a study on commodity derivative

7/29/2019 A Study on Commodity Derivative

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A Study

on

Commodity

Derivatives

Group:

Rajeev Gupta

Kumar Bhaskar

Chander Mohan Chugh

Sanjay Kumar Sekhardeo

PGEXP-2011-13

IIM- Ranchi


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OVERVIEW: COMMODITY DERIVATIVE AND ITS IMPORTANCE

Commodities are the oldest asset class known to man but perhaps one of the least understood

today. For thousands of years, commodities have been traded in bulk or in the form of

promissory notes at a standardised quantity for a given price.

Dating from time immemorial, farmers and merchants have used futures contracts to alleviate

some of the uncertainty involved in bringing the annual harvest to market. For the modern

investor, most commodities are traded on highly regulated exchanges and cash settlement is

the norm (as opposed to physical delivery). The wide spectrum of traded goods ranges from

grains and livestock to industrial materials such as iron ore and precious metals like gold and

rhodium. One of the primary advantages commodities provide is a measure of global

exposure that crosses the divide between developed and emerging economies. Other

attractive aspects include the relatively low level of historical correlation with other asset

classes. Empirical evidence shows their potential for use in downside risk management.

In the aftermath of the 2008 credit crisis, investment fundamentals have been reassessed as

never before. The role of non-correlated asset classes has been elevated as a critical factor for

institutions. The dynamics of the global economy have tilted in a market that emphasises new

factors. In particular, central banks around the world are becoming more actively involved in

asset markets, injecting vast amounts of liquidity and making full use of their policy arsenal

in an attempt to reignite faster economic growth and keep deflationary pricing at bay.

Meanwhile, most emerging markets have resumed their robust growth trajectories and have

to contend with higher rates of inflation. Against this macroeconomic backdrop, demand for

commodities has picked up in the emerging world and remains latent in the developed world.

Even if demand from the developed world does not recover any time soon, the structural shift

towards emerging economies coupled with stagnant production levels of commodities could

significantly impact the global demand and supply balance. All of which is not to say, of

course, that individual commodities prices will be spared the volatility that has become a

defining characteristic of the asset class. However, there is much more to commodities as an

investment than merely return and volatility. Commodities may affect the long-run downside

risk of a portfolio in times of extreme market stress and hence gained much importance of

late.

Amid all the uncertainty over past few years, we believe that commodities may be the most

relevant asset class for investors to consider as a refuge from extreme price movementsup

or down. In this paper, we have tried to understand and explain what a commodity is, how is

it useful as a financial derivative, a brief history and characteristics of the commodity

derivative market, and we have tied to examine the Indian Commodity Derivative market- its

functions characteristics and usefulness.


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CONTENTS

Sl.

NoTopic

Page

No.

1 What is Commodity? 42 Commodity Types & Examples 4

3 What is Commodity Derivative? 4

4 What is a Commodity Futures Contract? 4

5 Major Participants of Commodity Futures Market 5

6 The Commodity Market & Brief History 7

7 Commodity Exchanges in India 10

8 Commodity Market Structure 11

9 Commodity Eco-system 12

10 Indian Commodity Market Present Scenario 13

11 How to invest in Commodity Market 13

12 Characteristics of Commodity Market 15

13 Strategies for Trading In Commodities and Futures 16

14 Ways to trade in Commodity Market 16

15 Different Segments in Commodities Market 17

16 Risk associated with Commodities Market 18

17 Trend of global commodity price movement 18

18 Performance of Commodity derivatives & Macro-economy 19

19 Conclusion 22


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WHAT IS COMMODITY?

A commodity is an article, product or material/goods that can be produced, transported, bought

and sold in the market, except Actionable Claims, Money & Securities.

COMMODITY TYPES & EXAMPLES:

Metal & Alloys Gold, Silver, Aluminum, Copper, Lead, Zinc, Nickel, Tin, Iron, Steel etc.

Agricultural Products

& Plantations

Cereals, Pulses, Spices, Coffee, Vegetables, Oil & Oil seeds, Cotton Seed,

Rubber, Areca nut Cashew Kernel etc.

Raw Materials Iron Ore, Bauxite, Coal, Lignite,

Petrochemicals Crude Oil, Furnace Oil, Natural Gas, Coal-chemicalsFiber Cotton Staple, Cotton Yarn, Kapas

Precious Stones Diamond, Emerald, quartz, etc.

Others Anything which can be produced & transported except money & securities

HOW ARE COMMODITIES TRADED?

Trading of commodities consists of physical and derivatives trading. In this paper, though we

shall try to see trading of both, we will focus mainly on commodity derivatives that are traded on

exchanges and OTC derivatives markets.

WHAT IS COMMODITY DERIVATIVE?

Commodity Derivatives like other Financial Derivatives are basically Contracts i.e. Futures and

Options involving any of the above mentioned commodities as an underlying asset. The value of

the contract is derived from the underlying asset i.e. a commodity, hence the name Commodity

Derivative. Commodities actually offer immense potential to become a separate asset class for

market-savvy investors, arbitrageurs and speculators. Derivatives as a tool for managing risk first

originated from commodity trading only. They were then found useful as a hedging tool in many

financial markets for the Investors, Hedgers, Arbitrageurs and Day Traders.

