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A REPORT ON COMMODITY DERIVATIVESWITH REFERENCE TO ZEN SECURITIES PVT. LIMITED.HYDERABADProject report submitted to J.N.T.University, Kakinada in partial fulfillment for the Award of the Degree ofMASTER OF BUSINESS ADMINISTRATIONSubmitted byxxxxxxxxRegd.No.123456789

Under the esteemed guidance ofMr. G.V.SURYA PRASAD M.COM.,MBA,,MPHILLecturer in school of management studies

====================================================JAWAHARLAL NEHRU TECHNOLOGICAL UNIVERSITYSchool of Management studiesKAKINADABatch -2010-12

DECLARATION

I, B.K.Prasad hereby declare that the Project Report that is being submitted here which is a result of the completion of the project on commodity derivatives with reference to Zen Securities Limited, HYDERABAD.The report has been written and submitted by me under the personal guidance of Mr.G.V.SURYA.PRASAD, faculty in the school of management studies, Jawaharlal Technological University KakinadaI further declare that it is my original work done as a part of my academic course and as not been submitted elsewhere.

B.K.PRASAD

ACKNOWLEDGEMENT

The completion of the project gives me an opportunity to convey my gratitude to all those who are in the finance helped me to reach a stage where I have the confidence to launch my career in the competitive world.I would like to express my heart full thanks to Mr. SURENDAR REDDY of ZEN SECURITIES LTD for his inspiration and timely help in completing the project. I owe my sincere thanks to our Director Mr. K. VIJAY KUMAR for having provided me with an opportunity to do this project in the area of my choice.The project would not have been possible without my faculty guide Mr. G.V.SURYA.PRASAD for his excellent guidance who poured his whole hearted support and encouragement throughout my project.I take the opportunity to express my gratitude to the management and members of the JNTU for providing me an opportunity to have this project work done. Finally, I would like to thank my friends and my family members for their continuous encouragement and support during the entire course of the project.

(B.K.Prasad)

INDEXCONTENTSPgno.

Chapter 16

INTRODUCTION

1.1 Executive summary 7

1.2 Introduction to Derivatives8

1.3 Objective of the study10

1.4 Scope of the study10

1.5 Need of the study10

1.6 Research methodology10

1.7 Limitations of the study11

Chapter 212

COMPANY PROFILE

2.1 Zen Securities Limited13

2.2 Services offered by Zen securities15

Chapter 318

INDUSTRY PROFILE

3.1 Industry overview 19

3.2 The regulatory authority20

3.3 SEBI21

3.4 MCX23

3.5 NCDEX25

Chapter 431

REVIEW OF THE LITERATURE

4.1 Definition of derivatives31

4.2 History of derivatives31

4.3 Types of derivatives32

4.4 Trading futures34

4.5 Trading options39

4.6 About the commodity43

4.7 Commodity futures46

4.8 Advantages of futures Trading46

4.9 Mechanics of future trading 47

4.10 Commodity orders52

4.11 Commodity derivatives in India56

4.12 Dematerialization & settlement of warehouse receipts58

4.13 Role of clearing house61

Chapter 565

RESEARCH METHODOLOGY66

Chapter 668

ANALYSIS & INTERPRETATION

6.1 Gold69

6.2 Crude oil76

Chapter 783

RESEARCH FINDING S84

CONCLUSION86

SUGGESTIONS87

ABBREVATIONS88

BIBILOGRAPHY 89

List of tables and figures

CONTENTSPg N0.

Figure 1.1Typology of risk management system10

Figure 3.1Commodities traded in MCX25

Figure 3.2Commodities traded in NCDEX27

Table- 3.1 Exchanges and commodities in which futures contracts are traded.

28

Figure 4.1Types of derivatives34

Figure 4.2Orders and execution flows in electronic future trade54

Table 6.1Trade list of gold75

Figure 6.1Graph showing price fluctuations of gold76

Table 6.2Trade list of crude oil80

Figure 6.2Graph showing price fluctuations of crude oil83

Figure 6.3Graph showing correlation b/w gold & crude oil83

CHAPTER 1

INTRODUCTION1

1.1 EXECUTIVE SUMMARYOne of the interesting developments in financial market over the last 15 to 20 years has been the growing popularity of derivatives. In many situations, both hedgers and speculators find it more attractive to trade a derivative on an asset, commodity than to trade asset and commodity itself. Some commodity derivatives are traded on exchanges. In this report I have included history of commodity market. And after that I have discussed the mechanism of trading in commodity market in India.In this report I have taken a first look at forward, futures and options contract and other risk management instruments. Then after I have discussed the main components of future commodity trading like contract size, what actual margin is and delivery system etc. In the next section I discussed about the two major commodity exchanges in India that is MCX and NCDEX. How they are worked for developing this commodity market in India. And I have also given the list of other commodity exchanges in India.Then after I have discussed about the present scenario of commodity market in India.In the next I tried to analyze the trading pattern and investment pattern of commodity traders and other investors. This I have done through the help of historical data.On the basis of different charts prepared, I have at the end given the research findings and conclusion. And on the basis of my findings I have given suggestion and recommendation

1.2 INTRODUCTION TO DERIVATIVESInstability of commodity prices has always been a major concern of the producers as well as the consumers in an agriculture dominated country like India. Farmers direct exposure to price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise profitable activities. There are various ways to cope with this problem.Apart from increasing the stability of the market, various factors in the farm sector can better manage their activities in an environment of unstable prices through derivative markets. These markets serve a risk -shifting function, and can be used to lock -in prices instead of relying on uncertain price developments.There are a number of commodity-linked financial risk management instruments, which are used to hedge prices through formal commodity exchanges, over -the-counter (OTC) market and through intermediation by financial and specialized institutions who extend risk management services. These instruments are forward, futures and option contracts, swaps and commodity linked -bonds. While formal exchanges facilitate trade in standardized contracts like futures and options, other instruments like forwards and swaps are tailor made contracts to suit to the requirement of buyers and sellers and are available over-the counter.In general, these instruments are classified based on the purpose for which they are primarily used for price hedging, as part of a wider marketing strategy, or for price hedging in combination with other financial deals. While forward contracts and OTC options are trade related instruments, futures, exchange traded options and swaps between banks and customers are primarily price hedging instruments. In the case of swaps between intermediaries and producers, and commodity linked loans and bonds (CL&BS) price hedging are combined with financial deals.Forwards contracts are mostly OTC agreements to purchase or sell a specific amount of a commodity on a predetermined future date at a predetermined price. The terms and conditions of a forward contract are rigid and both the parties are obligated to give and take physical delivery of the commodity on the expiry of contract. The holders of forward contracts face spot (ready) price risk. When the prevailing spot price of the underlying commodity is higher than the agreed price on expiry of the contract, the buyer gains and the seller looses. The futures contracts are refined version of forwards by which the parties are insulated from bearing spot risk and are traded in organize exchanges. A detailed discussion on the futures contracts is presented in the next chapter.Both forwards and futures contracts have specific utility to commodity producers, merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgers and from hedgers to speculators, futures markets also play a major role in price discovery.Typology of risk management instruments

Fig. 1.1The price risk refers to the probability of adverse movements in prices of commodities, services or assets. Agricultural products, unlike others, have an added risk. Many of them being typically seasonal would attract only lower price during the harvest season.The forward and futures contracts are efficient risk management tools, which insulate buyers, and sellers from unexpected changes in future price movements. These contracts enable them to lock-in the prices of the products well in advance. Moreover, futures prices give necessary indications to producers and consumers about the likely future ready price and demand and supply conditions of the commodity traded. The cash market or ready delivery market on the other hand is a time-tested market system, which is used in all forms of business to transfer title of goods.

1.3 OBJECTIVE OF THE STUDY: To study the concepts of commodities trading in india. To study the role of commodities in Indian financial markets. To study in detail the role of futures and forwards. To know the investment pattern of commodity traders and people. To analyze the present situation of the commodities in Indian market and suggest for any improvements thereafter. 1.4 SCOPE OF THE STUDY:For analyzing the trading pattern and investment pattern of commodities and to observe the fluctuations, I have taken data from the zenmoney. The study has only made a humble attempt at the evaluation of derivatives market only in Indian context. The study is limited to commodity derivatives.1.5 NEED FOR THE STUDY:The study is undertaken to analyse the trading practices with special reference to commodity as tool of risk management techniques. The study is to understand why commodity derivatives are required and the role they can play in risk management. To understand the functioning of commodity-linked financial risk management instruments in India. And also to analyze the reasons for price fluctuations in non-agricultural commodities like gold and crude oil.

1.6 RESEARCH METHODOLOGYTo achieve the object of studying the commodities market in stoick market data have been collected.

primary dataIt refers to the first hand information and the data is collected through the way of interactions with the employees of ZEN MONEY.Secondary data:Company records, magazines, journals and websites were made use to collect secondary data regarding indices, operations of commodity market and growth patterns.The following are the steps involved in the study:1. Selection of contract: The future contract selection is done for gold and crude oil and the contract duration is for three months.2. Data collection: The data of gold and crude oil has been collected from the website www.ncdex.com. The data collected from different websites, journals, newspapers, textbooks and zenmoney has been used in preparation of project report.

1.7 LIMITATIONS OF THE STUDY:Limitations are the limiting lines that restrict the work in some way or other. In this research study also there were some limiting factors, some of them are as under: The study is not based on international perspective of commodity markets. It is limited to national level only. The trade list for 3 months is considered ie., from 19apr2011 to 20 aug 2011. The study is limited for gold and crude oil. The analysis is confined to future contracts of gold and crude oil. The time period for project is 6 weeks.

CHAPTER 2

COMPANY PROFILE13

COMPANY PROFILE

2.1 ZEN SECURITIES LTD.Zen Securities Limited is one of the leading Hyderabad based financial services companies - providing Financial and Investment related Services and Products.The Company commenced its membership on The Hyderabad Stock Exchange Ltd., Hyderabad as a proprietary concern of M/s K. Ravindra Babu, which was converted to a Limited company in February 1995 to Zen Securities Ltd. It has the distinction of being the First Corporate Member from Hyderabad and also the first A.P. based broking firm to start trading on the National Stock Exchange (NSE).ZEN is a registered Member on the Capital Market Segment and Futures & Options segment of NSE and a registered Member on the Capital Market Segment of BSE.ZEN is also a Depository Participant (DP) with National Securities Depository Ltd. (NSDL) and also with Central Depositories Services Ltd. (CDSL).ZEN is also a SEBI Registered Portfolio Manager offering Portfolio Management Services to customers.Zen Comtrade Pvt. Limited:It is a 100% subsidiary of ZSL and is a member of National Commodities & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange (MCX).ZSL operates from Hyderabad and has branches/franchisees in Andhra Pradesh, Tamil Nadu and Orissa.

Services Offered by Zen Securities Limited: 1. Investment advisory services 1. Trading in cash market of NSE and BSE 1. Trading in Futures and Options on NSE and BSE 1. Internet Trading in Stocks, futures and Options both NSE and BSE 1. Mutual Funds advisory service 1. Depository Services in Both NSDL and CDSL 1. Trading in Commodities on MCX and NCDEX 1. Portfolio Management Services 1. NRI Investor Services 1. PAN Application Service 1. Mutual Fund KYC Registration Service 1. New Pension System(NPS) 1. Fixed Income Securities / Fixed Deposits / RBI Bonds / Tax Saving Bonds

