Commodity Market and Derivatives: Notes for Exams

A commodity market is a market in which raw materials are bought and sold: gold and silver, copper and zinc, crude oil and natural gas, and farm produce such as wheat, guar seed, chana, cotton and castor. Trading takes place either in the spot market, where goods change hands against immediate payment, or in the derivatives market, where contracts about those goods are traded for delivery on a future date. Derivatives are a standard part of the economy syllabus for banking and civil services papers, and the Indian commodity market is also a favourite because its regulator changed in 2015. These notes explain what a derivative is, the four kinds of derivative contracts, how the Indian commodity exchanges are organised, and who regulates them.

What a derivative is

A derivative is a financial contract that has no value of its own; its value is derived from an underlying asset, which may be a commodity, a share, a stock index, a currency, an interest rate or even the weather. If the price of the underlying moves, the value of the derivative moves with it. Three kinds of participants use these contracts. A hedger, such as a farmer or a jeweller, uses them to lock in a price and remove the risk of an adverse movement. A speculator takes the opposite side, accepting risk in the hope of profit, and in doing so supplies liquidity to the market. An arbitrageur buys in one market and sells in another to profit from a difference in price, and that activity keeps prices in different markets in line with one another.

The four kinds of derivatives

A forward is a contract between two parties to buy or sell an asset at an agreed price on a future date. It is negotiated privately, over the counter, so the quantity and quality can be tailored to the parties, but each side carries the risk that the other will not perform. A future is a forward that has been standardised and brought on to an exchange: the quantity, quality, delivery date and delivery centre are fixed by the exchange, both sides deposit margin, the position is marked to market every day, and a clearing corporation stands between the two parties so that counterparty risk is removed. An option gives its buyer the right, but not the obligation, to buy or sell the underlying at a stated price, called the strike price, on or before a stated date; the buyer pays a premium for this right, and the seller, called the writer, must perform if the buyer exercises. A call option is the right to buy and a put option is the right to sell. A European option may be exercised only on the expiry date, while an American option may be exercised any time until expiry. A swap is an agreement to exchange one stream of cash flows for another, the common forms being interest rate swaps, where a floating rate is exchanged for a fixed rate, and currency swaps.

Forwards compared with futures

The commodity market in India

Organised futures trading in India is old. The Bombay Cotton Trade Association, set up in 1875, is regarded as the first organised futures market in the country, and trading in oilseeds, jute and bullion followed. Futures trading was banned in many commodities in the years of shortage after independence and was reopened gradually from the 1990s. The national electronic exchanges came up in 2003: the Multi Commodity Exchange, which handles the bulk of trading in bullion, base metals and energy, and the National Commodity and Derivatives Exchange, which deals mainly in agricultural commodities. The stock exchanges were permitted to open commodity derivatives segments in 2018, so a single exchange may now offer equity, currency and commodity contracts.

Until 2015 commodity futures were regulated separately. The Forward Markets Commission, set up in 1953 under the Forward Contracts (Regulation) Act, 1952, with its office in Mumbai, was the regulator of commodity derivatives, while the Securities and Exchange Board of India regulated the securities market. The Finance Act of 2015 repealed the 1952 Act, brought commodity derivatives within the definition of securities under the Securities Contracts (Regulation) Act, 1956, and merged the Forward Markets Commission with SEBI on 28 September 2015. This was the first merger of two regulators in India, and since then a single regulator oversees shares, currency derivatives and commodity derivatives alike. SEBI afterwards allowed options on commodity futures, the first of which were gold options in 2017, and it has insisted on compulsory delivery in agricultural contracts so that futures prices stay tied to the physical market.

Supporting institutions and terms

A commodity market cannot work without warehouses that can be trusted. The Warehousing Development and Regulatory Authority, created under the Warehousing (Development and Regulation) Act, 2007, registers warehouses and regulates negotiable warehouse receipts, which allow a farmer to deposit produce, receive a receipt, borrow against it and sell later. The electronic National Agriculture Market, launched in 2016, is a different thing altogether: it is an online spot market linking regulated mandis, not a derivatives platform. Two terms are asked often. The market is in contango when the futures price is above the spot price, which is the normal state when storage and interest cost money; it is in backwardation when the futures price is below the spot price, which usually signals a shortage today. The difference between the spot price and the futures price is called the basis.