WHAT IS A COMMODITY FUTURES CONTRACT?

Suppose a farmer of wheat is trying to secure a selling price for next season's crop, while a bread

maker may be trying to secure a buying price to determine how much bread can be made and at

what profit. So the farmer and the bread maker may enter into a futures contract requiring the

delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into

this futures contract, the farmer and the bread maker secure a price that both parties believe will

be a fair price in June. It is this contract that can then be bought and sold in the commodity

market.

A futures contract is an agreement between two parties: a short position, the party who agrees todeliver a commodity, and a long position, the party who agrees to receive a commodity. In the


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above scenario, the farmer would be the holder of the short position (agreeing to sell) while the

bread maker would be the holder of the long (agreeing to buy). In every commodity contract,

everything is specified: the quantity and quality of the commodity, the specific price per unit, and

the date and method of delivery. The price of a futures contract is represented by the agreed -

upon price of the underlying commodity or financial instrument that will be delivered in the

future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a

price of $4 per bushel. 2

The profits and losses of futures depend on the daily movements of the market for that contract

and are calculated on a daily basis. Unlike the stock market, futures positions are settled on a daily

basis, which means that gains and losses from a day's trading are deducted or credited to a

person's account each day. In the stock market, the capital gains or losses from movements in

price aren't realized until the investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the

futures market are settled in cash, and the actual physical commodity is bought or sold in the cash

market.

Prices in the cash and futures market tend to move parallel to one another, and when a futures

contract expires, the prices merge into one price. So on the date either party decides to close out

their futures position, the contract will be settled. Futures contract is really more like a financial

position. The two parties in the wheat futures contract discussed above could be two speculators

rather than a farmer and a bread maker. In such a case, the short speculator would simply have

lost $5,000 while the long speculator would have gained that amount. (Neither would have to go

to the cash market to buy or sell the commodity after the contract expires.)

Major Participants of Commodity Futures Market

1. Hedgersa. ProducersFarmers, manufacturers, importers and exporter

b. ConsumersRefineries, Food processing companies2. Speculators

a. Institutional proprietary tradersb. Brokerage housesc. Spot Commodity traders

3. Arbitrageursa. Brokerage houses

b. InvestorsHedgers

A Hedger can be Farmers, manufacturers, importers and exporter. A hedger buys or sells in the

futures market to secure the future price of a commodity intended to be sold at a later date in the

cash market. This helps protect against price risks.

The holders of the long position in futures contracts (buyers of the commodity), are trying to

secure as low a price as possible. The short holders of the contract (sellers of the commodity) will

want to secure as high a price as possible. The commodity contract, however, provides a definiteprice certainty for both parties, which reduces the risks associated with price volatility. By means


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of futures contracts, Hedging can also be used as a means to lock in an acceptable price margin

between the cost of the raw material and the retail cost of the final product sold.

Someone going long in a securities future contract now can hedge against rising equity prices in

three months. If at the time of the contract's expiration the equity price has risen, the investor's

contract can be closed out at the higher price. The opposite could happen as well: a hedger could

go short in a contract today to hedge against declining stock prices in the future. A potato farmerwould hedge against lower French fry prices, while a fast food chain would hedge against higher

potato prices. A company in need of a loan in six months could hedge against rising in the interest

rates future, while a coffee beanery could hedge against rising coffee bean prices next year.

Speculator

Other commodity market participants, however, do not aim to minimize risk but rather to benefit

from the inherently risky nature of the commodity market. These are the speculators, and they aim

to profit from the very price change that hedgers are protecting themselves against. A hedger

would want to minimize their risk no matter what they're investing in, while speculators want to

increase their risk and therefore maximize their profits. In the commodity market, a speculatorbuying a contract low in order to sell high in the future would most likely be buying that contract

from a hedger selling a contract low in anticipation of declining prices in the future. Unlike the

hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she

will enter the market seeking profits by offsetting rising and declining prices through the buying

and selling of contracts.

Long Short

Hedger Secure a price now to protect

against future rising prices

Secure a price now to protect against

future declining prices

Speculator Secure a price now inanticipation of rising prices

Secure a price now in anticipation ofdeclining prices

In a fast-paced market into which information is continuously being fed, speculators and hedgers

bounce off of--and benefit from--each other. The closer it gets to the time of the contract's

expiration, the more solid the information entering the market will be regarding the commodity in

question. Thus, all can expect a more accurate reflection of supply and demand and the

corresponding price. Regulatory Bodies the United States' futures market is regulated by the

Commodity Futures Trading Commission, CFTC, and an independent agency of the U.S.

government. The market is also subject to regulation by the National Futures Association, NFA, aself-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.

A Commodity broker and/or firm must be registered with the CFTC in order to issue or buy or

sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in

order to conduct business. The CFTC has the power to seek criminal prosecution through the

Department of Justice in cases of illegal activity, while violations against the NFA's business

ethics and code of conduct can permanently bar a company or a person from dealing on the

futures exchange. It is imperative for investors wanting to enter the futures market to understand

these regulations and make sure that the brokers, traders or companies acting on their behalf are

licensed by the CFTC.

