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Transcript of Comodity & Future Marketing
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1AEM - 202
AEM 202
Agri-Business and Entrepreneurship Development(3 Credits)
Block III
Commodity and Future Marketing
Unit 1 : Commodity Markets 3-20
Unit 2 : Introduction to Commodity Exchanges 21-38
Unit 3 : Futures Exchange and Risk Management 39-54
Unit 4 : Ware house Receipts and Collateral Management 55-69
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2Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
Published byNational Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030, Andhra Pradesh, IndiaFirst Published: 2008 MANAGE, 2008All rights reserved . No part of this work may be reproduced in any form, by mimeograph or anyother means without permission in writing from the MANAGE.
Shri K.V. Satyanarayana, IASDirector GeneralNational Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030Andhra Pradesh, India
Program CoordinatorsDr. M.N. Reddy, Director (Agri. Extn. & Commn.) & Principal Coordinator (PGDAEM)Ph. Off: (040) 24014527, email: [email protected]
Dr. N. Balasubramani, Assistant Director (Agri. Extn.)Ph. Off: (040) 24016702-708 Extn. 275, email: [email protected]
Course CoordinatorDr. Vikram Singh, Director (OB)National Institute of Agricultural Extension Management (MANAGE),Rajendranagar, Hyderabad 500 030, Andhra Pradesh, IndiaPh. Off: (040) 24016690, email: [email protected]
ContributorsThis material was originally prepared for YASHADA, Pune. The intellectual copy right of this materialbelongs to YASHADA, Pune
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3AEM - 202Agri-Business and Entrepreneurship Development
Unit 1
Commodity Markets
Structure
1.0 Objectives
1.1 Commodity markets
1.2 Classification of markets
1.3 Market players and motives
1.4 Motives of market participants
1.5 Forward and backward linkages in markets
1.6 Regulation of commodity markets
1.7 Recent innovation in commodities markets
1.8 Let us sum up
1.9 Key words
1.10 Further readings
1.11 Check your progress
1.0 Objectives
Agriculture occupies a very important place in the economic life of our country. It is the backbone
of our economic system. India is primarily an agricultural country. The fortunes of the economy are, even
now, dependent on the course of agricultural production. Commodity markets have been serving the
livelihood in the Indian economy. There were different kinds of markets based on products, nature of
competition, time etc. This Unit will help you to understand the following concepts viz:
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4Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
Commodity Markets
Classification of markets,
Market motives,
Market participants and
Forward and backward linkages.
1.1. Commodity Markets
1. What are commodities?
A commodity is anything for which there is demand, but which is supplied without qualitative
differentiation across a given market.
2. Characteristics of Commodities
They are essential things that are produced and consumed in large quantities.
Physical goods that have a value attached to them and hence can be called asset classes.
They are often used as inputs in the production of other goods or services.
The prices are determined as a function of their market as a whole.
There is little differentiation between commodity coming from one producer and the same
commodity from another producer.
Generally they do not have brands, if branded they are called as products
Include physical substances, such as food, grains, and metals, which are interchangeable
with another product of the same type, and which investors buy or sell.
3. How are commodities different from other assets?
Commodities are bulky in nature
They are perishable especially agro products
Commodities are physical assets - have added storage costs
They are goods, which have logistics problem - as they are bulky and as their production and
consumption centers are far apart
They have wide variations in quality and hence certain grades are taken as standards
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4. Markets
The term market means not a particular place in which things are bought and sold but the whole
of any region in which buyers and sellers are in such a free intercourse with one another that the prices
of the same goods tend to equality, easily and quickly.
1.2 Classification of Markets
There are different kinds of markets, which have been classified, based on the following aspects
Classification of markets based on:
Functioning Stage Products soldScale Time Place
1. Regulated
2. Unregulated
1. Primary
2. Secondary
1. Wholesale
2. Retail
1. Spot
2. Forwards
3. Futures
1. Physical
2. Electronic
1. Consumer
2. Industrial
Competition
1. Perfect
2. Imperfect
monopoly, duopoly and Oligopoly
The description of different kinds of markets is given below
1. Based on Functioning
Based on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categoriesBased on the functioning, markets are placed in two categories
a. Regulated Markets: These are markets in which business is done in accordance with the
rules and regulations framed by the statuary market organization representing different sections
involved in markets. The marketing costs in such markets are standardized and marketing
practices are regulated.
Important features of regulated markets
i) Method of sale: in regulated markets, the sale of agricultural produce is undertaken either
by open auction or by the close tender method.
Commodity Markets
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6Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
ii) Weighment of produce: Weighment of the produce is done by a licensed standard weights
and platform scale.
iii) Grading: the produce in the regulated markets is expected to be sold only after grading.
iv) Licensing of market functionaries: all the market functionaries , from the hamals (loaders)
to traders, working in the regulated markets have to obtain license from market committee.
b. Unregulated Markets: these are the markets in which business is conducted without any set
rules and regulations. Traders frame the rules for the conduct of the business and run the
market. These markets suffer from many ills, ranging from non-uniform charges for marketing
functions to imperfections in the determination of prices.
2. Based on the Stage of Marketing
Based on the marketing, the markets are divided into three categories
a. Primary Markets
They are markets where most of the raw materials / materials are sold without much processing.
They lie near the origin of commodities. In primary markets, the producers of goods sell their farm
products to the wholesalers and their agents.
b. Secondary Markets
These markets are mostly far away from the primary centers of production and located at the
consumption centers. This is the market where the wholesalers sell their goods to the retailers for onward
selling to the consumer. The middlemen buy goods from producers and manufacturers and sell to the
retailers.
c. Terminal Market
This is the market where goods are purchased for final use or consumption. The retailers sell
their goods to consumers. This market is one where the produce is either finally disposed of to the
consumers or processors, or assembled for exports. In these markets, merchants are well organized
and use modern methods of marketing.
The main objectives of setting up Terminal Markets are
i) To link the farmers to the markets by shortening the supply chain of perishables and enhance
their efficiency and thus increase farmers income,
ii) Provide professionally managed competitive alternative marketing structures that provide multiple
choices to farmers for sale of their agricultural produce,
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7AEM - 202Commodity Markets
iii) To drive reforms in the agricultural marketing sector resulting in accelerated development of
marketing and post harvest infrastructure including cool chain infrastructure in the country
through private sector investment.
iv) To bring transparency in the market transactions and price fixation for agricultural produce and
through provision of backward linkages to enable the farmers to realise higher price and thus
higher income to the farmers.
3. Based on scale/volume of business
a. Retail Markets
These markets cater to the needs of the general public who are consumers of the products.
Largely small-scale transactions take place at retail level. Retailers are scattered all over mostly
in residential areas. In short retail refers to a market where goods are sold in small quantity
directly to the consumer.
b. Wholesale Market
This market sells primarily to traders such as caterers and small shopkeepers. Members of the
public however, are not necessarily excluded. Large-scale transactions take place. Whole sale shops are
mostly concentrated in a particular location in a town/city. It is the market where the middlemen buy the
goods in bulk from the producers and manufacturers. Wholesaling is normally characterized by a system
of delivery by the wholesaler to the customer and the extension of credit facilities against bulk purchases.
4. Based on Time
a. Futures Market
This is an auction market in which participants buy and sell commodity/future contracts for
delivery on a specified future date. Futures exchanges act as a platform facilitating and regulating trade.
