justin final project

7/31/2019 Justin Final Project

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INTRODUCTION

1.1 An Overview

In ancient times, commodities trading at an officially designated marketplace were a

hallmark of civilization. Indeed, the Forum and the Agora defined Rome and Athens as

centers of civilization as much as the Pantheon and the Parthenon. While

commodities trading was normally conducted on the basis of barter or coin-and-carry,

the use of what are known as forward contracts dates at least to ancient Babyloniawhere they were regulated by Hammurabis code.

Commodities are not only essential to life, they are absolutely necessary for

quality of life. Every person in the world eats. Billions of dollars of agricultural

products are traded daily on the worlds commodity exchanges: everything from

soybeans, to rice, to corn and wheat, to beef, pork, cocoa, coffee, sugar and orange

juice. This is how commodity exchanges began. In the middle of the nineteenth

century in the USA, businessmen started to organize market forums to make the

buying and selling ofagricultural commodities easier. Farmers and grain merchants

met in central marketplaces to set quality and quantity standards and establish rules of

business. Over 1600 exchanges sprang up, mostly at major railheads, inland water ports

and seaports.

Around the early twentieth century, communications and transportations becamemore efficient. This allowed for the building of centralized warehouses in major

urban centers such as Chicago. Business became more national and less regional and

many of the smaller exchanges disappeared. Today business is global. There remain

about two dozen major exchanges, with 80 percent of the worlds business conducted

on about a dozen of them. Just about every major commodity vital to life, commerce

and trade is represented. Billions of dollars worth of energy products, from heating oil

to gasoline to natural gas and electricity are traded every business day. Metals, both

industrial (copper, aluminium, zinc, lead, palladium, nickel and tin), precious gold and


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some of which are both (platinum and silver). Wood products, textiles - how could we

live without these? Yet, few of us are aware of how the prices for these vital

components of life are set. Plus, today, the worlds futures exchanges trade financial

products essential to the economic function of the world as well as physical

commodities. From currencies, to interest rate futures, to stock market indices, more

money changes hands on the worlds commodity exchanges every day than on all the

worlds stock markets combined.

Governments allow commodity exchanges to exist so that producers and users of

commodities can hedge their price risks. Yet without the speculator, the system

would not work. Anyone can be speculator and contrary to popular belief, I do not

believe the odds are stacked against the individual.

1.2 - The Futures Contract

The basic unit of exchange in the futures markets is the futures contract. Each

contract is for a set quantity of some commodity or financial asset, and can only be

traded in multiples of that amount. A futures contract is a legally binding agreement

providing for the delivery of various commodities or financial entities at a

specific date in the future. When you buy or sell a futures contract, you are not

actually signing a written piece of paper drawn up by a lawyer you are entering into a

contractual obligation which can be met in one of two ways. The first is by making

or taking delivery of the actual commodity. This is the exception, not the rule

however, as less than 2 per cent of all futures contracts are met by actual delivery.

The other way to meet your obligation the method you most likely will use is by

offset: Very simply, offset is making the opposite, or offsetting sale or purchase of

the same number of contracts bought or sold sometime prior to the expiration date

of the contract. This can be easily done because futures contracts are

standardized. Every contract on a particular exchange for a specific

commodity is identical. The specifications are different for each commodity, but

the contract in each market is the same. In other words, every soybean contract traded

on the Chicago board of Trade is for 5000 bushels. Every gold contract traded on the


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New York Mercantile is for 100 troy ounces. Each contract listed on an exchange calls

for a specific grade and quality. For example the silver contract is for 5000 troy

ounces of 99.99 per cent pure. Therefore the buyers and sellers know exactly what

they are trading. Every contract is completely interchangeable. The only negotiable

feature of a futures contract is price. The size of the contract determines its value. To

determine how much you will make or lose on a particular price movement of a

specific commodity, you will need to know the following:

The contract size, how the price is quoted, the minimum price fluctuations & the value

of the minimum price fluctuations.

1.2.1 - Introduction to Futures Markets

When the possibility of speculative bubbles is excluded and the price follows a

unique path, the question remains as to whether the quality of price forecasts by

rational agents improves with the introduction of a futures market. Futures trading

have been viewed to serve for a better distribution of commodities over time, leading to

a reduction in their amplitude and frequency of price fluctuations. Since futures

traders, in their capacity as speculators, usually take a long position when the spot

price is expected to be higher than the delivery contract price and a short position

when price expectations are lower, futures activities are considered to improve the

intertemporal allocation of commodities and therefore stabilize prices. This

hypothetical view might appear consistent with economists, institutions but

empirical studies on price stabilizing effects of futures trading have revealed mixed

results.

Futures markets have been described as continuous auction markets and as

clearing houses for the latest information about supply and demand. They are

the meeting places of buyers and sellers of an extensive list of commodities.

Today, commodities that are sold include agricultural products (grains trading), metals

(such as gold and silver), Energies trading (crude and petroleum), financial

instruments, foreign currencies, stock indexes and more. Todays futures market has


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also become a major financial market. Participants in futures trading include

mortgage bankers, farmers and bond dealers as well as grain merchants, food

processors, savings and loan associations and individual spectators.

Indian markets have recently thrown open a new avenue for retail investors and

traders to participate: commodity derivatives. For those who want to diversify

their portfolio beyond shares, bonds and real estate, commodities is the best option.

With the setting up of three multi-commodity exchanges in the country, retail

investors can now trade in commodities futures without having physical stocks.

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

market savvy investors, arbitrageurs and speculators. Retail investors who claim

to understand the equity markets may find commodities an unfavorable market. In fact

the size of the commodities markets in India is also quite significant. Of the countrys

GDP of Rs 13,20,730 commodities related industries constitute about 58 percent.

Currently the various commodities across the country clock an annual turnover of

Rs.1,40,000 crore. With the introduction of futures trading the size of the

commodities market will grow many folds here on. Like any other market the

one for commodity futures plays a valuable role in information pooling and risk

sharing. The market mediates between buyers and sellers of commodities and

facilitates decisions related to storage and consumption of commodities. In the

process they make the underlying market more liquid. The commodities market has

three broad categories of market participants apart from brokers and the exchange

administration - hedgers, speculators and arbitrageurs. Brokers will intermediate,

facilitating hedgers and speculators. Hedgers are essentially players with an

underlying risk in a commodity - they may be either producers or consumers

who want to transfer the price-risk onto the market. Producer-hedgers are those

who want to mitigate the risk of prices declining by the time they actually produce

their commodity for sale in the market, consumer hedgers would want to do

the opposite.

The total turnover of the commodity futures market in India increased by a

whopping 71% to Rs.36.77 lakh crore in FY 2011-12. Such a thriving growth reflects


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the increasing popularity of commodity futures as an asset class Commodities are

not correlated with other asset classes an attribute frequently cited as an attraction for

adding them to the investment portfolio. Though major commodities like copper and

crude oil slumped very sharply at the fag end of the year, the commodities complex

was once again the limelight in the first three months of 2012. Precious metals, crude

oil and base metals rode high on renewed investor interest.

On the other hand global equity markets faced a sell-off in March 2012, with rising

risk aversion triggered by a sharp spike in the Japanese yen, pulling all the global

indices down quite substantially (Investors would borrow in low interest-bearing yen

to invest in risky but high return emerging markets).

Though most of the major equity markets have recovered from the recent slump

and hit fresh highs afterwards, the Indian markets lagged behind on continuous

monetary tightening by the Reserve Bank of India (RBI). Concerned over soaring

wholesale prices overheating the economy, RBI hiked the cash reserve ratio (CRR),

the cash that banks have to deposit with the central bank, for the third time in four

months and also raised the short-term repo rate (at which the central bank lends to

banks) twice in as many months on 31 March 2012.

In such a scenario, the thriving commodity futures market which was launched

three-and-a half years ago, provides an excellent opportunity for retail investors

to allocate part of their funds.