2.2 ZEN SERVICESStock BrokingZen Securities Limited provides the following equity related trading services to the investors:1. Capital Market Segment of NSE1. Futures & Options segment of NSE1. Capital Market Segment of BSE1. Capital Market Segment of BSEZEN operates out of a spacious office in Hyderabad and has over 100 branches in the state of Andhra Pradesh, Orissa and Tamil Nadu. The Company has over 50 VSAT installations with over 300 CM trading terminals and over 150 F&O trading terminals. All the trading terminals are connected via a gigabit Ethernet. Zen has a Virtual Private Network (VPN) to provide trading backbone to all the branches.Zen has a strong compliance department that ensures compliance to all the guidelines of SEBI / SCRA / the Stock Exchanges / Depositories and all other regulatory and statutory bodies. Zen has an internal audit department that conducts regular audit of the operations. The company has a robust centralized Risk Management system.Commodity BrokingZEN Securities provides trading in Commodities through its subsidiary, Zen Comtrade Pvt. Ltd.Zen Comtrade Pvt. Ltd. is a member of:1. National Commodities & Derivatives Exchange Limited (NCDEX) and1. Multi Commodities Exchange (MCX)PMS (Portfolio Management Services)Portfolio Management Services may be the right option for individuals who:Want to invest their money in equities but do not have the required expertise. Are equipped with the required awareness and knowledge to invest in equities but do not have time to actively manage their portfolio.Why ZEN PMS?In today's markets, equity investment has become a more involved activity and demands a greater awareness and in depth understanding of the business and economic variables that affect equity valuations.Stocks operate in a wonderful tax environment, with no tax on long-term capital gains and a minimal 10% tax on short-term capital gains. Also in this economy, there are no investment avenues other than stocks and real estate to earn inflation adjusted positive return and stocks offer more liquidity than real estate. Zen's portfolio managers fully understand these advantages of stocks and make them work in your favor.Zen's portfolio managers are supported by a strong research bureau that is well equipped to understand the market and deliver superior returns. Each portfolio is personalized keeping in mind your investment parameters, including return expectations, objectives, time horizon, liquidity constraints, a distinctive tax status, and most importantly, personal risk tolerances.New Pension SystemZen Securities Limited is registered as POP (Point of Presence) for NPS-PFRDA. It takes care of functions relating to registration of subscribers, undertaking KYC verification, receiving contributions and instructions from subscribers and transmission of the same to designated NPS intermediaries. It has 25 branches that are acting as Point of Presence Service Providers (POP-SP) which provides services like subscriber registration, receiving regular contributions, modifications in address, nominations, bank details, grievance handling and MIS uploading etc.NRI ServicesZEN Securities offers a total solution to its NRI clients. They offer services under the RBI's Portfolio Investment Scheme (PIS) to buy and sell shares through the Indian stock exchanges.They coordinate with the RBI approved Bank to open an NRI account. They also open the Brokerage account and the Demat Account for the NRI. These three accounts will be opened simultaneously in the NRI's name. They will coordinate the transfer of shares to/from NRI's demat account and money to/from NRI's bank account as per the settlement. They have setup a separate NRI Services team to guide the NRI through the application process and the day to day investment process.Depository ServicesZen is a depository participant offering flexible, cost effective and transparent depository services to its clients .Zen is a depository participant with the National Securities Depository Limited and Central Depository Services (India) Limited for trading and settlement of de-materialized shares. Zen performs clearing services for all securities transactions through its accounts. Zen offers depository services to create a seamless transaction platform execute trades through Zen Securities and settle these transactions through the Zen Depository Services.Zen Depository Services is a part of our value added services for our clients that creates multiple interfaces with the client and provides for a solution that takes care of all your needs.Basic Services Provided by Zen DP1. Account Opening1. Account Transfers - Market and Off-Market1. De-materialization1. Re-materialization1. Pledge

CHAPTER 3

INDUSTRY PROFILE30

INDUSTRY PROFILE

3.1 INDUSTRY OVERVIEWCommodity trading is one facility that investors can explore for investing their money. The Indian commodity market has undergone lots of changes due to the changing global economic scenario; thus throwing up many opportunities in the process. Demand for commodities both in the domestic and global market is estimated to grow by four times than the demand currently is by the next five years. The four categories of trading commodities include:1. Energy (including crude oil, heating oil, natural gas and gasoline)2. Metals (including gold, silver, platinum and copper) 3. Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)4. Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar).Despite having a robust economy, indias share in the global commodity market is not as big as estimated. Except gold the share in other sectors of the commodity market is not very significant. India accounts for 3% of the global oil demands and 2% of global copper demands. In agriculture indias contribution to international trade volume is rather less compared to huge production base available. Various infrastructure development projects that are undertaken in india are being seen as a key growth driver in the coming days. The commodities and futures market in the country is regulated by Forward Markets Commission (FMC).

3.2 THE REGULATORY AUTHORITY: FMCForward markets commission (FMC) headquartered at mumbai, is a regulatory authority for commodity futures market in india. It is a statutory body set up under forward contracts (regulation) act 1952. The exchanges are required to get prior approval of the FMC for opening of each contract in commodities which are notified under the relevant sections in FCRA 1952.The functions of FMC are as follows:a) To advice the central government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of forward contracts act 1952.b) To keep forward market under observation and to take such actions in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the act.c) To collect and whenever the commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is made applicable, including information regarding supply, demand and prices, and to submit to the central government, periodical reports on the working of forward markets relating to such goods.d) To make recommendations generally with a view to improving the organization and working of forwards marketse) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considers necessary. The commission functions under the administrative control of the ministry of consumer affairs, food & public distribution, department of consumer affairs, government of india.The act provide that the commission shall consist of not less than two but not exceeding four members appointed by the central government, out of them one being nominated by the central government to be the chairman of the commission. Currently the commission comprises of two members among whom Mr Ramesh Abhishek, IAS is the chairman, and Dr.M.Mathisekaran, IES is a member of the commission.

3.3 SEBI IntroductionIn 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers had been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91. The basic objectives of the Board were identified as1. To protect the interests of investors in securities1. To promote the development of Securities Market1. To regulate the securities market and1. For matters connected there with or incidental there toSEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the eligibility criteria, the code of obligations and the code of conduct for different intermediaries like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws, risk identification and risk management systems for Clearing houses of stock exchanges, surveillance system etc. which has made dealing in securities both safe and transparent to the end investor.Another significant event is the approval of trading in stock indices (like S&P CNX Nifty & SENSEX) in 2000. A market Index is a convenient and effective product because of the following reasons:1. It acts as a barometer for market behavior;1. It is used to benchmark portfolio performance;1. It is used in derivative instruments like index futures and index options;1. It can be used for passive fund management as in case of Index Funds.

SEBI - SEBI AdministrationThe Securities and Exchange Board of India Act, 1992 is having retrospective effect and is deemed to have come into force on January 30, 1992. Relatively a brief act containing 35 sections, the SEBI Act governs all the Stock Exchanges and the Securities Transactions in India.A Board by the name of the Securities and Exchange Board of India (SEBI) was constituted under the SEBI Act to administer its provisions. It consists of one Chairman and five members. One each from the department of Finance and Law of the Central Government, one from the Reserve Bank of India and two other persons and having its head office in Bombay and regional offices in Delhi, Calcutta and Madras. The Central Government reserves the right to terminate the services of the Chairman or any member of the Board. The Board decides questions in the meeting by majority vote with the Chairman having a second or casting vote.Section 11 of the SEBI Act provides that to protect the interest of investors in securities and to promote the development of and to regulate the securities market by such measures, it is the duty of the Board. It has given power to the Board to regulate the business in Stock Exchanges, register and regulate the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers, etc., also to register and regulate the working of collective investment schemes including mutual funds, to prohibit fraudulent and unfair trade practices and insider trading, to regulate take-over, to conduct enquiries and audits of the stock exchanges, etc.All the stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deed, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediary who may be associated with the Securities Markets are to register with the Board under the provisions of the Act, under Section 12 of the Sebi Act. The Board has the power to suspend or cancel such registration. The Board is bound by the directions vested by the Central Government from time to time on questions of policy and the Central Government reserves the right to supersede the Board. The Board is also obliged to submit a report to the Central Government each year, giving true and full account of its activities, policies and programs. Any one of the aggrieved by the Board's decision is entitled to appeal to the Central Government.

