COMMODITY TRADING

Under Standing Commodity Trading

Features of commodity futures


	Organized
	Standardized
	Eliminates counterparty risk
	Facilitate margin trading
	Closing a position
	Regulated market environment
	Physical delivery

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

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. Put 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.

Functions of Derivative Markets :

Derivative markets perform a number of economic functions

	Prices in an organized 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 organized 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 TRADING

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