Broadly there are 4 markets that exist within the commodity markets. These are the products that combine to create the overall constituency called the commodity markets.
Commodity Spot Markets:
The commodity spot market is a market where a buyer and a seller for commodities enter into a contract for immediate delivery of a commodity. In spot market there is no speculation and all transactions will result in delivery. Of course, commodities being bulky products will not result in effective immediate delivery but will be done through the exchange of Warehouse Receipts. The actual delivery will eventually be done in a few days and till then will be represented by the warehouse receipt.
Commodity Forward Markets:
In a commodity forward market the buyer and the seller of a commodity will enter into a contract for delivery of a commodity at a later date. The date, quantity and price of the commodity contract will be decided in advance and the parties to a forward commodity contract will pay a margin. Mostly, commodity forwards are unregulated and hence do not carry the exchange counter guarantee. Hence forward contracts will carry counter party risk. Forward contracts will necessarily result only in delivery and cannot be squared off.
Commodity Forward Markets:
The nature of a commodity futures market will be exactly like a forward contract in the sense that it will entail delivery of the commodity at a future data but at a price, date and time decided today. Commodity futures contracts are traded on the recognised exchange like the MCX or the NCDEX. Unlike forwards, commodity futures are standardized and can be squared off before the expiry date. Commodity futures contracts do not have counter party risk as the contract is guaranteed by the exchange and the clearing corporation acts as the counter party for each transaction.
Commodity Options Markets:
Like a commodity futures contract, an options contract will also be free of counter party risk. Options on commodities are yet to be introduced but have been approved. An option buyer will have limited risk to the extent of the premium paid whereas the option seller will have limited profit to the extent of the option premium received. Commodity options will lead to development into futures. A commodity call option will devolve into a long futures position while a commodity put option will devolve into a short futures position.
Deciphering a Commodity Futures Contract:
Let us understand the commodity futures contract through a live example. There is a Cotton Farmer who wants to ensure that he gets a good price per bale of cotton and the price does not fall below a certain level. On the other hand there is a spinning mill that buys cotton from that farmer and wants to ensure that the price of cotton does not rise above a certain level. Let us assume that the price of one cotton bale on the MCX is Rs.20,600. The farmer wants to ensure that he at least realizes a price of Rs.20,000/- per bale as the price will ensure a good profit margin for the farmer. The spinning mill wants to ensure that the price of cotton does not move above Rs.21,000/- per bale. This is where a futures contract in cotton can come into existence.
The farmer can sell Cotton Futures at a price of Rs.20,500/- per bale and the spinning mill will be happy to purchase the Cotton Futures at that price. For the farmer this price is better than the price he expects whereas the spinning mill is getting the cotton at a price lower than what it is expecting. Since it is a futures contract, both the farmer and the spinning will have to honour their side of the contract. On the expiry date of the futures contract if the price of cotton bale has fallen to Rs.19,000/-there is a notional loss for the spinning mill, but then its price is still protected. Similarly, on the expiry date of the futures contract, if the price of cotton bale has risen to Rs.22,000/- then the farmer will incur a notional loss but then he is still protected. Both the farmer and the spinning mill have used futures for hedging their risk and not to make speculative profits.
Who are the players in the Commodity Futures and Commodity Options market..
While the contracts in commodity futures and options are fairly standardized, there are 3 broad kinds of players who are active in the commodity markets...
Hedgers are those who actually have an underlying position in that commodity. Hedgers are not in the commodity market for making profits but they just want to protect their risk. In the above example of the cotton farmer and the spinning mill, both the parties are hedgers as they are trying to protect their price risk at a future date. Hedgers are more interested in measuring the risk and better planning of their future cash flows.
Unlike hedgers, speculators do not have underlying positions in the commodity. Speculators are in the commodity markets to make profits from price movements. They operate on the long side and the short side. Speculators are active in futures and in options and are focused purely on making profits out of price movements.
Arbitrageurs are unique players in the commodity markets who capitalize on the spread between the spot price and the futures price. By buying in the spot market and selling in the futures market, these arbitrageurs lock in the price differential and thus arbitrage acts as a fixed income instrument for them. Both arbitrageurs and speculators play an important role in the commodity markets as they provide liquidity to markets.
Deciphering Commodity Options Contracts:
To understand the idea of a commodity option, let us go back to the example of the farmer and the spinning mill. The farmer instead of selling cotton futures will now buy a put option on cotton at the price at which he wants to hedge. If the price falls below the strike price, then the loss on sale of cotton will be compensated by the profit on the put option. The spinning mill, instead of buying cotton futures will buy a call option on cotton at a strike price that they want to hedge. If the price goes above that then the loss on purchase of cotton will be compensated by the profit on the call option. For both the cotton farmer and the spinning mill in this case, options will be better suited as it will give them protection with a known maximum loss.
Of course, the final specifications of options contracts on commodities are still awaited. But one thing is certain that commodity options will eventually devolve into commodity futures.
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