1.

1NEED FOR THE STUDY

The derivative market in India is rapidly growing and at the same time it is providing a very good opportunity for the investors and traders to trade in the derivative market, and maximize their return on investment. Derivative market connects the local market with the global market. Commodity futures are the recent introduction into the Indian economy, which has opened new avenue for retail investors and traders to participate. It is a best available option for those who want to diversify their portfolios beyond equities, interest bearing securities or investments and real estate. The future and option contracts are designed to deal with the credit risk involved in locking- in prices and obtaining forward cover. These contracts can be used for hedging price risk and discovering future prices. The discovering future or option price or the market movement will help the trader or investor to use the strategies in a portfolio way and also at the same time to avoid the losses. 1.2 OBJECTIVES OF THE STUDY Primary objective To examine how futures can be effective alternative investment avenue. To know about gold futures and profit earning capacity of future trading. To learn about the impact of commodities in portfolio.

Secondary objective To study about the commodity market. To know about the future trading in commodities. To learn about exchanges, warehouses, exporters and brokers of commodities in India.

1.3 SIGNIFICANCE OF THE STUDY India with population of over 1billion is basically a commodity based economy. It is one of the worlds largest agrarian economies. Commodities contribute more than 50%to Indian GDP and engage two-third of the total workforce either directly or indirectly. Precious metal like gold and silver play an important role in the countrys saving and investment gamut, while commodities such as base metals (copper, aluminium, zinc, etc) and energy (coal, crude oil, natural gas) play a significant part in the growth and development of industries in India. Also is one of the largest importers of gold, silver, and edible oils, hence a potential market moves in these commodities worldwide. India has the potential to become a global hub for future trading with the expected turnover of this segment out growing the stock market within years. Indias strategic location between time zones of already established commodity exchanges worldwide is of great significances; As the Indian markets can trigger the prices of international market also.

Commodity Bullion Base metals Agri commodities Energy (Table 1.1) 2

Turnover Rs 40000 crores (US $ 9 Bn) Rs 60000 crores (US $ 13 Bn) Rs 500000 crores (US $ 110 Bn) Rs 500000 crores (US $ 110 Bn)

1.4 LIMITATION OF THE STUDY Restricted data because of official secrecy. Insufficient time. Limited knowledge of subject. Busy and hectic schedule of officials.

Respondents biases and personal prejudice, also may affect the information and hesitation in revealing certain facts also be an obstacle in giving furnishing certain details.

2.1 ABOUT ACUMEN

Acumen Multi Commodities India Limited (AMCIL) is a full service commodity futures brokerage firm, head quartered in Kochi, India offering round the clock access to four nation wide commodity exchanges in India, viz., National Multi Commodity Exchange of India (NMCE), Multi Commodity Exchange of India (MCX), National Commodity and Derivative Exchange of India(NCDEX). The company has access to international commodity exchanges through associate tie ups. In a short span of time, direct access to Worlds leading International Commodity Exchanges in West, East and Far East from Acumens own hub. AMCSL is a fully owned subsidiary of Acumen Capital Market Limited. It is promoted by a group of professional and expert stock brokers led by Mr. T.S. Anantaraman, CA, an Ex-UN, eminent financial columnist and investment consultant. Acumen has 98 branches spread across 9 states, with major presence in Kerala, Tamilnadu, Karnataka and Gujarat, and active customer base of over 3000. A large number of these branches are run by franchisees. Originally the company name was Peninsular Multi Comex Service Ltd. In September 2006 as per the regulation of Forward Market Commission (FMC-commodity market regulator), the company was asked to delete the term Comex from its name and as result the name of the company

changed to Peninsular Multi Commodity India Limited and in the last year they have changed their name to Acumen Multi Commodities India Limited

2.1.1STRATEGY The liberalization and growth of Indian economy has created significant opportunities to provide superior financial products and services to the corporate and retail segments. The key elements of retail strategy are; Focus on quality growth opportunity by; Building strong retail franchise. Maintaining and enhancing strength in its services.

Emphasis on conservative risk management practices and enhanced quality. Use of technology for competitive advantage. Attract and retain talented professionals.

2.1.2MANAGEMENT Acumen is on the fast growth track headed by a team of dynamic professionals drawn from various disciplines like chartered accountants, Businessmen, management graduates, researchers and market analysts.The company is lead by dynamic finance professional with decades of experience with the vision to transform the company into a highly professional organization. Their integrity and transparency in all dealings has earned them trust and has enabled them to build long term relationships. Their focus is on strategic evaluation and on long term appreciation while minimizing short-term risk. 2.1.3BOARD OF DIRECTORS

 Mr. T S Anantharaman (Chairman) Mr. Akshay Agarwal (Vice Chairman) Mr. Akhilesh Agarwal (Managing Director) Mr. Santhosh Kumar Agarwal Mr. P.R.Aravindakshan Nair Mr. E.J.Davis Acumen is recognized for: Individual client attention. Wide Net Work. Online back office support. Competitive brokerage and terms. Excellent market research support.

Your one stop for Commodity Futures. Connectivity options at competitive cost.

In Acumen, you get One source for commodity futures trading is in any commodity or any commodity exchange. One strong commitment to customer service sets Acumen apart from other brokerage firms. With our friendly and knowledgeable team of professionals, you can secure that your trading experience will be unlike any other. Quality of service thats right for you.

Acumens client service includes: Access to research and analysis. Market updates. Regular market outlook and recommendations. 6

Real time account status updates and much more. 100%transparency.

2.1.4 Acumens commitments QUALITY POLICY: Acumen commit to deliver services that best meet clients satisfaction; protection to its clients money maximizing the opportunities and minimizing the risk. Acumen further commit to get things right, the first time, to deliver the best value for money and time to its customers. Acumen will continuously invest in its people technologies and keep its people abreast with the latest changes and developments, information and technologies, to deliver quality and unparalleled services. EXCELLENT CUSTOMER SERVICE: Acumen strives to provide its customers with the best and the most reliable service while offering the best in todays market environment. MULTIPLE TRADING PLATFORMS: Acumen offers some of the best trading platforms available today. With platforms ranging from the most user friendly to the latest technology best, like trade in all exchanges through a single VSAT on a single computer etc. EXPERTISE: Acumen is dedicated to provide you with the exceptional commodity professionals works round the clock to provide you the best solution for your trade. EDUCATION AND COMMUNICATION: Acumen place high priorities on client education, awareness and communication. 2.1.5GOLDEN RULE OF ACUMEN Adopt a definite trading plan. If you are not sure, dont trade. Trade with stop loss, never straddle a loss. Cut your losses and let your profits ride. 7

If you cannot afford to lose, you cannot afford to win. Always trade within your margins. Dont attempt to buy the bottom or sell the top. Be aware of the trend. Dont trade too many products. Dont trade products with low trading volumes. You can usually sell the first rally or buy the first break. You should be able to be right 40% of the time and still show handsome profits.

2.2 INDUSTRY PROFILE

Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded. It is important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market. IMPACT OF WTO REGIME

India being a signatory to WTO may open up the agricultural and other commodity markets more to the global competition. Indias uniqueness as a major consumption market is an invitation to the world to explore the Indian market. Indian producers and traders too would have the opportunity to explore the global markets. Price risk management and quality consciousness are two important factors to succeed in the global competition. Futures and other derivatives contracts have significant role in price risk management. Indian companies are allowed to participate in the international commodity exchanges to hedge their price risk resultant from export and import activities of such companies. Due to the compliance issues and international exchange rules, 90 percent of the commodity traders and producers are not in a position to participate in the international exchanges. International exchanges have trading unit size, which are prohibitive for many of the Indian traders and producers to participate in the international exchanges. Addressing the risk management requirements of the majority is of concern and the way to address is through on-shore exchanges. In a more liberalized environment, Indian exchanges have significant role to play as vital economic institutions to facilitate risk management and price discovery; price discovery would have greater link to global demand and supply which could assist the producers to decide on what crops they should produce. WAY AHEAD Commodity exchanges in India are expected to contribute significantly in strengthening Indian economy to face the challenges of globalization. Indian markets are poised to witness further developments in the areas of electronic warehouse receipts (equivalent of dematerialized shares), which would facilitate seamless nationwide spot market for commodities. Amendments to Essential Commodities Act and implementation of Value-Added-tax would enable movement of across states and more unified tax regime, which would facilitate easier trading in commodities. Options contracts in commodities are being considered and this would again boost the commodity risk management markets in the country. We may see increased interest from the international players in the Indian commodity markets once national exchanges

become operational. Commodity derivatives as an industry are poised to take-off which may provide the numerous investors in this country with another opportunity to invest and diversify their portfolio. Finally, we may see greater convergence of markets equity, commodities, forex and debt which could enhance the business opportunities for those have specialized in the above markets. Such integration would create specialized treasuries and fund houses that would offer a gamut of services to provide comprehensive risk management solutions to Indias corporate and trade community. In short, we are poised to witness the resurgence of Indias commodity trading which has more than 100 years of great history. MARKETS Markets have existed for centuries in India and abroad for selling and buying of good and services. The concept of market started with agricultural products and hence it is as old as the agro products or the business of farming itself. Traditionally, the farmers used to bring their produce to a central place (called Mandi/Bazar) in a town/village where grain merchant/traders would also come and buy the produce and transport, distribute it to other markets. In a traditional market, agriculture produce would be brought and kept in the market and the potential buyers would come and see the quality of the produce and negotiate with the farmers directly for a price that they would be willing to pay and the quantity that they would like to buy. The deals were then stuck once mutual agreement was reached on the price and the quantity to be bought/sold. In the system of traditional markets, shortages of a commodity in a given season would lead to increase in price for the commodity or oversupply on even a single day (due to heavy arrivals) could result into decline in prices sometimes below the cost of production to the farers. Neither the farmers nor the food grain merchants were happy with this situation since they could not predict what the prices would be on a given day or in a given season. As a result, any times the farmers were required to return from the

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market with their produce since it did not fetch reasonable price and since there were no storage facilities available near the market place. It was in this context that farmers and food grain merchants in Chicago started negotiating for future supplies of grains in exchange of cash at a mutually agreeable price. This type of agreement was acceptable to both parties since the farmer would know how much he would be paid for his produce, and the dealer would know his cost of procurement in advance. This effectively started the system of organized commodity market and forward contracts, which subsequently evolved the futures market.

COMMODITY A Commodity is a product having commercial value, which can be produced, bought, sold and consumed. Commodities are basically the products of primary sector of an economy. Primary sector of an economy is that part of the economy, which is concerned with agriculture and extraction of raw materials. In order to qualify as a commodity, an article or a product has to meet some basic characteristics, these are listed below: The product has not gone through any complicated manufacturing activity, though simple processing (like mining, cropping, etc.) is not ruled out. In other words, the product must be in a basic raw, unprocessed state. (For instance wheat is a commodity; but wheat flour and bread are not commodities). The product has to be fairly standardized to facilitate writing of contracts on products of uniform quality. (e.g. Rice is rice though different varieties of rice can be treated as different commodities and hence traded as separate contracts) Major consideration while buying a particular commodity is its price (since there is hardly any difference in quality from seller to seller). Prices of the products are determined by market forces, demand and supply and they undergo rapid changes/fluctuations (price must fluctuate enough to create 11

uncertainty, which means both risk and potential profit / loss for buyers and sellers) Product should also be available in large volume.

Usually there should be many competing sellers and buyers of the product in the market to facilitate price discovery.

