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Commodities |
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Introduction to Commodity |
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Commodity can be defined as every kind of movable property
other than actionable claims, money and securities”. Futures’
trading is organized in such goods or commodities as are
permitted by the Central Government. At present, all goods and
products of agricultural (including plantation), mineral and
fossil origin are allowed for futures trading under the
auspices of the commodity exchanges recognized under the FCRA.
Commodities are having direct relation to our everyday life.
The wheat in our bread, cotton in our clothing, Gold and
silver in our jewellery or petrol in our cars all are
commodities. They are also traded in spot and futures all over
the world in form of derivates.
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WORLD OF COMMODITIES |
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The history of commodities dates back to the times when
mankind first started buying or selling or exchanging
(bartering) the goods for their daily needs. It is no doubt
worlds biggest market in itself however it comes after
currency in terms of size. This is the only market which is
having a cross linkages across the countries as one country is
a producer of goods and other country is user. The size wise
organized commodity market comes among top ranking markets in
the world. Exact global size is difficult to determine as in
the developing economies the markets are in transaction phase
and proper historic data are not available. Roughly fund of
around $110-120bn is likely to get invested in commodity
index. In 2005 this flow was expected around $80bn, which went
up from $55 in 2004. The global commodity derivatives market
is estimated at Rs 2,53,00,000 crore as stated by Bank of
International Settlements.
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COMMODITY EXCHANGES |
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What is ‘Commodity Exchange’?
A Commodity Exchange is an association, or a company of
any other body corporate organizing futures trading in
commodities. In a wider sense, it is taken to include any
organized market place where trade is routed through one
mechanism, allowing effective competition among buyers and
among sellers – this would include auction-type exchanges,
but not wholesale markets, where trade is localized, but
effectively takes place through many non-related
individual transactions between different permutations of
buyers and sellers. The emergence of the derivatives
markets as the effective risk management tools in 1970s
and 1980s has resulted in the rapid creation of new
commodity exchanges and expansion of the existing ones.
Evolution
In the 1840s, Chicago (U.S) had become a commercial center
with railroad and telegraph lines connecting it with the
East. Midwest farmers came to Chicago to sell their wheat
to dealers who, in turn, shipped it all over the country.
They brought their wheat to Chicago hoping to sell it at a
good price. The city had few storage facilities and no
established procedures either for weighing the grain or
for grading it. In short, the farmer was often at the
mercy of the dealer.
1848 saw the opening of a central place where farmers and
dealers could meet to deal in "spot" grain - that is, to
exchange cash for immediate delivery of wheat.
The futures contract; as we know it today, evolved as
farmers (sellers) and dealers (buyers) began to commit to
future exchanges of grain for cash. For instance, the
farmer would agree with the dealer on a price to deliver
to him 5,000 bushels of wheat at the end of June. The
bargain suited both parties. The farmer knew how much he
would be paid for his wheat, and the dealer knew his costs
in advance. The two parties may have exchanged a written
contract to this effect and even a small amount of money
representing a "guarantee."
Such contracts became common and were even used as
collateral for bank loans. They also began to change hands
before the delivery date. If the dealer decided he didn't
want the wheat, he would sell the contract to someone who
did. Or, the farmer who didn't want to deliver his wheat
might pass his obligation on to another farmer. The price
would go up and down depending on what was happening in
the wheat market. If bad weather had come, the people who
had contracted to sell wheat would hold more valuable
contracts because the supply would be lower; if the
harvest were bigger than expected, the seller's contract
would become less valuable. It wasn't long before people
who had no intention of ever buying or selling wheat began
trading the contracts. They were speculators, hoping to
buy low and sell high or sell high and buy low. In this
way the commodity futures came into existence.
