What is a Derivative contract?

Derivative Contract is a financial instrument for which the value is derived from one or more underlying assets. The assets can be stocks, bonds, commodities, indices etc. The common type of derivatives contracts are Forward, Futures, Options and Swaps. Derivatives contracts are normally used to control the exposure of risk. One party exposed to the unwanted risk can transfer some or all of the risk to the other party through the use of derivatives contract.

What is a forward contract?

A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. All the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of specific days, are forward contracts.

What are 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

What are customized contracts?

Forward contracts (other than futures) are customized. In other words, the terms of forward contracts are individually agreed between two counter-parties.

Is delivery mandatory in futures contract trading?

The provision for delivery is made in the Byelaws of an exchange so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery is generally at the option of the sellers. However, provisions vary from Exchange to Exchange. Byelaws of some exchange give both the buyer and seller the right to demand/give delivery.

What is the N.T.S.D. contract?

Non-Transferable Specific Delivery Contracts is an enforceable bilateral agreement under which the terms of contract are customized and the contract is performed by giving specific delivery of goods. The rights or liabilities under this contract cannot be transferred by transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods.

What is the T.S.D. contract?

Transferable Specific Delivery contracts is an enforceable customized agreement where unlike known transferable specific delivery contracts, the right or liabilities under the delivery order, transport receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.

FUTURES CONTRACTS

What is a futures contract?

Futures Contract is specie of forward contract. Futures are exchange - traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.

What are the commodities suitable for futures trading?

All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i.e., there should be large demand for and supply of the commodity - no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price. The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardization and gradation.

How are futures prices determined?

Futures prices evolve from the interaction of bids and offers emanating from all over the country - which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.

How professionals predict prices in futures?

Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist.

How is it possible to sell, when one doesn't own commodity?

One doesn't need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.

What is long position?

In simple terms, long position is a net bought position.

What is short position?

Short position is net sold position.

What is bull spread (futures)?

In most commodities and financial derivatives market, the term refers to buying contracts maturing in nearby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.

What is bear spread (futures)?

In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.

What is 'Contango'?

Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier.

When is futures contract in 'Contango'?

It arises normally when the contract matures during the same crop-season. In a well-integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.

What is 'Backwardation'?

When the prices of spot or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation.

When is futures contract at 'Backwardation'?

It is usual for a contract maturing in the peak season to be in backwardation during the lean period.

What is 'basis'?

It is normally calculated as cash price minus the futures price. A positive number indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.

What is cash settlement?

It is a process of performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt).

What is offset?

It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.

What is settlement price?

The settlement price is the price at which all the outstanding trades are settled, i.e., profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.

What is convergence?

This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.

Can one give delivery against futures contract?

Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.

Why the proportion of futures contracts resulting in delivery is so low?

The reason is, futures contracts may not be suitable for merchandising purpose, mainly because these are standardized contracts; hence various aspects of the contracts, viz., quality/grade of the goods, packing, place of delivery, etc. may not meet the specific needs of the buyers/sellers.

Why delivery of good is permitted when futures contract by their very nature not suitable for merchandising purposes?

The threat of delivery helps in dissuading the participants from artificially rigging up or depressing the futures prices. For example, if manipulators rig up the prices of a contract, seller may give his intention to make a delivery instead of settling his outstanding contract by entering into purchase contracts at such artificially high price.

How can one avoid delivery being imposed against outstanding purchase contracts?

All the Exchanges give option to the participants to liquidate their outstanding position by entering into offsetting contract, before the "delivery period" commences. There is no delivery if the contracts are so liquidated. The threat of delivery - whether in terms of physical goods or by warehouse receipts - becomes a reality once delivery period commences.

Can a buyer demand delivery against futures contract?

The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges trading contracts in some commodities provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position is settled at the "Due Date Rate".

What is delivery month?

It is the specified month within which a futures contract matures.

What is delivery notice?

It is a written notice given by sellers of their intention to make delivery against outstanding short open futures positions on a particular date.

What is Warehouse Receipt?

It is a document issued by a warehouse indicating ownership of a stored commodity and specifying details in respect of some particulars, like, quality, quantity and, some times, indicating the crop season.

Why do we need speculators in futures market?

Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market; therefore, it is difficult to imagine a futures market functioning without speculators.

What is the difference between a speculator and gambler?

Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market.

Does it mean that speculation need not be curbed?

Information and speculation is good for the market. However over-speculation needs to be curbed. There is no unanimity about what constitutes over-speculation.

How is over-speculation curbed?

