International Management Institute, Delhi

A Project Report on Commodity Derivatives

Under the Guidance of Ms. Richa Gupta AVP Treasury, ING Vysya Bank

Compiled By Prateek Gupta 07PGDM045

Table of Contents Acknowledgements Abstract Objective of the Project Data Collection Method Methodology 4 5 7 7 7

PART A
Organizational Profile Top Management Mission of ING Vision Five Forces Framework Plans of the Company and its various Business Segments

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PART B
What is a Commodity? Types of Commodities Traded Indian Scenario Segments in Commodity Market Commodity Derivatives Commodity Futures Types of Future Contracts Forward Contracts Limitations of Forward Markets Options Types of Options Pricing Commodity Futures Participants of Commodity Derivatives

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Economic Functions of Commodity Futures Market Margins for trading in Commodity Futures Risks Associated Regulation of Commodity Futures/ Forwards The Forward Contract (Regulation) Amendment Bill, 2008 RBI Guidelines Constraints and Major Challenges of Commodities Futures Market Major Commodities Traded in India Gold Aluminium Copper Lead Nickel Tin Zinc Crude Oil Conclusion Learning from the Project ANNEXTURES ANNEX 1 References

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ACKNOWLEDGEMENT

I feel immense pleasure in expressing my profound regard and deep sense of gratitude to my project guide Ms. Richa Gupta (AVP Treasury, ING Vysya Bank) for her expert guidance, keen interest, and constructive criticism and especially for creating in me the spirit of independent thinking.

Without her painstaking efforts and numerous suggestions, this project could never have been successful. I am indebted to her for all the help, encouragement, assistance and support she extended at each and every step in the materialization of this project. I would also like to thank Mr. Varun Goyal for his critical comments and valuable suggestions given to me from time to time which helped me recognize the flaws and involve a further new dimension to my thought process.

Prateek Gupta (07PGDM045)

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ABSTRACT
This project is an attempt to present the wholesome picture of commodity markets in India. Commodities are any agricultural or mining products which can be traded for cash in spot market and futures exchanges. Commodity markets provide an avenue for their sale.

Commodity markets are regulated all over the globe. In India, Forwards Markets Commission (FMC) regulates these markets via The Forward Contract (Regulation) Act (FCRA), 1952. The Act has provided for the establishment and constitution of Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers assigned to it by the Act. The provisions of FCRA, 1952 govern all types of forward contracts in India. The Forward Contract Regulations Act (1952) has been amended over the years. Various committees have worked on and reshaped the act in varying capacities but no amendment bill has yet been passed. For banks to deal in Commodity markets and allow its clients to hedge their price risk, they have to follow the guidelines issued by RBI in its master circular apart from FCRA, 1952.

Like in the equity market, for a market to succeed, it must have all three kinds of participants - hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery in the market. Commodity markets give opportunity for all three kinds of participants.

The commodity market exits in two distinct forms namely the Over the Counter (OTC) market and the Exchange based market. The functioning of both these markets are the same as that of equity markets except the fact that in Commodity trading, a lot more issues like warehousing, physical delivery, etc are involved. Thus a Commodity derivative is a bit different from equity derivatives, but the basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. The process of arriving at a price of the derivative contract also remains the same as in equity. The price is formulated mainly by using the cost of carry model Page | 5

wherein we also take into consideration the cost of storage of the commodity for the period of the contract.

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Objective of the Project

The objective of this project is to study the commodity derivatives market in India and come out with suggestions as to whether ING Financial Markets can start with a commodity trading desk along with forex derivatives, Trading & Market Making, Sales, Structuring and Asset Liability Management (ALM).

Data Collection Method

The information for this project was mainly collected via recent newspaper articles and websites. The primary objective was to prepare a questionnaire to be filled by various treasury units both from clients and competitors side and then analyze the trend followed in the industry. But finally, the project was limited to data collection mainly from websites and newspapers and present the same to the FM department of the bank.

