Executive Summery

Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. Spot trading is any transaction where delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints. A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price. A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Hedging, a common practice of farming cooperatives insures against a poor harvest by purchasing futures contracts in the same commodity. A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. Trading in derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper, et cetera. Commodity derivatives, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity derivatives market is being done by people who have no need for the commodity itself. India is among the top-5 producers of most of the commodities, in addition to being a major consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian economy. It employees around 57% of the labor force on a total of 163 million hectares of land. Agriculture sector is an imposrtant factor in achieving a GDP growth of 8-10%. All this indicates that India can be promoted as a major center for trading of commodity derivatives. An agreement to buy or sell a set amount of a commodity at a predetermined price and date. Buyers use these to avoid the risks associated with the price fluctuations of the product or raw material, while sellers try to lock in a price for their products. Like in all financial markets, others use such contracts to gamble on price movements.

1 Introduction
Commodities have been in our lives ever since the civilization started. The very reason for this lies in the fact that commodities represent the fundamental elements of utility for human beings. The term commodity refers to any material, which can be bought and sold. Commodities in a markets context refer to any movable property other than actionable claims, money and securities. Commodity can be understood as a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially unifor m across producers. A commodity can be a physical substance, such as food, grains, metals, oils, etc. The term is sometimes used more generally to include any product, which trades on a commodity exchange (an exchange for buying and selling commodities for future delivery). The price of the commodity is subject to supply and demand factors. The trading of the basic agricultural commodities in futures form began in order to avoid risk. For example, a far mer risks the cost of producing a product ready for market at sometime in the future because he doesnt know what the selling price will be. This resulted in trading mechanism called trading in futures. Commodity futures are contracts to buy or sell a commodity at a specific price and on a specific delivery date in future.

In the early days people followed a mechanism for trading called Barter System, which involved exchange of goods for goods. This was the first for m of trade between individuals. The absence of commonly accepted medium of exchange had initiated the need for Barter System. People used to buy those commodities, which they lack and sell those commodities, which were in excess with them. The commodities trade is believed to have its genesis in Sumeria. The early commodity contracts were carried out using clay tokens as medium of exchange. Animals are believed to be the first commodities, which were traded, between individuals. The inter nationalization of commodities trade can be better understood by observing the commodity market integration occurred after the European Voyages of Discovery. The development of international commodities trade is characterized by the increase in volumes of trade across the nations and the convergence and price related to the identical commodities at different markets. The major thrust for the commodities trade was provided by the changes in demand patterns, scarcity and the supply potential both within and across the nations

1.1 Objectives

To track the development of commodity markets in India. To understand the basic fundamentals of physical and futures commodity markets. To understand the main difference between the physical and futures markets. To understand the salient features of select agricultural and precious metal commodities. To understand how commodity futures market perform the price risk management function of an economy.

1.2 RESEARCH METHODOLOGY

Primary Data Primary data is a term for data collected on source which has not been subjected to processing or any other manipulation, it is also known as Raw data.

Secondary Data Secondary data is data collected by someone other than the user. Common sources of secondary data for social science include censuses, surveys, organizational records and data collected through qualitative methodologies or qualitative research.

Research Methodology

Primary Data

Secondary Data

Books:- Investment analysis and portfolio management, SY F/M commodity market Website:- rediff.com/business Wikipedia.com

2 Conceptual Framework 2.1 Commodity markets-Origin and History

Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. This article focuses on the history and current debates regarding global commodity markets. It covers physical product (food, metals, and electricity) markets but not the ways that services, including those of governments, nor investment, nor debt, can be seen as a commodity. Articles on reinsurance markets, stock markets, bond markets and currency markets cover those concerns separately and in more depth. One focus of this article is the relationship between simple commodity money and the more complex instruments offered in the commodity markets.

History
The modern commodity markets have their roots in the trading of agricultural products. While wheat and corn, cattle and pigs, were widely traded using standard instruments in the 19th century in the United States, other basic foodstuffs such as soybeans were only added quite recently in most markets. For a commodity market to be established there must be very broad consensus on the variations in the product that make it acceptable for one purpose or another. The economic impact of the development of commodity markets is hard to overestimate. Through the 19th century "the exchanges became effective spokesmen for, and innovators of, improvements in transportation, warehousing, and financing, which paved the way to expanded interstate and international trade.

