1. commodity markets

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COMMODITYMARKETS

Yogini Karpe

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MODULE I

UNDERSTANDINGCOMMODITY MARKETS

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LEARNING OBJECTIVES

On completing this module, you will able to:

Define Commodities

Know working of physical markets and value chain

Key features of the physical markets

Understand the regulations related to physical markets

Describe the need and objectives of electronic spot exchange Explain the factors affecting the price, Demand and Supply of

commodities

Understand the effects of demand and supply on market price

Understand the features and list the limitations of cash forward

transactions Understand the need for an organized exchange for Futures Trading

Know the difference between Forward and Futures

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WHATISTHECOMMODITY? A commodity refers to any good, merchandise or produce of land that can

be bought or sold. A commodity is an article that:

- is used for commerce

- is movable

- has value- can be bought and sold

-is produced or used as a subject in a barter or sale

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WHATISTHECOMMODITY?

The Chicago Board of Trade (CBOT) defines acommodity as:

An article of commerce or a product that can beused for commerce.

In a narrow sense, products traded on anauthorized commodity exchange.

Types of commodities include:

agricultural products, metals, petroleum, foreigncurrency and financial instruments etc.

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Physical Market

- Cash and Carry Market,

- Spot Market- Customized Deal (Quantity, Quality, Price)

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VALUE CHAIN

Consumers

Retailers

Distributers

ProcessorsTraders

Assemblers

Producers

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Key Features of physical Markets in India

Setting up Mandis

Products

Participants

Trading

Price

Clearing, Delivery and Settlement

Regulation

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Problems of the physical market

Lack of proper price dissemination and transparency in pricediscovery process

Very fragmented, isolated and unorganized market

Restrictions on interstate movements of goods

Lack of proper certification and standardization of commodities

Lack of proper warehousing and transport facilities Long chain of intermediaries

Processors not allowed to buy directly from cultivators in most states

Excessive dependence on and consequent exploitation by moneylenders

Distress sale by farmers Stock limits in essential commodities

High volatility in spot market prices

States having different tax and tariff structures

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Electronic Spot ExchangeNeed:-

Very high cost of intermediation

Distress sale

Price uncertainty making it difficult to predict the marketaccurately

Lack of an effective mechanism to eliminate price risk

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OBJECTIVESFORSETTINGUP ELECTRONICSPOT

EXCHANGE

Create market where farmers can get the best pricesand receive prompt payments

Facilitate better efficiency in procurement and bring

down the levels and costs of intermediation Create a market where traders, processors and end

users can procure agricultural produces at a competitiveprice without any quality and counterparty risk.

Provide quality certification, warehousing facilities and

other services Create a structured, organized and standardized spot

market to help the futures exchanges in facilitatingphysical delivery in agricultural commodities

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FACTORSAFFECTING PRICE, DEMANDAND SUPPLYOF

COMMODITIES

Demand is the relationship between a commoditys price and the quantityof that product that consumers are willing to buy at that price

Qd= f(P, Pr, I, T, O)

Where,

Qd The quantity demanded

P The price of the commodity

Pr The price of the related commodity (substitute-direct, complementary-inverse)

I Income of the consumer

T The tastes and preferences of the consumer

O other factors (population size ,supply)

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Continued

Demand


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DEMAND CURVE

Price (Rs per kg) 20 40 60 80 100

Quanity demanded permonth

700 500 350 200 100

#REF! 1

0

100

200

300

400

500

600

700

800

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Law of demand :

The law depicting the inverse relationship betweendemand and price

Shift in demand

A right (upward) shifts indicates that more of the

commodity is demanded at each price levelEx. Increase in the income level or increase in the price of the

complementary product

A left (downward) shifts indicates that less of the

commodity is demanded at each price levelEx. Fall in the price of the substitute, decrease in the price of the priceof complementary products, change in the taste or fashion

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ACTORS AFFECTING PRICE DEMAND AND SUPPLY OF


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ACTORSAFFECTING PRICE, DEMANDAND SUPPLYOF

COMMODITIES

Supply is the relationship between the price of the commodity and the amount ofthe commodity are willing to supply at that price at that time

Mathematically, the supply function is,:

Qs= f(P, Te, C., Pr, W, G, S, O)

where,

Qs The quantity supplied

P The price of the commodity

C the cost of production

Pr prices of the related commodities (substitute-inverse, complementary-

direct)W weather and seasonality

G Government policies

S Carry over stock

O Other factors

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Supply


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SUPPLY CURVE

Series 3 1

Column2 100 200 350 530 700

Price (rs per kg forpotatoes

20 40 60 80 100

0

100

200

300400

500

600

700

800

900

AxisTitle

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Law of supply

other things remaining the same, the quantity supplied

will increase as the price increases

Shift in supply

if supply increases due to better technology, decrease in the cost ofproduction etc, the supply curve shifts right (upwards), meaning

more is supplied at the same price.

