The correct answer is number 3.                                                                         ••
98                                                                         Using commodity futures

Q: A long hedge should be taken by a person who

     1. Wants to buy the underlying asset in the fu-    3. Expects to own the underlying asset in the
        future.                                         ture
     2. Sell the underlying asset in the future         4. None of the above

A: The correct answer is number 1.                                                                   ••




Q: A short hedge should be taken by a person who

     1. Wants to buy the underlying asset in the fu-    3. Wants to sell the underlying asset
        today. ture.
     2. Wants to sell the underlying asset in the future. 4. None of the above

A: The correct answer is number 2.                                                                   ••




Q: A farmer who has just sown wheat can hedge his position by _

     1. buying wheat futures                            3. buying index futures
     2. selling wheat futures                           4. selling the wheat

A: The correct answer is number 2.                                                                   ••




Q: On the 15th of January a refined soy oil producer has negotiated a contract to sell 10,000 Kgs
of soy oil. It has been agreed that the price that will apply in the contract is the market price on the
15th April. The spot price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil
futures price on the NCDEX is Rs.465 per 10 Kgs. Unit of trading in soy oil futures is 1000 Kgs
(=1 MT) and the delivery unit is 10000 Kgs (=10 MT). The producer can hedge his exposure by

     1. Selling 10 units of April futures.              3. Selling 100 units of April futures.
     2. Buying 10 units of April futures.               4. Buying 100 units of April futures.

A: The producer needs to take a short hedge to the extent of 10,000 Kgs of soy oil. One trading
unit is for 1000 Kgs of soy oil. He gets the hedge by selling 10 units of April futures. The correct
answer is number 1.
7.3 Arbitrage                                                                                        99

Q: On the 15th of January a firm involved in industrial fabrication knows that it will require 300
kgs of silver on April 15 to meet a certain contract. The spot price of silver is Rs.1680 per kg and
the April silver futures price is Rs. 1730. A unit of trading is 5 Kgs and the delivery unit is 30
Kgs. The fabricator can hedge his position by

   1. Selling 60 units of April silver futures.       3. Buying 30 units of April silver futures.
   2. Buying 60 units of April silver futures.        4. Selling 30 units of April silver futures.

A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. One trading unit is
for 5 Kgs of silver. He gets the hedge by selling 60 units of April silver futures. The correct
answer is number 2.


Q: A company knows that it will require 33,000 bales of cotton in three months. The hedge ratio
works out to be 0.85. The unit of trading is 11 bales and the delivery unit for cotton on the
NCDEX is 55 bales. The company can obtain a hedge by

   1. Buying 2550 units of three-month cotton fu-     3. Buying 2550 units of three-month cotton
      futures.                                        tures.
   2. Selling 2550 units of three-month cotton fu-    4. Selling 600 units of three-month cotton
      futures.                                        tures.

A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a
hedge by
         33,000
Buying           0.85 units of futures. The correct answer is number 3.                             ••
           11



Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three-month gold futures trade at
Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the
NCDEX is 1 kg. A speculator who expects gold prices to rise in the near future buys 10 units of
gold futures. Two months later gold futures trade at Rs.6400 per 10 gms. He makes a profit/loss
of

   1. (+)2,500                                        3. (+)25,000
   2. (-)2,500                                        4. (-)25,000

A: One unit of trading is 100 gms. He is long 10 units of futures, or 1000 grms of gold. He makes
                                                                   250
a profit of Rs.250 per 10 gms. His total profit from the position      1000. The correct answer is
                                                                   10
number 3. • •
100                                                                      Using commodity futures

Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three-month gold futures trade at
Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the
NCDEX is 1 kg. A speculator who expects gold prices to fall in the near future sells 10 units of
gold futures. Two months later gold futures trade at Rs.6000 per 10 gms. He makes a profit/loss
of

   1. (+)1,500                                         3. (-)15,000
   2. (-)1,500                                         4. (+)15,000

A: One unit of trading is 100 gms. He is short 10 units of futures, or 1000 grms of gold. He makes
a profit

                                                              150
of Rs.150 per 10 gms. His total profit from the position is        1000. The correct answer is
                                                              10
number 4.
Chapter 8
Trading

In this chapter we shall take a brief look at the trading system for futures on NCDEX. However,
the best way to get a feel of the trading system is to actually watch the screen and observe how it
operates.


8.1 Futures trading system
The trading system on the NCDEX, provides a fully automated screen-based trading for futures on
commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It
supports an order driven market and provides complete transparency of trading operations. The
trade timings on the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been
proposed for implementation at a later stage.
    The NCDEX system supports an order driven market, where orders match automatically.
Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity
fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery
unit for futures contracts on various commodities . The exchange notifies the regular lot size and
tick size for each of the contracts traded from time to time. When any order enters the trading
system, it is an active order. It tries to find a match on the other side of the book. If it finds a
match, a trade is generated. If it does not find a match, the order becomes passive and gets queued
in the respective outstanding order book in the system. Time stamping is done for each trade and
provides the possibility for a complete audit trail if required.


8.2 Entities in the trading system
There are two entities in the trading system of NCDEX - trading cum clearing members and
professional clearing members.

   1. Trading cum clearing members (TCMs): Trading cum clearing members are members of NCDEX.
      They can trade and clear either on their own account or on behalf of their clients including
      participants. The exchange assigns an ID to each TCM. Each TCM can have more than one user. The
      number of users allowed for each trading member is notified by the exchange from time to time.
102                                                                                                Trading


 While most exchanges the world over are moving towards the electronic form of trading, some
 still follow the open outcry method. Open outcry trading is a face—to-face and highly activate
 form of trading used on the floors of the exchanges. In open outcry system the futures contracts
 are traded in pits. A pit is a raised platform in octagonal shape with descending steps on the
 inside that permit buyers and sellers to see each other. Normally only one type of contract is
 traded in each pit like a Eurodollar pit, Live Cattle pit etc. Each side of the octagon forms a pie
 slice in the pit. All the traders dealing with a certain delivery month trade in the same slice. The
 brokers, who work for institutions or the general public stand on the edges of the pit so that
 they can easily see other traders and have easy access to their runners who bring orders.
 The trading process consists of an auction in which all bids and offers on each of the contracts
 are made known to the public and everyone can see the market's best price. To place an order
 under this method, the customer calls a broker, who time-stamps the order and prepares an
 office order ticket. The broker then sends the order to a booth on the exchange floor called
 broker's floor booth. There, a floor order ticket is prepared, and a clerk hand delivers the order
 to the floor trader for execution. In some cases, the floor clerk may use hand signals to convey
 the order to floor traders. Large orders typically go directly from the customer to the broker's
 floor booth. The floor trader, standing in a central location i.e. trading pit, negotiates a price by
 shouting out the order to other floor traders, who bid on the order using hand signals. Once
 filled, the order is recorded manually by both parties in the trade. At the end of each day, the
 clearing house settles trades by ensuring that no discrepancy exists in the matched-trade
 information.

                             Box 8.10: The open outcry system of trading


      Each user of a TCM must be registered with the exchange and is assigned an unique user ID. The
      unique TCM ID functions as a reference for all orders/ trades of different users. This ID is common
      for all users of a particular TCM. It is the responsibility of the TCM to maintain adequate control over
      persons having access to the firm's User IDs.

   2. Professional clearing members: Professional clearing members are members of NSCCL. The PCM
      membership entitles the members to clear trades executed through Trading cum Clearing Members
      (TCMs), both for themselves and/ or on behalf of their clients. They carry out risk management
      activities and confirmation/ inquiry of trades through the trading system.


8.2.1      Guidelines for allotment of client code
The trading members are recommended to follow guidelines outlined by the exchange for
allotment and use of client codes at the time of order entry on the futures trading system:
   1. All clients trading through a member are to be registered clients at the member's back office.

   2. A unique client code is to be allotted for each client. The client code should be alphanumeric and no
      special characters can be used.

   3. The same client should not be allotted multiple codes.
8.3 Contract specifications for commodity futures                                              103

Table 8.1 Commodity futures contract and their symbols
        1. Pure Gold Mumbai                                     GLDPURMUM
        2. Pure Silver New Delhi                                SLVPURDEL
        3. Soybean Indore                                       SYBEANIDR
        4. Refined Soya Oil Indore                              SYOREFTDR
        5. Rapeseed Mustard Seed Jaipur                         RMSEEDJPR
        6. Expeller Rapeseed Mustard Oil Jaipur                 RMOEXPJPR
        7. RBD Palm Olein Kakinada                              RBDPLNKAK
        8. Crude Palm Oil Kandla                                CRDPOLKDL
        9. J34 Medium Staple Cotton Bhatinda                    COTJ34BTD
        10. S06 L S Cotton Ahmedabad                            COTS06ABD




8.3 Contract specifications for commodity futures

NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market
Commission) but in a phased manner. In the first phase, under the category of bullion, it has
already started trading in gold and silver, and in agri commodities, trading has commenced in
cotton (long and medium staple), soybean, soya oil, rape/ mustardseed, rape/ mustard oil, crude
palm oil and RBD palmolein.
   In the second phase NCDEX plans to offer the following commodities for trading - rice,
wheat, coffee, tea. edible oil products like groundnut, sunflower, castor (seed, oil and cake), base
metals (aluminium, copper, zinc and nickel) and commodity indices like agri commodity index
and metal commodity index.
    Table 8.1 gives the list and symbols of underlying commodities on which futures contracts are
available. Table 8.2 and Table 8.3 give the futures contract specifications for gold and long staple
cotton.




8.4 Commodity futures trading cycle

NCDEX trades commodity futures contracts having one-month, two-month and three-month
expiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration
contract would expire on the 20th of January and a February expiry contract would cease trading
on the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall
expire on the previous trading day. New contracts will be introduced on the trading day following
the expiry of the near month contract. Figure 8.1 shows the contract cycle for futures contracts on
NCDEX.
104                                                                                     Trading

Table 8.2 Gold futures contract specification

      Trading system            NCDEX trading system
      Trading hours             Monday to Friday
                                Normal market hours - 10:00 am to 4:00 pm
                                Closing session - 4:15 pm to 4:30 pm
      Unit of trading           100 gms
      Delivery unit             lKg
      Quotation/ base value     Rs. per 10 gms of Gold with 999.9
                                fineness (called "Pure Gold" in trade circles)
      Tick size                 5 paisa
      Price band                Limit 10%. Limits will not apply if the limit is
                                reached during final 30 minutes of trading.
      Quality specification     Not less than 995 fineness bearing a serial
                                number and identifying stamp of a refiner
                                approved by NCDEX. List of approved
                                refiners will be available with the
                                exchange and also on its web site:
                                www.ncdex.com
      Quantity variation        None
      No. of active contracts   At any date, 3 concurrent month contracts
                                will be active. There will be a total of
                                twelve month contracts in a year.
      Delivery center           Mumbai
      Opening date              Trading in any contract month will open on
                                the 21st day of the month, 3 months prior
                                to the contract month i.e. January 2004
                                contract opens on 21st October 2003.
      Due date                  20th day of the delivery month, if 20th
                                happens to be a holiday then previous
                                working day.
      Position limits           Member-wise: Max (Rs.200 crore, 15% of open interest)
                                Client-wise: Max (Rs.100 crore, 10% of Open interest)
      Premium/ Discount         The discount will be given for the fineness
                                below 999.9. The settlement price for less
                                than 999.9 fineness will be calculated as:
                                (Actual fineness/ 999.9) * Settlement price




8.5 Order types and trading parameters
An electronic trading system allows the trading members to enter orders with various conditions
attached to them as per their requirements. These conditions are broadly divided into the
8.5 Order types and trading parameters                                                 105


Table 8.3 Long staple cotton futures contract specification
    Trading system              NCDEX trading system
    Trading hours               Monday to Friday
                                Normal market hours - 10:00 am to 4:00 pm
                                Closing session - 4:15 pm to 4:30 pm
    Unit of trading             18.7 Quintal (=11 bales)
    Delivery unit               93.5 Quintals (=55 bales)
    Quotation/ base value       Rs. per Quintal
    Tick size                   5paisa
    Price band                  Limit 10%. Limits will not apply if the limit is
                                reached during final 30 minutes of trading.
    Quality specification       Main/ Base Variety: Shankar-6
                                Staple Length: 27-30 mm (Basis: 29 mm)
                                Micronaire: 3.4-4.5 (Basis: 3.7-4.2)
                                Strength, Min: 21 G/ Tex
                                Grade: 'Good to Fully Good', 'Fully Good', 'Fine',
                                'Superfine', 'Extra Superfine', (Basis: 'Fine')
                                Crop: Current Year Crop in which the
                                delivery date falls (current year for
                                Shankar-6 is defined as from 1st Nov of
                                one year to 31st Oct of the subsequent
                                year), Moisture, % Max: 8.5