2.2 Types of derivatives Commodity Trading

Spot trading
Spot trading is any transaction where delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints. Spot trading normally involves visual inspection of the commodity or a sample of the commodity, and is carried out in markets such as wholesale markets. Commodity markets, on the other hand, require the existence of agreed standards so that trades can be made without visual inspection.

Forward contracts
A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price.

Futures contracts
A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Commodity and futures contracts are based on whats termed forward contracts. Early on these forward contracts agreements to buy now, pay and deliver later were used as a way of getting products from producer to the consumer. These typically were only for food and agricultural products. Forward contracts have evolved and have been standardized into what we know today as futures contracts. Although more complex today, early forward contracts for example, were used for rice in seventeenth century Japan. Modern forward, or futures agreements began in Chicago in the 1840s, with the appearance of the

railroads. Chicago, being centrally located, emerged as the hub between Midwestern farmers and producers and the east coast consumer population centers. In essence, a futures contract is a standardized forward contract in which the buyer and the seller accept the terms in regards to product, grade, quantity and location and are only free to negotiate the price

Hedging
Hedging, a common practice of farming cooperatives insures against a poor harvest by purchasing futures contracts in the same commodity. If the cooperative has significantly less of its product to sell due to weather or insects, it makes up for that loss with a profit on the markets, since the overall supply of the crop is short everywhere that suffered the same conditions.

Delivery and condition guarantees

In addition, delivery day, method of settlement and delivery point must all be specified. Typically, trading must end two (or more) business days prior to the delivery day, so that the routing of the shipment can be finalized via ship or rail, and payment can be settled when the contract arrives at any delivery point.

2.3 Definition of 'Derivative'

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties. Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form through which to extend credit. However, the strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to underpriced credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their payoff profile. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies. Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.

2.4 Commodity derivatives and history

Trading in derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper, et cetera. The first organized exchange, the Chicago Board of Trade (CBOT) -- with standardized contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce Exchange -- which is now known as Chicago Mercantile Exchange -- was, formed (CME). CBOT and CME are two of the largest commodity derivatives exchanges in the world

History
The modern commodity markets have their roots in the trading of agricultural products. While wheat and corn, cattle and pigs, were widely traded using standard instruments in the 19th century in the United States, other basic foodstuffs such as soybeans were only added quite recently in most markets. For a commodity market to be established there must be very broad consensus on the variations in the product that make it acceptable for one purpose or another. The economic impact of the development of commodity markets is hard to overestimate. Through the 19th century "the exchanges became effective spokesmen for, and innovators of, improvements in transportation, warehousing, and financing, which paved the way to expanded interstate and international trade. .

2.5 Indian Commodity Market

The Indian economy is witnessing a mini revolution in commodity derivatives and risk management. Commodity options trading and cash settlement of commodity futures had been banned since 1952 and until 2002 commodity derivatives market was virtually non-existent, except some negligible activity on an OTC basis. Now in September 2005, the country has 3 national level electronic exchanges and 21 regional exchanges for trading commodity derivatives. As many as eighty (80) commodities have been allowed for derivatives trading. The value of trading has been booming and is likely to cross the $ 1 Trillion mark in 2006 and, if all goes well, seems to be set to touch $5 Trillion in a few years. This paper analyses questions such as: how did India pull it off in such a short time since 2002? Is this progress sustainable and what are the obstacles that need urgent attention if the market is to realize its Full potential? Why are commodity derivatives important and what could other emerging economies learn from the Indian mistakes and experience?

The Indian scenario

Commodity derivatives have had a long and a chequered presence in India . The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts. There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5 lakh crore (Rs 5 trillion) by the end of 2004-2005. National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight. It is only in the last decade that commodity derivatives exchanges have been actively encouraged. But, the markets have suffered from poor liquidity and have not grown to any significant level, till recently. However, in the year 2003, four national commodity exchanges became operational; National MultiCommodity Exchange of India (NMCE), National Board of Trade (NBOT), National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). The onset of these exchanges and the introduction of futures contracts on new commodities by the Forwards Market Commission have triggered significant levels of trade. Now the commodities futures trading in India is all set to match the volumes on the capital markets.