In order to curb over-speculation, leading to distortion of price signals, limits are imposed on the open position held by speculators. The positions held by speculators are also subject to certain margins; many Exchanges exempt hedgers from this margins.

How should a futures contract be designed?

The most important principle for designing a futures contract is to take into account the systems and practices being followed in the cash market. The unit of price quotation, unit of trading should be fixed on the basis of prevailing practices. The "basis" - the standard quality/grade - variety should generally be that quality or grade which has maximum production. The delivery centers should be important production or distribution centers. While designing a futures contract care should be taken that the contract designed is fair to both buyers and sellers and there would be adequate supply of the deliverable commodity thus preventing any squeezes of the market.

What are the benefits from Commodity Forward/Futures Trading?

Forward/Futures trading performs two important functions, namely, price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It enables the 'Consumer' in getting an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. It is very useful to the 'exporter' as it provides an advance indication of the price likely to prevail and thereby helps him in quoting a realistic price and secure export contract in a competitive market. It ensures balance in supply and demand position throughout the year and leads to integrated price structure throughout the country. It also helps in removing risk of price uncertainty, encourages competition and acts as a price barometer to farmers and other functionaries in the economy.

What is hedging?

Hedging is a mechanism by which the participants in the physical/cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/cash markets to cover their price risk by taking opposite position in the futures market.

Illustrate hedging by a stockiest by using futures market?

To illustrate the concept of hedging, let us assume that, on 1st December, 2008, a stockiest purchases, say, 10 tonnes of paddy in the physical market @ MGA. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2009 contract is MGA.1750/- p.q., the stockist is able to lock in a spread of MGA. 150/- p.q., i.e., about 9% for about 6 months. The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is MGA. 1500/- p.q. The stockist would incur a loss of MGA. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from MGA. 1750/- p.q. to, say, MGA . 1725/- p.q. The stockist can liquidate his contract in the futures market by entering into purchase contract @ MGA. 1725/- p.q. He would end up earning a profit of MGA. 125/- in the futures segment. Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.

How does futures market benefit farmers?

World over, farmers do not directly participate in the futures market. They take advantage of the price signals emanating from a futures market. Price-signals given by long-duration new-season futures contract can help farmers to take decision about cropping pattern and the investment intensity of cultivation. Direct participation of farmers in futures market to manage price risk -either as associates of an Exchange or as clients of some associates- can be cumbersome as it involves meeting various associates criteria and payment of daily margins etc. Options in goods would be relatively more farmer-friendly.

Can the loss incurred on the futures market be set off against normal business profit?

Loss incurred in futures market by entering into contracts for hedging purposes can be set off against normal profit. The loss incurred on account of speculative transactions in futures market cannot be set off against normal business profit. This loss is however allowed to be carried forward for eight years, during which it can be set off against speculative profit.

How can futures trading be successful when the cash markets of the underlying commodities are fragmented?

It is true that in order to attract wide participation, the cash market of commodities should be geographically integrated and free from Government restrictions on production, marketing and distribution, like limit on stock-holding, movement of goods etc. It is however not a bad idea to introduce futures trading in commodity without waiting for the cash market in the commodity to become geographically integrated. Existence of futures/derivatives market as well as wide use of derivatives in commodities to manage price risk would create conditions for the Government to consider dilution/withdrawal of Administered price mechanism.

PARTICIPANTS IN DERIVATIVES MARKETS

Who can be Associates of the Exchange?

The Bye-laws and Articles of the Association prescribed the criteria for being associates of the Exchange. Any person desirous of being an associate of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website of MEX MADAGASCAR: . They may also refer to the Bye-law and rules of the concerned Exchange which contain various criteria for the associates of the Exchange.

Who are the participants in forward/futures markets?

Participants in forward/futures markets are hedgers, speculators, day-traders/scalpers, market makers, and, arbitrageurs.

Who is hedger?

Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.

What is arbitrage?

Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.

Who are day-traders?

Day traders are speculators who take positions in spot, futures or options contracts and liquidate them prior to the close of the same trading day.

Who is floor-trader?

A floor trader is an Exchange's associates or its employee, who executes trade by being personally present in the trading ring or pit, floor trader has also place in electronic trading systems.

Who is speculator?

A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.

Who is market maker?

A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.

What kinds of risks do participants face in derivatives markets?

Different kinds of risks faced by participants in derivatives markets are:

• credit risk
• market risk
• liquidity risk
• legal risk
• operational risk

What is credit risk?

Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts

What is market risk?

Market risk is the risk of loss on account of adverse movement of price.

What is liquidity risk?

