Module IV – Introduction to Derivatives

& Commodity Markets

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 Introduction to derivatives
What is a derivative?
• A derivative is a contract between two or more parties 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 price of underlying asset. Types
of Derivatives are:
o Futures: A contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial
instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange.
o Forward contract: forward contract is a private agreement between the buyer and seller to exchange the underlying asset for cash at a
particular date in the future and at a certain price.
o Options: A financial derivative that represents a contract (option to buy or sell) sold by one party (option writer) to another party (option
holder). The contract offers the option holder the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset
at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date) in return of a premium
• Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the
contract.

Financial derivative
Derivatives
Commodity derivative

Underlying asset is financial asset Underlying asset is physical asset

• Financial asset is a liquid asset that gets value
from the contractual right it gives or the
ownership claim it represents
• Examples: cash, stocks, bonds, mutual funds and Physical assets are real assets that draw their value
bank deposits from substances or properties, such as commodities
• Equity shares – claim of ownership in company like soybeans, wheat, oil, iron , gold, silver, copper etc
• Bonds- contractual right to future payment of
interest and repayment of principal
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 Financial Derivative and Commodity derivative
Parameters Financial Derivative Commodity Derivative

meaning A financial derivative is a financial contract that derives its value A commodity derivative is a financial contract that derives its
from an underlying asset being a financial asset (stocks, bonds, value from an underlying asset being a commodity
etc) . The buyer agrees to purchase the asset on a specific date
at a specific price.
Settlement In the case of financial derivatives, most of these contracts are Due to physical existence of the underlying assets (commodities),
cash settled or if delivery is intended then it is generally in physical settlement involves physical delivery of the underlying
electronic form. commodity.
Need for storage facility Since financial assets are not bulky, they do not need special The seller intending to make delivery would have to take the
facility for storage, transport even in case of physical commodities to a warehouse accredited by exchange and the
settlement. buyer intending to take delivery would have to go to the
designated warehouse and pick up the commodity. Proof of
physical delivery having been effected is forwarded by the seller
to the clearing house and the invoice amount is credited to the
seller's account.
Quality of asset varying quality of asset does not really exist as far as financial in the case of commodities, the quality of the asset underlying a
underlying are concerned. contract can vary largely. This becomes an important issue to be
managed.
Delivery notice period Delivery notice period not available typically a seller of commodity futures has the option to give
notice of delivery. This option is given during a period identified as
`delivery notice period'

Financial Derivatives explained -

https://www.youtube.com/watch?v=nf9ByTdX0aY
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 Future and forward contracts
• Futures contracts
o A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a
predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset
o It is an exchange-traded contract of standardized nature in terms of the quantity, date, and delivery of the item. The buyer holds long position while the seller
holds a short position in this contract.
o As the contracts are traded in the official exchange, which acts as both mediator and facilitator between the buyer and seller, the exchange has made
it mandatory for both the parties to pay an upfront cost as a margin.
Example :
o You have purchased a single futures contract of ABC Ltd., consisting of 200 shares and expiring in the month of December at price of Rs 1,000. If on expiry date,
ABC Ltd. Future closes at a price of Rs 1,050. You will receive a profit of Rs 50 per share (the settlement price of Rs 1,050 less your cost price of Rs 1,000), which
adds up to a sum of Rs 10,000 (Rs 50 x 200 shares). This amount is adjusted with the margins you have maintained in your account. If you receive profits, they will
be added to the margins that you have deposited. If you made a loss, the amount will be deducted from the margins.
• Forward contracts
o forward contract is a private agreement between the buyer and seller to exchange the underlying asset for cash at a particular date in the future and at a certain
price.
o On the settlement date, the contract is settled by physical delivery of asset in consideration for cash.
o Such contracts are traded in a decentralized market, i.e. Over the counter (OTC) where the terms of the contract can be customized as per the needs of the
parties concerned.
o The buyer in a forward contract is considered as long, and his position is assumed as long position while the seller is called short, holds a short position.
o When the price of the underlying asset rises and is more than the agreed price, the buyer makes a profit. But if the prices fall, and is less than the contracted
price the seller makes a profit.
Example:
For example, let's assume that in April 2021 a farmer enters a forward contract with a miller to sell 5,000 kgs of wheat at Rs.4.404 per Kg in July 2021. At expiry date
in July 2021, the market price of wheat falls to Rs.4.350, but the miller has to buy at the contract price of Rs.4.404, which is higher than the market price of Rs.4.350.
Instead of paying Rs.21,750 (4.350 x 5,000), he'll pay Rs.22,020 (4.404 x 5,000). That way the farmer can ensure a certain sum as sale proceeds for his produce
without worrying about the uncertainty of falling prices.
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 Difference between Futures and Forwards
Parameters Futures Forwards

