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Chapter 1

INTRODUCTION

Ever since the dawn of civilization commodities trading have become an

integral part in the lives of mankind. The very reason for this lies in the fact that

commodities represent the fundamental elements of utility for human beings. The

term commodity refers to any material, which can be bought and sold.

Commodities in a markets context refer to any movable property other than

actionable claims, money and securities. Over the years commodities markets havebeen experiencing tremendous progress, which is evident from the fact that the

trade in this segment is standing as the boon for the global economy today. The

promising nature of these markets has made them an attractive investment avenue

for investors.

In the early days people followed a mechanism for trading called Barter

System, which involves exchange of goods for goods. This was the first form of

trade between individuals. The absence of commonly accepted medium of

exchange has initiated the need for Barter System. People used to buy those

commodities which they lack and sell those commodities which are in excess with

them. The commodities trade is believed to have its genesis in Sumeria. The early

commodity contracts were carried out using clay tokens as medium of exchange.

Animals are believed to be the first commodities, which were traded, between

individuals. The internationalization of commodities trade can be better

understood by observing the commodity market integration occurred after the

European Voyages of Discovery. The development of international commodities

trade is characterized by the increase in volumes of trade across the nations and

the convergence and price related to the identical commodities at different

markets. The major thrust for the commodities trade was provided by the changes

in demand patterns, scarcity and the supply potential both within and across the

nations.

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Derivatives as a tool for managing risk first originated in the commodities

markets. They were then found useful as a hedging tool in financial markets as

well. In India, trading in commodity futures has been in existence from the

nineteenth century with 2rganized trading in cotton through the establishment of

Cotton Trade Association in 1875. Over a period of time, other commodities were

permitted to be traded in futures exchanges. Regulatory constraints in 1960s

resulted in virtual dismantling of the commodities future markets. It is only in the

last decade that commodity future exchanges have been actively encouraged.

However, the markets have been thin with poor liquidity and have not grown to

any significant level.

India has a long history of commodity futures trading, extending over 125

years. Still, such trading was interrupted suddenly since the mid-seventies in the

fond hope of ushering in an elusive socialistic pattern of society. As the country

embarked on economic liberalization policies and signed GATT agreement in the

early nineties, the government realized the need for futures trading to strengthen

the competitiveness of Indian agriculture and the commodity trade and industry.

Futures trading began to be permitted in several commodities, and the ushering in

of the 21st century saw the emergence of new National Commodity Exchanges

with countrywide reach for trading in almost all primary commodities and their

products.

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Chapter 2

COMMODITIES EXCHANGE TRADING

AN OVERVIEW

2.1. COMMODITY

Commodity includes all kinds of goods. FCRA [ Forward

Contract(Regulation) Act,1952] defines goods as every kind of movable

property other than actionable claims, money and securities. Futures trading is

organized in such goods or commodities as are permitted by the central

Government. At present, all goods and products of agricultural (including

plantation), mineral and fossil origin are allowed for futures trading under the

auspices of the commodity exchange recognized under the FCRA. The National

commodity exchange have been recognized by the central Government for

organized trading in all permissible commodities which include precious metals (

Gold & Silver ) and non-ferrous metals; cereals and pulses; ginned and un-ginned

cotton; oilseeds, oils and oilcakes; raw jute and jute goods; sugar and guar;

potatoes and onions; coffee and tea; rubber and spices, etc.

2.2. COMMODITY MARKET

Commodity market is an important constituent of the financial markets of

any country. A commodity exchange or market is a common platform, where

market participants from varied spheres trade in wide spectrum of commodity

derivatives.

It is the market where a wide range of products, viz., precious metals, base

metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded.

It is important to develop a vibrant, active and liquid commodity market. This

would help investors hedge their commodity risk, take speculative positions in

commodities and exploit arbitrage opportunities in the market.

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In simpler terms, it is a place where one can determine the price of

contracts on a current date, for goods to be transacted in future.

For example,

One can determine the price of goods to be transacted in the month of

October 2008 or even later in December 2008 through this mechanism, thereby

helping people to avoid fluctuations in the price of commodities.

2.3. THE REASON WHY PEOPLE TRADE IN COMMODITIES

MARKET:

HEDGING

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 move in

tandem, enabling the participants in the physical / cash markets to cover their price

risk by taking opposite position in the futures market.

SPECULATING

Speculating are participants who are willing to take risks in the expectation

of making profit. Nay person, who feels that the market will move in one

direction, can thus take a position in the market. The primary role of speculators

is to provide liquidity to the market.

ARBITRAGING

Arbitraging is primarily done in two different ways to make profit from the

futures market.

Simultaneously purchase and sale goods in two different markets so that theselling price is higher than the buying price by more than the transaction cost,

thereby enabling a person to make risk-less profits.

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Simultaneously purchase / sale in the spot market and sale / purchase in thefutures markets so that selling price is higher than the buying price by more than

the transaction cost & the interest cost, again resulting in risk-less profits.

2.4. MARKET DEVELOPMENT

In the context of the development of commodities markets, integration

plays a pivotal role in surmounting the barriers of trade. The development of

trading mechanisms in the commodities market segment largely helped the

integration of commodities markets. The major thrust for the integration of

commodities trading was given by the European discoveries and the march of the

world trade towards globalization. The commodities trade among different

countries was originated much before the voyages of Columbus and Da Gama.

During the first half of the second millennium India and China had trading

arrangements with Southeast Asia, Eastern Europe, the Islamic countries and the

Mediterranean. The advancements in shipping and other transport technologies

had facilitated the growth of the trade in this segment. The unification of the

Eurasian continent by the Mongols led to a wide transmission of people, ideas and

goods. Later, the Black Death of 1340s, the killer plague that reduced the

population of Europe and Middle East by one-third, has resulted in more per capita

income for individuals and thus increased the demand for Eastern luxuries like

precious stones, spices, ceramics and silks. This has augmented the supply of

precious metals to the East. This entire scenario resulted in the increased reliance

on Indian Ocean trade routes and stimulated the discovery of sea route to Asia.

