Commodity Derivatives

What is a commodity?

A commodity is an article or product that is used for commerce, is movable, has a value, can be bought and sold and that is produced or used as a subject in a barter or sale. Commodities are traded in the physical markets and in future markets.


Who are the major participants of the commodity market?

Producers, Traders and Brokers, Processors, Distributors, Packagers, Wholesalers and Retailers are the major Participants.


Which is the oldest Commodity Exchange?

Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) are the oldest ones.


Who are Hedgers, Speculators and Arbitrageurs?

Hedgers protect themselves by buying and selling futures contracts to offset the risks of changing prices in the spot market. Speculators engaged in buying or selling to take advantage of price movements. While the objective of hedgers is to avoid risks, speculators are more willing to accept risks. Arbitrageurs capitalize on price differences between markets.


What is a Closing Out?

It is the opposite transaction effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is closed out by a buy.


What is an OTC?

OTC or Over-The-Counter is a market conducted directly between dealers and principals via a telephone and computer network rather than an Exchange trading floor. Unlike an Exchange, there is no automatic disclosure of the price of deals to other market participants, and the deals and traded instruments are not standardized.


What is a Commodity SWAP?

A derivative contract, where two counterparties exchange one stream of cash flows against another stream is known as SWAP. And a SWAP where exchanged cash flows are dependent on the price of an underlying commodity is known as Commodity Swap. This is commonly used to hedge against the price of a commodity. E.g. oil.


What is a Payoff?

A payoff is the profit or loss that is likely to be faced by the market participants with changes in the price of the underlying asset. Payoff diagrams are used to graphically represent these, with the price of the underlying being plotted on the X axis and the Profit or Loss on the Y axis.


How are Commodity derivatives differ from Financial derivatives?

Commodity derivatives differ from financial derivatives in terms of physical settlement, need for warehousing and the importance of the quality of the underlying commodities.


What is a Derivative contract & what is Commodity future?

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.

Commodity future is a contract to buy or sell specific commodity, of a specific quality, at a specific price, for a specific future date on the exchange.


What is the difference between spot market and futures market?

In a spot market, commodities are physically bought or sold usually on a negotiable basis resulting in delivery. While in the futures markets, commodities can be bought or sold irrespective of the physical possession of the underlying commodity. The futures market trades in standardized contractual agreements of the underlying asset with specific quality, quantity, and mode of delivery whose settlement is guaranteed by regulated commodity exchanges.


What are the benefits of futures trading in commodities?

The biggest advantage of trading in commodity futures is price risk management and price discovery. Farmers can protect themselves against undesirable price movements and decide upon cropping pattern. The merchandisers avoid price risk. Processors keep control on raw material cost and decreasing inventory values. International traders also can lock in their prices.


What is hedging?

Hedging means taking a position in the futures or options market that is opposite to a position in the physical market. It reduces or limits risks associated with unpredictable changes in price. The objective behind this mechanism is to offset a loss in one market with a gain in another.


What are Short Hedges and Long Hedges?

When the cash commodities are sold, the open futures position is closed by purchasing an “equal number and type” of futures contracts as those initially sold. This is called short or a selling hedge. Long or purchasing hedge involves buying futures contracts to protect against a possible increase in the price of cash commodities in the future. At the time of purchase of the physical commodities, the futures position is closed by selling an “equal number and type” of futures contracts as those were initially purchased.


What is a Basis?

Basis is the difference between the futures price and the spot price. Generally for commodities, it is defined as spot price – futures price (S-F) as against the futures price – spot price (F-S) for financial assets.


What is arbitrage in commodity markets?

Arbitrage is making purchases and sales simultaneously in two different markets to profit from the price differences prevailing in those markets. The factors driving arbitrage are the real or perceived differences in the equilibrium price as determined by supply and demand at various locations.


Is an ISIN number also allotted to commodity like in equities?

Yes, the identifier is called as ICIN. Depending on the type of commodity, grade, validity, expiry date, name & location of warehouse, the exchanges allot ICIN to each commodity. ICIN differs from exchange to exchange.


What is cost-of-carry?

For physical commodities such as grains and metals, the cost of storage space, insurance, and finance charges incurred by holding a physical commodity.


What is Delivery in Commodity Derivatives?

The tender and receipt of the actual


What is the meaning of Basis?

Basis is the difference between the spot price of an asset and the futures price of the same asset underlying. The spot price is the ready price prevailing in the physical commodity market while the futures price is the price of any specific contract that is prevailing in the exchanges where it is traded.


What is meant by basis risk?

Generally, the spot price of a commodity and future price of the same underlying commodity do not change by the same amount during the life of the futures contract. This uncertainty in the variation of basis is known as basis risk.


What is “Contango” in commodity trading?

When the futures price is above the expected future spot price. Consequently the price will decline to the spot price before the delivery date.


What is initial margin?

It is the minimum percentage of the contract value required to be deposited by the members/clients to the exchange before initiating any new buy or sell position. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.


What do you mean by delivery period margin?

It is the extra margin imposed by the exchange on the contracts when it enters the concluding phase i.e. it starts with tender period and goes up to delivery/settlement of trade. This amount is applicable on both the outstanding buy and sell positions.


What is Mark-to-market (MTM)?

Mark-to-market margins (MTM or M2M) 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.


What is meant by the term “tender period”?

The contract enters into the tender period a few days before the expiry. This enables the members to express their intention whether to give or take delivery.


What is meant by due date rate?

It is the rate at which the contract is settled on the expiry date. Usually it is the average of the spot prices of the last few trading days (as specified by the exchange) before the contract maturity.


What is meant by spread?

Spread is the difference between prices of two futures contracts of the same underlying commodity. Futures market can be a normal market or an inverted market. If the price of the far month futures contract is higher than the near month one, then it is referred to as “normal market”. On the other hand, if the price of a far month futures contract is lower than the near month one, then the situation can be referred to as “inverted market”.


What do you mean by rolling over of hedge positions?

Rolling over of hedge position means the closing out of existing position in the futures contract and simultaneously taking a new position in a futures contract with a later date of expiry.


What is calendar spread?

A calendar spread means taking opposite positions in futures contract of the same commodity with different expiry dates. It is also known as an intra-commodity spread.


What do you mean by convergence of futures price with spot price?

A movement in the price of a futures contract towards the price of the underlying cash commodity, as the contract nears expiration.