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Tuesday, August 5, 2008

What is a Commodity Market?

1. What is a commodity market?

Commodity market is a place where trading in commodities takes place. It is similar to an Equity market, but instead of buying or selling shares one buys or sells commodities.

2. How old are the commodities market?

The commodities markets are one of the oldest prevailing markets in the human history. In fact derivatives trading started off in commodities with the earliest records being traced back to the 17th century when Rice futures were traded in Japan.

3. What are the different types of commodities that are traded in these markets?

World-over one will find that a market exits for almost all the commodities known to us. These commodities can be broadly classified into the following:
Precious Metals: Gold, Silver, Platinum etc
Other Metals: Nickel, Aluminum, Copper etc
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds, etc.
Soft Commodities: Coffee, Cocoa, Sugar etc
Live-Stock: Live Cattle, Pork Bellies etc
Energy: Crude Oil, Natural Gas, Gasoline etc

4. What are the different segments in the commodities market?

The commodities market exits in two distinct forms namely the Over the Counter (OTC) market and the Exchange based market. Also, as in equities, there exists the spot and the derivatives segment. The spot markets are essentially over the counter markets and the participation is restricted to people who are involved with that commodity say the farmer, processor, wholesaler etc. Majority of the derivative trading takes place through exchange-based markets with standardized contracts, settlements etc.

5. What are the characteristics of Over The Counter (OTC) commodity markets?

The OTC markets are essentially spot markets and are localized for specific commodities. Almost all the trading that takes place in these markets is delivery based. The buyers as well as the sellers have their set of brokers who negotiate the prices for them. This can be illustrated with the help of the following example: A farmer, who produces castor, wishing to sell his produce would go to the local 'mandi'. There he would contact his broker who would in turn contact the brokers representing the buyers. The buyers in this case would be wholesalers or refiners. In event of a deal taking place the goods and the money would be exchanged directly between the buyer and the seller. Thus it can be seen that this market is restricted to only those people who are directly involved with the commodity.

In addition to the spot transactions, forward deals also take place in these markets. However, they too happen on a delivery basis and hence are restricted to the participants in the spot markets.

6. What are the characteristics of the Exchange Traded markets?

The exchange-traded markets are essentially only derivative markets and are similar to equity derivatives in their working. I.e. everything is standardized and a person can purchase a contract by paying only a percentage of the contract value. A person can also go short on these exchanges. Also, even though there is a provision for delivery most of the contracts are squared-off before expiry and are settled in cash. As a result, one can see an active participation by people who are not associated with the commodity.

7. Do the commodity exchanges facilitate delivery?

The commodity exchanges do facilitate delivery, although it has been observed world-over that only 2% of all the trades result in actual delivery.

8. Why is the percentage of delivery ratio very low in the exchange based commodity derivatives?

Many people who participate in the exchanges are those who are not involved with the physical trading of the commodity. Thus they would not like receiving delivery and would not be in a position to give delivery.

Standardized contracts make an unfeasible proposition for any trader to give or take delivery. E.g. if the size of
1 soya contract is 10MT, a trader cannot buy / sell 15MT of soya through the exchange. Also one cannot avail a credit facility in the exchanges that may be available in the local market. These and a host of other factors deter a person from giving / receiving delivery through the exchanges.

9. What is the size of the commodities market as compared to the equity market?

In the developed markets the volumes on the exchange-based commodity derivates markets are about five times more than that of the equity markets.

10. What is the history of commodities markets in India?

India, being an agro-based economy, has markets for most of the agro-based commodities. India is the largest consumer of Gold in the world, which implies a huge market for the yellow metal. India has huge spot markets for all these commodities. E.g. Indore has a huge market for soya, Ahmedabad for castor seeds and Surendranagar for Cotton etc.

During the pre-independence era India also had a thriving futures market for commodities such as gold, silver, cotton, edible oils etc. In mid 1960's, due to wars, natural calamities and the consequent shortages, futures trading in most commodities were banned.

Currently, the futures markets that exist in India are localized for specific commodities. For example, Kerala has an exchange for pepper; Ahmedabad for castor seeds and Mumbai is the major center for Gold etc. These exchanges, however, have only a regional presence and are dominated by people who are involved with the physical trade of that commodity.

11. What are the current developments in this market?

The government has now allowed national commodity exchanges, similar to the BSE & NSE, to come up and let them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to offer a nation-wide anonymous, order driven, screen based trading system for trading. The Forward Markets Commission (FMC) will regulate these exchanges.

Consequently four commodity exchanges have been approved to commence business in this regard. They are:

o Multi Commodity Exchange of India Ltd. (MCX) located at Mumbai
o National Commodity and Derivatives Exchange Ltd (NCDEX) located at Mumbai
o National Board of Trade (NBOT) located at Indore
o National Multi Commodity Exchange (NMCE) located at Ahmedabad.

12. In which exchanges are Asit Mehta Comdex Services (Private) Ltd members of?

Asit Mehta Comdex Services (Private) Ltd has taken the membership of National Commodity & Derivatives Exchange (NCDEX) and Multi Commodity Exchange of India Ltd. (MCX).

13. What is the need for the exchange-traded commodity derivatives market?

The biggest advantage of having an exchange-based platform is reach. A wider reach ensures greater participation, which results into a more efficient price discovery mechanism. In fact it comes to a stage where the derivative market guides the spot market in terms of pricing.

This can be well understood by looking at the following example:

Imagine a soy wholesaler in Madhya Pradesh who, having bought the crop from the farmer, wishes to sell it to the oil refiners. To sell his crop he has to go to the local market at Indore. The price that he will get for his crop would be solely dependent upon the demand supply condition prevailing at that point of time at that market place. Also as the number of players is less there are chances of the prices being biased. In contrast the prices in the futures market are determined not only by the local demand supply conditions but also by the global scenario. Add to that the view taken on a commodity by various sets of people depending upon different parameters such as technical analysis, political news, exchange rates etc. The price that is thus quoted can be safely regarded as the most efficient price.

So, now looking at the futures price the trader can price his crop appropriately.

14. What opportunities do the commodity derivatives provide for investors?

Futures contract in the commodities market, similar to equity derivatives segment, will facilitate the activities of speculation, hedging and arbitrage to all class of investors.

o Speculation:

It facilitates speculation by providing opportunity to people, although not involved with the commodity, to trade on the views in the movement of commodity prices. The speculative position is taken with a small margin amount that is paid to the exchange, and the contract can be squared-off anytime during the trading hours.

o Hedging:

For the people associated with the commodities the futures market can provide an effective hedging mechanism against price movements.

For example an oil-seed farmer may go short in oil-seed futures, thus 'locking' his sale price and in the process hedging against any adverse price movements. On the other hand a processor of oil seeds may buy oil-seed futures and thus assure him a supply of oil-seeds at a pre-determined price. Similarly the oil-seed processor may go short in oil futures, which may be bought by a wholesaler of oil.
Also, there is a saying that 'Gold shines when everything fails'. Thus, gold can be used as a hedging tool against other investments.

o Arbitrage:

Traders may exploit arbitrage opportunities that arise on account of different prices between the two exchanges or between different maturities in the same underlying.

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