A futures contract is an agreement between two parties to buy or sell a specified and standardized
quantity and quality of an asset at a certain time in the future at a price agreed upon. It is a market in
which the buyers and sellers make agreement for delivery of goods in future. The contract is made on a
certain date but the goods will be delivered in future. Eg: MCX
b. Forward Market
Forward contract is an agreement between two parties to buy or sell an asset at a future date for
a price agreed upon by both. Contracts are booked in advance, to mitigate risk. Contracts are signed
by the buyers and sellers and they have their own set of norms. Forward trade may not involve the
activity of an Exchange.
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8Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
c. Spot Market
Commodities are physically bought and sold here so these are called physical markets. In this
market, delivery is taken immediately. Cash settlement is done within a maximum of 11 days. The spot
market is a ready market where the sellers on the spot physically hand over goods to the buyers. There is
an exchange of goods for money at the same time.
5. Based on Place
a. Electronic Market
These are markets wherein the buyers and sellers do not meet. They are also called as virtual
markets / online market place eg e-bay. In Futures exchanges also, now trading is taking place
electronically
b. Physical Markets
A market in which commodities, such as grain, gold, crude oil etc. are bought and sold for cash
and delivered immediately. This is also called cash market or spot market.
6. Based on Products sold
a. Industrial Markets
This involves the sale of goods between businesses. They are not aimed directly at the consumer.
Eg: primary market where the raw materials and inputs are obtained eg: cement.
b. Consumer Market
Here, the products and services are bought by individuals for their own or family use. Thiscan be broadly classified into:
1. Fast-Moving Consumer Goods (FMCG) - high volume, low unit value
2. Consumer durables - low volume but high unit value
3. Soft goods eg: clothes, shoes
4. Services - e.g. hairdressing, dentistry
7. Based on Competition
Based on competition the markets are classified into perfect and imperfect markets
a. Perfect Markets: A perfect market is one in which the following condition will hold good
There is a large number of buyers and sellers
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9AEM - 202Commodity Markets
All the buyers and sellers in the market have perfect knowledge
Prices at any one time are uniform over a geographical area plus or minus the cost
of supplies.
b. Imperfect Markets: The markets in which the conditions of perfect completion are lacking are
characterized as imperfect markets. The following are the situations based on the imperfections:
i. Monopoly: It is a persistent situation where there is only one provider of a product or
service in a particular market. Monopolies are characterized by a lack of economic com-
petition for the good or service that they provide and a lack of viable substitute goods.
ii. Oligopoly: It is a market form in which a market or industry is dominated by a small
number of sellers (oligopolists).
i. Duopoly: This is a specific type of oligopoly where only two producers exist in one
market
1.3 Market Players and Motives
There are different kinds of participants in the markets, which are listed below. Their activities
vary slightly according to the markets they operate and they also carry different names according to the
place of operation. eg. speculators, hedgers & arbitragers in futures market.
Buyers
Sellers
Stockists
Trade facilitators / brokers
1. Buyer
A person who buys commodities or products
Buyers are classified as consumer / industrial buyer
The buying behaviour varies with time, place etc.,
2. Seller
A person who has goods to offer for willing buyers to buy.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
3. Stockist
A trader who buys goods at lower levels and stores it for some time and sells when prices
improve.
They take advantage of the price variation
4. Brokers
Intermediaries who operate between buyers and sellers
They facilitate trade and take some part of the price margin
1.4 Motives of Market Participants
The market participants have different kinds of motives to meet physical requirement. The different
kinds of motives are listed below
Investment motive
Speculative motive
Arbitrage motive
1. Investment motive
A trader who is neither a producer nor a consumer of a produce, but operates in the markets for
profit motive is an investor. He works in the market by buying goods and selling it at a later period or in
a different market and gains from the price differences. Investment may be subdivided into 1) speculative
and 2) arbitrage motive
2. Speculative motive
A speculator buys, holds and sells commodities in the market to profit from the fluctuations in the
market. Risk involved is more when a person operates with a speculative motive.
3. Arbitrage motive
Arbitrage is the practice of taking advantage of a price differential between two or more markets,
time periods etc Eg. a person buying in the spot market and selling in the futures market or vice-versa
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1.5 Forward and Backward Linkages in Markets
The markets are linked with two types of linkages namely backward and forward linkages
1. Backward linkage
a. Contract Farming
b. Corporate Farming
a. Contract Farming
Contract farming has been prevalent in various parts of the country for commercial crops like
sugarcane, cotton, tea, coffee, etc. The concept has, however, gained importance in recent times in
the wake of economic liberalization. The main feature of contract farming is that farmers grow
selected crops under a buy back agreement with an agency engaged in trading or processing.
There are many success stories on contract farming such as potato, tomato, groundnut and
chilli in Punjab, Safflower in Madhya Pradesh, oil palm in Andhra Pradesh, seed production contracts
for hybrids seed companies in Karnataka, cotton in Tamil Nadu and Maharashtra etc. which helped
the growers in realization of better returns for their produce.
In our country contract farming has considerable potential where small and marginal farmers
can no longer be competitive without access to modern technologies and support. The contractual
agreement with the farmer provides access to production services and credit as well as knowledge of
new technology. Pricing arrangements can significantly reduce the risk and uncertainty of the market
place.
Small-scale farmers are frequently reluctant to adopt new technologies because of the possible
risks and costs involved. In contract farming, private agribusiness firms normally offer improved
methods and technologies because they have a direct economic interest in improving farmers
production to meet their needs. In many instances, the larger companies provide their own extension
support to contracting farmers to ensure that production is according to the specification. The farmer
learns many skills through contract farming like record keeping, improved methods of applying
chemicals, fertilizers and knowledge of the importance of quality and of the demands of export
markets.
In view of the above, contract-farming arrangements need to be encouraged widely. This
would require arrangement for registration of sponsoring companies and recording of contract
farming agreements, in order to check unreliable and spurious companies. A dispute resolution
mechanism needs to be set up near to farmers which can quickly settle issues, if any, arising between
Commodity Markets
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
the farmers and the company under a quasi-judicial manner. The farmers while raising the contracted
crops, run the risk of incurring debt and consequent displacement from land in the event of crop failure.
Farmers need to be indemnified from such displacement by law.
Eg: PepsiCo has emerged as one of the biggest providers of high quality seeds (especially tomatoes,
chillies and potatoes) for which farmers have to pay up front. The company recently imported 15,000
citrus plants from California, which are being distributed in Punjab. The idea is to try and develop Punjab
as a major citrus exporter.
b. Corporate Farming
Corporate farming refers to direct ownership or leasing in of farmland by business organizations
in order to produce for their captive processing requirements or for the open market.
Eg:, Jamnagar Farms Pvt. Ltd.- a subsidiary of Reliance Industries (Mukesh Ambani group)
with 7500 acres of farm land which has mango occupying 450 acres that makes it the largest
mango orchard in Asia. The farm was originally set up as an environmental protection measure
near its refinery. Now, it is being seen as a profitable venture in itself.
2. Forward linkage
Forward linkage means the dealings with retail chains and processors. The most essential things
in forward linkages are
Quantity and consistency in supply,
Competitive pricing of the produce,
Market knowledge, and
Farmers ability to build their associations, which are very much required.
Retailers buying process
Retail buying is the recent procurement strategy adopted by major retailers, i.e. they will not
agree with any pre-agreed price with farmer, however they give the prevailing market rate through
their collection centers in villages/taluk place. They directly buy the produce on cash and cheque
payments, some retail companies buy directly from existing open markets.
Eg: Relaince Retail buying of vegetables through their collection centers for their outlets.
3. Challenges for Commodities Markets
Encourage the retail companies to evolve sourcing models and meanwhile proactively prepare
farmer group to establish linkage with retailers.
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Necessary infrastructure in order to provide, Multi commodity service, preserving quality,
enhancing agri produce shelf life etc
Improved market access for farmers both in the national and overseas markets
Increase bargaining power of farmers by building their own associations
Introduce de-intermediation process into the current marketing system
Forward linkage of farmers and backward linkage of retail chain etc.
1.6 Regulation of Commodity Markets
Commodity markets are regulated at national and international level by the following organizations.
1. India
a. APMC
b. State Marketing Board
c. Forward Markets Commission (FMC)
2. International
a) WTO
b) United Nations Conference on Trade and Development (UNCTAD)
1.a APMC (Agricultural Produce Marketing Committee) Act
The Act provides improved regulation in marketing of agricultural produce, development of an
efficient marketing system, promotion of agri-processing and agricultural export and the establishment
and proper administration of markets for agricultural produce in the States. The modified APMC Act
has been made specifically responsible for:
Ensuring complete transparency in pricing system and transactions taking place in market area
Providing market-led extension services to farmers
Ensuring payment for agricultural produce sold by farmers on the same day
Promoting agricultural processing including activities for value addition in agricultural produce
Publicizing data on arrivals and rates of agricultural produce brought into the market area for
sale.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
Setup and promote public private partnership in the management of agricultural markets
Compulsory registration of all contract farming sponsors, recording of contract farming
agreements, resolution of disputes, if any, arising out of such agreement, exemption from
levy of market fee on produce covered by contract farming agreements and to provide for
indemnity to producers title/ possession over his land from any claim arising out of the
agreement
Provision made for direct sale of farm produce to contract farming sponsor from farmers
field without the necessity of routing it through notified markets
Provision made for imposition of single point levy of market fee on the sale of notified
agricultural commodities in any market area and discretion provided to the State Government
to fix graded levy of market fee on different types of sales
Licensing of market functionaries is dispensed with and a time bound procedure for registration
is laid down. Registration for market functionaries provided to operate in one or more than
one market areas
Commission agency in any transaction relating to notified agricultural produce involving an
agriculturist is prohibited and there will be no deduction towards commission from the sale
proceeds payable to agriculturist seller
Provision made for the purchase of agricultural produce through private yards or directly
from agriculturists in one or more than one market area
Provision made for the establishment of consumers/ farmers market to facilitate direct sale
of agricultural produce to consumers
Provision made for resolving of disputes, if any, arising between private market/ consumer
market and Market Committee
Market Committee permitted to use its funds among others to create facilities like grading,
standardization and quality certification; to create infrastructure on its own or through public
private partnership for post harvest handling of agricultural produce and development of
modern marketing system
1.b State Agricultural Marketing Board
The Board acts as a liaison agency between the Market Committees and the Government for all
round development of agricultural marketing in the State. The State Agricultural Marketing Board has
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been made specifically responsible for setting up of a separate marketing extension cell in the Board to
provide market-led extension services to farmers
(i) Promoting, grading, standardization and quality certification of notified agricultural produce
and for the purpose to set up a separate Agricultural Produce Marketing Standards Bureau
(ii) Funds of the State Agricultural Marketing Board permitted to be utilized for promoting either
on its own or through public private partnership, for the following
a) Market survey, research, grading, standardization, quality certification, etc.
b) Development of quality testing and communication infrastructure
c) Development of media, cyber and long distance infrastructure relevant to marketing of
agricultural and allied commodities
1.c Forward Markets Commission
It is a regulatory authority for all Commodity Derivatives Exchanges in India, which is overseen by
the Ministry of Consumer Affairs and Public Distribution, Government of India. It is a statutory body set
up in 1953 under the Forward Contracts (Regulation) Act, 1952.
The key functions of FMC are given below
(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition
from any association or in respect of any other matter arising out of the administration of the
Forward Contracts (Regulation) Act 1952.
(b) To keep forward markets under observation and to take such action in relation to them, as it
may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c) To collect whenever the Commission thinks it necessary, to publish information regarding the
trading conditions in respect of goods to which any of the provisions of the act is made
applicable, including information regarding supply, demand and prices, and to submit to the
Central Government, periodical reports on the working of forward markets relating to such
goods;
(d) To make recommendations generally with a view to improving the organization and working
of forward markets;
(e) To undertake the inspection of the accounts and other documents of any recognized association
or registered association or any member of such association whenever it considerers it
necessary.
Commodity Markets
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
2.a United Nations Conference on Trade and Development (UNCTAD)
The United Nations Conference on Trade and Development (UNCTAD) was established in 1964
as a permanent intergovernmental body, UNCTAD is the principal organ of the United Nations General
Assembly dealing with trade, investment and development issues.
To maximizing the trade and development prospects of developing countries and economies in
transition,
Assisting them in their beneficial integration into the globalizing and liberalizing world economy
and the international trading system, and
Aims to strengthen human, institutional and policy-making capacities by formulating and
implementing national trade policy frameworks conducive to economic, human and social
development and poverty alleviation, as well as in participating effectively in multilateral,
regional and sub regional trade negotiations.
To develop Comprehensive computer-based information system on trade control measures
that uses UNCTADs database.
2.b World Trade Organization (WTO)
WTO is the only international body dealing with the rules of trade between nations.
The main functions of WTO can be described in very simple terms. These are
To oversee implementation and administering of WTO agreements
To provide a forum for negotiations
To provide a dispute settlement mechanism and
Expand the production of and trade in goods and services.
1.7 Recent Innovation in Commodities Markets
1. Safal Market
This was the initiative by NDDB, which came into existence in April 2003 with setting up of a full-
fledged trading platform for Fruits and Vegetables at Bangalore. It has been formed to establish an
alternative market set-up that operates parallel to mandis to stimulate production, raise quality standards,
reduce losses etc
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Reasons for NDDBs debut into the F&V sector could be
Dominated by small farmers, who were unable to effectively bargain in the Mandis and get
remunerative prices
APMC Act emphasises on regulation and restrictions on marketing activity which create a
situation which is disadvantageous to growers
Mandi operations were poorly designed - inefficient & lack transparency
2. E-Choupal
E-Choupal is an initiative of ITC Limited (a large diversified group in India) to link directly with
rural farmers for the procurement of agricultural/aquaculture produce like soya, coffee, and prawns.
E-Choupal was conceived to tackle the challenges posed by the unique features of Indian agriculture,
characterized by fragmented farms, weak infrastructure and the involvement of numerous
intermediaries. Traditionally, these commodities are being procured in mandis (major agricultural
marketing centres in rural areas of India), where the middleman used to make most of the profit.
These middlemen used unscientific means to judge the quality of the product, the price difference in
the payout for good quality and inferior quality was less and hence there was no incentive for the
farmers to produce good quality yield. With e-choupal, role of the middleman was restricted.
ITC Limited has now established computers and Internet access in key rural areas where the
farmers can directly negotiate the sale of their produce with ITC Limited. The PCs and Internet access
at these centers enable the farmers to obtain information on mandi prices, good farming practices
and place orders for agricultural inputs like seeds and fertilizers. This helps farmers in improving the
quality of produce, and also helps in realizing a better price. Each ITC Limited kiosk having an
access to Internet is run by a sanchalaka trained farmer. The computer housed in a farmers house
is linked to the Internet via phone lines or by a VSAT connection and serves an average of 600
farmers in 10 surrounding villages within about a 5 km radius. The sanchalak bears some operating
cost but in return gets commissions for the e-transactions done through his eChoupal. The warehouse
hub is managed by middle-men called samyojaks. The samyojak acts as a local commission agent
for ITC Limited.
The system saves procurement costs for ITC Limited. The E-Choupal model is quite different
from the other models, as the farmers do not pay for the information and knowledge they get from
E-Choupals.
Commodity Markets
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
ITC Limited has extracted value in four steps through E-Choupal
(a) Elimination of non-value adding activities
(b) Differentiating product through identity preservation
(c) Value added products traceable to farm practices
(d) E-market place and support services to future exchange.
3. Metro Cash & Carry
Cash and Carry is a new initiative in wholesaling in which services of credit and delivery are
replaced with discounts. Metros Cash & Carrys business model brings together small, medium and
large-sized producers, farmers, agricultural cooperatives and manufacturers, with the dispersed
community of hotels, restaurants, caterers, traders, retailers and small to medium business enterprises,
under one roof. They buy directly from producers and manufacturers and sell to business customers
at wholesale centers. This way, they shorten the supply chain and thereby eliminate the high costs
associated with a fragmented supply chain. They also cut costs and wastage by building modern
trade infrastructure and implementing modern IT-based systems, which improve efficiency. By
aggregating the demand of small and medium businesses, they are able to buy in bulk quantities at
lower costs, a part of which is passed on to the customers.
1.8 Let us Sum Up
The fortunes of the economy are, even now, dependent on the course of agricultural production.
Commodity markets have been serving the livelihood in the Indian economy.
A commodity is anything for which there is demand, but which is supplied without qualitative
differentiation across a given market. The markets in which the commodities are trading are called
as commodities markets. There are different kinds of commodities markets, which have been classified
based on functioning, stage, scale of business, time and nature of business transaction, place and
area, products sold and competition.
In the markets, largely there are four kinds of participants, namely buyers, sellers, stockists
and trade facilitators. The market participants have investment, speculative and arbitrage motives.
The markets are bound with forward and backward linkages. The backward linkages consist
of contract farming and corporate farming models. In contract farming the farmers grow selected
crops under a buy back agreement with an agency engaged in trading or processing. Corporate
farming involves the direct ownership or leasing in of farmland by business organizations to produce
for their captive processing requirements or for the open market. Dealing with retail chains and
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processing units are termed as forward linkages. Under the changing scenario, commodity markets are
facing many challenges such as increased infrastructure requirement, market access to farmer, improving
the bargaining power of farmers, introduction of de-intermediation process. To pace up the challenges,
market functionaries have been introducing innovations in marketing such as E-Choupal, Cash and
Carry markets and Safal market.
1.9 Key Words
Arbitrage: 1) A transaction that generates a risk-free profit; 2) a leveraged speculative transaction;
and 3) the activity of engaging in either of the above two forms of arbitrage transactions.
Auction: An auction is the process of buying and selling goods by offering them up for bid, taking bids,
and then selling the item to the winning bidder. In economic theory, an auction is a method for determining
the value of a commodity that has an undetermined or variable price.
Buyer: A buyer is any person who contracts to acquire an asset in return for some form of consideration.
Contract: Contract: Contract: Contract: Contract: It is a legally binding exchange of promises or agreement between parties that the law will
enforce. It is an agreement between two or more competent parties to do, or not to do, some legal
act for a legal consideration.
Fast moving consumer goods: Fast Moving Consumer Goods (FMCG), also known as Consumer
Packaged Goods (CPG), are products that have a quick turnover and have a relatively low cost.
Though the absolute profit made on FMCG products is relatively small, they generally sell in large
numbers and so the cumulative profit on such products can be large.
Futures contract: It is a standardized contract, traded on a futures exchange, to buy or sell a certain
underlying instrument at a certain date in the future, at a specified price. The future date is called the
delivery date or final settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price.
Investment: It is the purchase of capital equipment. i.e. the purchase of machines, equipment, factories
etc. that firms need to enable them to produce.
Liberalisation: It refers to a relaxation of previous government restrictions, usually in areas of social or
economic policy.
Price: The amount of money, or other goods, that one has to give up to buy a good or service.
Sales: Sales are the activities involved in providing products or services in return for money or other
compensation. It is an act of completion of a commercial activity.
Commodity Markets
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)
1.10 Further Readings
Acharya S and N.L.Agarwal, 2005 Agricultural Marketing in India, Oxford & IBH Publishing Co Pvt.
ltd, New Delhi.
Various issues of Commodityindia.com
www.wto.org
www.agmarknet.nic.in
www.dgft.gov.in
www.unctad.org
www.fmc.gov.in
1.11 Check Your Progress
1. Define commodity and markets.
2. How do you classify the commodities markets?
3. What are the kinds of markets existing under time mode?
4. What are the major primary markets for different agricultural commodities
5. Who are all the different kinds of participants in commodities markets?
6. Explain the linkages in the commodities markets?
7. What is corporate farming? Explain with an example?
8. Give a brief description about the contract farming?
9. Explain the following terms
a. Terminal markets
b. Futures markets
c. Electronic markets
10. How do you classify the markets based on competition?
11. What are the challenges faced by the commodities market?
12. Explain the recent innovations in commodities markets?
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Unit 2
Introduction to Commodity Exchanges
Structure
2.0 Objectives
2.1. Introduction to derivatives
2.2. Instruments available for trading
2.3 Commodity exchanges and futures trading
2.4 Evolution of futures trading
2.5 Commodity exchanges at global and national level
2.6 Exchange transactions
2.7 Let us sum up
2.8 Key words
2.9 Further readings
2.10 Check your progress
2.0 Objectives
On completing this unit you will be able to
Understand the meaning of derivatives
Futures contract and exchanges
Evolution of futures trading
Commodity exchanges in India
Structure and members of commodity exchanges and
How to trade in the commodity exchanges
Agri-Business and Entrepreneurship Development
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2.1. Introduction to Derivatives
In the world of liberalization it is most indispensable to predict the future. It becomes more
requisite for agriculture, which faces more flux than other sectors. So the Government of India
introduced commodity futures trading in India through commodity exchanges.
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.
Derivative markets can broadly be classified as commodity derivative market and financial
derivatives markets. As the name suggests, commodity derivatives markets trade contracts 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. Financial derivatives markets trade
contracts that have a financial asset or variable as the underlying. The main types of derivatives are
futures, forwards, options, and swaps.
a.a.a.a.a. FFFFFuturesuturesuturesuturesutures: A futures contract is an agreement between two parties to buy or sell the underlying
asset at a future date at a future price. Futures contracts differ from forward contracts in the
sense that they are standardized and exchange traded.
b.b.b.b.b. OptionsOptionsOptionsOptionsOptions: There are two types of options - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.
c.c.c.c.c. WWWWWarrantsarrantsarrantsarrantsarrants: Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer dated options are
called warrants and are generally traded over the counter.
d.d.d.d.d. SwapsSwapsSwapsSwapsSwaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts.
2.2. Instruments available for Trading
In recent years, derivatives have become increasingly popular due to their applications for
hedging, speculation and arbitrage. Before we study about the applications of commodity derivatives,
we will have a look at some basic derivative products. There are three derivative contracts namely
forward, futures and options trading.
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a. Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price. Other contract details like
delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
The salient features of forward contracts are
They are bilateral contracts and hence exposed to counter party risk.
Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality
The contract price is generally not available in public domain
On the expiration date, the contract has to be settled by delivery of the asset
If the party wishes to reverse the contract, it has to compulsorily go to the same counter party,
which often results in high prices being charged.
b. Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard
features of the contract. It is a standardized contract with standard underlying instrument, a standard
quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference
purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior
to maturity by entering into an equal and opposite transaction. Majority of the futures transactions are
offset this way.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery
The units of price quotation and minimum price change
Location of settlement
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Distinction between futures and forwards
OTC in nature
Customized contract terms hence less liquid
No margin payment
Settlement happens at end of period
Futures Forwards
Trade on an organized exchange
Standardized contract terms hence more liquid
Requires margin payments
Follows daily settlement
Futures Terminology
Spot priceSpot priceSpot priceSpot priceSpot price: The price at which an asset trades in the spot market.
FFFFFutures priceutures priceutures priceutures priceutures price: The price at which the futures contract trades in the futures market.
Contract cycleContract cycleContract cycleContract cycleContract cycle: The period over which a contract trades. The commodity futures contracts on the
exchanges have one-month, two-months and three-months expiry cycles.
Expiry dateExpiry dateExpiry dateExpiry dateExpiry date: It is the date specified in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
Delivery unitDelivery unitDelivery unitDelivery unitDelivery unit: The amount of asset that has to be delivered under one contract. For instance, the
delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the
Gold futures in MCX contract is 1 kg.
BasisBasisBasisBasisBasis: Basis can be defined as the futures price minus the spot price. There will be a different basis for
each delivery month for each contract. In a normal market, basis is positive. This reflects that futures
prices normally exceed spot prices.
Cost of carryCost of carryCost of carryCost of carryCost of carry: The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
Initial marginInitial marginInitial marginInitial marginInitial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
MarkingMarkingMarkingMarkingMarking-to-to-to-to-to-market (MTM):-market (MTM):-market (MTM):-market (MTM):-market (MTM): In the futures market, at the end of each trading day, the margin account
is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is
called marking to market.
Maintenance margin:Maintenance margin:Maintenance margin:Maintenance margin:Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the
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balance in the margin account never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.
Short position:Short position:Short position:Short position:Short position: The sale of a security or commodities futures not owned by the seller at the time of the
trade. Short sales are usually made in anticipation of a decline in the price.
LLLLLong Pong Pong Pong Pong Position: osition: osition: osition: osition: Owning a commodity with an anticipation of increase in prices.
c. Options trading
An option gives the holder of the option the right to do something but the holder does not have
the obligation to exercise this right. In contrast, in a forward or futures contract, the two parties have
committed themselves to the act of buying and selling. Whereas it costs nothing (except margin
requirements) to enter into a futures contract, the purchase of an option requires an up front payment.
2.3 Commodity Exchanges and Futures Trading
A commodity exchange is an association or a company or any other body corporate that is
organizing futures trading in commodities.
A commodity futures contract is a contractual agreement between two parties to buy or sell a
specified quantity and quality of commodity at a certain time in future at a certain price agreed at the
time of entering into the contract on the commodity futures exchange.
1. Structure of Commodities exchange
A Commodities Exchange is formed with the following objectives
To create a platform for the market participants
To bring professionalism and transparency into commodity trading
To inculcate best international practices like de-modularization, technology platforms, low cost
solutions and information dissemination without noise etc. into the trade
To provide nation wide reach and consistent offering
To bring together the entities that the market can trust
2. Exchange membership
Membership of exchanges is open to any person, association of persons, partnerships, cooperative
societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of the
exchange have to register themselves with the competent authority before commencing their operations.
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The members of Exchanges fall into two categories, Trading cum Clearing Members (TCM) and Professional
Clearing Members (PCM).
a.a.a.a.a. TTTTTrading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member -rading cum Clearing Member - An individual or corporate can be admitted by the
Commodity Exchange as a Trading-Cum-Clearing Member (TCM) conferring upon them a right
to trade and clear through the clearing house of the Commodity Exchange. Moreover, the member
may be allowed to make deals for themselves (proprietary positions) besides trading on
behalf of registered approved / authorized users and to clear/ settle them.
b.b.b.b.b. PPPPProfessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) -rofessional Clearing Member (PCM) - Any Financial Institution or Bank, which is registered
as PCM is conferred the right only to clear and settle trades through the clearing-house of the
exchange. They may clear and settle trades of such members of the exchange who choose to
do so through that PCM.
3. Participants in the futures trading
There are three types of participants in futures trading namely hedgers, speculators, and
arbitragers.
a.a.a.a.a. HedgersHedgersHedgersHedgersHedgers: a person who makes investment in order to reduce the risk of adverse price
movements in a commodity, by taking an offsetting position in a related commodity, such as
long and short position is called as hedger. Hedgers could be government institutions, private
corporations like financial institutions, trading companies and even other participants in the
value chain, for instance farmers, extractors, ginners, processors etc., who are influenced by
the commodity prices.
b.b.b.b.b. SpeculatorsSpeculatorsSpeculatorsSpeculatorsSpeculators: 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.
c.c.c.c.c. Arbitragers:Arbitragers:Arbitragers:Arbitragers: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.
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2.4 Evolution of Futures Trading
History of modern futures trading begins in 1848, the Chicago Board of Trade (CBOT) the
worlds first modern futures exchange was formed. Trading was originally in forward contracts; the
first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contracts were
introduced. Today, the futures markets have far outgrown their agricultural origins.
Organized futures market evolved in India by the setting up of Bombay Cotton Trade
Association Ltd. in 1875. Futures trading in Raw Jute and Jute Goods began in Calcutta with the
establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd
was set up in 1927 for organizing futures trading in Raw Jute. The most notable amongst them was
the Chamber of Commerce at Hapur, which was established in 1913. Futures market in Bullion
began at Mumbai in 1920 and later similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur,
Delhi and Kolkata.
After independence, the Constitution of India brought the subject of Stock Exchanges and
futures markets in the Union list. As a result, the responsibility for regulation of commodity futures
markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee
headed by Prof. A.D.Shroff and Select Committees of two successive Parliaments and finally in
December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.
After the introduction of economic reforms since June 1991 and the consequent gradual
trade and industry liberalization in both the domestic and external sectors, the Govt. of India appointed
in June 1993 one more committee on Forward Markets und Chairmanship of Prof. K.N. Kabra. The
Committee recommended that futures trading be introduced in Basmati Rice, cotton, Jute, oilseeds,
silver and onions.
The liberalized policy being followed by the Government of India and the gradual withdrawal
of the procurement and distribution channel necessitated setting in place a market mechanism to
perform the economic functions of price discovery and risk management.
The National Agriculture Policy announced in July 2000 and the announcements of Honble
Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to
put in place a mechanism of futures trade/market. As a follow up the Government issued notifications
on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications
futures trading is not prohibited in any commodity. Options trading in commodity are, however
presently prohibited.
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FFFFForward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC)orward Market Commission (FMC) is a regulatory authority for all Commodity Derivatives
Exchanges in India, which is overseen by the Ministry of Consumer Affairs and Public Distribution,
Government of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation)
Act, 1952.
The functions of the FThe functions of the FThe functions of the FThe functions of the FThe functions of the Forward Markets Commission are as follows:orward Markets Commission are as follows:orward Markets Commission are as follows:orward Markets Commission are as follows:orward Markets Commission are as follows:
(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition
from any association or in respect of any other matter arising out of the administration of the
Forward Contracts (Regulation) Act 1952.
