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Commodity Market :


Definitions :

  • Spot market
  • A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. The spot market is also called the "cash market" or "physical market",†because prices are†settled in cash on the spot at current market prices, as opposed to forward prices.

  • Future price
  • The price at which the future contract trades in the future market.

  • Open Interest
  • The total number of futures contracts of a given commodity that have not yet been offset by an opposite futures positions nor fulfilled by delivery of the commodity.

  • Forward contract
  • It is an agreement between two entities to buy or sell the underlying assets at a future date, at the price agreed upon today.

  • Initial margin
  • The amount that must be deposited by a customer at the time of entering into a contract is called as initial margin. These Initial margins cover the largest potential loss in one day.

  • Maintenance margin
  • It is the minimum acceptable balance in the margin account. If the balance of the account falls below the maintenance level, the exchange makes a margin call upon the individual, who must then restore the account to the level of initial margin before the start of trading the following day.

  • Regulating Frame work
  • There are three tiers of regulation of future and forward trading system in India, namely the Government of India, Forward Markets Commission (FMC) and Commodity Exchanges.

    Ministry of consumer affairs ---> FMC ---> Commodity Exchange

    The Forward Markets Commission (FMC) approves rules and Byelaws which are made by the exchanges and provides regulatory oversight. It also acquires concurrent powers of regulation either while approving the rules and byelaws or by making such rules and byelaws under the delegated powers.

    The Central Government - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution is the ultimate regulatory authority. Only those associations, which are granted recognition by the Government, are allowed to organize forward trading in regulated commodities. Presently the recognition is commodity specific.
    Government has original powers to suspend trading, call for information, require the Exchanges to submit periodical returns, nominate directors on the Boards of the Exchanges, and supersede Board of Directors of the Exchange etc. Most of these powers are delegated to the FMC; otherwise the role of FMC is recommendatory in nature.

  • Trading
  • The exchange trading system supports an order driven market where orders match automatically. Order matching is essential on the basis of commodity, its price time and quantity. The exchange defines the unit of trading and delivery unit for future contract on various commodities. The Exchange notifies the regular lot size and tick size for each of the contract from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the order side of the book. If it finds match a trade is generated. If it does not find match, the order become passive and gets queued in the respective outstanding order book in the system.
  • Clearing and settlement
  • Most future contract holders rarely take actual delivery of the underlying assets. The settlement is done by closing out open position or cash settlements.
    All these settlements are taken care by an entity called clearing house or Clearing Corporation. Clearing of trades that take place on an exchange guarantee the faithful compliance of all trade commitment undertaken on the trading floor or electronically over the electronic trading system.
  • Settlement
  • Future contract have two type of settlement, the marked-to-market (MTM) settlement which happens on a continuous basis at the end of each day and final settlement which happen on the last trading day of the future contract.
  • Risk Management
  • The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making.†Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance.
    Risk management is a two-step process - determining what risks exist in an investment and then handling those risks in a way best-suited to your investment objectives.† Risk management†occurs everywhere in the financial world.†It†occurs when†an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges their currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing them a personal line of credit.


The Mechanics of Forward Contracts :

    A Forward Contract is a contract made today for delivery of an asset at a pre-specified time in the future at a price agreed upon today. The buyer of a forward contract agrees to take delivery of an underlying asset at a future time, T, at a price agreed upon today. No money changes hands until time T. The seller agrees to deliver the underlying asset at a future time, T, at a price agreed upon today. Again, no money changes hands until time T.

    A forward contract, therefore, simply amounts to setting a price today for a trade that will occur in the future. Since forward contracts are traded over-the-counter rather than on exchanges, the example illustrates a contract between a user and a producer of the underlying commodity.

    Futures Contracts
    A future contract is an agreement between two parties to buy or sell the underlying assets at a future date at future price. Futures contract differ from forward contract in the sense that the former are standardized.

    Standardized contracts
    Futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures contracts; but they merely accept terms of contracts standardized by the Exchange.