Role |
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Exchanges can concentrate on
the trade in futures and options contracts, or they could
primarily function as centers for facilitating physical
trade. |
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They
act as a focal point for trade transactions, and increase
the security of these transactions. |
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Well-organized commodity exchanges form natural reference
points for physical trade, and in this way, they help the
price discovery process. |
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If a
commodity exchange manages to link different warehouses in
the country, this allows trade to take place more
efficiently. |
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Global Exchanges
Few of the principal exchanges are NYME, COMEX, LME, LIFFE, TOCOM,
KLCE, CBOT etc. Majority of the matured and high volume exchanges
are based in United States. |
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COMMODITY VS EQUITY (Derivative markets) |
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Commodities are truly global in nature, with price
dynamics dependent on pure demand & supply situation and
macroeconomics. |
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There
is no need to study balance sheets for investing in
commodities. |
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Commodities, unlike equities are bulky and require special
storage in warehouses. |
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The
qualitative grading of commodities is essential for
commodities and contract design, as the quality of
commodity can vary largely. |
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Commodity futures squared off before expiry is cash
settled. |
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Unlike equity derivatives that are cash settled upon
expiry (Indian context), physical settlement is involved
in commodities. The physical delivery of the underlying
commodity takes place at the designated warehouse. |
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24 hour
globally integrated markets |
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Historically lower volatility leads to lower margins and
more leverage than equity derivatives but it is not the
case currently, in which the volatility has increased
manifold in recent past. |
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The concept of varying quality of asset does not really
exist as far as financial underlying is concerned. However
in the case of commodities, the quality of the asset
underlying a contract can vary at times. |
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INDIAN COMMODITY MARKET |
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Commodity market in India is estimated at around 5 lakh crore.
India is a net importer for pulses and edible oils while it is
self sufficient in food grain requirement and a exporter of
spices and many other food stuffs. It is fast emerging as
largest market for metals and energy too, in which again it is
net importer. No doubt this huge potential is now a target for
the foreign investors, manufacturers, funds to exploit
particularly in liberalized economy. This pave a way for the
fast emerging futures exchanges in the country for hedging and
price discovery mechanism.
Indian commodity market encompasses of lengthy value chain
from the farm gate till the actual consumer. This market is
highly fragmented and unorganized. With the advent of IT and
related services and futures market, the market operations are
undergoing transaction phase. Scientific approach to gather
data, interpretation, and tailor made options has been now the
featured attraction. The typical value chain players are
commission agent (adhtiya), stockist, traders, manufacturers,
distributors, dealers, consumer etc.
With the booming economy and growing middle class incomes
across the country the retail segment has grown manifold which
has in turn attracted the corporates to venture into this
segment. Based on this fact the market has grown with a fast
pace across the globe thanking to the activities in producing
and consuming countries. |
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INDIAN COMMODITY EXCHANGES |
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History |
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The first organized Futures
Market in India was established in 1875, by the ‘Bombay
Cotton trade Association’ to trade in cotton.
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Before the outbreak of the
Second World war, India had a thriving Futures market for a
number of commodities such as groundnut / oil, wheat, rice,
raw jute, precious metals like gold, silver etc. by 1960’s,
India had the necessary legislation in place with commodity
futures considered as a reasonably successful trading
market.
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In mid 1960’s due to wars,
natural calamities and the consequent shortages, Futures
trading in most commodities were banned.
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It took three decades before
Commodity Futures could be re-initiated into Indian markets.
This long period of hibernation for Commodity Futures in
India has come to be known as the “Lost Decades”.
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With the liberalization of the
economy, emphasis was once again, to develop Commodity
Futures trading. The Kabra committee, set up in 1993 to
examine Commodity Futures trading, recommended futures
trading in several commodities. Accordingly futures trading
for 16 commodities and their by-products, and international
futures trading for pepper and castor oil were permitted. By
2002 India had around 20 commodities exchanges, trading
around 42 commodities, with international contracts being
traded for pepper and castor oil.
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Developments |
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Forward Market Commission – the
governing body for commodity trading in India in 2002,
invited applications from associations / companies /
consortium of organizations (including the already
recognized exchanges) to set up a Nation-wide
Multi-Commodity Exchange.
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The aim was to create a nation
wide efficient commodity exchange, which could provide price
discovery and offer price-risk management, to all
participants involved in the commodity business cycle.
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Accordingly FMC gave approval
to four entities to setup National Multi Commodity
Exchanges.
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Out of aforesaid exchanges the
NBOT has emerged as largest exchange for soyoil while NCDEX
has emerged as agri commodity specific exchange and MCX is
famous for its volumes in precious, base metals and energy
products.
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The National Multi Commodity
exchanges have tried to address key problems that have
plagued commodity exchanges in the country so far Primarily.