The product should

have adequate shelf life so that delivery of a future

contract can be deferred. COMMODITY MARKET Market is a place where buyers and sellers meet to transact a business i.e. for exchange of goods or services for a consideration, which is usually money. In todays world, markets need not exist in physical form as long as the exchange of goods or services takes place for a consideration. Commodity market is therefore logically a market where commodities or Commodity derivatives are bought or sold for a consideration. It is an important constituent of the financial system for any country. Thus, it is a platform where a wide range of product like precious metals (gold and silver), base metals like aluminum, copper, zinc, crude oil, energy and other commodities like soy oil, palm oil, coffee, food grain such as rice and wheat, pulses, pepper are traded Existence of a vibrant, active and liquid commodity market is normally considered as a healthy sign of development of any economy. Commodity markets quite often have their centers in developed countries. Commodity futures in particular help price discovery and assist investors in hedging their risk by taking positions in commodities and exploiting arbitrage opportunities in the market. They also help producers to know what price their products could fetch in future. Assured prices and transparency are thus major hallmarks of commodity markets. Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity 12

markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the state and forwards and futures trading are selectively introduced with stringent controls. While free trade in many commodity items is restricted under the Essential Commodities Act (ECA), 1955, forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952. The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd., and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. The Gujrati Vyapari Mandali came into existence in 1900 which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association (EICA). Many exchanges were set up in major agricultural centers in north India before world war broke out and they were mostly engaged in wheat futures until it was prohibited. The existing exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was first organized by India Pepper and Spices Trade Association (IPSTA) in Cochin in 1957. Futures in gold and silver began in Mumbai in 1920 and continued until it was prohibited by the government by mid-1950s. Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until they along with futures were banned in 1939 (Ministry of Food and Consumer Affairs, 1999). However, the government withdrew the ban on futures with passage of FCRA in 1952. The Act has provided for the establishment and constitution of Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers assigned to it by the Act. Later, futures trade was altogether banned by the government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities. After the ban of futures trade all the exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On

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recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc. As part of economic liberalization of 1990s an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra was appointed by the government of India in 1993. Its report submitted in 1994 recommended the reintroduction of futures which were banned in 1966 and also to widen its coverage to many more agricultural commodities and silver. In order to give more thrust on agricultural sector, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk arising from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading. THE PRESENT STATUS Futures trading perform two important functions of price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It is useful to the producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him. It enables the consumer, in that he gets 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. Futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to hedge his risk by operating in futures market. Forward/futures trading involve a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc. Hence there is a need for the regulatory functions to be exercised by an exchange that is the Forward Markets Commission (FMC). Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public

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Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. Exchange is an association of members which provides all organizational support for carrying out futures trading in a formal environment. These exchanges are managed by the Board of Directors which is composed primarily of the members of the association. There are also representatives of the government and public nominated by the Forward Markets Commission. The majority of members of the Board have been chosen from among the members of the Association who have trading and business interest in the exchange. The Board is assisted by the chief executive officer and his team in day-to-day administration. FUNCTIONING OF COMMODITY MARKET IN INDIA There are three types of regulated markets in India: Spot Markets - Direct purchases for immediate consumption. Futures and Forward Markets - Agreements new to pay and received deliver later. Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered in the future. Derivatives Market is Purely financial transactions based on physical trading. The system includes following elements: Hedgers, Speculators, Investors, Arbitragers. Producers Farmers. Consumers, refiners, food processing companies, jewelers, textile mills, exporters & importers. There are two kinds of trade in commodities. The first is the spot trade, in which one pays cash and carries away the goods. The second is futures trade. The underpinning for futures is the warehouse receipt. A person deposits a certain amount

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of, say; good X in a warehouse and gets a warehouse receipt which allow him to ask for physical delivery of the good from the warehouse. But someone trading in commodity futures need not necessarily possess such a receipt to strike a deal. A person can buy or sell a commodity future on an exchange based on his expectation of where the price will go. Futures have something called an expiry date, by when the buyer or the seller either closes his account for all dealing parties in which the daily profit or loss due to changes in the future price is recorded. Squaring off is done by taking an opposite contract so that net outstanding is nil. The biggest benefits of commodity trading will accrue to commodity traders, farmers and companies dealing in commodity based products by allowing them to hedge their risks. Then there are speculators, who are in the game only to make money out of the volatility in prices. But unlike in stocks, few retail investors are expected to trade in commodity futures since it requires a fair bit of expertise. Even those who do will probably restrict themselves to trading in gold and silver. SCOPE OF COMMODITY MARKET Investment in commodity markets has been very popular and rewarding for investors in U.K. and U.S.A. For investors looking for diversification beyond stock markets, commodity markets offer another investment option. The commodity markets activity, volume and players multiplied in the recent past. In India, although the trading in commodity markets and commodity exchanges is booming, it has to cross few more hurdles like permitting Fills, banks and other financial institutions to operate in these markets. The reason why investors may look for opportunities in commodity markets may take us to the basic tenets of risk and return theory viz. expected return and risk. Normally it is a risk - reward relationship. The higher the risk higher is the expected return and vice versa. POTENTIAL OF COMMODITY MARKETS IN INDIA 16

The following salient features of the Indian economy/commodity markets and their related aspects would be adequate to stress the relevance of commodity market and the great potential that they offer for future development of India: India is the worlds leading producer of 17 agricultural commodities and is also the worlds largest consumer of edible oil and gold. India has 30 major markets and nearly 7,500 mandies with substantial arrivals of a variety of commodities. Over 27000 haats exist in country with seasonal arrivals of various commodities. Nearly 5 million traders are engaged in commodity trading in India Commodities related (and dependent) industries constitute approximately 58% of Indias GDP, which (at factor cost based on prices of year 1999-2000) for the year 2004-2005 was Rs. 23, 93,671 Crores. State and central Governments have invested substantial resources to boost production of agricultural commodities. Many of these would be traded on the futures markets as food processing increases from the current level of 2% to 4050% comparable to other countries. There are three national level Commodity Exchanges that trade in approximately 100 commodities at present and the list continues to expand. Indian spot market for commodities such as bullion, metals, agriculture produce and energy is estimated at approximately Rs 11,00,000 crore annually. According to the experts in the field, global trends indicate that the volumes in futures trading tend to be 5-7 times the size of commodities spot trading in the

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country (internationally, the multiple for physical versus derivatives is much higher at 15 to 20 times). This implies that the potential for futures trading market in India currently stands at a staggering Rs 55,00,000 crores to Rs 77,00,000 crore annually. Three nationwide electronic exchanges and 22 recognized regional or small commodity exchanges in India had an estimated that combined turnover of Rs 21.34 lakh crore for the year 2005-06. This translates into a 373% growth of the previous financial year. Many nationalized and private sector banks have announced plans to disburse substantial amounts to finance commodity-trading business. (private sector giant viz. HDFC Bank alone is planning to disburse over Rs 1,000 Crore for financing agriculture commodities in 2005-06). The government of India has initiated several measures to stimulate active trading interest in commodities. Some of these measures are lifting the ban on futures trading in commodities approving new exchanges developing exchanges with modern infrastructure and systems such as online trading; and removing legal hurdles to attract more participants possibility of allowing existing stock exchanges to also deal in commodities As a result of the above developments, both the spot and futures market in India are witnessing rapid growth. LIMITATION OF COMMODITY MARKET

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Commodity markets, like any other markets, have their own limitations too. Some of them are: Commodity market prices can fluctuate wildly depending on the factors, which are sometimes beyond human control (floods, storms, natural calamities like earthquakes, etc. can create temporary shortages of commodities and hence result in drastic changes in their prices in a very short time) Forward / futures trading involve a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc. Hence, it is necessary that the investors/players in the commodity markets understand the functioning of commodity markets, mechanism of commodity Exchanges properly and study the factors that can affect the commodity prices carefully. STRUCTURE OF COMMODITY MARKET IN INDIA

MINISTRY OF CONSUMER AFFAIRS

FORWARD COMMISSION

MARKETS

COMMODITY EXCHANGE

NATIONAL EXCHANGE

REGIONAL EXCHANGES

MCX

NMCE

NCDEX 19

(Chart 2.1) INDIAN COMMODITY MARKET History of trading in commodities in India is quite old. Even Kautilya's 'Arthashastra' makes a mention of commodity markets in India, which dates back to Maurya dynasty. In India there used to be a class called "Mahajans" who performed important role in trade and banking. They had social influence and were able to enforce integrity and honesty in trade and used to settle matters of dispute. The system continued till middle of nineteenth century.

INDIAS SHARE IN GLOBAL COMMODITY MARKETS At present, India's share in the global commodity markets - both agricultural and industrial, especially of energy products and base metals - is not big enough to make a major impact on international prices (bullion being an exceptional case). India currently accounts for only around 3 per cent of the global oil demand and 2 per cent of the global copper demand. In comparison, China accounts for 8 per cent and for oil and as high as 22 per cent of the global demand. However, in the gold market, bout 20 per cent of the world demand and remains a key buying support on price corrections. In case of agricultural commodities, Indias production base is large, but international trade volumes are still rather. India is the world's largest producer of Worlds second largest producer of rice and wheat after China aid the world 3 third largest producer of cotton after China and the US; though foreign trace (export and import) in these commodities is rather limited. However, in getable oil, India is the world's largest importer (with 4.5-5.0 million tones annually), as is the case with pulses (close to 2 million tones) also. Despite a modest share in the industrial products market, the prospects for growth for the industrial commodities in India are considerable. Despite a slowdown in industrial

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production at times overall the domestic economy in India continues to grow while imports and growth in demand for corporate borrowing also indicate a positive outlook. In addition, large infrastructure works are being undertaken across the country, covering rail, road, energy and sports. The outgoing Golden Quadrilateral project is an excellent example of road connective to the four corners of the country. Port modernization and involvement of the private sector in infrastructure development are likely to be the key growth drivers. A sectoral study of India conducted by consultants McKinsey had suggested that global steel consumption would increase to around 80-100 million tones by 2015, up from 33 million tones in 2003. due to robust demand growth from infrastructure, construction, manufacture and automotive sectors mainly in India and China. All these factors point out a very encouraging outlook for the growth of Indian commodity markets.

3.1RESEARCH METHODOLOGY
Methodology can be considered as the backbone of any project work. Methodology refers to the scientific methods used in the project for the purpose of investigation and research. Research is a search for knowledge. It is a careful investigation or enquiry especially through search for new facts in any branch of knowledge. According to Clifford Woody research comprises defining and redefining problems, formulating hypothesis or suggested solutions; collecting, organizing and evaluating data; making deductions and reaching conclusions; and at last carefully testing the conclusions to determine whether they fit the formulating hypothesis. Research methodology is a way to systematically solve the research problem. It is a science of studying how research is done scientifically. This project is to analyze the future prospects of commodity derivatives as the Indian Commodity markets and futures trading in the commodity exchanges have 21

great potential to develop as one of the fastest growing centers in the world. India belong an agrarian economy can definitely bolster its commodity trading volumes. Similarly India is also a large producer in various commodities and metals. If we consider consumption aspects of certain commodities, India again will figure as one of the largest consumers of such products. Being one of world's largest agrarian economies, commodities contribution (agricultural produce and other commodities) to the Indian economy said to account for about 50% to India's GDP.

Thus one can visualize the potential of Indian commodity exchanges to become a global hub for futures trading with the expected turnover of this segment out growing the stock market within a few years to come.

3.2RESEARCH DESIGN A research design is the arrangement of conditions for collection and analysis of data in a manner that aims to combine relevance to research purpose with economy in procedure. It is the conceptual structure within which research is conducted; it constitutes the blueprint for the collection, measurement and analysis of data. In other words, it is the conceptual structure within which research would be conducted. Research design is needed because it facilitates the smooth sailing of the various research operations, thereby making research as efficient as possible yielding maximal information with minimal expenditure of effort, time and money. There are three basic types of research design. They are:(a) Research design in case of exploratory research studies The main purpose of formulative research studies is that of formulating a research problem for more precise investigation of developing the working hypothesis from an operational point of view. The major emphasis in such studies is on the discovery of

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ideas and insights. The three methods are generally used in the context formulative research design is:(i) (ii) (iii) the survey of concerning literature experience survey The analysis of insight-stimulating examples.

(b) Research design in case of descriptive and diagnostic research studies Descriptive research studies are those studies which are concerned describing the characteristics of a particular individual, or of a group, whereas diagnostic research studies determine the frequency with which something occurs or its association with something else. The studies concerning whether certain variables are associated are examples of diagnostic research studies. (c) Research design in case of hypothesis-testing research studies Experimental studies are those where the researcher tests the hypotheses of causal relationship between variables. Such studies require procedures that will not only reduce bias and increase reliability, but will permit drawing inferences about causality. The research design designed for this study is of the descriptive type. Descriptive research includes surveys and fact finding inquiries of different kinds. The major purpose of descriptive research is description of the state of affairs as it exists at present. 3.3SOURCES OF DATA COLLECTION There are several ways of collecting the appropriate data which differ in context of money costs, time and other resources of at the disposal of the researcher. The two types of data are primary data and secondary data.

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3.3.1 Primary data: Primary data are those which are collected afresh and for the first time, and thus happen to be original in character. Primary data can be collected through observation, personal interview, telephone interviews, mailing of questionnaires, and schedules. The data was collected in the study through telephonic interviews by asking the respondents questions from the questionnaires which was already prepared. The names and contact numbers of the respondents are given from the company from its record book. 3.3.2 Secondary data: It provides a starting point for the project and offers the advantages of low cost and ready availability. Secondary data are those which have already been collected by someone else and which have already been passed through the statistical process. Secondary data may be either published or unpublished data. Usually published data are available in various books, magazines, newspapers, reports and publications of various associations connected with industry, business, banks, stock exchanges, public records and statistics, historical documents, and other sources of published information. The secondary data was collected in this study from documents given from the office, internet, company magazines, company articles, company website, investors handbook, statistics and circulars given by NCDEX and so forth.The secondary data is also collected from various books like NCFM Commodity Dealer Module NSE India and Diploma in Commodities trading. And for getting knowledge of current Scenario of commodity market over the entire world and in India different sites are used like http://www.mcx.com http://www.ncdex.com http://www.commoditiescontrol.com 3.4RESEARCH APPROACH

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There are two basic approaches to research (1) Quantitative approach (2) Qualitative approach. The qualitative approach involves the generation of data in quantitative form which can be subjected to rigorous quantitative analysis in a formal and rigid fashion. This approach can be further sub-classified into inferential, experimental and simulation approaches to research. The purpose of inferential research is to form a data base from which to infer characteristics or relationships of population. Experimental approach is characterized by much greater control over the research environment and in this case some variables are manipulated to observe their effect on other variables. Stimulation approach involves the construction of an artificial environment within which relevant information and data can be generated. The quantitative data used in this study is the sample size and the age of respondents. Qualitative approach to research is concerned with subjective assessment of attitudes, opinions and behavior. Research in such a situation is a function of researchers insights and impressions. Such an approach to research generates results either in non-quantitative form or in the form which are not subjected to rigorous quantitative analysis. The techniques of focus group interviews, projective techniques and depth interviews are used. The study did not include depth interview and so forth but included questions in the questionnaire to know about the level of knowledge in commodity trading of respondents, level of satisfaction of respondents and so forth. 3.5RESEARCH INSTRUMENTS The research instrument used in the study is a telephonic interview. This method of collecting information includes contacting respondents on telephone itself. The telephone interview made the study in much easier way. The response was obtained in a quick way, callbacks could be made, replies were recorded, interview was made at the time which is convenient to the respondents and interviewer could explain requirements more easily. And at the same time it has its own demerits. Possibility of bias of interviewer is possible and in most cases interview period is not likely to exceed five minutes.

