Financial

Markets &
Institutions
Module V: Introduction to Commodity
Derivatives
Reading material
 Participants in Commodity
Derivative market
Hedgers
Speculators
Arbitragers
 Participants in Commodity
Derivative market
Hedgers
They use the futures market to reduce a particular risk that they face.
Such might relate to price of any commodity that the person deals in.
The classic hedging example is that of wheat farmer who wants to hedge
the risk of fluctuations in the price of wheat around the time that his crop is
ready for harvesting. By selling his crop forward, he obtains a hedge by
locking in to a predetermined price.
Hedging does not necessarily improve the financial outcome ;indeed, it
could make the outcome worse.
They could be government institutions, private corporations like financial
institutions, trading companies and other participants like farmers,
extractors, ginners, processors etc., influenced by commodity prices.

2 kinds of hedges:
• A company that wants to sell an asset at a particular time in the future
can hedge by taking short futures position. This is called a short hedge.
• A company that knows that it is due to buy an asset in the future can
hedge by taking long futures position. This is known as long hedge.
 Participants in Commodity
Derivative market
Speculators
Speculators are those who are willing to take risk. These are the
people who take positions in the market & assume risks to profit
from price fluctuations.
In fact the speculators consume market information make
forecasts about the prices & put money in these forecasts. An entity
having an opinion on the price movements of a given commodity
can speculate using the commodity market.
While the basics of speculation apply to any market, speculating in
commodities is not as simple as speculating on stocks in the
financial market. For a speculator who thinks the shares of a given
company will rise, it is easy to buy the shares and hold them for
whatever duration he wants to. However, commodities are bulky
products and come with all the costs and procedures of handling
these products.
 Participants in Commodity
Derivative market
Arbitrage

A central idea in modern economics is the LAW OF ONE

PRICE.
This states that in a competitive market, if two assets are
equivalent from the point of view of risk and return, they
should sell at the same price. If the price of the same
asset is different in two markets, there will be operators
who will buy in the market where the asset sells cheap
and sell in the market where it is costly. This activity
termed as Arbitrage.
 Hedging – Basic concepts
What is Hedging?
• Hedging means taking a position in the futures market that is
opposite to a position in the physical market with the objective of
reducing or limiting risks associated with price changes. Similarly,
any position in the futures market against the export or import
commitments with a view to reduce / limit the price risk would be
considered as hedging.

• Futures contracts have been used as financial offsets to cash

market risk for more than a century. Hedgers are interested in
transferring risk associated with the physical asset. They use
commodity futures to reduce or limit the price risk of the physical
asset. Hedging is an insurance used to avoid or reduce price risks.
 Hedging – Basic concepts
• Commodity futures markets provide insurance opportunities to
commercials, merchants, importers, exporters, producers and processors,
against the risk of price fluctuation.
• In the case of a trader, an adverse price change brought about by
either supply or demand change, affects the total value of his
commitments. Larger the value of his inventory, larger the risk to which he
is exposed. Hedging allows a market participant to lock in prices and
margins in advance and reduce the potential for unanticipated loss or
competitive disadvantage. A hedge involves establishing a position in
the futures market that is equal and opposite of a position in the physical
market. The principle behind establishing equal and opposite positions in
the cash and futures markets is that a loss in one market should be offset
by a gain in the other market. Hedging works because cash prices and
futures prices tend to move in tandem, converging as the futures contract
reaches expiration.
• The degree of effectiveness of a hedge is determined by the
percentage of the actual gain or loss incurred in a futures transaction.
Though most hedges reduce risks related to price variations, they do not
eliminate them altogether.
 Hedging – Basic concepts
Example 1:
• If an electric cable manufacturer has fixed price commitment for
purchase of copper as raw material, which would be utilized to
manufacture electric cables made of copper, there is a risk of fall in
price of copper and therefore eventually, the risk of fall in price of the
copper made electric cables. The manufacturer would like to reduce his
risk by hedging his exposure in Copper on the futures market.

Example 2:
• An importer of Crude Palm Oil would like to mitigate his import risk of
price changes and exchange rate fluctuations by taking a position in
futures market

• In the above cases, the profit / loss incurred on account of price

movement in the underlying market is offset by the loss /profit in the
futures market thereby reducing / mitigating the adverse price
movements.
 Hedging – Basic concepts
Selling hedge or Short hedge
• Selling hedge is also called Short hedge. Selling hedge means
selling a futures contract to hedge a cash position. Selling hedge
strategy is used by manufacturers, processors and others. who
have exposure in the physical market.

