Commodity FAQ

What is a Derivative contract?
A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset; the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads

What is a forward contract?
A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.

What is a futures contract?
Futures Contract is specie of forward contract. Futures are exchange - traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.

How many commodities are permitted for futures trading ?
With the issue of the Notifications dated 1.4.2003 futures trading is not prohibited in any commodity. Futures trading can be conducted in any commodity subject to the approval /recognition of the Government of India. At present 105 commodities are in the regulated list i.e. these commodities have been notified under section 15 of the Forward Contracts (Regulation) Act. Forward trading in these commodities can be conducted only between, with, or through members of recognized associations. The commodities other than those listed under Section 15 are conventionally referred to as `Free` commodities. Forward trading in these commodities can be organized by any association after obtaining a certificate of Registration from Forward Markets Commission.

What is daily settlement price?
The daily settlement price is the price at which all the outstanding trades are settled, i.e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.

Can a buyer demand delivery against futures contract?
Most of the contracts in agricultural commodities traded at the Exchanges are ``Compulsory Delivery Contracts`` i.e all the outstanding position on the maturity of the contracts has to compulsory result in deliveries. The failure on the part of either buyer or seller to give/take deliveries attracts penalties with are prescribed in the Bylaws, Rules and Regulations of the Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some of the contracts provide the buyer and seller matches the delivery takes place.
The participants before entering in to a futures contracts are expected to make themselves abrast with the delivery logic of the contract as the same differs across Exchange and commodities

What is delivery month?
It is the specified month within which a futures contract matures.

What is Warehouse Receipt?
It is a document issued by a warehouse indicating ownership of a stored commodity and specifying details in respect of some particulars, like, quality, quantity and, some times, indicating the crop season.

What is hedging?
Hedging is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/ cash markets to cover their price risk by taking opposite position in the futures market.

Who are the participants in forward/futures markets?
Participants in forward/futures markets are hedgers, speculators, day-traders/ scalpers, and, arbitrageurs.

Who is hedger?
Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset. Hedgers are those who have an underlying interest in the commodity and are using futures market to insure themselves against adverse price fluctuations. Examples could be stockists, exporters, producers, etc. They require some people who are prepared to accept the country-party position(speculators)

What is arbitrage?
Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, resulting in risk-less profit. to the arbitrageur.

What kinds of risks do participants face in derivatives markets?
Different kinds of risks faced by participants in derivatives markets are:
a) credit risk
b)market risk
c) liquidity risk
d) legal risk
e) operational risk

What are the different types of margins payable on futures?
Different margins payable on futures contracts are: i. ordinary/initial margin, ii.mark-to-market margin, iii. special margin, iv volatility margin and v. delivery margin.

What is initial/ordinary margin?
It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contracts. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.

What is Mark-to-Market margin?
Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is entered into on that day) or the previous day`s clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.

Can a security broker obtain the membership of a Commodity Exchange?
The Forward Contracts (Regulation) Act, 1952 does not prohibit security broker from obtaining membership of a Commodity Exchanges. Certain restrictions are however, imposed on a security broker from participating in the Commodity Exchanges under Securities Contracts (Regulation) Rules, 1952. Notification has been issued removing such a restriction. The security broker will however have to set up a subsidiary - a separate legal entity - with separate capital adequacy and minimum networth for being able to trade on a commodity exchange.

What is bucketing?
Broker is said to be indulging in bucketing, when he takes directly or indirectly, the opposite side of a customer`s order either on his own account or into on account in which he or she has an interest, without executing the order on an Exchange. Appropriation of clients` trade without written consent constitutes contravention of Section. 15(4) of the Act and is punishable under Section. 20(e).

What is Options in goods?
Options in goods is an agreement by whatever name called, like, Teji- Mandi, Jota Fatak, Najrana, under which buyer of the option (called as applier) pays a premium to the seller of option (called as writer of the option) for acquiring from him right to buy or sell the goods at a mutually agreed rate (called as strike price), in respect of which the premium amount is paid. When the buyer acquires right to buy, it is called as a ``call`` (Teji) and when he acquires right to sell it is called a ``put`` (Mandi) option. It is possible to acquire a rights both to buy and to sell the goods; but in this case higher premium amount would have to be paid. The buyer acquires only right, i.e., he is under no obligation to buy or sell, as the case may be, at the mutually agreed price. Options in goods are presently prohibited under section 19 of the Act. There is a proposal to amend the Act to allow options in goods under regulated conditions