Methodology
The method to be followed for the project was to prepare a questionnaire to be filled by the treasury units of various financial institutions who are currently floating the commodity derivative contracts (such as banks like HSBC, etc) and their clients who use these derivative contracts to hedge their risk (such as companies like IOC, etc who hedge their oil price risk). For this purpose, a questionnaire was prepared (questionnaire included in ANNEXURE 1). But due to confidentiality, financial institutions, banks and corporates were not ready to share the strategy followed by them. Thus the project work was limited to research on commodity derivatives market in India and regulations the bank will have to follow in order to float commodity derivative products.

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PART A

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Organization Profile
ING Vysya Bank Ltd., is an entity formed with the coming together of erstwhile, Vysya Bank Ltd, a premier bank in the Indian Private Sector and a global financial powerhouse, ING of Dutch origin, during Oct 2002. The origin of the erstwhile Vysya Bank was pretty humble. It was in the year 1930 that a team of visionaries came together to found a bank that would extend a helping hand to those who weren't privileged enough to enjoy banking services. It's been a long journey since then and the Bank has grown in size and stature to encompass every area of present-day banking activity and has carved a distinct identity of being India's Premier Private Sector Bank. In 1980, the Bank completed fifty years of service to the nation and post 1985; the Bank made rapid strides to reach the coveted position of being the number one private sector bank. In 1990, the bank completed its Diamond Jubilee year. At the Diamond Jubilee Celebrations, the then Finance Minister Prof. Madhu Dandavate, had termed the performance of the bank Stupendous. The 75th anniversary, the Platinum Jubilee of the bank was celebrated during 2005.

The origin of ING Group

ING group originated in 1990 from the merger between Nationale Nederlanden NV the largest Dutch Insurance Company and NMB Post Bank Groep NV. Combining roots and ambitions, the newly formed company called Internationale Nederlanden Group. Market circles soon abbreviated the name to I-N-G. The company followed suit by changing the statutory name to ING Group N.V..

ING has gained recognition for its integrated approach of banking, insurance and asset management. Furthermore, the company differentiates itself from other financial service providers by successfully establishing life insurance companies in countries with Page | 9

emerging economies, such as Korea, Taiwan, Hungary, Poland, Mexico and Chile. Another specialisation is ING Direct, an Internet and direct marketing concept with which ING is rapidly winning retail market share in mature markets. Finally, ING distinguishes itself internationally as a provider of employee benefits, i.e. arrangements of nonwage benefits, such as pension plans for companies and their employees.

Top Management
The requirements for composition of the Board of Directors of the Bank are mainly governed by the relevant provisions of the Companies Act, 1956, the Banking Regulation Act, 1949 and Clause 49 of the Listing Agreement.

Mr. K R Ramamoorthy, Non- Executive Director is the Chairman of the Bank. As of 31Mar-2008, the Board has nine Directors out of which, three are Independent Directors, in compliance with the requirements under Clause 49 of the Listing Agreement.

The Bank has complied with the requirements of Section 10A(2) of the Banking Regulation Act, 1949, as per which more than 51% of the total number of members of the Board of Directors of the Bank should consist of persons who possess special knowledge or practical experience in respect of one or more of the areas specified in the said section and as per the guidelines of RBI. Further, two Directors possess special knowledge / practical experience in the areas of Agriculture and Rural Economy, Co-operation or Small Scale Industry as per requirement of Section 10A(2) of the Banking Regulation Act, 1949.

The composition of the Board as of 31-Mar-2008 is given below:

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Mission of ING
ING`s mission is to be a leading, global, client-focused, innovative and low-cost provider of financial services through the distribution channels of the clients preference in markets where ING can create value.

Vision
ING VYSYA Bank will be an Entrepreneurial Integrated Financial Services Institution where Innovation and Transformation are a way of life.

Five Forces Framework

The business strategist Michael Porter identified five competitive forces which tend to drive down the profitability of any industry as comprising: barriers to entry, many small suppliers, many small buyers, few substitutes and few competitors. Applying this version of Porters Five Forces Model to the banking industry, we observe that one of the critical factors barriers to entry no longer exists in banking. Competitors can come from any industry to "disintermediate" banks (i.e., eliminate banks as the interface between customers and suppliers). Product differentiation is very difficult for banks, since most of the products sold in retail banking are constrained by legal or industry regulations and, in any case, are readily imitated.