(b) To keep forward markets under observation and to take such action in relation to them, as it
may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c) To collect whenever the Commission thinks it necessary, to publish information regarding the
trading conditions in respect of goods to which any of the provisions of the act is made
applicable, including information regarding supply, demand and prices, and to submit to the
Central Government, periodical reports on the working of forward markets relating to such
goods;
(d) To make recommendations generally with a view to improving the organization and working
of forward markets;
(e) To undertake the inspection of the accounts and other documents of any recognized association
or registered association or any member of such association whenever it considerers it
necessary.
2.5 Commodity Exchanges at Global and National level
1. Commodity Exchanges at National level
The Government, in order to make the commodities market more transparent and efficient,
accorded approval for setting up of national level multi commodity exchanges. Accordingly three
national level exchanges are there which deal in a wide variety of commodities and which allow
nation-wide trading. They are
a. National Commodities Derivatives Exchange (NCDEX)
b. Multi Commodity Exchange (MCX)
c. National Multi Commodity Exchange (NMCE)
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Today commodity exchanges are offering spectacular growth opportunities and advantages to a
large cross section of the participants including Producers / Processors, Traders, Corporate, Regional
Trading Centers, Importers, Exporters, Cooperatives and Associations.
a. National Commodities Derivatives Exchange (NCDEX)
NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an
independent Board of Directors and professionals. It is a professionally managed by ICICI Bank, LIC,
NABARD and (NSE). NCDEX is a public limited company incorporated on April 23, 2003 under the
Companies Act, 1956.
Important Commodities traded at NCDEX
Commodity Unit of price
quotation
Unit of trading Yield/Re.
Movement
Precious metals
Gold
Kilo gold
Silver
Agricultural products
Soya oil
Cotton-l
Mustard
Mustard oil
Palmolein oil RBD
Pepper
Chana
Guar seeds
Rubber
10gm
10gm
1kg
10KG
1 T
20KG
10KG
10KG
1 T
1 T
1 T
1 T
100gm
1000gm
5KG
1000kg
11 bales
1000kg
1000kg
1000kg
1000kg
10000kg
10000kg
1000kg
10.00
100.00
5.00
100.00
18.70
50.00
100.00
100.00
10.00
100.00
100.00
10.00
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b. Multi Commodity Exchange (MCX)
MCX an independent and de-mutulised multi commodity exchange established on November
2003. It has permanent recognition from Government of India for facilitating online trading, clearing
and settlement operations for commodity futures markets across the country. Key shareholders of
MCX include Financial Technologies (I) Ltd., State Bank of India & associates, Fidelity International,
National Stock Exchange of India Ltd. (NSE) and National Bank for Agriculture and Rural Development
(NABARD).
Important Commodities traded at MCX
Commodity Unit of price
quotation
Unit of trading Yield/Re.
MovementPrecious metals
Gold-m
Gold
Silver-m
Silver
Agricultural products
Soya
Soya oil
Crude palm oil
Rbd palmolein
Castor seed
Castor oil
Ground nut oil
Gaur seed
Black pepper
Rubber
Kapas
Industrial metals
Steel long
Steel flat
Copper
Nickel
Tin
10gm
10gm
1kg
1kg
1 t
10kg
10kg
10kg
100kg
10kg
10kg
100kg
100kg
100kg
20kg
1 t
1 t
1kg
1kg
1kg
100gm
1000gm
5kg
30kg
10 t
1000kg
1000kg
1000kg
1 t
1 t
1 t
5 t
1 t
25 t
4 t
25 t
25 t
1 t
250kg
500kg
10.00
100.00
5.00
30.00
10.00
100.00
100.00
100.00
10.00
100.00
100.00
50.00
10.00
250.00
200.00
25.00
25.00
1000.00
250.00
500.00
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c. National Multi Commodity Exchange of India Limited
National Multi Commodity Exchange of India Limited (NMCEIL) is the first de-mutualized,
Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was granted approval by the
Government to organize trading in the edible oil complex. It has operationalized from November
26, 2002. It is being supported by Central Warehousing Corporation Ltd., Gujarat State Agricultural
Marketing Board and Neptune Overseas Limited. It got its recognition in October 2002.
Apart from these national exchanges there are other regional commodities exchanges in
India, which are listed below. Most of these commodity exchanges are offline and commodity specific.
Registered commodity exchanges in India
Bhatinda Om & Oil Exchange Ltd.
The Bombay Commodity Exchange Ltd.
The Rajkot Seeds oil & Bullion Merchants Association, Ltd. Castorseed
The Kanpur Commodity Exchange Ltd.
The Meerut Agro Commodities Exchange Co. Ltd.
The Spices and Oilseeds Exchange Ltd.Sangli
Ahmedabad Commodities Exchange Ltd.
Vijay Beopar Chamber Ltd., Muzaffarnagar
India Pepper & Spice Trade Association, Kochi
Rajdhani Oils and Oilseeds Exchange Ltd., Delhi
National Board of Trade, Indore
The Chamber of Commerce, Hapur
The East India Cotton Association, Mumbai
The Central India Commercial Exchange Ltd., Gwaliar
The East India Jute & Hessian Exchange Ltd., Kolkata
First Commodity Exchange of India Ltd., Kochi
The Coffee Futures Exchange India Ltd., Bangalore
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2. Global Commodities Exchanges
a.a.a.a.a. Chicago Board of TChicago Board of TChicago Board of TChicago Board of TChicago Board of Traderaderaderaderade
Chicago Board of Trade was established in 1948 and has been trading in agricultural produce,
interests, metals and US treasuries, soya complex, wheat and corn prices across the world are
referenced here. It has both electronic as well as open cry system of trading. It trades both in futures
as well as options.
b.b.b.b.b. New YNew YNew YNew YNew York Board of Tork Board of Tork Board of Tork Board of Tork Board of Trade (NYBOrade (NYBOrade (NYBOrade (NYBOrade (NYBOT)T)T)T)T)
New York Board of Trade (NYBOT) is the worlds largest commodities exchange for Coffee,
Sugar, Cotton and Frozen Concentrated Orange Juice. The exchange was founded as the New York
Cotton Exchange in 1870. NYBOT also facilitates trades in foreign currencies and derivative indices
for equities.
c.c.c.c.c. Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)
Chicago Mercantile Exchange (CME) is the largest futures exchange in US. The exchange
trades in interest rates, equities, foreign exchange and agricultural commodities. It has both open cry
as well as electronic trading systems. Agricultural commodities traded on the exchange include dairy
products (butter, milk cheese) and live stock futures.
d.d.d.d.d. LLLLLondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)ondon Metal Exchange (LME)
London Metal Exchange trades in Metals and non-ferrous metals like aluminum, copper,
lead, nickel, tin and zinc. Consumers as well as producers of metals use the official prices of LME for
their long-term contracts pricing. There are over 400 LME approved warehouse in some 32 locations
covering USA, Europe, the middle & the Far East. (At the moment there is none in India)., The
exchange has both open outcries as well as electronic system for trade.
e.e.e.e.e. New YNew YNew YNew YNew York Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)ork Mercantile Exchange (NYMEX)
New York Mercantile Exchange in its current form was created in 1994 by the merger of the
former New York Mercantile Exchange and the Commodity Exchange of New York (COMEX). Together
they represent one of worlds largest exchanges for precious metals and energy.
fffff..... TTTTTokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (Tokyo Commodity Exchange (TOCOM)OCOM)OCOM)OCOM)OCOM)
Tokyo Commodity Exchange (TOCOM) is the largest exchange in Japan and second largest
commodity exchange in the world for futures and options. Crude oil, gasoline, kerosene, gas oil,
gold, silver, aluminum, platinum and rubber are the commodities that are actively traded.
