Wednesday, May 18, 2011

Commodity Derivates

The origin of derivatives can be traced back to the need of farmers to protect themselves
against fluctuations in the price of their crop. From the time of sowing to the time of crop
harvest, farmers would face price uncertainty. Through the use of simple derivative products,
it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices.
These were simple contracts developed to meet the needs of farmers and were basically a
means of reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he would receive for his
harvest in September. In years of scarcity, he would probably obtain attractive prices. However,
during times of oversupply, he would have to dispose off his harvest at a very low price.
Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would face a price
risk - that of having to pay exorbitant prices during dearth, although favourable prices could
be obtained during periods of oversupply. Under such circumstances, it clearly made sense for
the farmer and the merchant to come together and enter into a contract whereby the price of
the grain to be delivered in September could be decided earlier. What they would then negotiate
happened to be a futures-type contract, which would enable both parties to eliminate the price
In 1848, the Chicago Board of Trade (CBOT) was established to bring farmers and merchants
together. A group of traders got together and created the `to-arrive' contract that permitted
farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved
useful as a device for hedging and speculation on price changes. These were eventually
standardised, and in 1925 the first futures clearing house came into existence.
Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton,
wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial
underlying like stocks, interest rate, exchange rate, etc.

A derivative is a product whose value is derived from the value of one or more underlying
variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity
or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their
harvest at a future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the 'underlying' in this case.
The Forward Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in
commodities all over India. As per this Act, the Forward Markets Commission (FMC) continues
to have jurisdiction over commodity forward/ futures contracts. However, when derivatives
trading in securities was introduced in 2001, the term 'security' in the Securities Contracts
(Regulation) Act, 1956 (SC(R)A), was amended to include derivative contracts in securities.
Consequently, regulation of derivatives came under the purview of Securities Exchange Board
of India (SEBI). We thus have separate regulatory authorities for securities and commodity
derivative markets.
Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed
by the regulatory framework under the SC(R)A. The Securities Contracts (Regulation) Act,
1956 defines 'derivative' to include -
1. A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying

Derivative contracts are of different types. The most common ones are forwards, futures,
options and swaps. Participants who trade in the derivatives market can be classified under
the following three broad categories: hedgers, speculators, and arbitragers.
1. Hedgers: The farmer's example that we discussed about was a case of hedging.
Hedgers face risk associated with the price of an asset. They use the futures or options
markets to reduce or eliminate this risk.
2. Speculators: Speculators are participants who wish to bet on future movements in
the price of an asset. Futures and options contracts can give them leverage; that is, by
putting in small amounts of money upfront, they can take large positions on the market.
As a result of this leveraged speculative position, they increase the potential for large
gains as well as large losses.
3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy
between prices of the same product across different markets. If, for example, they see
the futures price of an asset getting out of line with the cash price, they would take
offsetting positions in the two markets to lock in the profit.

Whether the underlying asset is a commodity or a financial asset, derivatives market performs
a number of economic functions.
• Prices in an organised derivatives market reflect the perception of market participants
about the future and lead the prices of underlying to the perceived future level. The
prices of derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus, derivatives help in discovery of future as well as current
• The derivatives market helps to transfer risks from those who have them but may not
like them to those who have an appetite for them.
• Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives the underlying market witnesses higher trading
volumes, because of participation by more players who would not otherwise participate
for lack of an arrangement to transfer risk.
• Speculative traders shift to a more controlled environment of the derivatives market.
In the absence of an organised derivatives market, speculators trade in the underlying
cash markets. Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kinds of mixed markets.
• An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. Derivatives have a history of attracting many
bright, creative, well-educated people with an entrepreneurial attitude. They often
energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense.
• Derivatives markets help increase savings and investment in the long run. The transfer
of risk enables market participants to expand their volume of activity.

Derivatives markets can broadly be classified as commodity derivatives market and financial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts are
those for which the underlying asset is a commodity. It can be an agricultural commodity like
wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy
products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade
contracts have a financial asset or variable as the underlying. The more popular financial
derivatives are those which have equity, interest rates and exchange rates as the underlying.
The most commonly used derivatives contracts are forwards, futures and options

No comments: