101 of Commodity Market - Energy Trading and Risk Management - Trading - Benefits of commodity futures

1. An introduction to Commodity Markets. Prepared by: Murali Venkatesh http://www.prestiva.com http://blog.prestiva.com 101 of Commodity Markets

2. Introduction To Derivatives Derivatives: Derivatives are financial contracts, which derive their value from the underlying asset. The underlying asset can be equity, commodity, foreign exchange, real estate or any other asset. In commodity derivatives the underlying asset is the spot price of the commodity. Broadly four types of derivatives are traded, namely forwards, futures, options and swaps. Forwards: A Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. A Forward contract is not traded on an exchange. Futures: A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange. An Option: An Option is the right but not the obligation of the holder, to buy or sell the underlying asset by a certain date at a certain price. There are two types of options: CALL OPTION and PUT OPTION Call Option: A call option is a contractual agreement, which gives the owner (holder) of the option, the right but not the obligation to purchase a stated quantity of the underlying asset (commodities, shares, indices, etc.) at a specified price (called the strike price), on the expiry date. Put Option: A put option is a contractual agreement, which gives the owner (holder) of the put option, the right but not the obligation to sell a stated quantity of the underlying asset (commodities, shares, indices, etc.) at a specified price (called the strike price), on the expiry date. Swap: Swap is an agreement between two parties to exchange different stream of cash flows in future according to a pre-determined formulae.

4. Difference between Cash and Future market Cash market is the market for buying and selling physical commodity at a negotiated price. Delivery of the commodity takes place immediately. Futures market is the market for buying and selling standardized contract of the commodity at a pre-determined price. Delivery of the commodity takes place during a future delivery period of the contract if the option of delivery is exercised. Difference between Futures and Forward contract Futures contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange. Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. Forward contract is not traded on an exchange. Trading place: Futures contract is entered on the centralized trading platform of the exchange. Forward contract is OTC in nature. Size of the contract: Futures contract is standardized in terms of quantity and quality as specified by the exchange. Size of the forward contract is customized as per the terms of agreement between the buyer and seller. Transparency in contract price: Contract price of futures contract is transparent as it is available on the centralized trading screen of the exchange. Contract price of forward contract is not transparent, as it is not publicly disclosed. Valuation of open position and margin requirement: In case of futures contract, valuation of open position is calculated as per the official closing price on a daily basis and ‘Mark-to-Market’ margin requirement exists. In case of forward contract, valuation of open position is not calculated on a daily basis and there is no provision of ‘Mark-to-Market’ margin requirement. Liquidity: Futures contract is more liquid as it is traded on the Exchange. Forward contract is less liquid due to its customized nature and mutual trade. Counter party risk: In futures contract the Clearing House becomes a counter party to each transaction, making counter party risk nil. In forward contract, counter party risk is high due to decentralized nature of the transaction. Regulations: Futures contract is regulated by a government regulatory authority and the Exchange. Forward contract, is not regulated by any authority or exchange.. Settlement: Futures contract can be settled in cash or physical delivery, depending on the commodity futures contract specification. Forward contract is generally settled by physical delivery. Delivery: Delivery tendered in case of futures contract should be of a standard quantity and quality as per contract specifications, at designated delivery centers of the Exchange. Delivery in case of forward contract is carried out at delivery centre specified in customized bilateral agreement.

5. Participants in Commodity derivatives: Hedgers: Hedgers are interested in transferring risk associated with transacting or carrying underlying physical asset. Speculators: Speculators are interested in making money by taking a view on future price movements. Commodity futures allow speculators to create high leveraged positions to undertake calculative risk, with the objective of correctly predicting the market movement. Arbitragers: Arbitragers are interested in locking in a minimum risk profit by simultaneously entering into transactions in two or more markets. Arbitragers lock in profit when they spot cash and carry arbitrage opportunity; or reverse cash and carry arbitrage opportunity.

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