    No. of active contracts     At any date, 3 concurrent month contracts
                                will be active. There will be a total of
                                twelve month contracts in a year.
    Delivery center             Ahmedabad
    Opening date                Trading in any contract month will open on
                                the 21st day of the month, 3 months prior
                                to the contract month i.e. January 2004
                                contract opens on 21st October 2003.
    Due date                    20th day of the delivery month, if 20th
                                happens to be a holiday then previous
                                working day.
    Position limits             Member-wise: Max (Rs.40 crore, 15% of open interest)
                                Client-wise: Max (Rs.20 crore, 10% of Open interest)
    Premium/ Discount           Will be given on the basis of Staple
                                Length (at 0.5 mm intervals) & grade
                                combinations. The exchange will
                                communicate the premium/ discounts
                                applicable before the settlement date.
106                                                                                              Trading

Figure 8.1 Contract cycle
The figure shows the contract cycle for futures contracts on NCDEX. As can be seen, at any given
point of time, three contracts are available for trading - a near-month, a middle-month and a far-
month. As the January contract expires on the 20th of the month, a new three-month contract
starts trading from the following day, once more making available three index futures contracts for
trading.




following categories:
      • Time conditions

      • Price conditions

      • Other conditions

    Several combinations of the above are possible thereby providing enormous flexibility to
users. The order types and conditions are summarised below. Of these, the order types available
on the NCDEX system are regular lot order, stop loss order, immediate or cancel order, good till
day order, good till cancelled order, good till date order and spread order.

      • Time conditions
           - Good till day order: A day order, as the name suggests is an order which is valid for the day on
             which it is entered. If the order is not executed during the day, the system cancels the order
             automatically at the end of the day. Example: A trader wants to go long on March 1, 2004 in
             refined palm oil on the commodity exchange. A day order is placed at Rs.340/ 10 kg. If the
             market does not reach this price the order does not get filled even if the market touches Rs.341
             and closes. In other words day order is for a specific price and if the order does not get filled
             that day, one has to place the order again the next day.
           - Good till cancelled (GTC): A GTC order remains in the system until the user cancels it.
              Consequently, it spans trading days, if not traded on the day the order is entered. The maximum
              number of days an order can remain in the system is notified by the exchange from time to time
              after which the order is automatically cancelled by the system. Each day counted is a calendar
              day inclusive of holidays. The days counted are inclusive of the day on which the order is
8.5 Order types and trading parameters                                                                       107

          placed and the order is cancelled from the system at the end of the day of the expiry period.
          Example: A trader wants to go long on refined palm oil when the market touches Rs.400/ 10kg.
          Theoritically, the order exists until it is filled up, even if it takes months for it to happen. The
          GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from the
          date of entering an order or when the contract expires, whichever is earlier.
        - Good till date (GTD): A GTD order allows the user to specify the date till which the order
          should remain in the system if not executed. The maximum days allowed by the system are the
          same as in GTC order. At the end of this day/ date, the order is cancelled from the system. Each
          day/ date counted are inclusive of the day/ date on which the order is placed and the order is
          cancelled from the system at the end of the day/ date of the expiry period.
        - Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as
          the order is released into the system, failing which the order is cancelled from the system. Partial
          match is possible for the order, and the unmatched portion of the order is cancelled immediately.
        - All or none order: All or none order (AON) is a limit order, which is to be executed in its
          entirety, or not at all. Unlike a fill-or-kill order, an all-or-none order is not cancelled if it is not
          executed as soon as it is represented in the exchange. An all-or-none order position can be
          closed out with another AON order.
        - Fill or kill order: This order is a limit order that is placed to be executed immediately and if the
          order is unable to be filled immediately, it gets cancelled.

   • Price condition

        - Limit order: An order to buy or sell a stated amount of a commodity at a specified price, or at a
          better price, if obtainable at the time of execution. The disadvantage is that the order may not get
          filled at all if the price for that day does not reach the specified price.
        - Stop-loss: A stop-loss order is an order, placed with the broker, to buy or sell a particular futures
          contract at the market price if and when the price reaches a specified level. Futures traders often
          use stop orders in an effort to limit the amount they might lose if the futures price moves against
          their position. Stop orders are not executed until the price reaches the specified point. When the
          price reaches that point the stop order becomes a market order. Most of the time, stop orders are
          used to exit a trade. But, stop orders can be executed for buying/ selling positions too. A buy
          stop order is initiated when one wants to buy a contract or go long and a sell stop order when
          one wants to sell or go short. The order gets filled at the suggested stop order price or at a better
          price. Example: A trader has purchased crude oil futures at Rs.750 per barrel. He wishes to limit
          his loss to Rs.50 a barrel. A stop order would then be placed to sell an offsetting contract if the
          price falls to Rs 700 per barrel. When the market touches this price, stop order gets executed and
          the trader would exit the market. For the stop-loss sell order, the trigger price has to be greater
          than the limit price.

   • Other conditions

        - Market price: Market orders are orders for which no price is specified at the time the order is
          entered (i.e. price is market price). For such orders, the system determines the price. Only the
          position to be taken long/ short is stated. When this kind of order is placed, it gets executed
          irrespective of the current market price of that particular asset.
108                                                                                               Trading


 After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange).
 Called Globex, this was introduced to meet the needs of an increasingly integrated global
 economy and to have an access to the currency price protection around the clock. Typically
 electronic trading systems are used in the open outcry exchanges after the day trading is over.

                           Box 8.11: After hours electronic trading system


         - Market on open: The order will be executed on the market open within the opening range. This
           trade is used to enter a new trade, or exit an open trade.
         - Market on close: The order will be executed on the market close. The fill price will be within
           the closing range, which may, in some markets, be substantially different from the setdement
           price. This trade is also used to enter a new trade, or exit an open trade.
         - Trigger price: Price at which an order gets triggered from the stop-loss book.
         - Limit price: Price of the orders after triggering from stop-loss book.
         - Spread order: A simple spread order involves two positions, one long and one short. They are
           taken in the same commodity with different months (calendar spread) or in closely related
           commodities. Prices of the two futures contract therefore tend to go up and down together, and
           gains on one side of the spread are offset by losses on the other. The spreaders goal is to profit
           from a change in the difference between the two futures prices. The trader is virtually
           unconcerned whether the entire price structure moves up or down, just so long as the futures
           contract he bought goes up more (or down less) than the futures contract he sold.
         - One cancels the other order : It is called one cancels the other order (OCO). An order placed so
           as to take advantage of price movement, which consists of both a stop and a limit price. Once
           one level is reached, one half of the order will be executed (either stop or limit) and the
           remaining order cancelled (either limit or stop). This type of order would close the position if
           the market moved to either the stop rate or the limit rate, thereby closing the trade and at the
           same time, cancelling the other entry order. Example: A trader has a buy position at Rs. 14,000/
           tonne on Soybean. He wishes to have both stop and limit orders in order to fill the order in a
           particular price range. A stop order is placed at Rs. 14,100/ tonne and a limit order at Rs.13,900/
           tonne. If the market trades at Rs.13,900/ tonne, the limit order gets filled and the stop order is
           immediately gets cancelled. The trader exits the market at Rs.13,900/ tonne.


8.5.1 Permitted lot size
The permitted trading lot size for the futures contracts on individual commodities is stipulated by
the exchange from time to time. The lot size currently applicable on individual commodity
contracts is given in Table 8.5


8.5.2 Tick size for contracts
The tick size is the smallest price change that can occur for the trades on the exchange. The tick
size in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise.
8.5 Order types and trading parameters                                                            109

Table 8.4 Commodity futures: Quantity freeze unit
             Instrument       Asset               Quantity
             Type Asset       Symbol              Freeze Unit

                FUTCOM            GLDPURMUM            30,000 Grams (gm)
                FUTCOM            SLVPURDEL            1,500 kilograms (Kgs)
                FUTCOM            SYBEANTDR            300 Metric Tonnes (MT)
                FUTCOM            SYOREFIDR            300 Metric Tonnes (MT)
                FUTCOM            RMSEEDJPR            300 Metric Tonnes (MT)
                FUTCOM            RMOEXPJPR            300 Metric Tonnes (MT)
                FUTCOM            RBDPLNKAK            300 Metric Tonnes (MT)
                FUTCOM            CRDPOLKDL            300 Metric Tonnes (MT)
                FUTCOM            COTJ34BTD            3,300 Bales
                FUTCOM            COTS06ABD            3,300 Bales




8.5.3 Quantity freeze
All orders placed by members have to be witiiin the quantity specified by the exchange in this
regard. Any order exceeding tiiis specified quantity will not be executed but will he pending with
the exchange as a quantity freeze. Table 8.4 gives the quantity freeze for each commodity
contract. In respect of orders which have come under quantity freeze, the member is required to
confirm to the exchange that there is no inadvertent error in the order entry and mat the order is
genuine. On such confirmation, the exchange can approve such order. However, in exceptional
cases, the exchange may, at its discretion, not allow the orders that have come under quantity
freeze for execution for any reason whatsoever including non-availability of exposure limits.


8.5.4 Base price
On introduction of new contracts, the base price is the previous days' closing price of the
underlying commodity in the prevailing spot markets. These spot prices are polled across multiple
centers and a single spot price is determined by the bootstrapping method. The base price of me
contracts on all subsequent trading days is the daily settlement price of the futures contracts on the
previous trading day.


8.5.5 Price ranges of contracts
In order to prevent erroneous order entry by trading members, operating price ranges on the
NCDEX are kept at +/- 10% from the base price. Orders exceeding me range specified are not
executed and he pending with the exchange as a price freeze. In respect of orders which have
come under price freeze, the members are required to confirm to the exchange that there is no
inadvertent error in the order entry and mat the order is genuine. The exchange can approve or
110 ___________________________________________________________________ Trading

disapprove such orders solely at its own discretion. Unless specifically notified by the exchange,
there will be no price ranges applicable in the last half hour of normal market trading.


8.5.6 Order entry on the trading system
The NCDEX trading system has a set of function keys built into the trading front-end. These keys
have been provided to facilitate faster operation of the system and enable quicker trading on the
system. The function keys can be operated from the keyboard of the user. The set of function keys
enable the following:
   • Buy open

   • Sell open

   • Order cancellation

   • Order modification

   • Exercise/ Position liquidation

   • Outstanding orders

   • Quick order cancel

   • Spread order entry

   • Market watch setup

   • Trade modify

   • Trade cancel

   • Client master maintenance

   • Market by order

   • Market by price

   • Activity log

   • Security list/ portfolio setup

   • Portfolio offline order entry

   • Spread market by price

   • Previous trades

   • Contract description

   • Alphabetical sorting of contracts
8.5 Order types and trading parameters                                                  111

Table 8.5 Commodity futures: Lot size and other parameters
    Instrument Asset               Market Quantity Price            Delivery Delivery
    Type Asset Symbol                   Lot Unit       Unit              Lot Unit

    FUTCOM        GLDPURMUM           100   GM       Rs./ 10 GM            1   KG
    FUTCOM        SLVPURDEL             5   Kg       Rs./Kg               30   KG
    FUTCOM        SYBEANIDR             1   MT       Rs./ Quintal         10   MT
    FUTCOM        SYOREFIDR             1   MT       Rs./ 10 Kg           10   MT
    FUTCOM        RMSEEDJPR             1   MT       Rs./20Kg             10   MT
    FUTCOM        RMOEXPJPR             1   MT       Rs./ 10 Kg           10   MT
    FUTCOM        RBDPLNKAK             1   MT       Rs./ 10 Kg           10   MT
    FUTCOM        CRDPOLKDL             1   MT       Rs./ 10 Kg           10   MT
    FUTCOM        COTJ34BTD            11   Bales    Rs./ Quintal         55   Bales
    FUTCOM        COTS06ABD            11   Bales    Rs./ Quintal         55   Bales




   • Spread order status

   • Spread activity log

   • Snap quote

   • Online offline order entry

   • Message log

   • Market movement

   • Full message display

   • Market inquiry

   • Spread outstanding orders

   • Net position upload

   • Order status

   • Liquidity schedule

   • Buy close

   • Sell close
112                                                                                                     Trading

8.6 Margins for trading in futures
Margin is the deposit money that needs to be paid to buy or sell each contract. The margin
required for a futures contract is better described as performance bond or good faith money. The
margin levels are set by the exchanges based on volatility (market conditions) and can be changed
at any time. The margin requirements for most futures contracts range from 2% to 15% of the
value of the contract.
    In the futures market, there are different types of margins that a trader has to maintain. We
will discuss them in more details when we talk about risk management in the next chapter. At this
stage we look at the types of margins as they apply on most futures exchanges.


