Commodity FAQ
Commodity market is a place where trading in commodities takes place. It is similar to an Equity market, but instead of buying or selling shares one buys or sells commodities.
The commodities markets are one of the oldest prevailing markets in the human history. In fact derivatives trading started off in commodities with the earliest records being traced back to the 17th century when Rice futures were traded in Japan.
Commodity exchanges are institutions, which provide a platform for trading in 'commodity futures' just as how stock markets provide space for trading in equities and their derivatives. They thus play a critical role in robust price discovery where several buyers and sellers interact and determine the most efficient price for the product. Indian commodity exchanges offer trading in `commodity futures' in a number of commodities. Presently, the regulator, Forward Markets Commission allows futures trading in over 120 commodities. There are two types of commodity exchanges in the country- 3 national level and 21 regional.
World-over one will find that a market exits for almost all the commodities known to us. These commodities can be broadly classified into the following:
- Precious Metals: Gold, Silver, Platinum etc.
- Other Metals: Nickel, Aluminum, Copper etc.
- Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds, etc.
- Soft Commodities: Coffee, Cocoa, Sugar etc.
- Energy: Crude Oil, Natural Gas, Gasoline etc.
The exchange-traded markets are essentially only derivative markets and are similar to equity derivatives in their working. I.e. everything is standardized and a person can purchase a contract by paying only a percentage of the contract value. A person can also go short on these exchanges. Also, even though there is a provision for delivery most of the contracts are squared-off before expiry and are settled in cash. As a result, one can see an active participation by people who are not associated with the commodity.
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.
A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.
Futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures contracts; but they merely accept terms of contracts standardized by the Exchange.
Forward contracts (other than futures) are customized. In other words, the terms of forward contracts are individually agreed between two counter-parties.
Future Contract is a type of forward contract. 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 adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.
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.
The provision for delivery is made in the Byelaws of the Associations so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery is generally at the option of the sellers. However, provisions vary from Exchange to Exchange. Byelaws of some Associations give both the buyer and seller the right to demand/give delivery.
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.
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.
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 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.
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.
The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges, particularly the northern Exchanges trading contracts in “gur”/jaggery provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position are settled at the “Due Date Rate”.
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 Association.
It is the specified month within which a futures contract matures.
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, sometimes, 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. Therefore futures markets are not “satta 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 counter party 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.
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.
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 of fmc: www.fmc.gov.in. 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, day-traders/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.
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.
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.
At present 21 Exchanges are recognized/registered for forward/ futures trading in commodities.
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).
Government identified the best international systems and practices in respect of trading, clearing, settlement and governance structure and invited applications from associations – existing and potential – to set up National Commodity Exchanges by introducing such systems and practices. The term, "National" used for these Exchanges does not mean that other Exchanges are restricted from having nationwide operations.
National Commodity Exchanges would be granted recognition in all permitted commodities; the other exchanges have to approach the Government for grant of recognition for each futures contract separately. Also, National Commodity Exchanges would be putting is place the best international practices in trading, clearing, settlement, and governance.
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.
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 entered 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.
It is a legal document entered into between the broker and the client setting out the conditions of their relationship and meeting the requirements of the relevant self-regulatory organization and the Regulator.
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.
No; but the Forward Contracts (Regulation) Act, 1952 is proposed to be amended to provide for registration of brokers with the Forward Markets Commission.
Forward Market Commission does not charge any regulatory fee from the Exchanges or its members and users. It is an office of the Government of India and sources its finances from the budget.
Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. No exchange or no person – whether he is a member of any recognized association or not - can organize or enter into or make or perform options in goods; it constitutes cognizable offence, which is punishable under section 20(e) of the Act.
At present, there are three tiers of regulations of forward/futures trading system exists in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges. The FC(R) Act, 1952 prohibits options in commodities. For the purpose of forward contracts in certain commodities can be regulated by notifying those commodities u/s 15 of the Act; forward trading in certain other commodities can be prohibited by notifying these commodities u/s 17 of the Act.
The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. The 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.
Forward Markets Commission is a regulatory body for commodity futures/ forward trade in India. This was set up under the Forward Contracts (Regulation) Act of 1952. It is responsible for regulating and promoting futures/ forward trade in commodities. The Forward Markets Commission's Head Quarter is located at Mumbai and Regional Office at Kolkata. The Address of the contact person is as follows: -
The Chairman, Forward Markets Commission, Ministry of Consumer Affairs, Food and Public Distribution, (Department of Consumer Affairs), Government of India, “Everest”, 3rd floor, 100, Marine Drive, Mumbai – 400 002. Tel : (022) 22811262/22811429, Fax : (022) 22812086, E-mail :- fmc@bom5.vsnl.nic.in , Web-site :- www.fmc.gov.in
FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association.
It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assign to it.
It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submits to the Government periodical reports on the operations of the Act and working of forward markets in commodities.
It makes recommendations for improving the organization and working of forward markets.It undertakes inspection of books of accounts and other documents of recognized / registered associations.
The F.C(R) Act provides that client's position cannot be appropriated by the member of the Exchange, except a written consent is taken within three days' time. Forward Markets Commission is persuading increasing number of Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. Commission 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 Commission has also mandated all the Exchanges following open outcry system to display at a prominent place in Exchange premises, the name, address, and 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, send comments and suggestions to the Commission. Officers of the Commission 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.
Forward Contracts in the permitted commodities, i.e., commodities notified under S.15 of the Forward Contracts (Regulation) Act, 1952, which are entered into other than: a) between the members of the recognized Association or b) through or c)with any such members.
Forward contracts in prohibited commodities, i.e., commodities notified under S. 17 of the Forward Contracts (Regulation) Act, 1952 (Presently no commodity has been notified under S. 17 of the Act.
Forward Contracts in contravention of the provisions contained in the Bye-laws of the Exchange, which attract S. 15(3) of the Act.
Forward Contracts in the commodities in which such contracts have been prohibited Options in goods.
Broker is said to be indulging in bucketing, when he takes directly or indirectly, the opposite side of a customer's order either on his own account or into on account in which he or she has an interest, without executing the order on an Exchange. Appropriation of clients' trade without written consent constitutes contravention of S. 15(4) of the Act and is punishable under S. 20(e).
