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introduction to commodity futures markets

published on : 4 months ago | tags: commodities

meaning and objectives of commodity futures
a commodity futures contract is a contractual agreement between two parties to buy or sell a specified quantity and quality of commodity at a certain time in future at a certain price agreed at the time of entering into the contract on the commodity futures exchange.

objectives and benefits of commodity futures are as follows -

hedging - price risk management by risk mitigation
speculation - take advantage of favorable price movements
leverage - pay low margin to enjoy large exposure
liquidity - ease of entry and exit of market
price discovery - for taking farming and business decisions
price stabilization along with balancing demand and supply position
facilitates integrated price structure
flexibility, certainty and transparency in purchasing commodities facilitate bank financing
facilitates 'informed' lending by the banks

the primary objectives for any futures exchange are effective price discovery and efficient price risk management. in commodity futures, it is necessary to distinguish between investment commodities and consumption commodities. an investment commodity is generally held for investment purposes whereas consumption commodities are held mainly for consumption purposes. gold and silver can be classified as investment commodities whereas oil and steel can be classified as consumption commodities.

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

basis	futures contract	forward contract
by definition	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	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, which is called ‘novation’, 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

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.