DERIVATIVE  CONTRACTS (“VAYADA KABALA”) AND THEIR BENEFITS

What is a Derivative contract?

A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset; the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads.
 

A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract.  Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.

What are standardized contracts?

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

What are customized contracts ?

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

Is delivery mandatory in futures contract trading?

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

What is the n.t.s.d. contracts ? 

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

Though the Forward Contracts (Regulation) Act, 1952, contains enabling provisions to regulate or prohibit such contract in notified goods, the Government have freed n.t.s.d. contracts from regulation or prohibition by issue of notification No.369(E) dated 1.4.2003.

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

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FUTURES CONTRACTS

What is a futures contract?

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

What are the commodities suitable for futures trading ?

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

How many commodities are permitted for futures trading ?

With the issue of the Notifications dated 1.4.2003 futures trading is not prohibited in any commodity.  Futures trading can be conducted in any commodity subject to the approval /recognition of the Government of India.  91 commodities are in the regulated list i.e. these commodities have been notified under section 15 of the Forward Contracts (Regulation) Act. Forward trading in these commodities can be conducted only between, with, or through members of recognized associations. The commodities other than those listed under Section 15 are conventionally referred to as 'Free' commodities. Forward trading in these commodities can be organized by any association after obtaining a certificate of Registration from Forward Markets Commission.

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

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

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

Short position is net sold position.

What is bull spread (futures)?

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

What is bear spread (futures)?

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

What is  ‘Contango’?

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

When is futures contract in ‘Contango’?

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

What is ‘Backwardation’?

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

When is futures contract at ‘Backwardation’?

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

What is  ‘basis’?

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

What is cash settlement?

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

What is offset?

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

What is settlement price?

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

What is convergence?

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

Can one give delivery against futures contract?

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

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

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

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

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

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

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

 Can a buyer demand delivery against futures contract?

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

What is “Due Date Rate”?

Due Date Rate is the weighted average of both spot and futures prices of the specified number of days, as defined in the Byelaws of Associations.

What is delivery month?

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

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

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

Participants in futures market include market intermediaries in the physical market, like, producers, processors, manufacturers, exporters, importers, bulk consumers etc., besides speculators. There is difference between speculation and gambling. Therefore futures markets are not “satta markets”.

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

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

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

How is over-speculation curbed?

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

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

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

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

To illustrate the concept of hedging, let us assume that, on 1st December, 2002, a stockist purchases, say, 10 tonnes of Castorseed  in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price.  Assuming the ruling price in May, 2003 contract is Rs.1750/- p.q., the stockist is able to lock in a spread/“badla” of Rs. 150/- p.q., i.e., about 9% for about 6 months.  The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is Rs. 1500/- p.q.. The stockist would incur a loss of Rs. 100/- p.q. on his physical stocks.  He would also make a loss of expenses incurred for carrying the stocks.  However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q. to, say, Rs. 1625/- p.a.  The stockist can liquidate his contract in the futures market by entering into purchase contract @ Rs. 1625/- p.q. He would end up earning a profit of Rs. 125/- in the futures segment.  Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.

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

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

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

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

It is true that in order to attract wide participation, the cash market of commodities should be geographically integrated and free from Government restrictions on production, marketing and distribution, like limit on stock-holding, movement of goods across state borders etc. Differential inter-state tax structure as well as the APMC Acts introduced by various State Governments restraining direct purchase from farmers also comes in the way of developing nationwide market. It is however not a bad idea to introduce futures trading in commodity without waiting for the cash market in the commodity to become geographically integrated. The number of commodities attracting Essential Commodities Act, as well as the restrictions imposed on production, marketing and distribution of the commodities under the Essential Commodities Act have declined rapidly. Existence of futures/derivatives market as well as wide use of derivatives in commodities to manage price risk would create conditions for the Government to consider dilution/withdrawal of Administered price mechanism.

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PARTICIPANTS IN DERIVATIVES MARKETS

The Bye-laws and Articles of the Association prescribed the criteria for being a member of the Exchange.  Any person desirous of being a member of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website of fmc: <www.fmc.gov.in>. They may also refer to the Bye-law and Articles of Association of the concerned Exchange which contain various criteria for the membership of the Exchange.

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

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

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

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

A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.

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

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

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

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

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

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

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

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EXCHANGES AND THEIR ROLE

How many recognized/registered associations engaged in commodity futures trading?

At present 21 Exchanges are recognized/registered for forward/ futures trading in commodities.

Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the Exchanges, which are granted recognition by the Central Government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution).