COMMODITIES MARKET - STOCK AND COMMODITY MARKET

Notes 9 Pages

Bengaluru City University

Bachelor of Business Administration

Contributed by

Tabeed Malpani

FACULTY NAME: Mrs NALINI.N
COLLEGENAME: MES INSTITUTE OF MANAGEMENT
SUB:STOCK AND COMMODITY MARKET

CHAPTER - 4

COMMODITIES MARKET

The term commodity refers to any material, which can be bought and sold.
Commodities in a market’s context refer to any movable property other than actionable
claims, money and securities. Commodities represent the fundamental elements of utility for
human beings. Commodity market refers to markets that trade in
primary rather then manufactured products. Soft commodities are agricultural
products such as wheat, coffee, cocoa and sugar. Hard commodities are mined, such as (gold,
rubber and oil).
Transactions in Commodity Market

1)
Spot Market

Market where commodities are brought and sold in physical form by paying cash is a spot
market.
For example, if you are a farmer or dealer of Chana and you have physical holding of 10 kg
of Chana with you which you want to sell in the market. You can do so by selling your
holdings in either of the three commodities exchanges in India in spot market at the existing
market or spot price.
2)
Futures Market

The market where the commodities are brought and sold by entering into contract to settle the
transaction at some future date and at a specific price is called futures market.
3)
Derivatives

Derivatives are instruments whose value is determined based on the value of an underlying
asset. Forwards, futures and options are some of the well-known derivatives instruments
widely used by the traders in commodities markets.
Types of Commodity Derivatives

Two important types of commodity derivatives are

1)
Commodity futures.

2)
Commodity options.

1) Commodity Futures Contracts: A futures contract is an agreement for buying or selling a
commodity for a predetermined delivery price at a specific future time. Futures are
standardized contracts that are traded on organized futures exchanges.
For example, suppose a farmer is expecting his crop of wheat to be ready in two months
time, but is worried that the price of wheat may decline in this period. In order to minimize
his risk, he can enter into a futures contract to sell his crop in two months’ time at a price
determined now. This way he is able to hedge his risk arising from a possible adverse change
in the price of his commodity.
Commodities suitable for futures trading

All the commodities are not suitable for futures trading. It must fulfill the following
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characteristics:
1) The commodity should have a suitable demand and supply conditions.
2) Prices should be volatile to necessitate hedging through futures price risk. As a result there
would be a demand for hedging facilities.
3) Prices should be volatile to necessitate hedging through futures trading in this case persons
with a spot market commitment face a price risk. As a result there would be a demand for
hedging facilities.
4) The commodity should be free from substantial control from Govt. regulations (or other
bodies) imposing restrictions on supply, distribution and prices of the commodity.
5) The commodity should be homogenous or, alternately it must be possible to specify a
standard is necessary for the futures exchanges to deal in standardized contracts.
6) The commodity should be storable. In the absence of this condition arbitrage would not be
possible and there would be no relationship between spot and futures.
Features of commodity Futures

a)

Trading in futures is necessarily organized under the recognized association so that such
trading is conducted with the procedure laid down in the Rules and Bye-laws of the
association.
b)

The units of price quotation and trading are fixed contracts, parties to the contracts not being
capable of altering these units.
c)

The delivery periods are specified.
d)

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 centres.

2) Commodity Options contracts: Like futures, options are also financial instruments used for
hedging and speculation. The commodity option holder has the right, but not the obligation,
to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified
date. Option contracts involve two parties – the seller of the option writes the option in favor
of the buyer (holder) who pays a certain premium to the seller as a price for the option.

There are two basic types of commodity options: a call option and a put option.
1) A call option gives the buyer, the right to buy the asset (commodity) at a given price. This
‘given price’ is called ‘strike price’.
For example: A bought a call at a strike price of Rs.500. On expiry the price of the asset is
Rs.450. A will not exercise his call. Because he can buy the same asset form the market at
Rs.450, rather than paying Rs.500 to the seller of the option.
2) A put option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Here the
buyer has the right to sell and the seller has the obligation to buy.
For example: B bought a put at a strike price of Rs.600. On expiry the price of the asset is
Rs.619. A will not exercise his put option. Because he can sell the same asset in the market at
Rs.619, rather than giving it to the seller of the put option for Rs.600.
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Participants in Commodity Derivative market

1) Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of
a commodity.
They trade in the futures market to transfer their risk of movement in prices of the commodity
they are actually physically dealing. Some of the hedgers are listed below and their objective
from trading in this market:-
a) Exporters: People who need protection against higher prices of commodities contracted
from a future delivery but not yet purchased.
b) Importers: People who want to take advantage of lower prices against the commodities
contracted for future delivery but not yet received.
c) Farmers: People who need protection against declining prices of crops still in the field or
against the rising prices of purchased inputs such as feed.
d) Merchandisers, elevators: People who need protection against lower prices between the time
of purchase or contract of purchase of commodities from the farmer and the time it is sold.
e) Processors: People who need protection against the increasing raw material cost or against
decreasing inventory values.
2) Speculators: Speculators are those who may not have an interest in the ready contracts, etc.
but see an opportunity of price movement favorable to them.
They provide depth and liquidity to the market. They provide a useful economic function and
are integral part of the futures the market. It would not be wrong to say that in absence of
speculators the market will not liquid and may at times collapse.
3) Arbitrageurs: Arbitrage refers to the simultaneous purchase and sale in two markets so that
the selling price is higher than the buying price by more than the transaction cost, resulting in
risk-less profit.
Advantages of commodity Derivatives

1) Management of risk: This is most important function of commodity derivatives. Risk
management is not about the elimination of risk rather it is about the management of risk.
Commodity derivatives provide a powerful tool for limiting risks that farmers and
organizations face in the ordinary conduct of their businesses.
2) Efficiency in trading: Commodity derivatives allow for free trading of risk components and
that leads to improving market efficiency.
Traders find commodity derivatives to be more attractive instrument than the underlying
security. This is mainly because of the greater amount of liquidity in the market offered by
derivatives as well as the lower transaction costs associated with trading a commodity
derivative as compared to the costs of trading the underlying commodity derivative as
compared to the costs of trading the underlying commodity in cash market.
3) Speculation: This is not the only use, and probably not the most important use, of
commodity derivatives. Commodity derivatives are considered to be risky. If not used
properly, these can leads to financial destruction in an organization.
4) Price discover: Another important application of commodity derivatives is the price
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discovery which means revealing information about future cash market prices through the
futures market.
5) Price stabilization function: Commodity Derivatives market helps to keep a stabilising
influence on spot prices by reducing the short-term fluctuations. In other words, derivative
reduces both peak and depths and leads to price stabilisation effect in the cash market for
underlying asset.

Risks faced by participants in commodity derivatives markets OR Efficiency of
Commodity markets

Different kinds of risks faced by participants in commodity derivatives markets are:

a)
Credit risk

b)
Market risk

c)
Liquidity risk

d)
Legal risk

e)
Operational risk

a) Credit risk: Credit risk on account of default by counter party: This is very low or almost
zeros because the Exchange takes on the responsibility for the performance of contracts.
b) Market risk: Market risk is the risk of loss on account of adverse movement of price.
c) Legal risk: Legal risk is that legal objections might be raised; regulatory framework might
disallow some activities.
d) Operational risk: Operational risk is the risk arising out of some operational difficulties,
like, failure of electricity or connectivity, due to which it becomes difficult to operate in the
market.

Governing Body

Need for regulating commodity market

The need for regulation arises on account of the fact that the benefits of futures markets
accrue in competitive conditions. The regulation is needed to create competitive conditions.
In the absence of regulation, unscrupulous participants could use these leveraged contracts
for manipulating prices. This could have undesirable influence on the spot prices, thereby
affecting interests of society at large... Regulation is also needed to ensure that the market has
appropriate risk management system.

The functions of the Forward Markets Commission

a)

FMC advises Central Government in respect of grant of recognition or withdrawal of
recognition of any association.
b)

It keeps forward markets under observation and takes such action in relation to them as it
may consider necessary, in exercise of powers assign to it.
c)

It collects and publishes information relating to trading conditions in respect of goods
including information relating to demand, supply and prices and submits to the Government
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periodical reports on the operations of the Act and working of forward markets in
commodities.
d)

It makes recommendations for improving the organization and working of forward markets.
e)

It undertakes inspection of books of accounts and other documents of recognized/registered
associations.
Powers of the Forward Market Commission