COMMODITY FUTURES EXCHANGES THE PROFILE AND REGULATORY ENVIRONMENT

3.4 Overview of MCXMCX an independent and de-mutualized multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX include Financial Technologies (I) Ltd., State Bank of India (Indias largest commercial bank) & associates, Fidelity International, National Stock Exchange of India Ltd. (NSE), National Bank for Agriculture and Rural Development (NABARD), HDFC Bank, SBI Life Insurance Co. Ltd., Union Bank of India, Canara Bank, Bank of India, Bank of Baroda and Corporation Bank.Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Through the integration of dedicated resources, robust technology and scalable infrastructure, since inception MCX has recorded many first to its credit.MCX has built strategic alliances with some of the largest players in commodities eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade Association.Vision and MissionThe vision of MCX is to revolutionize the Indian commodity markets by empowering the market participants through innovative product offerings and business rules so that the benefits of futures markets can be fully realized .Offering 'unparalleled efficiencies', 'unlimited growth' and 'infinite opportunities' to all the market participants.

Commodities

Fig. 3.1

PROFILENational Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed online multi commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE), Punjab National Bank (PNB), CRISIL Limited (formerly the Credit Rating Information Services of India Limited), Indian Farmers Fertilizer Cooperative Limited (IFFCO) and Canara Bank by subscribing to the equity shares have joined the initial promoters as shareholders of the Exchange. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nationwide reach, technology and risk management skills.NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has commenced its operations on December 15, 2003.NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an independent Board of Directors and professionals not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.Forward Market Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working.NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India. The reach will gradually be expanded to more centers.NCDEX currently facilitates trading of 45 commodities. At subsequent phases trading in more commodities would be facilitate.NCDEX PRODUCTAgro Products

CashewCastor Seed

ChanaChilli

Coffee ArabicaCoffee Robusta

Common Raw RiceCommon Parboiled Rice

Crude Palm OilCotton Seed Oilcake

Expeller Mustard OilGrade A Parboiled Rice

Grade A Raw RiceGroundnut (in shell)

Groundnut Expeller OilGuar gum

Guar SeedsGur

JeeraJute sacking bags

Lemon TurIndian Parboiled Rice

Indian Raw RiceIndian 28 mm Cotton

Indian 31 mm CottonMaharashtra Lal Tur

Masoor Grain BoldMedium Staple Cotton

Mentha OilMulberry Green Cocoons

Mulberry Raw SilkMustard Seed

PepperRaw Jute

Rapeseed-Mustard Seed OilcakeRBD Palmolein

Refined Soy OilRubber

Sesame SeedsSoyabean

SugarYellow Soybean Meal

TurmericUrad

V-797 KapasWheat

Yellow PeasYellow Red Maize

Base MetalsElectrolytic Copper Cathode

Mild Steel Ingots

Precious Metals

Gold

Silver

Fig. 3.2

Table- 3.1 Exchanges and Commodities in which futures contracts are traded.NOEXCHANGECOMMODITY

1India Pepper & Spice Trade Association, Kochi (IPSTA)Pepper (both domestic and international contracts)

2Vijai Beopar Chambers Ltd., MuzaffarnagarGuar, Mustard seed

3Rajdhani Oils & Oilseeds Exchange Ltd., DelhiGuar, Mustard seed its oil & oil cake

4 Bhatinda Om & Oil Exchange Ltd., BhatindaGuar

5The Chamber of Commerce, HapurGuar, Potatoes and Mustard seed

6The Meerut Agro Commodities Exchange Ltd., MeerutGuar

7The Bombay Commodity Exchange Ltd., MumbaiOil seed Complex, Castor oil international contracts

8Rajkot Seeds, Oil & Bullion Merchants Association, Rajkotoil & cake, cottonseed, its oil & cake, cotton (kapas) and RBD palmolein.

9The Ahmedabad CommodityExchange, AhmedabadCastorseed, cottonseed,oil and oilcake

10The East India Jute & HessianExchange Ltd., CalcuttaHessian & Sacking

11The East India CottonAssociation Ltd., Mumbai

Cotton

12The Spices & OilseedsExchange Ltd., Sangli. Turmeric

13National Board of Trade, Indore Soya seed, Soyaoil and Soya meals.Rapeseed/Mustardseed oil and oilcake and RBDPalmolien ( Also granted in-principle approval of Nationwide Multi-commodity Exchange Status)

14The first Commodities Exchange of India Ltd., KochiCopra/coconut, its oil & oil cake

15Central India CommercialExchange Ltd., GwaliorGuar and Mustard seed

16E-sugar India Ltd., MumbaiSugar

**17National Multi-Commodity Exchange of India Ltd., AhmedabadSeveral Commodities

18.# Coffee Futures ExchangeIndia Ltd., Bangalore Cofee

19Surendranagar Cotton Oil &Oilseeds , Surendranagar Cotton, Cottonseed, Kapas

20E-Commodities Ltd., New Delhi Sugar (trading yet to commence)

21**National Commodity & Derivatives, Exchange Ltd., Mumbai Several Commodities

22**Multi Commodity Exchange Ltd., Mumbai Several Commodities

23Bikaner commodity ExchangeLtd., Bikaner Mustard seeds its oil & oilcake, Gram. Guarseed.Guar Gum

24Haryana Commodities Ltd.,Hissar Mustard seed complex

25Bullion Association Ltd.,Jaipur Mustard seed complex

In-principle approval for trading in the specified commodities has been given to the following Exchanges/proposed Exchanges:-

Serial.Name of the AssociationCommodities

No.

1.M/s. NCS InfoTech Ltd., HyderabadSugar

2.Unites Planters Association of SouthTea

India, Connors (u/s 14B)

3.SGI Commodity Exchange, MumbaiSoya bean Ground nut

their oils and oilcakes.

