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PROJECT REPORT ON

A STUDY ON COMMODITY MARKET

SUBMITTED BY:

HARSH CHHADWA

T.Y.BMS (SEM-V)

USHA PRAVIN GANDHI COLLEGE OF MANAGEMENT

VILE PARLE (WEST)

MUMBAI-400056.

SUBMITED TO

UNIVERSITY OF MUMBAI

ACADEMIC YEAR

2007-2008

UNDER THE GUIDANCE OF

MR.AMIT CHHEDA

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PROJECT REPORT ON

A STUDY ON COMMODITY MARKET

SUBMITTED BY:

HARSH CHHADWA

T.Y.BMS (SEM-V)

USHA PRAVIN GANDHI COLLEGE OF MANAGEMENT

VILE PARLE (WEST)

MUMBAI-400056.

SUBMITED TO

UNIVERSITY OF MUMBAI

ACADEMIC YEAR

2007-2008

UNDER THE GUIDANCE OF

MR.AMIT CHHEDA

DATE OF SUBMISSION

OCTOBER 15TH, 2007.

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INDEX

SR NO. TOPICSPAGE

NO.

1

EXECUTIVE SUMMARY 1

2 COMMMODITY MARKET INTRODUCTION 3

3 BREIF HISTORY 4

4 MARKET DEVELOPMENT 5

5 INDIA CONNECTION 7

6 COMMODITY MARKET IN INDIA 8

7COMMODITY MARKET

CHARACTERISTICS11

8 HEDGERS AND SPECULATORS 20

9 HOW MARKET WORKS 23

10 HOW TO TRADE? 26

11ECONOMIC IMPORTANCE OF FUTURE

MARKET28

12 PRICING AND LIMITS 29

13OVER- THE-COUNTER AND HAVALA

MARKET31

14 ELEMENTS OF COMMODITY MARKET 3215 STRATEGIES FOR TRADING IN FUTURES 35

16 LIST OF VARIOUS MARKETS 39

17PARTICIPATION OF FII's AND MUTUAL

FUND's IN COMMODITY MARKET45

18TAXATION ISSUES IN COMMODITY

MARKET47

19 ISSUES FACED IN INDIA 50

20 INTERNATIONAL TREND 51

21 REGULATORY ISSUES 5322 REGULATORY PERSPECTIVE 55

23 MAIN TOPIC: CONCLUSION 60

24 CASE STUDY - COFFEE CRISIS 62

25 GENERAL QUESTIONS AND ANSWERS 83

26 BIBLIOGRAPHY 91

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Executive Summary

This project is about the study of the commodities market which will help you tounderstand the basic structure of the market and also the practicalities of this market. It is anoverview, a brief study, and the situation of this market in India.

Commodity market is a place where trading in commodities takes place. It is similar toan Equity market, but instead of buying or selling shares one buys or sells commodities.

The commodities markets are one of the oldest prevailing markets in the humanhistory. In fact derivatives trading started off in commodities with the earliest records beingtraced back to the 17th century when Rice futures were traded in Japan.

Main Topics:

This report shows different types of trading strategies used while trading in acommodity market. A brief description of how the market works and how one can trade in thismarket can also be understood.

Several measures taken by the FMC in regard to the commodity exchanges in Indiasuch as - Limit on open position of an individual operator to prevent over-trading, Limit onprice fluctuation to prevent abrupt upswing or downswing in prices - Special Margin depositsto be collected on outstanding purchases or sales etc.

Futures and options are two commodity traded types of derivatives. An optionscontract gives the owner the right to buy or sell an asset at a set price on or before a givendate. On the other hand, the owner of a futures contract is obligated to buy or sell the asset.Unlike the physical markets, futures markets trade in futures contracts which are primarilyused for risk management (hedging) on commodity stocks or forward physical market)

purchases and sales The two major economic functions of a commodity futures market areprice risk management and price discovery. Futures contracts ensure their liquidity by beinghighly standardized

Economic importance of the future market is stated as the commodity market is bothhighly active and central to the global marketplace; it's a good source for vital marketinformation and sentiment indicators. There are various factors like price discovery and riskreductions help the economy a great deal.

Here in this report it has been tried to show a basic understanding of the commoditymarket, its characteristics like Margins, Derivatives, Leverage, etc which are very important to

understand for studying or entering in to the Commodity Market.

Participation of FII and Mutual Funds in Commodity Markets is shown, before theseentities where not allowed in the commodity market but now the Government is consideringthe proposal to allow these entities to trade in commodity future markets.

Various issues like; India does not have a large nation-wide commodity market, butisolated regional commodity markets. In parallel with the underlying cash markets, Indian

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commodity futures markets too are dispersed and fragmented, with separate tradingcommunities in different regions and with little contact with one another.

Some recommendation showing what Forward Markets Commission should focus on;Regulators should move away from a concern about preventing volatility towards protectingmarket integrity. The regulators must set the regulatory template under which each of theexchanges is permitted to operate and is expected to run its business.

The case study is on Falling commodity prices and industry responses: some lessons from theinternational coffee crisis. It is a case study on the commodity coffee. It show theinternational crisis, various analysis and the reason behind the falling price of coffee.

In the end there are some general questions and answers about this market whichwould help you understand a little more about this market.

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Commodities Market Introduction

Overview:

Ever since the dawn of civilization commodities trading have become an integral part

in the lives of mankind. The very reason for this lies in the fact that commodities represent the

fundamental elements of utility for human beings. 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. Over the years commodities

markets have been experiencing tremendous progress, which is evident from the fact that the

trade in this segment is standing as the boon for the global economy today. The promising

nature of these markets has made them an attractive investment avenue for investors.

In the early days people followed a mechanism for trading called Barter System, which

involves exchange of goods for goods. This was the first form of trade between individuals.

The absence of commonly accepted medium of exchange has initiated the need for Barter

System. People used to buy those commodities which they lack and sell those commodities

which are in excess with them. The commodities trade is believed to have its genesis in

Samaria. The early commodity contracts were carried out using clay tokens as medium of

exchange. Animals are believed to be the first commodities, which were traded, betweenindividuals. The internationalization of commodities trade can be better understood by

observing the commodity market integration occurred after the European Voyages of

Discovery. The development of international commodities trade is characterized by the

increase in volumes of trade across the nations and the convergence and price related to the

identical commodities at different markets. The major thrust for the commodities trade was

provided by the changes in demand patterns, scarcity and the supply potential both within and

across the nations.