Uses of selling hedge strategy.

• To protect the price of finished products.
• To protect inventory not covered by forward sales.

Short hedgers are merchants and processors who acquire

inventories of the commodity in the spot market and who
simultaneously sell an equivalent amount or less in the futures
market. The hedgers in this case are said to be long in their spot
transactions and short in the futures transactions.
 Hedging – Basic concepts
Example
A tea masala manufacturer requires cardamom and other spices for the
manufacture of end product. He may either have an unsold inventory of
cardamom, or he may have bought it for later delivery. Since the
manufacturer owns the commodity, he would suffer losses if prices drop. By
hedging, the manufacturer can optimize his inventory levels while
managing his production levels. To hedge, the manufacturer would have to
sell the futures contracts. Now if prices drop, the cash market loss will be
offset by a gain in the futures contract. When the manufacturer sells his
inventory at the lower cash market price, he will simultaneously lift his hedge
by buying back the futures contracts at the lower price. The loss in the cash
market will be compensated by gain in futures’ contract.
 Hedging – Basic concepts
Hypothetical example:
• In April 2016 Mr. Ramesh, a Mumbai based gold Jeweller buys 2 Kg of
gold in the spot market at a price of Rs. 26700 per 10 gm as raw material
to make Jewellery from it. Mr. Ramesh wants to protect the reduction in
the price of gold till the Jewellery is ready for sale in May 2016. For the
above purpose Mr. Ramesh sells 2 contracts (1 kg. each) of Gold June
futures at the price of Rs. 26800 per 10 gm
• In May 2016 Mr. Ramesh sells 2 Kg of Jewellery at the reduced spot price
of Rs. 26600 per 10 gm and squares off his Gold June futures open short
position at Rs. 26700 per 10 gm. The above transactions have resulted in
a profit of Rs.100 per 10 gm in Gold June futures contract and a loss of
Rs.100 per 10 gm in the spot transaction, thereby protecting the price of
the finished material i.e Jewellery at Rs. 26700 per 10 gm.
• In the above example, we have assumed basis to remain unchanged

• Basis is the difference between the spot price and the relevant futures
price of Gold
 Hedging – Basic concepts
Selling hedge with basis risk:
• When future price increases more than that of the spot
price due to widening of basis, the hedger incurs a
larger loss on short futures position and a smaller profit
on the corresponding cash position. But when the spot
price increases more than that of the futures price due
to narrowing of basis, the hedger incurs a smaller loss
on the futures position and a larger profit on the
corresponding cash position. In order to ensure that an
effective hedge is made, historical data should be
used to arrive at an optimal hedge ratio.
Advantages & Limitations of Hedging
Advantages:
• 1. Hedging reduces or limits the price risk associated with the physical
commodity.
• 2. Hedging can be used to protect the price risk of a commodity for long
periods by rolling over contracts.
• 3. Hedging makes business planning more flexible without interfering
with routine business operations.
• 4. Hedging can facilitate low cost financing.

Limitations:
• 1. Hedging cannot eliminate the price risk associated with the physical
commodity in totality due to the standardized nature of futures contract.
• 2. Because of basis risk, hedging may not provide full protection against
adverse price changes.
• 3. Hedging involves transaction costs, though costs are quite minimal
compared to benefits.
• 4. Hedging may require closing out a futures position before it becomes
near month contract.
 NCDEX
(National Commodity And
Derivatives Exchange Of India)
NCDEX is a professionally managed on-line multi
commodity exchange promoted by LIC, National Bank
For Agriculture And Rural Development (NABARD) and
National Stock Exchange Of India (NSE).

NCDEX is only the commodity exchange in the country

which is promoted by national level institution.
 Commodities traded at NCDEX
Currently, approx. 57 commodities are traded
at NCDEX which are classified in three
categories they are as follows:-

 Agro. Products
 Non-Agro Products
 Others
Products and services of NCDEX
• NCDEX offers future trading in 31 agricultural
and non-agricultural commodities.
• It also offers an information product, that is
agricultural commodity index.
• NCDEX has also launched gold hedge, a
transparent price benchmark of gold to the
consumer.

https://www.ncdex.com/CustomerServices/FA
Q.aspx#
 Clearing & Settlement of NCDEX
For settlement, all the members of the exchange require to
open their accounts with the ‘Clearing Banks’.