      • Initial margin: The amount that must be deposited by a customer at the time of entering into a contract
        is called initial margin. This margin is meant to cover the largest potential loss in one day. The margin
        is a mandatory requirement for parties who are entering into the contract.

      • Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of
        the initial margin. To ensure that the balance in the margin account never becomes negative, a
        maintenance margin, which is somewhat lower than the initial margin, is set. If the balance in the
        margin account falls below the maintenance margin, the trader receives a margin call and is requested
        to deposit extra funds to bring it to the initial margin level within a very short period of time. The
        extra funds deposited are known as a variation margin. If the trader does not provide the variation
        margin, the broker closes out the position by offsetting the contract.

      • Additional margin: In case of sudden higher than expected volatility, the exchange calls for an
        additional margin, which is a preemptive move to prevent breakdown. This is imposed when the
        exchange fears that the markets have become too volatile and may result in some payments crisis, etc.

      • Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted to
        reflect the trader's gain or loss. This is known as marking to market the account of each trader. All
        futures contracts are settled daily reducing the credit exposure to one day's movement. Based on the
        settlement price, the value of all positions is marked-to-market each day after the official close. i.e. the
        accounts are either debited or credited based on how well the positions fared in that day's trading
        session. If the account falls below the maintenance margin level the trader needs to replenish the
        account by giving additional funds. On the other hand, if the position generates a gain, the funds can
        be withdrawn (those funds above the required initial margin) or can be used to fund additional trades.


    Just as a trader is required to maintain a margin account with a broker, a clearing house
member is required to maintain a margin account with the clearing house. This is known as
clearing margin. In the case of clearing house member, there is only an original margin and no
maintenance margin. Clearing house and clearing house margins have been discussed further in
detail under the chapter on clearing and settlement.
8.7 Charges                                                                                               113

8.7 Charges
Members are liable to pay transaction charges for the trade done through the exchange during the
previous month. The important provisions are listed below: The billing for the all trades done
during the previous month will be raised in the succeeding month.

    1. Rate of charges: The transaction charges are payable at the rate of Rs.6 per Rs.one Lakh trade done.
       This rate is subject to change from time to time.

    2. Due date: The transaction charges are payable on the 7th day from the date of the bill every month in
       respect of the trade done in the previous month.

    3. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to
       collect the transaction charges through Electronic Clearing System.

    4. Registration with BJPL and their services: Members have to fill up the mandate form and submit
       the same to NCDEX. NCDEX then forwards the mandate form to BJPL. BJPL sends the log-in ID
       and password to the mailing address as mentioned in the registration form. The members can then
       log on through the website of BJPL and view the billing amount and the due date. Advance email
       intimation is also sent to the members. Besides, the billing details can be viewed on the website upto
       a maximum period of 12 months.

    5. Adjustment against advances transaction charges: In terms of the regulations, members are required
       to remit Rs.50,000 as advance transaction charges on registration. The transaction charges due first
       will be adjusted against the advance transaction charges already paid as advance and members need to
       pay transaction charges only after exhausting the balance lying in advance transaction.

    6. Penalty for delayed payments: If the transaction charges are not paid on or before the due date, a penal
       interest is levied as specified by the exchange.


    Finally, the futures market is a zero sum game i.e. the total number of long in any contract
always equals the total number of short in any contract. The total number of outstanding contracts
(long/ short) at any point in time is called the "Open interest". This Open interest figure is a good
indicator of the liquidity in every contract. Based on studies carried out in international
exchanges, it is found that open interest is maximum in near month expiry contracts.


Solved Problems
Q: The trading system on the NCDEX, does not provide

    1. A fully automated screen-based trading.              3. Online monitoring and surveillance
    mechanism.
    2. Trading on a nationwide basis.                       4. Trading by open-outcry

A: The correct answer is number 4.
                                                                                                            »
»
114 ____________________________________________________________________ Trading

Q: Order matching on the NCDEX happens on the basis of

   1. Commodity                                        3. Quantity
   2. Price and time                                   4. All of the above

A: Correct answer is number 4.                                                             ••



Q: COTS06ABD is the symbol for

   1. Medium staple cotton Bhatinda                    3. Small staple cotton Aurangabad
   2. Long staple cotton Ahmedabad                     4. None of the above

A: The correct answer is number 2.                                                         ••



Q: Initial margin is meant to cover the largest potential loss over a

   1. One day horizon                                  3. One hour horizon
   2. One week horizon                                 4. One month horizon

A: The correct answer is number 1.                                                         ••



Q: NCDEX does not trade commodity futures contracts having __ expiry cycles

   1. One-month                                        3. Three-month

   2. Two-month                                        4. Six-month

A: The correct answer is number 4.                                                         ••



Q: Billing to members for the all trades done on the NCDEX will be raised

   1. At the end of each day.                          3. At the end of each week.
   2. In the succeeding month.                         4. Once every two weeks.

A: The correct answer is number 2.                                                         ••
8.7 Charges                                                                                                  115

Q: A trader buys 10 units of gold futures at Rs.6,500 per 10 gms. What is the value of his open
long position? Unit of trading is 100 gms and delivery unit is one Kg

   1. Rs.6,50,000                                            3. Rs.6,500

   2. Rs.65,000                                             4. Rs.65,00,000

A: One trading unit is for 100 gms. He has bought 10 units. The value of his long gold futures
             5,500            
position is         100  10. The correct aanswer is number 1.
             10               

Q: A trader sells 20 units of gold futures at Rs.7,100 per 10 gms. What is the value of his open long
position? Unit of trading is 100 gms and delivery unit is one Kg

   1. Rs.1,42,000                                            3. Rs.1,420

   2. Rs. 14,200                                            4. Rs. 14,20,000

A: One trading unit is for 100 gms. He has bought 20 units. The value of his long gold futures position is

 7,100           
        100  20. The correct answer is number 4.
 10              

Q: A trader requires to take a long gold futures position worth Rs. 10,00,000 as part of his hedging strategy.
Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg.
Roughly how many units must he purchase to give him the hedge?

   1. 10 units                                               3. 14 units

   2. 20 units                                              4. 28 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. He has
                     10,00,000
to take a position             , i.e. in 1428.57 gms of gold gms. He has to buy 14 units of gold futures
                        700
contracts. The correct answer is number 3.                                                                    ••


Q: A trader requires to take a long gold futures position worth Rs.7,00,000 as part of his hedging strategy.
Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg.
How many units must he purchase to give him the hedge?

   1. 10 units                                               3. 1,000 units

   2. 100 units                                             4. 10,000 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To take
a position in 1000 gms of gold he has to buy 10 units of gold futures contracts. The correct answer is
number 1.                                                                                          ••
116 ___________________________________________________________________ Trading

Q: A trader requires to take a short gold futures position worth Rs.7,00,000 as part of his hedging
strategy. Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery
unit is one Kg. How many units must he sell to give him the hedge?

   1. 10 units                                        3. 1,000 units
   2. 100 units                                       4. 10,000 units

A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To
take a position in 1000 gms of gold he has to sell 10 units of gold futures contracts. The correct
answer is number 1.                                                                             ••
Chapter 9
Clearing and settlement

Most futures contracts do not lead to the actual physical delivery of the underlying asset. The
settlement is done by closing out open positions, physical delivery or cash settlement. All these
settlement functions are taken care of by an entity called clearing house or clearing corporation.
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades
executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX.


9.1     Clearing
Clearing of trades that take place on an exchange happens through the exchange clearing house. A
clearing house is a system by which exchanges guarantee the faithful compliance of all trade
commitments undertaken on the trading floor or electronically over the electronic trading systems.
The main task of the clearing house is to keep track of all the transactions that take place during a
day so that the net position of each of its members can be calculated. It guarantees the
performance of the parties to each transaction. Typically it is responsible for the following:
   1. Effecting timely settlement.

   2. Trade registration and follow up.

   3. Control of the evolution of open interest.

   4. Financial clearing of the payment flow.

   5. Physical settlement (by delivery) or financial settlement (by price difference) of contracts.

   6. Administration of financial guarantees demanded by the participants.

     The clearing house has a number of members, who are mostly financial institutions
responsible for the clearing and settlement of commodities traded on the exchange. The margin
accounts for the clearing house members are adjusted for gains and losses at the end of each day
(in the same way as the individual traders keep margin accounts with the broker). On the NCDEX,
in the case of clearing house members only the original margin is required (and
118                                                                    Clearing and settlement

not maintenance margin). Everyday the account balance for each contract must be maintained at
an amount equal to the original margin times the number of contracts outstanding. Thus depending
on a day's transactions and price movement, the members either need to add funds or can
withdraw funds from their margin accounts at the end of the day. The brokers who are not the
clearing members need to maintain a margin account with the clearing house member through
whom they trade in the clearing house


9.1.1 Clearing mechanism
Only clearing members including professional clearing members (PCMs) are entitled to clear and
settle contracts through the clearing house.
    The clearing mechanism essentially involves working out open positions and obligations of
clearing members. This position is considered for exposure and daily margin purposes. The open
positions of PCMs are arrived at by aggregating the open positions of all the TCMs clearing
through him, in contracts in which they have traded. A TCM's open position is arrived at by the
summation of his clients' open positions, in the contracts in which they have traded. Client
positions are netted at the level of individual client and grossed across all clients, at the member
level without any set-offs between clients. Proprietary positions are netted at member level
without any set-offs between client and proprietary positions.
    At NCDEX, after the trading hours on the expiry date, based on the available information, the
matching for deliveries takes place firstly, on the basis of locations and men randomly, keeping in
view the factors such as available capacity of the vault/ warehouse, commodities already
deposited and dematerialized and offered for delivery etc. Matching done by this process is
binding on the clearing members. After completion of the matching process, clearing members are
informed of the deliverable/ receivable positions and the unmatched positions. Unmatched
positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as
determined on the basis of final settlement price.


9.1.2 Clearing banks
NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must
be settled. Every clearing member is required to maintain and operate a clearing account with any
one of the designated clearing bank branches. The clearing account is to be used exclusively for
clearing operations i.e., for settling funds and other obligations to NCDEX including payments of
margins and penal charges. A clearing member can deposit funds into this account, but can
withdraw funds from this account only in his self-name. A clearing member having funds
obligation to pay is required to have clear balance in his clearing account on or before the
stipulated pay-in day and the stipulated time. Clearing members must authorise their clearing bank
to access their clearing account for debiting and crediting their accounts as per the instructions of
NCDEX, reporting of balances and other operations as may be required by NCDEX from time to
time. The clearing bank will debit/ credit the clearing account of clearing members as per
instructions received from NCDEX. The following banks have been designated
9.2 Settlement                                                                                           119

as clearing banks - ICICI Bank Limited, Canara Bank, UTI Bank Limited and HDFC Bank
Limited.


9.1.3 Depository participants
Every clearing member is required to maintain and operate a CM pool account with any one of the
empanelled depository participants. The CM pool account is to be used exclusively for clearing
operations i.e., for effecting and receiving deliveries from NCDEX.


9.2 Settlement
Futures contracts have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last trading
day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in
respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing
accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward,
created during the day or closed out during the day, are marked to market at the daily settlement
price or the final settlement price at the close of trading hours on a day.

   • Daily settlement price: Daily settlement price is the consensus closing price as arrived after closing
     session of the relevant futures contract for the trading day. However, in the absence of trading for a
     contract during closing session, daily settlement price is computed as per the methods prescribed by
     the exchange from time to time.