Reasons for the rise in Commodity Price:

Interest in commodities as an assets started in 2002, when global interest rates

were comparatively low levels and the rally in the merging markets still nascent.

Over the next nine years, heavy demand from major economies across the globe,

particularly China, spiked prices of metals and energy. Surging credit growth widening

trade surplus and double digit economic expansion lent support to the explosive

Chinese demand for minerals. This contributed to the sharp increase in world


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consumption of metals and minerals in recent years, outstripping supply. As a result

commodity prices have shown unusual strength in recent years and the robustness has

been spread broadly across all the sectors: bullion, base metals prices have

skyrocketed. So have livestock and grains, of late. Even precious metals have reached

prices not seen since inflation was raging in the late 1970s.

Whats behind the price explosion? First, there has been lack of investment in the

production of energy, industrial metal and other commodities in the 1990s. Oil

companies were loath to repeat the cycle of enthusiastic expansion of capacity leading

to overproduction, which pulled down prices. Industrial metals producers harbored

similar sentiments. Second, political turmoil and military action in the Middle East,

Nigeria, Russia, Venezuela and other major petroleum producers added a substantial risk

premium to oil prices. Third the global economic growth led by American

consumers also powered robust demand for commodities. The housing boom in the

US and many other countries hyped demand for lumber, copper, gypsum, plastics

and many other similar commodities. Fourth and foremost the excess liquidity

sloshing around the world, the demand for high returns, the speculativeatmosphere and rising risk appetite drove investors beyond conventional asset

classes like stocks and bonds and into riskier areas, including commodities. Yield

hungry investors legitimized commodities as a serious asset class in the global

markets in the last few years.

Hedge funds, pension funds and other institutional investors have poured money into

commodities directly and through investment pools. Thus, with supply limitations

and strong demand from commodity users and investors, inventories of

many commodities are quite low relative to production an demand. This is true of

copper and zinc, and generally for agricultural products specially corn and wheat,

which scaled up decades highs in the last year.


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1.2.2 - Agricultural Commodities

The prices of essential food articles like wheat, pulses and edible oils hardened

sharply in the spot market in FY 2011-12. This rise was reflected in the futures

market as well, with a generous increase in the volume of business,

indicating increased participation by market players. Apart from the notable

exception of sugar, whose spot prices drifted lower during the year on supply glut,

all pulses, grains, spices, edible oils and oilseeds as well as other soft commodities

went up at a sharp pace.

As a result futures also rose on very good buying support. Bulk of the gains in theessential commodities segment stemmed from the poor growth of agriculture in FY

2011-12. The spices complex beat the commodity street. Spices majors jeera and

pepper rocked the markets with astounding gains of 118% and 84.47% respectively,

in FY 2011-12, Chana gained 26.41% and refined soy oil 22%. While the supply

crunch pushed up food grains higher spices were boosted by a combination of

stagnant output and excellent overseas demand. Exports of spices crossed Rs.3000

crore in April-February 2011-12 for the first time and surpassed the target both in

volume and value set for the current fiscal. Total exports of spices have been

estimated at 3.11 lakh tones valued at Rs 3020 as against 2-92 lakh tones worth

Rs.2100.40 crore in April-February 2010-11. Thus exports have shown an increase of

6% in quantity and 44% in value. If this trend persists the spices complex is bound to

be the out performer amongst the agro commodities in FY 2012-13 as well. The spurt

in the prices of major food articles prompted farmers to plant more pulses and

grains this year leading to an increase in the estimated production of certain

commodities.

According to the third advance estimates, the countrys production of wheat,

maize, pulses, cotton as well as sugarcane is placed at a moderately higher

level compared with last year. Wheat output is estimated at 73.7 million tones - up

6.27% over the last year, while output of pulses is estimated to have grown 5.30% to

14.1 million tones.


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However oilseeds production has dipped quite alarmingly. The country imports

50% of its edible oil requirement. In such a scenario, a staggering drop of 17%

in estimated oilseeds production points towards a sustained rise in prices of edible oils in

the coming months. The best measure to evaluate the consolidated performance of

prices of agro commodities on the futures market is the Ncdex Futexagri. The index

shot up quite strongly in first half of FY 2011-12 and topped a high of 1,726.01

in the last week of November 2011. The barometer eased afterwards as the kharif

(April-September) output arrived in the domestic markets, easing the spot prices of

major agro commodities, before peaking up early 2012 as a poor edible oilseeds crop

pushed up the index.

Strong gains in the entire spices complex also played a part in the recent rally

which saw the index close at 1,625.01 on 31 March 2012 - recording a significant jump

of 20% over the last year. Though the agriculture sector grew by 6% in FY

2011-12, recording a stable output of food grains and keeping prices relatively

comfortable, the plight of agriculture worsened in FY 2011 with incessant rains in

various states like Maharashtra, Andhra Pradesh and Gujarat affecting the kharif

output to major extent. Futures started soaring well advance of the actual produce from

kharif season arriving in the market. The whole price index started shooting up from

the first week of December and rose well above 6.50% in January 2012, prompting the

government to announce a surprise ban on futures trading in tur and urad. The markets

were pinned down further as the government announced a ban on the introduction of

new futures contracts in wheat and rice. This ban has confused genuine hedgers

as they are not clear whether a commodity on which they need to hedge will last till

its expiry period. Therefore, traders are not coming forward to hedge their risk entirely.

Outlook: The outlook for major commodities in the domestic and global markets

remains bullish. The recent spurt in the metals and energy prices is an indication that the

commodity Bull Run has resumed its course and further gains can be expected

for commodity heavy weights like gold, crude oil, zinc and copper. The

International Monetary Funds latest World Economic Outlook states that the

world economy still looks well set for continued robust growth in 2012 and 2013,

notwithstanding the recent bout of financial volatility; the intense sell-off endured


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by the major asset classes in March 2012 on risk aversion triggered by a sudden

appreciation in the Japanese yen. While the US economy has slowed more than was

expected earlier, spillovers have been limited, growth around the world looks well

sustained and inflation risks have moderated. Thus, with a global economic growth

projected to be at elevated levels, steady gains can be expected in the metals and energy

complex. The global picture is slightly different for soft commodities. The United

Nations Food and Agriculture Organization (FAO) has forecast a record cereal crop

for 2012 - World cereal production in 2012 is estimated to increase 4.3% to a record

2,082 million tones, according to the April issue of FAOs Crop Prospects and Food

Situation Report. The bulk of the increase is expected in maize, with

a bumper crop already in South America, and a sharp increase in plantings expected in

the US. A significant rise in wheat output is also foreseen, with recovery in some

major exporting countries after weather problems last year. FAO forecasts wheat

output to increase 4.8% to about 626 million tones. Global rice production in 2012

could also rise marginally to 423 million tones in milled terms - about three million

tones more than in 2011. Thus in terms of prices the grains are likely to remain under

constraints on account of seemingly adequate supplies. The outlook for domestic

agro commodities would largely depend on the vagaries of monsoon. The monsoon is

likely to be normal this year. Recently, the World Meteorological Organization

(WMO) projected that there is a substantial possibility of the emergence of La

Nina, a weather effect, which invariably has a positive influence on the monsoon. This

should augur well for the kharif crop in the country. However, the short term

fluctuations in the prices of major commodities like chana, jeeera, pepper, guarseed,

menthe oil and red chilli are likely to generate substantial opportunities for market

participants. Moreover since the basic trading units in the commodities market are

futures players can protect themselves quite safely against the

unanticipated deviations in either direction. Despite the recent confrontations

stemming from the ban on futures trading of certain key commodities, Indian

commodities exchanges are tipped for good time in the coming months. Spurred by

growing investor interest in stock exchanges, the government has very recently

decided to allow foreign investment in commodity exchanges as well. The

Government has pegged the foreign investment limit for commodity exchanges at 49%

on the line of equity bourses. While foreign direct investment, FDI will be capped at


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26%, the limit for foreign institutional investors (FIIs) is fixed at 23%.