The Commission has powers of deemed civil court for (a) Summoning and enforcing the
attendance of any person and examining him on oath; (b) Requiring the discovery and
production of any document; (c) Receiving evidence on affidavits, and (d) Requisitioning any
public record or copy thereof from any office.
Regulatory measures prescribed by Forward Markets Commission

Forward Markets Commission provides regulatory oversight in order to ensure financial
integrity (i.e. to prevent systematic risk of default by one major operator or group of
operators), market integrity (i.e. to ensure that futures prices are truly aligned with the
prospective demand and supply conditions) and to protect & promote interest of
customers/non-members.
The Forward Markets Commission prescribes following regulatory measures:
a)

Limit on net open position as on the close of an individual operator and at Member level to
prevent excessive speculation.

b)

Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt
upswing or downswing in prices.

c)

Imposition of margins to prevent defaults by Members/clients.
d)

Physical delivery of contracts and penalty for default/delivery obligations.

e)

Dialy mark to marketing of the contracts.
Difference between Commodity and Financial derivatives

Financial Derivatives

Commodity Derivatives

Most of these contracts are cash
settled.
Some contracts may be settled
physically.
Even in the case of physical settlement,
financial assets are not bulky and do not need
special facility
for storage.
Due to the bulky nature of the underlying
assets, physical settlement in commodity
derivatives creates the
need for warehousing.
Concept of varying quality of asset
does not really exist.
The quality of the asset underlying a
contract can vary at times.

Management of commodity exchanges

These exchanges are managed by the Board of Directors which is composed primarily of the
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members of the association.
Members of commodity exchanges includes:

1) 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.

2) Trading Members: These members execute buy and sell orders in the trading ring the
exchange on their account, on account of ordinary members and other clients.

3)
Trading-cum-Clearing Members:
They have the right to participate in clearing and
settlement in respect of transactions charred out on their account and on account of their
clients.

4) 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.

5) Designated Clearing Bank: It provides banking facilities in respect of pay- in, pay-out and
other monetary settlements.

Preconditions for a Successful Commodity Exchange

1) Clear Objectives: A commodity exchange needs a clear plan with a well- defined scope. The
exchange must have a detailed business plan, operating budget and strategy to engage
productively with stakeholders.
2) Good Governance: A commodity exchange must have a well-thought-out governance
structure that emphasizes and responds to membership needs while maintaining an effective
board and advisory structure that upholds business standards and meets performance targets.
3) Industry/Stakeholder Buy-in: commodity exchange leadership must meet with farmers,
traders, processors, banks, the Central Bank, Ministry of Agriculture, Ministry of Finance and
donors/relief agencies to generate support for the exchange.
4) Enabling Environment/Infrastructure: The host country needs to have legislation in place
that consistently addresses agricultural, financial, trade and legal policies.
5) Well-Designed Trading and Clearing Systems: The exchange must develop a system that
is appropriate to the environment in which it is operating.
6) Clear Rules, Consistent Enforcement: A commodity exchange must have clear,
consistently applied and balanced rules and regulations designed to protect the integrity of the
exchange.
7) Accurate Contracts: The exchange should work with members and the industry to develop
and agreed contract to facilitate trades and more detailed commodities-specific contracts that
contain standard information on quality
standards, analysis, delivery and weights, demurrage, force majeure and arbitration, among
others.
8) Extensive, Continuous Education and Trading: Training and certification of members
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and brokers is critical to ensuring the integrity of the exchange.

9) Relevant and Adaptable: An exchange serves the market. It must therefore constantly re-
evaluate its performance, regulations, systems and membership to ensure that it is delivering
value and maintaining its integrity.

Large Volumes of Commodities Traded:
To stay viable, exchanges must attract large
volumes of commodity across its trading floor.

Major Commodity exchanges in India

The major commodity exchanges in India in terms of volume of trade are given below:

1)
The Multi Commodity Exchange of India Limited (MCX)

2)
National Commodity and derivatives Exchange (NCDEX)

3)
National Multi Commodity Exchange (NMCE)

4)
Indian Commodity Exchange Limited (ICEX)

5)
ACE Commodity exchange

1.
Multi Commodity Exchange of India Limited (MCX)

The Multi Community Exchange of India Limited (MCX), India’s first listed exchange, is
a state-of-the-art, commodity futures exchanges that facilitates online trading, and clearing
and settlement of commodity futures transactions, thereby providing a platform for risk
management. It was established in 2003 and is based in Mumbai. It is regulated by the FMC.
Vision & Mission of MCX Vision:

We envision a unified Indian commodity market that is driven by market forces and
continually provides a level playfield for all stakeholders ranging from the primary producer
to the end-consumer; corrects historical aberrations in the system; leverages technology to
achieve exceptional efficiencies and ultimately lead to a common world market.
Mission:

The Exchange will continue to minimize the adverse effects of price volatilities; providing
commodity ecosystem participants with neutral, secure and transparent trade mechanisms;
formulating quality parameters and trade regulations in conjunction with the regulatory
authority.
Features:
MCX is a state of the art electronic commodity future exchange with permanent government
recognition.
MCX offers more than 40 commodities across various segments such as bullion, ferrous and
non ferrousmetals , energy and agro commodities.
It has introduced standardized commodity futures contracts on its platform.
It has several strategic alliances with various leading global commodity exchanges.
MCX COMDEX is India’s first and only composite commodity price index.
2.
National Commodity & Derivatives Exchange Limited (NCDEX)

NCDEX is a professionally managed online multi commodity exchange based in India and
located in Mumbai.
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It was incorporated as a private limited company incorporated in April 2003 under the
Companies Act, 1956. It was originally promoted by ICICI Bank , NSE , NABARD and LIC.
It is the country’s second largest commodity exchange which mainly deals in agricultural
commodities.
Its shareholders include national level institutions, large public sector bank and companies.
It is regulated by the FMC.
Facilities provided by NCDEX include :
1. NCDEXofferstradinginmore than31agricultural&nonagri commodities
2. NCDEXprovidesanagriculturalcommodityindexcalled DHAANYA which is weighted
value index.
3. It has introduced N-charts – an advanced web based charting tool provided to users free
of cost, helping them in technical analysis.
4. Launched COMTRACK – a proprietary electronic warehouse accounting system
5. Exchange for physicals – recently announced EFP (Exchange for Physicals)

3.
National Multi Commodity Exchange (NMCE)

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by commodity-
relevant public institutions, viz., Central Warehousing Corporation (CWC), National
Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries
Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB),
National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).
While various integral aspects of commodity economy, viz., warehousing, cooperatives,
private and public sector marketing of agricultural commodities, research and training were
adequately addressed in structuring the Exchange, finance was still a vital missing link.
Punjab National Bank (PNB) took equity of the Exchange to establish that
Linkage. Even today, NMCE is the only Exchange in India to have such investment and
technical support from the commodity relevant institutions.
Mission
 Improving efficiency of marketing through online trading in dematerialized form
 Minimization of settlement risks
 Improving efficiency of operations by providing best infrastructure and latest
technology
 Rationalizing the transaction fees to optimum level.
 Implementing best quality standards of warehousing grading and testing in tune with
trade practices.
 Improving facilities for structured finance
 Improving quality of services rendered by suppliers
 Promoting awareness about on-line features trading services of NMCE across the
length & breadth of the country.

4)
Indian Commodity Exchange Limited (ICEX)

Indian Commodity Exchange Limited is a nation-wide screen based online
derivatives exchange for commodities and has established a reliable, efficient and transparent
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trading platform. It has put in place assaying and warehousing facilities in order to facilitate
deliveries.
Vision & Mission of ICEX

 Provide fair, transparent and efficient trading
platform to all participants.
 Meet the international benchmarks for the Indian commodity market.
 Provide equal opportunity and access to investors al over the country through the
modern communication modes.
 Attract a wide array of end-users, financial intermediaries and hedgers.
 Become a major trading hub for most of the commodities.
 To provide product portfolio to suit the trading community needs in an efficient
manner.
ACE Commodity Exchange
Kotak promoted, Ace Derivatives and Commodity Exchange Limited is a screen based online
derivatives exchange for commodities in India. Ace Commodity Exchange earlier known as
Ahmedabad Commodity Exchange has been in existence for more than 5 decades in
commodity business, bringing in the best and transparent business practices in the Indian
commodity space.

IMPORTANT QUESTIONS

Section B
1. Differentiate between physical and futures market
2. Discuss the organisation structure of a commodity market

SECTION C

1. Discuss about FMC – functions, powers
2. Discuss the conditions for a successful commodity exchange
3. Write notes on : MCX , NMCE, NCDEX , ICEX

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