Liquidity risks are the risk that unwinding of transactions may be difficult, if the market is illiquid.

What is Legal risk?

Legal risk is that legal objections might be raised; regulatory framework might disallow some activities.

What is operational risk?

Operational risk is the risk arising out of some operational difficulties, like, failure of electricity, due to which it becomes difficult to operate in the market.

What is "National" Commodity Exchange?

The best international systems and practices in respect of trading, clearing, settlement and governance structure and invited applications from associations - existing and potential - to set up National level of Commodity Exchanges by introducing such systems and practices. The term," National" used for these Exchanges does not mean that other Exchanges are restricted from having nationwide operations.

What is the role of an Exchange in futures trading?

An Exchange designs a contract, which alone would be traded on the Exchange. The contract is not capable of being modified by participants, i.e., it is standardized. The Exchange also provides a trading platform, which converges the bids and offers emanating from geographically dispersed locations. This creates competitive conditions for trading. The Exchange also provides facilities for clearing, settlement, arbitration facilities. The Exchange may also provide financially secure environment by putting in place suitable risk management mechanism (margining system etc.), and guaranteeing performance of contract through the process of novation.

Why does Exchange collect margin money?

The aim of margin money is to minimize the risk of default by either counter party. The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin, is very low. The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract.

What are the different types of margins payable on futures?

Different margins payable on futures contracts are:

Ordinary/initial margin, maintenance margin, mark-to-market margin, special margin, volatility margin, and delivery margin.

What is initial/ordinary margin?

It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contract. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.

What is Mark-to-Market margin?

Mark-to-market margins (MTM or M2M) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is entered into on that day) or the previous day's clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.

Why is Mark-to-Market margin collected daily in commodity market?

Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction. Hence the risk of default is reduced. Also, the participants are required to pay less upfront margin - which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position. Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity.

What is Volatility?

It is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.

What is a Client Account?

Client Account is an account maintained for any individual or entity being serviced by an agent (Member), for a commission. A customer's business must be segregated from the Member's /principal's own business and clients' money should be kept in segregated accounts.

What is a client agreement?

It is a legal document entered into between the Member and the client setting out the conditions of their relationship and meeting the requirements of the relevant self-regulatory organization and the Regulator.

What is the 'Trade Guarantee Fund'?

The main objectives of Trade Guarantee fund are (a) to guarantee settlement of bonafide transactions of the associates of the Exchange (b) thereby, to inculcate confidence in the minds of market participants' (c) to protect the interest of the investors. All the associates of the Exchange are required to make initial contribution towards trade guarantee fund of the Exchange.

What is the role of Clearing House?

Clearing House performs post trading functions like confirming trades, working out gains or losses made by the participants during the course of the clearing period - usually a day-collecting the losses from the members and paying out to other who have made gains.

What is novation?

Some Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house become buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.

How does an exchange ensure the guarantee of the performance of the contract?

The performances of the contracts registered by the exchange are guaranteed either by the exchange or it's clearing house. The exchange interposes itself between each buyer and seller thereby becoming a seller to every buyer and a buyer to every seller. The Exchange In order to safeguard its interest by imposing mark to market margin (which is clearing all the transactions at the closing price of the day. All the profits and losses are either paid in or paid out). This minimizes the chances of default as buyer or seller is exposed to one day of price movements. The Exchange also maintains its own TGF / SGF which can be used in case of a default. The Exchange also puts in place criteria of associates and some of the new Exchanges have also prescribed certain minimum capital adequacy norms.

REGULATION

What are the legal and regulatory provisions for customer protection?As trading based on contractual form of agreement, so all the investors are protected legally about their trade as contract. Apart from that, exchange is regulating the behavior of its members, so customers are fully protected through legal way and from exchange's side as well.

What is bucketing?

Member is said to be indulging in bucketing, when he takes directly or indirectly, the opposite side of a customer's order either on his own account or into on account in which he or she has an interest, without executing the order on an Exchange. Appropriation of clients' trade without written consent constitutes unauthorized activities of Members.

What is Options in Commodities?

Options in goods is an agreement under which buyer of the option (called as applier) pays a premium to the seller of option (called as writer of the option) for acquiring from him right to buy or sell the goods at a mutually agreed rate (called as strike price), in respect of which the premium amount is paid. When the buyer acquires right to buy, it is called as a "call" and when he acquires right to sell it is called a "put" option. It is possible to acquire rights both to buy and to sell the goods; but in this case higher premium amount would have to be paid. The buyer acquires only right, i.e., he is under no obligation to buy or sell, as the case may be, at the mutually agreed price.