The second half of the second millennium is characterized by the

connectivity of the markets related to the Old and the New worlds. In the year

1571, the city of Manila was found, which linked the trade between America,

Asia, Africa ad Europe. During the initial stages, because of the high

transportation costs, preference of trade was given to those commodities, which

had high value to weight ratio. In the aftermath of the discoveries huge volumes ofsilver was pumped into world trade. With the discovery of the Cape route, the

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Venetian and Egyptian dominance of spice exports was diluted. The introduction

of New world crops into China has lead to the increased demand for silver and a

growth in exports of tea and silk. Subsequently, Asia has become the prime trader

of spices and silk and Americas became the prominent exporter of silver.

Earlier investors invested in those companies, which specialized in the

production of commodities. This accounted for the indirect investments in

commodity assets. But with the establishment of commodity exchanges, a shift in

the investment patterns of individuals has occurred as investors started recognizing

commodity investments as an alternative investment avenue. The establishment of

these exchanges has benefited both the producers and traders in terms of reaping

high profits and rationalizing transaction costs. Commodity exchanges play a vital

role in ensuring transparency in transactions and disseminating prices. The

commodity exchanges ensured the standard of trading by maintaining settlement

guarantee funds and implementing stringent capital adequacy norms for brokers.

In the light of these developments, various commodity based investment products

were created to facilitate trading and risk management. The commodity based

products offer a huge array of benefits that include offering risk-return trade-offs

to investors, providing information on market trends and assisting in framing asset

allocation strategies. Commodity investments are always considered as defensive

because during the times of inflation, which adversely affects the performance of

commodities and bonds, commodities provide a defense to investors, maintaining

the performance of their portfolios.

The commodities trade in the 18th and 19th centuries was largely

influenced by the shifts in macro economic patterns, the changes in government

regulations, the advancement in technology, and other social and political

transformations around the world. The 19th century has seen the establishment of

various commodities exchanges, which paved the way for effective transportation,

financing and warehousing facilities in this arena. In a new era of trading

environment, commodities exchanges offer innumerable economic benefits by

facilitating efficient price discovery mechanisms and competent risk transfer

systems.

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2.5. ROLE OF COMMODITY TRADING EXCHANGE

Earlier, all the sellers and buyers of a commodity used to come to a

common market place for the trade. Buyer could judge the amount of produce that

year while the seller could judge the amount of demand of the commodity. They

could dictate their terms and hence the counter party was left with no choice.

Thus, in order to hedge from this unfavorable price movement, need of the

commodity exchange was felt.

An exchange designs a contract, which alone would be traded on the

exchange. The contract is not capable of being modified by participants, i.e., it is

standardized. The exchange also provides a trading platform, which converges the

bids and offers emanating from geographically dispersed locations, thereby

creating competitive conditions for trading. The exchange also provide facilities

for clearing, settlement, arbitration facilities, along with a financially secure

environment by putting in a place suitable risk management mechanism and

guaranteeing performance of contract.

2.6. PARTICIPANTS OF COMMODITY MARKET

For a market to succeed, it must have all three kinds of participants -

hedgers, speculatorsand arbitragers. The confluence of these participants ensures

liquidity and efficient price discovery on the market. Commodity markets give

opportunity for all three kinds of participants.

Hedgers

Many participants in the commodity futures market are hedgers. They use

the futures market to reduce a particular risk that they face. This risk might relate

to the price of any commodity that the person deals in. The classic hedging

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example is that of wheat farmer who wants to hedge the risk of fluctuations in the

price of wheat around the time that his crop is ready for harvesting. By selling his

crop forward, he obtains a hedge by locking in to a predetermined price.

Hedging does not necessarily improve the financial outcome; indeed, it

could make the outcome worse. What it does however is, that it makes the

outcome more certain. Hedgers could be government institutions, private

corporations like financial institutions, trading companies and even other

participants in the value chain, for instance farmers, extractors, ginners, processors

etc., who are influenced by the commodity prices.

There are basically two kinds of hedges that can be taken. A company that

wants to sell an asset at a particular time in the future can hedge by taking short

futures position. This is called a short hedge. A short hedge is a hedge that

requires a short position in futures contracts. As we said, a short hedge is

appropriate when the hedger already owns the asset, or is likely to own the asset

and expects to sell it at some time in the future.

Similarly, a company that knows that it is due to buy an asset in the future

can hedge by taking long futures position. This is known as long hedge. A long

hedge is appropriate when a company knows it will have to purchase a certain

asset in the future and wants to lock in a price now.

Speculators

If hedgers are the people who wish to avoid price risk, speculators are

those who are willing to take such risk. These are the people who takes positionsin the market & assume risks to profit from price fluctuations in fact the

speculators consume market information make forecasts about the prices & put

money in these forecasts. An entity having an opinion on the price movements of a

given commodity can speculate using the commodity market. While the basics of

speculation apply to any market, speculating in commodities is not as simple as

speculating on stocks in the financial market. For a speculator who thinks the

shares of a given company will rise, it is easy to buy the shares and hold them for

whatever duration he wants to. However, commodities are bulky products and

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come with all the costs and procedures of handling these products. The

commodities futures markets provide speculators with an easy mechanism to

speculate on the price of underlying commodities.

Arbitrage

A central idea in modern economics is the law of one price. This states that

in a competitive market, if two assets are equivalent from the point of view of risk

and return, they should sell at the same price. If the price of the same asset is

different in two markets, there will be operators who will buy in the market where

the asset sells cheap and sell in the market where it is costly. This activity termed

as arbitrage. The buying cheap and selling expensive continues till prices in the

two markets reach equilibrium. Hence, arbitrage helps to equalise prices and

restore market efficiency.

2.7. DERIVATIVES

Another major leap in the development of commodities markets is the

growth in commodities derivative segment. Derivatives trading has a long history.

The first recorded incident of commodities trade was traced back to the times of

ancient Greece. In the year 1688 De la Vega reported the trading in 'time bargains'

which were the then commonly used terms for options and futures. Though the

first recorded futures trade was found to have happened in Japan during the 17th

century, evidences reveal that the trading in rice futures was existent in China,

6000 years ago. Derivatives are useful for both the producers and the traders for

the mitigation of risk in their business. Trading in futures is an outcome of the

mankind's efforts towards maintaining the supply balance of seasonal commodities

throughout the year. Farmers derived the real benefits of derivatives contracts by

assuring the prices they want to procure on their products.