The accounts should be named as follows:-

1. Member name - Settlement A/C &
2. Member name – Exchange dues A/C.

Members can open clearing accounts in these clearing banks:-

 Axis Bank Ltd. (formerly known as UTI Bank Ltd).
 Bank Of India.
 Canara Bank.
 Development Credit Bank ltd.
 HDFC Bank Ltd.
 ICICI Bank Ltd.
 Multi Commodity Exchange Of
India Ltd (MCX)
 Multi Commodity Exchange Of India Ltd, with it’s
headquarter in Mumbai is a demutualised nationwide
electronic commodity futures exchange set up by
Financial Technologies (India) Ltd, with permanent
recognition from GOI for facilitating online trading,
clearing and settlement operations for futures market
across the country.
 Commodities Traded At MCX

 MCX offer futures trading in more than 40

commodities from various market segments
including bullion, energy, ferrous & non-
ferrous metals, oil & oil seeds, cereals,
pulses, spices, plastic & fiber.
 Clearing & settlement of MCX

 The exchange has an in-house clearing which

monitors & performs all the activities related to
delivery fund settlement, margining &
managing the settlement guarantee funds.
 MCX has 16 clearing banks to provide banking
services to trading members.

https://www.mcxindia.com/faq
 THE TOKYO COMMODITY
EXCHANGE
• TOCOM is a non-profit organization and regulates trading of futures
contracts and option products of all commodities in JAPAN.
• The TOKYO Gold exchange, the Tokyo rubber exchange and the Tokyo
textile exchange merged in 1984 to form TOCOM.
• On Dec 1, 2008 , TOCOM demutualized and transformed itself into a
corporation and changed its name to Tokyo commodity exchange Inc.
• It was one of the first commodity futures exchanges in Japan to undergo
such a transformation .
• Morgan Stanley became the first overseas member in 2006 from an in-
house unit to the independent Japan commodity clearing house .
• In early August 2010 , the exchange began allowing foreign commodity
brokers to participate in the market through intermediaries .
• Gold options were the single –largest product in 2006 , accounting for a
third of total contract volume , with gasoline futures ranked second at
22 % followed by platinum at 16 % and rubber at 14 %..
 Dalian Commodities
Exchange
• The DCE is a self-regulated, non-profit organization,
overseen by the China Securities Regulatory Commission.
• A commodities exchange located in Dalian, China. The
Dalian Commodities Exchange trades futures contracts on
soybeans and soybean oil, corn, palm oil, soymeal, etc.
• The Dalian Exchange was established on February 28, 1993,
and has the deepest pool of liquidity of any commodities
exchange in China. It is a non-profit, self-regulating entity
with about 200 members and over 160,000 investors. It also
has the largest volume of any commodities exchange in
China.
 Shanghai Future Exchange
• The Shanghai Futures Exchange (SHFE) is one of the
largest commodities markets in China. The exchange lists
contracts in steel, copper, aluminium, natural rubber, fuel oil,
zinc and gold.
• The Shanghai Futures Exchange (SHFE) was formed from the
amalgamation of the Shanghai Metal Exchange, Shanghai
Foodstuffs Commodity Exchange, and the Shanghai
Commodity Exchange in December 1999.
• It is a non-profit-seeking incorporated body regulated by
the China Securities Regulatory Commission.
• It currently trades futures contracts in copper, aluminium,
zinc, natural rubber, fuel oil, and gold.
 CME group.
• CME Group Inc. (Chicago Mercantile Exchange) is one of the
largest options and futures exchanges.
• In 2014, it gained regulatory approval to open a derivatives
exchange in London
• It also owns the Dow Jones stock and financial indexes, and CME
Clearing Services, which provides settlement and clearing of
exchange trades.
• The corporation was formed by 2007 merger of the Chicago
Mercantile Exchange (CME) and Chicago Board of Trade (CBOT).
• On March 17, 2008, CME Group announced it had acquired NYMEX
Holdings, Inc., the parent company of the New York Mercantile
Exchange and Commodity Exchange, Inc (COMEX). The acquisition
was formally completed on August 22, 2008.
• The four exchanges now operate as designated contract markets
(DCM) of the CME Group.
 Practise Problems
• A trader buys three-month put options on 1 unit of gold with a
strike of Rs.17000/10 gms at a premium of Rs.70. Unit of trading is
1kg. On the day of expiration, the spot price of gold is Rs.16800/10
gms. What is his net payoff?
• Profit of 13000

