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How the commodity market works
Commodity Online | March 15, 2007 14:14 IST
Last Updated: March 15, 2007 14:49 IST
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
Types of derivative contracts
Forwards: A forward contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price.
Futures: Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. Options: there are two types of options -- call and put.
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.
Swaps: 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.
Participants in derivative contracts
Hedgers: They are in the position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk. For example, a farmer may use futures or options to establish the price for his crop long before he harvests it.
Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. The farmer can watch prices discovered in trading at the commodity exchange and when they reflect the price he wants, sell futures contracts to assure him of a fixed price for his crop.
Hedging usually presupposes that the spot and futures markets of any commodity move in the same direction and by almost the same magnitude. But this relationship depends on the amount of carrying or storage costs till the maturity month of the futures contract. Normally when the stocks are abundant, the futures price will exceed the spot price by the cost of storage till the maturity month of the futures contract. This is called as 'Contango.'
The cost of storage declines toward the maturity month of the futures contract thereby resulting in convergence of futures price with the spot price. But at times the futures price may even fall below the spot price when there are scarce stocks or there seems to be uncertainty in deliveries. This is called as 'Backwardation.'
Speculators: Speculators wish to bet on the futures movement in the price of an asset. They use derivatives to get extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.
Arbitrageurs: They are in the business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the future prices of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Functions of Derivative Markets
Derivative markets perform a number of economic functions.
Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.
Derivatives, due to their inherent nature are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.
Benefits to Commodity Trading Participants
Hedging the price risk associated with futures contractual commitments.
Spaced out purchases possible rather than large cash purchases and its storage.
Efficient price discovery prevents seasonal price volatility.
Greater flexibility, certainty and transparency in procuring commodities would aid bank lending.
Facilitate informed lending.
Hedged positions of producers and processors would reduce the risk of default faced by banks.
Lending for agriculture sector would reduce the risk of default faced by banks.
Commodity exchanges to act as distribution network to retail agri-finance from Banks to rural households.
Provide trading limit finance to traders in commodities exchanges.
Options: There are two types of options - call and put. 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. Put gives 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.
Swaps: 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.