The Mechanics of Futures Contracts :

    A futures contract is similar to a forward contract except for two important differences. First, intermediate gains or losses are posted each day during the life of the futures contract. This feature is known as marking to market. The intermediate gains or losses are given by the difference between today's futures price and yesterday's futures price. Second, futures contracts are traded on organized exchanges with standardized terms whereas forward contracts are traded over-the-counter (customized one-off transactions between a buyer and a seller).
    • Hedging
    • Hedgers make an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Investors use this strategy when they are unsure of what the market will do.
    • Speculation
    • Speculators are participant who wish to bet on the future movement in the price of an asset. Options contract can give them leverage. Speculators take large risks, especially with respect to anticipating future price movements, or gambling, in the hopes of making quick, large gains.
    • Arbitrage
    • Arbitragers work at making profits by taking advantages of discrepancy between prices of the product across different market or simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces. Also known as a "risk less profit".
    • Margin
    • Futures exchanges require both the buyer and the seller to post a security deposit known as margin. Margin is typically set at an amount that is larger than usual one-day moves in the futures price. This is done to ensure that both parties will have sufficient funds available to mark to market.


Global commodity exchange :


Commodity trading :

    The process of trading commodities is also known as futures trading. Unlike other kinds of investments, such as stocks and bonds, when we trade futures, we do not actually buy anything or own anything. We speculate on the future direction of the price of the commodity we are trading. This is like betting on future price direction. The terms "buy" and "sell" merely indicate the direction we expect future prices will take.

  • Objectives of commodity futures
    • Hedge- The producers and industry persons mitigate the risk through hedging. In the textiles industry, the industry persons hedge for cotton to mitigate the risk in fluctuating cotton prices.
    • Speculation- Speculators take advantage of favorable price movements in the commodity market.
    • Investors can leverage off by paying low margins to enjoy large exposure and prices can be discovered for taking farming and business decisions.

  • Commodity classification
  • Commodities are classified on the basis of objectives of commodities. There are two kinds of commodities.
    • Investment commodities - An investment commodity is generally held for investment purposes. Gold and Silver can be classified as investment commodities
    • Consumption commodities are held mainly for consumption purposes like oil and steel can be classified as consumption commodities.


It`s all about US dollar that rule Gold, oil

    In broader sense, oil prices are influenced by socio economic as well as geo political factors.
    When political tensions arise in oil regions, oil prices seem to climb upward.
    It has been noted that there is strong relation between Oil, gold and dollar, however it is the market trend that decides whether the relation is direct or inverse.

    Let`s glance through a few indicators-
    • Gold crude oil and dollar are interconnected and interdependent for the valuation since there was age-old practice of oil producing countries to hold gold in exchange for oil.
    • Oil, gold and commodities have all been priced in US dollars since 1975 when OPEC officially agreed to sell its oil exclusively for US dollars. Since then the global oil trade was priced in dollar. Hence any appreciation or depreciation of dollar impacted oil prices.
    • Crude prices directly affect the oil import bill of any country resulting into trade deficit. This trade deficit would pressurize the value of local currency eventually hitting money circulation in the economy thereby leading to the inflation. Inflationary conditions in crude oil markets, which stoke uncertainty, have inevitably sparked a rally in global gold prices.
    • Gold plays an anticipatory role. Gold which acts as the hedging option against the inflationary situation for investor, attract investments, thereby leading to appreciation in value. , If crude price rises, Gold will also move up.
    • All over the world, the international trade is denominated in US currency. Hence any negative news about the US economy, such as slowdown in consumption, rise in inflation, or a cut in interest rates by the Federal Reserve, that weakens the dollar. As the dollarís exchange value falls, it takes more dollars to buy gold so the dollar gold price rises and vise-versa.
    • Similarly, most of the countries hold foreign reserves in the form of US dollars. If the dollar loses value, the entire basket which is denominated in US dollar ,loses value. So, countries will look for safe heaven i.e. Gold. If dollar loses value, Gold will move up, and vice versa.
    • Foreign gold market pave the path for the Indian gold market as almost entire gold requirement is get fulfill thought imports. Along with this, volatile financial markets also appear to be good for gold as an investment.

    In conclusion, one would find inverse relation between dollar and gold; however the gold and oil prices are directly related to each other. In recent days, the gold, crude oil are considered to be crucial commodities whose prices directed by geopolitical tensions, economic uncertainties. However, make a note that it is the US currency ruling the gold and oil markets.


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