Commodities FAQ's
A market is defined as a place where buyers and sellers meet to exchange goods and services.
Financial markets can be divided into different sub-types: Capital Markets, Commodity Markets, Money Markets, Derivatives Markets and Foreign Exchange Markets.
The capital market is the market for securities, where companies and governments can raise long-term funds.
The Capital Market includes stock markets and bond markets.
The Capital Market consists of Primary Market and Secondary Market.
The primary markets are where new stock and bonds issues are sold to investors.
The secondary markets are where existing securities are sold and bought from one investor/ trader/ speculator to another, usually on an exchange. e.g. the Stock Exchange of Mauritius.
Commodity markets are markets where raw or primary products are exchanged.
These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.
An exchange or in other terms bourse, is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.
A commodities exchange is an exchange where various commodities and derivatives products are traded.
Most of the commodities Exchanges on Agricultural products and other Raw Materials.
The most prominent agricultural products traded on the Exchange are: Wheat, Maize, Barley, Sugar, Cotton, and Cocoa.
The most prominent other products traded on the exchange are Oil/Crude, Natural Gas, Kerosene, Gasoline, Rubber, Gold, Silver, Platinum, Palladium, Nickel, Aluminum, Zinc, Copper and Exotic Products.
Yes, commodities traded in an exchange are traded as per the contract specifications.
Any commodity traded on exchange will have a fixed specification based on the product, size, weight, quality.
A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset.
The underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc.
Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads.
Futures Contract is specie of forward contract.
Forward contracts are customized; the terms of forward contracts are individually agreed between two counter-parties.
Futures are exchange traded contracts: to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price.
Futures contracts are used generally for protecting against the price fluctuation, which is also knows as hedging amongst the finance fraternity.
A hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment.
Yes, however provisions vary from Exchange to Exchange. Byelaws of some Associations give both the buyer and seller the right to demand/give delivery.
Non-Transferable Specific Delivery Contracts is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. The rights or liabilities under this contract cannot be transferred by transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods.
Transferable Specific Delivery contracts is an enforceable customized agreement where unlike known transferable specific delivery contracts, the right or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.
A significant bifurcation in the instrument is whether the derivative is traded on the exchange or over the counter. Exchange-traded contracts are standardized (futures). It is easy to buy and sell contracts (to reverse positions) and no negotiation is required. The OTC market is largely a direct market between two parties who know and trust each other. Most common example for OTC is the forward contract. Forward Contracts are directly negotiated, tailor-made for the needs of the parties, and are often not easily reversed.
A commodity is a product that has commercial value, which can be produced, bought, sold, and consumed. Commodities are basically the products of the primary sector of an economy. The primary sector of an economy is concerned with agriculture and extraction of raw materials such as metals, energy (crude oil, natural gas), etc., which serve as basic inputs for the secondary sector of the economy.
Cash transaction results in immediate delivery of a commodity for a particular consideration between the buyer and the seller. A marketplace that facilitates cash transaction is referred to as the cash market and the transaction price is usually referred to as the cash price. Buyers and sellers meet face to face and deals are struck. These are traditional markets. Example of a cash market is the ‘LaFoire De Quatre Borne’ where vegetables and food grains are sold in bulk. Farmers would bring their products to this market and merchants/traders would immediately purchase the products, and they settle the deal in cash and take or give delivery immediately. Cash markets thus call for immediate delivery of commodities against actual payment.
In this case, the agreements are normally made to receive the commodities at a later date in future for a pre-determined consideration based on agreed upon terms and conditions. Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered on a particular future date. Forwards and Futures markets allow delivery at some time in the future, unlike cash markets that call for immediate delivery. These advance sales help both buyers and sellers with long-term planning. Forward contracts laid the groundwork for futures contracts. The main difference between these two contracts is the way in which they are negotiated.
Existence of a vibrant, active, and liquid commodity market is normally considered as a healthy sign of development of a country’s economy. Growth of a transparent commodity market is a sign of development of an economy. It is therefore important to have active commodity markets functioning in a country.
It is widely believed that the futures trade first started about approximately 6,000 years ago in China with rice as the commodity. Futures trade first started in Japan in the 17th century. In ancient Greece, Aristotle described the use of call options by Thales of Miletus on the capacity of olive oil presses. The first organized futures market was the Osaka Rice Exchange, in 1730.
The commodity markets ecosystem includes the following components:
- Buyers/Sellers or Consumers/Producers: Farmers, manufacturers, wholesalers, distributors, farmers’ co-operatives, APMC mandis, traders, state civil supplies corporations, importers, exporters, merchandisers, oil refining companies, oil producing companies, etc.
