Commodity market
Commodity market
Commodity market
Q1: Explain the meaning, growth, role and aims of commodity market. / Write a note on commodity market.
ANS: COMMODITY MARKETS:
*INTRODUCTION:
~ The introduction of liberalisation in 1991 led to a significant increase in the levels of trade.
~ This gave rise to the increasing significance of the commodities markets (both physical and derivatives)
~ The commodity market facilitates multi-commodity exchange within and outside the country.
~ This helps in the production process and also in reducing risks arising out of fluctuations in the prices of commodities.
*MEANING:
~ The market for trading commodities is called the commodity market.
~ Commodity markets are of two types:Physical Market, Derivatives Market.
#PHYSICAL COMMODITY MARKET:
~ In this market, goods are sold for cash and delivered immediately. Hence, it is also called cash market or spot market.
~ The prices are settled in cash on the spot at current market prices.
~ In physical markets, people involved with the commodities are active participants and trading (delivery based) is done through brokers and other intermediaries.
~ The agricultural produce sector plays the most dominant part in the Indian commodity sector.
~ Physical commodities markets are localised, highly volatile and exposed to risk.
# DERIVATIVES COMMODITY MARKET:
~ Derivatives commodity markets are based on contracts.
~ All the terms of the contract including the price are set now and the delivery and payment occur at a pre-determined future date.
~ This protects the investors against price fluctuations.
~ Physical and derivatives commodity markets exist all over the world for almost all commodities like iron ore, crude oil, coal, aluminium, gold, silver, sugar, coffee beans, rice, wheat, etc
~ These markets deal in futures, forwards options, swaps and other derivatives.
*GROWTH:
~ Commodity markets are as old as human history and forward agreements have always been an integral part of commodity markets.
~ The growth of commodity exchanges and derivatives market can be traced to two important global factors:
^Capital and commodity market liberalisation.
^ Promotion of derivatives as a new tool of investment by financial intermediaries
~ India has also witnessed phenomenal growth in commodity derivatives market post liberalisation.
~ At present, there are 22 commodity exchanges in India, out of which 3 are national level multi commodity exchanges. They are:
i) National Multi Commodity Exchange of India LTD. (NMCE) 2002: It is based in Ahmedabad.
ii) Multi-Commodity Exchange (MCX) 2003: It is based in Mumbai and has the benefits of screen-based transparent price discovery.
iii) National Commodity and Derivatives Exchange LTD. (NCDEX) 2003: It is also based in Mumbai and has the benefits of screen-based transparent price discovery.
*REGULATIONS:
~ Forwards / futures trading system is regulated by three tier system comprising of:-
i) The Government of India.
ii) Forward Markets Commission.
iii) The Commodity Exchanges.
~ The Forward Markets Commission ensures financial integrity and market integrity.
~ It promotes and protects the interests of customers and non- members.
*AIMS:
~The Commodity Exchanges are set up to achieve the following aims:
i)To achievetransparency in the discovery of market prices through aggregation of demand and supply in individual types of commodities.
ii) To provideprotection to investors against price volatilities by encouraging hedging strategies.
iii) To raise the liquidity of contracts in commodity exchange markets by increasing the open positions through speculations.
*FEATURES:
i)DEMAT ACCOUNT: The investor needs to have a separate commodity demat account from NSDL to trade on NCDEX.
ii) AGREEMENT WITH BROKER:The investor has to enter into an agreement with the broker and it includes procedures related to KYC (Know Your Customer) format.
iii) MARGIN REQUIREMENT:The margin requirement differs for each commodity and it is basen on Value At Risk (VAR) system. It is been 5% to 10% of the contract price and it keeps changing as per changes in price.
vi) CIRCUIT FILTERS:The exchanges have circuit filters that vary from commodity to commodity, the maximum individual commodity circuit filter being 6%. If the price of any commodity fluctuates (increases / decreases) beyond its limit, there will be a circuit breaker.
v) DELIVERY OF COMMODITIES:During delivery, the margin increases to 20%-25% of contract value.
vi) DEFAULT:In case of default the exchanges exercise the penalty clause. There is also a separate arbitration panel of exchanges. The exchanges also maintain settlement guarantee funds.
vii) BROKERGE AND TRANSACTION COSTS:These costs range from 0.10% to 0.25% of contract value. It varies from commodity to commodity. The maximum limit is prescribed by the exchanges.
*COMMODITY DERIVATIVES:
~ The important types of commodity derivatives are:
i)FORWARDS:
~ It is an agreement between two parties to exchange a particular good / instrument at a set price on a future date specified today.
~ It is an over-the-counter agreement.
~ Each forwards contract is unique in terms of contract size, expiration date and asset type.
ii) FUTURES:
~Futures are legally binding, standardised contracts between buyers and sellers, who fix the terms of the exchange that will take place between them at a fixed future date.
~ Futures are traded in an organised exchange.
iii) OPTIONS:
~ An option is a common form of a derivative.
~ In fact it is a contract that gives one party (The option holder) the right, but not the obligation to perform the said transaction with another party (The option writer) as per specified terms.
~ Commodity Option is a contract wherein the seller of the option agrees to pay the buyer the difference between the agreed strike price and the commodities market price if the market price is higher than the strike price of the underlying commodity.
iv) SWAPS:
~ A SWAP is an agreement between two parties to exchange sequences of cash flows for a set period of time.
~ This result in exchange of financial obligations as per the terms of the agreement.
~ A commodity swap involves an exchange of obligations (a variable price is exchanged for a fixed price).
~ It is ideal for hedging against price fluctuations by exchanging cash flows.
~ There is no physical delivery of commodities.
*SIGNIFICANCE OF COMMODITY DERIVATIVES:
i) PRICE DISCOVERY:
~ Due to their highly competitive, the commodities derivative market has become an important tool to determine price.
~ Price of a commodity is determined by the market forces of demand and supply.
~ These forces in turn depend on various regional economic social and political factors and a continuous flow of information from around the world.
~ An impending change in these factors can have its impact on the demand / supply of a particular commodity and thus on the current and future prices of the underlying commodity on which the derivatives contract is based.
~ Thus, derivates help in determining the current or future prices of an underlying commodity.
~ This helps in discovering the true price of the commodity.
~ The price in the derivates market reflects the perceptions of the market participants about the future and this lead the prices of the underlying commodity to the perceived future level.
ii) RISK MANAGEMENT:
~ Commodity derivatives help to manage the risk and thus increase the willingness to hold the underlying asset.
~ Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and changing the actual level to the desired level.
~ This involves hedging and speculation.
~ Hedging implies reducing the risk in holding a market position whereas speculation implies taking a position in the way the market will move.
~ Thus, hedging and speculation, along with commodity derivatives enable companies to manage risk more effectively.
iii) INCREASE LIQUIDITY:
~Commodity derivatives increase the liquidity in the market for the underlying assets'
~ It provides a liquid market where traders readily trade commodities or financial instruments for a price that is close to its true value.
~ The trading volume increases in the underlying market due to participation by a large number of players.
vi) RESOURCE ALLOCATION:
~ Commodity derivatives provide prices that guide current consumption and production decisions. They also help in planning for future consumption and production.
~ This facilitates optimum allocation of resources in the economy.
*CONCLUSION:
~ Thus commodity prices have been extremely volatile due to the impact of many factors like floods, droughts, wars, fluctuations in economic activities, etc.
~ This results in financial risks for businesses.
~ Hence, derivatives market plays a vital role in offsetting large fluctuations in commodity prices.
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