The next big step for the commodities market would be setting up online spot

exchanges. Both the Multi Commodity Exchange (MCX) and the National

Commodities and Derivatives Exchange (NCDEX) are set to launch national online

spot exchanges, giving an instantaneous spot price discovery across the nation. This is

likely to reduce the disparity in the spot prices, which are currently determined solely by

the interplay of the local demand supply factors in thousands of local markets

or mandis. These developments are likely to provide the much needed fillip to the

commodities market in terms of exposure as well as increased participation. Right

now, it is good time for retail investors to participate in this highly geared market and

enhance as well hedge the value to their investment portfolio.

1.2.3 - History

Although the first recorded instance of futures trading occurred with rice in 17th

Century Japan, there is some evidence that there may also have been rice futures traded

in China as long as 6,000 years ago.

Futures trading are a natural outgrowth of the problems of maintaining a year-

round supply of seasonal products like agricultural crops. In Japan, merchants stored

rice in warehouses for future use. In order to raise cash, warehouse holders sold

receipts against the stored rice. These were known as "rice tickets." Eventually, such

rice tickets became accepted as a kind of general commercial currency. Rules came

into being to standardize the trading in rice tickets. These rules were similar to the

current rules ofAmerican futures trading.

In the United States, futures trading started in the grain markets in the middle of

the 19th Century. The Chicago Board of Trade was established in 1848. In the 1870s

and 1880s the New York Coffee, Cotton and Produce Exchanges were born. Today

there are ten commodity exchanges in the United States. The largest are the Chicago

Board of Trade, The Chicago Mercantile Exchange, the New York Mercantile

Exchange, the New York Commodity Exchange and the New York Coffee, Sugar

and Cocoa Exchange. Worldwide there are major futures trading exchanges in over


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twenty countries including Canada, England, France, Singapore, Japan, Australia and

New Zealand. The products traded range from agricultural staples like Corn and

Wheat to Red Beans and Rubber traded in Japan.

The biggest increase in futures trading activity occurred in the 1970s when futures

on financial instruments started trading in Chicago. Foreign currencies such as the

Swiss Franc and the Japanese Yen were first. Also popular were interest rate

instruments such as United States Treasury Bonds and T-Bills. In the 1980s futures

began trading on stock market indexes such as the S&P 500.

The various exchanges are constantly looking for new products on which to trade

futures. Very few of the new markets they try survive and grow into viabletrading vehicles. Some examples of less than successful markets attempted in recent

years are Tiger Shrimp and Cheddar Cheese.

Futures trading are regulated by an agency of the Department of Agriculture called

the Commodity Futures Trading Commission. It regulates the futures exchanges,

brokerage firms, money managers and commodity advisors.

The futures contract, as we know it today, evolved as farmers (sellers) and dealers

(buyers) began to commit to future exchanges of grain for cash. For instance, the farmer

would agree with the dealer on a price to deliver to him 5,000 bushels of wheat at the end

of June. The bargain suited both parties. The farmer knew how much he would be paid

for his wheat, and the dealer knew his costs in advance. The two parties may have

exchanged a written contract to this effect and even a small amount of money

representing a "guarantee."

Such contracts became common and were even used as collateral for bank loans. They

also began to change hands before the delivery date. If the dealer decided he didn't want

the wheat, he would sell the contract to someone who did. Or, the farmer who didn't

want to deliver his wheat might pass his obligation on to another farmer the price

would go up and down depending on what was happening in the wheat market. If bad

weather had come, the people who had contracted to sell wheat would hold more

valuable contracts because the supply would be lower; if the harvest were bigger than

expected, the seller's contract would become less valuable. It wasn't long before people


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who had no intention of ever buying or selling wheat began trading the

contracts. They were speculators, hoping to buy low and sell high or sell high and buy

low.

The ancient system of oral agreement between farmer and buyer which is the

prototype of Future Trading gradually became contracts. Later the buyer began to

make some advance payment for the surety of the contracts. When contracts became

a normal practice, they were assigned the value of the commodities themselves.

Also these contracts began to be sold and bought just as the commodities. Humans

ever since they began farming searched for ways to face the vagaries of weather.

With the arrival of market systems, their challenge increased. They now needed to

ensure just price for their product. Indian farming faced with droughts, floods and

natural calamities has always been a bet on the nature. When the farmer wins the

bet and comes to the market the supply is more than the actual demand. That pushes

the price down shattering the farmer. Futures trading should be seen as an idea

originated from framers search to face the challenges of unpredictable weather and

fluctuating market prices. It must have originated from the execution of a prior to

harvest agreement made between the farmer (who promises to sell the harvest at a

definite price) and one who needs the grain (who agrees to buy it at that price).

In India it started in an organized manner in 1875 at Mumbai for cotton by

Bombay Cotton Trade Association. It then began to spread. Certain mill

owners unhappy with the working of their association began a new association in

1893, called the Bombay Cotton Exchange Limited. It conducted Futures Trading for

cotton. In 1890 a Gujarati merchant Mandali started the Futures Trade of oil seeds.

They also did futures trading for cotton and peanuts. Although futures trading

worked in Punjab and Uttar Pradesh earlier too the Chambers of Commerce, Hampur

which came into being in 1931 was the first one to get noticed. Soon after wheat

futures market started in various places in Punjab like Amritsar, Moga, Ludhiana,

Jalandhar, Fasilka, Dhuri, Baamala and Bhatinda and in Uttar Pradesh at

Muzzafarnagar, Chandahusi, Meerut, Charanput, Hatras, Ghaziabad, bareili etc. In

due time futures market started for pepper, turmeric, potato, sugar and jaggery.

When the Indian constitution was framed share market and futures market were put

in the union list. So the regulation of futures markets is with the central government.


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According to the Futures Contracts Regulation Act, a three-leveled regulatory

system came into existence, Central Food and Public Distribution Ministry, Futures

Market Commission (FMC) and the associations that are recommended by the

FMC for conducting futures market. When futures trade was temporarily breezed in

the 1970s many associations were de-activated. In 1980 Khusro Committee

suggested to restart Futures trade for cotton, jute etc. It also sanctioned Futures

Trade in potato and onion. In 1994, the Prof. K. N. Kabra Committee which was

appointed in view of the marker liberalization, recommended Futures Trading of

Basmati rice, cotton, jute, oilseeds, groundnut oil, onion, silver etc. There was

also a suggestion to raise Futures Market for Pepper to the international levels.

With the liberalization government intervention began to decrease in setting price

limits of commodities. The government also narrowed its role of buying and

distributing commodities. Gradually by 2003 the Central Government gave

consent to start Futures Trading for most of the major commodities. Along

with major agricultural commodities like rubber, pepper and cardamom, there are

127 commodities that can be traded in the Futures markets now.

1.2.4 - About commodities

Almost everything you see around is made of what market considers commodity. A

commodity could be an article a product or material that is bought and sold. It could be

an article a product or material that is bought and sold. It could be any kind of

movable property, except actionable claims, money and securities. Commodity

trade forms the backbone of world economy. The Indian commodity market is

estimated to be around Rs.11 million and forms almost 50 percent of the Indian GDP.

It deals with agricultural commodities such as rice, wheat, groundnut, tea, coffee, jute,

rubber, spices and cotton. Besides precious metals such as gold and silver the

commodity market also deals with base metals like iron and Aluminium and energy

commodities such as crude oil and coal.


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1.2.5 - Commodity Exchanges in India

There are three national commodity futures market exchanges in India. The

Futures Market Commission (FMC) which is under the Central Government

supervises and regulated the working of all these commodities market.

National Multi Commodity Exchange of India Limited (NMCE) Ahmedabad.