1. Meaning A financial contract obligating the buyer to purchase an A contract between parties to buy and sell the underlying
asset (or the seller to sell an asset), such as a financial asset at a specified date and agreed rate in future.
instrument or physical commodity, at a predetermined
future date and price.

2. Contract Standardized contracts are available on the exchanges Tailor-made contracts. Terms of contract differ from trade to
specifications where these are traded. trade, according to needs of the parties to contract.

3. Operational Traded on organised exchange Traded over the counter (OTC) between two parties not on
mechanism any exchange.

4. Default No such probability as these are exchange traded and the As they are private agreement, the chances of default are
exchange takes care of settlement. Also margins are relatively high.
payable before contracts are executed.

5. Liquidity High since these are exchange traded Low, since these are not exchange traded

6. Risk Low due to higher liquidity and exchange regulated High due to low liquidity and self-regulated by parties.
There is no other independent party to regulate them.

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 Key words
• Underlying - In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the
cash flows of the derivative depend on the value of this underlying
• Spot price - The spot price is the current market price at which an asset is bought or sold for immediate payment and delivery. It is
differentiated from the forward price or the futures price, which are prices at which an asset can be bought or sold for delivery in
the future
• Future price - Futures are derivative financial contracts that obligate the parties to transact an asset at a
predetermined future date and price. This pre-determined price is called future price. The main difference between spot and
futures prices is that spot prices are for immediate buying and selling, while futures contracts delay payment and delivery to
predetermined future dates. The spot price is usually below the futures price.
• Expiry date – In a futures / forward contract the buyer must purchase or the seller must sell the underlying asset at the set price,
regardless of the current market price on the pre-determined date. That date is called the expiration date.
• Physical settlement vs. Cash settlement
In finance especially in a derivative market, the contracts are often executed on a pre-decided settlement date. In case of futures
and options, on the settlement date, if delivery of underlying asset is taken (which is termed as physical settlement) or if simply
settled at the net position through cash (i.e. cash settlement).
https://www.youtube.com/watch?v=3bPRN_GhHiY
• ‘Long Position’ means the net outstanding purchase obligations of a person, in respect of his transactions in a contract month for a
commodity or security (Obligation to buy)
• The short futures position is net outstanding sale obligations that can be entered into by the futures speculator to profit from a fall
in the price of the underlying. The short futures position is also used by a producer to lock in a price of a commodity that he is
going to sell in the future. (obligation to sell)