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e.e.e.e.e. Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)Dubai Gold & Commodity Exchange (DGCX)
Dubai Gold & Commodity Exchange (DGCX) was formed in Dubai by joint participation of
Dubai government as well as MCX and FTIL. Dubai has an advantage of its location of serving all
time zones.
fffff..... Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)Dubai Mercantile Exchange (DME)
Dubai Mercantile Exchange (DME) is a joint venture between a Dubai holding, the New York
Mercantile Exchange (NYMEX) and the Oman Investment Fund (OIF). It is a premier international
energy futures and commodities exchange in the Middle East.
2.6 Exchange Transactions
There are three components in exchanges transaction viz: trading, clearing and settlement.
1. Trading
The trading system on the electronic exchanges provide a fully automated screen based trading
for futures on commodities on a nationwide basis as well as an online monitoring and surveillance
mechanism, which is called as terminal. It supports an order driven market and provides complete
transparency of trading operations. The system supports an order driven market, where orders match
automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All
quantity fields are in specified units and price in rupees. The exchange specifies the unit of trading and
the delivery unit for futures contracts on various commodities. The exchange notifies the regular lot size
and tick size for each of the contracts traded from time to time. When any order enters the trading
system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a
trade is generated. If it does not find a match, the order becomes passive and gets queued in the
respective outstanding order book in the system. Electronic recording is done for each trade and this
provides the possibility for a complete audit trail if required.
a.a.a.a.a. How to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchangeHow to invest/trade in commodities exchange
The following diagram should give an investor/trader clear understanding of how to go about
investing/trading in commodities market. The prerequisite for trading in commodities markets are
a.1a.1a.1a.1a.1 Client codeClient codeClient codeClient codeClient code: The client who is interested to trade in commodity exchanges has to open a
trading account with a commodity broker by signing the client agreement form. The broker
in turn submits the details to the TCM and PCM of the exchanges. The validity of client
agreement will be verified in the exchanges and specific client code is allotted to trade in the
exchanges.
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a.2. Depositing initial margin
An initial amount has to be deposited by a customer at the time of entering into a contract, which
is termed as initial margin. The initial margin will differs based on the commodities. The exchanges fix the
margin for each commodity and it is a small percentage (5-6%) of the value of the lot.
Procedure for opening client-trading account
a.3a.3a.3a.3a.3 TTTTTrading processrading processrading processrading processrading process
The next step is trading in the exchange terminal. The client has to place his trade with broker
through NCDEX/MCX terminals. The trade placed at brokers terminal is submitted to the exchange
terminal. When any order enters the trading system, it is an active order. It tries to find a match on the
other side of the book. If it finds a match, a trade is generated. From the exchange terminal the trade
confirmation is sent to the broker and broker in turn gives the trade confirmation to the client.
a.4a.4a.4a.4a.4 PPPPPayayayayay-in / P-in / P-in / P-in / P-in / Payayayayay-----outoutoutoutout
NCDEX/MCX
BROKER BROKER BROKER
CLIENT CLIENT CLIENT CLIENT CLIENT CLIENT
Client opens trading account, by signing Client Agreement with the Broker
Commodity Broker, TCM/PCM Member of the Exchange
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PAY-IN PAY-OUT
NCDEX/MCX
BROKER
CLIENT
Daily exchanges calculate the difference of the entry value and closing price of the particular
date. If the difference is positive the exchanges credit that particular amount into the client account.
In case the difference is negative, the exchanges deduct that particular amount from the credit
account. If the account does not have balance then pay in request is sent to the clients.
2. Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed
on the exchanges. The settlement guarantee fund is maintained and managed by exchanges. Only
clearing members including Professional Clearing Members (PCMs) are entitled to clear and settle contracts
through the clearinghouse. At exchanges, after the trading hours on the expiry date, based on the
available information, the matching for deliveries takes place firstly, on the basis of locations and then
randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities
already deposited and dematerialized and offered for delivery etc. Matching done by this process is
binding on the clearing members. After completion of the matching process, clearing members are
informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions
have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the
basis of final settlement price.
3. Settlement
Futures contracts have two types of settlements, the MTM settlement, which happens on a
continuous basis at the end of each day, and the final settlement, which happens on the last trading
day of the futures contract. On the Exchanges, daily MTM settlement and final MTM settlement in
respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing
accounts of CM (Clearing Member) with the respective clearing bank. All positions of a CM, either
brought forward created during the day or closed out during the day, are marked to market at the
daily settlement price or the final settlement price at the close of trading hours on a day. On the date
of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement
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is on a trading cum clearing member for all trades done on his own account and his clients trades. A
professional clearing member is responsible for settling all the participants trades, which he has confirmed
to the exchange. On the expiry date of a futures contract, members submit delivery information through
delivery request window on the trader workstations provided by the exchanges for all open positions for
a commodity for all constituents individually. Exchanges on receipt of such information match the
information and arrive at a delivery position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated warehouse. These
commodities have to be assayed by the exchange specified assayer. The commodities have to meet the
contract specifications with allowed variances. If the commodities meet the specifications, the warehouse
accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a
credit in the depositors electronic account. The seller then gives the invoice to his clearing member, who
would courier the same to the buyers clearing member. On an appointed date, the buyer goes to the
warehouse and takes physical possession of the commodities.
2.7 Let us Sum Up
The agricultural sector in India is facing more flux in prices than other sector. So the government
of India introduced commodity futures trading in India through commodity exchanges. A commodity
exchange is an association or a company or any other body corporate that is organizing futures
trading in commodities. The members of Exchanges are Trading cum Clearing Members (TCM) and
Professional Clearing Members (PCM). While the participants of futures trading are hedgers,
speculators, and arbitragers.
Organized futures market evolved in India by the setting up of Bombay Cotton Trade
Association Ltd. in 1875. The consequent gradual trade and industry liberalization in both the
domestic and external sectors emphasized the need for futures trading and on 1.4.2003 the
Government permitted futures trading in the commodities. The national commodity exchanges in
India are National Commodities Derivatives Exchange (NCDEX), Multi Commodity Exchange (MCX)
and National Multi Commodity Exchange (NMCE)
Globally, the major commodity exchanges are New York Mercantile Exchange, Chicago
Board of Trade, New York Board of Trade, Chicago Mercantile Exchange and London Metal Exchange.
Exchange transactions involve trading, clearing and settlement. To start trading the participant has to
create trading account in exchange and has to place the trades at broker terminals. The exchanges
undertake the pay in and pay out of trades executed. National Securities Clearing Corporation
Limited (NSCCL) undertakes clearing of trades executed on the exchanges. At last the contracts are
settled.
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2.8 Key Words
Contract expiration: Derivatives contracts expire on a predetermined date and time up to which the
contract is available for trading. This is notified by the exchange in advance. The contract expiration
period will not exceed twelve months or as the exchange may specify from time to time.
Contract Specification - Contract specification is a document, which provides detailed guidelines
and parameters of any relevant commodity traded on the exchange. The contract ensures the standards
of commodity futures through various parameters such as trading details, contract duration or expiry
date, quality parameters, delivery mode and its details. It includes every possible detail for the successful
execution of the trade conducted on the exchange. These include trading lot, price quote, order size,
tick size, limits of daily price, margin and open positions, delivery centers, settlement price and
procedure, tender / delivery period, taxation, legal obligation, etc.