Arbitrageurs


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Arbitrage refers to the opportunity of taking advantage between the price difference between two

different markets for that same stock or commodity.

In simple terms one can understand by an example of a commodity selling in one market at price

x and the same commodity selling in another market at price x + y. Now this y, is the difference

between the two markets is the arbitrage available to the trader. The trade is carried

simultaneously at both the markets so theoretically there is no risk. (This arbitrage should not beconfused with the word arbitration, as arbitration is referred to solving of dispute between two or

more parties.)

The person who conducts and takes advantage of arbitrage in stocks, commodities, interest rate

bonds, derivative products, forex is know as an arbitrageur.

An arbitrage opportunity exists between different markets because there are different kind of

players in the market, some might be speculators, others jobbers, some market-markets, and some

might be arbitrageurs.

In India there are a good amount of Arbitrage opportunities between NCDEX, MCX in

commodities.

THE COMMODITY MARKET

Commodity market is an important constituent of the financial markets of any country. It is the

market where a wide range of commodities are traded. It is important for any country to develop a

vibrant, active and liquid commodity market. This helps investors hedge their risk, take

speculative positions in commodities and exploit arbitrage opportunities in the market. Raw

commodities and related derivatives are traded on regulated commodities exchanges, in which

they are bought and sold in standardized contracts.

Exchange trading

(Standardized contract size and

maturity dates)

OTC trading

(Individually tailored)

Physical

trading

Accounts for a small proportion of

trading on exchanges. It is typically

used to balance out an excess of

demand or supply on the physical

market

Accounts for most OTC trading.

Participants include farmers, refiners

and whole-sellers. Trading is done on

the spot and forwards market and is

delivery based.

Derivativestrading

Accounts for most of trading on

exchanges. Traders include hedgers,

speculators and arbitragers. Dominates

soft commodities trading.

Precious metals and more recently

energy contracts are often traded

through OTC derivatives markets.

Trading of commodities consists of direct physical trading and derivatives trading. Commodities

include a range of diverse products. More recently there has been growing sophistication of

commodities investments with the introduction of new exotic products such as weather

derivatives, telecommunications bandwidth, gas and power derivatives and environmental

emissions trading. Other products that are traded on commodity markets include foreign

currencies and financial instruments and indexes.


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Commodity trading is conducted on OTC markets and exchanges, and consists of spot trading,

physical forwards and derivatives.

OTC Commodities Markets

Physical trading OTC commodities markets are essentially wholesale markets in which

individually-tailored contracts are traded. The most popular physical commodities contracts can

be broken down into: metals, energy, grains and soy, livestock, food and fibre and exotic

commodities as shown in table at page-3. A large proportion of OTC commodities trading is

transacted between producers, refiners and wholesalers on the spot market. Trading is delivery

based and typically done through intermediaries. For most commodities that are physically traded

there is no market in a central meeting place and where it exists it typically handles only a small

part of the total trade.

Derivatives trading The notional value outstanding of banks OTC commodities derivatives

contracts fell 3% in the six months to June 2010 to $2.9 trillion. This was down two-thirds on thevalue outstanding three years earlier as investors reduced risk following a five-fold increase in

value outstanding in the previous three years. Commodities share of the overall notional value

outstanding of OTC derivatives fell during this period from around 2.0% to 0.5% as investors

retreated from this market due to uncertain global economic conditions. Precious metals

accounted for 19% of the total in 2010, down from their 41% share a decade earlier as trading in

energy derivatives rose. The vast majority of OTC derivatives trading is in interest rate contracts

and foreign exchange contracts.

OTC trading accounts for the majority of trading in gold. Twice as much gold was traded on

OTC markets than on exchanges in 2010. Around 40% of silver is traded on OTC markets.

London is by far the largest global centre for OTC transactions in precious metals and accounts

for much of global physical trade. Other important centres include New York, Zurich and Tokyo.

London is also a leading centre for energy brokers operating in energy and carbon markets.

Exchange traded commodities

Exchange trading provides a central regulated market in which large numbers of buyers and

sellers can come together to deal in a competitive, transparent and open environment. Derivatives

exchanges are more standardised in terms of contract sizes, maturity dates and marginrequirements than OTC markets and tend to dominate trading of soft commodities. The vast

majority of trading on commodity exchanges is in derivatives.

Commodity exchanges have gradually developed from physical markets where deals were made

out of warehouses, to futures markets which allow for both hedging to protect against losses in a

declining market and speculation for gains in a rising market. The derivative markets for futures

were developed initially to help agricultural producers and consumers manage their price risks.

Commodities accounted for 9.0% of the value of global exchange-traded derivatives in 2010. This

was up from 6.4% two years earlier and less than 3% in 2005. During these five yearscommodities share of the number ofcontracts outstanding increased from 8.7% to 12.3%.