On the other hand, the supply curve shifts left (downward), when

the cost of production increases or there is fall in the prices of thecomplements.

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MARKET EQUILIBRIUM

A market is said to be in equilibrium when buyers and sellers

buy and sell at the given price, without trying to change the

quantity or the price

The equilibrium price of a commodity is the price at which the

quantity demanded equals the quantity supplied

At prices above the equilibrium price, the quantity supplied will

exceed the quantity demanded, leading to a surplus of the

commodity, which would drive the prices down

At prices below the equilibrium price, the quantity supplied to

the market will come down, while demand will increase, thusleading to a shortage of commodity, which would increase in

the price

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CASH FORWARD TRANSACTIONS

Two types of cash transaction in the physical market

1. Immediate delivery in the spot market

2. Delivery of a specific commodity to the buyer some time in the

future

- Cash forward contract

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Forward Contract

A forward contract is a bilateral agreement in which a buyer and selleragree upon the delivery of a specified quality and quantity of an asset ona specified future date at a pre-determined price

Features of Forward Contract

Forward contracts are over the counter (OTC) contracts. They arebilateral contracts and hence are exposed to counter party risks

Each contract is custom designed and hence unique in terms of contractsize, expiration date and the asset type and quality

Generally, only parties to the contract know the price

On the expiration date, the contract has to be settled by delivery of the

asset. If party wishes to reverse the contract, it has to compulsorily goto the same counter party, which often results in high prices beingcharged

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Difference between a spot and forward

Transaction

1. Trading

2. Clearing

3. Settlement

In a forward transaction, cash does not changes hands on the

date of entering into the contract. While the trading happens on the

current day, clearing and settlement happens at the end of the

specified period. Hence, in a forward contract, the trading, clearingand settlement do not happen simultaneously as in spot contract

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FUTURE CONTRACTS

Evolved out of forward contracts

Exchange traded versions of forward contracts

Future contracts are also agreement to buy and sell a specified

quantity of a commodity during a designated month in the future, at a

price agreed upon by the buyer and seller at the time of entering intothe contract

Future contracts are the standardized (quality, quantity, and the date

and time and expiry of the contract

A future contract need not be settled through physical delivery

It can be closed by entering into an equal and opposite contract

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BENEFITSOF FUTURE TRADING

Price discovery and price dissemination

Price risk management

Price stability

Common platform for all traders

Low transaction costs

Absence of counter party credit risk

Lower credit risk

Liquidity

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FORWARDS VS FUTURESCriteria Forward Contracts Future Contracts

Characteristics Over the Counter contracts

Bilateral contractsExposed to high

counterparty

risk

Custom designed

Settled by delivery of the

asset on expiration date

Exchange traded

Large number of marketparticipants

Insignificant counter-party

risk

Standardized

Settled by payment of

differences without anyphysical delivery of goods

Determining

price

Forward price = spot or the

cash price + cost of carry

Price discovery based on

demand and supply

Functions of

the

market

Neither the market nor the

exchange has a role to

play

in a forward transaction

Futures markets perform

various important

economic functions and

meet the needs of futures

market users

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FORWARDS VS FUTURES

Criteria Forward Contracts Future Contracts

Advantages No margin systemCustomized contracts

Standard specificationsAbsence of credit risk

High liquidity

High leverage

Price stabilization

Easy access to all

marketparticipants

Limitations No exchange

guarantees

No transparency in

prices

Profit or loss is realized

only on maturity date

Settlement only through

actual delivery

Lack of standardization

Perfect hedge is not

possible due to

standardization of

contracts

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EXERCISE

Read APMC Act of your respective state

Visit the websites of

1. NCDEX

2. MCX

3. NMCE

4. UCX

5. ACE

6. FMC

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1. commodity markets

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