Module 2

Introduction to Commodities Market

Commodities are another class of assets just like stocks and bonds. However, they
are different in the sense that they are products that come from the earth. Major
commodities include cotton, oil, gas, corn, wheat, oranges, gold, and uranium.
Basically, they are the raw materials needed by large manufacturing companies in
running their businesses. The price of commodity is subject to supply and demand.
Commodity can be defined as "A physical substance, such as food, grains and
metal, which is interchangeable with another product of same type and which
investor buy or sell usual through future contract."

Meaning
The commodity market is a market where traders buy and sell commodities.
Commodities are raw materials or primary agricultural products. In other words,
things that farmer, mining companies and oil and gas companies produce or
extract.
Commodity markets are similar to stock market trading of (shares, securities,
debentures, bonds). However, commodities are actual physical goods such as corn,
silver, gold, crude oil, and so on. Futures are commodity contracts that are traded
on a exchange. Futures contracts have expanded beyond commodities to include
futures contracts on financial markets such as foreign currencies, interest rates, and
so on.

History & Origin

Commodities markets have a long and rich history that dates back thousands of
years. The origins of commodity trading can be traced to ancient civilizations,
where goods such as grains, livestock, and metals were exchanged.
1. Ancient Times: The earliest forms of commodity trading can be seen in
agricultural societies, where farmers would trade surplus crops for other goods. For
example, in Mesopotamia around 3000 BC, barley and other grains were used as a
medium of exchange.
2. Medieval Period: As trade routes expanded, the concept of trading commodities
evolved. In Europe during the Middle Ages, markets began to form where
merchants would gather to exchange goods. The Italian city-states, like Venice and
Genoa, became important trading hubs.
3. Formation of Exchanges: The first formal commodity exchanges began to
emerge in the 17th century. The Amsterdam Stock Exchange, established in 1602,
included the trading of commodities. The Chicago Board of Trade (CBOT),
founded in 1848, was one of the first organized exchanges in the United States,
focusing on agricultural products like wheat and corn.
4. Modern Era: The 20th century saw significant changes in commodities trading
with the introduction of futures contracts, allowing traders to buy and sell
commodities at predetermined prices for future delivery. This innovation helped
stabilize prices and manage risk for producers and consumers.
5. Globalization and Technology: In recent decades, the commodities market has
become increasingly globalized. Advancements in technology have also
transformed trading, with electronic trading platforms allowing for faster and more
efficient transactions.

Today, commodities markets involve a wide range of products, including

agricultural goods, energy resources (like oil and gas), and metals (like gold and
silver). These markets play a crucial role in the global economy, affecting prices
and availability of essential goods.

In summary, the commodities market has evolved from ancient barter systems to
sophisticated global exchanges, reflecting changes in trade practices, economic
needs, and technological advancements.

Types of Commodities Market

Commodities are divided into two different categories: hard and soft commodities.
 Hard Commodities: Hard commodities consist of natural resources that is
mined or extracted. The hard commodities are classified into two categories:
(1) Metals: Gold, Silver, Zinc, Copper, Platinum.
(2) Energy: Natural gas, Crude oil, Gasoline, Heating oil.
 Soft Commodities: Soft commodities refer to those commodities that are
grown and cared for rather than extracted or mined. The soft commodities
are classified into two categories:
(1) Agriculture: Rice, Corn, Wheat, Cotton, Soybean, Coffee, Salt,
Sugar.
(2) Livestock and meat: Feeder cattle, Live cattle, Egg.

TYPES OF COMMODITIES:
(1) Agricultural: Agricultural commodities are those such as coffee, corn an
important source of food for livestock and humans, sugar, soybeans whose oil is
used for making crackers, breads, cakes, and cookies, and wheat most important
food crops in the world.
(2) Livestock and Meat: examples include feeder cattle, live cattle, poultry, eggs,
pork bellies, and lean hogs.
(3) Energy: Energy commodities include crude oil used in transportation activities
and production of plastics, natural gas used for electricity generation, and gasoline,
which powers light-duty trucks and cars.
(4) Metals: Metals come in gold, used in making jewellery, silver, also used for
jewellery and having many industrial uses as well, and copper, the most widely
used form of electrical wiring.
(5) Materials: Materials such as wood or concrete.
(6) Global Common: Shared essential resources such as air and water. The value of
global commons may be estimated to account for pollution and resource depletion.
For example, if a factory produces a widget with a value of $1 that results in $4
pollution per widget, this isn't a productive economic process.
(7) Products: Products that customers view as the same such that they mostly buy
the cheapest item. Firms work hard to develop brand image and quality that
prevent this from happening. However, many industries slowly move towards
becoming a commodity with time.
(8) Services: Services that customers view as the same with purchase decisions
based mostly on price. For example, a budget airline that can't sell many seats if
they raise their price $10 above the competition on a particular route.