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Commodity Exchanges

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 Commodity Exchanges
• A commodities exchange determines and enforces rules and procedures for trading
standardized commodity contracts (where the underlying asset is a commodity)
• India has Five national commodity exchanges for trading of Futures and Options related to
commodities:
• Multi Commodity Exchange of India (MCX)
• National Commodity & Derivatives Exchange Limited (NCDEX)
• Indian Commodity Exchange Limited (ICEX)
• National Stock Exchange (NSE)
• Bombay Stock Exchange
o Global Commodity Exchanges include the following:
• Chicago Mercantile Exchange - CME Group
• Shanghai Exchange
• The Tokyo Commodity Exchange
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 Multi-Commodity Exchange of India (MCX)
Role of Multi-Commodity Exchange of India (‘MCX’)
• MCX was started operations in November 2003 as a commodity derivatives exchange
o facilitates online trading of commodity derivatives thereby providing a platform for price discovery and risk
management
• Commodity futures transactions (leading commodities exchange in India based on value of commodity futures
traded)
• Commodity options contracts (India’s first exchange to offer commodity options contracts)
• MCX offers trading in commodity derivative contracts across varied segments:
o Bullion
o industrial metals
o energy
o agricultural commodities.
• MCX focuses on providing commodity value chain participants with neutral, secure and transparent trade mechanisms, and
formulates quality parameters and trade regulations, in conformity with the regulatory framework.
• Multi Commodity Exchange Clearing Corporation Limited (MCXCCL), a wholly-owned subsidiary of MCX, is the first clearing
corporation in the commodity derivatives market.
o MCXCCL provides collateral management and risk management services, along with clearing and settlement of trades
o It provides a settlement guarantee for all trades executed on MCX via Settlement Guarantee Fund (SGF)
• MCX has forged strategic alliances with leading international exchanges eg. London Metal Exchange (LME), Taiwan Futures
Exchange (TAIFEX). The Exchange has also tied-up with various trade bodies, corporates, educational institutions and
research centres across the country.
o These alliances enable the Exchange in improving trade practices, increasing awareness, and the overall commodity
market.
• Operates under the regulatory framework of Securities and Exchange Board of India (SEBI).
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MCX

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 National Commodity & Derivatives Exchange Limited (NCDEX)
Role of National Commodity & Derivative Exchange Limited
• National Commodity & Derivatives Exchange Limited is a professionally managed on-line multi commodity exchange.
• NCDEX is a commodities exchange dealing primarily in agricultural commodities in India.
• As of March 31, 2019, the Exchange offered:
o futures contracts in 19 agricultural commodities
o options contracts in 5 agricultural commodities
• Exchanges like NCDEX have also played a key role in improving Indian agricultural practices.
• Barley, wheat, and soybeans are some of the leading agricultural commodities traded on the NCDEX.

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 Types of margins

• Initial margin
• Additional margin
• Special margin
• Tender period margin
• Delivery period margin
• Extreme loss margin
 Types of Margins
• Margins in commodities derivatives:
o To transact on commodities exchange, user must deposit specific amount of money with the broker
called the “margin:”
o level of margin to be placed by traders is set by the exchange based on the amount of volatility and
volume.
o Parties cannot enter into any contract without margins.
o For most future contracts, the margin requirement in the range of 4%-15%.

• Following margins are applicable in commodities market:

o Initial Margin: The ‘initial margin’ is the amount that is required to be placed by the trader when they
intend to enter a contract. This amount is meant to compensate for a potential loss that may occur in
that day. Initial margin is applicable on derivatives contracts using the methods that the exchange finds
feasible such as ‘Value at Risk (VaR)’or any other concept.

o Additional margin: ‘Additional margin’ is called forth on occasional situations where there has been
unexpected volatility in the market. To prevent potential default, the exchanges necessitate this so that
the system/exchange does not lose its stability in unfavourable situations.

o Special Margin : Special margin is usually imposed by an exchange on certain commodities as a

surveillance measure during times when there is more than 20% price movement in the same direction
from a pre-determined base (underlying spot price). It is be levied by market regulators when there is
excess volatility in the market. 13
 Types of Margins
o Tender Period Margin/Pre-expiry Margin:
• Tender Period days are those days during which the seller member deposits the goods with the designated
warehouse of Exchange and gives his intention for delivery to the Exchange.
• The margins are applicable on both buy and sell side. The tender period margin is calculated at the rate
pre specified by the Exchange in the contract specification. The tender margin continues up to the
settlement of delivery obligation or expiry of the contract, whichever is earlier.
• Tender margins are over and above the normal & special margins (if any) applied by the Exchange.
• Exchange shall determine the quantum of tender period margin as appropriate based on the risk
characteristics of the particular commodity.

o Delivery Period Margin: Appropriate delivery period margin shall be levied on the long and short positions
marked for delivery till the pay-in is completed by the member. SEBI has specified that delivery period margins
shall be higher of:
• a) 3% + margin calculated based on VaR; Or
• b) 20%

o Extreme loss Margin

• Clearing members shall be subject to exposure margins in addition to initial margins. ELM of 1% on gross
open positions shall be levied and shall be deducted from the liquid assets of the clearing member on an
online, real time basis

