All about Commodity Futures & Interest Rate Derivatives

COMMODITY FUTURES

1. History:-Futures Trading in Commodity is a natural outgrowth of the problems of maintaining and managing supply of Agricultural Products and other commodities. Worldwide there are many exchanges operating in commodity futures. It has a very long history in today’s world, the first exchange “The Chicago Board of Trade” (CBOT) was established in 1848 for trading in commodity futures. In 1880 and 1890 the New York Coffee, Cotton and Product Exchanges became operative.

The products like Corn, Wheat, Oil, Rice, Rubber, Tea, Coffee, Sugar, Cotton, Iron, Gold, Silver etc. are the products regularly traded on the commodity exchanges.

2. Commodity Exchange

is a systematic and organized market where the commodity trades among the buyers and sellers are carried on regularly under the supervision and control of the exchange and as per well devised rules, regulations and bye-laws laid down by the Exchange.

3. Commodity Future Contracts

Futures in which the underlying asset is a commodity are commodity futures. Future contracts are part of exchange traded derivative contracts whereby the parties entered into the contracts for deliveries to be settled in future at predetermine price.

In India the Forward Contracts Regulation Act, 1952 governs the trading in commodity futures. The exchange under this Act, can formulate their rules, regulations and bye-laws for carrying on commodity trading on day-to-day basis. Forward Markets Commission (FMC) approves the rules and regulations of the market and supervise the functioning of exchange.

MCX (Multi Commodity Exchange of India Limited) and NCDEX (National Commodity and Derivative Exchange Limited) are the two exchanges which have begun the operations in commodity futures in our country. Barring few exceptions the pattern of trading, market mechanism, margining system and settlement procedures in commodity futures are similar to that of future trading in stocks/ indices. Applicability of physical deliveries, sales tax, bad deliveries are the few exceptions which distinguish them with stocks /indices futures.

The party who buys the commodity derivative contracts is assuming a long position in the market with the expectation the price will go up, similarly the party who sells the contract assumes a short position expecting the price to go down.

4. The typical future price quotation will look like as under:

5. Margins

The buyer or the seller of the contract has to deposit the initial margin before entering into the trade. They are also subject to marked to market margin (MTM) as applicable in Derivative segment of securities market . The buyer has to deposit the margin, with the commodity broker and the broker in turn has to deposit the margin with clearing corporation for clearing house.

The exchange will specify in its contract description, the particular grade, variety, quality settlement, strike price etc. pertaining to any commodity. A range will be specified for all the properties & only those grades, which fall within the range, will be accepted for delivery. In case the properties fall within the range but differs from bench marks specifications the exchange will specify rebate/premium for the same.

6. Futures Contract Specifications

The typical contract of a commodity future will have following important ingredients apart from other usual factors.

7. A clearing corporation/house of the exchange guarantees the successful settlement of the contract traded electronically on the trading system of the exchange. The main functions of the clearing house is to maintain broker/client wise exposures on the exchange, and to honour the settlement obligations. The margin paid by the client/broker are also deposited with the clearing corporation.

8. Settlement Procedure

All contracts settling in cash would be settled on following day after the contract expiry date. All contracts materializing into deliveries would be settled in a period of two to seven days after the expiry on the basis of rules & regulations of an exchange. The Contracts for Commodity Futures are either deliverable or non- deliverable. Options of Delivery remains with the buyer, seller or with both of them depending on the nature of contract chosen at the time of entering into trade. Contracts, which are not assigned for delivery, shall be settled in cash.

The system of Pay-In, Pay- Out, Margining will be similar to that of Trading in Shares and Securities. A buyer intending to take physical delivery would have to request to an intermediary which in turn passes the same to the warehouse on any specified day, the buyer can pickup the delivery from designated warehouses. The seller intending to make a delivery has to take it to designated warehouse where it will be assessed for its quality assurance according to the prescribed norms. The warehouse on satisfying with the quality shall issue the receipt (may be in an electronic form) for the same.

The Contract such converted into deliveries shall be subject to sales tax at a rate and procedure applicable to the individual states. Those who trade with the intention of taking or giving delivery should have sales tax registration before settlement of the delivery based trade.

INTEREST RATE DERIVATIVES

Interest Rate Derivative is a part of Financial Derivatives which enables to manage the risk, pertaining to “Interest Rates” fluctuations. It is a derivative instrument whose pay-offs depends on the prevalent interest rates over the period of time. Underlying variable in such instrument is “Rate of Interest”.

1. Interest Rate Futures

An interest rate future is an agreement between two parties to exchange interest payment for a “Notional Principal Amount” on settlement date for a specified period. In order to manage interest rate risk SEBI has permitted exchanges to allow trades in Interest Rate Derivatives, which are at present in operation on both BSE as well as on NSE.

Exchanges have introduced the products for a short term as well as long term management of Interest rate risk. “Notional Treasury Bill” is for a short-term management, whereas, 10 years coupon yielding Bond and zero coupon bond are for a long term Management. The underlying in such contracts is either Treasury Bill, 10 years coupon yielding Bond or zero coupon bond. Trading in future reflects the views of the party about future movements of the Interest rate. For instance, the person having a long position of future contracts relating to coupon yielding Bond expects the interest rate to fall over the life of the contract and the person going short in similar contract expects the relevant interest rate to rise over the life of the contract. The exchange specifies the contract description, the size of the contract, settlement procedures and margin mechanism for different kinds of contract.

2. Interest Rate Option

The basic feature of this product is similar to that of other option contracts with the difference of underlying, which in this case is the “Interest Rate”. Caps, Floors & Collars are popular types of Interest rate options.

3. Caps

If an upper limit of strike price is set, it is called a Cap. The purchase of an interest rate Cap guarantees the borrower of a floating rate loan that the interest liability shall not exceed the Cap rate. If the market price on the maturity date is higher than the Cap price, then the Cap price will be the settlement price.

4. Floors

If the lower limit of strike price is set, it is called Floor. The purchase of interest rate Floor guarantees a lender of a floating rate loan that its interest income will not reduce below the Floor rate. If the market price on the maturity date is lower than the Floor price then the settlement will be at Floor price.

5. Collars

An interest rate Collar refers to a combination of an Interest Rate Cap & Interest Rate Floor whereby both minimum and maximum, Cap (maximum), Floor (minimum) is guaranteed to the buyer of contract. In Collars, the strike price cannot be higher than the Cap price and lower than the Floor price.

6. Interest Rate Swaps

Interest rate swap is an agreement between the counter parties to exchange two streams of payments for an agreed period of time based upon a notional principal. Typically one party pays interest based on an agreed fixed rate and the other party pays interest linked to a floating rate. Interest rate swaps accounts for the majority of activity of banks which swaps the fixed rate for floating rate and vice-versa.

In such a swap one party agrees to make fixed rate interest payment in return for floating rate interest payment from counter party. This interest is calculated on hypothetical “Notional principal”. This notional principal amount does not change hands but used only for the purpose of interest calculations. A swap is settled by entering into off setting swap or by settling the difference in case.