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The issue of single commodity
exchanges with low liquidity has been addressed. The modern
exchanges will enable multiple commodities trading on online
world standard platforms, with nation wide reach.
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The exchanges now provide real
time price and trade data dissemination.
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The new exchanges maintain
capital settlement guarantee funds and have stringent
capital adequacy norms for brokers, which ensures trade
guarantee to participants.
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The new exchanges enable
deliveries in electronic form. Warehouse receipts exchanges
through the depository participants facilitates efficient
settlement procedures and attract participants from all key
sections of the commodity business cycle.
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The institutions managing the
new exchanges comprise banks and government organizations,
which bring with them institutional building experience,
trust, nation wide reach, technology and risk management
skills.
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The new exchanges have
rule-based management by professionals having no trade
interest.
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Other Developments |
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Since 1998, Indian corporate
with commodity price risk exposure on their imports or
exports can hedge their price risk, through international
exchanges.
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Since the inception of this
legislation, some large commodity corporates have accessed
international exchanges, converting awareness of price risk
management into practice.
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Hedging has improved
competitiveness for corporates in terms of pricing and
improved profitability through improved margins.
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But access has been restricted
to large players, due to large margin requirements. Hence
well-managed local commodity exchanges, could attract the
market segment that was left out.
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In tune with major developments
and reforms in commodity futures trading. It is proposed to
restructure the Commodity Market Regulator – Forward Market
Commission on professional lines as an autonomous
organization. To develop a closer relationship between the
commodities futures regulator and equity markets regulator.
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Objective & Scope |
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India’s commodity related
industry is valued at 5,000 billion rupees with a dependent
industry at 2,000 billion rupees. Commodities account for
58% of India’s GDP. Considering a conservative 3 times
multiple for the derivatives market, Rs 15,00,000 crore
market is waiting to be explored. The need for commodity
price risk management is immense and hence commodity risk
management products should find a large audience.
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The physical markets of
commodities still encounter a lot of obstacles in the shape
of various government controls and regulations, minimum
support price, monopoly procurement, varying tax structures
etc.
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Efforts are being made to
tackle these problems by various administrative departments.
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The objective of all the
endeavors is to provide an efficient risk management
mechanism and increase the value of commodity futures
trading to 10% of GDP by 2007 from 1.26% at the end of 2002.
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List Of Commodities
The commodity markets can be classified as markets trading the
following types of commodities. |
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Agricultural products (Pulses,
Edible oil complex, spices, guar complex, cotton, sugar etc)
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Precious metal (Gold, Silver)
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Other metals (Copper, Aluminum,
Zinc, Nickel etc )
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Energy (Crude oil, Furnance oil
etc)
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Performance |
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Since 2003 two of the exchanges
have emerged truly as a national level representative
exchanges namely NCDEX and MCX
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The combined turnover on daily
basis has crossed 15000 crore which has surpassed daily
volume of BSE equity trading.
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In just two-year time MCX has
reached on second position just after Comex for silver. It
has surpassed TOCOM exchange volumes.
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Few of the commodity introduced
over Indian exchanges have never been traded or listed on
any other exchange of the world like Mentha oil, pulses etc
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These two exchanges have
established themselves and set price discovery platform for
various commodities.
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Two of the exchanges and the
commodities traded in it are having sync with other global
financial and commodity markets.
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Deliveries & Settlement
In the futures commodities market there exist a mechanism of
deliveries of goods. The hedgers of the goods and other market
players are free to give or take deliveries. Ideally exchanges
are not meant for deliveries or it is not encouraged but the
process and warehouses are created which can cater to the
need, which could arise out of stuck positions, arbitrage
opportunities and hedging of goods.
Exchanges are having settlement of contract on any particular
and pre-decided date and on the basis of the pooling prices in
spot market the prices are settled. Ideally the spot and
futures prices converge on the date of expiry. Few of the
contracts are cash settled, intention matching, seller’s
option or buyer’s option etc. The goods in warehouses are
checked with the specifications specified with the exchanges
and according to the variations in the produce or goods the
premium and discount are decided.
The process requirement for delivery is
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Demat account with the exchange
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Sales tax registration
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Adequate knowledge of the
particularly commodity
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Knowledge of transportation
cost
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Knowledge of labour charges
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Details of various taxes
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Comfort level with the physical
market
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Assaying charges and agents
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MARKET PARTICIPANTS |
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Participants who trade in the derivatives market can be
classified under the following four broad categories.