Structure of Commodities Market

The commodities market exists in two distinct forms:
(a) Over-the-counter (OTC) market,
(b) Exchange based market.

STRUCTURE OF THE INDIAN COMMODITY MARKET:

The Indian commodity market follows a 3-tier structure for commodity trading
with the Forward Market Commission acting as an intermediary regulatory body
between the government and the commodity exchanges.
In 2003, Forward Market Commission (FMC) was formed for regulating the
commodity exchanges in the Indian commodity market. In 2015, FMC was merged
with the Securities and Exchange Board of India (SEBI). Building a stronger
regulatory system was the aim of the merger. The regulatory system remains
stringent with regulatory guidelines and frameworks for transparency of deliveries
and to ensure that malpractices are kept at bay in the market.
MCX and NCDEX are the leading national-level commodity exchanges in India
today. There are a number of regional commodity exchanges dealing in specific
commodities spread across India.
(a) MCX: Established in 2003, Multi Commodity Exchange of India (MCX)
facilitates commodity trading across various segments. It is the first listed
exchange of India. MCX is the leading national commodity exchange with its
presence in over 1200 towns and cities around the country.
By adapting to latest technologies and through alliances with international
exchanges, MCX has grown into a dominant player in the Indian commodity
market. As per the MCX website, in terms of value of commodity futures contracts
traded in the first quarter of 2017-18, MCX enjoys a market share of 89.93 percent.
(b) NCDEX: National Commodity and Derivatives Exchange Limited (NCDEX)
was founded in 2003. It is a public listed company with leading public sectors
banks and companies as shareholders/promoters. Based on the records given on the
NCDEX website, the exchange provided trading of 25 commodity contracts across
segments as of 31 March 2017. Out of the 25 commodity contracts, 22 were
agricultural contracts.
(c) ICEX: Indian Commodity Exchange Limited (ICEX) is SEBI regulated online
Commodity Derivative Exchange. The provide nationwide trading platform
through its appointed brokers. Some of Prominent shareholders are MMTC Ltd.,
Indian Potash Ltd., KRIBHCO, IDFC Bank Ltd., Reliance Exchange next Ltd. and
India bulls Housing Finance Ltd.
(d) NMCE: National Multi Commodity Exchange of India Ltd. (NMCE) is the first
demutualized multi commodity exchange and was promoted by commodity
relevant public institutions, namely, Central Warehousing Corporation (CWC),
National Cooperative Marketing Federation of India (NAFED), Gujarat Agro
Industries Corporation Limited (GAICL) and Punjab National Bank (PNB).

Participants in Commodities Market

As a commodity market participant, you could take up one of three roles: hedger,
speculator, and arbitrageur:
(1) Hedgers: They are generally the commercial producers and consumers of the
traded commodities. They participate in the market to manage their spot market
price risk. Commodity prices are volatile and their participation in the futures
market allows them to hedge or protect themselves against the risk of losses from
fluctuating prices.
For example, a copper smelter will hedge by selling copper futures, since it is
exposed to the risk of falling copper prices.
For example, an airline company faces the risk is price rise of fuel. So, they will go
for a long position (buy an oil futures contract) to hedge, just to cover the amount
of fuel they expect to buy.
(2) Speculators: Speculators enter the market only to make a profit, without caring
much for the implicit risk. They are traders who speculate on the direction of the
futures prices with the intention of making money. Thus, for the speculators,
trading in commodity futures is an investment option. Most Speculators do not
prefer to make or accept deliveries of the actual commodities; rather they liquidate
their positions before the expiry date of the contract.
(3) Arbitrageurs: Arbitrageurs are also driven by the profit motive. They are traders
who buy and sell to make money on price differentials across different markets.
Arbitrage involves simultaneous sale and purchase of the same commodities in
different markets. Arbitrage keeps the prices in different markets in line with each
other. Usually such transactions are risk free.
A simple example of arbitraging is simultaneously buying a gold at lower price
from one exchange and selling it on another exchange for higher price. So, they
make profit from price difference.
Some other participants of market are:
(a) Day Traders or Intraday: They are the short-term traders. Who take position for
a single day or less time? Trader can take share market tips from various resources.
(b) Position Traders: They are the long-term traders. Who take position for a week
or even months?
(c) Brokers: It acts as a mediator between and exchange and provides a platform to
buy or sell commodities.
(d) Exchange: It is a central place where financial instrument is traded. Financial
instrument like Commodities, Equity, Mutual funds etc.
Derivatives
Introduction
Derivatives are financial contracts whose value is dependent on an underlying asset
or group of assets. The commonly used assets are stocks, bonds, currencies,
commodities and market indices. The value of the underlying assets keeps
changing according to market conditions. The basic principle behind entering into
derivative contracts is to earn profits by speculating on the value of the underlying
asset in future. Imagine that the market price of an equity share may go up or
down. You may suffer a loss owing to a fall in the stock value. In this situation,
you may enter a derivative contract either to make gains by placing accurate bet.
Or simply cushion yourself from the losses in the spot market where the stock is
being traded.

