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Wednesday, August 6, 2008

What are commodity exchanges?

Commodity exchanges are institutions which provide a platform for trading in 'commodity futures' just as how stock markets provide space for trading in equities and their derivatives. They thus play a critical role in robust price discovery where several buyers and sellers interact and determine the most efficient price for the product. Indian commodity exchanges offer trading in 'commodity futures' in a number of commodities. Presently, the regulator, Forward Markets Commission allows futures trading in over 120 commodities. There are two types of commodity exchanges in the country- 3 national level and 21 regional.

What are the unique features of national level commodity exchanges?

The unique features of national level commodity exchanges are:

**They are demutualized, meaning thereby that they are run professionally and there is separation of management from ownership. The independent management does not have any trading interest in the commodities dealt with on the exchange.

**They provide online platforms or screen based trading as distinct from the open outcry systems (ring trading) seen on conventional exchanges. This ensures transparency in operations as everyone has access to the same information.

**They allow trading in a number of commodities and are hence multi-commodity exchanges.

**They are national level exchanges which facilitate trading from anywhere in the country. This a corollary of being an online exchange.

What are spot and futures prices?

Spot price is the price in the cash market (where one buys and sells goods 'on the spot' just as we make purchases from a shop by paying cash) while future prices are prices of the same commodity at a future date. Therefore, if the spot price of gold is Rs 6000/10 gms today, the 1-month future price would be Rs 6050, while the 2-month future price would be Rs 6100. The difference between spot and futures prices is the cost of carry i.e. interest cost, storing, insurance etc. Normally futures prices are higher than spot prices. The exception is when the futures prices are lower than the spot price, which is called 'backwardation'. This situation is more common in case of agriculture commodities where due to the arrival of crop on certain future dates, the future prices would be lower than the current spot price.

What are futures & futures contract?

Futures are financial instruments based on a physical underlying (commodity, equities etc.). A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Therefore (delete), the futures price of wheat is the price of a financial instrument called wheat futures at say, Rs 10/kg at a future date. Market participants are able to buy and sell a certain commodity at a pre-determined price at a later date as specified by the Exchange. For example, if a person wants to buy 10 gms of gold after three months when the price today is say, Rs 6000 per 10 gms (spot prices) and Rs 6050 after three months (futures prices). He enters into a contract through a member of NCDEX to buy gold. On the due date if the price in the spot market is say, Rs 6100, then he still has to pay only Rs 6050, and has hence hedged himself against the price risk.

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