The volatility of prices has made the commodity derivatives not onlysignificant risk hedging instruments but also strategic exchange traded assets.

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Slowly, traders and speculators, who never intended to take the delivery of goods,

entered this segment. They traded in these instruments and made their margins by

taking the advantage of price volatility in commodity markets.

The dawn of the 21st century brought back the good times for commodity

markets. With the end of a 20 year bear market for commodities, following the

global economic recovery and increased demand from China and other developing

nations, has revitalized the charisma of commodities markets. According to the

forecasts given by experts commodities markets are likely to experience a bright

future with the depreciation in the value of financial assets. Furthermore,

increasing global consumption, declining U.S. Dollar value, rising factor-input

costs and the recent recovery of the market from the clutches of bear trend are

considered to be the positive symptoms, which contribute to the acceleration of

growth in commodity markets segment.

Meaning of Derivatives:

A derivative is a product whose value is derived from the value of one or

more underlying variables or assets in a contractual manner. The underlying asset

can be equity, forex, commodity or any other asset.

In other words, Derivative means having no independent value. i.e. the value

is derived from the value of the underlying asset. Derivative means a forward,

future, option or any other hybrid contract of predetermine fixed duration, linked

for the purpose of contract fulfillment to the value of a specified real of financial

asset or to an index securities. Thus, a derivative contract is an enforceable

agreement whose value is derived from the value of an underlying asset. The four

most common examples of derivative instruments are forwards, futures, options

and swaps / spreads.

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2.8. TYPES OF DERIVATIVE CONTRACTS

FORWARD CONTRACT

A forward contract is an agreement between two parties to buy or sell the

underlying asset at a future date at todays future price. Forward contract is very

valuable in hedging and speculation. It can help a farmer to hedge himself against

any unfavorable movement of the price of his crop by forward selling his harvest

at a known price.

FUTURES CONTRACT

A futures contract is a contract traded on a futures exchange for the delivery of a

specified commodity at a specified future time. The contract specifies the item to

be delivered and the terms and conditions of delivery. Future contract is alone

executed in the commodity exchange trading.

What is the different between the futures contracts and forward contracts?

Following are some of the basic differences between the futures and forward

contract:

While futures contracts are traded on the exchange, forwards contracts are tradedover-the-counter market.

In case of futures contracts, the exchange specifies the standardize features of thecontract, while no predetermined standards are there in the forward contracts.

The exchange provides the mechanism that gives the two parties a guarantee thatthe contract will be honored whereas there is no surety / guarantee of the trade

settlement in case of forward contract.

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2.9.DETERMINATION OF FUTURE PRICE

Futures prices evolves form the interaction of bids and offers emanating from all

over the countrywhich converge in the trading floor or the trading engine. The

bid and offer prices are based on the expectations of prices on the maturity date.

How do professionals predict prices in futures

Futures price evolve form the interaction of bids and offers emanating from all

over the countrywhich converge in the trading floor or the trading engine. The

bid and offer prices are based on the expectations of prices on the maturity date.

There are two methods for predicting futures prices fundamental analysis is

concerned with basic supply and demand information, such as, weather patterns,

carryover supplies, relevant policies of the government and agricultural reports.

On the other hands, 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 exit.

2.10. ADVANTAGES AND LIMITATION OF THE FUTURES

TRADING

THE ADVANTAGES OF FUTURES TRADING

The main advantages of futures trading are:

i. Leverageii. Ability to go shortiii. Hedgingiv. Portfolio diversificationv. Automated, emotionless tradingvi. Flexible point of entryvii.Predictability

(i) Leverage

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Trading a futures / commodity contract allows one to trade higher quantity

with less money.

(ii) Ability to go short

Most traditional stock mechanisms do not permit traders to short sell without

large account size, or large experience. With futures going short is as simple and

as common as going long. There are also no margin penalties or additional

requirements for going short.

(iii) Hedging

This is beneficial when protecting a stock portfolio by going short futures, or

buying a futures, or other various strategies. This is also very important for the

world producers of commodities such as coffee, where they can lock in their price

for delivery at a price as sometime in the future.

(iv) Portfolio diversification

Trading commodities and futures is probably a great idea for large investors

who can diversify from traditional portfolio models like bonds, stocks, and cash.

(v) Automated, Emotionless trading

Systems trading helps avoid the risky decisions an investor tends to make

when a strategy in not in place at the time the position is entered.

(vi) Flexible point of entry

Entry timing becomes irrelevant because some trades will go long, someshort, some will reverse, etc. and it really doesnt matter what market prices are or

what day of the week it is to get started.

(vii) Predictability

Past performance of system trading is no guarantee but it is a mighty

good predictor over a long period of time. Because results arent based on price

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appreciation, but rather catching appropriate long and short trades, its easy to

back-test a system and sees a few years history of completed trades for that

particular market.

LIMITATIONS OF FUTURES TRADING

(i) First they are impersonal contracts traded in exchange and provide little scope

to farmers to choose particular buyers. Commodity futures also play marginal role

in nurturing subsidy chains comprising farmers, processors and customers.

(ii) Commodity futures market is yet to develop fully as an efficient mechanism

of risk management and price discovery. The volume of transaction is low and the

liquidity is poor. The risk remains high indicating poor integration with the

physical market and inadequate participation by hedgers. The market are further

deficient in infrastructure, coupled with linkages with financial institutions.

FUTURES TRADING ARE EXTREMELY RISKY

Futures contracts are leveraged investments, meaning that one can control

something more valuable than the amount of money one used to trade it. With

stocks, if one wants to trade 5 shares of Infosys, one would have to pay an amount

equal to 5 times the current share price of insfosys. With futures, one is able to

trade one contract of the nifty that is worth Rs.3,00,000/- ( based on todays

prices) with only Rs.50,000/- to Rs.60,000 in his account. This type of leverage

power can be very dangerous to the amateur futures trader if used improperly. Iftraders were placed without setting protective stop losses, one could lose

substantial sum of money.