- Logistics Companies: Storage and transport companies/operators, quality testing and certifying companies, valuers, etc.
- Markets and Exchanges: Spot markets (mandis, bazaars, etc.) and commodity exchanges (national level and regional level)
- Support agencies: Depositories/de-materializing agencies, central and state warehousing corporations, and private sector warehousing companies
- Lending Agencies: Banks, financial institutions
Trading in futures provide two important functions of price discovery and price risk management with reference to the given commodity. It is therefore useful to all the segments of the economy and particularly to all the constituents of the commodity market system. It is important to know how resorting to commodity trading benefits the constituents.
As the constituents of the Commodities Market Ecosystem get benefited, the country’s economy is also benefited. Growth in the organized commodity markets and their constituents implies that there would be tremendous advantages and benefits accrued to the country’s economy in terms of business generation and growth in employment opportunities. Within the country importing bulk of raw material (especially in base metals and energy), there is scope for minimizing price risk for International commodities for the Mauritian economy as a whole. With the consumption of commodities, especially in developing countries such as China and India increasing rapidly, the prices of commodities are volatile, thereby, emphasizing the need for organized commodity derivatives exchanges for the participants in the commodity.
Futures prices evolve from the interaction of bids and offers emanating from all over the country - which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.
All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i.e., there should be large demand for and supply of the commodity - no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price. The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardization and gradation.
Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist.
One doesn't need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.
In simple terms, long position is a net bought position.
Short position is net sold position.
In most commodities and financial derivatives market, the term refers to buying contracts maturing in nearby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.
In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.
Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier.
It arises normally when the contract matures during the same crop season. In a well- integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.
When the prices of spot or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation.
It is usual for a contract maturing in the peak season to be in backwardation during the lean period.
It is normally calculated as cash price minus the futures price. A positive number indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.
It is a process for performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt)
It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.
The settlement price is the price at which all the outstanding trades are settled, i.e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.
This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.
Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.
The reason is, futures contracts may not be suitable for merchandising purpose, mainly because these are standardized contracts; hence various aspects of the contracts, viz. quality/grade of the goods, packing, place of delivery, etc. may not meet the specific needs of the buyers/sellers.
The threat of delivery helps in dissuading the participants from artificially rigging up or depressing the futures prices. For example, if manipulators rig up the prices of a contract, seller may give his intention to make a delivery instead of settling his outstanding contract by entering into purchase contracts at such artificially high price.
All the Exchanges give option to the participants to liquidate their outstanding position by entering into offsetting contract, before the "delivery period" commences. There is no delivery if the contracts are so liquidated. The threat of delivery - whether in terms of physical goods or by warehouse receipts - becomes a reality once delivery period commences.
The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges, particularly the northern Exchanges trading contracts in Gold provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position are settled at the "Due Date Rate".
Due Date Rate is the weighted average of both spot and futures prices of the specified number of days, as defined in the Byelaws of Associations.
It is the specified month within which a futures contract matures.
It is a written notice given by sellers of their intention to make delivery against outstanding short open futures positions on a particular date.
It is a document issued by a warehouse indicating ownership of a stored commodity and specifying details in respect of some particulars, like, quality, quantity and, some times, indicating the crop season.
Participants in futures market include market intermediaries in the physical market, like, producers, processors, manufacturers, exporters, importers, bulk consumers etc., besides speculators. There is difference between speculation and gambling. Gambling is the wagering of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods. Speculation on the other hand may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities.59. Therefore futures markets are not "Gambling markets".
Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market, therefore, it is difficult to imagine a futures market functioning without speculators.
Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market.
Informed and speculation is good for the market. However over-speculation needs to be kerbed. There is no unanimity about what constitutes over-speculation.
In order to curb over-speculation, leading to distortion of price signals, limits are imposed on the open position held by speculators. The positions held by speculators are also subject to certain margins; many Exchanges exempt hedgers from this margins.
The most important principle for designing a futures contract is to take into account the systems and practices being followed in the cash market. The unit of price quotation, unit of trading should be fixed on the basis of prevailing practices. The "basis" - the standard quality/grade - variety should generally be that quality or grade which has maximum production. The delivery centers should be important production or distribution centers. While designing a futures contract care should be taken that the contract designed is fair to both buyers and sellers and there would be adequate supply of the deliverable commodity thus preventing any squeezes of the market.
Forward/Futures trading performs two important functions, namely, price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It enables the 'Consumer' in getting an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. It is very useful to the 'exporter' as it provides an advance indication of the price likely to prevail and thereby helps him in quoting a realistic price and secure export contract in a competitive market It ensures balance in supply and demand position throughout the year and leads to integrated price structure throughout the country. It also helps in removing risk of price uncertainty, encourages competition and acts as a price barometer to farmers and other functionaries in the economy.