CHAPTER 4REVIEW OF LITERATURE

REVIEW OF LITERATURE4.1 Derivatives The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived". A derivative is a financial instrument, which derives its value from some other financial price. This other financial price is called underlying. The most common underlying assets include stocks, bonds, commodities, currencies, livestock, interest rates and market indexes.A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying. The terms derivative contract, derivative product, or derivative are used interchangeably.Examples of DerivativesA very simple example of derivatives is cloth, which is derivative of cotton. The price of cloth depends upon the price of cotton, which in turn depends upon the demand, and supply of cotton.There are two broad types of derivatives:Financial derivatives: - Here the underlying includes treasuries, bonds, stocks, stock index,foreign exchange etc.Commodity derivatives: Here the underlying is a commodity such as wheat, cotton, peppers, turmeric, corn, soybeans, rice crude oil etc.4.2 HISTORYThe first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago board of trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralized location to negotiate forward contracts, where forward contracts on various commodities were standardized around 1865.The primary market intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financialexchanges of any kind in the world today. From then on, futures contracts have remained more or less in the same form, as we know them today.The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S & P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France etc.However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments - such as bond, currencies, stocks and stock indiceshas now far outstripped that for the commodities contracts.India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desais government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities was allowed to trade on exchanges.

4.3 TYPES OF DERIVATIVESThere are basically of 3 types of Derivatives and Futures:1. Forwards and Futures1. Options1. Swaps Fig.4.1FORWARD CONTRACTA forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying assed on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.The salient features of forward contracts are: They are bilateral contracts hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. It has to compulsorily go to the same counter party, which often results in high price being charged.

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

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IllustrationSahil wants to buy a Laptop, which costs Rs 30,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of laptop will hike 3 months from now. So in order to protect himself from the rise in prices Sahil enters into a contract with the laptop dealer that 3 months from now he will buy the laptop for Rs 30,000. What Sahil is doing is that he is locking the current price of a LAPTOP for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Sahil at the end of three months and Sahil in turn will pay cash equivalent to the LAPTOP price on delivery.4.4 FUTURES CONTRACTFutures markets were designed to solve the problems that exist in forward market. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. So, the counter party to a future contract is the clearing corporation of the appropriate exchange. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. Future contracts are often settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transaction is offset this way.The standardized items in a futures contract are: Quantity of the Underlying. Quality of the Underlying. The date and month of delivery. The units of price quotation and minimum price change. Location of settlement. Distinction between futures and forwards contracts:Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. The distinction between futures and forwards aresummarizedbelow.

FuturesForwards

1.Trade on an organized exchange1.OTC in nature

2.Standardized contract terms2.Customized contract terms

3.Hence more liquid3.Hence less liquid

4.Requires margin payments4.No margin payment

5.follows daily settlement5.Settlement happens at the end period

OPTIONS CONTRACTOption means several things to different people. It may refer to choice or alternative or privilege or opportunity or preference or right. To have option is normally regarded good. Options are valuable since they provide protection against unwanted, uncertain happenings. They provide alternatives to bail out from a difficult situation. Options can be exercised on the happening of certain events.An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.Options may be explicit or implicit. When you buy insurance on your house, it is an explicit option that will protect you in the event there is a fire or a theft in your house. If you own shares of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt.Options have assumed considerable significance in finance. They can be written on any asset, including shares, bonds, portfolios, stock indices currencies, etc. They are quite useful in risk management. For example, Rohit discover a bungalow that Rohit love to purchase. Unfortunately, Rohit won't have the cash to buy it for another three months. Rohit talk to the owner and negotiate a deal that gives Rohit an option to buy the bungalow in three months for a price of Rs.20,00,000. The owner agrees, but for this option, Rohit pay a price of Rs.50,000.

Now, consider two theoretical situations that might arise:1. It is discovered that the bungalow is actually having a historical importance! As a result, the market value of the bungalow increases to Rs. 50,00,000. Because the owner sold rohit the option, he is obligated to sell Rohit the bungalow for Rs.20,00,000. In the end Rohit stand to make a profit of Rs.29, 50,000.(Rs.50,00,000Rs.20,00,000Rs.50,000).2. While touring the bungalow, Rohit discover not only that the walls are chock-full of asbestos, but also that it is a home place of numerous rats. Though Rohit originally thought Rohit had found the bungalow of Rohit dreams, Rohit now consider it worthless. On the upside, because Rohit bought an option, Rohit are under no obligation to go through with the sale. Of course, Rohit still loss the Rs.50,000 price of option.This example demonstrates two veryimportant points. First, whenRohit buy an option, Rohit have a right but not an obligation to do something. Rohit can always let the expiration date go by, at which point the option becomes worthless. If this happens, Rohit lose 100% of Rohit investment, which is the money Rohit used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives; means an option derives its value from something else. In our example, the bun glow is the underlying asset. Most of the time, the underlying asset is a stock or an index.Types of OptionsThere are two types of options:Call Options: - It gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.Put Option: - It gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.Here is the important distinction between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Terminology Associated With The Options Market.Option Price: - Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium.Expiration Date: - The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.Strike Price: - The price specified in the options contract is known as the strike price or the exercise price.Listed Options: - An option that is traded on a national options exchange such as the National Stock Exchange is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents a predetermined number of shares of company stock (known as a contract).In-the-money Option: - An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.At-the-money Option: - An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).Out-of-the-money Option:- An out-of-the-money (OTM) option is an option that would lead to a negative cash flow when exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.Depending on when an option can be exercised, it is classified in on of the following two categories:American Options: - American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.European Options: - European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.4.5 TRADING IN OPTIONSIf one buys an option contract he is buying the option, or "right" to trade a particular underlying instrument at a stated price.An option that gives you the right to eventually make a purchase at a predetermined price is called a "call" option. If you buy that right it is called a long call; if you sell that right it is called a short call.An option that gives you the right to eventually make a sale at a predetermined price is called a "put" option. If you buy that right it is called a long put; if you sell that right it is called a short put.Trading in CallSuppose a call option with an exercise/strike price equal to the price of the underlying (100) is bought today for premium Re.1.Profit/ Loss for a Long Call.