COMMODITIES SUITABLE FOR FUTURES TRADING

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All the commodities are not suitable for future 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 of 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 free from substantial government control. The

commodity should government control. The commodity should have long shelf-

life and be capable of standardization and gradation.

THE PRINCIPLE FOR DESIGNING A FUTURES CONTRACT

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 base 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.

2.11. MARGIN REQUIREMENTS AND SETTINGS

By collecting margins, the possibility of accumulating loss, particularly

when futures price moves only in one direction, gets substantially reduced, thereby

reducing the risk of default. Thus, margin requirement is a good faith deposit to

help back the traders position. If the positions goes against him, then he will

eventually receive a margin call requiring a deposit of funds to bring the equity

back up to where he began the trade with, known as the original margin. The

respective exchange set the margin requirements which are 15 20 percent of the

total value of the commodity being traded. In certain cases, when prices and

volatility rise sharply the exchanges may raise margin requirements to a higher

percentage of the total value.

The aim of the margin money is to minimize the risk of default by eitherparty. The amount of initial margin is so fixed as to ensure that the probability of

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loss on account of worst possible price fluctuation, which cannot be met by the

amount of ordinary / initial margin, is very low. The exchanges fix margin rates

on the requirement for balancing high security of contract and low cost of entering

into contract. The daily collection of margin funds ensure that sufficient funds

are in place to receive their gains. Therefore, while futures offers the opportunity

to enter into highly leveraged transactions, the margin system prevents losses as a

result of nonperformance by the other party.

The main types of margins payable on futures contracts are:

Initial / Ordinary margin It is the amount to be deposited by the marketparticipants in his margin account with clearing house before they can place order

to buy or sell futures contracts. This must be maintained throughout the time their

position is open and is returnable at delivery, exercise, expiry or closing out.

Mark-to-market margins - these are payable based on closing prices at the end ofeach trading day. These margins will be paid by the buyer if the price declines

and by the seller if the price rises. This margin is worked out on difference

between the closing / clearing rate and the rate of the contract or the previous

days clearing rate. The exchange collects these margins from buyers if the prices

decline and pays to the seller and vice versa.

2.12. COMMODITY EXCHANGE TRADING REGULATIONS

IN INDIA

Commodity Derivative markets started in India in cotton in 1875 and in

oilseeds in 1900 at Bombay. Forward trading in raw jute and jute goods started at

Calcutta in 1912. Forward markets in wheat have been functioning at Hapur since1913 and in bullion at Bombay since 1920. After independence, the Constitution

of India brought the subject of stock exchanges and futures markets into the Union

list. As a result, the responsibility for regulation of commodity futures markets

devolved on the Government of India. A Bill on forward contracts was referred to

an expert committee headed by Prof. A.D.Shroff and select committees of two

successive Parliaments and finally in December 1952, the Forward Contracts

(Regulation) Act, 1952, was enacted. The Act provided for three-tier regulatorysystem:

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The Forward Markets Commission (FMC) (set up in September 1953)(http://www.fmc.gov.in)

An association recognized by the Government of India on the recommendation ofForward Markets Commission

The Central Government.Forward Contracts (Regulation) Rules were notified by the Central Government in

July 1954. The Act divides the commodities into three categories with reference to

extent of regulation:

Commodities in which futures trading is prohibited. Commodities in which futures trading can be organized under the auspices of a

recognized association. Commodities that have neither been regulated for being traded under the

recognized association nor prohibited are referred to as free commodities and theassociation involved in such free commodities must obtain the Certificate ofRegistration from the Forward Markets Commission.

In the seventies, most registered trade associations became inactive, as futures, as

well as forward trading in the commodities for which they were registered, were

either suspended or prohibited altogether.

The liberalized policy now being followed by the Government of India and

the gradual withdrawal of the procurement and distribution channel necessitated

setting in place a market mechanism to perform the economic functions of price

discovery and risk management. The National Agriculture Policy announced in

July 2000 and the declarations in the 2002-2003 Budget indicated the

Governments resolve to put in place a mechanism of a futures market.

As a follow up, the government issued notifications on 1 April 2003

permitting futures trading in all commodities. The authorities subsequently granted

licenses to three national commodity exchanges: Multi Commodity Exchange

(MCX), National Commodity & Derivatives Exchange (NCDEX) and National

Multi Commodity Exchange of India (NMCE), which began operations in 2004.

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COMMODITY TRADING REGULATOR AND EXCHANGES IN INDIA

DIFFERENT TYPES OF COMMODITIES TRADED

World-over one will find that a market exits for almost all the commodities

known to us. These commodities can be broadly classified into the following:

PRODUCTS COMMODITIES

Precious

Metals

Gold, Silver, Platinum etc

Other

Metals

Nickel, Aluminum, Copper etc

Agro-Based

Commodities

Wheat, Corn, Cotton, Oils,

Oilseeds.

Soft

Commodities

Coffee, Cocoa, Sugar etc

Live-Stock Live Cattle, Pork Bellies etc

Energy Crude Oil, Natural Gas, Gasoline

etc

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DIFFERENT SEGMENTS IN COMMODITIES MARKET

The commodities market exits in two distinct forms namely the Over the

Counter (OTC) market and the Exchange based market. Also, as in equities,

there exists the spot and the derivatives segment. The spot markets are essentially

over the counter markets and the participation is restricted to people who are

involved with that commodity say the farmer, processor, wholesaler etc.

Derivative trading takes place through exchange-based markets with standardized

contracts, settlements etc.

2.13. LEADING COMMODITY MARKETS OF WORLD

Some of the leading exchanges of the world are

New York Mercantile Exchange (NYMEX),The London Metal Exchange (LME) andThe Chicago Board of Trade (CBOT).

2.14. LEADING COMMODITY MARKETS OF INDIA

The government has now allowed national commodity exchanges, similar

to the BSE & NSE, to come up and let them deal in commodity derivatives in an

electronic trading environment. These exchanges are expected to offer a nation-

wide anonymous, order driven, screen based trading system for trading. The

Forward Markets Commission (FMC) will regulate these exchanges.