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Brief History:

Before the North American futures market originated some 150 years ago, farmers

would grow their crops and then bring them to market in the hope of selling their commodity

of inventory. But without any indication ofdemand, supply often exceeded what was needed,

and unpurchased crops were left to rot in the streets. Conversely, when a given commodity

such as Soybeans were out of season, the goods made from it became very expensive because

the crop was no longer available, lack of supply.

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

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

(spot trading) or for forward delivery. The latter contracts, forwards contracts, were the fore-runners to today's futures contracts. In fact, this concept saved many farmers from the loss of

crops and helped stabilize supply and prices in the off-season.

Today's commodity market is a global marketplace not only for agricultural products,

but also currencies and financial instruments such as Treasury bonds and securitiessecurities

futures. It's a diverse marketplace of farmers, exporters, importers, manufacturers and

speculators. Modern technology has transformed commodities into a global marketplace

where a Kansas farmer can match a bid from a buyer in Europe.

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Market Development

In the context of the development of commodities markets, integration plays a pivotal

role in surmounting the barriers of trade. The development of trading mechanisms in the

commodities market segment largely helped the integration of commodities markets. The

major thrust for the integration of commodities trading was given by the European discoveries

and the march of the world trade towards globalization. The commodities trade among

different countries was originated much before the voyages of Columbus and Da Gama.

During the first half of the second millennium India and China had trading arrangements with

Southeast Asia, Eastern Europe, the Islamic countries and the Mediterranean. The

advancements in shipping and other transport technologies had facilitated the growth of the

trade in this segment. The unification of the Eurasian continent by the Mongols led to a widetransmission of people, ideas and goods. Later, the Black Death of 1340s, the killer plague that

reduced the population of Europe and Middle East by one-third, has resulted in more per

capita income for individuals and thus increased the demand for Eastern luxuries like precious

stones, spices, ceramics and silks. This has augmented the supply of precious metals to the

East. This entire scenario resulted in the increased reliance on Indian Ocean trade routes and

stimulated the discovery of sea route to Asia.

The second half of the second millennium is characterized by the connectivity of the

markets related to the Old and the New worlds. In the year 1571, the city of Manila was found,

which linked the trade between America, Asia, Africa ad Europe. During the initial stages,

because of the high transportation costs, preference of trade was given to those commodities,

which had high value to weight ratio. In the aftermath of the discoveries huge volumes of

silver was pumped into world trade. With the discovery of the Cape route, the Venetian and

Egyptian dominance of spice exports was diluted. The introduction of New world crops into

China has lead to the increased demand for silver and a growth in exports of tea and silk.Subsequently, Asia has become the prime trader of spices and silk and Americas became the

prominent exporter of silver.

Earlier investors invested in those companies, which specialized in the production of

commodities. This accounted for the indirect investments in commodity assets. But with the

establishment of commodity exchanges, a shift in the investment patterns of individuals has

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occurred as investors started recognizing commodity investments as an alternative investment

avenue. The establishment of these exchanges has benefited both the producers and traders in

terms of reaping high profits and rationalizing transaction costs. Commodity exchanges play a

vital role in ensuring transparency in transactions and disseminating prices. The commodity

exchanges ensured the standard of trading by maintaining settlement guarantee funds and

implementing stringent capital adequacy norms for brokers. In the light of these

developments, various commodity based investment products were created to facilitate trading

and risk management. The commodity based products offer a huge array of benefits that

include offering risk-return trade-offs to investors, providing information on market trends and

assisting in framing asset allocation strategies. Commodity investments are always considered

as defensive because during the times of inflation, which adversely affects the performance of

stocks and bonds, commodities provide a defense to investors, maintaining the performance of

their portfolios.

The commodities trade in the 18th and 19th centuries was largely influenced by the

shifts in macro economic patterns, the changes in government regulations, the advancement in

technology, and other social and political transformations around the world. The 19th century

has seen the establishment of various commodities exchanges, which paved the way for

effective transportation, financing and warehousing facilities in this arena. In a new era of

trading environment, commodities exchanges offer innumerable economic benefits by

facilitating efficient price discovery mechanisms and competent risk transfer systems.

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India Connection

Coming to the Indian scenario, despite a long history of commodity markets,

commodity markets in India are still in their initial stages of development. The essential

contributors of this scenario include stringent regulatory restrictions, intermediate ban on

commodity trading and policy interventions by the government. Commodity markets have a

huge potential in the Indian context particularly because of the agro-based economy. With the

government's initiative for agricultural liberalization, commodities' trading in India has gained

increased momentum in activities. To increase the efficiency of the markets the Forward

Markets Commission (FMC), the governing body of commodities trading in India has taken

several initiatives for the establishment of national level multi-commodity exchanges in India.

These exchanges serve as platforms for facilitating transparent trading, trading in multiple

commodities, electronic delivery systems and efficient regulatory mechanisms, creating a

world class environment for Indian traders. In order to sustain the increasing volumes in

commodities trade, the need for proper clearing and settlement systems, warehousing facilities

and efficient pricing mechanisms has been identified. With the recent boom in commodities

markets, Indian participants are gearing up for exploiting the potential opportunities in the

future.

Commodity markets are of great help not only for their participants but also the

economy as a whole. The twenty year bear market for commodities has drastically reduced the

prices of many commodities to their lowest levels. The present shift in trend in commodity

trading complimented by the global increase in demand will certainly hold a promising future

for the investments in this segment.

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Commodities M arket 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, has given mandate to four entities to set-up

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

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

effectively translates 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). Above four policy decisions have the potential

to proliferate futures contracts usage in India to manage price risk. National level

exchanges would make availability 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 rawmaterial

requirements, to facilitate storage as a profitable economic activityand also to manage supply

and demand risk; forward contracts give rise toprice risk, so to the need of price risk

management.

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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. Any economy grows when the constituents willingly accept the risk for

better returns; if risks are not compensated with adequate or more returns, economic activity

will come into a standstill.

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 tobe managed. All these factors augur well for the future of futures.

Way ahead

Commodity 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 marketfor 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.