Meaning
A derivative is a financial security with a value that is reliant upon, or derived
from, an underlying asset or group of assets. The derivative itself is a contract
between two or more parties, and its price is determined by fluctuations in the
underlying asset. The most common underlying assets include stocks, bonds,
commodities, currencies, interest rates and market indexes. The most common
types of derivatives are futures, options, forwards and swaps.
Derivatives are often used as an instrument to hedge risk for one party of a
contract, while offering the potential for high returns for the other party.
Derivatives have been created to mitigate a remarkable number of risks:
fluctuations in stock, bond, commodity, and index prices; changes in foreign
exchange rates; changes in interest rates; and weather events, to name a few.
Example: In Gold futures contract the contract allows you to pay for Gold now for
delivery a few months from now. Hence you lock in a price today despite not
needing the asset today. This is a form of protection against price fluctuation.
Elements of Derivative Contract
Derivative contracts are financial instruments whose value is derived from the
value of an underlying asset, index, or rate. Here are the key elements that
constitute a derivative contract:
1. Underlying Asset: This is the asset upon which the derivative is based. It can be
anything from commodities (like oil or wheat), financial instruments (like stocks or
bonds), currencies, or market indices.
2. Contractual Agreement: A derivative contract is a legal agreement between two
parties that specifies the terms of the transaction. This includes details about how
the contract will be executed and the obligations of each party.
3. Price: The contract will specify the price at which the underlying asset can be
bought or sold. This can be a fixed price or determined by market conditions at a
future date.
4. Expiration Date: Most derivatives have a set expiration date, which is the date
when the contract must be settled. After this date, the contract becomes void.
5. Settlement Method: Derivative contracts can be settled in two ways: cash
settlement or physical delivery. In cash settlement, the difference between the
contract price and the market price at expiration is paid, while in physical delivery,
the actual underlying asset is exchanged.
6. Leverage: Derivatives often involve leverage, meaning that a small amount of
capital can control a large position in the underlying asset. This can amplify both
potential gains and losses.
7. Risk Management: Derivatives are commonly used for hedging purposes,
allowing parties to manage risk associated with price fluctuations in the underlying
asset.

These elements work together to define the structure and function of derivative
contracts, making them essential tools for traders, investors, and companies
seeking to manage financial risk.
Types of Derivatives
One form of classification of derivative instruments is between commodity
derivatives and financial derivatives. The basic difference between these is the
nature of the underlying instrument or asset.
In a commodity derivative, the underlying instrument is a commodity which may
be wheat, cotton, pepper, sugar, jute, turmeric, corn, soya beans, crude oil, natural
gas, gold, silver, copper and so on.
In a financial derivative, the underlying instrument may be treasury bills, stocks,
bonds, foreign exchange, stock index, gilt- edged securities, cost of living index,
etc. It is to be noted that financial derivative is fairly standard and there are no
quality issues whereas in commodity derivative, the quality may be the underlying
matter. However, despite the distinction between these two from structure and
functioning point of view, both are almost similar in nature.

The most commonly used derivatives contracts are forwards, futures and options.
(1) Forward: In this type of contract, one party commits to buy and the other
commits to sell an underlying asset at a certain price on a certain future date. The
underlying can either be a physical asset or a stock. The loss or gain of a particular
party is determined by the price movement of the asset. If the price increases, the
buyer incurs a gain as he still gets to buy the asset at the older and lower price. On
the other hand, the seller incurs a loss in the same scenario.
(2) Exchange Traded Contracts/Futures: Exchange traded forward commitments
are called futures. A future contract is another version of a forward contract, which
is exchange- traded and standardized. Unlike forward contracts, future contracts
are actively traded in the secondary market, have the backing of the clearinghouse,
follow regulations and involve a daily settlement cycle of gains and losses.
(3) Options: Options are the type of contingent claims that are dependent on the
price of the underlying at a future date. Unlike the forward commitments
derivatives where payoffs are calculated keeping the movement of the price in
mind, the options have payoffs only if the price of the underlying crosses a certain
threshold. Options are of two types: Call and Put. A call option gives the option
holder right to buy the underlying asset at exercise or strike price. A put option
gives the option holder right to sell the underlying asset at exercise or strike price.
(a) Interest Rate Options: Options where the underlying is not a physical
asset or a stock, but the interest rates. It includes Interest Rate Cap, floor and collar
agreement. Further forward rate agreement can also be entered upon.
(b) Warrants: Warrants are the options which have a maturity period of more
than one year and hence, are called long-dated options. These are mostly OTC
derivatives.
(c) Convertible Bonds: Convertible bonds are the type of contingent claims
that gives the bondholder an option to participate in the capital gains caused by the
upward movement in the stock price of the company, without any obligation to
share the losses.
(d) Callable Bonds: Callable bonds provide an option to the issuer to
completely pay off the bonds before their maturity.
(e) Asset-Backed Securities: Asset-backed securities are also a type of
contingent claim as they contain an optional feature, which is the prepayment
option available to the asset owners.
(4) Swap: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:
(a) Interest rate swaps: These entails swapping only the interest related cash
flows between the parties in the same currency.
(b) Currency Swaps: These entails swapping both principal and interest on
different currency than those in the opposite direction.