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 Hedging in commodities markets
• A hedge is 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.
• In relation to commodity market, hedging means taking a position in futures market that is opposite to a
position in physical market or anticipated physical position, with the objective of reducing or limiting risk
associated with price change in specific commodity.
• If any entity has an underlying physical stock of commodity and anticipates a fall in price, the entity can
take an equal and opposite position by selling futures contracts of that commodity. The loss in the underlying
market due to fall in prices can be offset by the profit made by selling futures.
• In order to appropriately hedge in the investment world, one must use various instruments in a strategic
fashion to offset the risk of adverse price movements in the market. The best way to do this is to make
another investment in a targeted and controlled way.
• The most common way of hedging in the investment world is through derivatives. Derivatives are securities
that move in correspondence to one or more underlying assets.

• Example of short hedge: In April 2018, Mr. A, a Mumbai based gold Jeweller buys 2 Kg of gold in the spot market at a price of
Rs.30800 per 10 gm as raw material to make Jewellery from it. Mr. Ramesh wants to protect the reduction in the price of gold till
the Jewellery is ready for sale in May 2018. For the above purpose Mr. Ramesh sells 2 contracts (1 kg. each) of Gold June futures
at the price of Rs. 30900 per 10 gm
• In May 2018, Mr. Ramesh sells 2 Kg of Jewellery at the reduced spot price of Rs. 30700 per 10 gm and squares off his Gold June
futures open short position at Rs. 30800 per 10 gm (Futures price). The above transactions have resulted in a profit of Rs.100 per
10 gm in Gold June futures contract and a loss of Rs.100 per 10 gm in the spot transaction, thereby protecting the price of the
finished material i.e Jewellery at Rs. 30800 per 10 gm.
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 Hedging – Examples
Example 1:
• If an electric cable manufacturer has fixed price commitment for
purchase of copper as raw material, which would be utilized to
manufacture electric cables made of copper, there is a risk of fall in
price of copper and therefore eventually, the risk of fall in price of the
copper made electric cables. The manufacturer would like to reduce his
risk by hedging his exposure in Copper on the futures market.

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

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

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

Uses of selling hedge strategy.

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

Short hedgers are merchants and processors who acquire

inventories of the commodity in the spot market and who
simultaneously sell an equivalent amount or less in the futures
market. The hedgers in this case are said to be long in their spot
transactions and short in the futures transactions.
 Hedging – Basic concepts
Example
A tea masala manufacturer requires cardamom and other spices for the
manufacture of end product. He may either have an unsold inventory of
cardamom, or he may have bought it for later delivery. Since the
manufacturer owns the commodity, he would suffer losses if prices drop. By
hedging, the manufacturer can optimize his inventory levels while
managing his production levels.

To hedge, the manufacturer would have to sell the respective futures

contracts (i.e enter into a future contract to sell at a future date at a pre-
decided price). Now if prices drop, the cash market loss will be offset by a
gain in the futures contract (because the selling price is locked at a higher
level). When the manufacturer sells his inventory at the lower cash market
price, he will simultaneously lift his hedge by buying back the futures
contracts at the lower price (square off - sell high buy low). The loss in the
cash market will be compensated by gain in futures’ contract.
Advantages & Limitations of Hedging
Advantages:
1. Hedging reduces or limits the price risk associated with the physical
commodity.
2. Hedging can be used to protect the price risk of a commodity for long
periods by rolling over contracts.
3. Hedging makes business planning more flexible without interfering with
routine business operations.
4. Hedging can facilitate low cost financing

Limitations:
1. Hedging cannot eliminate the price risk associated with the physical
commodity in totality due to the standardized nature of futures contract.
2. Because of basis risk, hedging may not provide full protection against
adverse price changes.
3. Hedging involves transaction costs, though costs are quite minimal
compared to benefits.
4. Hedging may require closing out a futures position before it becomes
near month contract.