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 exchange rules, 90 percent of the commodity traders and producers are not in

a position to participate in the 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 toglobal demand and supply which could assist the producers to decide on what crops they

should produce.

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Commodity Market Characteristics

Given the nature of the Commodity futures market, the calculation of profit and loss

will be slightly different than on a normal stock exchange. Let's take a look at the main

concepts:

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

with comparatively small levels of capital. In other words, with a relatively small amount of

cash, you can enter into a futures contract that is worth much more than you initially have to

pay (deposit into your margin account). It is said that in the futures market, more than any

other form of investment, price changes are highly leveraged, meaning a small change in afutures price can translate into a huge gain or loss.

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

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

part of the reason why the futures market is useful but also very risky). The smaller the margin

in relation to the cash value of the futures contract, the higher the leverage. So for an initial

margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000

pounds of coffee valued at $50,000, which would be considered highly leveraged investments.

You already know that the futures market can be extremely risky, and therefore not for

the faint of heart. This should become more obvious once you understand the arithmetic of

leverage. Highly leveraged investments can produce two results: great profits or even greater

losses.

Due to leverage, if the price of the futures contract moves up even slightly, the profit

gain will be large in comparison to the initial margin. However, if the price just inches

downwards, that same high leverage will yield huge losses in comparison to the initial margin

deposit. For example, say that in anticipation of a rise in stock prices across the board, you

buy a futures contract with a margin deposit of $10,000, for an index currently standing at

1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000),

meaning that for every point gain or loss, $250 will be gained or lost.

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If after a couple of months, the index realized a gain of 5%, this would mean the index

gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor

earned a profit of $16,250 (65 points x $250); a profit of 162%!

On the other hand, if the index declined 5%, it would result in a monetary loss of

$16,250--a huge amount compared to the initial margin deposit made to obtain the contract.

This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that

a small change of 5% to the index could result in such a large profit or loss to the investor

(sometimes even more than the initial investment made) is the risky arithmetic of leverage.

Consequently, while the value of a commodity or a financial instrument may not exhibit very

much price volatility, the same percentage gains and losses are much more dramatic in futures

contracts due to low margins and high leverage.

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Derivatives

Another major leap in the development of commodities markets is the growth in

commodities derivative segment. 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. Derivatives

trading have a long history. The first recorded incident of commodities trade was traced back

to the times of ancient Greece. In the year 1688 De la Vega reported the trading in 'time

bargains' which were the then commonly used terms for options and futures. Though the first

recorded futures trade was found to have happened in Japan during the 17th century,

evidences reveal that the trading in rice futures was existent in China, 6000 years ago.

Derivatives are useful for both the producers and the traders for the mitigation of risk in theirbusiness. Trading in futures is an outcome of the mankind's efforts towards maintaining the

supply balance of seasonal commodities throughout the year. Farmers derived the real benefits

of derivatives contracts by assuring the prices they want to procure on their products. The

volatility of prices has made the commodity derivatives not only significant risk hedging

instruments but also strategic exchange traded assets. Slowly, traders and speculators, who

never intended to take the delivery of goods, entered this segment. They traded in these

instruments and made their margins by taking the advantage of price volatility in commodity

markets.

The dawn of the 21st century brought back the good times for commodity markets.

With the end of a 20 year bear market for commodities, following the global economic

recovery and increased demand from China and other developing nations, has revitalized the

charisma of commodities markets. According to the forecasts given by experts commodities

markets are likely to experience a bright future with the depreciation in the value of financial

assets. Furthermore, increasing global consumption, declining U.S. Dollar value, rising factor-

input costs and the recent recovery of the market from the clutches of bear trend are

considered to be the positive symptoms, which contribute to the acceleration of growth in

commodity markets segment.

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Margin

Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk

to the exchange, who always acts as counterparty. To minimize this risk, the exchange

demands that contract owners post a form of collateral, in the US formally called performance

bond,

Settlement

Settlement is the act of consummating the contract, and can be done in one of two

ways, as specified per type of futures contract:

1. Physical delivery - the amount specified of the underlying asset of the contract is

delivered by the seller of the contract to the exchange, and by the exchange to the buyers of

the contract. Physical delivery is common with commodities and bonds. In practice, it occurs

only on a minority of contracts. Most are cancelled out by purchasing a covering position -

that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to

liquidate an earlier purchase (covering a long).

2. Cash settlement - a cash payment is made based on the underlying reference rate,

such as a short term interest rate index such as Euribor, or the closing value of a stock market

index.

3. Expiry is the time when the final prices of the future are determined. For many equity

index and interest rate futures contracts (as well as for most equity options), this happens on

the third Friday of certain trading month. On this day the t+1 futures contract becomes the t

forward contract. For example, for most CME and CBOT contracts, at the expiry on

December, the March futures become the nearest contract. This is an exciting time for

arbitrage desks, as they will try to make rapid gains during the short period (normally 30

minutes) where the final prices are averaged from. At this moment the futures and the

underlying assets are extremely liquid and any miss pricing between an index and an

underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume

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is caused by traders rolling over positions to the next contract or, in the case of equity index

futures, purchasing underlying components of those indexes to hedge against current index

positions.

Margins: In the futures market, margin refers to the initial deposit ofgood faith made

into an account in order to enter into a futures contract. This margin is referred to as good faith

because it is this money that is used to debit any losses.

When you open a futures account, the futures exchange will state a minimum amount of

money that you must deposit into your account. This original deposit of money is called the

initial margin. When your contract is liquidated, you will be refunded the initial margin plus or

minus any gains or losses that occur over the span of the futures contract. In other words, the

amount in your margin account changes daily as the market fluctuates in relation to your

futures contract. The minimum-level margin is determined by the futures exchange and is

usually 5% to 10% of the futures contract. These predetermined initial margin amounts are

continuously under review: at times of high market volatility, initial margin requirements can be

raised.

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

contract, but the maintenance margin is the lowest amount an account can reach before

needing to be replenished. For example, if your margin account drops to a certain levelbecause of a series of daily losses, brokers are required to make a margin call and request that

you make an additional deposit into your account to bring the margin back up to the initial

amount.

Let's say that you had to deposit an initial margin of $1,000 on a contract and the

maintenance margin level is $500. A series of losses dropped the value of your account to

$400. This would then prompt the broker to make a margin call to you, requesting a deposit of

at least an additional $600 to bring the account back up to the initial margin level of $1,000.