Promoted by Central Warehousing Corporation, National Agricultural Cooperative

Marketing Federation of India Limited, Gujarat Agro Industries Corporation Limited,

Gujarat State Agricultural Marketing Board, National Institute of Agricultural

Marketing, Neptune Overseas Limited and Punjab National Bank.

Multi Commodity Exchange of India Limited (MCX), Mumbai. Promoted by

Financial Technologies (India) Ltd, State Bank of India, Union Bank of India, Bank

of India, Corporation Bank and Canara Bank.

National Commodity and Derivatives Exchange Limited (NCDEX), Mumbai,

Promoted by ICICI Bank Limited, Life Insurance Corporation of India, National Bank

for Agriculture and Rural Development and National Stock Exchange of India

Limited, Punjab National Bank, CRISIL Limited, Indian Farmers Fertilizer

Cooperative Limited and Canara Bank.

Commodity Exchanges: Wooed by Foreign investors:

In the 1960s the government banned forward trading in most of the commodities.Only after the country embraced free-market reforms in the early 1990s was the need

for structured commodity futures trading appreciated. In 1991, the Kabra Committee

advised resumption of futures markets in 17 commodities initially. The entire

commodity spectrum opened up for futures trading by April 2003.

In the last quarter of2003, the Multi Commodity Exchange (MCX), National Multi

Commodity Exchange (NMCE) and National Commodity and Derivatives Exchange

(NCDEX) started functioning in full swing, making good the difference between


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the buying/selling of the futures and the prevailing price of the futures at the expiry

of the contract. Futures trading is conducted on margin. This makes the market

highly leveraged for the retail customer. He can trade by locking only a fraction of

the actual contract value of a particular commodity.

Futures market attracts hedgers, who minimize their risk, and encourages competition

from other traders who possess market information and price judgment. While

hedgers have a long term perspective of the market, traders or arbitragers hold an

instantaneous view of the market. The primary objectives of a futures market are

price discovery and risk management. This is very much possible because a large

number of different market players participate in buying and selling activities in the

market based on diverse domestic and global information such as price, demand and

supply, climatic conditions and other market related information.

All these factors put together result in efficient price discovery. This also facilitates

effective risk management by physical market participants by taking an

appropriate position in the respective commodity futures. With the constantly rising

volumes and increasing retail participation a number of overseas entities picked up

stakes in the domestic commodity bourses. Fidelity International, a leading foreign

institutional investor, bought about 9% (equivalent to about $49 million) equity in

MCX in 2010.


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1.2.6 - How an Organized Market Works

An organized futures market is an institution that is the result of long experience

and adaptation to needs. No single person can claim credit as its investor.

Its development, still continuing, is the work of many hands. Starting from spot

trades between a buyer and a seller, there gradually arose an increasingly refined

and abstract financial instrument in response to changing circumstances. The

advantage of deferred delivery may have been discovered by sheer accident. In this

process improvements were made, defects removed and safeguards developed. At

some point in the last third of the nineteenth century came the growing recognition

that an important new commercial discovery, the organized futures market, was

in operation. Even those who are most familiar with the actual daily operationof these markets may be unaware of their important distinguishing features and

may thus be puzzled by the growing number of things traded on organized futures

markets. I believe that one reason for this growth is that the invention has attained a

level of performance that makes it a useful tool for a wide range of commodities.

A well-run, organized futures market now has features making it a reliable

instrument suitable for trading a wide range of goods.

Let us now consider the main features of an organized exchange. It is first

necessary to have a contract such that the principals can give instruction to their

agents who trade on their behalf in terms of price and quantity alone. Buying or selling

an actual physical commodity requires more information than this. The

commodity must be inspected, its quality ascertained, its location determined, and

so on. In these circumstances a principal instructing his agent who will, say, buy on

his behalf must tell him more than how much he wants and the most he is willing to

pay. He must also tell his agent what attributes to seek and how to compare one with

another. The agent needs guidance to convert these into bids according to the needs of

his principal. Plainly, this process requires judgement, honesty, and familiarity with

the principals needs. Judgement of another kind is necessary to act on behalf of a

principal for the purpose of trading a standardized commodity such as a futures

contract. Now the focus is on the price and on the forces affecting it. The principal

can instruct his agent in terms of prices and quantities, and the agent can carry out these

orders for futures contracts. Familiarity with the properties of the commodity and the


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preferences of the principal is not necessary. Hence by trading futures contracts the

principal can reap the advantages of specialization because he can supervise his agents

at a lower cost.

An organized futures market confines trades to those who are its members. This

limitation has definite advantages. Each member has a proprietary interest in the

survival of the exchange and in the value of his membership. He wants the other

members to be reliable. Members who trust each other can trade more quickly at a

lower cost. Members may also trade as agents of nonmembers. They are liable to

the exchange for faithfully carrying out the terms of these trades. Exchange members

will therefore accept accounts only from those in whom they have confidence. All of

these considerations enable the exchange to operate on a larger scale, which increases

liquidity.

The clearing house of the exchange also has a vital part in this process. A

member who buys futures contracts obtains liabilities of the clearing house that are

offset by the sales of futures contracts which constitute the assets of the clearing

house. In terms of the quantities of futures contracts bought and sold, the assets and

liabilities of the clearing house are always equal. The clearing house is to its membersas a bank is to its depositors and debtors. The backing of the clearing house behind

the futures contracts traded on the exchange enhances the fungibility of the contract.

It enables the transition from trading in forward contracts, where the identity of the

parties involved is necessary information to judge the safety and reliability of the

contract, to trading in futures contracts whose validity depends on the faith and

credit of the organized exchange itself and not on the individual parties to a transaction.

Consequently a futures contract acquires the same advantages over a forward

contact as trade conducted with the aid of money has over barter. Because a

futures contact has some of the attributes of money, it becomes suitable as a

temporary abode of purchasing power. It is this aspect of a futures contract that is

relevant to hedging. An inventory holder can sell futures in a liquid market so that he

can choose the best time for making final sales of his inventory with little effect on the

current futures price. One who has made commitments to sell the commodity can

buy futures contracts as a temporary substitute for the purchases of the actual


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commodities and also have little effect on the price. Money is the most liquid of all

assets for two reasons. First, the transaction cost ofbuying money by selling goods

or buying goods by selling money is a minimum. Second, the real price of

money is the amount of goods and services that can be exchanged for one dollar.

The effect on the general price level of a small change in the quantity of money

offered in exchange for a quantity of goods and services is negligibly small. This is to

say that the elasticity of demand for money facing an individual seller of money who

is a buyer of goods and services is infinitely elastic. Similarly, the elasticity of supply

of money facing an individual seller of goods and services is infinitely elastic.

Therefore, owing to the low transaction cost and the highly elastic excess demand

for money facing an individual, money is the most liquid of all assets. An organized

futures market is a device for making a futures contract a highly liquid instrument

of trade. It accommodates a given volume of trade at the least transaction cost. It

can furnish the services of its members so that the excess demand for futures

contracts facing an individual trader is highly elastic, provided it can maintain a

highly liquid market.

The analogy between money and futures contracts is even closer than the

preceding argument implies. Just as the total liability of a bank is limited by the size

of its reserves, so too the total liabilities of the clearing house of an organized

exchange is limited by the total amount of the commodity that may be delivered

to settle futures commitments that are still outstanding during the month the

futures contracts mature. This total stock of the deliverable commodity stands to the

total liability of the clearing house as the reserves of the bank stand to its deposits

which are its liabilities. However in contrast to a bank there need not be fixed

relation between the deliverable stock of the commodity and the size of theoutstanding commitments of futures contracts. It is always possible to extinguish a

futures commitment by an offsetting transaction before the maturity date. This

occurs at the then prevailing price of the futures contract and not at the price of the

original futures transaction. The very absence of a close tie between the

size of the outstanding futures commitments and the stock of deliverable supplies of

the commodity enhances the liquidity of the futures contract. It allows the size

of the outstanding commitment to adjust flexibly to the needs of the transactors and

to depend on the mutually agreeable terms they can arrange among themselves. There


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is a risk of a price squeeze only during the delivery month of the contract. Such a

squeeze resembles a run on a bank. A run on a bank occurs when nearly all of the

depositors withdraw their deposits almost at once. The effect on the bank is almost

the same as would be the effect on the clearinghouse if all buyers of future contracts

stood for delivery. The analogy is imperfect because the clearinghouse itself has

assets in the form of commitments from those who owe it the commodity in the

delivery month because they had previously sold futures contracts. A bank cannot call

all of its loans to settle the demands of its depositors who wish to withdraw their funds.