At expiry, if the securitys price has fallen below the strike price, the option will be allowed to expire worthless and the position has lost Re.1. This is the maximum amount that you can lose because an option only involves the right to buy or sell, not the obligation. In other words, if it is not in your interest to exercise the option you dont have to and so if you are an option buyer your maximum loss is the premium you have paid for the right.If, on the other hand, the securitys price rises, the value of the option will increase by Re.1 for every Re.1 increase in the securitys price above the strike price (less the initial Re.1 cost of the option).Note that if the price of the underlying increases by Re.1, the option purchaser breaks even - breakeven is reached when the value of the option at expiry is equal to the initial purchase price. For our call option, the breakeven price is 101. If the price of the security is greater than 101, the call buyer makes money.Profit/Loss for a short call.

Here profit is limited to the premium received for selling the right to buy at the exercise price - again Re.1. For every Re.1 rise in the price of the underlying security above the exercise price the option falls in value by Re.1. Here again, the breakeven point is 101.Trading in Put:Consider that a put option with an exercise/strike price equal to the price of the underlying (100) is bought today for premium Re.1.Profit/Loss graph for a Long Put.

At expiry the put is worth nothing if the securitys price is more than the strike price of the option but, as with the long call, the option buyers loss is limited to the premium paid.The breakeven for this option is 99, so the put purchaser makes money if the underlying security is priced below 99 at expiry.Profit/Loss graph for a short put.

Here profit is limited to the premium received for selling the right to sell at the strike price. For every Re.1 fall in the price of the underlying security below the strike price the option falls in value by Re.1. Here again, the breakeven point is 99.

Difference between Future and OptionsFuturesOptions

ObligationBoth the buyer and the seller are under obligation to fulfill the contract.The buyer of the option has the right and not the obligation whereas the seller is under obligation to fulfill the contract.

RiskThe buyer and seller are subject to unlimited risk of losing.The seller is subject to unlimited risk of losing whereas the buyer has a limited potential to lose.

ProfitThe buyer and seller have unlimited potential to gain.The seller has limited potential to gain while the buyer has unlimited potential to gain.

PriceIt is one-dimensional as its priceIt is bi-dimensional as its price

BehaviorDepends on the price of the underlying only.Depends upon both the price and the volatility of the underlying.

PayoffLinear payoffNonlinear payoff

Price and Strike pricePrice is zero and strike price movesStrike price is fixed and price moves

PricePrice is always zeroPrice is always positive

RiskBoth long and short at riskOnly short at risk

SWAP CONTRACT:Swaps are similar to futures and forwards contracts in providing hedge against financial risk. A swap is an agreement between two parties, called counter parties, to trade cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situation. Two most popular swaps are currency swaps and interest-rate swaps. These two swaps can be combined when interest on loans in two currencies are swapped. The development of swaps in the eighties is a significant development. The interest rate and currency swap markets enable firms to arbitrage are differences between capital markets. They make use of their comparative advantage of borrowing in their domestic market and arranging swaps for interest rates or currencies that they cannot easily access.Interest rate swaps: - These entail swapping only the interest related cash flows between the parties in the same currency.Currency swaps: - These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

4.6 ABOUT THE COMMODITY INTRODUCTIONKeeping in view the experience of even strong and developed economies of the world, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments which allow fund managers to better manage or reduce these risks.The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.COMMODITIES MARKETOrganized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oil seeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab.A three-pronged approach has been adopted to revive and revitalize the market. Firstly, on policy front many legal and administrative hurdles in the functioning of the market have been removed. Forward trading was permitted in cotton and jute goods in 1998, followed by some oilseeds and their derivatives, such as groundnut, mustard seed, sesame, cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy, issued in July, 2000 by the government that futures trading will be encouraged in increasing number of agricultural commodities was indicative of welcome change in the government policy towards forward trading.

Secondly, strengthening of infrastructure and institutional capabilities of the regulator and the existing exchanges received priority. Thirdly, as the existing exchanges are slow to adopt reforms due to legacy or lack of resources, new promoters with resources and professional approach were being attracted with a clear mandate to set up dematerialized, technology driven exchanges with nationwide reach and adopting best international practices.The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all the commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets. Of the country's total GDP, commodities related (and dependent) industries constitute about roughly 50-60 %, which itself cannot be ignored.Most of the existing Indian commodity exchanges are single commodity platforms; are regional in nature, run mainly by entities which trade on them resulting in substantial conflict of interests, opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. But with the strong emergence of: National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai (NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will be addressed rapidly. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges.The current mindset of the people in India is that the Commodity exchanges are speculative (due to non delivery) and are not meant for actual users. One major reason being that the awareness is lacking amongst actual users. In India, Interest rate risks, exchange rate risks are actively managed, but the same does not hold true for the commodity risks. Some additional impediments are centered on the safety, transparency and taxation issues. WHY COMMODITIES MARKET?India has very large agriculture production in number of agri-commodities, which needs use of futures and derivatives as price-risk management system. Fundamentally price you pay for goods and services depend greatly on how well business handle risk. By using effectively futures and derivatives, businesses can minimize risks, thus lowering cost of doing business.Commodity players use it as a hedge mechanism as well as a means of making money. For e.g. in the bullion markets, players hedge their risks by using futures Euro-Dollar fluctuations and the international prices affecting it.For an agricultural country like India, with plethora of mandis, trading in over 100 crops, the issues in price dissemination, standards, certification and warehousing are bound to occur. Commodity Market will serve as a suitable alternative to tackle all these problems efficiently.WHY TRADE IN COMMODITIES?1. Big market-diverse opportunitiesIndia, a country with a population of over one billion, has an economy based on agriculture, precious metals and base metals.Thus, trading in commodities provides lucrative market opportunities for a wider section of participants of diverse interests like investors, arbitragers, hedgers, traders, manufacturers, planters, exporters and importers.2. Get to the soreCommodity trading has been a breakthrough in expanding the investment from investing in a metal company to trading in metal itself.3. Huge potentialCommodity exchanges see a tremendous daily turnover of more than Rs.15,000 cores. This gives a lunge potential to market participant to make profits.4. Exploitable fundamentalThe fundamental for commodity trading is simple price is a function of demand and supply so is hedging, by taking appropriate contract. This makes things really easy to understand and exploit.5. Portfolio diversifierCommodity futures derive their prices from the underlying commodity and commodity prices cannot become zero. Commodity has a global presence and their prices move with global economics and hence, its a good portfolio diversifier.4.7 COMMODITY FUTURES:Commodity futures are simply the standard futures contracts traded through exchange. These contracts have their respective commodity as underlying asset and derive the dynamics from it. Such contracts allow the participant to buy and sell certain commodity at a certain price for future delivery. Futures trading is a natural outgrowth of the problem of maintaining a year-round supply of seasonal products like agriculture crops. The best thing about a commodity futures contract is that it is generally leveraged giving opportunity to all types of investors to participate. Characteristically, such a contract has an expiry and delivery attached with it. 4.8 ADVANTAGE OF FUTURES TRADINGFutures trading remove the hassles and costs of settlement and storage for traders who do not want custody.Though, the most lucrative element of futures trading is that it allows investors to participate and trade at nominal costs at a much lesser amount:No longer need to put the whole amount for trading; only the margin is required.No sales tax is applicable if the trade is required off. Sales tax is applicable only if a trade results in delivery.Traders can short sell. If a trader buys an equivalent contract back before the contract expires, he will be able to profit from a falling price. This is difficult in spot marketers because it requires the seller to borrow the commodity. It is next to impossible for retail investors in case of something like gold.All participants trade exactly the same notional right i.e. those defined on the standard contract, so the market grows deeper and more liquid in the standard futures contract than in spot bullion where different qualities of bullion exit, each of which has different prices.Greater liquidity provides a reliable real-time price something which is absolutely not available in the OTC bullion market.