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Largest commodity exchanges Worldwide, there are around 50 major commodity exchanges that

trade in more than 90 commodities. Softcommodities are traded around the world and dominate

exchange trading in Asia and Latin America. Metals are predominantly traded in London, New

York, Chicago and Shanghai. Energy contracts are mainly traded in New York, London, Tokyo

and the Middle East. More recently a number of energy exchanges have emerged in several

European countries. In terms of the number of futures contracts traded, in 2009 China and the

UK had three exchanges amongst the largest ten, the US two and Japan and India one each. The

Dalian Commodity Exchange was the largest commodities exchange in the world followed by the

Shanghai Futures Exchange and CME Group. The UKs ICE Futures Europe was fifth and the

London Metal Exchange seventh. Trading on exchanges is fairly concentrated. In 2009 the top

five exchanges accounted for 86% of contracts traded globally up on their 82% share in the

previous year. China and India have gained in importance in recent years with their emergence as

significant commodities consumers and producers. Over the past decade a number of large

exchanges have opened in China and India such as the Shanghai Futures Exchange, Zhengzhou

Commodity Exchange and the Dalian Commodity Exchange in China and the National

Commodity and Derivatives Exchange and MCX in India. Chinese exchanges accounted for morethan 60% of exchange-traded commodities in 2009, up on their 40% share in the previous year.

HISTORY OF COMMODITY MARKET

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.

In the mid-19th century, grain markets were established in US and a central marketplace was

created for farmers to bring their commodities and sell them either for immediate delivery (spot

trading) or for forward delivery. This saved many farmers from the loss of crops and helped

stabilize supply and prices in the off-season.

The world's oldest established futures exchange, the Chicago Board of Trade, was founded in

1848. Forward contracts on corn were introduced in 1851. The Chicago Mercantile Exchange wasfounded as the Chicago Butter and Egg Board in 1898. Most of the exchanges in the developing


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World were established in the 1980s and 1990s in response to government liberalization of

commodity markets. In the 21st century, online commodity trading has become increasingly

popular, and commodity brokers offer front-end interfaces to trade these electronic-based markets.

Today's commodity market is a diverse marketplace of farmers, exporters, importers,

manufacturers and speculators. Modern technology has transformed commodities into a global

marketplace where a Haryana farmer can match a bid from a buyer in EuropeIndian Commodity Markets have their presence in country for over 120 years. Trade in

commodities has been unorganised in regional markets & Local Mandis. Cotton Trade

Association started futures trading in 1875 Derivatives trading started in oilseeds in Bombay

(1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in

Bombay (1920)

After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952. The Act

envisages three-tier regulation: The Exchange which organizes forward trading in commodities

can regulate trading on a day-to-day basis; the Forward Markets Commission provides regulatory

oversight under the powers delegated to it by the central Government, and the CentralGovernment - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public

Distribution is the ultimate regulatory authority. In 1960s, following several years of severe

draughts that forced many farmers to default on forward contracts (and even caused some

suicides), forward trading was banned in many commodities considered primary or essential.

Commodity derivatives and risk management commodity options were banned in India between

1952 and 2002. Commodity market restarted from 2003 onwards. Almost all stock exchanges

have commodity market segments apart from 3 national level electronic exchanges. Trading in

Futures Contracts has been permitted in over 120 commodities. Physical commodity market size

in India is estimated to be around 25 lakh crore per annum.

COMMODITY EXCHANGES IN INDIA

FUTURES

1. MCX (Multi Commodity Exchange)2. NCDEX (National Commodity & Derivative Exchange) &3. NMCE (National Multi-commodity Exchange)4. ICEX ( Indian Commodity Exchange)

SPOT

5.NSEL (SPOT)

6. NCDEX Spot Exchange Ltd. (NSPOT)


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NCDEX & MCX put together have a leadership position with >90% share of total trading through

exchanges in India

COMMODITY MARKET STRUCTURE


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COMMODITY ECOSYSTEM

Global commodity market and indias place in world

Business Potential

Commodities Size of Physical Market(Rs. Crore)

Conservative Multiplier

(Rs. Crore)

( In 3 years)

Global Multiplier

(Rs. Crore)

(In 35 Years)

Gold & Silver Rs. 43000 cr 20 Times

Rs. 8,30,000 cr

50 Times

Rs. 21,50,000 cr

Edible Oils Rs. 30000 cr 10 Times

Rs. 3,00,000 cr

20 Times

Rs. 6,00,000 cr

Metals Rs.11000 cr 10 Times

Rs. 1,10,000 cr

20 Times

Rs. 2,20,000 cr

Total Rs. 84,000 cr Rs. 12,40,000cr Rs. 29,70,000cr

COMMODITY INDIA WORLD SHARE RANK

RICE (PADDY) 240 2049 11.71 THIRD

WHEAT 74 599 12.35 SECOND

PULSES 13 55 23.64 FIRSTGROUNDNUT 6 35 17.14 SECOND

RAPESEED 6 40 15.00 THIRD

SUGARCANE 315 1278 24.65 SECOND

TEA 0.75 2.99 25.08 FIRST

COFFEE(GREEN) 0.28 7.28 3.85 EIGTH

JUTE AND JUTE FIBERS 1.74 4.02 43.30 SECOND

COTTON (LINT) 2.06 18.84 10.09 THIRD


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INDIAN COMMODITY MARKET- PRESENT SCENARIO

Despite intermittent curbs, Indias ten-year-old commodity futures market has seen a steady

stream of new entrants, drawn by the promise of richer rewards. The intense growth, even in the

absence of basic reforms, has attracted financial institutions, trading companies and banks to set

up large commodity bourse. Since, Indian Commodity Exchange (ICEX), promoted by India bulls

Financial Services Ltd in partnership with MMTC has started its operation in November 2009; ithas created a competition among national level commodity exchanges. Commodity derivatives

market of India is drawing attention from all over the world, albeit FMC had banned nine

commodities since early 2007, out of which 4 are still out of trade and even financial institutions

and foreign entities are barred from trading in the market.

