Financial
Markets &
Institutions
Module V: Introduction to Commodity
Derivatives
Objective
• To understand definitions and terminologies of
commodity derivatives
• To know the various participants in this market
and their roles
• To gain an initial overview into commodities
market
COMMODITY DEFINED
Every kind of movable goods excluding money and
securities.
Example:
Metals (Bullion & Other Metals)
Agro Products
Features:
• It is tangible
• They can be Perishable or Non Perishable
• They can be either Consumable or Non Consumable
COMMODITY DERIVATIVES
An instrument (also called as a Derivative), that
DERIVES its value, from the price of another
underlying asset, which is a commodity.
Example:
The value of a Copper future will derive its value from the value of the
underlying Metal i.e. copper
Features:
• It is a financial instrument
• It derives its value from another asset
• The other asset is called the underlying asset
• The movement in price of underlying asset directly affects its value.
COMMODITY DERIVATIVES
An instrument (also called as a Derivative), that
DERIVES its value, from the price of another
underlying asset, which is a commodity.
Underlying asset explained:
Commodity derivatives include derivatives in:
✓ PRECIOUS METALS (Gold, silver, platinum etc)
✓ OTHER METALS (tin, copper, lead, steel, nickel etc)
✓ AGRO PRODUCTS (coffee, wheat, pepper, cotton)
✓ ENERGY PRODUCTS (crude oil, heating oil,natural gas)
Types of margins
Initial margin
Additional margin
Special margin
Tender period margin
Delivery period margin
Extreme loss margin
LETS EXPLORE THESE….
Types of margins
Initial margin:
Customer's funds put up as security for
a guarantee of contract fulfilment at
the time a futures market position is
established.
Required for all commodity derivative
contracts.
Types of margins
Additional margin
Margins imposed on both long and
short sides over and above the OTHER
MARGINS, would be called additional
margin.
Types of margins
Special margin
The margins which are imposed only on one side, i.e.
either on long side or short side would be called as
special margin.
The purpose of this margin is to control excessive
speculation and to protect the interest of common
traders and investors.
This will be applicable for all the traders who have an
open position and they can't trade further unless this
special margin amount is paid.
Types of margins
Tender period margin
Tender Period days are those days during which the seller member
deposits the goods with the designated warehouse of Exchange and
gives his intention for delivery to the Exchange. On start of the tender
period, tender margin is applied on the open interest position of the
member. The margins are applicable on both buy and sell side. The
tender period margin is calculated at the rate pre specified by the
Exchange in the contract specification. This rate is then multiplied by the
open interest position held by the clients in the expiring contract. The
tender margin continues up to the settlement of delivery obligation or
expiry of the contract, whichever is earlier. Tender margins are over and
above the normal & special margins (if any) applied by the Exchange.
Tender period margin is imposed at such percentages as defined in the
product/ contract specification. Such margin is imposed on incremental
basis and applicable on both outstanding buy and sales side, which
continues up to the expiry of the contract.
Tender Period margin is released for the position when Delivery Period
Margin is imposed.
Types of margins
Delivery period margin
When a contract enters the delivery period at the end of its
life cycle, delivery period margin is imposed as per contract
specification. Such margin is applicable on all outstanding
buy and sell side and continues up to the settlement of
delivery obligation.
When seller submits delivery documents with surveyor’s
certificate, his position is treated as settled and his delivery
period margin to such extent is reduced.
When buyer pays money for the delivery allocated to him, his
delivery period margin is reduced on such quantity for which
he has paid the amount.
Delivery Margin is levied on the open interest position that has
been marked for delivery. After the delivery is marked Tender
period Margin is released and Delivery Period Margin is levied.
Types of margins
Extreme loss margin
Extreme Loss Margin (ELM) is levied to cover
the loss in situations that lie outside the
coverage of the SPAN based initial margin.
Types of Commodity Derivatives
Future contracts – Revise!!
Standardised contract entered into between
two parties
For the purchase (“long”) or sale (“short)
Of an agreed quantity of an asset (“the
underlying”)
At an agreed price (“Future rate”)
To be settled on a specific date in the future
(“expiry date”)
Commodity Future contract
A Commodity futures contract is an agreement for
buying or selling a commodity for a predetermined
delivery price at a specific future time.
They are standardized contracts that are traded on
organized futures exchanges that ensure performance
of the contracts and thus remove the default risk.
Commodity Future contract -
Example
Suppose a farmer is expecting a crop of wheat to be
ready in 2 months time, but is worried that the price of
wheat may decline in this period. In order to minimize the
risk ,he can enter into futures contract to sell his crop in 2
months time at a price that is determined and fixed now.
Thus, he is able to hedge his risk arising from a possible
adverse change in the price of his commodity.
Commodity Option contract
The commodity option holder has the right, but not the obligation, to buy(or sell) a
specific quantity of a commodity at a specified price on or a before a specified
date.
The seller of the Commodity option contract writes the option in favour of the
buyer (holder) who pays a certain premium to the seller as a price for the options.
A call option gives holder a right to buy a commodity at an agreed price, while a
put option gives the holder a right to sell a commodity at an agreed price on or
before a specified date (called a expiry a date)’
The option holder will exercise the option only if it is beneficial to him, otherwise he
will let the option lapse.
Commodity Option contract -
Example
Suppose a farmer buys a put option to sell 50 quintals of wheat at price
of Rs. 500 per quintal and pays a premium of Rs. 20 per quintal.
1) Thus, he pays a total premium of ?
2) If price of wheat declines to Rs.450 before expiry, farmer will exercise
his option to sell his wheat at the agreed price of Rs. 500 per quintal.
3) If market price of wheat increases to say Rs. 600 per quintal it would
be advantageous for the farmer to sell it directly in the open market at
the spot price rather than exercise his commodity put option.