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The questionnaire was another research instrument used in this study. This method of data collection is quite popular. It is being adopted by private individuals, research workers, private and public organizations and even by governments. The questionnaire includes the questions relating to collect primary data regarding the scope and challenges of commodity futures. The questions were asked to the respondents from the already set questionnaires so that it is free from the bias of the interviewer and not only that bias due to no-response were also avoided. The questionnaire consists of two parts. The first part is to collect the personal profile of the respondents such as the name, age, gender, marital status, working status and place of residence. The second part of the questionnaire contains questions to know about the knowledge level, satisfaction level of the respondents regarding the commodity futures. Since the questions were asked through the telephone, the respondents answered their own; they did not get any time to discuss. 3.6SAMPLING DESIGN A sampling design is a definite plan for obtaining a sample from a given population. It refers to the technique or procedure the researcher would adopt in selecting items for the sample. Sampling design may as well lay down the number of items to be included in the sample, that is, the size of the sample. Sampling design is determined before data are collected. UNIVERSE The set of objects is technically called as universe. The universe in this study is the clients register given from Acumen Commodities (India) Ltd. It includes the personal details and contact details of the companys clients. The universe in this study was finite. It included the details of more than 100 clients. SAMPLE SIZE

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This refers to the number of items to be selected from universe to constitute a sample. The size of sample used for collecting data is 50 clients from the companys register. They belong to Ernakulam and Kottayam districts. SAMPLING PROCEDURE The researcher must decide about the type of sample to be used in the study, must decide about the technique to be used in selecting the items for the sample. The sample of this survey is selected through convenience and deliberate sampling. The sample includes respondents from urban and rural areas. The sample also contains both the male and female respondents who are married and unmarried, who are working and non- working. 3.7RESEARCH PERIOD The period of study was for a month. It was from 1 st of December 2008 to 31st of December 2008. 3.8STATISTICAL METHODS One of the important functions of statistics is to present the data in a manner by which it can be readily understood. Diagrams are one of the statistical methods which simplify the complexity of quantitative data and make them easily intelligible. The statistical method used in this study is pie diagram. Pie diagrams are used when the aggregate and heir divisions are to shown together. The aggregate is shown by means of a circle and he divisions by the sectors of the circle. In constructing a pie diagram the various components are first expressed as percentages and then the percentages are multiplied by 3.6. So we get angle for each component. Then the circle is divided into sectors such that angles of the components and angles of the sectors are equal. Therefore one sector represents one component. SOFTWARES USED

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The software tool used for the study are Microsoft Office especially Microsoft word and Microsoft excel.

4.1 INTRODUCTION TO DERIVATIVES The word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc. A derivative is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables. Derivatives are derived from the following products: A. Shares B. Debentures

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C. Mutual funds D. Gold E. Steel F. Interest rate G. Currencies. A derivative is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivative having same views about the market. In short it is like an INSURANCE market where investors cover their risk for a particular position. Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential. Derivatives trading have been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks.

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Initially derivatives were launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities. The first product which was launched by BSE and NSE in the derivatives market was index futures. The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favorable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the to-arrive contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence. 30

Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc. DERIVATIVES DEFINED According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else. Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns. 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 asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets.

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Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to include A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities. 4.2Products, Participants and Functions Derivative contacts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories- hedgers, speculators, and arbitragers. Hedgers The farmers example discussed in the introduction was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk. Speculators Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses. Arbitragers Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they

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see the future price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. Whether the underlying asset is a commodity or a financial asset, derivative markets performs 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 the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 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 kinds of mixed markets. An important incidental benefit that flows derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

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Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.

4.3 COMMODITY TRADING IN INDIA 4.3.1 History of Evolution of commodity markets Commodities future trading was evolved from need of assured continuous supply of seasonal agricultural crops. The concept of organized trading in commodities evolved in Chicago, in 1848. But one can trace its roots in Japan. In Japan merchants used to store Rice in warehouses for future use. To raise cash warehouse holders sold receipts against the stored rice. These were known as rice tickets. Eventually, these rice tickets become accepted as a kind of commercial currency. Latter on rules came in to being, to standardize the trading in rice tickets. In 19th century Chicago in United States had emerged as a major commercial hub. So that wheat producers from Mid-west attracted here to sell their produce to dealers & distributors. Due to lack of organized storage facilities, absence of uniform weighing & grading mechanisms producers often confined to the mercy of dealers discretion. These situations lead to need of establishing a common meeting place for farmers and dealers to transact in spot grain to deliver wheat and receive cash in return. Gradually sellers & buyers started making commitments to exchange the produce for cash in future and thus contract for futures trading evolved, Whereby the producer would agree to sell his produce to the buyer at a future delivery date at an agreed upon price. In this way producer was aware of what price he would fetch for his produce and dealer would know about his cost involved, in advance. This kind of agreement proved beneficial to both of them. As if dealer is not interested in taking delivery of the produce, he could sell his contract to someone who needs the same. Similarly producer who not intended to deliver his produce to dealer could pass on the same responsibility to someone else. The price of such contract would dependent on the price movements in the wheat market. Latter on by making some modifications 34

these contracts transformed in to an instrument to protect involved parties against adverse factors such as unexpected price movements and unfavorable climatic factors. This promoted traders entry in futures market, which had no intentions to buy or sell wheat but would purely speculate on price movements in market to earn profit. Trading of wheat in futures became very profitable which encouraged the entry of other commodities in futures market. This created a platform for establishment of a body to regulate and supervise these contracts. Thats why Chicago Board of Trade (CBOT) was established in 1848. In 1870 and 1880s the New York Coffee, Cotton and Produce Exchanges were born. Agricultural commodities were mostly traded but as long as there are buyers and sellers, any commodity can be traded. In 1872, a group of Manhattan dairy merchants got together to bring chaotic condition in New York market to a system in terms of storage, pricing, and transfer of agricultural products. In 1933, during the Great Depression, the Commodity Exchange, Inc. was established in New York through the merger of four small exchanges the National Metal Exchange, the Rubber Exchange of New York, the National Raw Silk Exchange, and the New York Hide Exchange. The largest commodity exchange in USA is Chicago Board of Trade, The Chicago Mercantile Exchange, the New York Mercantile Exchange, the New York Commodity Exchange and New York Coffee, sugar and cocoa Exchange. Worldwide there are major futures trading exchanges in over twenty countries including Canada, England, India, France, Singapore, Japan, Australia and New Zealand. 4.3.2 History of Commodity Market in India The history of organized commodity derivatives in India goes back to the nineteenth century when Cotton Trade Association started futures trading in 1875, about a decade after they started in Chicago. Over the time datives market developed in several commodities in India. Following Cotton, derivatives trading started in oilseed in Bombay (1900), raw jute and jute goods in Calcutta (1912), Wheat in Hapur (1913) and Bullion in Bombay (1920). However many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying 35

commodities, resulting in to banning of commodity options trading and cash settlement of commodities futures after independence in 1952. The parliament passed the Forward Contracts (Regulation) Act, 1952, which regulated contracts in Commodities all over the India. The act prohibited options trading in Goods along with cash settlement of forward trades, rendering a crushing blow to the commodity derivatives market. Under the act only those associations/exchanges, which are granted reorganization from the Government, are allowed to organize forward trading in regulated commodities. The act envisages three tire regulations: (i) Exchange which organizes forward trading in commodities can regulate trading on day-to-day basis; (ii) Forward Markets Commission provides regulatory oversight under the powers delegated to it by the central Government. (iii) The Central Government- Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution- is the ultimate regulatory authority. The commodities future market remained dismantled and remained dormant for about four decades until the new millennium when the Government, in a complete change in a policy, started actively encouraging commodity market. After Liberalization and Globalization in 1990, the Government set up a committee (1993) to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also recommended strengthening forward Markets Commission, and certain amendments to Forward Contracts (Regulation) Act 1952, particularly allowing option trading in goods and registration of brokers with Forward Markets Commission. The Government accepted most of these recommendations and futures trading was permitted in all recommended commodities. It is timely decision since internationally the commodity cycle is on upswing and the next decade being touched as the decade of Commodities. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say. Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the

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vital market. A big difference between a typical auction, where a single auctioneer announces the bids and the Exchange is that people are not only competing to buy but also to sell. By Exchange rules and by law, no one can bid under a higher bid, and no one can offer to sell higher than someone elses lower offer. That keeps the market as efficient as possible, and keeps the traders on their toes to make sure no one gets the purchase or sale before they do. Since 2002, the commodities future market in India has experienced an unexpected boom in terms of modern exchanges, number of commodities allowed for derivatives trading as well as the value of futures trading in commodities, which crossed $ 1 trillion mark in 2006. Since 1952 till 2002 commodity datives market was virtually non- existent, except some negligible activities on OTC basis. In India there are 25 recognized future exchanges, of which there are three national level multi-commodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai, Multi Commodity Exchange of India Limited (MCX) Mumbai and National Multi-Commodity Exchange of India Limited (NMCEIL) Ahmedabad.There are other regional commodity exchanges situated in different parts of India.

4.4 Price discovery Price discovery is the general process used in determining spot prices. These prices are dependent upon market conditions affecting supply and demand. For example, if the demand for a particular commodity is higher than its supply, the price will typically increase (and vice versa). Unlike the physical market, a futures market facilitates offsetting the trades without changing physical goods until the expiry of a contract. As a result, futures market attracts hedgers for risk management, and

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encourages considerable external competition from those who possess market information and price judgment to trade as traders in these commodities. While hedgers have long-term perspective of the market, the traders or arbitragers, prefer an immediate view of the market. However, all these users participate in buying and selling of commodities based on various domestic and global parameters such as price, demand and supply, climatic and market related information. These factors, together, result in efficient price discovery, allowing large number of buyers and sellers to trade on the exchange. MCX is communicating these prices all across the globe to make the market more efficient and to enhance the utility of this price discovery function. The price discovery process is the process of determining the price of an assets in the marketplace through the interactions of buyers and sellers Price discovery is different from valuation. Price discovery process involves buyers and sellers arriving at a transaction price for a specific item at a given time. It involves: Buyers and seller (number, size, location, and valuation perceptions) Market mechanism (bidding and settlement process, liquidity); Available information (amount, timeliness, significance and reliability) including futures and other related markets. Risk management choices.

In a dynamic market, the price discovery takes place continuously. The price will sometimes fall below the duration average and sometimes exceed the average as a result of the noise due to uncertainties. The price would fluctuate between the support and resistance levels, which are associated with the ends of the expectation spectrum. 4.5 Price Risk Management Hedging is the practice of off-setting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. This technique is very useful in case of any long-term requirements for which the prices have to be firmed

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to quote a sale price but to avoid buying the physical commodity immediately to prevent blocking of funds and incurring large holding costs. Hedging is the most common method of price risk management. Futures markets are used as a mode by hedgers to protect their business from adverse price change. This could dent the profitability of their business. Hedging benefits who are involved in trading of commodities like farmers, processors, merchandisers, manufacturers, exporters, importers etc. Price risk management instruments are financial tools available in the international markets (exchanges). They can be futures, options, swaps or combinations of these products. They are traded in Standardized futures and options tend to be traded on organized commodity exchanges, most of which are based in the world's leading financial centers such as London, New York and Chicago. There are also exchanges in countries such as Argentina, Brazil, China, India, and South Africa, which mainly trade contracts for domestic use. Price risk management market cover commodities like metals, petroleum products, and certain agricultural products (e.g. coffee, cocoa, soybean and soybean products, wheat, and maize), there are relatively liquid markets that are used for risk management on a daily basis. In fact, the volume of contracts traded is several times the volume of physical production of several commodities traded on international exchanges. For other agricultural products important to many developing countries, such as rice and tea, there are currently no such exchanges available to transfer risk.

5.1 Introduction to commodity futures

A commodity futures contract is a type of derivative, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for delivery at a particular price at a later date. If you buy a commodity contract, you are basically agreeing to buy something, for a set price, that a seller has

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not yet produced. But participating in the commodity market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities, remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than delivery (which is the primary activity of the cash/spot market). That is why Commodities are used as financial instruments by not only producers and consumers but also speculators. Commodity Futures, which forms an essential component of Commodity Exchange, can be broadly classified into precious metals, agriculture, energy and other metals. Current futures volumes are miniscule compared to underlying spot market volumes and thus have a tremendous potential in the near future. Futures trading in commodities results in transparent and fair price discovery on account of large-scale participations of entities associated with different value chains. It reflects views and expectations of a wider section of people related to a particular commodity. It also provides effective platform for price risk management for all segments of players ranging from producers, traders and processors to exporters/importers and end-users of a commodity. It also helps in improving the cropping pattern for the farmers, thus minimizing the losses to the farmers. It acts as a smart investment choice by providing hedging, trading and arbitrage opportunities to market players. Historically, pricing in commodities futures has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option. Raw materials form the most key element of most of the industries. The significance of raw materials can further be strengthened by the fact that the "increase in raw material cost means reduction in share prices". In other words "Share prices mimic the commodity price movements". Industry in India today runs the raw material price risk; hence going forward the industry can hedge this risk by trading in the commodities market.