Even, industry players are of the view that commodity market regulator (FMC) should permit

banks and financial institutions to trade in commodity futures, allow options, exchange-traded

indices and some more powers to the market regulator from Ministry of Consumer Affairs to

develop the market.

Unlike developed markets, participation in Indian market is more retail & individual and notinstitutional.

Commodity Futures Trading in India had long tradition; market now being revived; paradigm

shift in thinking with huge appetite for speculation is seen; equity players expand into

commodities with more liquidity.

New Developments Banks, MFs, FIIs may be allowed to trade commodities; huge fund flow

expected; volatility will create market opportunities for investors; Gold ETF has all ready

launched. A gold exchange-traded fund (or GETF) is an exchange-traded fund (ETF) that aims to

track the price of gold. Gold exchange-traded funds are traded on the major stock exchanges

including Zurich, Mumbai, London, Paris and New. All exchange-traded instruments, including

those that hold physical gold for the benefit of the investor, carry risks beyond those inherent in

the precious metal itself. The most popular gold ETF (SPDR Gold Trust, symbol GLD) has been

compared with mortgage-backed securities and collateralised debt obligations due to its

complexity. The extensive analysis and criticism received by GLD is instructive for reviewing all

gold ETF's, many of which are similarly complex and have received little scrutiny.

Usually derivatives markets are much larger than the spot markets. In India itself, the derivatives

markets in equity instruments are at least 2 to 3 times the size of the spot markets. With similar

assumptions, one can expect daily volumes of Rs. 1,00,000 crores in the commodity derivatives

markets.

The futures market is a centralized market place for buyers and sellers from around the world who

meet and enter into commodity futures contracts. Pricing mostly is based on an open cry system,

or bids and offers that can be matched electronically. The commodity contract will state the price

that will be paid and the date of delivery. Almost all futures contracts end without the actual

physical delivery of the commodity.

HOW TO INVEST IN COMMODITIES

We list here five ways in which investors can gain exposure to commodities, describing some of

the benefits as well as potential risks and costs in each case. Exhibit 14 summarises the pros and

cons of these various investment vehicles.


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The most direct way to invest in commodities is to purchase physical commodities directly. The

main advantage of this approach is that direct physical ownership gives an investor the most

control over the asset. By definition, this strategy also provides the best opportunity to maximise

spot performance. On the other hand, taking delivery of commodities entails storage as well as

transportation costs. Also, it is usually not easy to sell these commodities on short notice without

incurring extra costs, so direct ownership is a very illiquid way of gaining exposure to the asset

class. Moreover, purchasing commodities directly is not always possible for every type of

investor.

A common alternative to direct physical ownership is an investment in commodity futures. A

commodities futures contract is an agreement to buy or sell a set amount of a commodity at a

predetermined price and date. Buyers purchase such contracts to avoid the risks of commodity

price fluctuations, and sellers use them to set prices for their products. Futures are highly liquid,

unlike physical ownership of the underlying commodities. The main risk to investors is that even

a very small move in the price of a commodity could result in large gains or losses. Unlike

options, futures imply an obligation to buy and sell the underlying commodities at the set price. Ifthe contract is not rolled over, investors face the risk of having to take delivery of the underlying

commodities, which entails storage and transportation costs.

An alternative is to invest in a commodity index, such as the S&P GSCI or the Dow Jones

Commodity Index. An index tracks the performance of a basket of commodities. These indices

are often traded on exchanges, allowing investors to gain easier access to commodities without

having to enter the futures market. The value of these indices depends on the commodities which

constitute the index, and this value can be traded on an exchange in a similar fashion to stock

index futures. An advantage of trading a commodity index is that, unlike trading the commodities

directly, it is a very liquid investment. It is also accessible to many investors by virtue of being

traded on an exchange. On the other hand, it is by definition a passive investment, so any returns

will be purely beta driven. What is more, the carry on an index is often negative.

Another, though more indirect way, to invest in commodities is by investing in commodity

producing companies equity. Of course, this is by nature more of an equity investment than a

commodities investment, at least in terms of asset class allocations. Their main advantages

include the fact that they are highly liquid as publicly traded investments and that they may offer

dividends. On the other hand, stocks of commodities companies carry equity risk, and as with

any equity investment, also incorporate stock-specific risk.

Alternatives to these investment vehicles involve entering into the realm of actively managed

investments. One example of this involves a Commodity Trading Advisor, or CTA, which is

either a person or a firm paid to provide specialised advice on the trading of commodity-related

investments. A CTA will typically trade liquid commodity futures and bring all the benefits of

active management to the investment. Investors should be aware, however, that CTAs tend to base

their trading strategies on trends, and their bets are not necessarily confined to commodities: their

decisions can typically also involve other investments, such as foreign exchange positions.