   • Final settlement price: Final settlement price is the closing price of the underlying commodity on the
      last trading day of the futures contract. All open positions in a futures contract cease to exist after its
      expiration day.


9.2.1      Settlement mechanism
Settlement of commodity futures contracts is a little different from settlement of financial futures
which are mostly cash settled. The possibility of physical settlement makes the process a little
more complicated.

Daily mark to market settlement
Daily mark to market settlement is done till the date of the contract expiry. This is done to take
care of daily price fluctuations for all trades. All the open positions of the members are marked to
market at the end of the day and the profit/ loss is determined as below:
   • On the day of entering into the contract, it is the difference between the entry value and daily
     settlement price for that day.

   • On any intervening days, when the member holds an open position, it is the difference between the
      daily settlement price for that day and the previous day's settlement price.
120                                                                            Clearing and settlement

Table 9.1 MTM on a long position in cotton futures
A clearing member buys one December expiration long staple cotton futures contract at Rs.6435 per Quintal
on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The
member closes the position on December 19. The MTM profits/ losses get added/ deducted from his initial
margin on a daily basis.


                                 Date               Settlement price     MTM
                                   Dec 15,2003                   6320     -115
                                   Dec 16,2003                   6250       -70
                                   Dec 17,2003                   6312       +62
                                   Dec 18,2003                   6310         -2
                                   Dec 19,2003                   6315        +5



      • On the expiry date if the member has an open position, it is the difference between the final
        settlement price and the previous day's settlement price.

    Table 9.1 explains the MTM margins to be paid by a member who buys one unit of December
expiration long staple cotton contract at Rs.6435 per Quintal (18.7 Quintals = 11 bales) on
December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of
cotton. The member closes the position on December 19. The MTM profit/ loss per unit of trading
shows at he makes a total loss of Rs.120 per Quintal of trading. So upon closing his position, he
makes a total loss of Rs.2244, i.e. (18.7 x 120) on the long position taken by him. The profit/ loss
made by him however gets added/ deducted from his initial margin on a daily basis.
    Table 9.2 explains the MTM margins to be paid by a member who sells December expiration
long staple cotton futures contract at Rs.6435 per Quintal on December 15. The unit of trading is
11 bales(18.7 Quintals) and each contract is for delivery of 55 bales of cotton. The member closes
the position on December 19. The MTM profit/ loss shows that he makes a total profit of Rs.120
per Quintal. So upon closing his position, he makes a total profit of Rs.2244 on the short position
taken by him. The profit/ loss made by him however gets added/ deducted from his initial margin
on a daily basis.

Final settlement
On the date of expiry, the final settlement price is the spot price on the expiry day. The spot prices
are collected from members across the country through polling. The polled bid/ ask prices are
bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price. The
responsibility of settlement is on a trading cum clearing member for all trades done on his own
account and his client's trades. A professional clearing member is responsible for settling all the
participants trades which he has confirmed to the exchange.
    On the expiry date of a futures contract, members are required to submit delivery information
9.2 Settlement                                                                                       121

Table 9.2 MTM on a short position in cotton futures
A clearing member sells one December expiration long staple cotton futures contract at Rs.6435 on
December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The
member closes the position on December 19. The MTM profits/ losses get added/ deducted from his initial
margin on a daily basis.


                                   Date              Settlement price     MTM
                                    Dec 15,2003                   6320 +115
                                    Dec 16,2003                   6250   +70
                                    Dec 17,2003                   6312   -62
                                    Dec 18,2003                   6310    +2
                                    Dec 19,2003                   6315    -5




through delivery request window on the trader workstations provided by NCDEX for all open
positions for a commodity for all constituents individually. NCDEX on receipt of such
information, matches the information and arrives at a delivery position for a member for a
commodity. A detailed report containing all matched and unmatched requests is provided to
members through the extranet.

    Pursuant to regulations relating to submission of delivery information, failure to submit
delivery information for open positions attracts penal charges as stipulated by NCDEX from time
to time. NCDEX also adds all such open positions for a member, for which no delivery
information is submitted with final settlement obligations of the member concerned and settled in
cash.

    Non-fulfilment of either the whole or part of the settlement obligations is treated as a violation
of the rules, bye-laws and regulations of NCDEX and attracts penal charges as stipulated by
NCDEX from time to time. In addition NCDEX can withdraw any or all of the membership rights
of clearing member including the withdrawal of trading facilities of all trading members clearing
through such clearing members, without any notice. Further, the outstanding positions of such
clearing member and/ or trading members and/ or constituents, clearing and settling through such
clearing member, may be closed out forthwith or any time thereafter by the exchange to the extent
possible, by placing at the exchange, counter orders in respect of the outstanding position of
clearing member without any notice to the clearing member and/ or trading member and/ or
constituent. NCDEX can also initiate such other risk containment measures as it deems
appropriate with respect to the open positions of the clearing members. It can also take additional
measures like, imposing penalties, collecting appropriate deposits, invoking bank guarantees or
fixed deposit receipts, realizing money by disposing off the securities and exercising such other
risk containment measures as it deems fit or take further disciplinary action.
122                                                                     Clearing and settlement

9.2.2 Settlement methods
Settlement of futures contracts on the NCDEX can be done in three ways - by physical delivery of
the underlying asset, by closing out open positions and by cash settlement. We shall look at each
of these in some detail. On the NCDEX all contracts settling in cash are settled on the following
day after the contract expiry date. All contracts materialising into deliveries are settled in a period
2-7 days after expiry. The exact settlement day for each commodity is specified by the exchange.


Physical delivery of the underlying asset
For open positions on the expiry day of the contract, the buyer and the seller can announce
intentions for delivery. Deliveries take place in the electronic form. All other positions are settled
in cash.
    When a contract comes to settlement, the exchange provides alternatives like delivery place,
month and quality specifications. Trading period, delivery date etc. are all defined as per the
settlement calendar. A member is bound to provide delivery information. If he fails to give
information, it is closed out with penalty as decided by the exchange. A member can choose an
alternative mode of settlement by providing counter party clearing member and constituent. The
exchange is however not responsible for, nor guarantees settlement of such deals. The settlement
price is calculated and notified by the exchange. The delivery place is very important for
commodities with significant transportation costs. The exchange also specifies the precise period
(date and time) during which the delivery can be made. For many commodities, the delivery
period may be an entire month. The party in the short position (seller) gets the opportunity to
make choices from these alternatives. The exchange collects delivery information. The price paid
is normally the most recent settlement price (with a possible adjustment for the quality of the asset
and the delivery location). Then the exchange selects a party with an outstanding long position to
accept delivery.
    As mentioned above, after the trading hours on the expiry date, based on the available
information, the matching for deliveries is done, firstiy, on the basis of locations and then
randomly keeping in view factors such as available capacity of the vault/ warehouse, commodities
already deposited and dematerialized and offered for delivery and any other factor as may be
specified by the exchange from time to time. After completion of the matching process, clearing
members are informed of the deliverable/ receivable positions and the unmatched positions.
Unmatched positions have to be settled in cash. The cash settlement is done only for the
incremental gain/ loss as determined on the basis of the final settlement price.
    Any buyer intending to take physicals has to put a request to his depository participant. The
DP uploads such requests to the specified depository who in turn forwards the same to the
registrar and transfer agent (R&T agent) concerned. After due verification of the authenticity, the
R&T agent forwards delivery details to the warehouse which in turn arranges to release the
commodities after due verification of the identity of recipient. On a specified day, the buyer would
go to the warehouse and pick up the physicals.
    The seller intending to make delivery has to take the commodities to the designated
9.2 Settlement ______________________________________________________ 123

warehouse. These commodities have to be assayed by the exchange specified assayer. The
commodities have to meet the contract specifications with allowed variances. If the commodities
meet the specifications, the warehouse accepts them. Warehouses then ensure that the receipts get
updated in the depository system giving a credit in the depositor's electronic account. The seller
then gives the invoice to his clearing member, who would courier the same to the buyer's clearing
member.
    NCDEX contracts provide a standardized description for each commodity. The description is
provided in terms of quality parameters specific to the commodities. At the same time, it is
realized that with commodities, there could be some amount of variances in quality/ weight etc.,
due to natural causes, which are beyond the control of any person. Hence, NCDEX contracts also
provide tolerance limits for variances. A delivery is treated as good delivery and accepted if the
delivery lies within the tolerance limits. However, to allow for the difference, the concept of
premium and discount has been introduced. Goods that come to the authorised warehouse for
delivery are tested and graded as per the prescribed parameters. The premium and discount rates
apply depending on the level of variation. The price payable by the party taking delivery is then
adjusted as per the premium/ discount rates fixed by the exchange. This ensures that some amount
of leeway is provided for delivery, but at the same time, the buyer taking delivery does not face
windfall loss/ gain due to the quantity/ quality variation at the time of taking delivery. This, to
some extent, mitigates the difficulty in delivering and receiving exact quality/ quantity of
commodity

Closing out by offsetting positions
Most of the contracts are settled by closing out open positions. In closing out, the opposite
transaction is effected to close out the original futures position. A buy contract is closed out by a
sale and a sale contract is closed out by a buy. For example, an investor who took a long position
in two gold futures contracts on the January 30, 2004 at 6090, can close his position by selling two
gold futures contracts on February 27, 2004 at Rs.5928. In this case, over the period of holding the
position, he has suffered a loss of Rs.162 per unit. This loss would have been debited from his
margin account over the holding period by way of MTM at the end of each day, and finally at the
price that he closes his position, that is Rs.5928 in this case.

Cash settlement
Contracts held till the last day of trading can be cash settled. When a contract is settled in cash, it
is marked to the market at the end of the last trading day and all positions are declared closed. The
settlement price on the last trading day is set equal to the closing spot price of the underlying asset
ensuring the convergence of future prices and the spot prices. For example an investor took a short
position in five long staple cotton futures contracts on December 15 at Rs.6950. On 20th
February, the last trading day of the contract, the spot price of long staple cotton is Rs.6725. This
is the settlement price for his contract. As a holder of a short position on cotton, he does not have
to actually deliver the underlying cotton, but simply takes away the profit of Rs.225 per trading
unit of cotton in the form of cash.
124                                                                            Clearing and settlement

9.2.3 Entities involved in physical settlement
Physical settlement of commodities involves the following three entities - an accredited
warehouse, registrar & transfer agent and an assayer. We will briefly look at the functions of each.


Accredited warehouse
NCDEX specifies accredited warehouses through which delivery of a specific commodity can be
effected and which will facilitate for storage of commodities. For the services provided by them,
warehouses charge a fee that constitutes storage and other charges such as insurance, assaying and
handling charges or any other incidental charges. Following are the functions of an accredited
warehouse:

   1. Earmark separate storage area as specified by the exchange for the purpose of storing commodities to
      be delivered against deals made on the exchange. The warehouses are required to meet the
      specifications prescribed by the exchange for storage of commodities.

   2. Ensure and co-ordinate the grading of the commodities received at the warehouse before they are
      stored.

   3. Store commodities in line with their grade specifications and validity period and facilitate
      maintenance of identity. On expiry of such validity period of the grade for such commodities, the
      warehouse has to segregate such commodities and store them in a separate area so that the same are
      not mixed with commodities which are within the validity period as per the grade certificate issued by
      the approved assayers.


Approved registrar and transfer agents (R&T agents)
The exchange specifies approved R&T agents through whom commodities can be dematerialized
and who facilitate for dematerialization/ re-materialization of commodities in the manner
prescribed by the exchange from time to time. The R&T agent performs the following functions:

   1. Establishes connectivity with approved warehouses and supports them with physical infrastructure.

   2. Verifies the information regarding the commodities accepted by the accredited warehouse and assigns
      the identification number (ISIN) allotted by the depository in line with the grade/ validity period.

   3. Further processes the information, and ensures the credit of commodity holding to the demat account
      of the constituent.

   4. Ensures that the credit of commodities goes only to the demat account of the constituents held with
      the exchange empanelled DPs.

   5. On receiving a request for re-materialization (physical delivery) through the depository, arranges for
      issuance of authorisation to the relevant warehouse for the delivery of commodities.
9.3 Risk management                                                                                       125

    R&T agents also maintain proper records of beneficiary position of constituents holding
dematerialized commodities in warehouses and in the depository for a period and also as on a
particular date. They are required to furnish the same to the exchange as and when demanded by
the exchange. R&T agents also do the job of co-ordinating with DPs and warehouses for billing of
charges for services rendered on periodic intervals. They also reconcile dematerialized
commodities in the depository and physical commodities at the warehouses on periodic basis and
co-ordinate with all parties concerned for the same.