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List of Commodity traded in India

Milk product:Kirana:Milk powder,other milkproducts,paneer Ajwaij,cardamom,copra,dhania,dry ginger, dry mango , dry pomegranates seeds, gond, methi, other-kinarna, pepper,poppyseed,red chillies, saffron,soanf,turmeric,zeera. Jute goods:Canvas,hessian,kalidhari twine. Iron-steel:Billets,ingot, iron,angles, iron sariar, iron sheet, plate, scrap. Herbs:Gur and sugar:afganistani herbs,desi hubs,nepali hubs. Co-operative mills, co-operative mill gur, private mills, sugar. Grains and pules:Arhar, flour,gram,masoor,moong,other old gunny bags,

grains,pulses,rice,urad,wheat. Ghee and vanaspati:Fruits ands vegitable:desi ghee, ghee,vasanpati. Fruits,garlics, ginger, onion,other

vegitables,potatoes,tomato. Dry fruits:Almod, cashew kerner,chilgoza,dry

dates,fig,kishmish,other dry fruits pistachio. Cotton:Chemicals:Waste,yarn. acids, paraffin calcium, wax, menthol, soda-ash, otherchemicals, sodium ,

titaniumioxide. Bullion:Building material:Non-Ferrous Metals:gold, silver. Bricks,cement,pop,rodi stones and sand. Aluminium, antimony, brass, cadmium,

copper, gun metal srap , lead, nickel , tin, zinc.

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List of commodity stock exchanges in India

1. Bhatinda Om & Oil Exchange Ltd., Batinda.

2. The Bombay Commodity Exchange Ltd.Mumbai

3. The Rajkot Seeds oil & Bullion Merchants` Association Ltd

4. The Meerut Agro Commodities Exchange Co. Ltd., Meerut

5. The Spices and Oilseeds Exchange Ltd.

6. Ahmedabad Commodity Exchange Ltd.

7. Vijay Beopar Chamber Ltd.,Muzaffarnagar

8. India Pepper & Spice Trade Association.Kochi

9. Rajdhani Oils and Oilseeds Exchange Ltd. Delhi

10. National Board of Trade. Indore.

11. The Chamber Of Commerce.,Hapur

12. The East India Cotton Association Mumbai.

13. The Central India Commercial Exchange Ltd, Gwaliar

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2.6 Investing in commodity derivatives

Commodity derivatives, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity derivatives market is being done by people who have no need for the commodity itself. They just speculate on the direction of the price of these commodities, hoping to make money if the price moves in their favor. The commodity derivatives market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities. For example, an investor can invest directly in a steel derivative rather than investing in the shares of Tata Steel It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company -- which depend on many other factors than just the demand -- and supply of the products they manufacture and sell or trade in. Also, derivatives are much cheaper to trade in as only a small sum of money is required to buy a derivative contract. Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead. Before we look into how investment in a derivative contract works, we must familiarize ourselves with the buyer and the seller of a derivative contract. A buyer of a derivative contract is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a certain date in the future. On the other hand, the seller accepts the margin and agrees to fulfill the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract. Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here. On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price -- Spot Price is the current market price of the commodity at any point in time). The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%.

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If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract. At present, the option of cash settlement lies only with the seller of the contract. If the seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfill his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract. In the above example, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%. The above example shows that with very little investment, the commodity futures market offers scope to make big bucks. However, trading in derivatives is highly risky because just as there are high returns to be earned if prices move in favor of the investors, an unfavorable move results in huge losses. The most critical function in a commodity derivatives exchange is the settlement and clearing of trades. Commodity derivatives can involve the exchange of funds and goods. The exchanges have a separate body to handle all the settlements, known as the clearing house. For example, the seller of a futures contract to buy soybean might choose to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organisation, in such a case, is to take care of possible problems of default by the other party involved by standardizing and simplifying transaction processing between participants and the organization.

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2.7 Why are Commodity Derivatives Required?