Commodity specialist hedge funds are another way to gain actively managed exposure to

commodities. Their experience is specific to individual commodities or groups of commodities.


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While their expertise can bring higher returns for individual commodity investments, they are

typically less diversified across commodity sectors.

CHARACTERISTICS OF COMMODITY MARKET

Commodity futures market, the calculation of profit and loss will be slightly different than on a

normal stock exchange. The main concepts in commodity market are:

Margins

In the futures market, margin refers to the initial deposit of good faith made into an account in

order to enter into a futures contract. This margin is referred to as good faith because it is this

money that is used to debit any losses.

The initial margin is the minimum amount required to enter into a new futures contract, but the

maintenance margin is the lowest amount an account can reach before needing to be replenished.

Leverage

Leverage refers to having control over large cash amounts of a commodity with comparatively

small levels of capital. In other words, with a relatively small amount of cash, one can enter into a

futures contract that is worth much more than one initially has to pay (deposit into ones margin

account). It is said that in the futures market, more than any other form of investment, price

changes are highly leveraged, meaning a small change in a futures price can translate into a huge

gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the exchanges are

relatively small compared to the cash value of the contracts in question (which is part of the

reason why the futures market is useful but also very risky)..

Due to leverage, if the price of the futures contract moves up even slightly, the profit gain will belarge in comparison to the initial margin. However, if the price just inches downwards, that same

high leverage will yield huge losses in comparison to the initial margin deposit.

Pricing and Limits

Contracts in the Commodity futures market are a result of competitive price discovery. Prices are

quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels,

barrels, index points, percentages and so on).

Prices on futures contracts, however, have a minimum amount that they can move. These

minimums are established by the futures exchanges and are known as ticks.Futures prices also have a price change limit that determines the prices between which the

contracts can trade on a daily basis. The price change limit is added to and subtracted from the

previous day's close, and the results remain the upper and lower price boundary for the day.

The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the

exchange to abolish daily price limits in the month that the contract expires (delivery or spot

month). This is because trading is often volatile during this month, as sellers and buyers try to

obtain the best price possible before the expiration of the contract.

In order to avoid any unfair advantages, the CTFC and the Commodity futures exchanges impose

limits on the total amount of contracts or units of a commodity in which any single person can


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invest. These are known as position limits and they ensure that no one person can control the

market price for a particular commodity.

STRATEGIES FOR TRADING IN COMMODITIES AND FUTURES

Futures contracts try to predict what the value of an index or commodity will be at some date in

the future. Speculators in the futures market can use different strategies to take advantage of rising

and declining prices. The most common strategies are known as going long, going short andspreads.

Going Long

When an investor goes long, that is, enters a contract by agreeing to buy and receive delivery of

the underlying at a set price, it means that he or she is trying to profit from an anticipated future

price increase.

Going Short

A speculator who goes short, that is, enters into a futures contract by agreeing to sell and deliver

the underlying at a set price, is looking to make a profit from declining price levels. By selling

high now, the contract can be repurchased in the future at a lower price, thus generating a profit

for the speculator.

Spreads

As going long and going short, are positions that basically involve the buying or selling of a

contract now in order to take advantage of rising or declining prices in the future. Another

common strategy used by commodity traders is called spreads. Spreads involve advantage of the

price difference between two different contracts of the same commodity. Spreading is considered

to be one of the most conservative forms of trading in the futures market because it is much safer

than the trading of long / short (naked) futures contracts.

There are many different types of spreads, including:

Calendar spread - This involves the simultaneous purchase and sale of two futures of the same

type, having the same price, but different delivery dates.

Inter-Market spread - Here the investor, with contracts of the same month, goes long in one

market and short in another market. For example, the investor may take Short June Wheat and

Long June Pork Bellies.

Inter-Exchange spread - This is any type of spread in which each position is created in different

futures exchanges. For example, the investor may create a position in the Chicago Board of Trade,CBOT and the London International Financial Futures and Options Exchange, LIFFE.

WAYS TO TRADE IN COMMODITY MARKET

One can invest in the futures market in a number of different ways, but before taking the plunge,

one must be sure of the amount of risk he is willing to take. As a futures trader, one should have

a solid understanding of how the market works and contracts function. It is also needed to

determine how much time, attention, and research one can dedicate to the investment. Talk to the

broker and ask questions before opening a futures account.

Unlike traditional equity traders, futures traders are advised to only use funds that have been

earmarked as risk capital. Once the initial decision is made to enter the market, the next question

should be, how? Here are three different approaches to consider:


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Self Directed Full Service Commodity pool

Self Directed: - As an investor, one can trade ones own account, without the aid or advice of a

Commodity broker. This involves the most risk because one become responsible for managing

funds, ordering trades, maintaining margins, acquiring research, and coming up with ones own

analysis of how the market will move in relation to the commodity in which one has invested. It

requires time and complete attention to the market.

Full Service: - Another way to participate in the market is by opening a managed account, similar

to an equity account. A broker would have the power to trade on any ones behalf, following

conditions agreed upon when the account was opened. This method could lessen ones financial

risk, because a professional broker would be assisting, or making informed decisions on ones

behalf. However, one would still be responsible for any losses incurred and margin calls.