Word to the wise: when a margin call is made, the funds usually have to be

delivered immediately. If they are not, the brokerage can have the right to liquidate your

Commodity position completely in order to make up for any losses it may have incurred on

your behalf. but commonly known as margin.

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Margin requirements are waived or reduced in some cases for hedgers who have

physical ownership of the covered commodity or spread traders who have offsetting contracts

balancing the position.

1. Initial margin is paid by both buyer and seller. It represents the loss on that contract,

as determined by historical price changes that is not likely to be exceeded on a usual day's

trading. Because a series of adverse price changes may exhaust the initial margin, a further

margin, usually called variation or maintenance margin, is required by the exchange. This is

calculated by the futures contract, i.e. agreeing a price at the end of each day, called the

"settlement" or mark-to-market price of the contract.

2. Margin-equity ratio is a term used by speculators, representing the amount of their

trading capital that is being held as margin at any particular time. Traders would rarely (and

unadvisedly) hold 100% of their capital as margin. The probability of losing their entire

capital at some point would be high. By contrast, if the margin-equity ratio is so low as to

make the trader's capital equal to the value of the futures contract itself, then they would not

profit from the inherent leverage implicit in futures trading. A conservative trader might hold a

margin-equity ratio of 15%, while a more aggressive trader might hold 40%.

3. Mark-to-Market margin

Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the

end of each trading day. These margins will be paid by the buyer if the price declines and by

the seller if the price rises. This margin is worked out on difference between the

closing/clearing rate and the rate of the contract (if it is entered into on that day) or the

previous day's clearing rate. The Exchange collects these margins from buyers if the prices

decline and pays to the sellers and vice versa

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Key Characteristics

Nature of Commodities

Commodities are real assets that are produced and consumed in an industrial or other

process. In contrast, other asset classes of interest rates, currency or equity represent financial

claims on different aspects of real assets. This aspect of commodities ha a number of

dimensions, including:

1. Consumption goods commodities are primarily consumption goods rather than

investment products. This means that demand is not purely price dependent. In addition, some

commodities may display characteristics not normally found in financial assets. For example,

zero or negative price may occur in electricity markets where generators seek to ensure that

their plants are dispatched for contiguous blocks of time longer than a simple slot for which

separate time bids are accepted. This is driven by the desire of the generator to shed excess

output as electricity cannot be stored.

2. Non standard structure commodities are generally not standardized. This reflects the

heterogeneous nature of commodity production in terms of quality or grade. This contrasts

with other financial assets that are homogenous. This dictates that the commodity market has

two layers. The physical or cash market that trades a range of commodities of varying quality,

location and structure, and a commodity derivatives market that trades a range of instruments

on (artificially) standardized commodities. This is driven by the need to facilitate trading. It

creates basis risk in commodity derivatives.

3. Cost of production commodity prices frequently gravitate towards the cost of

production. This is because the market will adjust over time. If prices are significantly above

or below the cost of production (including a "normal" profit component), then supply willadjust in the longer term.

4. Price behavior commodity prices display seasonality and may change over different

phases of the commodity life. Seasonal patterns in consumption and production are manifested

in recurring behavior of prices and volatility. Forward prices of commodities will generally

change as time to maturity changes.

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Hedger and Speculator

The players in the futures market fall into two categories: hedger and speculator. A

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

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

the cash market. This helpsprotect against price risks.

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

trying to secure as low a price as possible. The short holders of the contract ( sellers of the

commodity) will want to secure as high a price as possible. The commodity contract, however,

provides a definite price certainty for both parties, which reduces the risks associated with

price volatility. By means offutures contracts, Hedging can also be used as a means to lock in

an acceptable price margin between the cost of the raw material and the retail cost of the finalproduct sold.

Example:

A silversmith must secure a certain amount of silver in six months time for earrings

and bracelets that have already been advertised in an upcoming catalog with specific prices.

But what if the price of silver goes up over the next six months? Because the prices of the

earrings and bracelets are already set, the extra cost of the silver can't be passed onto the retail

buyer, meaning it would be passed onto the silversmith. The silversmith needs to hedge, or

minimize his risk against a possible price increase in silver. How? The silversmith would enter

the futures market and purchase a silver contract for settlement in six months time (let's say

June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash

market is actually $6 per ounce, so the silversmith benefits from the futures contract and

escapes the higher price. Had the price of silver declined in the cash market, the silversmith

would, in the end, have been better off without the futures contract. At the same time,

however, because the silver market is very volatile, the silver maker was still shelteringhimself from risk by entering into the futures contract. So that's basically what a hedger is: the

attempt to minimize risk as much as possible by locking in prices for a later date purchase and

sale.

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

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

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

hedger could go short in a contract today to hedge against declining stock prices in the future.

A potato farmer would hedge against lower French fry prices, while a fast food chain would

hedge against higher potato prices. A company in need of a loan in six months could hedge

against rising in the interest rates future, while a coffee beanery could hedge against rising

coffee bean prices next year.

Speculators

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

to benefit from the inherently risky nature of the commodity market. These are the

speculators, and they aim to profit from the very price change that hedgers are protecting

themselves against. A hedger would want to minimize their risk no matter what they're

investing in, while speculators want to increase their risk and therefore maximize their profits.

In the commodity market, a speculator buying a contract low in order to sell high in the future

would most likely be buying that contract from a hedger selling a contract low in anticipation

of declining prices in the future.

Unlike the hedger, the speculator does not actually seek to own the commodity in question.

Rather, he or she will enter the market seeking profits by off setting rising and declining prices

through thebuying and selling of contracts.

Long Short

HedgerSecure a price now to protect

against future rising prices

Secure a price now to protect against

future declining prices

SpeculatorSecure a price now in

anticipation of rising prices

Secure a price now in anticipation of

declining prices

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

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

contract's expiration, the more solid the information entering the market will be regarding the

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

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

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

government. The market is also subject to regulation by the National Futures Association,

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NFA, a self-regulatory body authorized by the U.S. Congress and subject to CFTC

supervision.