(5) Warrants: Options generally have lives of up to one year; the majority of
options traded on options exchanges having maximum maturity of nine months.
Longer-dated options are called warrants and are generally traded over-the-
counter.
(6) Leaps: The acronym LEAPS mean long term equity anticipation securities.
These are options having a maturity of up to three years.
(7) Baskets: Basket options are options on portfolios of underlying assets. The
index options are a form of basket options.
(8) Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus, a swaptions is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver swaptions
and payer swaptions. A receiver swaption is an option to receive fixed and pay
floating. A payer swaption is an option to pay fixed and receive floating.

Types of Underlying Assets

INTRODUCTION:
Underlying asset are the financial assets upon which a derivative's price is based.
Options are an example of a derivative. A derivative is a financial instrument with
a price that is based on a different asset.
Underlying assets give derivatives their value. For example, an option on stock
XYZ gives the holder the right to buy or sell XYZ at the strike price up until
expiration. The underlying asset for the option is the stock of XYZ.

MEANING:
Derivatives are contracts, which convey the right/obligation to buy or sell a
specified asset at a specified price at a specified future date. An underlying asset
(or also called Commodity) of the derivative contract is the one that is to be bought
or sold on a future date.
Existing currencies within Oracle FLEXCUBE can be identified as underlying
assets. For example, US Dollar (USD), which is recognized as a currency in Oracle
FLEXCUBE, would be the underlying asset for a US Dollar option. Similarly,
Equities, Bonds and Zero-Coupon bonds can also be defined as underlying assets.
DEFINITION:
(1) An underlying asset is defined as "a security on which a derivative is based."
(2) Underlying asset is defined as "the financial instrument that a derivative derives
its value."

Types of Underlining Asset:

Specify the Asset Type under which your asset should be grouped includes the
following:
(a) Bond, (b) Commodity, (c) Currency, (d) Derivatives, (e) Equity, (f) Index,
(g) Interest rates

Participants of Underlying Assets

Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. The following three broad categories of
participants hedgers, speculators, and arbitrageurs trade in the derivatives market.
a. Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce or eliminate this risk. For example - Tata
Consultancy Services is a software and services providing company which
has major Sales in U.S.A so if the price of US $ falls to Indian rupee the
Companies profit will severely be affected. Hence, to avoid this company
will enter into futures contract of foreign exchange of 3 months with its
clients/bankers so as to safeguard against any increase or decrease in the $ to
rate.
b. Speculators wish to bet on future movements in the price of an asset. Futures
and options contracts can give them an extra leverage; that is, they can
increase both the potential gains and potential losses in a speculative
venture.
c. Arbitrageurs are in business to take advantage of a discrepancy between
prices in two different markets. For Example, Mr. A purchases 1,000 shares
of TCS @₹2,500 in NSE and if at the same time the price in BSE is₹
2,502/share then he Arbitrage the difference in the two exchange and thus
made a profit of 2/share.
Difference Between – Forward Contract & Futures Contract
Basis for Forward Contract Futures Contract
Comparison
Meaning Forward Contract is an A contract in which the parties
agreement between parties agree to exchange the asset for
to buy and sell the cash at a fixed price and at a
underlying asset at a future specified date, is known
specified date and agreed as future contract.
rate in future.
What is it? It is a tailor-made contract. It is a standardized contract.
Traded on Over the counter, i.e. there Organized stock exchange.
is no secondary market.
Settlement On maturity date. On a daily basis.
Risk High. Low.
Default As they are private No such probability.
agreement, the chances of
default are relatively high.
Size of contract Depends on the contract Fixed.
terms.
Collateral Not required. Initial margin required.
Maturity As per the terms of contract. Predetermined date.
Regulation Self-regulated By stock exchange.
Liquidity Low. High.
Margin Not required. Requires margin payments.
Payments
Squaring off Contract can be reversed Can be reversed with any
only with the same counter- member of the Exchange.
party with whom it was
entered into.

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