1. Hedgers 2. Speculators (Traders & Investors ) 3.
Arbitragers 4. Funds
Hedgers: |
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Hedgers use futures for
protection against adverse future price movements in the
underlying cash commodity. The rationale of hedging is based
upon the demonstrated tendency of cash prices and futures
values moving in tandem.
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The hedgers are very often
businesses or individuals who at one point or another deal
in the underlying cash commodity.
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Take, for instance, a Soya
trader who buys Soya seed for oil; If Soya prices go up he
has to pay the farmer or the Soya seed dealer more. For
protection against higher Soya prices, the trader can
'hedge' his risk exposure by buying enough Soya futures
contracts to cover the amount of Soya he expects to buy.
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Alternatively, you could be a
hedger.
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Let's suppose that every year
during the festival season you purchase gold. You realize
that the price of gold becomes quite unpredictable during
the season but it is inconvenient for you to purchase it in
advance since you typically use your annual bonus for this
purchase. Now you can hedge yourself against the vagaries of
gold prices by purchasing a contract in advance, for an
upfront margin of just 5 per cent of the contract value. At
the time of settlement you can pay the remainder and have
the gold transferred to your commodity demat account. When
you need the physical gold, incase you wish to convert it
into jewellery, you can have the gold rematerialized.
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Speculators: |
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Hedgers use futures for
protection against adverse future price movements in the
underlying cash commodity. The rationale of hedging is based
upon the demonstrated tendency of cash prices and futures
values moving in tandem.
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Speculators are the second
major group of futures players. These participants include
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Independent traders and
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Investors.
They benefit from price variations and serve as
counter-parties to hedgers. In fact, they accept the risk
offered by the hedgers in a bid to gain from favorable
price changes.
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Let's say that you think that
the price of gold nearer Diwali this year will be lower than
usual. So, you could sell a contract to a merchant at his
price, which is more or less the average price that exists
around that time of the year. Nearer the time, you can buy
gold at a lower price from the market and supply it to him
or you could square off your position at the difference
between the contract price and the settlement price. This
way you could make money by speculating on the price of
gold.
If your surmise turns out to be correct, you could benefit
but if the price in the market around the time of settlement
is higher than that contracted by the merchant, you will
have to bear a loss. So, you as a speculator have taken on
the risk with the hope of a good return.
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For speculators, futures have a
number of advantages over other investments.
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They need to invest less
capital in futures than in the cash market since they are
required to pay only a fraction of the value of the
underlying contract (usually between 3.5-10 per cent) as
margin.
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Further, commission/brokerage
charges on futures traders are small compared to what they
are in case of physical traders and other investments.
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Moreover, there are no
transportation charges, no insurance costs, no storage
charges and no security concerns when someone traders in
futures.
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Arbitragers:
Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across different
markets. If, for example, they see the futures price of an asset
getting out of line with the cash price, they would take
offsetting positions in the two markets to lock in the profit.
Funds
There are two types of funds operating in the matured and ideal
market, Hedge funds and Trading funds. These funds help investors
to make money irrespective of their domain knowledge about the
commodity itself. They take pool of funds from the investors and
trade on informed decisions in the market betting on their
experience team.
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THE REGULATOR AND REGULATIONS |
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Commodity Futures and the Commodity Exchanges are regulated
by the Central Government under the Forward Contracts
(Regulation) Act and the Forward Contract Regulation Rules.
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The Forward Market Commission (FMC), which functions under
the Ministry of Consumer Affairs, Food and Public
Distribution, regulates the Futures Market in Commodities.
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The FMC deals with exchange administration and seeks to
inspect the books of brokers only if foul practices are
suspected or if the exchanges themselves fail to take
action.
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In a sense, therefore, the commodity exchanges are more
self-regulating than stock exchanges. But this could change
if retail participation in commodities grows substantially.
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Unlike the equity markets, brokers don't need to register
themselves with the regulator.
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They are responsible for intermediating and facilitating
hedgers and speculators.
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Many established equity brokers have taken up membership of
the new commodity exchanges as the online trading platforms
are similar to those used for equity.
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At the same time, some old-style commodity brokers are not
yet conversant with online screen based trading.