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The consensus in the investment world is that the Commodities market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The commodity market is extremely liquid, risky, and complex by nature, but it can be understood if we break down how it functions. While commodities are not for the risk-averse, they are useful for a wide range of people. In this tutorial, you'll learn how the commodity market works, who uses commodities and why, and which strategies will make you a successful commodity trader. 5.2 Commodity future contract A commodity futures contract is a tradable standardized contract, the terms of which are set in advance by the commodity exchange organizing trading in it. The futures contract is for a specified variety of a commodity, known as the "basis", though quite a few other similar varieties, both inferior and superior, are allowed to be deliverable or tenderable for delivery against the specified futures contract. All contracts in commodities providing for delivery of goods and/or payment of price after 11 days from the date of the contract are "forward" contracts. Forward contracts are of two types - "Specific Delivery Contracts" and "Futures Contracts". Specific delivery contracts provide for the actual delivery of specific quantities and types of goods during a specified future period, and in which the names of both the buyer and the seller are mentioned. The term 'Futures contract' is nowhere defined in the FCRA. But the Act implies that it is a forward contract, which is not a specific delivery contract. However, being a forward contract, it is necessarily "a contract for the delivery of goods". A futures contract in which delivery is not intended is void (i.e., not enforceable by law), and is, therefore, not permitted for trading at any commodity exchange. The quality parameters of the "basis" and the permissible tenderable varieties; the delivery months and schedules; the places of delivery; the "on" and "off" allowances for the quality differences and the transport costs; the tradable lots; the modes of price quotes; the procedures for regular periodical (mostly daily) clearings; the payment of prescribed clearing and margin monies; the transaction, clearing and other fees; the

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arbitration, survey and other dispute redressing methods; the manner of settlement of outstanding transactions after the last trading day, the penalties for no issuance or nonacceptance of deliveries, etc., are all predetermined by the rules and regulations of the commodity exchange. Consequently, the parties to the contract are required to negotiate only the quantity to be bought and sold, and the price. Everything else is prescribed by the Exchange. Because of the standardized nature of the futures contract, it can be tradedwith ease at a moments notice. 5.3 Features of Futures Contract The commodity future will always have a fixed period, like one month, three month etc. as the life of the contract may be different in different commodity exchanges. At the end of contract period, the future contract would expire and the concerned parties will have to give and receive delivery of the commodity mentioned in the contract. Both the tie and the place of delivery are prescribed by the exchange and this will form part of the futures contract. There is usually a time difference between the expiry of futures contract and the delivery period. As a result of this intervening period, the cash price for a commodity would be different from its futures price mentioned in the contract. Buyers Obligation: The buyers of futures contract have two obligations. One, he has to take delivery of the commodity purchased if the contract is allowed to run its full life term. Second, he has to pay the purchase price. The buyer also has a right to the facility of offsetting his existing obligation through an opposite trade. This unique feature in the futures contract gives the buyer flexibility with regards to delivery on expiry. Sellers obligation: The sellers obligation is to deliver the commodity as per standardized quantity and quality and receive the price. He too has the facility of offsetting the existing contract. 42

Closing out position: Closing out position means entering into a trade of opposite to the original one to

settle the contract. Position limit: Some commodity exchanges prescribe position limit for speculators. Position limit refers to the maximum number of contracts that a speculator can hold at a particular point of time. Initial margin: Let us assume that an investor contacts his Exchange Broker to buy three November Gold futures contract. We will assume that the November futures contract is Rs 9000 per 10 gm. The member will require the investor to deposit funds in the form of margin in margin account. Let us say, it is Rs 2000 per contract of 10 g. since the investor has bought three November Gold futures, the margin amount will be Rs 6000 (3 x 2000). The investor must deposit this sum in the margin account with the member. This margin is known as initial margin. Marking to market: At the end of every trading day, the margin account is adjusted to reflect the investor gain or loss. Supposing, on the second day of the contract, the November futures price for gold closes at 9100 per 10 gm. This will result into a gain of Rs 300 (3 x 100) on the three contracts bought by the investor and vice versa if loss. The resultant gain or loss will on day to day basis will be taken to margin account. While the gain is credited to the margin account and will have an impact of increasing the balance in margin account, a loss sustained will be debited to the margin account. This daily valuation of the account is known as marking the market. Margin call: You are now aware that the daily valuation of the traders future position results into a loss or gain depending upon price movements. When such valuation results into a

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loss the exchange will make a margin call on the trader. The effect of such margin call is that the trader should bring in that much of fresh funds to be deposited in that margin account. Thus margin calls are made by the exchanges only when the futures p[position of a trader results into a loss as compared to its value on the previous day. Maintenance margin: Maintenance margin is that portion of the initial margin which should be the minimum prescribed margin, which should always be available in the margin account. In many exchanges, the maintenance margin is usually about 75% of initial margin. The main purpose of maintenance margin is to ensure that the margin account never becomes negative. Clearing margin: Every trader is required to maintain margin account with the broker/members. In the same way every broker of the exchange is required to place certain money with the clearing house. Thus the margin amount provided by the broker with the clearing house is known as clearing margin. 5.4 Objectives of Commodity Futures Contract hedging with a view to transfer the price risk; price discovery through a large number of transaction and players; maintenance of buffer stock and better allocation of resources; reduction in inventory requirement and thereby reduction in cost of carry; price stabilization through balanced demand and supply position; Help raise bank finance through transparency and flexibility coming with futures contract.

5.5 Pricing Commodity Futures: The relationship between cash price and future price can be explained in terms of cost of carry. Cost of carry is an important element in determining pricing relationship between 44

spot and futures prices as well as between prices of futures contract of different expiry months. According to the cost of carry model, futures prices depend on the spot price of the commodity and the cost of storing the commodity from the date of spot price to the date of delivery of the futures contract. Cost of storage and insurance and cost of financing constitute cost of carry. Estimated cost of futures price is also called full carry futures price. Cost of Carry Model: F=S+C Where F = Future price S = Spot price C = Cost of carry For example: if the cost 100gm of gold in the spot market is Rs. 60,000 & the cost of carry is 12% p.a., the fair value of a 4 month futures contract will be F=S+C F = 60,000 + 2400 F = Rs 62400 The fair value of a futures contract is the theoretical value of where a futures contract should be positioned, given the current spot price, cost of financing and the tie for expiration. Fair value of a futures contract can be calculated using the following equation: F = S (1 + r) Where F = Future price S = Spot price R = % cost of financing (annually compounded)

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n = time till expiration of the contract If the value of r is compounded m times in a year, the formula to calculate the fair value will be F = S (1 + r/m) Where m = no. of times compounded in a year For example The cost of 100 gm of gold in the spot market is Rs. 60000 and the cost of financing is 12% p.a. compounded monthly, the fair value of a 4 month futures contract will be F = S(1 + r/m) F = 60,000 (1 + 0.12/12) F = 60,000 x 1.0406 F = 62,436 The fair value of a futures price with continuous/daily compounding can be expressed as F = Se Where F = Future price S = Spot price R = % COST OF FINANCING N = time till expiration of contracts in years and

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E = 2.71828 The above formula is used to calculate the futures price of a commodity when no storage costs are involved The futures price is equal to the sum of money S invested at a rate of interest r for a period of n years. 5.6 Statutory frame work for regulating commodity futures The government at different times appointed four different comities to study this sector: The Shroff Committee in 1950: this committee in fact was asked to go into details of the draft of Futures Markets (Regulation) Bill and revise it wherever necessary. The committee was formed even before the Forward Contracts (regulation) Act, 1952 came into force. The findings of the Committee are therefore no more relevant. The Datwala Committee in 1966: This committee remembers of reintroduction of futures trading in major commodities. The Khusro Committee in 1980: Apart from the Datwala Committee, this Committee also recommended the reintroduction of futures trading in major commodities. The government finally brought back forward trading in agricultural commodities that did not have a very significant role in the economy-castor seed and castor oil, jaggery, jute, pepper, potato and turmeric. Several localized exchanges started trading in the same commodity, each of them with a local broker/wholesalemerchandiser constituency. But, even after a decade, none of the market achieved the levels of liquidity that existed prior to the ban on commodity future trading.

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The Kabra Committee in 1993, this committee made significant contribution to the cause of commodity trading in the country and is in a way responsible for todays modern system of commodity trading with three national level and 22 other commodity exchanges/association in operation. This committee findings and recommendations have therefore been given more coverage not only in this book but also in training sessions and academic circles in general.

Once futures trading became operational, inspite of liberalization, it has been difficult for trade to be transferred from illegal black market, which has zero tax liability & no reporting requirements to the legal authorities as compared to the regulated markets, where taxes & reporting are part of the legal procedures. It was in response to this need for commodity futures in India that the fourth committee by the name of Kabra Committee was set up in June 1993, for assessing the scope for forwards and futures development of futures trading in India. The committee so instituted was known as the Kabra Committee in the name of its chairman r. Kamal Nayan Kabra, who was a professor of Economics in the Indian Institute of Public Administration, Delhi. Many of the recommendation of the Kabra Committee have been implemented. This gave an impetus to the activities of the commodity market in the country. With the current initiatives of the regulators, these markets have shown further revolutionary changes in the last few years, with the national-level multi commodity exchanges in India showing tremendous potential to tap the commodity derivatives market.

38-STEPS TO BE A SUCCESSFUL TRADER

1. We accumulate information--buying books, going to seminars and researching. 2. We begin to trade with our "new" knowledge. 3. We consistently "donate" and then realize we may need more knowledge or information. 4. We accumulate more information. 5. We switch the commodities we are currently following. 6. We go back into the market and trade with our "updated" knowledge.

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7. We get "beat up" again and begin to lose some of our confidence. Fear starts setting in. 8. We start to listen to "outside news" & other traders. 9. We go back into the market and continue to donate. 10. We switch commodities again. 11. We search for more information. 12. We go back into the market and start to see a little progress. 13. We get "overconfident" & market humbles us. 14. We start to understand that trading successfully is going to take more time and more knowledge then we anticipated. 15. We get serious and start concentrating on learning a "real" methodology. 16. We trade our methodology with some success, but realize that something is missing. 17. We begin to understand the need for having rules to apply our methodology. 18. We take a sabbatical from trading to develop and research our trading rules. 19. We start trading again, this time with rules and find some success, but overall we still hesitate when it comes time to execute. 20. We add, subtract and modify rules as we see a need to be more proficient with our rules. 21. We feel we are very close to crossing that threshold of successful trading. 22. We start to take responsibility for our trading results as we understand that our success is in us, not the methodology. 23. We continue to trade and become more proficient with our methodology and our rules. 24. As we trade we still have a tendency to violate our rips and our results are still erratic. 25. We know we are close. 26. We go back and research our rules. 27. We build the confidence in our rules and go back into the market and trade. 28. Our trading results are getting better, but we are still hesitating in executing our rules.

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29. We now see the importance of following our rules as we see the results of our trades when we don't follow them. 30. We begin to see that our lack of success is within us (a lack of discipline in following the rules because of some kind of fear) and we begin to work on knowing ourselves better. 31. We continue to trade and the market teaches us more and more about ourselves. 32. We master our methodology and trading rules. 33. We begin to consistently make money. 34. We get a little overconfident and the market humbles us. 35. We continue to learn our lessons. 36. We stop thinking and allow our rules to trade for us (trading becomes boring, but successful) and our trading account continues to grow as we increase our contract size. 37. We are making more money then we ever dreamed to be possible. 38. We go on with our lives and accomplish many of the goals we had always dreamed of.

5.7 National level commodity exchanges in India In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. National Status implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively.