Approved assayer
The exchange specifies approved assayers through whom grading of commodities (received at
approved warehouses for delivery against deals made on the exchange) can be availed by the
constituents of clearing members. Assayers perform the following functions:

   1. Inspect the warehouses identified by the exchange on periodic basis to verify the compliance of
      technical/ safety parameters detailed in the warehousing accreditation norms of the exchange. The
      compliance certificate so given by the assayer forms the basis of warehouse accreditation by the
      exchange.

   2. Make available grading facilities to the constituents in respect of the specific commodities traded on
      the exchange at specified warehouse. The assayer ensures that the grading to be done (in a certificate
      format prescribed by the exchange) in respect of specific commodity is as per the norms specified by
      the exchange in the respective contract specifications.

   3. Grading certificate so issued by the assayer specifies the grade as well as the validity period up to
      which the commodities would retain the original grade, and the time up to which the commodities are
      fit for trading subject to environment changes at the warehouses.


9.3 Risk management
NCDEX has developed a comprehensive risk containment mechanism for the its commodity
futures market. The salient features of risk containment mechanism are:
   1. The financial soundness of the members is the key to risk management. Therefore, the requirements
      for membership in terms of capital adequacy (net worth, security deposits) are quite stringent.

   2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies the
      initial margin requirements for each futures contract on a daily basis. It also follows value-at-risk
      (VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin from
      the TCMs and their clients respectively.

   3. The open positions of the members are marked to market based on contract settlement price for each
      contract. The difference is settled in cash on a T+l basis.

   4. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.
      Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation
      by the PCM.
126                                                                                 Clearing and settlement

   5. A separate settlement guarantee fund for this segment has been created out of the capital of members.

    The most critical component of risk containment mechanism for futures market on the
NCDEX is the margining system and on-line position monitoring. The actual position monitoring
and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk)
system.


9.4 Margining at NCDEX
In pursuance of the bye-laws, rules and regulations, the exchange has defined norms and
procedures for margins and limits applicable to members and their clients. The margining system
for the commodity futures trading on the NCDEX is explained below.


9.4.1 SPAN
SPAN is a registered trademark of the Chicago Mercantile Exchange, used by NCDEX under
license obtained from CME. The objective of SPAN is to identify overall risk in a portfolio of all
futures contracts for each member. Its over-riding objective is to determine the largest loss that a
portfolio might reasonably be expected to suffer from one day to the next day based on 99% VaR
methodology.


9.4.2 Initial margin
This is the amount of money deposited by both buyers and sellers of futures contracts to ensure
performance of trades executed. Initial margin is payable on all open positions of trading cum
clearing members, up to client level, at any point of time, and is payable upfront by the members
in accordance with the margin computation mechanism and/ or system as may be adopted by the
exchange from time to time. Initial margin includes SPAN margins and such other additional
margins that may be specified by the exchange from time to time.


9.4.3 Computation of initial margin
The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose of
real-time initial margin computation. Initial margin requirements are based on 99% VaR (Value at
Risk) over a one-day time horizon.
    Initial margin requirements for a member for each contract are as under:

   1. For client positions: These are netted at the level of individual client and grossed across all clients, at
      the member level without any set-offs between clients.

   2. For proprietary positions: These are netted at member level without any set-offs between client and
      proprietary positions.
9.4 Margining at NCDEX                                                                              127

Table 9.3 Calculating outstanding position at TCM level
             Account                    Number of       Number of            Outstanding
             units bought                               units sold              position
              Proprietary                        3000              1000       Long 2000
              CUent A                            2000              1500        Long 500
              Client B                                             1000       Short 1000
              Net outstanding position                                               3500



Table 9.4 Minimum margin percentage on commodity futures contracts
                Commodity                       Minimum margin percentage

             Pure gold Mumbai                                                            4
             Pure silver New Delhi                                                       4
             J34 medium staple cotton Bhatinda                                           3
             S06 L S cotton Ahmedabad                                                    3
             Soybean Indore                                                              4
             Refined soya oil Indore                                                     4
             Rapeseed mustard seed Jaipur                                                4
             Expeller rapeseed mustard oil Jaipur                                        4
             Crude palm oil Kandla                                                       4
             RBD palm olein Kakinada                                                     4




    Consider the case of a trading member who has proprietary and client-level positions in a
April 2004 gold futures contract. On his proprietary account, he bought 3000 trading units and
sold 1000 trading units within the day. On account of client A, he bought 2000 trading units at the
beginning of the day and sold 1500 units an hour later. And on account of client B, he sold 1000
trading units. Table 9.3 gives the total outstanding position for which the TCM would be
margined.
    For the purpose of SPAN margin, various parameters as given below will be specified from
time to time:
   1. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR
      purpose for the prices of futures contracts. The minimum margin percentages for various commodities
      are given in Table 9.4. These may change from time to time as specified by the exchange.

   2. Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may be
      specified by the exchange from time to time.

   3. Calendar spread charge: Calendar spread is defined as the purchase of one delivery month of a given
      futures contract and simultaneous sale of another delivery month of the same commodity on the same
128                                                                                 Clearing and settlement

      exchange. Margins are charged on all open calendar spread positions at 2% on the higher value of the near month
      or the far month position, or at such rate as may be specified by the exchange from time to time. The near month
      position is the buy/ sell position on the calendar-spread position that expires first. The far month position is the
      buy/ sell position on the calendar-spread position that expires next. A calendar spread position is treated as non-
      spread (naked) positions in the far month contract, 3 trading days prior to expiration of the near month contract.
      However, calendar spread position is reduced gradually at the rate of 33^% per day for three days or at such rate as
      may be prescribed by the exchange from time to time. The reduction of the spread position starts five days before
      the date of expiry of the near month contract.



9.4.4 Implementation aspects of margining and risk management
We look here at some implementation aspects of the margining and risk management system for trading on
NCDEX.

   1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateral
      security deposits in the form of bank guarantees, fixed deposits receipts and approved Government of
      India securities.

   2. Payment of initial margin: The initial margin is payable upfront by members.

   3. Effect of failure to pay initial margins: Non-fulfilment of either the whole or part of the initial margin
      obligations is treated as a violation of the rules, bye-laws and regulations of the exchange and attracts
      penal charges as stipulated by NCDEX from time to time. In addition, the exchange can withdraw any
      or all of the membership rights of a member including the withdrawal of trading facilities of the
      members clearing through such clearing members, without any notice. The outstanding positions of
      such members and/ or constituents clearing and settling through such members, can be closed out
      forthwith or any time thereafter at the discretion of the Exchange, to the extent possible, by placing
      counter orders in respect of the outstanding position of members. Such action is final and binding on
      the members and/ or constituents.
      The exchange can also initiate such other risk containment measures as it deems fit with respect to the
      open positions of the members and/ or constituents. The exchange can take additional measures like
      imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts,
      realizing money by disposing off the securities and exercising such other risk containment measures
      as it deems fit.

   4. Exposure limits: This is defined as the maximum open positions that a member can take across all
      contracts and is linked to the liquid net worth of the member available with the exchange. The
      member is not allowed to trade once the exposure limits have been exceeded on the exchange. The
      trader workstation of the member is disabled and trading permitted only on enhancement of exposure
      limits by deposit of additional capital.

        (a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at
             any point in time. The liquid networth maintained by the members at any point in time cannot
             be less than Rs.25 lakh (referred to as minimum liquid net worth) or such other amount, as may
             be specified by the exchange from time to time.
9.4 Margining at NCDEX                                                                                     129


        (b) Effective deposits: This includes all deposits made by the members in the form of cash or cash
            equivalents form the effective deposits. For the purpose of computing effective deposits, cash
            equivalents mean bank guarantees, fixed deposit receipts and Government of Indian securities.
        (c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the
            liquid net worth, i.e. a member can have an exposure limit of x times his liquid net worth. The
            multiple is as specified in Table 9.5 or as may be prescribed by the exchange from time.
        (d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures,
            contracts are treated as open position of one third of the value of the far month futures contract.
            However the spread positions is treated as a naked position in far month contract three trading
            days prior to expiry of the near month contract.

   5. Imposition of additional margins and close out of open positions: As a risk containment measure, the
      exchange may require the members to make payment of additional margins as may be decided from
      time to time. This is in addition to the initial margin, which are or may have been imposed. The
      exchange may also require the members to reduce/ close out open positions to such levels and for such
      contracts as may be decided by it from time to time.

   6. Failure to pay additional margins: Non-fulfilment of either the whole or part of the additional margin
      obligations is treated as a violation of the rules, bye-Laws and regulations of the exchange and attracts
      penal charges as stipulated by NCDEX. The exchange may withdraw any or all of the membership
      rights of the members including the withdrawal of trading facilities of trading members clearing
      through such members, without any notice.
      In addition, the outstanding positions of such members and/ or constituents, clearing and settling
      through such members, can be closed out forthwith or any time thereafter, at the discretion of the
      exchange, to the extent possible, by placing counter orders in respect of their outstanding positions.

   7. Return of excess deposit: Members can request the exchange to release excess deposits held by it or by
      a specified agent on behalf of the exchange. Such requests may be considered by the exchange subject
      to the bye-laws, rules and regulations.

   8. Initial margin deposit or additional deposit or additional base capital: Members who wish to make a
      margin deposit (additional base capital) with the exchange and/ or wish to retain deposits and/ or such
      amounts which are receivable by them from the exchange, at any point of time, over and above their
      deposit requirement towards initial margin and/ or other obligations, must inform the exchange as per
      the procedure.

   9. Position limits: Position wise limits are the maximum open positions that a member or his constituents
      can have in any commodity at any point of time. This is calculated as the higher of a specified
      percentage of the total open interest in the commodity or a specified value. Open interest is the total
      number of open positions in that futures contract multiplied by its last available traded price or closing
      price, as the case may be.

  10. Intra-day price limit: The maximum price movement during a day can be +/- 10% of the previous
      day's settlement price prescribed for each commodity. If the price hits the intra day price limit (at
      upper side or lower side), there will be a cooling period of 15 minutes. During the cooling period,
      trading in that particular contract will be suspended and normal trading will resume after the cooling
      period. The base price when trading resumes after cooling period will be the last traded price before
      the commencement of cooling period. There would be no cooling period if the price hits the intra day
      limit during the last 30 minutes of trading.
130                                                                            Clearing and settlement

Table 9.5 Exposure limit as a multiple of liquid net worth
                   Commodity                                            Multiple
                   Pure gold Mumbai                                            25
                   Pure silver New Delhi                                       25
                   J34 medium staple cotton Bhatinda                           40
                   S06 L S cotton Ahmedabad                                    40
                   Soybean Indore                                              25
                   Refined soya oil Indore                                     25
                   Rapeseed mustard seed Jaipur                                25
                   Expeller rapeseed mustard oil Jaipur                        25
                   Crude palm oil Kandla                                       25
                   RBD palm olein Kakinada                                     25



        (a) Daily settlement price: The daily profit/ losses of the members are settled using the daily
            settlement price. The daily settlement price notified by the exchange is binding on all members
            and their constituents.
        (b) Mark-to-market settlement: All the open positions of the members are marked to market at the
            end of the day and the profit/ loss determined as below: (a) On the day of entering into the
            contract, it is the difference between the entry value and daily settlement price for that day. (b)
            On any intervening days, when the member holds an open position, it is the difference between
            the daily settlement value for that day and the previous day's settlement price, (c) On the expiry
            date if the member has an open position, it is the difference between the final settlement price
            and the previous day's settlement price.

  11. Intra-day margin call: The exchange at its discretion can make intra day margin calls as risk
      containment measure if, in its opinion, the market price changes sufficiently. For example, it can make
      an intra-day margin call if the intra day price limit has been reached, or any other situation has arisen,
      which in the opinion of the exchange could result in an enhanced risk. The exchange at its discretion
      may make selective margin calls, for example, only for those members whose variation losses or
      initial margin deficits exceed a threshold value prescribed by the exchange.