Hedging is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/ cash markets to cover their price risk by taking opposite position in the futures market.
To illustrate the concept of hedging, let us assume that, on 1st December, 2008, a stockist purchases, say, 10 tonnes of Castorseed in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2003 contract is Rs.1750/- p.q., the stockist is able to lock in a spread/"badla" of Rs. 150/- p.q., i.e., about 9% for about 6 months. The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is Rs. 1500/- p.q.. The stockist would incur a loss of Rs. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q. to, say, Rs. 1625/- p.a. The stockist can liquidate his contract in the futures market by entering into purchase contract @ Rs. 1625/- p.q. He would end up earning a profit of Rs. 125/- in the futures segment. Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.
World over, farmers do not directly participate in the futures market. They take advantage of the price signals emanating from a futures market. Price-signals given by long-duration new-season futures contract can help farmers to take decision about cropping pattern and the investment intensity of cultivation. Direct participation of farmers in futures market to manage price risk -either as members of an Exchange or as non-member clients of some member - can be cumbersome as it involves meeting various membership criteria and payment of daily margins etc. Options in goods would be relatively more farmer-friendly, as and when they are legally permitted.
Loss incurred in futures market by entering into contracts for hedging purposes can be set off against normal profit. The loss incurred on account of speculative transactions in futures market cannot be set off against normal business profit. This loss is however allowed to be carried forward for eight years, during which it can be set off against speculative profit.
The Bye-laws and Articles of the Association prescribed the criteria for being a member of the Exchange. Any person desirous of being a member of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website. They may also refer to the Bye-law and Articles of Association of the concerned Exchange which contain various criteria for the membership of the Exchange.
Participants in forward/futures markets are hedgers, speculators, daytraders/ scalpers, market makers, and, arbitrageurs.
Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.
Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.
Day traders are speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.
A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.
A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.
A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.
Different kinds of risks faced by participants in derivatives markets are: a) credit risk b) market risk c) liquidity risk d) legal risk e) operational risk.
Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts.
Market risk is the risk of loss on account of adverse movement of price.
Liquidity risks is the risk that unwinding of transactions may be difficult, if the market is illiquid.
Legal risk is that legal objections might be raised, regulatory framework might disallow some activities.
Operational risk is the risk arising out of some operational difficulties, like, failure of electricity, due to which it becomes difficult to operate in the market.
An Exchange designs a contract, which alone would be traded on the Exchange. The contract is not capable of being modified by participants, i.e., it is standardized. The Exchange also provides a trading platform, which converges the bids and offers emanating from geographically dispersed locations. This creates competitive conditions for trading. The Exchange also provides facilities for clearing, settlement, arbitration facilities. The Exchange may also provide financially secure environment by putting in place suitable risk management mechanism (margining system etc.), and guaranteeing performance of contract through the process of novation.
The aim of margin money is to minimize the risk of default by either counter party. The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin is very low. The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract.
Different margins payable on futures contracts are: i. ordinary/initial margin, ii. Mark-to-market margin, iii. Special margin, IV, volatility margin and v. delivery margin.
It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contracts. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.
Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is enterned into on that day) or the previous day's clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.
Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction. Hence the risk of default is reduced. Also, the participants are required to pay less upfront margin - which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position. Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity.
It is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
Client Account is an account maintained for any individual or entity being serviced by an agent (broker, members), for a commission. A customer's business must be segregated from the broker's/member's/principal's own business and clients' money should be kept in segregated accounts.
The main objectives of Trade Guarantee fund are (a) to guarantee settlement of bonafide transactions of the members of the Exchange (b) thereby, to inculcate confidence in the minds of market participants' (c) to protect the interest of the investors. All the members of the Exchange are required to make initial contribution towards trade guarantee fund of the Exchange.
Clearing House performs post trading functions like confirming trades, working out gains or losses made by the participants during the course of the clearing period - usually a day-collecting the losses from the members and paying out to other who have made gains.
Some Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.
The performance of the contracts registered by the exchange are guaranteed either by the exchange or its clearing house. The exchange interposes itself between each buyer and seller thereby becoming a seller to every buyer and a buyer to every seller. The Exchange In order to safeguard its interest by imposing mark to market margin (which is clearing all the transactions at the closing price of the day. All the profits and losses are either paid in or paid out). This minimizes the chances of default as buyer or seller is exposed to one day of price movements. The Exchange also maintains its own TGF / SGF which can be used in case of a default. The Exchange also puts in place membership criteria and some of the new Exchanges have also prescribed certain minimum capital adequacy norms.
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