The clearinghouse, however always have assets that match exactly in timing its

liabilities. Nevertheless, an unexpectedly large demand for delivery by the buyers of

futures contracts accompanies an unexpectedly large increase in the spot price for

deliverable supplies during the delivery month. So there is said to be a price squeeze.


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Fig-1.1: Diagrammatic Representation of Trading Procedure in the

Futures Market


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1.2.7- Advantages of Futures contracts

Farmers:

Efficient Price Discovery/Forecast made by the exchange will enable

farmers decide cropping pattern and investment on inputs.

Price Stability resulting from equilibrium in supply and demand for a

commodity would be possible through exchanges.

Get an extensive market opened for them.

Get opportunity to trade, knowing the national and international trends

and standards.

Can sell the commodity to the customer without any agents.

Can decide the market even before harvest.

Get an opportunity to gain profit by spending only a small percentage of the

actual commodity price.

There is an opportunity to keep the commodity in the warehouse and usethe warehouse receipt to deal with financial needs, as it is an endurable

document.

Farmers can trade by asking the help of the experts in trading organizations

even if they are computer illiterate.

Traders:

Can trade by spending only the margin amount.

Can sell the commodities that he buys from the ready market and can

rescue himself from the loss happening from price fall.

For those who have kept their commodity in the Central Warehouse, loans

are available on the basis of the stock. The benefit is that you can keep the

commodity somewhere without blocking the working capital in the stock.


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Consumer, Industrialist & Exporters:

Can be sure that the commodity is available when they require it.

Can calculate the price since it is predetermined and can arrange

everything according to that.

Can buy goods without agents.

Can buy them even while sitting in their office.

Can be assured the quality of the good.

Commodities can be purchased with only margin amount instead of giving

the whole price.

1.2.8- Commodity Futures In India

Government of India, in 2002-03, has demonstrated its commitment to revive the

Indian agriculture sector and commodity futures markets. Prime Ministers

Independence Day address to the nation on August 15, 2002, which enlisted nation-

building initiatives, included setting-up of national commodity exchange among the

important initiatives. The year 2002-03, certainly was an eventful year in terms of

regulatory changes and market developments that could set the agenda for development

for the years to come.

Policy Initiatives:

Firstly, Government of India, in early 2003, had given mandate to four entities to

set-up nation-wide multi commodity exchanges. Secondly, expansion of permitted list

ofcommodities under the Forward Contracts (Regulation) Act, 1952 (FC(R)A).

This effectively translated into futures trading in any commodities that can be

identified. Thirdly, 11 days restriction to complete a spot market transaction

(ready delivery contract) is being abolished. Fourthly, non-transferable specific

delivery (NTSD) contracts are removed from the purview of the FC(R).

The above four policy decisions have the potential to proliferate futures contractsusage in India to manage price risk. National level exchanges would make availability


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of futures contracts across the nation in the most cost-effective manner through

technology and at the same time would improve the risk management systems to

improve and maintain financial integrity of futures markets in the country.

Expansion of list of commodities would make available risk management

mechanism for all commodities where such a demand exists but never made possible

in the past. Abolition of the 11 days restriction on spot market transactions and

removal of NTSD contracts from the purview of FC(R)A would effectively mean

unhindered forward contracting among the constituents of commodity trade value

chain.

Forward contracting is an important activity for any economy to meet raw materialrequirements, to facilitate storage as a profitable economic activity and also to

manage supply and demand risk; forward contracts give rise to price risk, so to the

need of price risk management. Futures markets and forward contracts

compliment each other for effective price discovery and pricing of forward

contracts. Price risk in forward contracts can be managed through futures contracts.

Performance of commodity exchanges:

Year 2002-03 witnessed a surge in volumes in the commodity futures markets in

India. The 20 plus commodity exchanges clocked a volume of about Rs.100,000 crore

in volumes against the volume of 34,500 crore in 2001-02 remarkable performance

for an industry that is being revived. This performance is more remarkable

because the commodity exchanges as of now are more regional and are for few

commodities namely soybean complex, castor seed, few other edible oilseed complex,

pepper, jute and gur.

Interestingly commodities in which future contracts are successful are commodities

those are not protected through government policies; and trade constituents of

these commodities are not complaining too. This should act as an eye-opener to

the policy makers to leave pricing and price risk management to the market forces

rather than to administered mechanisms alone.


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With the value of Indias commodity economy being around Rs.300,000 crore a

year potential for much greater volumes are evident with the expansion of list of

commodities and nationwide availability. Opening up of the world trade barriers

would mean more price risk to be managed. All these factors augur well for the future

of futures.

National commodity exchanges and regional commodity exchanges:

Demutualization has gathered pace around the world and Indian commodity

exchanges are also looking into it. Existing single and regional commodity

exchanges have realized the possible threat that the national level exchange may pose

on their future. Given the experience of the regional stock exchanges in India,

commodity exchanges are becoming proactive to counter such a threat. Commodity

exchanges may not face the threat of extinction because of the following reasons.

Commodity exchanges are trading in futures contracts on those commodities,

which have regional relevance. It is not going to be easy as a share of a

company to get listed in a different exchange.

Delivery of commodity is a physical activity; delivery of shares is an electronicactivity

Commodity exchange members are stakeholders in those commodities

wherein stock exchange members were never the owners of the stock to

control where the stock should get traded.

Importance of commodity exchanges wherein success of a stock exchange is

more on transparency and low transaction cost.

Above reasons are possibilities; national level exchanges could woo the existing

commodity exchanges and their members to the national stream. Such exchanges

and members are of relevance to the Indian economy as a whole and for the

success of commodity futures in particular important aspect the regulator and

exchanges should address is the regulator cost. Unless the regulator cost is kept

low, thriving parallel markets will never join the mainstream exchanges.


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Impact of WTO regime: India being a signatory to WTO may open up the

agricultural and other commodity markets more to the global competition.

Indias uniqueness as a major consumption market is an invitation to the world to

explore the Indian market. Indian producers and traders too would have the

opportunity to explore the global markets. Price risk management and quality

consciousness are two important factors to succeed in the global competition. Futures

and other derivatives contracts have significant role in price risk management.

Indian companies are allowed to participate in the international commodity

exchanges to hedge their price risk resultant from export and import activities of such

companies. Due to the compliance issues and international exchanges rules, 90 percent of

the commodity traders and producers are not in a position to participate inthe international exchanges International exchanges have trading unit size,

which are prohibitive for many of the Indian traders and producers to participate in

the international exchanges. Addressing the risk management requirements of the

majority is of concern and the way to address is through on-shore exchanges. In a

more liberalized environment, Indian exchanges have significant role to play as vital

economic institutions to facilitate risk management and price discovery; price

discovery would have greater link to global demand and supply which could assist theproducers to decide on what crops they should produce.