  12. Delivery margin: In case of positions materialising into physical delivery, delivery margins are
      calculated as i\ days VaR margins plus additional margins. N days refer to the number of days for
      completing the physical delivery settlement. The number of days are commodity specific, as described
      hereunder or as may be prescribed by the exchange from time to time. There is a mark up on the VaR
      based delivery margin to cover for default. Table 9.6 gives the number of days for physical settlement
      on various commodities.



9.4.5 Effect of violation
Whenever any of the margin or position limits are violated by members, the exchange can
withdraw any or all of the membership rights of members including the withdrawal of trading
9.4 Margining at NCDEX                                                                        131

Table 9.6 Number of days for physical settlement on various commodities
                 Commodity                                 Number of days for
                                                           physical settlement

                 Pure gold Mumbai                                       2
                 Pure silver New Delhi                                  4
                 J34 medium staple cotton Bhatinda                     10
                 S06 L S cotton Ahmedabad                              10
                 Soybean Indore                                         7
                 Refined soya oil Indore                                7
                 Rapeseed mustard seed Jaipur                           7
                 Expeller rapeseed mustard oil Jaipur                   7
                 Crude palm oil Kandla                                  7
                 RBD palm olein Kakinada                                7




facilities of all members and/ or clearing facility of custodial participants clearing through such
trading cum members, without any notice. In addition, the outstanding positions of such member
and/ or constituents clearing and settling through such member, can be closed out at any time at
the discretion of the exchange. This can be done without any notice to the member and/ or
constituent. The exchange can initiate further risk containment measures with respect to the open
positions of the member and/ or constituent. These could include imposing penalties, collecting
appropriate deposits, invoking bank guarantees/ fixed deposit receipts, realizing money by
disposing off the securities, and exercising such other risk containment measures it considers
necessary.


Solved Problems
Q: The settlement of futures contracts cannot be done by

   1. Closing out open positions.                     3. Cash settlement.
   2. Physical delivery.                             4. Carrying forward the position.

A: The correct answer is number 4.                                                              ••


Q: ____ undertakes clearing and settlement of all trades executed on the NCDEX

   1. NSE                                             3. NSDL
   2. NSCCL                                          4. NCDEX

A: The correct answer is number 2.                                                              ••
132                                                              Clearing and settlement

Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by

   1. NSE                                            3. NSDL
   2. NSCCL                                          4. NCDEX

A: The correct answer is number 4.                                                                 ••



Q: The clearing house of an exchange is responsible for

   1. Effecting timely settlement.                   3. Financial clearing of the payment flow.

   2. Control of the evolution of open interest.     4. All of the above.

A: The correct answer is number 4.                                                                 ••



Q: On expiry of a commodity futures contract, the settlement price is the

   1. Spot price of the underlying asset             3. Spot price plus cost-of-carry
   2. Futures close price                            4. None of the above.

A: The correct answer is number 1.                                                                 ••



Q: The clearing house of an exchange is not responsible for

   1. Effecting timely settlement.                   3. Control of the evolution of open interest.
   2. Ensuring that the buyer and seller get the best
      price.                                          4. Financial clearing of the payment flow.

A: The correct answer is number 2.                                                                 ••



Q: The exposure limit for each member is linked to the………of the member available with the
exchange.

   1. Liquid net worth.                              3. Bank guarantees.
   2. Security deposits.                             4. Base capital.

A: The correct answer is number 1.                                                                 ••
9.4 Margining at NCDEX                                                                        133

Q: A cotton trader bought ten one-month, long staple cotton futures contracts at Rs.6020 per
Quintal at the beginning of the day. The unit of trading is 11 bales and each contract is for
delivery of 55 bales. The settlement price at the end of the day was Rs.6050 per Quintal. The
trader's MTM account will show

   1. AprofitofRs.5610                                3. A profit of Rs. 1500
   2. AlossofRs.5610                                  4. A loss of Rs. 1500

A: He makes a profit of Rs.30 per Quintal on his futures position. One futures contract consists is
for
18.7 Quintals. He has bought ten futures contract. So he makes a profit of 30 * 18.7 * 10 =
Rs.5610.                                                                                      The
correct answer is number 1.                                                                     •
•



Q: A gold merchant bought two units of one-month gold futures contracts at Rs.6000 per 10 gms
at the beginning of the day. The unit of trading is 100 gms and each contract is for delivery of one
kg of gold. The settlement price at the end of the day was Rs.6025 per 10 gms. The trader's MTM
account will show

   1. AprofitofRs.500                                 3. A profit of Rs.5000
   2. AlossofRs.500                                   4. A loss of Rs.5000

A: Each unit of trading is 100 gms. He has bought two units. This means he has a long position in
200
gms of gold. He makes a profit of Rs.25 per 10 gms on his futures position. So he makes a profit
of
            20
Rs.500, i.e     200 = Rs.500. The correct answer is number 1.                                 ••
            10



Q: A trading member took proprietary positions in a March 2004 cotton futures contract. He
bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per Quintal. What is
the outstanding position on which he would be margined?

   1. Long 3000 units                                 3. Long 5400 units
   2. Short 2400 units                                4. Long 600 units

A: After netting, the trading member has a long open position in 600 trading units. The correct
answer is number 4.                                                                         ••
134                                                                  Clearing and settlement

Q: A trading member has proprietary and client positions in a March cotton futures contract. On
his proprietary account, he bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at
Rs.6015 per Quintal. On account of client A, he bought 2000 trading units at Rs.6012 per Quintal,
and on account of client B, he sold 1000 trading units at Rs.5990 per Quintal. What is the
outstanding position on which he would be margined?

   1. 3000 units                                     3. 3600 units
   2. 8400 units                                     4. 1600 units

A: After netting, the trading member has a proprietary open position in 600 trading units. He
would be margined on a net basis at the proprietary level and on a gross basis across clients, i.e.
(600 + 2000 +1000). The correct answer is number 3.                                            ••


Q: A trading member has proprietary and client positions in a April 2004 gold futures contract.
On his proprietary account, he bought 3000 trading units at Rs.6000 per 10 gms. On account of
client A, he bought 2000 trading units at Rs.6012 per 10 gms and sold 1500 units at Rs.6020 per
10 gms, and on account of client B, he sold 1000 trading units at Rs.5990 per 10 gms. What is the
outstanding position on which he would be margined?

   1. 3000 units                                     3. 3600 units
   2. 4500 units                                     4. 7500 units

A: He would be margined on a net basis at the proprietary level and at the individual client level
and on a gross basis across clients, i.e. (3000 + (2000 - 1500) + 1000). The correct answer is
number 2.                                                                                      • •
Chapter 10

Regulatory framework

At present, there are three tiers of regulations of forward/futures trading system in India, namely,
government of India, Forward Markets Commission(FMC) and commodity exchanges. The need
for regulation arises on account of the fact that the benefits of futures markets accrue in
competitive conditions. Proper regulation is needed to create competitive conditions. In the
absence of regulation, unscrupulous participants could use these leveraged contracts for
manipulating prices. This could have undesirable influence on the spot prices, thereby affecting
interests of society at large.. Regulation is also needed to ensure that the market has appropriate
risk management system. In the absence of such a system, a major default could create a chain
reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation
is also needed to ensure fairness and transparency in trading, clearing, settlement and management
of the exchange so as to protect and promote the interest of various stakeholders, particularly non-
member users of the market.


10.1      Rules governing commodity derivatives exchanges
The trading of commodity derivatives on the NCDEX is regulated by Forward Markets
Commission(FMC). Under the Forward Contracts (Regulation) Act, 1952, forward trading in
commodities notified under section 15 of the Act can be conducted only on the exchanges, which
are granted recognition by the central government (Department of Consumer Affairs, Ministry of
Consumer Affairs, Food and Public Distribution). All the exchanges, which deal with forward
contracts, are required to obtain certificate of registration from the FMC. Besides, they are
subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward
Commission (Regulation) Act and various other legislations, which impinge on their working.
    Forward Markets Commission provides regulatory oversight in order to ensure financial
integrity (i.e. to prevent systematic risk of default by one major operator or group of operators),
market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demand
and supply conditions) and to protect and promote interest of customers/ non-members. It
prescribes the following regulatory measures:
136                                                                               Regulatory framework

   1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on
      intra-day net open position. The limit is imposed operator-wise, and in some cases, also memberwise.

   2. Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing
      or downswing in prices.

   3. Special margin deposit to be collected on outstanding purchases or sales when price moves up or
      down sharply above or below the previous day closing price. By making further purchases/sales
      relatively costly, the price rise or fall is sobered down. This measure is imposed only on the request of
      the exchange.

   4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from
      falling below as rising above not warranted by prospective supply and demand factors. This measure
      is also imposed on the request of the exchanges.

   5. Skipping trading in certain derivatives of the contract, closing the market for a specified period and
      even closing out the contract: These extreme measures are taken only in emergency situations.

    Besides these regulatory measures, the F.C(R) Act provides that a client's position cannot be
appropriated by the member of the exchange, except when a written consent is taken within three
days time. The FMC is persuading increasing number of exchanges to switch over to electronic
trading, clearing and settlement, which is more customer-friendly. The FMC has also prescribed
simultaneous reporting system for the exchanges following open out-cry system. These steps
facilitate audit trail and make it difficult for the members to indulge in malpractices like trading
ahead of clients, etc. The FMC has also mandated all the exchanges following open outcry system
to display at a prominent place in exchange premises, the name, address, telephone number of the
officer of the commission who can be contacted for any grievance. The website of the commission
also has a provision for the customers to make complaint and send comments and suggestions to
the FMC. Officers of the FMC have been instructed to meet the members and clients on a random
basis, whenever they visit exchanges, to ascertain the situation on the ground, instead of merely
attending meetings of the board of directors and holding discussions with the office-bearers.


10.2 Rules governing intermediaries
In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed
thereunder, exchanges are governed by its own rules and bye laws(approved by the FMC). In this
section we have brief look at the important regulations that govern NCDEX. For the sake of
convenience, these have been divided into two main divisions pertaining to trading and clearing.
The detailed bye laws, rules and regulations are available on the NCDEX home page.

10.2.1       Trading
The NCDEX provides an automated trading facility in all the commodities admitted for dealings
on the spot market and derivative market. Trading on the exchange is allowed only through
10.2 Rules governing intermediaries                                                           137

approved workstation(s) located at locations for the offlce(s) of a trading member as approved by
the exchange. If LAN or any other way to other workstations at any place connects an approved
workstation of a trading Member it shall require an approval of the exchange.
    Each trading member is required to have a unique identification number which is provided by
the exchange and which will be used to log on (sign on) to the trading system. A trading member
has a non-exclusive permission to use the trading system as provided by the exchange in the
ordinary course of business as trading member. He does not have any title rights or interest
whatsoever with respect to trading system, its facilities, software and the information provided by
the trading system.
    For the purpose of accessing the trading system, the member will install and use equipment
and software as specified by the exchange at his own cost. The exchange has the right to inspect
equipment and software used for the purposes of accessing the trading system at any time. The
cost of the equipment and software supplied by the exchange, installation and maintenance of the
equipment is borne by the trading member.

Trading members and users
Trading members are entitled to appoint, (subject to such terms and conditions, as may be
specified by the relevant authority) from time to time -
   • Authorised persons
   • Approved users

    Trading members have to pass a certification program, which has been prescribed by the
exchange. In case of trading members, other than individuals or sole proprietorships, such
certification program has to be passed by at least one of their directors/ employees/ partners /
members of governing body.
    Each trading member is permitted to appoint a certain number of approved users as notified
from time to time by the exchange.
    The appointment of approved users is subject to the terms and conditions prescribed by the
exchange. Each approved user is given a unique identification number through which he will have
access to the trading system. An approved user can access the trading system through a password
and can change the password from time to time.
    The trading member or its approved users are required to maintain complete secrecy of its
password. Any trade or transaction done by use of password of any approved user of the trading
member, will be binding on such trading member. Approved user shall be required to change his
password at the end of the password expiry period.

Trading days
The exchange operates on all days except Saturday and Sunday and on holidays that it declares
from time to time. Other than the regular trading hours, trading members are provided a facility to
place orders off-line i.e. outside trading hours. These are stored by the system but get traded only
once the market opens for trading on the following working day.
138                                                                    Regulatory framework

    The types of order books, trade books, price limits, matching rules and other parameters
pertaining to each or all of these sessions is specified by the exchange to the members via its
circulars or notices issued from time to time. Members can place orders on the trading system
during these sessions, within the regulations prescribed by the exchange as per these bye laws,
rules and regulations, from time to time.