A Commodity brokerand/or firm must be registered with the CFTC in order to issue or

buy or sell futures contracts. Futures brokers must also be registered with the NFA and the

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

through the Department of Justice in cases of illegal activity, while violations against the

NFA's business ethics and code of conduct can permanently bar a company or a person from

dealing on the futures exchange. It is imperative for investors wanting to enter the futures

market to understand these regulations and make sure that the brokers, traders or companies

acting on their behalf are licensed by the CFTC.

Arbitrators

According to dictionary definition, a person who has been officially chosen to make a

decision between two people or groups who do not agree is known as Arbitrator. In

commodity market Arbitrators are the people who take the advantage of a discrepancy

between prices in two different markets. If he finds future prices of a commodity edging out

with the cash price, he will take offsetting positions in both the markets to lock in a profit.

Moreover the commodity futures investor is not charged interest on the difference between

margin and the full contract value.

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How Market Works:

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

the world who meet and enter into commodity futures contracts. Pricing mostly is based on an

open cry system, or bids and offers that can be matched electronically. The commodity

contract will state the price that will be paid and the date of delivery. Almost all futures

contracts end without the actual physical delivery of the commodity.

What exactly is a commodity Contract? Let's say, for example, that you decide to

subscribe to satellite TV. As the buyer, you enter into an agreement with the company to

receive a specific number of channels at a certain price every month for the next year. This

contract made with the satellite company is similar to a futures contract, in that you have

agreed to receive a product or commodity at a later date, with the price and terms for deliveryalready set. You have secured your cost for now and the next year, even if the price of satellite

rises during that time. By entering into this agreement, you have reduced your risk of higher

prices.

That's how the futures market works. Except instead of a satellite TV provider, a

producer of wheat may be trying to secure a selling price for next season's crop, while a bread

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

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

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

entering into this futures contract, the farmer and the bread maker secure a price that both

parties believe will be a fair price in June. It is this contract that can then be bought and sold in

the commodity market.

A futures contract is an agreement between two parties: a short position, the party who

agrees to deliver a commodity, and a long position, the party who agrees to receive a

commodity. In the above scenario, the farmer would be the holder of the short position

(agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy).

(We will talk more about the outlooks of the long and short positions in the section on

strategies, but for now it's important to know that every contract involves both positions.)

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In every commodity contract, everything is specified: the quantity and quality of the

commodity, the specific price per unit, and the date and method of delivery. The price of a

futures contract is represented by the agreed - upon price of the underlying commodity or

financial instrument that will be delivered in the future. For example, in the above scenario,

the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Profit And Loss - Cash Settlement. The profits and losses of futures depend on the

daily movements of the market for that contract and is calculated on a daily basis. For

example, say the futures contracts for wheat increases to $5 per bushel the day after the above

farmer and bread maker enter into their commodity contract of $4 per bushel. The farmer, as

the holder of the short position, has lost $1 per bushel because the selling price just increased

from the future price at which he is obliged to sell his wheat. The bread maker, as the long

position, has profited by $1 per bushel because the price he is obliged to pay is less than whatthe rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X

5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000

bushels). As the market moves every day, these kinds of adjustments are made accordingly.

Unlike the stock market, futures positions are settled on a daily basis, which means that gains

and losses from a day's trading are deducted or credited to a person's account each day. In the

stock market, the capital gains or losses from movements in price aren't realized until the

investor decides to sell the stock or cover his or her short position.

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

transactions in the futures market are settled in cash, and the actual physical commodity is

bought or sold in the cash market. Prices in the cash and futures market tend to move parallel

to one another, and when a futures contract expires, the prices merge into one price. So on the

date either party decides to close out their futures position, the contract will be settled. If the

contract was settled at $5 per bushel, the farmer would lose $5,000 on the contract and the

bread maker would have made $5,000 on the contract.

But after the settlement of the wheat futures contract, the bread maker still needs wheat

to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool)

for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when

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he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go

towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000

- $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the

cash market at $5 per bushel, but, because of his losses from the futures contract with the

bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's

loss in the commodity contract is offset by the higher selling price in the cash market--this is

referred to as hedging.

Now that you see that a futures contract is really more like a financial position, you can

also see that the two parties in the wheat futures contract discussed above could be two

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

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

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

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How to Trade?

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

the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader,

you should have a solid understanding ofhow the market works and contracts function. You'll

also need to determine how much time, attention, and research you can dedicate to the

investment. Talk to your broker and ask questions before opening a futures account.

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

been earmarked as risk capital. Once you've made the initial decision to enter the market, the

next question should be, How? Here are three different approaches to consider:

Self Directed - As an investor, you can trade your own account, without the aid or advice of a

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

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

analysis of how the market will move in relation to the commodity in which you've invested. It

requires time and complete attention to the market.

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

similar to an equity account. Your broker would have the power to trade on your behalf,

following conditions agreed upon when the account was opened. This method could lessenyour financial risk, because a professional brokerwould be assisting you, or making informed

decisions on your behalf. However, you would still be responsible for any losses incurred and

margin calls.

Commodity pool - A third way to enter the market, and one that offers the smallest risk, is to

join a commodity pool. Like a mutual fund, the commodity pool is a group of

commodities which can be invested in. No one person has an individual account; funds

are combined with others and traded as one. The profits and losses are directly

proportionate to the amount of money invested. By entering a commodity pool, you also

gain the opportunity to invest in diverse types of commodities. You are also not subject

to margin calls. However, it is essential that the pool be managed by a skilled broker, for

the risks of the futures market are still present in the commodity pool.

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Economic Importance of the Futures Market

Because the commodity market is both highly active and central to the global

marketplace, it's a good source for vital market information and sentiment indicators.

Price Discovery - Due to its highly competitive nature, the futures market has become an

important economic tool to determine prices, based on today's and tomorrow's estimated

amount of supply and demand. Futures market prices depend on a continuous flow of

information from around the world and thus require a high amount of transparency. Factors

such as weather, war, debt default, refugee displacement, land reclamation, and deforestation

can all have a major effect on supply and demand, and hence the present and future price of a

commodity. This kind of information and the way people absorb it constantly changes the

price of a commodity. This process is known asprice discovery.

Risk Reduction - Futures markets are also a place for people to reduce risk when making

purchases. Risks are reduced because the price is pre-set, therefore letting participants know

how much of the commodity they will need to buy or sell. This helps reduce the ultimate cost

to the retail buyer, because with less risk there is less chance of manufacturers hiking up prices

to make up for profit losses in the cash market.