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REGISTERED COMMODITY EXCHANGES IN INDIA Exchanges Bhatinda Om & Oil Exchange Ltd. The Bombay Commodity Exchange Ltd. Product traded Gur Sunflower Oil, Cotton (seed & oil), Safflower (seed, oil and oil cake), Groundnut, Castor oil, Castor Seed, Sesamum (Oil and Oil Cake), Rice Bran, The Kanpur Commodity Exchange Ltd. Ahmedabad Commodities Exchange Ltd. India Pepper and Spice Trade Association, Kochi Rajdhani Oils & Oil Seeds Exchange Ltd, Delhi The East India Cotton Association, Mumbai The Central India Commercial Exchange Ltd, Gwaliar The East Inida Jute & Hessian Exchange Ltd, Kolkata First Commodity Exchange of India Ltd, Kochi National Multi Commodity Exchange of India Ltd, Ahmedabad Rice Bran Oil & Oil Cake, Crude Palm Oil Rape Seed/Mustard Seed Oil & Cake Cotton Seed, Castor Seed. Pepper Gur, Rapeseed/Mustard Cotton Gur Hessian, Sacking Copra, Cocunut oil & Copra Cake Gur, RBD, Pamolien Crude Palm Oil, Copra, Rapeseed/Mustard Seed, Soybean, Cotton, Safflower, Groundnut (Seed, Oil, Oil Cake), Sugar, Gram, Coconut (oil And Oil Cake), Castor Oil, Sesamum, Linseed, Rice Bran oil, Pepper, Guarseed, Aluminium Ingots, Nickel, Vanaspati, The Coffee Futures Exchange India Ltd, Bangalore National Commodity and Derivatives Exchange Ltd 51 Rubber, Copper, Zinc, Lead Coffee Soybean, refine soy oil, Mustard Seed, Mustard Oil, Medium Staple Cotton, Long

Staple Cotton, Palmolien Crude Palm Oil, Multi Commodity Exchange Gold, Silver and many more Castor Oil, Castor Seeds, Cotton Seeds, Crude Palm Oil, Groundnut Oil, Cotton Long Staple, Cotton Medium Staple, Cotton Short Staple, Kapas, Aluminium, Copper, Nickel, Sponge Iron, Steel Flat, Steel Long, Tin and many more. (Table 5.1) MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank. Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Centers, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure. MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art

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nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading. Commodities Traded at MCX: Bullion:Gold, Silver, Silver Coins, Minerals:Aluminum, Copper, Nickel, Iron/steel, Tin, Zinc, Lead Oil and Oil seeds:Castor oil/castor seeds, Crude Palm oil/ RBD Pamolein, Groundnut oil, Mustard/ Rapeseed oil, Soy seeds/Soy meal/Refined Soy Oil, Coconut Oil Cake, Copra, Sunflower oil, Sunflower Oil cake, Tamarind seed oil, Pulses:Chana, Masur, Tur, Urad, Yellow peas Grains:Rice/ Basmati Rice, Wheat, Maize, Bajara, Barley, Spices:Pepper, Red Chili, Jeera, Cardamom, Cinnamon, Clove, Ginger, Plantation:Cashew Kernel, Rubber, Areca nut, Betel nuts, Coconut, Coffee, Fiber and others:Kapas, Kapas Khalli, Cotton (long staple, medium staple, short staple), Cotton Cloth, Cotton Yarn, Gaur seed and Guargum, Gur and Sugar, Khandsari, Mentha Oil, Potato, Art Silk Yarn, Chara or Berseem, Raw Jute, Jute Goods, Jute Sacking, Petrochemicals:High Density Polyethylene (HDPE), Polypropylene (PP), Poly Vinyl Chloride (PVC) 53

Energy:Brent Crude Oil, Crude Oil, Furnace Oil, Middle East Sour Crude Oil, Natural Gas

NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency. Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centers throughout India. The reach will gradually be expanded to more centers. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal. Commodities Traded at NCDEX:-

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Bullion:Gold KG, Silver, Brent Minerals:Electrolytic Copper Cathode, Aluminum Ingot, Nickel Cathode, Zinc Metal Ingot, Mild steel Ingots

Oil and Oil seeds:Cotton seed, Oil cake, Crude Palm Oil, Groundnut (in shell), Groundnut expeller Oil, Cotton, Mentha oil, RBD Pamolein, RM seed oil cake, Refined soya oil, Rape seeds, Mustard seeds, Caster seed, Yellow soybean, Meal

Pulses:Urad, Yellow peas, Chana, Tur, Masoor, Grain:Wheat, Indian Pusa Basmati Rice, Indian parboiled Rice (IR36/IR-64), Indian raw Rice (ParmalPR-106), Barley, Yellow red maize

Spices:Jeera, Turmeric, Pepper Plantation:Cashew, Coffee Arabica, Coffee Robusta Fibers and other:Guar Gum, Guar seeds, Guar, Jute sacking bags, Indian 28 mm cotton, Indian 31mm cotton, Lemon, Grain Bold, Medium Staple, Mulberry, Green Cottons, , , Potato, Raw Jute, Mulberry raw Silk, V-797 Kapas, Sugar, Chilli LCA334

Energy:Crude Oil, Furnace oil

Agro Products

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Cashew Chana Coffee - Arabica Crude Palm Oil Expeller Mustard Oil Groundnut Expeller Oil Guar Seeds Jeera Lemon Tur Indian Pusa Basmati Rice Indian Raw Rice Indian 31 mm Cotton Medium Staple Cotton Mulberry Green Cocoons Mustard Seed Potato Rapeseed-Mustard Seed Oilcake Refined Soy Oil Sesame Seeds Sugar Turmeric V-797 Kapas

Castor Seed Chilli Coffee - Robusta Cotton Seed Oilcake Groundnut (in shell) Guar gum Gur Jute sacking bags Indian Parboiled Rice Indian Traditional Basmati Rice Indian 28 mm Cotton Masoor Grain Bold Mentha Oil Mulberry Raw Silk Pepper Raw Jute RBD Palmolein Rubber Soyabean Yellow Soybean Meal Urad Wheat

Yellow Peas

Yellow Red Maize

Metals Electrolytic Copper Cathode Aluminium Ingot Nickel Cathode Zinc Ingot Mild Steel Ingots Sponge Iron Precious Metals Gold

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Silver NCDEX Energy Brent Crude Oil Furnace Oil (Table 5.2) NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN).

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NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.

5.8 International commodity exchanges

Futures trading is a result of solution to a problem related to the maintenance of a year round supply of commodities/ products that are seasonal as is the case of agricultural produce. The United States, Japan, United Kingdom, Brazil, Australia, Singapore are homes to leading commodity futures exchanges in the world.

The New York Mercantile Exchange (NYMEX):The New York Mercantile Exchange is the worlds biggest exchange for trading in physical commodity futures. It is a primary trading forum for energy products and precious metals. The exchange is in existence since last 132 years and performs trades trough two divisions, the NYMEX division, which deals in energy and platinum and the COMEX division, which trades in all the other metals. Commodities traded: - Light sweet crude oil, Natural Gas, Heating Oil, Gasoline, RBOB Gasoline, Electricity Propane, Gold, Silver, Copper, Aluminum, Platinum, Palladium, etc. London Metal Exchange:-

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The London Metal Exchange (LME) is the worlds premier non-ferrous market, with highly liquid contracts. The exchange was formed in 1877 as a direct consequence of the industrial revolution witnessed in the 19th century. The primary focus of LME is in providing a market for participants from non-ferrous based metals related industry to safeguard against risk due to movement in base metal prices and also arrive at a price that sets the benchmark globally. The exchange trades 24 hours a day through an inter office telephone market and also through a electronic trading platform. It is famous for its open-outcry trading between ring dealing members that takes place on the market floor. Commodities traded:- Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy, North American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density Polyethylene, etc. The Chicago Board of Trade:The first commodity exchange established in the world was the Chicago Board of Trade (CBOT) during 1848 by group of Chicago merchants who were keen to establish a central market place for trade. Presently, the Chicago Board of Trade is one of the leading exchanges in the world for trading futures and options. More than 50 contracts on futures and options are being offered by CBOT currently through open outcry and/or electronically. CBOT initially dealt only in Agricultural commodities like corn, wheat, non storable agricultural commodities and non-agricultural products like gold and silver. Commodities Traded: - Corn, Soybean, Oil, Soybean meal, Wheat, Oats, Ethanol, Rough Rice, Gold, Silver etc.

Tokyo Commodity Exchange (TOCOM):The Tokyo Commodity Exchange (TOCOM) is the second largest commodity futures exchange in the world. It trades in to metals and energy contracts. It has made rapid advancement in commodity trading globally since its inception 20 years

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back. One of the biggest reasons for that is the initiative TOCOM took towards establishing Asia as the benchmark for price discovery and risk management in commodities like the Middle East Crude Oil. TOCOMs recent tie up with the MCX to explore cooperation and business opportunities is seen as one of the steps towards providing platform for futures price discovery in Asia for Asian players in Crude Oil since the demand-supply situation in U.S. that drives NYMEX is different from demand-supply situation in Asia. In Jan 2003, in a major overhaul of its computerized trading system, TOCOM fortified its clearing system in June by being first commodity exchange in Japan to introduce an in-house clearing system. TOCOM launched options on gold futures, the first option contract in Japanese market, in May 2004. Commodities traded: - Gasoline, Kerosene, Crude Oil, Gold, Silver, Platinum, Aluminum, Rubber, etc Chicago Mercantile Exchange:The Chicago Mercantile Exchange (CME) is the largest futures exchange in the US and the largest futures clearing house in the world for futures and options trading. Formed in 1898 primarily to trade in Agricultural commodities, the CME introduced the worlds first financial futures more than 30 years ago. Today it trades heavily in interest rates futures, stock indices and foreign exchange futures. Its products often serves as a financial benchmark and witnesses the largest open interest in futures profile of CME consists of livestock, dairy and forest products and enables small family farms to large Agri-business to manage their price risks. Trading in CME can be done either through pit trading or electronically. Commodities Traded: - Butter milk, Diammonium phosphate, Feeder cattle, frozen pork bellies, Lean Hogs, Live cattle, Non-fat Dry Milk, Urea, Urea Ammonium Nitrate, etc

6.1 INTRODUCTION TO DERIVATIVES

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Derivative markets can broadly be classified as commodity derivative market and financial derivative markets. As the name suggests, commodity markets trade contracts for which the underlying asset is a commodity. It can be agricultural commodity like wheat, soybeans, cotton, rapeseed, etc or precious metals like gold, silver, etc. financial derivatives markets trade contracts that have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as the underlying. The most commonly used derivatives contracts are forwards, futures and options. Emergence Of financial derivative products Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis--vis derivative products based on individual securities is another reason for their growing use. Commonly Used Derivatives Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage. Forwards A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at todays pre-agreed price. Futures 61

A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at todays future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. Options There are two types of options- calls and puts. 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. Puts 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. Warrants Options generally have lives of up to one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options. 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. The two commonly used swaps are: Interest rate swaps These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps

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These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. 6.2 Emergence of Commodity Derivatives Derivatives as a tool for managing risks first originated in the commodities market. They were then found useful as the hedging tool in the financial markets as well. In India trading in commodity futures has been in existence from the 19 th century with organized trading in cotton through the establishments of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. A regulatory constraint in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity futures exchanges have been actively encouraged. Trading in derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper, et cetera. Derivatives as a tool for managing risks first originated in the commodities market. They were then found useful as the hedging tool in the financial markets as well. In India trading in commodity futures has been in existence from the 19 th century with organized trading in cotton through the establishments of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. A regulatory constraint in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity futures exchanges have been actively encouraged.

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Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the state and forwards and futures trading are selectively introduced with stringent controls. While free trade in many commodity items is restricted under the Essential Commodities Act (ECA), 1955, forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952. The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd., and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. The Gujrati Vyapari Mandali came into existence in 1900 which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association (EICA). Many exchanges were set up in major agricultural centres in north India before world war broke out and they were mostly engaged in wheat futures until it was prohibited. The existing exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was first organized by India Pepper and Spices Trade Association (IPSTA) in Cochin in 1957. Futures in gold and silver began in Mumbai in 1920 and continued until it was prohibited by the government by mid-1950s. Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until they along with futures were banned in 1939 (Ministry of Food and Consumer Affairs, 1999). However, the government withdrew the ban on futures with passage of FCRA in 1952. The Act has provided for the establishment and constitution of Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers assigned to it by the Act. Later, futures trade was altogether banned by the

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government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities. After the ban of futures trade all the exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc. As part of economic liberalization of 1990s an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra was appointed by the government of India in 1993. Its report submitted in 1994 recommended the reintroduction of futures which were banned in 1966 and also to widen its coverage to many more agricultural commodities and silver. In order to give more thrust on agricultural sector, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk arising from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading. The first organised exchange, the Chicago Board of Trade (CBOT) -- with standardised contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce Exchange -- which is now known as Chicago Mercantile Exchange -- was formed (CME). CBOT and CME are two of the largest commodity derivatives exchanges in the world. Participants of Commodity Derivatives For a market to succeed, it must have all three kinds of participants - hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on the market. Commodity markets give opportunity for all three kinds of participants.

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Hedgers
Many participants in the commodity futures market are hedgers. They use the futures market to reduce a particular risk that they face. This risk might relate to the price of any commodity that the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a predetermined price. Hedging does not necessarily improve the financial outcome; indeed, it could make the outcome worse. What it does however is, that it makes the outcome more certain. Hedgers could be government institutions, private corporations like financial institutions, trading companies and even other participants in the value chain, for instance farmers, extractors, ginners, processors etc., who are influenced by the commodity prices. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. This is called a short hedge. A short hedge is a hedge that requires a short position in futures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.

Speculators
If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. These are the people who takes positions in the market & assume risks to profit from price fluctuations in fact the speculators consume market information make forecasts about the prices & put money in these forecasts. An entity having an opinion on the price movements of a given commodity can speculate using 66

the commodity market. While the basics of speculation apply to any market, speculating in commodities is not as simple as speculating on stocks in the financial market. For a speculator who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for whatever duration he wants to. However, commodities are bulky products and come with all the costs and procedures of handling these products. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. To trade commodity futures on the NCDEX, a customer must open a futures trading account with a commodity derivatives broker. Buying futures simply involves putting in the margin money. This enables futures traders to take a position in the underlying commodity without having to actually hold that commodity. With the purchase of futures contract on a commodity, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract).