Way ahead:

Commodities exchanges in India are expected to contribute significantly in

strengthening Indian economy to face the challenges of globalization. Indian markets

are poised to witness further developments in the areas of electronic warehouse

receipts (equivalent of dematerialized shares) which would facilitate seamless

nationwide spot market for commodities. Amendments to Essential

Commodities Act and implementation of Value-Added-tax would enable movement

of across states and more unified tax regime, which would facilitate easier trading

in commodities. Options contracts in commodities are being considered and this

would again boost the commodity risk management markets in the country. We

may see increased interest from the international players in the Indian commodity


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markets once national exchanges become operational. Commodity derivatives as an

industry is poised to take-off which may provide the numerous investors in this

country with another opportunity to invest and diversify their portfolio. Finally, we

may see greater convergence of markets equity, commodities, forex and debt -which

could enhance the business opportunities for those have specialized in the above

markets. Such integration would create specialized treasuries and fund houses that

would offer a gamut of services to provide comprehensive risk management solutions to

Indias corporate and trade community.

In short, we are poised to witness the resurgence of Indias commodity trading which

has more than 100 years of great history.


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REVIEW OF LITERATURE & RESEARCH DESIGN

2.1 Introduction

The Research is based on an article written by MARK J. POWERS titled Does

Futures Trading Reduce Price Fluctuations in the Cash Markets?

One of the recurring arguments made against futures markets is that by

encouraging or facilitating speculation they give rise to price instability. In case

ofperishable commodities like onions and potatoes it suggests that a) the seasonal

price range is lower with a futures market because of speculative support at harvesttime b) sharp adjustments at the end of a marketing season are diminished under

futures trading because they have been anticipated c) year-to-year price fluctuations

are reduced under futures trading because of the existence of the futures market as

a reliable guide to production planning. These conclusions are most valid for

seasonally produced storable commodities they probably do not hold for other

commodities particularly those that are continuously produced or semi or non storable.

The underlying research work aims at identifying if this is true with respect to

commodities wheat, maize, castor, gur, turmeric and soyabean.

2.2Review of Literature

Research Article - 1:

Does Futures Trading Reduce Price Fluctuation in the Cash Markets?

Mark J. Powers

(The American Economic Review, Vol.60, No.3. (Jun.,1970)

Methodology followed by the author:

MARK J. POWERS in his article has collected weekly cash prices for pork bellies

and live beef for eight years, four years preceding the start of futures trading and

four afterwards. The four-year periods considered for port bellies were 1958 through

1961, and 1962 through 1965. For beef, the four-year periods were 1961 through


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1964 and 1965 through 1968. The cash prices used for choice live steers represented

the average weekly prices paid for choice steers at Chicago. The data were analyzed

on the basis of four-year and two year periods.

For the purposes of conducting the study it was hypothesized that (The Variance

error or Random component which represents noise and disturbance in the price

system) would be lower during time periods with futures trading than during time

periods without futures trading.

To analyze the data and test the hypothesis it was desirable to use a technique

which would isolate and estimate the random element in a variable which is changingover time. The technique actually selected was the Variate Difference Method,

developed by Gerhard Tintner. The Variate difference method fits our purpose best,

mainly because it is a statistical method that does not require specification of a rigid

model and it isolates and estimates the random element without affecting the

systematic component. The Variate difference method starts from the assumption

that an economic time-series consists of two additive parts. The first is the

mathematical expectation or systematic component of the time-series. The second is

the random or unpredictable component. The assumption is that these two parts are

connected by addition but are not correlated. It is further assumed that the random

element is not auto correlated and has a mean of zero; that the random element is

normally distributed; and that the systematic component is a smooth' function of time.

The steps involved in the analysis are essentially three. First, the random element

is isolated in the time-series. This is accomplished by finite differencing.

Successive finite differencing of a series will eliminate or at least reduce to any

desired degree the systematic component without changing the random element

at all. The random component cannot be reduced by finite differencing because it

is not ordered in time. Second the variance of the random element is calculation. Then

the variance of the series was calculated. In order to determine whether or not there

is a statistically significant difference in the random variance for price series in


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different time periods, a standard error-difference formula for testing the difference

between two variances was used.

Conclusion: In each of the two-year periods considered in live beef, the random

fluctuations were significantly lower than in each of the two-year periods without

futures trading. Likewise for port bellies the analysis indicates that for similar years

in the price cycle the random fluctuations were significantly lower when there was

futures trading than when there was not.

During the time periods considered in this study the only major changes in

information flows for these commodities were those resulting from futurestrading. Therefore part of the reduction in the variance in the random element can be

attributed to the inception of futures trading in these commodities and the

relationship between the reductions in random price fluctuations and futures

trading is explained in part by the improvements in the information flows fostered by

futures trading.

Research Article - 2

Price Volatility of Storable Commodities under Rational Expectations in

Spot and Futures Markets.

Masahiro Kwai

(International Economic Review, Vol. 24, No.2 (Jun.1983)

When the possibility of speculative bubbles is excluded and the price follows a

unique path, the question remains as to whether the quality of price forecasts by

rational agents improves with the introduction of a futures market. Futures trading

has been viewed to serve for a better distribution of commodities over time, leading to

a reduction in the amplitude and frequency of price fluctuations. Since futures

traders, in their capacity as speculators, usually take a long position when the spot

price is expected to be higher than the delivery contract price and a short position

when price expectations are lower, futures activities are considered to improve the


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intertemporal allocation of commodities and therefore stabilize prices. This

hypothetical view might appear consistent with economists institutions, but

empirical studies on price stabilizing effects of futures trading have revealed mixed

results. Only a few works have attempted to resolve the issued from theoretical

perspectives and they have emphasized a price-stabilizing tendency of the futures

market. Price determination process of storable commodities by explicitly taking

into account the important fact that the introduction of a futures market alters the

decision-making procedure of individual optimizing agents in a way described in the

text. Then the effect on spot volatility would be evaluated. First, the microeconomic

decision-making problems of risk-averse, price-taking agents

(producers, inventory holding dealers, and pure speculators) are presented in order

to derive individual linear supply and demand functions in terms of a set of known

prices, as well as the subjective expectations and variances of the random price.

Second, market supply and demand functions for the commodity and futures contracts

are obtained by aggregating individual functions over all agents. Third the

equilibrium price distributions are solved under rational expectations and the rational

price variances are compared in the presence and in the absence of futures trading.

Methodology used:

Variance Analysis

Conclusion:

The research work began by analyzing the optimizing behaviour of agents, who

produce and trade storable commodities in the absence or presence of opportunitiesfor futures contracting, and derived a set of individual supply and demand functions

under price uncertainty and risk aversion. This optimizing approach enables us to

understand how activities of production and inventory holding should be modified as

a consequence of introducing futures markets. After aggregating individual functions

over all agents and obtaining market supply and demand schedules, equilibrium

commodity price distributions are solved in a stochastic rational expectations

framework. The usual non-speculative bubble condition is imposed on the rationalexpectations equilibrium path of prices. A futures market plays the role of transferring


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price risk from hedgers to speculators. The futures market provides another

important facility for distributing commodity demand and supply from one period

to the next and, hence, may have a potential to reduce price fluctuations over time. The

conditional variances of the T-period ahead spot prices are computed and compared for

the absence and presence of a futures market. The nonlinear relationships among the

structural parameters, which are required by the rationality of expectations

formation, make a general comparison virtually impossible, particularly in the

light of the possibilities of non-existence and non-uniqueness of the solution as

discussed by Mc Cafferty and Driskill. However, with additional restrictions

concerning the nature of inventory holding or the agents attitudes towards risk and with

the aid of numerical examples, it is found that the identification of the source of

random disturbances is crucial in this comparison. If the consumption demand

disturbance is the primary random element in the commodity market then the

introduction of a futures market tends to stabilize spot prices; whereas if the inventory

demand disturbance is preponderant, a futures market tends to be price

destabilizing (except for the case of infinitely large marginal cost of inventory

carrying). The role of production disturbances is generally ambiguous. The existence

of a futures market may extend the scope of successful price stabilization through

government intervention. It has been shown that, if the consumer demand or output

supply disturbance predominates the market, the futures intervention rule of fixing

futures prices while maintaining constant (or even zero) reserves can stabilize at least

short-term price volatility. In this case the role of futures trading as an intertemporal

resource allocator can be effectively exploited by the intervening authority. However,

the authority has to be quite cautious in implementing this intervention scheme,

because it can be detrimental in the face of large unanticipated shocks in inventory

holding.

