Commodity Derivative Market- An Overview

1. Meaning of Commodity Derivative Market:  Commodity Derivative is Market is a place, where the investor can directly incest in Commodities, rather than investing in those companies that trade in these commodities.

In other words, Commodity Derivative  markets are  the market, where the trade is undertaken through a future/options/swap contracts. Under these contracts, as the name suggest, transaction is completed at a future date.

Commodity Derivatives markets are a good source of critical information and indicator of market sentiments. Since, commodities are frequently used as input in the production of goods or services, uncertainty and volatility in commodity prices and raw materials makes the business environment erratic, unpredictable and subject to unforeseeable risks.

2. Commodity Derivative Contract: A derivative contract, which has a commodity as its underlying, is known as a ‘commodity derivatives’ contract. According to clause (bc) of section 2 of the SCRA, commodity derivative” means a contract:

(i) for the delivery of such goods, as may be notified by the Central Government in the Official Gazette, and which is not a ready delivery contract; or

(ii) for differences, which derives its value from prices or indices of prices of such underlying goods or activities, services, rights, interests and events, as may be notified by the Central Government, in consultation with the Board, but does not include securities as referred to in sub-clauses (A) and (B) in the definition of Derivatives.

3. Types of Derivative Contracts: There are 4 types of derivative contracts are involved in the commodity market :

√ Forwards – Private agreements where the buyer commits to buy, and the seller commits to sell.

√ Futures – Standardized forms of forwards that trade on exchanges.

√ Options – Give the holder the right to buy or sell the underlying asset on a fixed date in the future.

√ Swaps – Contracts through which two parties exchange streams of cash flows.

4. Trading Mechanism:  In this market, the Commodity Derivative Trading is done by people who have no need for the Commodity itself, but who first speculate on the direction of the Price of these commodities, hoping to gain if the Price movement is in their favour.

5. Settlement:  The most vital function in a Commodity Derivatives Market is the settlement and clearing of trades. Commodity Derivatives can involve the exchange of funds and goods. There are separate bodies to handle all the settlements, known as Clearing House.

Example: The holder of a Future Contract to buy Gold might choose to take delivery of Gold rather than closing his position before maturity. The function of Clearing House, in such a case, is to take care of possible problems of default by the other party involved, by standardizing and simplifying transaction processing between participants and the organization.

6. Need for Commodity Derivative Market

There are two types of needs for Commodity Derivative Market, such as;

(a) Instrumental Needs: Hedgers needs for price risk reduction are called as Instrumental Needs. Their main requirement is to reduce or eliminate Portfolio Risk at a Low Cost.

(b) Convenient Needs: The other aspects that are to be considered are flexibility in doing business, easy access to the market, and an efficient clearing system. These are called Convenience Needs. It deals with Customer’s need to able to use the services provided by the Exchange with ease. The extent of satisfaction of convenience needs determines the Process Quality.

7. Features of Commodity Derivative Markets

The followings are the features of commodity Derivative Market;

(a) Complement to investment in Companies that use commodities.

(b) Defines pattern of Country’s Production and Consumption.

(c) Gains are in the forms of Price increases, not dividends.

8. Difference between ‘Spot Market’ and ‘Derivative Market’

The differences between spot market and the commodity derivatives market are tabulated below:

9.  Various advantages of commodity derivatives markets

Commodity derivatives market provides various direct and indirect benefits to commodity value chain participants. The key benefits of Commodity derivatives market are as follows:

(a) Price Discovery: Provides a nationwide platform for discovery of prices and enabling physical market participants to hedge their price

(b) Hedging Price Risk: In the absence of Derivatives, various value chain participants like small producers and end users lose an invaluable tool for hedging their price risk, getting advance price signals of the commodity and for making informed decision on cropping, timing of sales

(c) Investment Opportunity: A successful derivative contract in any commodity catalyzes the development of marketing infrastructure like warehousing, assaying facilities which in turn facilitates pledge financing through warehousing and banks

(d) Diversification: Commodity prices are prone to supply-demand dynamics, weather conditions, geo-political tensions and natural disasters. Accordingly, commodities are an independent asset class, and can prove to be an effective means of diversification in one’s investment portfolio.