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Consequently four commodity exchanges have been approved to commence

business in this regard. They are:

Multi Commodity Exchange (MCX) located at Mumbai. National Commodity and Derivatives Exchange Ltd (NCDEX) located atMumbai.

National Board of Trade (NBOT) located at Indore. National Multi Commodity Exchange (NMCE) located at Ahmedabad.

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Chapter 3

Gold

4.1. INTRODUCTION

Gold is a unique asset based on few basic characteristics. First, it is

primarily a monetary asset, and partly a commodity. As much as two thirds of

golds total accumulated holdings relate to store of value considerations.

Holdings in this category include the central bank reserves, private investments,

and high-cartage jewelry bought primarily in developing countries as a vehicle for

savings. Thus, gold is primarily a monetary asset. Less than one third of golds

total accumulated holdings can be considered a commodity, the jewelry bought in

Western markets for adornment, and gold used in industry.

The distinction between gold and commodities is important. Gold has

maintained its value in after-inflation terms over the long run, while commodities

have declined.

Some analysts like to think of gold as a currency without a country. It is

an internationally recognized asset that is not dependent upon any governments

promise to pay. This is an important feature when comparing gold to conventional

diversifiers like T-bills or bonds, which unlike gold, do have counter-party risk.

Gold is a monetary metal whose price is determined by inflation, by

fluctuations in the dollar and U.S. stocks, by currency-related crises, interest rate

volatility and international tensions, and by increases or decreases in the prices of

other commodities. The price of gold reacts to supply and demand changes and

can be influenced by consumer spending and overall levels of affluence.

Gold is different from other precious metals such as platinum, palladium

and silver because the demand for these precious metals arises principally from

their industrial applications. Gold is produced primarily for accumulation; othercommodities are produced primarily for consumption. Golds value does not arise

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from its usefulness in industrial or consumable applications. It arises from its use

and worldwide acceptance as a store of value. Gold is money.

4.2. WHAT MAKES GOLD SPECIAL?

Timeless and Very Timely Investment:

For thousands of years, gold has been prized for its rarity, its beauty, and above

all, for its unique characteristics as a store of value. Nations may rise and fall,

currencies come and go, but gold endures. In todays uncertain climate, many

investors turn to gold because it is an important and secure asset that can be tapped

at any time, under virtually any circumstances. But there is another side to gold

that is equally important, and that is its day-to-day performance as a stabilizing

influence for investment portfolios. These advantages are currently attracting

considerable attention from financial professionals and sophisticated investors

worldwide.

Gold is an effective diversifier:

Diversification helps protect your portfolio against fluctuations in the value of any

one-asset class. Gold is an ideal diversifier, because the economic forces that

determine the price of gold are different from, and in many cases opposed to, the

forces that influence most financial assets.

Gold is the ideal gift:

In many cultures, gold serves as a family treasure or a wealth transfer vehicle that

is passed on from generation to generation. Gold bullion coins make excellent

gifts for birthdays, graduations, weddings, holidays and other occasions. They are

appreciated as much for their intrinsic value as for their mystical appeal and

beauty. And because gold is available in a wide range of sizes and denominations,

you dont need to be wealthy to give the gift of gold.

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Gold is highly liquid:

Gold can be readily bought or sold 24 hours a day, in large denominations and at

narrow spreads. This cannot be said of most other investments, including stocks of

the worlds largest corporations. Gold is also more liquid than many alternative

assets such as venture capital, real estate, and timberland. Gold proved to be the

most effective means of raising cash during the 1987 stock market crash, and

again during the 1997/98 Asian debt crisis. So holding a portion of your portfolio

in gold can be invaluable in moments when cash is essential, whether for margin

calls or other needs.

Gold responds when you need it most:

Recent independent studies have revealed that traditional diversifiers often fall

during times of market stress or instability. On these occasions, most asset classes

(including traditional diversifiers such as bonds and alternative assets) all move

together in the same direction. There is no cushioning effect of a diversified

portfolio leaving investors disappointed. However, a small allocation of gold

has been proven to significantly improve the consistency of portfolio performance,

during both stable and unstable financial periods. Greater consistency of

performance leads to a desirable outcome an investor whose expectations are

met.

4.3. THE REASON WHY INVESTORS OWN GOLD

There are six primary reasons why investors own gold: They may never be

more relevant than they are today.

1. As a hedge against inflation.2. As a hedge against a declining dollar.3. As a safe haven in times of geopolitical and financial market instability.4. As a commodity, based on golds supply and demand fundamentals.5. As a store of value.

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6. As a portfolio diversifier.

1. HEDGE AGAINST INFLATIONGold is renowned as a hedge against inflation. The most consistent factor

determining the price of gold has been inflation - as inflation goes up, the price of

gold goes up along with it. Since the end of World War II, the five years in which

U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During

those five years, the average real return on stocks, as measured by the Dow, was -

12.33%; the average real return on gold was 130.4%.

Today, a number of factors are conspiring to create the perfect inflationary

storm: extremely simulative monetary policy, a major tax cut, a long term decline

in the dollar, a spike in oil prices, a huge trade deficit, and Americas status as the

worlds biggest debtor nation. Almost across the board, commodity prices are up

despite the short-term absence of a weakening dollar which is often viewed as the

principal reason for stronger commodity prices.

Oil, Inflation and Gold

Although the prices of gold and oil don't exactly mirror one another, there

is no question that oil prices do affect gold prices. If oil prices rise or fall sharply,

investors can expect a corresponding reaction in gold prices, often with a lag.

There have been two major upward moves in the price of gold since it was

freed to float in 1968. The first occurred between 1972 and 1974 when oil pricesclimbed 325%, from $2.44 to $10.36. During the same period, gold prices rose

268% (on a quarterly average basis) from $47.45 to $174.76.

The second major price move occurred between 1978 and 1980, when oil

prices increased 105%, from $12.70 to $26.00. Over the same period, quarterly

average gold prices rose 254% from $178.33 to $631.40.