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Pricing and Limits

As we mentioned before, contracts in the Commodity futures market are a result of

competitive price discovery. Prices are quoted as they would be in the cash market: in

dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and

so on).

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

These minimums are established by the futures exchanges and are known as ticks. For

example, the minimum sum that a bushel of grain can move upwards or downwards in a day is

a quarter of one U.S. cent. For futures investors, it's important to understand how the

minimum price movement for each commodity will affect the size of the contract in question.

If you had a grain contract for 3,000 bushels, a minimum of $7.50 (0.25 cents x 3,000) could

be gained or lost on that particular contract in one day.

Futures prices also have a price change limit that determines the prices between which

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

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

day.

Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per

ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower

boundary would be $4.75. If at any moment during the day the price of futures contracts for

silver reaches either boundary, the exchange shuts down all trading of silver futures for the

day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to

the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until

an equilibrium price is found. Because trading shuts down if prices reach their daily limits,

there may be occasions when it is NOT possible to liquidate an existing futures position at

will.

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

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

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

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

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

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

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

control the market price for a particular commodity.

Concept of Over-The-Counter

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OTC is an alternative trading platform, linked to a network of dealers who do not physically

meet but instead communicate through a network of phones and computers. Trades are usually

transacted between financial institutions that can also act as market makers for the commonly

trade instruments. All transactions over the telephone are recorded, incase of future disputes

that may arise. The buyer and seller to suit their requirements can customize the contracts

traded in these markets. Hence terms of the contract need not be specified as in the case of an

exchange.

Concept of Havala Markets

These are the unofficial commodity exchanges, which, have operated for many decades and

have built up a reasonable reputation in terms of integrity and liquidity and some of these

trade up to 20 to 30 times the volume of the official futures exchanges. They are oftenlocalized in close proximity to official exchanges. The offer not only futures, but also options

contracts. Transactions costs are low, and they therefore attract many speculators and the

smaller hedgers. Absence of regulation and proper clearing arrangements, however, mean that

these markets are mostly "regulated" by the reputation of the main players.

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Elements of Commodity Futures Market

Forward Contracts

Commodity Futures contracts are based on whats termed "Forward" Contracts. Early on these

"forward" contracts (agreements to buy now, pay and deliver later) were used as a way of

getting products from producer to the consumer. These typically were only for food and

agricultural Products. Forward contracts have evolved and have been standardized into what

we know today as futures contracts. Although more complex today, early Forward contracts

for example, were used for rice in seventeenth century Japan. Modern "forward", or futures

agreements, began in Chicago in the 1840s, with the appearance of the railroads, Chicago

being centrally located emerged as the hub between Midwestern farmers and producers and

the east coast consumer population centers.

Meaning of a future contract

A futures contract is a type of "forward contract". Forward Contract (Regulation) Act,

1952 (FCRA) defines forward contract as "a contract for the delivery of goods and which is

not a ready delivery contract". Under the Act, a ready delivery contract is one, which provides

for the delivery of goods and the payment of price therefore, either immediately or within suchperiod not exceeding 11 days after the date of the contract, subject to such conditions as may

be prescribed by the Central Government.

A ready delivery contract is required by law to be fulfilled by giving and taking the

physical delivery of goods. In market parlance, the ready delivery contracts are commonly

known as "spot" or "cash" contracts. All contracts in commodities providing for delivery of

goods and/or payment of price after 11 days from the date of the contract are "forward"

contracts.

Forward contracts are of two types - "Specific Delivery contracts" and "Futures

Contracts". Specific delivery contracts provide for the actual delivery of specific quantities

and types of goods during a specified future period, and in which the names of both the buyer

and the seller are mentioned.

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The term 'Futures contract' is nowhere defined in the FCRA. But the Act implies that it

is a forward contract, which is not a specific delivery contract. However, being a forward

contract, it is necessarily "a contract for the delivery of goods". A futures contract in which

delivery is not intended is void (i.e., not enforceable by law), and is, therefore, not permitted

for trading at any commodity exchange.

Commodity Futures Contracts

A commodity futures contract is a tradable standardized contract, the terms of which

are set in advance by the commodity exchange organizing trading in it. The futures contract is

for a specified variety of a commodity, known as the "basis", though quite a few other similar

varieties, both inferior and superior, are allowed to be deliverable or tender able for delivery

against the specified futures contract. The quality parameters of the "basis" and thepermissible tender able varieties; the delivery months and schedules; the places of delivery;

the "on" and "off" allowances for the quality differences and the transport costs; the tradable

lots; the modes of price quotes; the procedures for regular periodical (mostly daily) clearings;

the payment of prescribed clearing and margin monies; the transaction, clearing and other

fees; the arbitration, survey and other dispute redressing methods; the manner of settlement of

outstanding transactions after the last trading day, the penalties for non-issuance or non-

acceptance of deliveries, etc., are all predetermined by the rules and regulations of the

commodity exchange.

Consequently, the parties to the contract are required to negotiate only the quantity to

be bought and sold, and the price. Everything else is prescribed by the Exchange. Because of

the standardized nature of the futures contract, it can be traded with ease at a moment's notice.

Advantages of Futures Contracts

1. If price moves are favorable, the producer realizes the greatest return with this marketing

alternative.

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2. No premium charge is associated with futures market contracts.

Disadvantages of Future Contracts

1. Subject to margin calls.

2. Unable to take advantage of favorable price moves.

3. Net price is subject to Basis change.

The main differences between the physical and futures markets

The physical markets for commodities deal in either cash or spot contract for ready

delivery and payment within 11 days, or forward (not futures) contracts for delivery of goods

and/or payment of price after 11 days. These contracts are essentially party to party contracts,

and are fulfilled by the seller giving delivery of goods of a specified variety of a commodity as

agreed to between the parties. Rarely are these contracts for the actual or physical delivery

allowed to be settled otherwise than by issuing or giving deliveries. Such situations may arise

when unforeseen and uncontrolled circumstances prevent the buyers and sellers from

receiving or taking deliveries.

The contracts may then be settled mutually. Unlike the physical markets, futuresmarkets trade in futures contracts which are primarily used for risk management (hedging) on

commodity stocks or forward physical market) purchases and sales. Futures contracts are

mostly offset before their maturity and, therefore, scarcely end in deliveries. Speculators also

use these futures contracts to benefit from changes in prices and are hardly interested in either

taking or receiving deliveries of goods.