Arbitrage
A central idea in modern economics is the law of one price. This states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price. If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. This activity termed as arbitrage. The buying cheap and selling expensive continues till prices in the two markets reach equilibrium. Hence, arbitrage helps to equalise prices and restore market efficiency. F = (S + U)erT Where: r = Cost of financing (annualised) T = Time till expiration U = Present value of all storage costs The cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets. The above equation gives the fair value of a futures contract on an investment commodity. Whenever the futures price deviates substantially from its fair

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value, arbitrage opportunities arise. To capture mispricings that result in overpriced futures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that result in underpriced futures, the arbitrager must sell spot and buy futures. In the case of investment commodities, mispricing would result in both, buying the spot and holding it or selling the spot and investing the proceeds. However, in the case of consumption assets which are held primarily for reasons of usage, even if there exists a mispricing, a person who holds the underlying may not want to sell it to profit from the arbitrage. 6.3 Credit derivatives A credit derivative is a financial instrument used to mitigate or to assume specific forms of credit risk by hedgers and speculators. These new products are particularly useful for institutions with widespread credit exposures. Some observers suggest that credit derivatives may herald a new form of international banking in which banks resemble portfolios of globally diversified credit risk more than purely domestic lenders. Local banks can take advantage of their informational edge in terms of assessing the default risk and recovery rates in their regional market. They make loans based upon this credit assessment and then use credit derivatives to swap these cash flows for more internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk. Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate debt. CREDIT SWAPS Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve. The credit spread is volatile in and of itself and it may be correlated with the level of interest rates. For example, in a declining, low interest rate environment combined

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with strong domestic growth, we might expect corporate bond spreads to be smaller than their historical average. The corporate who has issued the bond will find it easier to service the cash flows of the corporate bond and investors will be hungry for any kind of premium they can add to the risk-free rate. This is an off-balance sheet transaction and the swap will typically have zero value at inception. Moreover, credit swaps (particularly ones based on a spread index) are clean structures without the messy difficulty of finding individual corporate bond supply, etc. 6.4 Weather derivatives Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains of the sporting event, fewer tickets will be sold. Heating degree days are one of the most common types of weather derivative. Typical terms for an HDD contract could be: for the November to March period, for each day where the temperature falls below 18 degrees Celsius keep a cumulative count of the difference between 18 degrees and the average daily temperature. Depending upon whether the option is a put option or a call option, pay out a set amount per heating degree day that the actual count differs from the strike. The use of weather derivatives THE introduction of index futures may create a market for more derivatives products in India. While such products may be of academic interest for now, it is nevertheless interesting to look at some of them. One such product is weather derivatives. This

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product helps a business lower the risk of a fall in income due to change in the weather. Take, `Z', an ice-cream vendor. He sells more ice-creams during hot summers but has to settle for a lower income if the summer turns out to be milder. Weather derivatives can help `Z' protect his income during mild summers. Here's how: `Z' will a buy a weather derivative structured by, say, AB Services. Thus, if the summer is mild, `Z' will receive money from AB to make good the lost income. `Z' will not receive money if the summer is hotter or normal. In return for the risk protection, `Z' pays a premium to AB Services. Weather derivatives can also be of use to the consumers. Here's an example: Electricity suppliers in the US charge the residential consumers a non-fixed tariff; the per unit rate is primarily dependent on weather which determines the levels of electricity consumption. A case for derivatives arose because residential consumers preferred a fixed rate. A suitable deal was, hence, structured. XY Services advised the electricity supplier to collect a fixed amount from each consumer based on their respective energy consumption pattern in the past. Let us suppose the amount for consumer `D' is $1500. If the actual bill for this consumer works out to $1200, the energy supplier will pay XY Services $300 ($1500-1200). If the bill is, say, $1900, XY Services will pay $400 ($1900-1500) to the electricity supplier. To hedge its risk of being asked to pay the electricity supplier, XY will buy a weather derviative, just like the ice-cream vendor in the previous example. Thus, the consumer gets to pay a fixed energy bill, the energy supplier actually charges a non-fixed rate, and XY Services gets a return for the risk taken. 6.5 Electricity derivatives Electricity spot prices in the emerging power markets are volatile, a consequence of the unique physical attributes of electricity production and distribution. Uncontrolled exposure to market price risks can lead to devastating consequences for market participants in the restructured electricity industry. We review different types of 70

electricity financial instruments and the general methodology for utilizing and pricing such instruments. In particular, we highlight the roles of these electricity derivatives in mitigating market risks and structuring hedging strategies for generators, load serving entities, and power marketers in various risk management applications. Finally, we conclude by pointing out the existing challenges in current electricity markets for increasing the breadth, liquidity and use of electricity derivatives for achieving economic efficiency. 6.6 Energy derivatives A derivative instrument with underlying assets based on equity securities. An equity derivative's value will fluctuate with changes in its underlying asset's equity, which is usually measured by share price. Investors can use equity derivatives to hedge the risk associated with taking a position in stock by setting limits to the losses incurred by either a short or long position in a company's shares. The investor receives this insurance by paying the cost of the derivative contract, which is referred to as a premium. If an investor purchases a stock, he or she can protect against a loss in share value by purchasing a put option. On the other hand, if the investor has shorted shares, he or she can hedge against a gain in share price by purchasing a call option. Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds or stock index futures. Definition The basic building blocks for all derivative contracts are the Futures and swaps contracts. For the energy markets these are traded in New York NYMEX, in Tokyo TOCOM and on-line through the Intercontinental Exchange. A future is a contract to deliver or receive oil (in the case of an oil future) at a defined point in the future. The price is agreed on the date the deal/agreement/bargain is struck together with volume, duration, and contract index. The price for the futures contract at the date of delivery

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(contract expiry date) may be different. At the expiry date, depending upon the contract specification the 'futures' owner may either deliver/receive a physical amount of oil (this is a rare occurrence), they may settle in cash against expiration price set by the exchange, or they may close out the contract prior to expiry and pay or receive the difference in the two prices. In futures markets you always trade with a formal exchange, every participant has the same counterpart. 6.7 Property derivatives A property derivative is a financial derivative whose value is derived from the value of an underlying real estate asset. In practice, because real estate assets fall victim to market inefficiencies and are hard to accurately price, property derivative contracts are typically written based on a real estate property index. In turn, the real estate property index attempts to aggregate real estate market information to provide a more accurate representation of underlying real estate asset performance. Property derivatives usually take the form of a total return swap or forward contract, or can adopt a funded format where the property derivative is embedded into a bond or note structure. Under the total return swap or forward contract the parties will usually take contrary positions on the price movements of a property index. 6.8 Inflation derivatives In finance, inflation derivatives (or inflation-indexed derivatives) refer to over-thecounter and exchange-traded derivatives that are used to transfer inflation risk from one counterparty to another. Typically, real rate swaps also come under this bracket, such as asset swaps of inflation-indexed bonds (government-issued inflation-indexed bonds, such as the Treasury Inflation Protected Securities, UK Inflation Linked Gilts, ILGs, French OATei's, Italian BTPei's, German Bundei's and Japanese JGBi's are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity (i.e., the derivative form of inflation indexed bonds).

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Inflation swaps are typically priced on a zero-coupon basis (ZC), with payment exchanged at the end of the term. One party pays the compounded fixed and the other the actual inflation rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate used is still the year-on-year rate. Options on inflation, including caps, floors and straddles, can also be traded. These are typically priced against YOY swaps, whilst the swaption is priced on the ZC curve. Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at maturity is exchanged for interest rate payments expressed as a premium or discount to LIBOR for the relevant bond coupon period, all dates are co-terminus. The redemption pickup is the above par redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The proceeds notional equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the LIBOR leg. Real rate swaps are the nominal interest rate swap rate less the corresponding inflation swap. 6.9 Fund derivative A fund derivative is a financial structured product related to a fund, normally using the underlying fund to determine the payoff. This may be a mutual fund or a hedge fund. Purchasers might want exposure to a fund to get exposure to a star fund manager or management style as well as the asset class. Typical fund derivatives might be a call option on a fund, a CPPI on a fund, or a leveraged note on a fund. More complicated structures might be a guarantee sold to a fund that ensures it cannot fall in value by more than a certain amount. Maturities might range from three to ten years. The big players in this field are BNP Paribas, Societe Generale, Barclays, Deutsche Bank, Citigroup, Credit Suisse, etc. Fund derivatives have had explosive growth over the past 10 years but are still a major growth area. New structures are constantly being developed to suit market and client opportunities. 73

6.10 Interest rate derivative An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate. The interest rate derivatives market is the largest derivatives market in the world. Market observers estimate that $60 trillion dollars by notional value of interest rate derivatives contract had been exchanged by May 2004.Measuring the size of the market is difficult because trading in the interest rate derivative market is largely done over-the-counter. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for stock options. 6.11 Emissions trading Emissions trading (or emission trading) is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It is sometimes called cap and trade.

A coal power plant in Germany. Due to emissions trading, coal might become less competitive as a fuel. A central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or

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credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emission allowance must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society. There are active trading programs in several pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market to reduce acid rain and several regional markets in nitrous oxide. Markets for other pollutants tend to be smaller and more localized. Carbon trading is sometimes seen as a better approach than a direct carbon tax or direct regulation. By solely aiming at the cap it avoids the consequences and compromises that often accompany other methods. It can be cheaper, and politically preferable for existing industries because the initial allocation of allowances is often allocated with a grandfathering provision where rights are issued in proportion to historical emissions. In addition, most of the money in the system is spent on environmental activities, and the investment directed at sustainable projects that earn credits in the developing world can contribute to the Millennium Development Goals. Critics of emissions trading point to problems of complexity, monitoring, enforcement, and sometimes dispute the initial allocation methods and cap. Kyoto Protocol The Kyoto Protocol is a 1997 international treaty which came into force in 2005, which binds most developed nations to a cap and trade system for the six major greenhouse gases. (The United States is the only industrialized nation under Annex I which has not ratified and therefore is not bound by it.) Emission quotas were agreed by each participating country, with the intention of reducing their overall emissions by 5.2% of their 1990 levels by the end of 2012. Under the treaty, for the 5-year compliance period

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from 2008 until 2012, nations that emit less than their quota will be able to sell emissions credits to nations that exceed their quota. It is also possible for developed countries within the trading scheme to sponsor carbon projects that provide a reduction in greenhouse gas emissions in other countries, as a way of generating tradable carbon credits. The Protocol allows this through Clean Development Mechanism (CDM) and Joint Implementation (JI) projects, in order to provide flexible mechanisms to aid regulated entities in meeting their compliance with their caps. The UNFCCC validates all CDM projects to ensure they create genuine additional savings and that there is no leakage. The Intergovernmental Panel on Climate Change has projected that the financial effect of compliance through trading within the Kyoto commitment period will be 'limited' at between 0.1-1.1% of GDP among trading countries. By comparison the Stern report placed the costs of doing nothing at five to 20 times higher. 6.12 Currency derivatives Currency derivatives or currency futures are standardized foreign exchange derivative contracts traded on a stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract. The Exchange Traded Currency Futures (ETCF) contracts facilitate increased transparency, efficient price discovery as well as reduced transaction costs. It also enables better counterparty credit risk management, wider participation Currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts. These are basically risk management tools in forex and money markets used for hedging risks and act as insurance against unforeseen and unpredictable currency and interest rate movements. Any individual or corporate expecting to receive or pay certain amounts in foreign currencies at future date can use these products to opt for a fixed rate - at which the currencies can be exchanged now itself. Risks arising out of borrowings, in foreign currency, due to currency rate and interest rate movements can be contained. When

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receivables or payments or expenditure are denominated or to be incurred in multiple currencies, derivatives can be used for matching the inflows and outflows. In this, Market risks can't be avoided, but have to be managed. And currency derivative serve the purpose of financial risk management encompassing various market risks, as in the case of insurance an upfront premium is payable for buying a derivative. While there could be some gains, depending on the markets and market movement and the type of derivative selected, losses are contained. Entering into contracts not backed by genuine business cash flows in relevant currencies amounts to speculation and can lead to losses. Difference between forex derivatives and currency derivatives There is a thin line dividing the two. Derivatives based on currency exchange rates are forward contracts (or forward rate agreements); options and swaps and are popularly known as forex derivatives. Those are meant to hedge interest rate risks and cash mismatches in different currencies such as currency swaps and options are known as currency derivatives. There are interest rate forward rate agreements and swaps for managing the interest rate movements risk within same currency. On the lines of commodity futures, there are currency and interest rate futures, which are nothing but standardized forward contracts. A committee appointed by the RBI (Reserve Bank of India) has recommended making available the currency futures at authorized dealers. 6.13 Foreign exchange derivatives Foreign exchange derivatives are used by banks and companies to hedge their foreign exchange risks arising from overseas operations. These operations include foreign currency loans and bonds to raise funds and export receivables denominated in dollars. Besides forex derivatives, banks and companies are also exposed to credit derivatives including credit-linked notes based on loans and bonds raised in the overseas market. FX derivatives reduce the cost of adjustment of foreign exchange positions both for participants in the market that want to hedge their initial positions, as for those that want

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to increase their exposure to foreign exchange risk. Similarly, they can help amplify the effects on the foreign exchange rate of the decisions of the agents that in any point in time may help to stabilize it, but also can amplify the effects of those agents whose decisions tend to destabilize it. In the aggregate, the net effects of FX derivatives could well be to increase the volatility of the exchange rate, and/or the overall exposure of the agents of the economy to fluctuations in the exchange rate. The end result could be more rather than less overall vulnerability to foreign currency risk. 6.14 Freight derivatives Freight derivatives, which includes Forward Freight Agreement (FFA) and options based on these, are financial instruments for trading in future levels of freight rates, for dry bulk carriers and tankers. These instruments are settled against various freight rate indices published by the Baltic Exchange (for Dry and some Wet contract) & Platt's (some Wet contracts.) FFAs are often traded over-the-counter (through brokers such as ICAPHYDE, Clarkson's Securities, SSY- Simpson, Spence and Young, FIS -Freight Investor Services, GFI, BRS & Tradition-Platou), but screen-based trading is becoming more popular, through various screens. Trades can be given up for clearing by the broker to one of the clearing houses that support such trades. There are three clearing houses for freight: NOS Clearing, LCH.Clearnet & SGX (Singapore). Freight derivatives are primarily used by ship owners and operators, oil companies, trading companies and grain houses as tools for managing freight rate risk. Recently with Commodities now standing at the forefront of international economics; the large financial trading house, including banks and hedge funds have entered the market.