India is among the top-5 producers of most of the commodities, in addition to being a major consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian economy. It employees around 57% of the labor force on a total of 163 million hectares of land. Agriculture sector is an imposrtant factor in achieving a GDP growth of 8-10%. All this indicates that India can be promoted as a major center for trading of commodity derivatives. It is unfortunate that the policies of FMC during the most of 1950s to 1980s suppressed the very markets it was supposed to encourage and nurture to grow with times. It was a mistake other emerging economies of the world would want to avoid. However, it is not in India alone that derivatives were suspected of creating too much speculation that would be to the detriment of the healthy growth of the markets and the farmers. Such suspicions might normally arise due to a misunderstanding of the characteristics and role of derivative product. It is important to understand why commodity derivatives are required and the role they can play in risk management. It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibility of adverse price changes in future creates risk for businesses. Derivatives are used to reduce or eliminate price risk arising from unforeseen price changes. A derivative is a financial contract whose price depends on, or is derived from, the price of another asset. Important derivatives are futures, forwards and options.

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2.8 Future Contract

Definition:An agreement to buy or sell a set amount of a commodity at a predetermined price and date. Buyers use these to avoid the risks associated with the price fluctuations of the product or raw material, while sellers try to lock in a price for their products. Like in all financial markets, others use such contracts to gamble on price movements.

Introduction:In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short). In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate

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daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking
to market). A closely related contract is a forward contract. A forward is like futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss.

Standardization:Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.

The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made.

The delivery month.

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The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

Margin:To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as variation margin, margin

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called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the clients account. Some U.S. exchanges also use the term maintenance margin, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term initial margin and variation margin. The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets). A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1) (year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

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Settlement physical versus cash-settled future:Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. ICE Brent futures use this method.

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.

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Who treads Future? :Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.

Hedgers
Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap

Speculators
Speculators typically fall into three categories: position traders, day traders, and swing traders (swing trading), though many hybrid types and unique styles exist. In general position traders hold positions for the long term (months to years), day traders (or active traders) enter multiple trades during the day and will have exited all positions by market close, and swing traders aim to buy or sell at the bottom or top of price swings. With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter. An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often "equities" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of

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every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

Options on Futures:In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the Black-Scholes formula, namely Black's formula for futures. Investors can either take on the role of option seller/option writer or the option buyer. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises his or her right to the futures position specified in the option. The price of an option is determined by supply and demand principles and consists of the option premium, or the price paid to the option seller for offering the option and taking on risk.

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2.9 Forward Contract

Definition:A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.

Introduction:In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a

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forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

How a Forward contract works:Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current ratethese two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

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Example of how Forward price should be agreed upon:Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him the opportunity cost will be covered.

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2.10 Hedge

Definition:Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Introduction:A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and rate fluctuations.

Etymology:Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s.

Examples:Agricultural commodity price hedging:A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting

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and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined. If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.

Hedging fuel consumption:Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina.

Brif:How does it work? For instance, if a manufacturer of copper wires expects the copper prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase. Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds. Who can hedge? Any manufacturer that faces risks due to volatile commodity prices. Prior approval from the Reserve Bank of India is required. The products that are available for hedging are futures, options, and over the counter derivatives (where individual parties can strike a deal based on their requirements through a broker).

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What are the costs involved? In case of futures, the party hedging would have to pay a margin a percentage cost of the contract value (usually between 5-8%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due. Is hedging risky? Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tonne and decides to sell 300 tonne on the futures exchange the remaining 100 tonne is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tonne he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tonne.

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2.11 Types of Traders in a Derivatives Market

Hedgers:Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed priceofhisproduce.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. Hedgers are often businesses, or individuals, who at one point or another deal in the underlyingcashcommodity.

Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices go up. For protection against higher prices of the produce, he hedge the risk exposure by buying enough future contracts of the produce to cover the amount of produce he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if the price of the produce rise enough to offset cashlossontheproduce.

Speculators:Speculators are somewhat like a middle man. They are never interested in actual owing the commodity. They will just buy from one end and sell it to the other in anticipation of future price movements. They actually bet on the future movement in the price of an asset.

They are the second major group of futures players. These participants include independent floor traders and investors. They handle trades for their personal clients or brokerage firms.

Buying a futures contract in anticipation of price increases is known as going long. Selling a futures contract in anticipation of a price decrease is known as going short. Speculative participation in futures trading has increased with the availability of alternative methods of participation.

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Speculators

have

certain

advantages

over

other

investments

they

are

as

follows:

If the traders judgement is good, he can make more money in the futures market faster because prices tend, on average, to change more quickly than real estate or stock prices.

Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place.

Arbitrators:According to dictionary definition, a person who has been officially chosen to make a decision between two people or groups who do not agree is known as Arbitrator. In commodity market Arbitrators are the person who takes the advantage of a discrepancy between prices in two different markets. If he finds future prices of a commodity edging out with the cash price, he will take offsetting positions in both the markets to lock in a profit. Move over the commodity futures investor is not charged interest on the difference between margin and the full contract value.

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2.12 Top 10 Commodities

Taking together the turnover in commodities futures seen at the above three multi-commodity exchanges during the two-week period 15-09-2005 to 30-09-2005, the following emerge as the top-10 Commodity Guar seed Gold Silver Crude oil Chana (chick peas Urad (Black Legume) Soy oi Gur (Jaggery: cane sugar) Guar Gu Tur (Lentils) Turnover in $ Millions* 4,432.71 4,082.15 3,869.36 3,380.13 2,100.15 624.71 478.28 369.72 345.08 329.35

* Note: The local currency values were translated into USD using the monthly average exchange rate INR43.8445 per USD prevailing in September 2005. The above does indicate that the commodity derivatives market has a bright future in India. The volume and value of trade in commodity derivatives could in fact take a quantum jump as bullion, crude oil and other high value commodities being added with each passing day get more actively traded in the coming months. It is also being speculated by market operators that finally the commodity derivatives market would out-pace and overtake the market for stock derivatives.

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2.13 Risk Management Tools

Derivatives are powerful risk management tools. To illustrate, lets take the example of an investor who holds the stocks of Infosys, which are currently trading at Rs 2,096. Infosys options are traded on the National Stock Exchange of India, which gives the owner the right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the contract would be worthless for the owner and he would lose the money he paid to buy the option, known as premium. However, the premium is the maximum amount that the owner of the contract can lose. Hence he has limited his loss. On the other hand, if the share price of Infosys goes above Rs 2,220, the owner of the call option can exercise the contract, buy the share at Rs 2,220 and make profits by selling the share at the market price of Infosys. The upward gain can be unlimited. Say the share price of Infosys zooms to Rs .3,000 by June 2005, the owner of the call option can buy the shares at Rs 2,220, the exercise price of the option, and then sell it in the market for Rs 3,000. Making a profit of Rs 780 less the premium that has been paid. If the premium paid to buy the call option is say Rs 10, the profit would be Rs 770.

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3 conclusions

Commodity market is very new concept in India. Its still developing. Though Physical commodity market is very concept where trading of commodity takes place hand to hand or on cash basis. In ancient there was a barter system where commodity is exchange for a commodity. Then after discovery of money commodity being traded for money. Now days trading are done in electronic form. Buyers and sellers didnt meet each other personally. Emerging market like India its still undeveloped.

India is one of the top producers of a large number of commodities, and also has a long history of trading in commodities and related derivatives. The commodities derivatives market has seen ups and downs, but seem to have finally arrived now. The market has made enormous progress in terms of technology, transparency and the trading activity. Interestingly, this has happened only after the Government protection was removed from a number of commodities, and market forces were allowed to play their role. This should act as a major lesson for the policy makers in developing countries, that pricing and price risk management should be left to the market forces rather than trying to achieve these through administered price mechanisms. The management of price risk is going to assume even greater importance in future with the promotion of free trade and removal of trade barriers in the world. All this augurs well for the commodity derivatives markets.

Due to Inflation and currency value fluctuation there is still lack of volume in commodity market. Government has to make good policies and regulations for commodity market. Commodity market are attractive because of low risk, good returns, high Liquidity, less volatile

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4 Suggestions and recommendations

Need of transparency in trade cycle Need to develop electronic trading process Need to provide knowledge to public about commodity market People have to get aware of benefits of commodity trading. Government has to make some good rules and regulations for smooth working of market.

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5 Bibliography

Books names:Investment analysis and portfolio management SY. F/M commodity market

Websites:http://www.eurojournals.com/ http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf http://finance.indiamart.com http://en.wikipedia.org/wiki/Hedge_(finance) http://en.wikipedia.org/wiki/Futures_contract http://en.wikipedia.org/wiki/Commodity_market http://www.rediff.com/money/

Newspaers:Economics Times

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