Commodity Pool: - A third way to enter the market, and one that offers the smallest risk, is tojoin a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which

can be invested in. No one person has an individual account; funds are combined with others and

traded as one. The profits and losses are directly proportionate to the amount of money invested.

By entering a commodity pool, one gains the opportunity to invest in diverse types of

commodities. One is also not subject to margin calls. However, it is essential that the pool be

managed by a skilled broker, for the risks of the futures market are still present in the commodity

pool.

DIFFERENT SEGMENTS IN COMMODITIES MARKET

The commodities market exits in two distinct forms namely the Over the Counter (OTC) market

and the Exchange based market. Also, as in equities, there exists the spot and the derivatives

segment. The spot markets are essentially over the counter markets and the participation is

restricted to people who are involved with that commodity say the farmer, processor, wholesaler

etc. Derivative trading takes place through exchange-based markets with standardized contracts,

settlements etc.

Market share of commodity exchanges in India (APPROX)

% of market share of exchange

MCX, 74%

NCDEX, 22%

NMCE, 1% NBOT, 2% OTHERS, 1%


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RISK ASSOCIATED WITH COMMODITIES MARKET

No risk can be eliminated, but the same can be transferred to someone who can handle it better or

to someone who has the appetite for risk. Commodity enterprises primarily face the following

classes of risk. Namely: The price Risk, the quantity risk, the yield/output risk and the political

risk, talking about the nationwide commodity exchanges, the risk of the counter party not

fulfilling his obligations on due date or at any time therefore is the most common risk.This risk is mitigated by collection of the following margins:-

Initial margins Exposure margins Mark to Market on daily positions Surveillance

TREND OF GLOBAL COMMODITY PRICE MOVEMENT

While not all commodity prices move in lock-step, throughout history there have been markedperiods of generalised spikes and swoons. In the 1970s, prices of many commodities trended

higher, but by the 1990s prices typically weakened. Decade of weak price signals left a legacy of

under-investment and dwindling supplies. From 2000 onward, however, demand picked up for all

types of commodities. A bull market that kicked off in 2006 pushed some prices to record levels.

The reasons for this were manifold, but perhaps the chief driving force was a sharp rise in demand

from emerging economies. In the wake of the financial crisis in 2008, global demand dropped as a

result of negative GDP growth in most of the developed world and lower growth in many

developing economies. But prices for many commodities have rebounded over the past two years

as demand has recovered, especially in emerging economies.


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PERFORMANCE OF COMMODITY DERIVATIVES & MACRO-ECONOMY

In the wake of the 2008 credit crisis and subsequent unprecedented injections of liquidity into

world markets, a major concern for many investors is the prospect for higher rates of inflation in

the future. At the same time, with growth in developed economies still well below trend, deflation

is also a significant concern as it may be a more immediate threat.

Both pricing regimes inflation and deflation present challenges to investors seeking to maximisethe purchasing power of their portfolio assets over the mid-to-long term. While real assets such as

commercial real estate have historically tended to perform best during periods of high inflation

and fixed income investments have been a safe harbour amid deflation, the role of commodities in

these pricing environments is perhaps less well understood. Can a strategic allocation to

commodities act as a hedge in either caseor both?

In order to understand the relationship between inflation and asset returns, including commodity

returns, JP Morgan conducted an empirical analysis in which they sought to isolate the impact of

inflation on various asset prices, taking into account the fact that asset returns are also driven by

other factors such as prospects for economic growth, interest rates, capital flows, currencyvaluation, financial regulation, government policy (including taxes) and changes to investor risk

appetite, to name but a few variables.

Results of analysis suggest that inflation detracts from equity performance, as profit margins are

depressed and both higher variable input costs as well as labour costs tend to impede earnings

growth. Fixed income (in the form of government-issued securities), meanwhile, is negatively

affected by strong GDP growth as well as by a higher unemployment rate. Corporate bonds,

which have both equity15 and fixed income qualities, suffer in a high inflationary environment

because that is when their fixed income characteristics tend to dominate. Long positions in

commodities are perhaps the closest thing to a pure inflation hedge relative to the other liquid

asset classes considered in this analysis. That is because, as our results show, unlike equities or

fixed income, commodities exhibit a significant positive return in inflationary environments. In

other words, inflation and commodity returns have strong positive correlations.

Given the current slack in economies around the world, investors are also concerned about the

potential for deflation. In this section, we define deflation as a decrease in the general price level

of goods and services. Deflation occurs when the annual inflation rate becomes negative, resulting

in an increase in the real value of money.

It is found that the immediate impact of deflation on equities is to depress prices, but that

moderates over a three-year time frame. As for fixed income, it reacts positively in deflationary


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cycles, but this effect dissipates over time. Credit, however, benefits in both short-and mid-term

deflationary scenarios. Commodities, on the other hand, display an unambiguously negative

response to deflation. But that is not necessarily a disincentive for an investor because that strong

correlation

According to modern financial theory as it was pioneered by Harry Markowitz in 1952, the risk

associated with asset returns is divided into two components: the asset-specific risk and the

market risk. In theory, it is not possible to avoid market risk by portfolio diversification, as only

asset-specific risk may be reduced in this way. For example, because commodity returns and

equity returns are negatively correlated, holding both these asset classes can reduce the asset-

specific risk taken by sharing it between the two assets. The market risk, however, is un-

diversifiable.