Benefits derived from the literature review:

The above citied articles and other articles reviewed during the process of

gathering information on the topic have helped in understanding the reasons

why fluctuations exist in certain markets whether it is due to pure speculative

causes or whether any other hidden elements are influencing the price of the

commodities in the market. Also the various methods of analyzing the data using


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different statistical tools were learnt and how these statistical tools help in interpreting

the data.

Another thing leant from the literature review is that one of the major advantages

of organizing futures exchanges is that the authority can influence the movement of

spot prices through futures intervention without causing fluctuations in commodity

reserves held by the intervention authority and hence without actually storing any

commodity reserves. An infinitely elastic spot-market intervention could, of course,

fix the spot price at an arbitrary level, but would induce changes in official commodity

reserves.

Also that market information has a particularly important place among the factors

that determine what is offered for sale and what is demanded, and hence among the

factors that determine prices. As markets become more decentralized, information

concerning current and future demand and supply conditions must be carefully

collected and interpreted. Commodity future exchanges have been termed

clearing centers for information. Information relative to supplies, movements,

withdrawals from storage, purchases, current production, cash and futures prices

and volume of futures trading, is collected, collated and distributed by the exchange

its members and the institutions such as brokerage houses which serve the

exchange. This information is used not only by current and potential traders in

futures, but it is also carefully evaluated by cash market operators.

As such the literature review helped in understanding the market forces that

determine that demand and supply conditions in the market and how futures markets

have helped in this and to what extent they have influenced the prices of the

commodities.


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2.3 - Statement of the Problem

What would happen to the systematic and random parts if a viable futures

market were introduced into the pricing system?

There have been few studies of the impact of futures trading on the variance of

the systematic component associated with fundamental economic conditions.

Is the commodity future an effective tool to hedge against price fluctuations

or else it leads to the price fluctuations of the underlying commodity?

To examine whether the introduction of futures markets has caused volatility in the

prices of the commodities in the futures market and whether the introduction has

caused benefit or loss to the farmers by helping get an optimum price for their

commodities.

2.4 -Genesis of the problem

In recent times we have seen fluctuations in the prices of various essential

commodities. A lot of the speculation has been attributed to the futures markets of

these commodities i.e. by encouraging or facilitating speculation they give rise to

price instability. Most ofthe research done in this regard has been on perishable

commodities like onion and potatoes which suggest that the seasonal price range

is lower with a futures market because of speculative support at harvest time.

Secondly sharp adjustments at the end of a marketing season are diminished

under futures trading because they have been anticipated and lastly year-to-year

price fluctuations are reduced under futures trading because of the existence of the

futures market as a reliable guide to production planning. By this research we aim

to study by examining commodity prices after and before introduction of futures

markets whether volatility exists.


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2.5-Scope of the Study

This study helps in understanding the reasons why fluctuations exist in certain

markets, is it due to pure speculative causes or any other hidden elements.

It further helps in understanding the market forces that determine the demand

and supply conditions in the market and how futures markets would help in

and to what extent it would influence the prices of the commodities.

2.6-Objectives of the Problem

This study has been undertaken to:

To study the effect of variance of the error or random component which

represents disturbance in the price system when futures market is injected with

commodities like wheat, rice, maize, gharm, tur, urad, palm oil, sunflower oil

and ground oil.

To analyze if futures trading has an impact on the price of the commodities.

Need and importance of the study

The study done until recently on whether commodity futures markets affects the

prices of the commodities by encouraging speculation have always considered

selected commodities like onion and potatoes. As such to assume that they hold

good for other commodities would be wrong particularly those commodities that

are continuously produced and semi-or non storable. A more general approach to

the study of the impact of futures trading on cash prices is needed. The statistical

evidence assembled in support of the three conclusions namely:

The seasonal price range is lower with a futures market because of

speculative support at harvest time.

Sharp adjustments at the end of a marketing season are diminished under

futures trading because they have been better anticipated.

Year-to-Year price fluctuations are reduced under futures trading because of

the existence of the futures market as a reliable guide to production


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planning.

The above conclusions have always dealt with the total seasonal variation in cash

prices. The research concerns itself with an analysis of the impact of futures trading

on the fluctuations of the separate elements of price series. It focuses mainly on the

effect futures trading has on the random element.

2.7 - Hypothesis:

Null Hypothesis (Ho)

The volatility before and after the introduction of futures is the same

Alternative hypothesis (H1)

The volatility after the introduction of futures is less


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2.8Operational Definition of Concepts

Arbitrage: The simultaneous purchase and sale of similar commodities in

different exchanges or in different contracts of the same commodity in one

exchange to take advantage of a price discrepancy.

Carry Forward Position: The situation in which a client does not square off his

open positions on that day and carries it to the next day is known as the Carry

Forward Position.

Cash Commodity: The actual physical commodity as distinguished from the

futures contract based on the physical commodity.

Cash Settlement: A method of settling future contracts whereby the seller pays the

buyer the cash value of the commodity traded according to a procedure specified in

the contract.

Clearing: The procedure through which the clearing house or association becomes

the buyer to each seller of a futures contract and the seller to each buyer and

assumes responsibility for protecting buyers and sellers from financial loss

by assuring performance on each contract.

Clearing House: An agency or separate corporation of a futures exchange that is

responsible for settling trading accounts, collecting and maintaining margin

monies, regulating delivery and reporting trade data.

Convergence: The tendency for prices of physical commodities and futures to

approach one another usually during the delivery month.


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Day Trader: A speculator who will normally initiate and offset a position within a

single trading session.

Default: The failure to perform on a futures contract as required by exchange

rules, such as a failure to meet a margin call or to make or take delivery.

Delivery: The tender and receipt of an actual commodity or warehouse receipt or

other negotiable instrument covering such commodity in settlement of a futures

contract.

Delivery Period: The interval between the time when the warehouse receipt is given

to the exchange by the seller and the time incurred by the buyer in getting this

warehouse receipt is known as delivery period.

Derivative: A financial instrument traded on or off the exchange the price of which

is directly dependent upon the value of one or more underlying securities, equity

indices, debt instruments, or any agreed upon pricing index or arrangement.

Hedging: The practice of offsetting the price risk inherent in any cash market

position by taking the opposite position in the futures market. Hedgers use the

market to protect their businesses from adverse price changes.

Long: One who has bought futures contracts or owns a cash commodity.

Mark-to-Market: To debit or credit on a daily basis a margin account based on the

close of that day's trading session.


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Open Interest: The sum of all long or short futures contracts in one delivery month

or one market that have been entered into and not yet liquidated by an offsetting

transaction or fulfilled by delivery.

Position: A commitment, either long or short, in the market.

Price Discovery: The process of determining the price level of a commodity based on

supply and demand factors.

Price Limit: The maximum advance or decline from the previous day's

settlement price permitted for a futures contract in one trading session.

Settlement Price: The daily price at which the clearing house settles all accounts

between clearing members for each contract month. Settlement prices are used

to determine both margin calls and invoice prices for deliveries. The term also

refers to a price established by the clearing organization to calculate account values

and determine margins for those positions still held and not yet liquidated.

Short: One who has sold futures contracts or the cash commodity.

Speculator: One who tries to profit from buying and selling future contracts

by anticipating future price movements.

Spot: Usually refers to a cash market price for a physical commodity that is

available for immediate delivery.

Squaring: The practice by which the goods sold in the market are bought back

before the term ends to meet the cycle or the practice that the bought goods are sold

before the term ends to settle the deal is called squaring. Here price or commodity is


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not exchanged, but only profit or loss.