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7.1 Introduction
Gold for years have remained primary choice for investment for the middle class. Gold is multi purpose product. Deep inside India rural people still believe gold as their primary Investment option. Main advantage people consider to invest in gold is the liquidity factor. Even governments stock gold to improve their credibility in the international market along with foreign exchanges. The value of the currency also depend on the gold stock. Gold is a unique asset based on few basic characteristics. First, it is primarily a monetary asset, and partly a commodity. As much as two thirds of golds total accumulated holdings relate to store of value considerations. Holdings in this category include the central bank reserves, private investments, and high-caratage jewelry bought primarily in developing countries as a vehicle for savings. Thus, gold is primarily a monetary asset. Less than one third of golds total accumulated holdings can be considered a commodity, the jewelry bought in Western markets for adornment, and gold used in industry. The distinction between gold and commodities is important. Gold has maintained its value inafter-inflation terms over the long run, while commodities have declined. Some analysts like to think of gold as a currency without a country. It is an internationally recognized asset that is not dependent upon any governments promise to pay. This is an important feature when comparing gold to conventional diversifiers like T-bills or bonds, which unlike gold, do have counter-party risk. India and world has opened the futures trading in gold and commodities some times ago. This made world to sit and take notice of the investment opportunity gold offers. Particularly during slump in the stock market gold offers a great alternative trading option. One of the greatest benefits of gold in futures trading is the margin

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benefit the brokers offer to us. Let us see an example. If you were to invest 100000 in physical gold market and sell after three months with a margin of 5 percent you make 5000 in physical trading. But in futures trading You are required only to deposit 5 percent of the value of the product thus enabling you to trade in 20 lots and thus making 20 times more profit in case of forward movement in price. The same advantage becomes a disadvantage when backward movement occurs of prices fall. The physical bullion markets repel private bullion investment for reasons of cost, transparency and convenience. Because of this, and the more short term requirements of gold speculators, there is a thriving gold futures market. Many speculators' requirements can be met by a standardized and transferable quarterly futures contract [footnote future explained]. Gold is among only a handful of financial assets that is not matched by a liability. It can provide 'insurance' against extreme movements on the value of traditional asset classes that can happen in unsettled times. A different class of asset Most investment portfolios are invested primarily in traditional financial assets such as stocks and bonds, as shown in the table below: Domestic International Domestic International equities (%) USA 47 UK 39 Japan 29 equities (%) 13 28 16 bonds (%) 33 23 26 bonds (%) 1 1 11 Real Cash estate Other (%) (%) 1 2 11 2 7 1 (%) 3 0 6

Source: UBS Global Asset Management - Pension Fund Indicators 2005 (Table7. 1)

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The reason for holding diverse investments is to protect the portfolio against fluctuations in the value of any single asset class. Portfolios that contain gold are generally more robust and better able to cope with market uncertainties than those that don't. Adding gold to a portfolio introduces an entirely different class of asset. Gold is unusual because it is both a commodity and a monetary asset. It is an 'effective diversifier' because its performance tends to move independently of other investments and key economic indicators. Recent independent studies have shown that traditional diversifiers (such as bonds and alternative assets) often fail during times of market stress or instability. Even a small allocation of gold has been proven to significantly improve the consistency of portfolio performance during both stable and unstable financial periods. 7.2 Features of gold Timeless and Very Timely Investment: For thousands of years, gold has been prized for its rarity, its beauty, and above all, for its unique characteristics as a store of value. Nations may rise and fall, currencies come and go, but gold endures. In todays uncertain climate, many investors turn to gold because it is an important and secure asset that can be tapped at any time, under virtually any circumstances. But there is another side to gold that is equally important, and that is its day-to-day performance as a stabilizing influence for investment portfolios. These advantages are currently attracting considerable attention from financial professionals and sophisticated investors worldwide. Gold is an effective diversifier: Diversification helps protect your portfolio against fluctuations in the value of any one-asset class. Gold is an ideal diversifier, because the economic forces that determine the price of gold are different from, and in many cases opposed to, the forces that influence most financial assets.

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Gold is the ideal gift: In many cultures, gold serves as a family treasure or a wealth transfer vehicle that is passed on from generation to generation. Gold bullion coins make excellent gifts for birthdays, graduations, weddings, holidays and other occasions. They are appreciated as much for their intrinsic value as for their mystical appeal and beauty. And because gold is available in a wide range of sizes and denominations, you dont need to be wealthy to give the gift of gold.

Gold is highly liquid: Gold can be readily bought or sold 24 hours a day, in large denominations and at narrow spreads. This cannot be said of most other investments, including stocks of the worlds largest corporations. Gold is also more liquid than many alternative assets such as venture capital, real estate, and timberland. Gold proved to be the most effective means of raising cash during the 1987 stock market crash, and again during the 1997/98 Asian debt crisis. So holding a portion of your portfolio in gold can be invaluable in moments when cash is essential, whether for margin calls or other needs.

Gold responds when you need it most: Recent independent studies have revealed that traditional diversifiers often fall during times of market stress or instability. On these occasions, most asset classes (including traditional diversifiers such as bonds and alternative assets) all move together in the same direction. There is no cushioning effect of a diversified portfolio leaving investors disappointed. However, a small allocation of gold has been proven to significantly improve the consistency of portfolio performance, during both stable and unstable financial periods. Greater consistency of performance leads to a desirable outcome an investor whose expectations are met.

7.3 Gold as an alternative investment In the search for effective diversification against a background of increasing convergence among mainstream asset classes, investors are considering a variety of non-traditional alternative investment vehicles. Prominent among these are hedge and private equity funds, although gold, commodities, timber and forestry, fine art and collectibles may also come under review.

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Investors should give careful consideration to each of these alternatives in the light of their particular requirements and may choose to invest in several of them. Despite its relatively low expected returns gold offers superior diversification with high liquidity and low cost. 7.4 What makes Gold different from other commodities? The flow demand of commodities is driven primarily by exogenous variables that are subject to the business cycle, such as GDP or absorption. Consequently, one would expect that a sudden unanticipated increase in the demand for a given commodity that is not met by an immediate increase in supply should, all else being equal, drive the price of the commodity upwards. However, it is our contention that, in the case of gold, buffer stocks can be supplied with perfect elasticity. If this argument holds true, no such upward price pressure will be observed in the gold market in the presence of a positive demand shock. The existence of a sophisticated liquid market in gold has, over the past 15 years, provided a mechanism for gold held by central banks and other major institutions to come back to the market. Although the demand for gold as an industrial input or as a final product (jewellery) differs across regions, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. This is not to say that exogenous shifts in flow demand will have no influence at all on the price of gold, but rather that the large supply of inventory is likely to dampen any resultant spikes in price. The extent of this dampening effect depends on the gestation lag within which liquid inventories can be converted in industrial inputs. In the gold industry such time lags are typically very short. Gold has three crucial attributes that, combined, set it apart from other commodities: firstly, assayed gold is homogeneous; secondly, gold is indestructible and fungible; and thirdly, the inventory of aboveground stocks is astronomically large relative to changes in flow demand. One consequence of these attributes is a dramatic reduction in gestation lags, given low search costs and the well-developed leasing market. One would expect

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that the time required to convert bullion into producer inventory is short, relative to other commodities which may be less liquid and less homogenous than gold and may require longer time scales to extract and be converted into usable producer inventory, making them more vulnerable to cyclical price volatility. Of course, because of the variability of demand, the price responsiveness of each commodity will depend in part on precautionary inventory holdings. There is low to negative correlation between returns on gold and those on stock markets, whereas it is well known that stock and bond market returns are highly correlated with GDP. This is because, generally speaking, GDP is a leading indicator of productivity: during a boom, dividends can be expected to rise. On the other hand, the increased demand for credit, countercyclical monetary policy and higher expected inflation that characterize booms typically depress bond prices. The fundamental differences between gold and other financial assets and commodities give rise to the following hard line hypothesis: the impact of cyclical demand using as proxies GDP, inflation, nominal and real interest rates, and the term structure of interest rates on returns on gold, is negligible, in contrast to the impact of cyclical demand on other commodities and financial assets. Using the gold price and US macroeconomic and financial market quarterly data from January 1975 to December 2005, the following conclusions may be drawn: There is no statistically significant correlation between returns on gold and changes in macroeconomic variables, such as GDP, inflation and interest rates; whereas returns on other financial assets, such as the Dow Jones Industrial Average, Standard & Poors 500 index and 10-year government bonds, are highly correlated with changes in macroeconomic variables. Macroeconomic variables have a much stronger impact on other commodities (such as aluminum, oil and zinc) than they do on gold. Returns on gold are less correlated with equity and bond indices than are returns on other commodities. Assets that are not correlated with mainstream financial assets are valuable when it comes to managing portfolio risk. This research establishes a theoretical underpinning for the absence of a relationship that has been demonstrated 84

empirically for a number of years; namely, that between returns on gold and those on other financial assets.

(Chart 7.1) South Africa is the world's largest gold producer, with 393.7 tons in 2001, according to the Chamber of Mines. From 1884 through 2001 it has produced nearly 49,000 tons, which is around 35% of all gold ever mined. No challenger is in sight or likely to be in the foreseeable future. The United States is the second-largest gold-producing nation in the world. Most of this gold is produced in western states such as Nevada, which produces more gold than any other state. Australia is the world's third largest producer of gold with output of 285.0 tons in 2001 a decline of 4% from 296.4 tons in 2000. Western Australia alone provides almost 70% of the production. Gold Fields Mineral Services Ltd estimate the above-ground stocks of gold to have been some 145,200 tons at the end of 2001, a figure that dwarfs annual new mined supply of around 2,600 tons. Much of this is held in a form that can readily come back to the market under the right conditions. This is obviously true for investment 85

forms of gold but it is also true for much jewellery in Asia and the Middle East. In these regions jewellery traditionally fulfills a dual role, both as a means of adornment and as a means of savings. Notably, it is particularly important for women in Muslim and Hindu cultures where traditionally a womans jewellery was often in practice her only financial asset. Such jewellery is of high caratage (21 or 22 carats), and is traded by weight and sold at the current gold price plus a moderate mark-up to allow for dealing and making costs. It is also fairly common for jewellery to be bought or part-bought by the trading in of another piece of equivalent weight; the traded-in piece will either be resold by the jeweller or melted down to create a new piece. In Asia and the Middle East both gold investments and gold jewellery are considered as financial or semi-financial assets. It is not known how much of the total stocks of gold lie in these regions but in recent years they have accounted for approximately 60% of total demand; while the long held cultural affinity to gold would suggest that the majority of stocks in private hands lie in this area. Consumers are very aware of price movements and very sensitive to them. Gold will be sold in times of financial need but holders will frequently take profits and sell gold back to the market if the price rises. Thus the supply of scrap gold will normally automatically rise if the gold price rises. Even gold used for industrial purposes such as electrical contacts in electronic equipment is frequently recovered as scrap and a rise in the gold price will increase the incentive for such recovery. 7.5 Benefits from Gold Futures Development of gold futures would help in efficient price discovery and emergence of healthy and transparent practices in the market. The basic framework for such an exchange already exists with 13 banks active in import of precious metals. Five of them have launched the Gold Deposit Scheme also. They can also enter into forward contracts in a limited way. To begin with the banks can start trading among themselves and then with MMTC, STC and also with big traders according to the demand/supply dynamics.

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The demand driven gold market of India may well become the dictator of gold prices over a period of a few years displacing the supplier driven international market.

Futures trading will facilitate to bring down hoarding demand and help in bringing the idle gold into the market/official pool (mobilize domestic gold) or permit their use as a financial asset in the banking sector.