Trading hours and trading cycle

The exchange announces the normal trading hours/ open period in advance from time to time. In
case necessary, the exchange can extend or reduce the trading hours by notifying the members.
Trading cycle for each commodity/ derivative contract has a standard period, during which it will
be available for trading.


Contract expiration

Derivatives contracts expire on a pre-determined date and time up to which the contract is
available for trading. This is notified by the exchange in advance. The contract expiration period
will not exceed twelve months or as the exchange may specify from time to time.


Trading parameters
The exchange from time to time specifies various trading parameters relating to the trading
system. Every trading member is required to specify the buy or sell orders as either an open order
or a close order for derivatives contracts. The exchange also prescribes different order books that
shall be maintained on the trading system and also specifies various conditions on the order that
will make it eligible to place it in those books.
    The exchange specifies the minimum disclosed quantity for orders that will be allowed for
each commodity/ derivatives contract. It also prescribes the number of days after which Good Till
Cancelled orders will be cancelled by the system. It specifies parameters like lot size in which
orders can be placed, price steps in which orders shall be entered on the trading system, position
limits in respect of each commodity etc.


Failure of trading member terminal
In the event of failure of trading members workstation and/ or the loss of access to the trading
system, the exchange can at its discretion undertake to carry out on behalf of the trading member
the necessary functions which the trading member is eligible for. Only requests made in writing in
a clear and precise manner by the trading member would be considered. The trading member is
accountable for the functions executed by the exchange on its behalf and has to indemnity the
exchange against any losses or costs incurred by the exchange.
10.2 Rules governing intermediaries                                                                         139

Trade operations
Trading members have to ensure tiiat appropriate confirmed order instructions are obtained from
the constituents before placement of an order on the system. They have to keep relevant records or
documents concerning the order and trading system order number and copies of the order
confirmation slip/ modification slip must be made available to the constituents.
    The trading member has to disclose to the exchange at the time of order entry whether the
order is on his own account or on behalf of constituents and also specify orders for buy or sell as
open or close orders. Trading members are solely responsible for the accuracy of details of orders
entered into the trading system including orders entered on behalf of their constituents.
    Trades generated on the system are irrevocable and 'locked in'. The exchange specifies from
time to time the market types and the manner if any, in which trade cancellation can be effected.
Where a trade cancellation is permitted and trading member wishes to cancel a trade, it can be
done only with the approval of the exchange.

Margin requirements
Subject to the provisions as contained in the exchange bye-laws and such other regulations as may
be in force, every clearing member, in respect of the trades in which he is party to, has to deposit a
margin with exchange authorities.
     The exchange prescribes from time to time the commodities/ derivative contracts, the
settlement periods and trade types for which margin would be attracted. The exchange levies
initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other
concept as the exchange may decide from time to time. The margin is charged so as to cover one-
day loss that can be encountered on the position on 99% of the days. Additional margins may be
levied for deliverable positions, on the basis of VaR from the expiry of the contract till the actual
settlement date plus a mark-up for default.
     The margin has to be deposited with the exchange within the time notified by the exchange.
The exchange also prescribes categories of securities that would be eligible for a margin deposit,
as well as the method of valuation and amount of securities that would be required to be deposited
against the margin amount.
     The procedure for refund/ adjustment of margins is also specified by the exchange from time
to time. The exchange can impose upon any particular trading member or category of trading
member any special or other margin requirement. On failure to deposit margin/s as required under
this clause, the exchange/clearing house can withdraw the trading facility of the trading member.
After the pay-out, the clearing house releases all margins.

Unfair trading practices
No trading member should buy, sell, deal in derivatives contracts in a fraudulent manner, or
indulge in any unfair trade practices including market manipulation. This includes the following:

    • Effect, take part either directly or indirectly in transactions, which are likely to have effect of
      artificially, raising or depressing the prices of spot/ derivatives contracts.
140                                                                                 Regulatory framework

      • Indulge in any act, which is calculated to create a false or misleading appearance of trading, resulting
        in reflection of prices, which are not genuine.

      • Buy, sell commodities/ contracts on his own behalf or on behalf of a person associated with him
        pending the execution of the order of his constituent or of his company or director for the same
        contract.

      • Delay the transfer of commodities in the name of the transferee.

      • Indulge in falsification of his books, accounts and records for the purpose of market manipulation.

      • When acting as an agent, execute a transaction with a constituent at a price other than the price at
        which it was executed on the exchange.

      • Either take opposite position to an order of a constituent or execute opposite orders which he is
        holding in respect of two constituents except in the manner laid down by the exchange.


10.2.2 Clearing
As mentioned earlier, National Securities Clearing Corporation Limited (NSCCL) undertakes
clearing of trades executed on the NCDEX. All deals executed on the Exchange are cleared and
settled by the trading members on the settlement date by the trading members themselves as
clearing members or through other professional clearing members in accordance with these
regulations, bye laws and rules of the exchange.

Last day of trading
Last trading day for a derivative contract in any commodity is the date as specified in the
respective commodity contract. If the last trading day as specified in the respective commodity
contract is a holiday, the last trading day is taken to be the previous working day of exchange.
    On the expiry date of contracts, the trading members/ clearing members have to give delivery
information as prescribed by the exchange from time to time. If a trading member/ clearing
member fails to submit such information during the trading hours on the expiry date for the
contract, the deals have to be settled as per the settlement calendar applicable for such deals, in
cash together with penalty as stipulated by the exchange.

Delivery
Delivery can be done either through the clearing house or outside the clearing house. On the
expiry date, during the trading hours, the exchange provides a window on the trading system to
submit delivery information for all open positions.
    After the trading hours on the expiry date, based on the available information, the matching
for deliveries takes place - firstly, on the basis of locations and then randomly keeping in view the
factors such as available capacity of the vault/ warehouse, commodities already deposited and
dematerialized and offered for delivery and any other factor as may be specified by the exchange
from time to time. Matching done is binding on the clearing members. After completion of the
10.2 Rules governing intermediaries                                                              141

matching process, clearing members are informed of the deliverable / receivable positions and the
unmatched positions. Unmatched positions have to be settled in cash.
    The cash settlement is only for the incremental gain/ loss as determined on the basis of the
final settlement price. All matched and unmatched positions are settled in accordance with the
applicable settlement calendar.
    The exchange may allow an alternate mode of settlement between the constituents directly
provided that both the constituents through their respective clearing members notify the exchange
before the closing of trading hours on the expiry date. They have to mention their preferred
identified counter-party and the deliverable quantity, along with other details required by the
exchange. The exchange however, is not be responsible or liable for such settlements or any
consequence of such alternate mode of settlements. If the information provided by the buyer/
seller clearing members fails to match, then the open position would be settled in cash together
with penalty as may be stipulated by the exchange.
    The clearing members are allowed to deliver their obligations before the pay in date as per
applicable settlement calendar, whereby the clearing house can reduce the margin requirement to
that extent.
    The exchange specifies the parameters and methodology for premium/ discount, as the case
may be, from time to time for the quality/ quantity differential, sales tax, taxes, government levies/
fees if any. Pay in/ Pay out for such additional obligations is settled on the supplemental
settlement date as specified in the settlement calendar.

Procedure for payment of sales tax/VAT
The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/central
tax/fee applicable to the deals culminating into sale with physical delivery of commodities.
    All members have to ensure that their respective constituents, who intend to take or give
delivery of commodity, are registered with sales tax authorities of all such states in which the
exchange has a delivery center for a particular commodity in which constituent has or is expected
to have open positions. Members have to maintain records/details of sales tax registration of each
of such constituent and furnish the same to the exchange as and when required.
    The seller is responsible for payment of sales tax/VAT, however the seller is entitled to
recover from the buyer, the sales tax and other taxes levied under the local state sales tax law to
the extent permitted by law. In no event is the exchange/ clearing house liable for payment of
sales tax/ VAT or any other local tax, fees, levies etc.

Penalties for defaults
In the event of a default by the seller or the buyer in delivery of commodities or payment of the
price, the exchange closes out the derivatives contracts and imposes penalties on the defaulting
buyer or seller, as the case may be. It can also use the margins deposited by such clearing member
to recover the loss. The settlement for the defaults in delivery is to be done in cash within the
period as prescribed by the exchange at the highest price from the last trading date till the final
settlement date with a mark up thereon as may be decided from time to time.
142                                                                    Regulatory framework

Process of dematerialization

Dematerialization refers to issue of an electronic credit, instead of a vault/ warehouse receipt, to
the depositor against the deposit of commodity. Any person (a constituent) seeking to
dematerialize a commodity has to open an account with an approved depository participant (DP).
The exchange provides the list of approved DPs from time to time.
    In case of commodities (other than precious metals) the constituent delivers the commodity to
the exchange-approved warehouses. The commodity brought by the constituent is checked for the
quality by the exchange-approved assayers before the deposit of the same is accepted by the
warehouse. If the quality of the commodity is as per the norms defined and notified by the
exchange from time to time, the warehouse accepts the commodity and sends confirmation in the
requisite format to the R & T agent who upon verification, confirms the deposit of such
commodity to the depository for giving credit to the demat account of the said constituent.
    In case of precious metals, the commodity must be accompanied with the assayers' certificate.
The vault accepts the precious metal, after verifying the contents of assayers certificate with the
precious metal being deposited. On acceptance, the vault issues an acknowledgement to the
constituent and sends confirmation in the requisite format to the R & T agent who upon
verification, confirms the deposit of such precious metal to the depository for giving credit to the
demat account of the said constituent.


Validity date

In case of commodities having validity date assigned to it by the approved assayer, the delivery of
the commodity upon expiry of validity date is not considered as a good delivery. The clearing
member has to ensure that his concerned constituent removes the commodities on or before the
expiry of validity date for such commodities.
    For the depository, commodities, which have reached the trading validity date, are moved out
of the electronic deliverable quantity. Such commodities are suspended from delivery. The
constituent has to rematerialize such quantity and remove the same from the warehouse. Failure to
remove deliveries after the validity date from warehouse is levied with penalty as specified by the
relevant authority from time to time.


Process of rematerialisation

Re-materialization refers to issue of physical delivery against the credit in the demat account of
the constituent. The constituent seeking to rematerialize his commodity holding has to make a
request to his DP in the prescribed format and the DP then routes his request through the
depository system to the R & T agent issues the authorisation addressed to the vault/ warehouse to
release physical delivery to the constituent. The vault/warehouse on receipt of such authorisation
releases the commodity to the constituent or constituent's authorised person upon verifying the
identity.
10.2 Rules governing intermediaries                                                                   143

Delivery through the depository clearing system
Delivery in respect of all deals for the clearing in commodities happens through the depository
clearing system. The delivery through the depository clearing system into the account of the buyer
with the depository participant is deemed to be delivery, notwithstanding that the commodities are
located in the warehouse along with the commodities of other constituents.

Payment through the clearing bank
Payment in respect of all deals for the clearing has to be made through the clearing bank(s);
Provided however that the deals of sales and purchase executed between different constituents of
the same clearing member in the same settlement, shall be offset by process of netting to arrive at
net obligations.

Clearing and settlement process
The relevant authority from time to time fixes the various clearing days, the pay-in and payout
days and the scheduled time to be observed in connection with the clearing and settlement
operations of deals in commodities/ futures contracts.

   1. Settlement obligations statements for TCMs: The exchange generates and provides to each trading
      clearing member, settlement obligations statements showing the quantities of the different kinds of
      commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or
      receivable by him in his capacity as clearing member and by professional clearing member for deals
      made by him for which the clearing Member has confirmed acceptance to settle. The obligations
      statement is deemed to be confirmed by the trading member for which deliveries are to be given and/
      or taken and funds to be debited and/ or credited to his account as specified in the obligations
      statements and deemed instructions to the clearing banks/ institutions for the same.

   2. Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to
      each professional clearing member, settlement obligations statements showing the quantities of the
      different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the
      funds payable or receivable by him. The settlement obligation statement is deemed to have been
      confirmed by the said clearing member in respect of every and all obligations enlisted therein.