Tick: The smallest allowable increment of price movement for a contract. Also

referred to as Minimum Price Fluctuation.

Trade Account: To trade in the Futures market the client has to register himself and

open an account with the broking organization known as trading account.

Trading Lot: Each commodity should be sold and bought in the Futures market at a

specific quantity. These quantities are called trading lots fixed by the exchanges.

For rubber and pepper it is 1 ton, while it is 1 quintal for cardamom.

Volatility: A measurement of the change in price over a given time period.

Warehouse Receipt: When the commodity sold in the Futures market is taken to the

warehouse, the client receives a legal document from the warehouse known as

warehouse receipt. This document has a trade value.


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2.9 Methodology

2.9.1- Type of research

The Research work undertaken in the report is both a

qualitative and quantitative one. Qualitative data was analyzed to find for any reasons

that may exist in which cause any variations in the commodity futures

markets. Quantitative data like the prices of the commodities for the two years

preceding the date of introduction of futures to after introduction of futures was

collected and analyzed.

2.9.2 - Sampling technique

The sample size includes the following commodities and the prices two years prior to

introduction and after the introduction of futures were considered. The commodities

are as follows:

Maize

Wheat

Castor

Gur

Turmeric

Soyabean


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2.9.3 - Sample Description

Synoptic view of the commodities selected as sample:

MAIZE

Maize is a cereal grain that was domesticated in Mesoamerica and then spread

throughout the American continents. It spread to the rest of the world after

European contact with the Americas in the late 15 th century and early 16th century.

Corn is a shortened form of Indian corn i.e. the Indian grain. Maize is widely cultivated

throughout the world and a greater weight of maize is produced each year than any

other grain. While the United States produces almost half of the worlds harvest other

top producing countries are as widespread as China, Brazil, France, Indonesia

and South Africa. Worldwide production was over 600 million metric tons in 2003 -

just slightly more than rice or wheat. In 2004, close to 33 million hectares of maize

were planted worldwide with a production value of more than $23 billion.

Human consumption of corn and cornmeal constitutes a staple food in many regions

of the world


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WHEAT:

WHEAT SCENARIO IN INDIA:

Wheat is one of the most important staple food grains of human race. India produces

about 70 million tones of wheat per year or about 12 per cent of world production. It is

now the second largest producer of wheat in the world. Being the second largest in

population, it is also the second largest in wheat consumption after China, with a huge

and growing wheat demand.

Relevance of Wheat Futures Trading:

For a commodity to be suitable for smooth futures trading, generally a favorable

supply-demand balance is considered necessary, though this condition is no longer very

relevant in globalized commodity markets. There are no quantitative restrictions on

imports of food grains under the EXIM policy of India. Nevertheless, India is no longer

dependent on imports of food grains with nearly 2% of surplus of Wheat over the last

decade.

With the withdrawal of Government in the Wheat market, volatility and vibration in

wheat market would be conducive for Futures trading in the country. Traders and

manufactures could do away with storing excessive stock of Wheat resulting in

increased carrying cost. For instance, the economic cost of carrying buffer stocks of

Wheat for FCI is projected to rise to Rs 921/per quintal in 2003-04 from the present

cost of 879.16/per quintal due to increase in MSP, open ended procurement and hike in

the rates of state taxes and levies. In light of this, futures trading in Wheat would


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provide a mechanism to lock in prices today of future production or future sale. This

would enable reduction of buffer stocks with traders and stockiest who would use

futures to maintain optimal levels of Wheat stocks. The locking in of Futures price and

buying/selling forward on estimated production would help in removing intra seasonal

and inters seasonal abnormal price variance.

Such a futures market would not only provide management of price risks through

hedging but also assist in efficient discovery of prices, which could serve as reference

for trade in physical commodities in both domestic and international markets.

SOYBEAN:

Soybean is a species of legume native to Eastern Asia. It is an annual plant

that may vary in growth, habit and height. Beans are classified as pulses whereas

soybeans are classified as oilseeds. Soybeans occur in various sizes, and in several hull

or seed coat colors, including black, brown, blue, yellow and mottled. Soybeans are an

important global crop, grown for oil and protein. The bulk of the crop is solvent

extracted for vegetable oil and then defatted soy meal is used for animal feed. A very

small proportion of the crop is consumed directly as food by humans. Soybean

products, however appear in a large variety of processed foods. Soybean is a fast

expanding oilseed crop in India. During recent years, it has shown a tremendous

growth in production in the country. Out of the estimated production of 15.06 million

tonnes of all the oil seeds in the country, the soybean shared about 30 percent (4.56

million tonnes) during the year 2002-03. The soybean has a vibrant international trade

due to its multiple beneficial qualities. Soybean is being promoted as an important


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oilseed under the Technology Mission on Oilseeds and Pulses in India. For its

nutritional profile the soy food market has the potential to grow at about 200 percent per

annum.

TURMERIC:

Turmeric is a member of the ginger family. Its also called tumeric or kunyit

insome Asian countries. Its dried roots are ground into a deep yellow spice

commonly used in curries and other South Asian cuisine. Its active ingredient

is curcumin and it has an earthy bitter peppery flavour.

Sangli a town in the southern part of the Indian state of Maharashtra, it is the largest and

most important trading centre for turmeric in Asia or perhaps in the entire world.

Tumeric powder is used extensively in Indian cuisine. Turmeric has found application

in canned beverages, baked products, dairy products, ice cream, yogurt, yellow

cakes, biscuits, popcorn-color, sweets, cake icings, cereals, sauces, gelatings,

etc. It is significant ingredient in most commercial curry prowders. Turnmeric is used

to protect food products from sunlight. Over-coloring such as in pickles, relishes and

mustard, is sometimes used to compensate for fading. In the Ayurvedic medicine,

turmeric is thought to have many medicinal properties and many in India use it as a

readily available antiseptic for cuts and burns. It is taken in some Asian countries as a

dietary supplement which allegedly helps with stomach problems and other ailments.

Turmeric is currently used in the formulation of some sunscreens. Turmeric paste is

used by some Indian women to keep them free of superfluous hair.


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CASTOR OIL:

It is a vegetable oil obtained from the castor bean. Castor oil and its derivatives have

applications in the manufacturing of soaps, lubricants, hydraulic and brake fluids, paints,

dyes coatings, inks, cold resistant plastics, waxes and polishes, nylon,

pharmaceuticals and perfumes. In internal combustion engines, castor oil is renowned for

its ability to lubricate under extreme conditions and temperatures such as in air-cooled

engines. In the food industry, Castor oil (food grade) is used in food additives, flavored

candy (i.e. chocolate) as a mold inhibitor and in packaging. Castor oil is also used in the

food stuff industries. Castor oil has 1000 patented industrial applications and is used in

the following industries: automobile, aviation, cosmetics, electrical, electronics,

manufacturing, pharmaceutical, plastics and telecommunications. Castor oils value

was recognized by the United States Congress in the Agricultural Materials Act of 1984

and classified as a strategic material.

GUR:

Jaggery is the traditional unrefined sugar used in India. Though jaggery is used

for the products of both sugarcane and the date palm tree, technically the word refers

solely to sugarcane sugar. The sugar made from the sap of the date palm is both more

prized and less available outside of the districts where it is made. Hence outside of

these areas, sugarcane jaggery is sometimes called gur to increase its market value.

Jaggery is considered by some to be a particularly wholesome sugar and, unlike refined

sugar, it retains more mineral salts. Moreover the process does not involve chemical

agents. Ayurvedic medicine considers jaggery to be beneficial in treating throat and

lung infections. Jaggery is used as an ingredient in both sweet and savory dishes across

India and Sri Lanka. Jaggery is also considered auspicious in many parts of India, and is

eaten raw before commencement

justin final project

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