2. GOLD - HEDGE AGAINST A DECLINING DOLLAR

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Gold is bought and sold in U.S. dollars, so any decline in the value of the

dollar causes the price of gold to rise. The U.S. dollar is the world's reserve

currency - the primary medium for international transactions, the principal store of

value for savings, the currency in which the worth of commodities and equities are

calculated, and the currency primarily held as reserves by the world's central

banks. However, now that it has been stripped of its gold backing, the dollar is

nothing more than a fancy piece of paper.

3. GOLD AS A SAFE HAVEN

Despite the fact that the United States is the worlds only remaining

superpower, there are many problems festering around the world, any one of

which could explode with little warning. Gold has often been called the "crisis

commodity" because it tends to outperform other investments during periods of

world tensions. The very same factors that cause other investments to suffer cause

the price of gold to rise. A bad economy can sink poorly run banks. Bad banks can

sink an entire economy. And, perhaps most importantly to the rest of the world,

the integration of the global economy has made it possible for banking and

economic failures to destabilize the world economy.

As banking crises occur, the public begins to distrust paper assets and turns

to gold for a safe haven.

When all else fails, governments rescue themselves with the printing

press, making their currency worth less and gold worth more. Gold has always

risen the most when confidence in government is at its lowest.

4. GOLD - SUPPLY AND DEMAND

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First, demand is outpacing supply across the board. Gold production is

declining; copper production is declining; the production of lead and other metals

is declining. It is very difficult to open new mines when the whole process takes

about seven years on average, making it hard to address the supply issue quickly.

Gold output in South Africa, the world's largest gold producer, fell to its lowest

level since 1931 this past year as the rand's gains prompted Harmony Gold Mining

Co. and rivals to close mines despite 16 year highs in the gold price.

Growing Demand - China, India and Gold

India is the largest gold-consuming nation in the world. China, on the other

hand, has the fastest-growing economy in modern history. Both India and China

are in the process of liberalizing laws relating to the import and sale of gold in

ways that will facilitate gold purchases on a huge scale.

China is teaching the West something new. Its economy, growing at 9

percent per year, is expected to become the second largest in the world by 2020,

behind only the United States. Last year Americans spent $162 billion more on

Chinese goods than the Chinese spent on U.S. products. That gap has been

growing by more than 25 percent per year. China's consumer class, meanwhile, is

spending on everything from bagels to Bentleys and will soon outnumber the

entire U.S. population. China's explosive growth "could be the dominant event of

this century," says Stapleton Roy, former U.S. ambassador to China. "Never

before has a country risen as fast as China is doing."

China recently passed legislation that will allow the country's four major

commercial banks to sell gold bars to their customers in the near future. Currently,

individuals in China are only allowed to buy gold-backed certificates from the

Bank of China and the Industrial and Commercial Bank of China.

5. GOLDSTORE OF VALUE

One major reason investors look to gold as an asset class is because it will

always maintain an intrinsic value. Gold will not get lost in an accounting scandal

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or a market collapse. Economist Stephen Harmston of Bannock Consulting had

this to say in a 1998 report for the World Gold Council,

although the gold price may fluctuate, over the very long run gold has

consistently reverted to its historic purchasing power parity against other

commodities and intermediate products.

Historically, gold has proved to be an effective preserver of wealth. It has

also proved to be a safe haven in times of economic and social instability. In a

period of a long bull run in equities, with low inflation and relative stability in

foreign exchange markets, it is tempting for investors to expect continual high

rates of return on investments. It sometimes takes a period of falling stock prices

and market turmoil to focus the mind on the fact that it may be important to invest

part of ones portfolio in an asset that will, at least, hold its value.

Today is the scenario that the World Gold Council report was referring to in 1998.

6. GOLD - PORTFOLIO DIVERSIFIER

The most effective way to diversify your portfolio and protect the wealth

created in the stock and financial markets is to invest in assets that are negatively

correlated with those markets. Gold is the ideal diversifier for a stock portfolio,

simply because it is among the most negatively correlated assets to stocks.

Investment advisors recognize that diversification of investments can

improve overall portfolio performance. The key to diversification is finding

investments that are not closely correlated to one another. Because most stocks are

relatively closely correlated and most bonds are relatively closely correlated with

each other and with stocks, many investors combine tangible assets such as gold

with their stock and bond portfolios in order to reduce risk. Gold and other

tangible assets have historically had a very low correlation to stocks and bonds.

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Although the price of gold can be volatile in the short-term, gold has

maintained its value over the long-term, serving as a hedge against the erosion of

the purchasing power of paper money. Gold is an important part of a diversified

investment portfolio because its price increases in response to events that erode the

value of traditional paper investments like stocks and bonds.

4.4. TRADING PARAMETERS FOR GOLD INCOMMODITY EXCHANGE MARKET

Authority

Trading of Gold futures may be conducted under such terms and conditions asspecified in the Rules, Byelaws & Regulations and directions of the Exchangeissued from time totime.

Unit of Trading

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The unit of trading of Gold shall be 1 Kg and 100gm mini lot. Bids and offers maybe accepted in lots of Gold shall be 1 Kg or multiples thereof.

Months Traded In

Trading in Gold futures may be conducted in the months as specified by theExchange from time to time.

Tick Size

The tick size of the price of Gold shall be Re. 1.00.

Basis Price

The basis price of Gold shall be Ex-Mumbai inclusive of Customs Duty andOctroi, excluding Sales Tax.

Unit for Price Quotation

The unit of price quotation for Gold shall be in Rupees per 10 gms of Gold with995 Fineness.

Hours of Trading

The hours of trading for futures in Gold shall be as follows: Mondays through Fridays 10.00 AM to 11.30 PM Saturdays 10.00 AM to 02.00 PM

Or as determined by the Exchange from time to time. All timings are as per IndianStandard Timings (IST)

Last Day of Trading

Last day of trading for Gold shall be 20th calendar day of contract month, if 20 thhappens to be a holiday or a Saturday or a Sunday, then the previous working day,which is other than a Saturday.

