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A commodity is a product having commercial value that can be produced, bought, sold,
and consumed.
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A derivative contract is an enforceable agreement whose value is derived from the
value of an underlying asset; the underlying asset can be a commodity, precious
metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most
common examples of derivative instruments are forwards, futures, options and swaps/spreads.
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Commodity future is a contract to buy or sell specific commodity, of a specific
quality, at a specific price, for a specific future date on the exchange.
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A forward contract is a legally enforceable agreement for delivery of goods or the
underlying asset on a specific date in future at a price agreed on the date of contract.
Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of
goods, which are settled by payment of money difference or where delivery and payment
is made after a period of 11 days, are forward contracts.
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Futures Contract is a type of forward contract. Futures are exchange traded contracts
to sell or buy standardized financial instruments or physical commodities for delivery
on a specified future date at an agreed price. Futures contracts are used generally
for protecting against rich of adverse price fluctuation i.e. hedging.
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Futures prices evolve from the interaction of bids and offers emanating from all
over the country which converge in the trading floor or the trading engine. The
bid and offer prices are based on the expectations of prices on the maturity date.
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In simple terms, long position is a net bought position.
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In simple terms, short position is net sold position.
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In a spot market, commodities are physically bought or sold usually on a negotiable
basis resulting in delivery. While in the futures markets, commodities can be bought
or sold irrespective of the physical possession of the underlying commodity. The
futures market trades in standardized contractual agreements of the underlying asset
with specific quality, quantity, and mode of delivery whose settlement is guaranteed
by regulated commodity exchanges.
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As in capital markets, a commodity exchange is an association or a company or any
other body corporate that is organizing futures trading in commodities and is registered
with FMC (Forward Market Commission). Two major national level commodities exchanges
are Multi Commodities Exchange of India (MCX), National Commodities and Derivatives
Exchange of India (NCDEX).
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Commodity Market in India is regulated by Forward Market Commission (FMC) under
the guidance of the Ministry of Consumer Affairs, Food, & Public Distribution.
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The biggest advantage of trading in commodity futures is price risk management and
price discovery. Farmers can protect themselves against undesirable price movements
and decide upon cropping pattern. The merchandisers avoid price risk. Processors
keep control on raw material cost and decreasing inventory values. International
traders also can lock in their prices.
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Hedging means taking a position in the futures or options market that is opposite
to a position in the physical market. It reduces or limits risks associated with
unpredictable changes in price. The objective behind this mechanism is to offset
a loss in one market with a gain in another.
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Arbitrage is making purchases and sales simultaneously in two different markets
to profit from the price differences prevailing in those markets. The factors driving
arbitrage are the real or perceived differences in the equilibrium price as determined
by supply and demand at various locations.
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It is a document issued by a warehouse indicating ownership of a stored commodity
and specifying details in respect of some particulars, like, quality, quantity and,
some times, indicating the crop season. The original depositor or the holder in
due course can claim the commodities from the warehouse by producing the warehouse
receipt.
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Yes, the identifier is called as ICIN. Depending on the type of commodity, grade,
validity, expiry date, name & location of warehouse, the exchanges allot ICIN to
each commodity. ICIN differs from exchange to exchange.
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Commodities have predefined lot sizes (set by the respective exchanges as per existing
regulation) where current price of a particular commodity, for selected expiry,
is shown in contract information available & rate units differ for different commodities.
The standard unit based on which the price of the contract is quoted for trading
is called quotation or base value. E.g. for gold contract, the quotation or base
value is 10 grams while it is 1 kg in case of silver on MCX.
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It is the quantity of a commodity specified in the contract as tradable units. The
lot size is different for each commodity. The details about lot sizes / delivery
lot can be obtained from the respective exchanges’ website.
Each contract has a lot size and a delivery size, which are not the same; in the
case of gold, the lot size on the NCDEX is 100 gm while the delivery size is 1000
gm. If a person wants to enter into a delivery settlement for gold, he will have
to enter into a minimum of 10 contracts or multiples thereof. Market participants
are required to negotiate only the quantity and price of the contract, as all other
parameters are predetermined by the exchange.
Please note the trading/delivery lot varies from exchange to exchange.
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The cost-of-carry of a commodity is the sum of all the costs including interest,
insurance, storage costs, and other miscellaneous costs. Usually, the commodity
futures price in the exchange is the spot price plus cost-of-carry.
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Basis is the difference between the spot price of an asset and the futures price
of the same asset underlying. The spot price is the ready price prevailing in the
physical commodity market while the futures price is the price of any specific contract
that is prevailing in the exchanges where it is traded.
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Generally, the spot price of a commodity and future price of the same underlying
commodity do not change by the same amount during the life of the futures contract.
This uncertainty in the variation of basis is known as basis risk.
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Contango means a situation, where futures contract prices are higher than the spot
price and the futures contracts maturing earlier. It arises normally when the contract
matures during the same crop season. In a well-integrated market, Contango is equal
to the cost of carry viz. Interest rate on investment, loss on account of loss of
weight or deterioration in quantity etc.