CHARACTERISTICS OF FUTURES TRADINGA "Futures Contract" is a highly standardized contract with certain distinct features. Some of the important features are as under:Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Bye-laws of the association.It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tenderable varieties".The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units.The delivery periods are specified.The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers.In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place.4.10 MECHANICS OF FUTURES TRADINGFutures are a segment of derivative markets. The value of a futures contract is derived from the spot (ready) price of the commodity underlying the contract. Therefore, they are called derivatives of spot market. The buying and selling of futures contracts take place in organized exchanges. The members of exchanges are authorized to carryout trading in futures. The trading members buy and sell futures contract for their own account and for the account of non-trading members and other clients. All other persons interested to trade in futures contracts, as clients must get themselves registered with the exchange as registered non-members. WHAT IS A COMMODITY FUTURE EXCHANGE?Exchange is an association of members, which provides all organizational support for carrying out futures trading in a formal environment. These exchanges are managed by the Board of Directors, which is composed primarily of the members of the association. There are also representatives of the government and public nominated by the Forward Markets Commission. The majority of members of the Board have been chosen from among the members of the Association who have trading and business interest in the exchange. The chief executive officer and his team in day-to-day administration assist the Board. There are different classes of members who capitalize the exchange by way of participation in the form of equity, admission fee, security deposits, registration fee etc.a. Ordinary Members: They are the promoters who have the right to have own account transactions without having the right to execute transactions in the trading ring. They have to place orders with trading members or others who have the right to trade in the exchange.b. Trading Members: These members execute buy and sell orders in the trading ring of the exchange on their account, on account of ordinary members and other clients.c. Trading-cum-Clearing Members: They have the right to trade and also to participate in clearing and settlement in respect of transactions carried out on their account and on account of their clients. d. Institutional Clearing Members: They have the right to participate in clearing and settlement on behalf of other members but do not have the trading rights. e. Designated Clearing Bank: It provides banking facilities in respect of pay-in, payout and other monetary settlements. The composition of the members in an exchange however varies. In so me exchanges there are exclusive clearing members, broker members and registered non -members in addition to the above category of members. WHAT IS COMMODITY FUTURES CONTRACT?Futures contracts are an improved variant of forward contracts. They are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. While forward contracts are mainly over-the-counter and tailor-made which physical delivery futures settlement standardized contracts whose transactions are made in formal exchanges through clearing houses and generally closed out before delivery. The closing out involves buying a different times of two identical contracts for the purchase and sale o the commodity in question, with each canceling the other out. The futures contracts are standardized in terms of quality and quantity, and place and date of delivery of the commodity. The commodity futures contracts in India as defined by the FMC has the following features:(a) Trading in futures is necessarily organized under the auspices of a recognized association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules and Bye-laws of the association. (b) It is invariably entered into for a standard variety known as the basis variety with permission to deliver other identified varieties known as tender able varieties. (c) The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units. (d) The delivery periods are specified. (e) The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers.(f) In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. The terms and specifications of futures contracts vary depending on the commodity and the exchange in which it is traded. The major terms and conditions of contracts traded in six sample exchanges in India. These terms are standardized and applicable across the trading community in the respective exchanges and are framed to promote trade in the respective commodity For example, the contract size is important for better management of risk by the customer. It has implications for the amount of money that can be gained or lost relative to a given change in price levels. I also affect the margins required and the commission charged. Similarly, the margin to be deposited with the clearing house has implications for the cash position of customers because it blocks cash for the period of the contract to which he is a party the strength and weaknesses of contract specifications are discussed under constraints and policy options. WHO ARE THE PARTICIPANTS IN FUTURES MARKET?Broadly, speculators who take positions in the market in an attempt to benefit from a correct anticipation of future price movements, and hedgers who transact in futures market with an objective of offsetting a price risk on the physical market for a particular commodity make the futures market in that commodity. Although it is difficult to draw a line of distinction between hedgers and speculators, the former category consists of manufacturing companies, merchandisers, and farmers. Manufacturing companies who use the commodity as a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at a predetermined price, which facilitates immunity against price fluctuations. While exporters in addition to using the price discovery mechanism for getting better prices for their commodities seek to hedge against their overseas exposure by way of locking-in the price by way of buying futures contracts, the importers utilize the liquid futures market for the purpose of hedging their outstanding position by way of selling futures contracts. Futures market helps farmers taking informed decisions about their crop pattern on the basis of the futures prices and reduces the risk associated with variations in their sales revenue due to unpredictable future supply demand conditions. Above all, there are a large number of brokers who intermediate between hedgers and speculators create the market for futures contracts.How does futures contract facilitate hedging against price risk?The futures contracts are designed to deal directly with the credit risk involved in locking-in prices and obtaining forward cover. These contracts can be used for hedging price risk and discovering future prices. For commodities that compete in world or national markets, such as coffee, there are many relatively small producers scattered over a wide geographic area. These widely dispersed producers find it difficult to know what prices are available, and the opportunity for producer, processor, and merchandiser to ascertain their likely cost for coffee and develop long range plans is limited. Futures trading, used in the Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955, provides the industry with a guide to what coffee is worth now as well as todays best estimate for the future. Moreover, since all transactions are guaranteed through a central body, clearing house, which is the counter party to each buyer and seller ensuring zero default risk, market participants need not worry about their counterparts creditworthiness.Hedge is a purchase or sale on a futures market intended to offset a price risk on the physical (ready) market. It involves establishing a position in the futures market again ones position or firm commitments in the physical market. The producers who seek to protect themselves from an expected decline in prices of their commodity in future go for short hedge (also called sell hedge). He undertakes the following operations in the market to lock-in the price in advance which he is going to receive after the product. I ready for physical sale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2 units of contracts in Cochin pepper exchange) of pepper in March, the futures price for March delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and the prevailing (say, October) ready market price is Rs.8100 per quintal.a. In October, the producer goes short (sells) in the futures market selling 2 March futures contracts at Rs.8400 per quintal. This is called price fixing.b. In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sells pepper in the ready market for Rs.8200. c. Simultaneously, he closes out his short position in futures by buying (long position) 2 March futures contracts at Rs.8200 per quintal. The result is that the producer sold futures contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a net gain of Rs.200 per quintal or Rs.5000 per contract. For the physical sale, the producer received the market price of Rs.8200 prevailing on the day of the sale and the gain of Rs.200 per quintal from closing-out of futures contracts makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the price realized in the ready market is lower than the price in future contract, the loss on the physical market is compensated by the higher price realized on the future contract. On the other hand, if the price in the ready market is higher than in futures contract, the gain in the ready market is offset by the loss on the repurchase of the futures contract.Since futures market prices move in tandem with the ready market prices over the course of time tending to converge as the contract matures, a gain in the futures market in a developed commodity market under normal conditions, will be offset by a loss in the ready market, or vice versa. However, market imperfections will lead to the basis risk emerging from the mismatch between the gain/loss from the futures market not compensated by loss/gain in the ready market. 4.9 COMMODITY ORDERSThe buy and sell orders for commodity futures are executed on the trading floor where floor brokers congregate during the trading hours stipulated by the exchange. The floor brokers/trading members on receipt of orders from clients or from their office transmits the same to others on the trading floor by hand signal and by calling out the orders (in an open outcry system they would like to place and price. After trade is made with another floor broker who takes the opposite side of the transaction for another customer or for his own account, the details of transactions are passed on to the clearing house through a transaction slip on the basis o which the clearinghouse verifies the match and adds to its records.Following the experiences of stock exchanges with electronic screen based trading commodity exchanges are also moving from outdated open outcry system to automated trading system. Many leading commodity exchanges in the world including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International Petroleum Exchange (IPE), London, have already computerized the trading activities. In India, coffee futures exchange, Bangalore has already put in place the screen based trading and many others are in the process of computerization. To add to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for a common electronic trading platform connecting all commodity exchanges to conduct screen based trading. In electronic trading, trading takes place through a centralized computer network system to which all buy and sell orders and their respective prices are keyed in from various terminals of trading members. The deal takes place when the central computer finds matching price quotes for buy and sell. The entire procedural steps involved in electronic trading beginning from placing the buy/sell order to the confirmation of the transaction have been shown in figure -2.1 below.