Mark to Market

The outstanding positions in futures contract in Gold would be marked to marketdaily

based on the Daily Settlement Price (DSP) as determined by the Exchange.

Position limits

At the commodity level, the member-wise position limit will be a maximum of 6MT or15% of market-wide open position whichever is higher. The Client-wise positionlimit will be a maximum of 2 MT. Both position limits will be subject to NCDEXRegulations and directions from time to time. The above position limits will not

apply to bona fide hedgers as determined by the Exchange.

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Margin Requirements

NCDEX will use Value at Risk (VaR) based margin calculated at 99% confidenceinterval for one day time horizon. NCDEX reserves the right to change, reduce orlevy any additional margins including any mark up margin.

Special Margin

In case of additional volatility, a special margin of at such other percentage, asdeemed fit, will be imposed immediately on both buy and sell side in respect of alloutstanding positions, which will remain in force for next 2 days, after which thespecial margin will be relaxed.

Pre-Expiry Additional Margin

There will be an additional margin imposed for the last 2 trading days, includingthe expiry date of the Gold contract. The additional margin will be added to thenormalexposure margin and will be increased by 5% everyday for the last 2 trading daysof thecontract.

Delivery Margins

In case of open positions materializing into physical delivery, delivery margins asmay bedetermined by the Exchange from time to time will be charged. The deliverymargins will

be calculated based on the number of days required for completing the physicaldeliverysettlement (the look-ahead period and the risks arising thereof).

Arbitration

Disputes between the members of the Exchange inter-se and between membersand

constituents, arising out of or pertaining to trades done on NCDEX shall be settledthrough arbitration. The arbitration proceedings and appointment of arbitratorsshall beas governed by the Bye-laws and Regulations of the Exchange.

4.5. DELIVERY PROCEDURES

Unit of Delivery

The unit of delivery for Gold shall be 1 kg.

Delivery Size

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Delivery is to be offered and accepted in lots of 1 kg Net only or multiples thereof.Noquantity variation is permitted as per contract specification.

Delivery Requests

The procedure for Gold delivery is based on the contract specifications as per

Exhibit

IA and Exhibit IB. All the open positions shall have to be compulsorily deliveredeither

by giving delivery or taking delivery as the case may be. That is, upon expiry of

the contracts, any seller with open position shall give delivery of the

commodity. The corresponding buyer with open position as matched by the

process put in place by the Exchange shall be bound to settle by taking

physical delivery. In the event of default by seller or buyer to give delivery or

take delivery, as the case may be, such defaulting seller or buyer will be liable

to penalty as may be prescribed by the Exchange from time to time.

The Buyers and the Sellers need to give their location preference through the frontend of the trading terminal. If the Sellers fail to give the location preference thenthe allocation to the extent of his open position will be allocated to the baselocation.

Delivery Allocation

The Exchange would then compile delivery requests received from members onthe lasttrading day, as specified in Chapter 1 above. The buyers / sellers who have toreceive / give delivery would be notified on the same day after the close of tradinghours. Deliveryof Gold is to be accepted by Buyers at the accredited warehouse/s where the Sellereffects delivery in accordance with the contract specifications.

Gold Delivery

Where Gold is sold for delivery in a specified month, the seller must haverequisite electronic credit of such Gold holding in his Clearing Members Pool

Account before thescheduled date of pay in. On settlement the buyers Clearing Members PoolAccount would be credited with the said delivery quantity on pay out. TheClearing Member is expected to transfer the same to the buyers depositoryaccount.

Quality Standards

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The contract quality for delivery of Gold futures contracts made under NCDEXRegulations shall be Gold conforming to the quality specification indicated in thecontract. No lower grade/quality shall be accepted in satisfaction of futurescontracts fordelivery except as and to the extent provided in the contract specifications.

Delivery of higher grade would be accepted with premium.

Packaging

The gold bars to be accepted at the designated vault shall be directly imported andhallmarked from the approved list of refiners through the approved logistic agencyi.e.Brinks Arya India (Pvt.) Ltd. or their affiliates / associates. The Gold barsdelivered at theExchange designated vault, indicated in Exhibit 4, should bear the refinery serialno. and

accompanied with the Refinery certificate. Gold held at the NCDEX approvedvaults will

be on un -allocated basis i.e. it will be co mingled with those gold bars pertainingto the

participants of NCDEX. These bars will be of 1 Kg only.

Standard Allowances

No standard allowance is allowed on account of sample testing.

Weight

The quantity of Gold received and or delivered at the NCDEX designated vaultwould bedetermined / calculated by the weight together with serial number as indicated intheenclosed Refinery certificate submitted at the time of delivery into the designatedvaultand would be binding on all parties.

Good / Bad delivery Norms

Gold delivery into NCDEX designated Warehouse would constitute good deliveryor baddelivery based on the good / bad delivery norms as per Exhibit 3. The listcontained inExhibit 3 is only illustrative and not exhaustive. NCDEX would from time to timereviewand update the good / bad delivery norms retaining the trade / industry practices.

Accredited Assayer

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NCDEX has approved the Assayer for quality testing and certification of Goldreceived at the designated warehouse. The quality testing and certification of Goldwill be undertaken only by the approved Assayer. The assayer details are given inthe Exhibit 2alongside the warehouses.

Quality Testing Report

Gold delivered into the NCDEX designated vault. This must be accompanied withthecertificate from the LBMA approved Refinery. A specimen of the certificateissued byLBMA approved refinery is posted under Exhibit 6.

Assayer Certificate

Testing and quality certificate issued by NCDEX approved Assayer for Golddelivered atdesignated warehouse in Mumbai, Ahmedabad and at such other locationsannounced

by the Exchange from time to time shall be acceptable and binding on all parties.Eachdelivery of Gold at the warehouse must be accompanied by a certificate from

NCDEXapproved Assayer in the format as perExhibit 4.

Validity period

The validity period of the Assayers Certificate for Gold is till the withdrawalfrom thewarehouse.