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This situation arises when the price of futures contract is below the spot price
of the same commodity. This happens when there is a shortage for the underlying
asset in the cash market, but also there is an expectation that the supply of the
commodity will increase in the future.
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It is the minimum percentage of the contract value required to be deposited by the
members/clients to the exchange before initiating any new buy or sell position.
This must be maintained throughout the time their position is open and is returnable
at delivery, exercise, expiry or closing out.
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It is the extra margin imposed by the exchange on the contracts when it enters the
concluding phase i.e. it starts with tender period and goes up to delivery/settlement
of trade. This amount is applicable on both the outstanding buy and sell positions.
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Mark-to-market margins (MTM or M2M) 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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The contract enters into the tender period a few days before the expiry. This enables
the members to express their intention whether to give or take delivery.
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It is the rate at which the contract is settled on the expiry date. Usually it is
the average of the spot prices of the last few trading days (as specified by the
exchange) before the contract maturity.
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Spread is the difference between prices of two futures contracts of the same underlying
commodity. Futures market can be a normal market or an inverted market. If the price
of the far month futures contract is higher than the near month one, then it is
referred to as “normal market”. On the other hand, if the price of a far month futures
contract is lower than the near month one, then the situation can be referred to
as “inverted market”.
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In most commodities and financial derivatives market, the term refers to buying
contracts maturing in nearby month, and selling the deferred month contracts, to
profit from the wide spread which is larger than the cost of carry.
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In most of commodities and financial derivatives market, the term refers to selling
the nearby contract month, and buying the distant contract, to profit from saving
in the cost of carry.
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Rolling over of hedge position means the closing out of existing position in the
futures contract and simultaneously taking a new position in a futures contract
with a later date of expiry.
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A calendar spread means taking opposite positions in futures contract of the same
commodity with different expiry dates. It is also known as an intra-commodity spread.
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Hedge ratio is the ratio of number of futures contracts to be purchased or sold,
to the quantity of cash asset that is required to be hedged. It is calculated as
product of the coefficient of correlation between the change in cash prices and
the change in futures prices, and the ratio between the standard deviation of the
change in cash price and the standard deviation of the change of futures prices
of the commodity.
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It is significant because the spot price and futures price may not vary in the same
proportion. By using this ratio, one can cover his basis risk, which is the difference
between the spot price and futures price.
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This refers to the tendency of difference between spot and futures contract to decline
continuously, so as to become zero on the date on maturity.
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Some Clearing Houses interpose between buyers and sellers as a legal counter party
i.e., the clearing house becomes buyer to every seller and vice versa. This obviates
the need for ascertaining credit-worthiness of each counter party and the only credit
risk that the participants face is the risk of clearing house committing a default.
Clearing House puts in place a sound risk-management system to be able to discharge
its role as a counter party to all participants.
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It is a process of settling a futures contract by payment of money difference rather
than by delivering the physical commodity or instrument representing such physical
commodity (like, warehouse receipt). In India, most of the future trades are cash
settled.
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Yes, like equity markets, commodity market has circuit breakers. Exchanges have
circuit filters in place. The filters vary from commodity to commodity but the maximum
individual commodity circuit filter is 6 per cent. The price of any commodity that
fluctuates either way beyond its set price limit will fall in circuit breaker category.
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A.Credit risk:
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Credit risk on account of default by counter party: This is very low or almost zeros
because the Exchange takes on the responsibility for the performance of contracts
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B.Market risk:
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Market risk is the risk of loss on account of adverse movement of price.
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C.Liquidity risk:
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Liquidity risks is the risk that unwinding of transactions may be difficult, if
the market is illiquid
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D.Legal risk:
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Legal risk is that legal objections might be raised; regulatory framework might
disallow some activities.
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E.Operational risk:
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Operational risk is the risk arising out of some operational difficulties, like,
failure of electricity, due to which it becomes difficult to operate in the market.
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A settlement takes place either through squaring off your position or by cash settlement
or physical delivery. Squaring off is taking a opposite position to the initial
stance, which means in the case of an original buy contract an investor would have
to take a sell contract.
An investor who intends to give or take delivery would have to inform his broker
of the same prior to the start of delivery period. In case of delivery, a warehouse
receipt is provided. Delivery is at the option of the seller; a buyer can take delivery
only in case of a willing seller. All unmatched/rejected/excess positions are cash
settled; all open positions for which no delivery information is submitted are also
cash settled. Under cash settlement, the difference between the contract price and
settlement price is to be paid or received.
In online commodity trading, client can not go for delivery & all positions are
cash settled.
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While trading in commodities, with any registered broker, client has to pay certain
charges (apart from margin requirements for trading) which are as follows:
1. Brokerage
2. Service tax
3. Education Cess
4. Exchange Transaction Charges
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