If we take into account the cyclical nature of economic growth, however, we find that an

investment in commodities can, in fact, help reduce the systematic, market risk taken by a port-folio. Indeed, if we can identify patterns between asset class returns and economic cycles, an

investor employing sophisticated hedging techniques may be able to exploit them.


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In particular, commodities tend to perform well in the early stages of a recession, a time when

stock returns generally deteriorate. In later stages of recessions, commodity returns also start to

deteriorate, but this is typically when equities begin to outperform. An investor employing

sophisticated hedging techniques may therefore be able to take advantage of this apparent pattern

in asset class returns and economic cycles.

The above graph depicts a classic business cycle in stylized form identifying the peak and

troughas determined by the US National Bureau of Economic Research (NBER). The

corresponding cycles are divided into phases, which are calculated by dividing the number of

months from peak-to-trough (or trough-to-peak) into equal halves to indicate Early Recession and

Late Recession (and then Early Expansion and Late Expansion). In this way, the Early and Late

Expansion phases correspond to an economic expansion, while the Early and Late Recession

phases correspond to an economic contraction.

Each of the four stages in the exhibit have been defined as a combination of the level of the output

gap (i.e., the difference between actual output and potential output) and the rate of economicgrowth. In Stage No. 1, the economy is in a late expansionary phase characterized by fast growth

and above-trend output, so capacity constraints begin to come into play and commodity prices

rise. In Stage No. 2, labeled Early Recession in the diagram, output is still above-trend but it starts

to slow as capacity constraints lead to a rise in unemployment. Eventually, output drops below its

trend average and the economy enters a Late Recession phase. Thus, in Stage No. 3, output

continues to decline, unemployment levels peak and capacity utilisation bottoms out. Finally, in

Stage No. 4, the Early Expansion, the economy emerges from recession with rising, but still

below trend, output and moderating unemployment levels.

The obvious question for the long-term investor is: How well do major asset classes performacross each of the four stages of an economic cycle? To answer that, we looked at average

annualised quarterly returns and volatility (via standard deviation) for four major asset classes

during the four stages of a complete cycle.

From this simple analysis, we can see that commodities tend to perform better than the other three

asset classes when the economy is in a late expansionary phase, with average returns of 19.97%

and relatively low volatility. As the economy enters recession, this analysis shows that

commodity returns are still higher than the returns to the other asset classes, but that bonds and

bills are on the rise and equities underperform. In the latter part of a recession, we have

determined that equities and bonds seem to outperform, while in an early expansion, commoditiesregain the upper hand. In this respect, historically speaking, a tactical allocation to equity


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investments would have been optimal just when the economy was at its worst, while an

opportunistic allocation to commodities would seem to have been most logical just as an

economic recovery got underway.

It should be emphasised that these results are purely descriptive and are not meant to imply a

trading strategy since the business cycles used are dated ex-post facto. However, one key

takeaway that emerges from this analysis is that equities, bonds, and treasuries display similar riskcharacteristics relative to the economic cycle. Commodities, in contrast, behave very differently

from other asset classes, offering potential for lowly correlated macroeconomic diversification

within an investment portfolio.

CONCLUSION

The commodity Market is poised to play an important role of price discovery and risk

management for the development of agricultural and other sectors in the supply chain. New issue

and problems Govt. regulators and other share holders will need to proactive and quick in their

response to new developments. WTO regime makes it all the more urgent to develop these

markets to enable our economy, especially agriculture to meet the challenge of new regime and

benefits from the opportunities unfolding before U.S. with risks not belong absorbed any more the

idea is to transfer it as the focus is shifting to Manage price change rather than change prices

the commodity markets will play a key role for the same.

Our overall conclusion is that the risk/return case for including commodities as one component of

a diversified portfolio has become stronger in the wake of the 2008 financial crisis and amid the

economic ascendancy of China. In particular, there are significant supply constraints on

commodities amid burgeoning demand for them, not only among developed nations and China

but also from a broader swath of the developing world. This includes emerging economies in

places as far afield as Africa, Asia and South America, many of which, up until recently, have

been characterized as commodity exporters as opposed to commodity consumers. Empirical

research indicates that commodities may offer protection in moderately inflationary as well as in

deflationary environments because of the way in which commodities behave across the business

cycle. Commodities may offer protection against inflation and provide other diversification

benefits across the business cycle. Even in a deflationary environment, for example, investors

could be poised to benefit from short positions. There is prospect for achieving higher returns

through active management.

Commodities present a combination of challenges and opportunities unlike any other asset class

and therefore must be assessed differently from more traditional investment options such as equity

and fixed income. An allocation to commodities as part of a balanced portfolio may help diversify

and potentially bolster performance in a number of different macroeconomic environments

especially if top quartile actively managed strategies are considered. To be sure, commodities

involve higher risk profiles and may be best utilised to complement larger allocations to other

asset classes. However, it is obvious that, they do deserve a place in the pantheon of portfolio

choices. Linkages between and among commodities could potentially be exploited by an active

manager with a flexible approach so as to outperform an index-based strategy tied to a fixed

basket of commodities.

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a study on commodity derivative

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