Electronic transfer

Any buyer or seller receiving and or effecting Gold would have to open a

depositoryaccount with an NCDEX empanelled Depository Participant (DP) to hold the Goldinelectronic form. On settlement, the buyers account with the DP would be creditedwiththe quantity of Gold received and the corresponding sellers account would be

debited.The Buyer wanting to take physical delivery of the Gold holding has to make arequest in

prescribed form to his DP with whom depository account has been opened. TheDP would route the request to the warehouse for issue of the physical commodity

i.e. Gold to the buyer and debit his account, thus reducing the electronic balance tothe extent of Gold

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so rematerialized.

Charges

All charges and costs payable at the designated warehouse towards delivery of

Goldincluding sampling, grading, weighing, handling charges, storage etc. from thedate ofreceipt into designated warehouse upto date of pay in & settlement shall be paid

by theseller.

No refund for warehouse charges paid by the seller for full validity period shall begivento the seller or buyer for delivery earlier than the validity period. All charges andcosts associated & including storage, handling etc. after the pay out shall be borne

by the buyer. Warehouse storage charges will be charged to the member / client bythe respective Depository Participant. The Assayer charges for testing and qualitycertification should be paid to the Assayer directly at the delivery location either

by cash / cheque / demand draft.

Duties & levies

All duties, levies etc. up to the point of sale will have to be fully borne by theseller andshall be paid to the concerned authority. All related documentation should becompleted

before delivery of Gold into the NCDEX accredited warehouse.

Stamp Duty

Stamp duty is payable on all contract notes issued as may be applicable in theStatefrom where the contract note is issued or State in which such contract note isreceived

by the client.

Taxes

Service tax

Service tax will be payable by the members of Commodity Exchanges on thegrossamount charged by them from their clients on account of dealing in commodities.

Sales Tax / VATLocal taxes/ VAT wherever applicable is to be paid by the seller to the sales

tax/VAT

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authorities on all contracts resulting in delivery. Accordingly the buyer will haveto paythe taxes/VAT to the seller at the time of settlement. Members and / or theirconstituents requiring to receive or deliver Gold should register with the relevanttax/VAT authorities of the place where the delivery is proposed to be received /

given. In the event of sales tax exemption, such exemption certificate should besubmitted before settlement of the obligation. There will be no exemptions onaccount of resale or second sale in VAT regime.

Premium / Discount

Premium & Discount on the Gold delivered will be provided by the Exchange onthe basis of quality specifications:

The Exchange will communicate the premium / discounts amount applicable. Suchamount will be adjusted to the members account through the supplementary

settlement.

Grade Premium / (Discount) %

9999 0.499990 0.409950 0.00

Formula used = 100 - (Delivery Grade / Standard Grade) * 100, e.g. 100-(0.995/0.9999)*100

4.6. CLEARING AND SETTLEMENTDaily Settlement

All open positions of a futures contract would be settled daily based on the DailySettlement Price (DSP).

Daily Settlement Prices

The Daily Settlement Price (DSP) will be as disseminated by the Exchange at theend ofevery trading day. The DSP will be reckoned for marking to market all open

positions.

Final Settlement Prices

The Final Settlement Price (FSP) will be determined by the Exchange uponmaturity ofthe contract. The open positions for which information have been provided for andhave been matched by the Exchange, would result in physical delivery.

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Spot Prices

NCDEX will announce / disseminate spot prices for Gold relating to thedesignated delivery center and specified grade/ quality parameters determinedthrough the process

of polling a set of market participants representing different segments of the valuechainsuch as traders, importers / exporters, processors etc. The polled prices shall beinput to a normalizing algorithm (like bootstrapping technique) to arrive at arepresentative, unbiased and clean benchmark spot price for Gold. The securityof data and randomness of polling process will ensure transparency andcorrectness of prices. The Exchange has absolute right to modify the process ofdetermination of spot prices at any time without notice.

Dissemination of Spot Prices

Spot prices for Gold will be disseminated on daily basis.

Pay in and Pay out for Daily Settlement / Final Settlement

The table below illustrates timings for pay in and pay out in case of dailysettlement aswell as cash settled positions for final settlement. The buyer clients would have todeposit requisite funds with their respective Clearing Member before pay in.All fund debits and credits for the Member would be done in the Members

Settlement Account with the Clearing bank.

Time (E+1) Activity

On or before 11.00 hrs - PAYIN - Debit paying member a/cfor funds

After 13.00 hrs - PAYOUTCredit receiving membera/c for funds

Pay in and Pay out for final physical settlement

The table below illustrates timings for pay in and pay out in case of positionsmarked for

physical settlement. The buyers / sellers would have to deposit requisite funds /Goldwith their respective Clearing member before pay in.

Pay in and Pay out for Final Settlement in case of physical deliveries

Time (E+2) ActivityOn or before 11.00 hrs

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PAYIN

- Debit Buyer Member Settlement a/cfor funds

- Debit Seller Members CM PoolAccount for Gold

After 13.00 hrsPAYOUT

- Credit Seller Member Settlement a/cfor funds

- Credit Buyer Members CM PoolAccount for Gold

Additionally the supplemental settlement for Gold futures contracts for premium /discount adjustments relating to quality of Gold delivered, actual quantitydelivered andclose out for shortages, will also be conducted on the same day. Clearing Membersarerequired to maintain adequate fund balances in their respective accounts.

Pay in and Pay out for supplemental settlement

Time (E + 2) Activity

On or before 16.00 hours - PAY IN - Debit Member Settlementa/c for funds

After 18.00 hours - PAY OUTCredit Member

Settlement a/c for funds

Supplementary Settlement for Taxes

The Exchange will conduct a separate supplementary settlement, as illustratedbelow,two days after normal pay out for completion of tax transactions.In order to facilitate issue of invoice to right parties, the buyer Clearing Members

are required to give the buyer client details to the Exchange latest by 15.00 noonon E+3 day.

The amounts due to the above differences will be debited / credited to Members

clearing bank account similar to normal settlement.

Pay in and Pay out for Taxes

Time (E + 4) Activity

On or before 15.00 hours - PAY IN: Debit Buyer Member Settlementa/c for funds.

After 17.00 hours - PAY OUT: Credit Seller MemberSettlement a/c for funds

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