fig 4.2Difference Between Commodity And Financial DerivativesThe basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Since financial assets are not bulky, they do not need special facility for storage even in case of physical settlement. On the other hand, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However, in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.I. Physical SettlementPhysical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets.We take a general overview at the process flow of physical settlement of commodities. Later on in chapter 9, we will look into the details of physical settlement through the Exchange providing platform for commodity derivatives trading, National Commodity and Derivatives Exchange Limited (NCDEX).Delivery notice periodUnlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period'.AssignmentWhenever delivery notices are given by the seller, the clearing house of the Exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process.DeliveryThe procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. The period available for the buyer to take physical delivery is stipulated by the Exchange. Buyer or his authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. The clearing house decides on the delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. II. Warehousing

One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close at Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly, the person who sold this futures contract at Rs.100 does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. It means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the Exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Such warehouses have to perform the following functions: Earmark separate storage areas as specified by the Exchange for storing commodities; Ensure proper grading of commodities before they are stored; Store commodities according to their grade specifications and validity period; and Ensure that necessary steps and precautions are taken to ensure that the quantity and grade of commodity, as certified in the warehouse receipt, are maintained during the storage period. This receipt can also be used as collateral for financing.In India, NCDEX has accredited over 775 delivery centers which meet the requirements for the physical holding of goods that are to be delivered on the platform. As future trading is delivery based, it is necessary to create the logistics support for the same.

III. Quality of Underlying AssetsA derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the Exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Trading in commodity derivatives also requires quality assurance and certifications from specialized agencies. In India, for example, the Bureau of Indian Standards (BIS) under the Department of Consumer Affairs specifies standards for processed agricultural commodities. AGMARK, another certifying body under the Department of Agriculture and Cooperation, specifies standards for basic agricultural commodities.4.10 COMMODITY DERIVATIVES IN INDIACommodity derivatives have a crucial role to play in the price risk management process especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed and developing countries in the world. However, they have been utilized in a very limited scale in India Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity markets to control prices. The government controls the production, supply and distribution of many agricultural commodities and only forwards and futures trading are permitted in certain commodity items. Free trade in many commodity items is restricted under the Essential Commodities Act, 1956, and forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act, 1952.The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd., and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. The Gujarati Vyapari Mandali came into existence in 1900, which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association. Many exchanges came up in the agricultural centers in north India before world war broke out and engaged in wheat futures until it was prohibited. Futures in gold and silver began in Mumbai in 1920 and continued until the government prohibited it by mid-1950s. Later, futures trade was altogether banned by the government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities. Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until the along with futures were banned in 1939. However, the government withdrew the ban on futures with passage of Forward Contract (Regulation) Act in 1952.After the ban of futures trade many exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc.Further in 1993 the government of India appointed an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra and the report of the committee was submitted in 1994 which recommended the reintroduction of futures already banned and to introduce futures on many more commodities including silver. In tune with the ongoing economic liberalization, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk emerging from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading.In India, currently there are 15 commodity exchanges actively undertaking trading in domestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association (IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recently upgraded to international exchanges to deal in international contracts in pepper and castor oil respectively. Another 8 exchanges are proposed and some of them are expected to start operation shortly. There are 4 exchanges, which are specifically approved for undertaking forward deals in cotton. 4.11 Dematerialization and Settlement of Warehouse Receipts NSDL, the first depository in the country was established in the year 1996 to remove the difficulties arising out of use of physical