Futures in gold apart from offering jewellery manufacturers and exporters the chance of hedging their inventories would provide many other investors or speculators with a cheap and highly efficient way of getting into gold.

Studies show in India the consumers on an average would be paying Rs. 8,000 crores extra each year by virtue of the questionable quality of gold sold to them. In particular, the rural and middle class and women are especially vulnerable to the low quality of gold. (Refer Annexure) Development of futures market would make a positive contribution to the protection of consumer and improvement of the industry by setting the benchmark quality for trading. 7.6 Suitability of Gold Futures Uncontrolled and uncertain supply Besides new mining supply, the available supply of gold in the market is made up of three major above-ground sources. In recent years, the growth in gold supply has come from these aboveground sources. A. reclaimed scrap, or gold reclaimed from jewelry and other industries such as electronics and dentistry; B. official, or central-bank, sales C. gold loans made to the market from official gold reserves for borrowing and lending purposes.

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Following the growing pattern of liberalization of the gold trade since the early 1990's the local markets and exchanges of countries like India and Turkey can flourish legitimately. Consequently the pattern of gold flows from mine to end-user, whether in jewellery, industry or investment, is more direct. This pattern has also been influenced by growing gold production, particularly in Australia and the United States, which are now major sources of supply for Asian markets. World gold output rose from only 1,311 tons in 1980 to 2,604 tons in 2001, i.e almost double. In 1993 the Indian government permitted non-resident Indians to bring 5kg of gold into the country twice yearly on the payment of import tax of Rs. 250 per 10 grammes (at current rates this equates to US$14.56/ounce or 4.2%). The allowance was raised to 10 kg per trip in January 1997. 1997 Open General Licence (OGL) was introduced in India, paving the way for substantial direct imports by local banks from the international market for sale or loan to jewelers and exporters, thus partly eliminating the regional supplies from Dubai, Singapore and Hong Kong. At present, 13 banks are active in the import of gold. The quantum of gold imported through these banks has been in the range of 500 tons per year. Gold consumers are very aware of its price movements and very sensitive to them. Gold is sold in times of financial need but holders frequently take profits and sell gold back to the market if the price rises. Thus the supply of scrap gold normally automatically rise if the gold price rises. Even gold used for industrial purposes such as electrical contacts in electronic equipment is frequently recovered as scrap and a rise in the gold price increases the incentive for such recovery. Fluctuating and uncertain demand The deregulation of the Indian gold market during the 1990s brought about a dramatic change. Jewellery demand increased from 208 tons in 1991 to peak at 658 tons in 1998, while demand for investment bars grew from 10 tons in 1991 to 116 tons in 1998, and registered 85 tons in 2002. India in 2001 it absorbed around 700 tons from the world market compared to just 320 tons in 1994; that is without taking into account the recycling of scrap. In India the rural population accounts for approximately 70% of

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national gold demand. Thus Indias annual gold consumption is dictated both by the monsoon, with its effect on the harvest, and the marriage season. Between 1998-2001 annual Indian demand for gold in jewellery exceeded 600 tons, however in 2002, due to rising and volatile prices and a poor monsoon season, this dropped back to 490 tons, and coin and bar demand dropped to 67 tons. Indian jewellery off-take is sensitive to price increases and even more so to volatility, although this decline in tonnage since 1998 is also due in part to increasing competition from white and brown goods and alternative investment vehicles, but is also a reflection of the increase in price. In the cities, however, gold has to compete with the stock market, investment in internet industries, and a wide range of consumer goods. In the rural areas 22 carat jewellery remains the basic investment. Indian gold jewellery exports have increased dramatically since 1996, and in 2001 stood at over 60 tons. The major factors influencing demand for gold in India are, a. generation of large market surplus in rural areas as a result of all round increase in agricultural production b. unaccounted income/wealth generated mainly in the service sector c. domestic gold prices relative to those of ordinary shares and international gold prices Wide and unforeseen price variation Economic forces that determine the price of gold are different from, and in many cases opposed to, the forces that influence most financial assets. Econometric studies indicate that the price of gold is determined by two sets of factors: supply and macroeconomic factors. Supply and the gold price are inversely related. In the case of macro-economic factors, the U.S. dollar tends to be inversely related to gold, while inflation and gold tend to move in tandem with each other. Also, high low-interest rates are generally a positive factor for gold. Overall, the impact of all of these determinants on the gold price is judged to be neutral-to-positive at this time. Also there is low to negative correlation between returns on gold and those on stock markets.

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8.1 Gold futures as an investment avenue

In the search for effective diversification against a background of increasing convergence among mainstream asset classes, investors are considering a variety of non-traditional alternative investment vehicles. Prominent among these are hedge and private equity funds, although gold, commodities, timber and forestry, fine art and collectibles may also come under review. Investors should give careful consideration to each of these alternatives in the light of their particular requirements and may choose to invest in several of them. Despite its relatively low expected returns gold offers superior diversification with high liquidity and low cost.

8.2 Adding commodities or gold to a portfolio

Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds. A correlation coefficient is a number between -1 and 1 that measures the degree to which two variables are linearly related. If there is perfect linear relationship, youll have a correlation coefficient of 1. A positive correlation means that when one variable has a high (low) value, so does the other. If there is a perfect negative relationship between the two variables, youll have a correlation coefficient of -1. A negative correlation means that when one variable has a low (high) value, the other will have a high (low) value. A correlation coefficient of 0 means that there is no linear relationship between the variables.

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In order to get the true diversification value of commodities and the negative correlation to stock returns, youll need to seek out funds with direct commodity investments since buying a natural-resources fund will typically just add more stock holdings to your portfolio. Two options would be the PIMCO Commodity Real Return Strategy Fund (which uses the DJ-AIGCI as an index) or the Oppenheimer Real Asset Fund (uses the GSCI as the index). Several exchange-traded funds based on commodity indexes are being planned for the future. The reason for holding diverse investments is to protect the portfolio against fluctuations in the value of any single asset class. Portfolios that contain gold are generally more robust and better able to cope with market uncertainties than those that don't. Adding gold to a portfolio introduces an entirely different class of asset. Gold is unusual because it is both a commodity and a monetary asset. It is an 'effective diversifier' because its performance tends to move independently of other investments and key economic indicators. Recent independent studies have shown that traditional diversifiers (such as bonds and alternative assets) often fail during times of market stress or instability. Even a small allocation of gold has been proven to significantly improve the consistency of portfolio performance during both stable and unstable financial periods. Quantitative Analysis

1. Investors preferences: -

Other
7% 23% 43%

Share Market Bank F.D.

27%

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Commodity Market

(Chart8.1) Investment Prefrences specified in other category

3% 30% Real Estate Jwelary Not Specified 67%

(Chart 8.2) Analysis of data revels that majority of people prefer investment in Real Estate (28.81% of total sample) which specified in other category investment and it is greater than share market investment preference.

3. Peoples knowledge about Commodity Market: -

13% Know

Dont Know 87%

(Chart 8.3)

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Very few people heard of commodity market. Vast majority of people are unaware about Commodity Market.

4. Investors interested to invest in Commodity Market: (Out of those, who know Commodity Market)

Interested

50%

50%

Not Interested

(Chart 8.4) Though some people heard of commodity market due to lack of complete knowledge about it half of then are not interested in investing in Commodity Market.

4.Commodity Market Investors Preferences

13% 20% 37% Bullion Metals Agricultural Fossils/Energy 30%

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(Chart 8.5) Above data revels that majority of commodity investors like to invest in Bullion (Gold & Silver).

6. Perception about Commodity Market

25% Less Risky Risky 50% 25% Very Risky

(Chart 8.6) Analysis of data shows that majority of people who are aware about commodity market; feel that investment in commodity market is very risky. So efforts should be done to minimize the risk in commodity investment and make peoples about minimum risk in commodity investment. 7. Opinion about Commodity Market Advertisements (Expressed by those who know commodity market)

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Not Info rmative

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(Chart 8.7) There is no second opinion amongst commodity investors, that commodity market advertisements do not give all the necessary information. 8.Gender of the persons doing trade
No: of persons

42

Male Female

(Chart 8.8) From the study we can infer that 84% of the persons doing trade are male. Because they are ready to take more risk than female. 9. Occupation of the respondents

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No: of persons

4 12 Student Business Profession Others Not working

24

(Chart 8.9) 48% of the respondents doing trade are professionals,24 % are business men. The persons with regular income doing trade are only 16%.The students and not working persons doing trade are only 8% and 4% respectively.

10. Educational background of clients

No: of persons

4 10 Under graduate Graduate Post graduate 36

(Chart 8.10) Majority of the persons doing trade are highly educated whereas the graduates and under graduates are doing trade.

11.Annual income of clients

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No: of persons

25 20 15 10 5 0 20 23 No: of persons

less than 3 Between 3- Between 6- More than lakhs 6 lakhs 10 lakhs 10 lakhs

(Chart8.11) Majority of the persons doing trade are having income in between 3-6 lakhs and 40% of respondents doing trade are having income less than 3 lakhs. 12. Factors affecting the price of commodity
No: of persons 50 50 45 40 35 30 25 20 15 10 5 0

32 No: of persons

18

Seasons

Speculators

News

(Chart 8.12) The price of the commodity is largely affected by seasons and also speculators. Only a few believe that news affects the price of the commodity. by

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13.Source of news
No: of persons 20 18 16 14 12 10 8 6 4 2 0 20

13 8

No: of persons

2 Newspaper Brokers Friends

(Chart 8.13) 40% of the respondents take internet as a source of news, 26% consider brokers as a source of news, the friends or relatives and news are considered as a source of news by 14% and 16% respectively.

14.Traded commodities
Percentage

Rubber 16%

Silver 14% Pepper 18%

Coffee 10%

Copper Wheat 10% Soya bean Corn 6% 4% 2% Gold 20%

(Chart8.14) Gold and pepper has been traded more by the respondents. Very few respondents are trading in soyabean and corn. 98

Qualitative Analysis
1. Investment preferences: Most of the investors prefer least risky investment which gives higher returns. That is why majority (70% of sample) of people interested in investments other than Share and commodity market. Very less number of people (only 7%) showed their interest in investment in commodity market. Main reason for this is lack of awareness and complete information about commodity market. 2. Commodity Exchanges: People who are interested in commodity investment showed more concern towards NCDEX; for its brand name and people think there might be surety of transaction at NCDEX. 3. Commodities: -

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Bullion is most preferred commodity for investment. Because one can expect maximum returns from such investment due to rapidly increasing prices of bullion in market. 4. Advertisements: Commodity market Advertisements should be more informative. And it is the failure of commodity markets advertisement campaign to attract peoples attention; as majority of people are not aware about commodity market.

9.1 SUMMARY The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since 100

their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives visvis derivative products based on individual securities is another reason for their growing use.

9.2 FINDINGS Even though people are aware about commodity markets but majority of them has no idea about future trading in commodities. Seasons and speculations are the main factors affecting the price of any commodity. Majority of the people trade on the basis of the brokers recommendation and news. Gold is valued in India as a saving and investment vehicle and is the second preferred investment after bank deposit. In a liquid market, the number of speculators far out numbers the number of hedgers, and hedgers normally carry much larger open positions. Futures contracts are standardized and deal in specific quantities. The size of these contracts can present problems.

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Lack of storage space in may warehouse across the country is a serious issue, especially in states like kearla where pepper are not finding any space to store their commodities,

Mal practices in weighting and analyzing process in the warehouse are also a huge problem faced by the exporters and others while taking delivery of commodities.

And finally many exporters are of the opinion that state warehouses are much reliable.

9.3 SUGGESTION The development of future market is necessary because it would make a positive contribution to the protection of consumers and improvement of the industry by setting the bench mark quality for trading. The technical problems from the companys side are highly unfavorable for a retail trader. The problems to be sorted out immediately and should also make sure such problems will reduce to the minimum. This is very important since customers stays back with the company only if it is satisfied with the support of the technical which considered being very important in trading of commodities. The commodity trading is considered to be a facility which will reduce the risk of the farmers. But the reality is that around 90% of the trading is speculative trading. The awareness to the farmers with regard to commodity trading is low. The government as well as trading houses should formulate policies which will encourage farmers to trade in commodities. Otherwise to a country in which 60% of the population finds their daily means from agriculture will not have any impact on the commodity trading. The potential of course of trading in commodities is largely untapped and unexplored. Government has to take adequate steps to give support to commodity futures with the use of technology and on the policies to create awareness on the people.

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9.4 RECOMMENDATIONS
Commodity exchanges must take initiative in arranging free training programmes for farmers, exporters and others on commodity futures trading. More warehousing facilities should be arranged. Activities in the warehouses must be continuously monitored by the exchanges. Weather deerivatives to be permitted to cover volumetric risk. Banks to be permitted to act as aggregators. Public shares to be used for data dissemination. The Regulatory authority has to be more stringent and should have a major role in the working of exchanges. (The FMC should have a greater say in the operations of the exchanges).

9.5 Conclusion

Commodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. And it can be extremely beneficial in agriculture-dominated economy, like India, as the commodity market also involves agricultural produce. Derivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utilized in a very limited scale. Only forwards and futures trading are permitted in certain commodity items. The project has discussed the recognized exchanges and their organizational, trading and the regulatory set up for futures trading in commodities.

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