10. Various disadvantages of commodity derivatives markets

Despite the benefits that derivatives bring to the commodity markets, the derivative contracts come with some significant drawbacks;

(i) High risk

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

(ii) Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

(iii) Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.

11. How is a commodity derivative contract different from equity derivative contract? 

While the basic concepts of a derivative contract remain the same, whether the underlying is an equity share or a commodity, there are some features which makes a commodity derivative contract uniquely different from an equity derivative contract. The main differences are given as under:

12.  The nature of Commodities that can be trades in the Commodity Derivative Market

The following features should exist in Commodities, to be eligible for Derivatives Trading-

1. Storage and Durability:  Commodity should be durable with storage possibilities, since it provides a hedge against Price Risk for the carrier of Stocks.

2. Homogeneous:  Units must be homogeneous, so that the commodities are actually delivered in the Derivative Market.

3. Price Fluctuation: The Commodity must be subject to frequent price fluctuations with wide amplitude, supply and demand must be large, since it creates greater avenues for trading in Commodity Derivatives.

4. Cash Market Risk: Supply must flow naturally to market and there must be breakdowns in an existing pattern of forward contracting. This indicates that, the Cash Market Risk must be present, for Commodity Derivative Market to came into existence. If the Price fluctuations are eliminated using a Cash Forward Contract, the Commodity Derivatives Market would be of limited use.

13. Various players in the commodity derivatives market

The players in the commodity derivatives market can be classified into two major categories – risk givers and risk takers.

• Risk givers or hedgers refer to those who have a risk due to physical exposure to the commodity, and are looking to pass on their risk by taking a sell or buy position on Stock Exchange.
• Risk takers or investors refer to those who do not have physical exposure to the commodity, but who are willing to take a buy or sell position or risk with the aim of making gains from inequalities in the market. Financial investors and arbitrageurs are the investors in this market. 

14. Regulatory framework for Commodity Derivatives Market

1. Who regulates the commodity derivatives market in India?

Securities and Exchange Board of India (SEBI) regulates the commodity derivatives market in India since September 28, 2015. Before September 28, 2015, the Commodity derivatives market was regulated by erstwhile Forward Markets Commission (FMC).

2. What is the need for regulating the commodity derivatives market?

Regulation is needed to ensure fairness and transparency in trading, clearing, settlement and management of the market institutions including stock exchanges, clearing corporations, and broking houses, and also to maintain the integrity of the marketplace, so as to protect and promote the interest of various stakeholders and investors.

3. What is the broad regulatory framework in which the commodity derivatives market operates in India?

The regulatory framework for commodity derivatives market comprises of Government of India, Securities and Exchange Board of India SEBI and SEBI recognised stock exchanges/ clearing corporations which also perform supervisory functions over their members.

15. The types of commodities traded in the commodity derivatives market

The commodities traded in the Indian commodity derivative markets are usually classified into four segments. These are as follows:

a. Agricultural Commodities: These are generally perishable agricultural products such as soybean, cotton, chana, maize, sugar, guar seed Processed agricultural commodities like soybean oil, palm oil, guar gum etc. are also considered as agricultural commodities.

b. Bullion and Gems: This segment predominantly consists of precious metals like gold, silver and precious gems like

c. Energy commodities: This segment includes commodities that serve as major energy sources. These commodities are traded in both the unprocessed form in which they are extracted or in various refined forms or by-products of refining / Crude oil, natural gas etc. are examples of energy commodities.

d. Metal commodities: This segment includes various non-precious metals that are mined or processed from the mined metals such as copper, brass, iron, steel,

16. Conclusion:

Commodities constitute a major asset class like equities, fixed income instruments and money market instruments. Commodities are basically raw materials or primary products regularly used for consumption. The value or the price of commodity changes as per the demand supply situation in the commodity market. Commodity Derivative is the contract whose value is derived from the underlying commodity that is to be settled on a specific future date. The main purpose of commodity derivative contracts is to reduce risk arising out of future price uncertainty. Commodity derivatives were the first form of derivatives ever introduced and later the concept of derivatives was introduced in other securities and assets.