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What are commodity futures markets?

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August 07, 2007 15:20 IST
India has a long history of commodity futures trading, dating back to more than 125 years. But futures trading in commodities was interrupted in the mid seventies as the government wanted to usher in an elusive socialistic pattern of society.

But after India embarked on economic liberalization policies and signed the GATT agreement in the early nineties, the government realized the need for futures trading to strengthen the competitiveness of Indian agriculture and the commodity trade and industry.

Thus, four years back, the government approved futures trading in several commodities.

Soon several commodity exchanges were born. And the main among them are the Multi Commodity Exchange, the National Commodity and Derivatives Exchange and the National Multi Commodity Exchange.

Here we explain the nuances involved in commodity futures trading for your easy understanding:

What is statutory framework to regulate commodity futures in India?

Commodity futures contracts and the commodity exchanges are regulated by the government under the Forward Contracts (Regulation) Act, 1952. The nodal agency to regulate the future market is the Forward Markets Commission, situated at Mumbai, which functions under the aegis of the ministry of consumer affairs.

What is a 'Commodity'?

A commodity includes all kinds of goods. FCRA defines "goods" as "every kind of movable property other than actionable claims, money and securities". Futures' trading is organized in such goods or commodities as are permitted by the government. At present, all goods and products of agricultural (including plantation), mineral and fossil origin are allowed for futures trading under the auspices of the commodity exchanges recognized under the FCRA.

What is a Commodity Exchange?

A commodity exchange is an association, or a company or any other body corporate organizing futures trading in commodities.

What is the meaning of Futures Contract?

A futures contract is a type of "forward contract". FCRA defines forward contract as "a contract for the delivery of goods and which is not a ready delivery contract". Under the Act, a ready delivery contract is one, which provides for the delivery of goods and the payment of price therefore, either immediately or within such period not exceeding 11 days after the date of the contract, subject to such conditions as may be prescribed by the central government. A ready delivery contract is required by law to be fulfilled by giving and taking the physical delivery of goods. In market parlance, the ready delivery contracts are commonly known as "spot" or "cash" contracts.

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.

What are the main differences between the physical and futures markets?

The physical markets for commodities deal in either cash or spot contract for ready delivery and payment within 11 days, or forward (not futures) contracts for delivery of goods and/or payment of price after 11 days. These contracts are essentially party-to-party contracts, and are fulfilled by the seller giving delivery of goods of a specified variety of a commodity as agreed to between the parties. Rarely are these contracts for the actual or physical delivery allowed to be settled otherwise than by issuing or giving deliveries. Such situations may arise when unforeseen and uncontrolled circumstances prevent the buyers and sellers from receiving or taking deliveries. The contracts may then be settled mutually.

Unlike the physical markets, futures markets trade in futures contracts which are primarily used for risk management (hedging) on commodity stocks or forward (physical market) purchases and sales. Futures contracts are mostly offset before their maturity and, therefore, scarcely end in deliveries. Speculators also use these futures contracts to benefit from changes in prices and are hardly interested in either taking or receiving deliveries of goods.

What is price risk management? How does a commodity futures market perform this economic function?

The two major economic functions of a commodity futures market are price risk management and price discovery. Among these, the price risk management is by far the most important, and is the backbone of a commodity futures market. The need for price risk management, through what is commonly called "hedging", arises from price risks in most commodities. The larger, the more frequent and the more unforeseen is the price variability in a commodity, the greater is the price risk in it. Whereas insurance companies offer suitable policies to cover the risks of physical commodity losses due to fire, pilferage, transport mishaps, etc., they do not cover similarly the risks of value losses resulting from adverse price variations. The reason for this is obvious. The value losses emerging from price risks are much larger and the probability of the recurrence is far more frequent than the physical losses in both the quantity and quality of goods caused by accidental fires and mishaps, or occasional thefts.

Ranjan Jha, Commodity Online