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So, although they have the requisite knowledge about futures
trading in commodities, learning to use technology is a huge
adjustment for them.
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Glossary |
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Arbitrage: The simultaneous purchase and sale of
similar commodities in different markets to take advantage of
a perceived price discrepancy.
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Basis: The difference between the current cash price
and the futures price of the same commodity for a given
contract month.
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Bear Market: A period of declining Market prices
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Bull Market: A period of rising market prices
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Broker: A company or individual that executes futures
and options orders on behalf of financial and commercial
institutions and / or the general public.
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Cash (Spot) Market: A place where people buy and sell
the actual cash commodities, i.e. grain elevator, livestock
market, etc.
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Commission (Brokerage) Fee: A fee charged by a broker
for executing a transaction
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Convergence: A term referring to cash and future prices
tending to come together as the futures contract nears
expiration.
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Cross-hedging: Hedging a commodity using a different
but related futures contract when there is no futures contract
for the cash commodity being hedged and the cash and futures
markets follow similar price trends.
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Daily Trading Limit: The maximum price change set by
the exchange each day for a contract.
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Day Traders: Speculators who take positions in futures
or options contracts and liquidate them prior to the close of
the same trading day.
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Delivery: The transfer of the cash commodity from the
seller of a futures contract to the buyer of a futures
contract.
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Forward (cash) contract: A cash contract in which a
seller agrees to deliver a specific cash commodity to a buyer
at a specific time in the future.
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Fundamental analysis: A method of anticipating futures
price movement using supply and demand information.
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Futures contract: A legally binding agreement, made
through a futures exchange, to buy or sell a commodity or
financial instrument sometime in the future. Futures contracts
are standardized according to the quality, quantity and
delivery time and location for each commodity.
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Hedger: An individual or company owing or planning to
own a cash commodity – corn, soybeans, wheat, etc. may
anticipate a change in the cost of the commodity before they
intend to buy or sell it in the cash market. A hedger achieves
a protection against the price fluctuations by purchasing or
selling futures contracts of the same or the similar commodity
and later squaring off their positions. The loss (gain) in the
spot (cash) market is offset by the gain (loss) in the futures
market.
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Hedging: The practice of offsetting the price risk
inherent in the any cash market position by taking an equal
but opposite position in the futures market.
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Initial margin: The amount of futures market anticipant
must deposit into his / her margin account at the time he /
she places an order to buy or sell a futures contract.
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Liquidate: Selling (or purchasing) futures contracts of
the same delivery month purchased (or sold) during an earlier
transaction or making (or taking) delivery of the cash
commodity represented by the futures contract.
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Long: One who has bought futures contract or plans to
own a cash commodity.
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Maintenance margin: A set minimum margin (per
outstanding futures contract) that a customer must maintain in
his margin account.
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Nearby (delivery) month: The future contract closet to
expiration. Also referred to as spot month.
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Open interest: The total number of futures contracts of
a given commodity that has not yet been offset by an opposite
futures positions nor fulfilled by delivery of the commodity.
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Purchasing hedge (long hedge): Buying futures contracts
to protect against a possible price increase of cash
commodities that will be purchased in the future. At the time
cash commodities are bought, the open futures position is
closed by selling an equal number and type of futures contract
as those that were initially bought.
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Selling hedge (short hedge): Selling futures contract
to protect against possible hedge declining prices of
commodities that will be sold in the future. At the time the
cash commodities are sold, the open futures positions is
closed by purchasing an equal number and type of futures
contracts as those that were initially sold.
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Short position: Selling futures contracts or initiating
a cash forward contract sale.
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Speculator: A market participant who tries to profit
from buying and selling futures contracts by anticipating
futures price movements. Speculators assume market price risk
and add liquidity and capital to the futures markets. They do
not hold equal and opposite cash market risks.
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Spread: The price difference between two related
markets or commodities.
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Technical analysis: Anticipating future price movements
using historical prices, trading volume, open interest, and
other trading data to study price patterns.
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Volatility: A measurement of the change in price over a
given time period. It is often expressed as a percentage and
computed as the annualized standard deviation of percentage
change in daily price.
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Volume: The number of purchase or sales of a commodity
futures contract made during a specified period of time, often
the total transactions for one trading day.
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