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Strategies for Trading Futures

Essentially, futures contracts try to predict what the value of an index or commodity will be at

some date in the future. Speculators in the futures market can use different strategies to take

advantage of rising and declining prices. The most common strategies are known as going

long, going short and spreads.

Going Long- When an investor goes long, that is, enters a contract by agreeing to buy and

receive delivery of the underlying at a set price, it means that he or she is trying to profit from

an anticipated future price increase.

For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys

one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By

buying in June, Joe is going long, with the expectation that the price of gold will rise by the

time the contract expires in September.

By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the

contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000

and the profit would be $2,000. Given the very high leverage (remember the initial margin

was $2,000), by going long, Joe made a 100% profit!

Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The

speculator would have realized a 100% loss. It's also important to remember that throughout

the time the contract was held by Joe, the margin may have dropped below the maintenance

margin level. He would have thus had to respond to several margin calls, resulting in an even

bigger loss or smaller profit.

Going Short; A speculator who goes short, that is, enters into a futures contract by agreeing to

sell and deliver the underlying at a set price, is looking to make a profit from declining price

levels. By selling high now, the contract can be repurchased in the future at a lower price, thus

generating a profit for the speculator.

Let's say that Sara did some research and came to the conclusion that the price ofCrude Oil was

going to decline over the next six months. She could sell a contract today, in November, at the

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current higher price, and buy it back within the next six months after the price has declined.

This strategy is called going short and is used when speculators take advantage of a declining

market.

Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract

(one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.

By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on

her profits. As such, she bought back the contract which was valued at $20,000. By going

short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and

she had made a different decision, her strategy could have ended in a big loss.

Spreads; As you can see these strategies, going long and going short, are positions that

basically involve the buying or selling of a contract now in order to take advantage of rising or

declining prices in the future. Another common strategy used by commodity traders is called

spreads. Spreads involve taking advantage of the price difference between two different

contracts of the same commodity. Spreading is considered to be one of the most conservative

forms of trading in the futures market because it is much safer than the trading of long / short

(naked) futures contracts.

There are many different types of spreads, including:

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

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

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

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

Long June Pork Bellies.

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

different futures exchanges. For example, the investor may create a position in the Chicago

Board of Trade, CBOT and the London International Financial Futures and Options Exchange, LIFFE.

Options: Meaning

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Futures contracts are similar to Options. Both represent actions that occur in future. But

Options are contract on the underlying futures contract where as futures are either to accept or

deliver the actual physical commodity. To make a decision between using a futures contract or

an options contract, producers need to evaluate both alternatives

An option on futures gives the right to but not the obligation on the part of the holder to buy or

sell the underlying futures contract by a certain date at a certain price.

Types of Options.

There are two types of options

1. A call option is a contract that gives the owner of the call option the right, but not

obligation to buy the underlying asset by a specified date and a specified price.

2. A put option is a contract that gives the owner of the put option, the right, but not

obligation to sell the underlying asset by a specified date and a specified price. A Commodity

option gives the owner a right to buy or sell a commodity at a specified price and before a

specified time. Options can be traded either in an exchange or over the counter. Over the

counter option contracts are tailor-made contracts matching the specific needs of investors.

The initial cash transfer (premium) is to be paid by the buyer of the option to the seller (option

writer). The purchase of an option limits the maximum loss and at the same time allows the

buyer to take advantage of favorable price movements.

Sellers of option contracts (option writers) are exposed to margin requirements.

Commodity options are exercisable into the corresponding future contracts of the commodity

rather than the physical commodity.

Based on the exercise mode there are two types of options that arecurrently traded.

1. American Style Options:

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In an American option, the buyer of the option can choose to exercise his option at any

given period of time between the purchase date and the expiry date of the underlying

futures contract.

2. European Style Options:

In a European option, the buyer of the option can choose to exercise his option only on the

date of expiration of the underlying futures contract. Since the American option provides

greater degree of flexibility to the investor, the premium paid to buy an American Style

Option is equal to or greater than the European Style Option. However in India options

have still not been introduced as necessary legal formalities are yet to be completed.

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List of International Commodities Derivatives Exchanges

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National Level Multi Commodity Exchanges

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Regional Exchanges

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Participation of FII and Mutual Funds in Commodity Markets

Mutual Funds and Foreign Institutional Investors are presently not allowed to trade in

commodity markets. The Government is considering the proposal to allow these entities to

trade in commodity future markets.

For commodity markets to grow rapidly, retail participation is essential as has been the

experience in developed countries. But the extent of knowledge dissemination of commodity

futures among the mass market is at an abysmal level.

Unlike the financial derivatives market, one can enter the commodity derivatives

market with a much lower investment, since margins are lower in the range of 5-10%. The

leverage that can be obtained in the commodity futures market is much higher. In case mutual

funds are allowed to participate in commodity markets by structuring commodity funds for

retail investors, this would prove to be an added advantage for the lay investor, who may not

have the knowledge and wherewithal to trade in such markets. The commodity futures

exchange remain largely in the shadows of the booming equity market exchanges due to low

awareness levels.

Tracking commodity prices is not just a balance sheet analysis or a company specific study.

Global factors and rather macro factors play a much important role in it. That demands

domain expertise in commodities, market dynamics and price forecasting. This is the reason

for mutual funds to participate in commodity markets since, they are equipped with qualified

analysts and fund management who undertake value investing and boost up the reliability for

the retail investors.

Globally, commodity markets are being acknowledged as an effective market to hedge

against the vagaries of the equity markets. The presence of foreign funds in the securitiesmarket has been found to have correlation with the interest as well as activity in equity

segment. A similar scenario is expected to be replicated in the commodity market, in case

regulation permits the entry of Foreign Institutional Investors into this market.

Yet the other set of challenges in front of the exchanges are creating awareness and

information dissemination. While volumes are important for commodity exchanges, what is

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probably more critical is awareness. There is a need for exchanges to keep relentlessly

pursuing an awareness creation strategy. Awareness at the grassroots will be essential to

materialize and sustain the success it is foreseeing. Disseminating market discovered prices to

the farmer level calls for a mammoth structural framework and massive investments.

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Taxation Issues in Commodity Market

Sales tax implications on commodity future transactions

A commodity future is an agreement to buy or sell a specified quantity and quality of a

commodity in future at a certain price. Commodity futures contracts can be settled either by

way of squaring off or by physical settlement. Commodity futures contracts, which are

squared off before expiry of the contracts, do not have implications of sales tax. In other

words, sales tax is not applicable on futures contracts, because selling a futures contract means

a commitment to sale, which is different from actual sale. Therefore it is not necessary to

obtain sales tax registration prior to entering into a futures contract. However, if the seller does

not square off the position and intends to deliver the goods in respect of his sale position, then

he is required to have sales tax registration.

As per law, in respect of any commodity that attracts sales tax, only sellers having

sales tax registration can give delivery; otherwise it becomes URD (Un Registered Dealer)

transaction. At the time of sale, the seller must submit a sale bill specifying the commodity,

quantity, rate, name of the buyer, etc. and the bill must contain his LST (Local Sales Tax) and

CST (Central Sales Tax number). Such sales tax registration should pertain to the state, where

the specified delivery centre of the futures contract as per MCX rules us located.

For example, if the designated delivery centre for a commodity is Ahmedabad, a seller

having sales tax registration of Gujarat is entitled to deliver goods at Ahmedabad along with a

bill specifying Gujarat sales tax no., but a seller having sales tax registration of Delhi is not

entitled to deliver to deliver at Ahmedabad along with a bill having Delhi sales tax registration

number. Further, in case it is URD transaction, it would attract higher amount of tax, which

must be collected by the buyer from the seller in case of URD and deposited with the Sales tax

department. Due to higher tax rates, it is practically not possible to carry out URD sales.

In case the seller is not registered with the sales tax department in the relevant state, another

option available to him is to deliver through a consignment agent having relevant sales tax

registration. It is not necessary for the buyer to have a sales tax registration, but if the buyer

takes delivery in one contract and wants to give delivery in a subsequent contract, he needs to

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have sales tax registration for offering delivery; otherwise it would URD attracting higher tax

rates.

Sale tax implications in Commodity Futures Transactions resulting in delivery from the seller

and buyers point of view is as follows.

Sellers Point of View:

1. All sellers giving delivery of the physical commodity against open positions in a futures

contract shall have the necessary Registration with the corresponding Sales tax authority of the

state where delivery is being offered.

2. In case the selling member does not have a Sales Tax Registration number, then he can

appoint n Agent / Nominee who had the required Sales tax registration and deliver thecommodity through him.

3. Goods being delivered by the seller may be of different types taxable, tax-paid or tax-

exempted. If the goods are taxable (which means if sales tax is not already paid on such goods

in that state), then it is the seller's responsibility to pay sales tax to the State Government on

the basis of sales tax applicable on such commodity. In such cases, whether he has to recover

sales tax from the buyer will depend on the price quotation as specified in the contract

specifications. If the price quotations as per the contract is inclusive of sales tax, then the

seller cannot recover sales tax from the buyer. If the price quotation is exclusive of sales tax,

then the seller will charge sales tax from the buyer as per the applicable rate.

4. If the goods being delivered by the seller are tax paid (that is in case of resale), then the

seller is not required to pay sales tax to the state govt. provided the buyer is also located in the

same state. If the buyer is located in some other state then the seller is required to pay CST,

which will be recovered by him from the buyer, irrespective of the fact whether the price

quotation specified in the contract is exclusive or inclusive of tax.

5. If the price quotation is exclusive of tax, then the seller will claim the tax from the buyer

irrespective of the fact whether the goods were taxable or tax paid.

6. If the goods are tax exempted then there is no question of sales tax being paid.

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Buyer's Point of View.

1. It is not necessary for buyers taking delivery of the physical commodity against their

positions in the futures contract to be registered with the Sales Tax Authorities if

delivery is in the same state. But if they wish to deliver goods in future, they have to

have sales tax registration.

Service Tax

Members of Commodity Exchanges are liable to pay service tax @ 12% in addition to an

Education Cess @ 2% on the service tax. Therefore, the members are required to collect

Service Tax and Education Cess effectively @ 12.24% of the brokerage charged from

client or persons to whom they provide service relating to future contracts and receive

brokerage or any other charges for providing such services.

Bombay Stamp Act, 1948

Based on the provisions of the relevant articles of the Bombay Stamp Act 1958, the stamp

duty applicable for all commodities future transactions is Rs.1 per lakh of turnover.

Background Information on Issues Faced In India.

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Situation of the Indian Commodity Exchanges

India does not have a large nation-wide commodity market, but isolated regional

commodity markets. In parallel with the underlying cash markets, Indian commodity

futures markets too are dispersed and fragmented, with separate trading communities in

different regions and with little contact with one another. While the exchanges have

varying degrees of success, the industry is generally viewed as unsuccessful. The

exchanges with a few exceptions have acknowledged that they need to embrace new

technologies, and, above all, modern and transparent methods of doing business. But

management often finds it difficult to chart out a route into the future, and have had

difficulties in convincing their membership. Next to the officially approved exchanges,

there are many Havala markets. Many market participants feel that as this system has

worked well for a long time, there is no reason to fear a breakdown of this system based

on trust. However, this clearly cannot be the base for government policy, which has a

duty to protect the public against the risks that use of these markets pose.

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International Trends

As a result of globalization and liberalization, more and more farmers and traders are

becoming exposed to the vagaries of world commodity prices, and to heightened

international competition. As s result, the importance of commodity exchanges and other

tools for the transfer of risk (essential elements of an efficient market place) is increasing.

Meanwhile, developments in, primarily, technology and communications are driving a

drastic upheaval of the commodity exchange sector. Key factors affecting exchanges

include:

1. The trend towards electronic trading; even the exchanges that have a legacy of open outcry

(and the concomitant problem of floor brokers keen on defending their turf) are now

moving towards electronic trading.

2. The emergence of Internet-based commodity exchanges and Electronic Communication

Networks (ECNs) using a combination of dedicated networks and the Internet, as

competitors to exchanges.

3. Globalization of financial markets, where players now use multiple products on multiple

exchanges.

4. Few new products available for futures exchanges to launch.

These factors have forced e

Commodities Market Hrc

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