Delivery - The tender and receipt of the actual commodity, the cash value of the commodity or of
a delivery instrument covering the commodity (e.g., warehouse receipts) used to settle a futures
contract.
Lot size: The permitted trading lot size for the futures contracts on individual commodities is stipulated
by the exchange from time to time. The lot size currently applicable on individual commodity contracts.
Mark-to-Market (MTM)- At the end of every trading day, the margin account of the trader / client
is adjusted to reflect the participants gain or loss. The price changes on the close of every trading
day may result in some gain or loss as compared to the previous days closing price. These price
variations are netted into the daily margin account. This process is known as marking to the market.
Outcry: Open outcry trading is a face to face and highly activate form of trading used on the floors
of the exchanges.
Over-the-Counter (OTC): Trading is to trade financial instruments such as stocks, bonds,
commodities or derivatives directly between two parties. It is contrasted with exchange trading, which
occurs via corporate-owned facilities constructed for the purpose of trading
Pay in - It refers to the transfer of funds from the buyer-members settlement account to the exchange
before he takes delivery of the commodity from the exchange specified warehouse.
Payout - It refers to the transfer of funds to the selling-members settlement account from the
exchange, after the buyer lifts the commodity.
Tic Size: It is the minimum jump in the price.
Trading cycle: Trading cycle for each commodity/ derivative contract has a standard period,
during which it will be available for trading.
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Trading hours: The exchange announces the normal trading hours/ open period in advance from time
to time. In case necessary, the exchange can extend or reduce the trading hours by notifying the members.
Unit of price quotation: Unit of price quotation is the price shown on the trading screen.
Unit of trading: Unit of trading or lot size or contract size is all unanimous. Lot size is the minimum size
of the derivatives, futures or options contract.
Yield / Rupee = Lot Size (Unit of Trading)/ Unit of price quotation.
2.9 Further Readings
Derivatives FAQ by Ajay Shah and Susan Thomas
Options, futures and other derivatives by John Hull.
http://www.ncdex.com
http://fmc.gov.in
2.10 Check Your Progress
1. What are commodity futures?
2. Who is the watchdog of futures trading?
3. Define TCM
4. What are the benefits of commodity exchanges?
5. Brief the structure of commodity exchanges?
6. Explain the exchange transactions in brief?
7. How commodity exchanges evolved into India?
8. What are the commodities identified for trading?
9. What are the benefits in futures trading in commodities?
10. How would contracts settle?
11. What happens when the commodities reach the validity date?
12. Explain pay in and pay out in the commodity futures?
13. What is NMCEIL and who are the promoters of NMCEIL ?
14. What are the key commodity exchanges in India
15. What do you mean by lot size?
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Unit 3
Futures Exchange and Risk Management
Structure
3.0 Objectives
3.1. Price risk
3.2 Causes of price risk
3.3. Methods of tackling price risks
3.4. Evaluation of methods for their efficiency and limitation
3.5. Hedging
3.6. Advantages of hedging
3.7 Basic principles of hedging
3.8. Limitation of hedging
3.9 Types of hedging
3.10 Hedge ratio
3.11 Let us sum up
3.12 Key words
3.13 Further readings
3.14 Check your progress
3.0 Objectives
This unit has been designed to help you to understand
Price risk, causes of price risks
Methods of handling price risk
Hedging, advantages and limitations of hedging
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Types of hedging-long hedge
Short hedge and cross hedge and hedge ratio
3.1 Price Risk
Risk has always been a part of agriculture. The rate of price volatility in agricultural produce
would create uncertainty and risks, which could hamper the performance of the agricultural sector
and negatively impact the income and welfare of the farmers. Besides, it will have a negative impact
on overall economic growth, income distribution and poverty alleviation. Therefore understanding
agricultural risks and the ways for managing it becomes important. Price volatility is perhaps the
most pressing issue facing the producers of primary commodities.
Agricultural production implies an expected outcome or yield to achieve the expected returns.
Variability in outcomes from those, which are expected, poses risks to the ability to achieve financial
goals. In this context Price risk is basically the risk that returns from the investment in physical
agricultural goods or commodities will be reduced or lost due to a fall in the future market price of
the commodity owned. Here it is important to understand the difference between risk and variability.
It is well known that agricultural prices vary from month to month and year to year. However, if the
variation were predictable, farmers would face no price risk. There are many numbers of risks that
are associated with the agricultural commodities, especially at the production, storage, transport,
marketing and processing stages. Hence it becomes important to identify the cause for price risks
and manage them.
3.2 Causes of Price Risks
a. Production Risks
As the demand for agricultural products is inelastic, supply shocks caused due to production
variations are magnified in price variations. Agricultural production risks may be due to those arising
out of weather related factors, pests or diseases, farm and management practices, genetics, machinery
efficiency, quality of inputs and also due to risks from variable prices.
b. Financial or Credit Risk
Farm credit has always been an important factor in improving agricultural productivity and
strengthening the rural economy. However, complicated operational mechanism of farm credit services,
high transaction costs, uncomfortable repayment schedules, higher interest rates, lower access to
credit, heavy reliance on money lenders, insolvency problems etc have increased the associated
price risks of the commodities.
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c. Institutional Risks
If Government policy framework may come unwarranted that would create a profound impact
on the prices. The government intervention sometimes instead of protecting may result in distortion
of trade, as it does not let the natural market forces of supply and demand in identifying the prices.
Eg. Reform measures like restriction on storage and movement of produces, direct price support
measures, subsidies etc.
d. Market linked Risks
In a developing economy like India, wild swings in market prices due to supply and demand
factors arise due to nascent nature of such markets. Lack of participation, non-availability or low
dissemination of market information, infrastructure bottlenecks, market structure etc tend to increase
the price risks.
3.3 Methods of Tackling Price Risks
a. Handling price risks
Price risks may be handled in any one of the following ways. They may be
1) Retained holding the risk, that is taking no protection for the downside risk
2) Avoided Risks can be avoided fully by going for a totally new venture
3) Reduced risks can be reduced or mitigated by different possible ways in order to get someassured income.
b. Self-insurance
Here the farmers use the previous periods accumulated savings to protect themselvesagainst uncertainties that they cannot control.
c. Crop storage It is a means of avoiding seasonally low prices when there is expectation of
price fall in the season and adequate price rise later. However financial resources and storagespace are required which may limit the scope of this kind of risk management.
d. Diversification It is the combining of different production processes so that low income in
one will be offset by higher income from other enterprises. It can include growing of differentcrops or different types of the same crop, mixed farming with combining crops and livestocketc.
e. Taking credit The farmers may lean on to credit given by government banks, co-operative
societies, commercial banks, etc as well as money lenders. If collateral is insisted on advancingof the loan then this measure may not be feasible for poor farmers.
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f. Contract farming Contract farming is normally associated with vertical integration, where
an agribusiness firm coordinates all aspects of a producer from production to obtaining the
end produce. Here a stable market or price is guaranteed.
g. Crop Insurance Insuring a crop against the risks basically gives protection against the
losses and also sometimes offers opportunity for gains.
h. Hedging in futures
With the advent of futures, the use of futures and other derivative products to manage risk
has turned out to be one of the most important and practical innovations in evolving market economies.
Of all the measures intended to reduce risk in futures, hedging is a concept that gains utmost
importance and is used as a financial offset to cash market risks, prevalently. Here the risk averse
producers can buy protection from the risk taking speculators looking for profit.
Hedging is defined as, the establishing of a position in the futures market that is equal and
opposite the po