18.9 How commodity market is organised in India?
In India, commodity trading is taking place through spot market and forward and futures contracts. Spot Market results in immediate delivery of a commodity for a particular consideration between the buyer and the seller. Buyers and sellers meet face to face and deals are struck. These are traditional markets. Example of a cash market is a mandi where food grains are sold in bulk. Farmers bring their products to this market and merchants/traders immediately purchase the products and settle the deal in cash and take or give delivery immediately. In case of forward market and futures markets, agreements are normally made to receive the commodities at a later date in future for a pre-determined consideration based on agreed upon terms and conditions. We shall discuss below in detail about each of these markets:
Spot Market
Spot markets are those in which the commodity is traded immediately in exchange for cash or some other good. You go to the local jewellery store and buy an ounce of gold. That’s a spot trade. You pay the jeweller in cash, he gives you an ounce of gold, usually in the form of a coin, ‘on the spot’. Other traders exchange commodities on spot markets in much greater quantities – thousands of ounces of gold or millions of barrels of crude oil. Spot trading is any transaction where delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints. Spot trading normally involves visual inspection of the commodity or a sample of the commodity, and is carried out in markets such as wholesale markets. Commodity markets, on the other hand, require the existence of agreed standards so that trades can be made without visual inspection.
Please note that the spot market in commodities is controlled to a large extent by the State Governments therefore taxation and governance differ from state to state. There are restrictions on holding of stocks, turnover and movement of goods and there are variations in the duties levied by the different State Governments. This fragments the commodity spot markets and impedes the commodity futures markets from reaching the market players outside the boundaries of the states, or zones in which the exchanges are located.
The FCRA (Forward Contract Regulation Act) classifies contracts/agreements into two broad categories, viz., ready delivery contract and forward contract. Ready delivery contract are those where delivery of goods and full payment of price therefore is made within a period of eleven days. It is further clarified that notwithstanding the period of performance contract, if the contract is performed by payment of money difference, it would not be a ready delivery contract.
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 counterparty, which often results in high prices being charged.
Forward contracts are very useful in hedging and speculation. If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.
How forward contracts work?
Forward contracts have a buyer and a seller, who agree upon a price, quantity and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the price agreed upon and receives the agreed quantity of the asset.
If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price (current market price) or price of the asset at expiry is higher than the agreed upon forward price. If the spot price is lower than the forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash-settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset.
A quick example would help illustrate the mechanics of a cash-settled forward contract. On January 1, 2010 Company Spice Trading Corporation Ltd. agrees to buy from Ramlal Enterprise 100 kgs of cardamom on April 1, 2010 at a price of Rs 1,000 per kg. If on April 1, 2010, the spot price (also known as the market price) of cardamom is greater than Rs 1,000, at say Rs 1,250 a kg, the buyer has gained. Rather than having to pay Rs 1,250 a kg for cardamom, it only needs to pay Rs 1,000. However, the STCL’s gain is the Ramlal Enterprise’s loss. The seller must now sell 100 kgs of cardamom at only Rs 1,000 per kg when it could sell it in the open market for Rs 1,250 per kg. Rather than the buyer giving the seller Rs 100,000 for 100 kgs of cardamom as he would for physical delivery, the seller simply pays the buyer Rs 25,000. This Rs.25,000 is the cash difference between the agreed upon price and the current spot price (1,250-1000)*100.
Futures Market
A future contract, unlike the privately-traded forward contract, is publicly traded. Futures markets were designed to solve the problems that exist in forward markets. 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. More than 99% of futures transactions are offset this way.
A buyer and seller create a futures contract. It will consist of a standardized contract of a commodity established by a futures exchange.
It will consist of:
- 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
The only reason that people are willing to buy and sell futures contracts with anonymous counter parties is that the exchange which facilitates the transaction guarantees all trades. So, unlike forward contracts, where each side is exposed to the credit risk of its counterparty, with futures, the exchange assumes the credit risk if a party defaults on its obligations.
For example, customers who buy and sell futures contracts are required to post a security deposit, known as a margin, against their market position. They are also required to cover their losses on a daily basis, which is commonly referred to as being “marked to the market”. Additionally, exchanges demand that delivery of the underlying instrument at the expiration of the contract be done at the then current spot price.
How Future Markets Work... An Example
The main role of futures market(s) is to allow two important groups, i.e., Commercial Commodity Producers, and Commercial Commodity Consumers to minimize the potential of adverse future commodity price movements on their respective businesses down the road. In the case of grain commodities like corn and wheat, the farmers and farm cooperative organizations are the commercial commodity producers. They plant, harvest and sell their corn. Whereas Commercial Commodity Consumers could be cereal companies, bread manufacturers and other commercial firms who take the raw corn commodity and refine/turn it into a final end product that they sell to retail end-users/consumers like you.
Producers want to hedge their crop against potential falling prices when harvest time comes. Whereas commercial commodity consumers want to lock in a good price today for future delivery of raw commodities in case of expected rising price. Individual traders like you hope to profit on either rising or falling commodities prices via trading futures contracts, exit trades before the contract delivery date...hopefully with a profit. That’s how commodity trading market works.