• One unit of trading for Guar Seed futures is 10 MT. A trader sells 1
unit of Guar Seed at Rs.2500/Quintal on the futures market. A
week later Guar Seed futures trade at Rs.2550/Quintal. How much
profit/loss has he made on his position?
• Loss of 5000

• A bread manufacturer bought five one-month wheat futures

contracts at Rs.1155 per Quintal at the beginning of the day. The
unit of trading is 100kgs. The settlement price at the end of the
day was Rs.1165 per Quintal. The trader's MTM account will show
• +50
 Practise Problems
• Gold trades at Rs.16000 per 10 gms in the spot market. Three-month gold
futures trade at Rs.16150. One unit of trading is 1kg and the delivery unit
for the gold futures contract on the NCDEX is 1 kg. A speculator who
expects gold prices to rise in the near future buys 1 unit of gold futures.
Two months later gold futures trade at Rs.15900 per 10 gms. What is the
profit/loss?
• Loss of 25000

• A trader sells 5 units of gold futures at Rs.16500 per 10 grams. What is the
value of his open short position? Unit of trading is 1 Kg and delivery unit is
one Kg.
• 82,50,000

• A trader has sold crude oil futures at Rs.3750 per barrel. He wishes to limit
his loss to 20%. He does so by placing a stop order to buy an offsetting
contract if the price goes to or above
• 4500
 Practise problems
• A call option with a strike price of 150 trades in the market at
premium of Rs.12. The spot price is Rs.160. The time value of
the option is Rs._________.
• 2
• A put option with a strike price of 150 trades in the market at
Rs.8. The spot price is Rs.160. The intrinsic value of the option is
Rs._________.
• 0
• A company that wants to sell an asset at a particular time in
the future can hedge by taking short futures position.
• True
• The total number of outstanding contracts (long/short) at any
point in time is called______________.
• Open Interest
 Practise problems
• An investor enters into a short forward contract to sell 100,000 British
pounds for US dollars at an exchange rate of 1.4000 US dollars per pound.
How much does the investor gain or lose if the exchange rate at the end
of the contract is (a) 1.3900 and (b) 1.4200?
• The investor is obligated to sell pounds for 1.4000 when they are worth
1.3900. The gain is (1.4000-1.3900) ×100,000 = $1,000. The investor is
obligated to sell pounds for 1.4000 when they are worth 1.4200. The loss is
(1.4200-1.4000)×100,000 = $2,000
• A trader enters into a short cotton futures contract when the futures price
is 50 cents per pound. The contract is for the delivery of 50,000 pounds.
How much does the trader gain or lose if the cotton price at the end of
the contract is (a) 48.20 cents per pound; (b) 51.30 cents
per pound?
• The trader sells for 50 cents per pound something that is worth 48.20 cents
per pound. Gain ($0.5000 - $0.4820) * 50 000 = 900
The trader sells for 50 cents per pound something that is worth 51.30 cents
per pound. Loss ($0.5130 - $0.5000) * 50 000 = 650
 Practise problems
• Suppose that you write a put contract with a strike price of $40
and an expiration date in three months. The current stock
price is $41 and the contract is on 100 shares. What have you
committed yourself to? How much could you gain or lose?
• You have sold a put option. You have agreed to buy 100
shares for $40 per share if the party on the other side of the
contract chooses to exercise the right to sell for this price. The
option will be exercised only when the price of stock is below
$40. Suppose, for example, that the option is exercised when
the price is $30. You have to buy at $40 shares that are worth
$30; you lose $10 per share, or $1,000 in total. If the option is
exercised when the price is $20, you lose $20 per share, or
$2,000 in total. The worst that can happen is that the price of
the stock declines to almost zero during the three-month
period. This highly unlikely event would cost you $4,000. In
return for the possible future losses, you receive the price of
the option from the purchaser.