Delivery of commodities
Based on the settlement obligations statements, the exchange generates delivery statement and
receipt statement for each clearing member. The delivery and receipt statement contains details of
commodities to be delivered to and received from other clearing members, the details of the
corresponding buying/ selling constituent and such other details. The delivery and receipt
statements are deemed to be confirmed by respective member to deliver and receive on account of
his constituent, commodities as specified in the delivery and receipt statements.
    On respective pay-in day, clearing members effect depository delivery in the depository
clearing system as per delivery statement in respect of depository deals. Delivery has to be made
in terms of the delivery units notified by the exchange.
144                                                                               Regulatory framework

    Commodities, which are to be received by a clearing member, are delivered to him in the
depository clearing system in respect of depository deals on the respective pay-out day as per
instructions of the exchange/ clearing house.


Delivery units
The exchange specifies from time to time the delivery units for all commodities admitted to
dealings on the exchange. Electronic delivery is available for trading before expiry of the validity
date. The exchange also specifies from time to time the variations permissible in delivery units as
per those stated in contract specifications.


Depository clearing system
The exchange specifies depository(ies) through which depository delivery can be effected and
which shall act as agents for settlement of depository deals, for the collection of margins by way
of securities for all deals entered into through the exchange, for any other commodities movement
and transfer in a depository(ies) between clearing members and the exchange and between
clearing member to clearing member as may be directed by the relevant authority from time to
time.
    Every clearing member must have a clearing account with any of the Depository Participants
of specified depositories. Clearing Members operate the clearing account only for the purpose of
settlement of depository deals entered through the exchange, for the collection of margins by way
of commodities for deals entered into through the exchange. The clearing member cannot operate
the clearing account for any other purpose.
    Clearing members are required to authorise the specified depositories and depository
participants with whom they have a clearing account to access their clearing account for debiting
and crediting their accounts as per instructions received from the exchange and to report balances
and other credit information to the exchange.


10.3 Rules governing investor grievances, arbitration
In matters where the exchange is a party to the dispute, the civil courts at Mumbai have exclusive
jurisdiction and in all other matters, proper courts within the area covered under the respective
regional arbitration center have jurisdiction in respect of the arbitration proceedings falling/
conducted in that regional arbitration center.
     For the purpose of clarity, we define the following:

      • Arbitrator means a sole arbitrator or a panel of arbitrators.

      • Applicant means the person who makes the application for initiating arbitral proceedings.

      • Respondent means the person against whom the applicant lodges an arbitration application, whether or
        not there is a claim against such person.
10.3 Rules governing investor grievances, arbitration                                                     145

    If the value of claim, difference or dispute is more than Rs.25 Lakh on the date of application,
then such claim, difference or dispute are to be referred to a panel of three arbitrators. If the value
of the claim, difference or dispute is up to Rs.25 Lakh, then they are to be referred to a sole
arbitrator. Where any claim, difference or dispute arises between agent of the member and client
of the agent of the member, in such claim, difference or dispute, the member, to whom such agent
of the member is affiliated, is impeded as a party. In case the warehouse refuses or fails to
communicate to the constituent the transfer of commodities, the date of dispute is deemed to have
arisen on
   1. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of
      the constituent.

   2. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for
      transfer with the seller, whichever is later.


10.3.1       Procedure for arbitration
The applicant has to submit to the exchange application for arbitration in the specified form (Form
No. I/IA) along with the following enclosures:
   1. The statement of case (containing all the relevant facts about the dispute and relief sought).

   2. The statement of accounts.

   3. Copies of member - constituent agreement.

   4. Copies of the relevant contract notes, invoice and delivery challan.

   The Applicant has to also submit to the exchange the following along with the arbitration
form:
   1. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of
      National Commodity & Derivatives Exchange Limited.

   2. Form No. II/IIA containing list of names of the persons eligible to act as arbitrators.

    If any deficiency/ defect in the application is found, the exchange calls upon the applicant to
rectify the deficiency/ defect and the applicant must rectify the deficiency/ defect within 15 days
of receipt of intimation from the exchange. If the applicant fails to rectify the deficiency/ defect
within the prescribed period, the exchange returns the deficient/ defective application to the
applicant. However, the applicant has the right to file a revised application, which will be
considered as a fresh application for all purposes and dealt with accordingly.
    Upon receipt of Form No.I/IA, the exchange forwards a copy of the statement of case and
related documents to the respondent. The respondent then has to submit Form H/HA to the
exchange within 7 days from the date of receipt. If the respondent fails to submit Form n/HA
within the time period prescribed by the exchange, then the arbitrator is appointed in the manner
as specified in the regulation. The respondent(s) should within 15 days from the date of receipt
146                                                                             Regulatory framework

of Form No. I/IA from the exchange, submit to the exchange in Form No. IH/IIIA three copies in
case of sole arbitrator and five copies in case of panel of arbitrators along with the following
enclosures:

    • The statement of reply (containing all available defences to the claim)

    • The statement of accounts

    • Copies of the member constituent agreement.

    • Copies of the relevant contract notes, invoice and delivery challan

    • Statement of the set-off or counter claim along with statements of accounts and copies of relevant
      contract notes and bills

    The respondent has to also submit to the exchange a cheque/ pay order/ demand draft for the
deposit payable at the seat of arbitration in favour of National Commodity & Derivatives
Exchange Limited along with Form No.ni/IIIA If the respondent fails to submit Form III/niA
within the prescribed time, then the arbitrator can proceed with the arbitral proceedings and make
the award ex-parte. Upon receiving Form No. UMIIA from the respondent the exchange forwards
one copy to the applicant. The applicant should within ten days from the date of receipt of copy of
Form III/TIIA, submit to the exchange, a reply to any counterclaim, if any, which may have been
raised by the respondent in its reply to the applicant. The exchange then forwards the reply to the
respondent. The time period to file any pleading referred to herein can be extended for such
further periods as may be decided by the relevant authority in consultation with the arbitrator
depending on the circumstances of the matter.


10.3.2 Hearings and arbitral award
No hearing is required to be given to the parties to the dispute if the value of the claim difference
or dispute is Rs.25,000 or less. In such a case the arbitrator proceeds to decide the matter on the
basis of documents submitted by both the parties provided. However the arbitrator for reasons to
be recorded in writing may hear both the parties to the dispute.
     If the value of claim, difference or dispute is more than Rs.25,000, the arbitrator offers to hear
the parties to the dispute unless both parties waive their right for such hearing in writing.
     The exchange in consultation with the arbitrator determines the date, the time and place of the
first hearing. Notice for the first hearing is given at least ten days in advance, unless the parties, by
their mutual consent, waive the notice. The arbitrator determines the date, the time and place of
subsequent hearings of which the exchange gives a notice to the parties concerned.
     If after the appointment of an arbitrator, the parties settle the dispute, then the arbitrator
records the settlement in the form of an arbitral award on agreed terms. All fees and charges
relating to the appointment of the arbitrator and conduct of arbitration proceedings are to borne by
the parties to the reference equally or in such proportions as may be decided by the arbitrator. The
costs, if any, are awarded to either of the party in addition to the fees and charges, as decided by
the arbitrator.
10.3 Rules governing investor grievances, arbitration                                            147

Solved Problems
Q: Which of the following is not involved in regulating forward/futures trading system in India?

   1. Government of India                               3. Commodity exchanges

   2. Forward Markets Commission(FMC)                   4. Commodity board of trading

A: The correct answer is number 4.                                                                 ••


Q: All the exchanges, which deal with forward contracts, are required to obtain certificate of
registration from the

   1. Government of India                               3. Commodity exchanges
   2. Forward Markets Commission(FMC)                   4. Commodity board of trading

A: The correct answer is number 2.                                                                 ••


Q: To ensure financial integrity and market integrity, the FMC prescribes certain regulatory
measures. Which of the following is not a measure prescribed?

   1. Limit on net open positions.                      3. Special margin deposits.
   2. Circuit-filters or limit on price fluctuations.   4. Price determination

A: The correct answer is number 4.                                                                 ••


Q: Every trading member is required to specify the buy or sell orders as either an open order or a
close order for derivatives contracts.

   1. Open order or close order                         3. take order or give order
   2. call order or put order                           4. bid order or ask order

A: The correct answer is number 1.                                                                 ••


Q: In matters where the NCDEX is a party to the dispute, the civil courts at ______ have exclusive
jurisdiction.

   1. Delhi                                             3. Ahmedabad
   2. Mumbai                                            4. Calcutta

A: The correct answer is number 2.                                                                 ••
148                                                                         Regulatory framework

Q: No hearing is required to be given to the parties to the dispute if the value of the claim
difference or dispute is Rs.25,000 or less.

   1. Rs.25,000                                        3. Rs. 1,00,000
   2. Rs.50,000                                        4. Rs.10,000

A: The correct answer is number 1.                                                                   ••

Q: In the case of an arbitration, the exchange in consultation with the _ determines the date, the
time
and place of the first hearing.

   1. Respondent                                       3. Arbitrator
   2. Applicant                                        4. Warehouse

A: The correct answer is number 3.                                                                   ••
Chapter 11
Implications of sales tax

The physical settlement in the case of commodities futures contracts involves issues concerned
with sales tax. The fact that delivery could happen across various states, and these states have
different sales tax rules, makes the issue a little complicated. In the case of settlements
culminating into delivery, sales tax at the rates applicable in the state where the delivery center is
located will be payable. In many states, the sales tax laws, also provide for levy of additional tax,
turnover tax, resale tax, etc. which may or may not be recoverable from the buyer depending on
the provisions of the local state sales tax law.
    The NCDEX has examined the implications of trading on NCDEX system under the relevant
state sales tax laws and has also sought opinion from independent tax advisors on the matter. The
present understanding of the implications are given below for reference.

    • Futures contracts are in the nature of agreement to buy or sell at a future date and hence are
      not liable for payment of sales tax.

    • If the futures contract is closed out and settled between the constituents prior to the
      settlement date without actually buying or selling the commodities, there is no liability for
      payment of sales tax.

    • When the futures contract fructifies into a sale and culminates into delivery, there would be
      liability for payment of sales tax. This liability will arise in the state in which the warehouse
      (into which the goods are lodged by the constituent) is situated when the commodities are
      delivered to the buyer.

    • It is the responsibility of the selling constituent to comply with the relevant local state sales
      tax laws and other local enactments. The selling constituent will be responsible for the
      following:

         1. Obtaining registration under the relevant state sales tax laws, filing of returns, payment
            of taxes and due compliance of laws.
         2. Payment of entry tax, octroi, etc., when the commodities are brought into the
            designated local area for lodging the same with the warehouse.
         3. Complying with any check-post regulations prescribed under the local sales tax, entry
            tax or other municipal laws and ensuring that the prescribed documents accompany the
            goods.
         4. Liability for central sales tax if the commodities are moved from outside the state
            pursuant to a transaction of sale.
150                                                                   Implications of sales tax

        5. The selling constituent may move the commodities into the warehouse well in
           advance and ensure compliance of provisions of law.
        6. Furnishing of duly completed sales invoices, declaration forms and certificates
           prescribed under the local sales tax, entry tax or other municipal laws to enable the
           buyer to avail of exemption or deduction as provided in the relevant laws.
   • It is the responsibility of the buying constituent to comply with the applicable local state
      sales tax laws and other local enactments. The buying constituent will be responsible for the
      following:
        1. Obtaining registration under the relevant state sales tax laws based on the purchase of
           commodities, filing of returns, payment of taxes and due compliance of laws.
        2. Furnishing of duly completed declaration forms and certificates prescribed under the
           local sales tax, entry tax or other municipal laws to enable the seller to avail of
           exemption or deduction as provided in the relevant laws.


Solved Problems
Q: When the futures contract fructifies into a sale and culminates into delivery, the payment of
sales tax
is to be done in the state in which the __is situated.

   1. Clearing corporation                            3. Buyer
   2. Warehouse                                       4. Seller
A: The correct answer is number 2.                                                                   •
•

Q: It is the responsibility of the __ to comply with the relevant local state sales tax laws and other
local
enactments.

   1. Warehouse                                         3. Seller
   2. Buyer                                             4. Buyer and seller

A: The correct answer is number 4.                                                                   •
•

Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and
culminates
into ___ of the underlying.

   1. Payment                                           3. Delivery
   2. Sale                                              4. Exchange

A: The correct answer is number 3.