Many countries have de-regulated their banking sector. So government policies no longer form an entry barrier to banks. Technological know-how in banking also provides little protection to existing banks. The only significant entry barrier is likely to be the brand name of the service providers in retail banking. However, many non-bank, but identifiable, names such as TATA are entering the banking arena. Page | 12

Below we present the application of Porters Five Forces model to ING Vysya bank:

The bargaining power of suppliers would be high as there are a small number of fairly large players in the industry. However, the tendency of banks to amalgamate, rationalizing operational costs and thus diminishing the number of banking organizations in any country, is being offset by means of the development of online banks and financial intermediaries. By contrast, the bargaining power of consumers is increasing. Switching costs are becoming lower (with Internet banking gaining momentum) and consumer loyalties are harder to retain. The threat of substitutes to banking in terms of competition from the non-banking financial sector is increasing rapidly.

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Plans of the Company and its various Business Segments

Plans for the Year 2008-09

To re-look at the application landscape and network topology of the Bank with a view to move to a more stable architecture. To introduce new delivery channels such as Mobile Banking. To enhance the MIS capability, through a data warehousing solution. To modernize the branch infrastructure. To move the current single vendor based support model to a multi-vendor support model.

An overview of various business segments along with their performance in 2007-08 and their future strategies is presented below:

Retail Banking

The Retail Banking business continues to be focus area for the bank. The business is organized into Branch Banking, Consumer Loans, Business Banking (SME) and Agricultural & Rural Banking (ARB). The key priorities for the Bank have been acquisition of new customers, deepening existing customer relationship through crossselling, profitable expansion of distribution and building an enhanced brand presence to serve the target segments.

Branch Banking

During the year, the Retail Branch Banking business launched a slew of products to provide clients with enhanced solutions to meet their financial needs besides the traditional deposit products. This was keeping in line with the endeavor to differentiate our products in the market place and offer value added products and services to our customers. The growth was possible by focusing on acquisition of different customer Page | 14

segments through launch of Freedom Savings Account, Orange Salary and Advantage Current Account. As a result, the business saw a growth in customer numbers to 1.38 million.

The branch network of the Bank grew to 446 (including 39 extension counters) as at 31Mar-2008 with the number of ATMs across the country being 203 (including 13 Self Bank ATMs). The Bank has received approval from RBI to open 56 new branches and 100 offsite ATMs during the year.

Consumer Loans

Consumer Loans include Home, Personal and Commercial Vehicle Loans and other value-added products and services to salaried and self-employed individuals. The consumer assets portfolio has seen significant growth in financial year 2007-08, with monthly volumes increasing from Rs.100 Crore in March 2007 to Rs.250 Crore in March 2008. The Home Loan business contributed the largest growth to the consumer assets book. During the year 2007-08, new home loan products for various segments have been introduced, which have made the product more competitive in the market. This has helped the Consumer Assets business achieve a growth of more than 70% over the previous year.

Life Insurance linked to the Home Loan was also launched in the third quarter of the year, and has seen rapid growth since its launch. Personal Loans and Commercial Vehicle Loans also grew in excess of 40%. While Personal Loans has been identified as a focus area for the year 2008-09 with the target segment being salaried individuals, the housing finance segment would continue to grow rapidly and the bank has identified Home Loans as a core focus product.

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Business Banking (SME)

The Bank has traditionally focused on the Micro, Small and Medium Enterprise business (SME), which has accounted for a sizeable proportion of total advances. This segment identifies the needs of business enterprises with annual sales turnover upto Rs.75 Crore for both domestic and export credit requirements. The Bank has a large number of relationships enabling us to cross-sell other Retail Bank Products. The business is spread across 11 sub-regions of the Bank, with 14,500 relationships; fund-based outstanding of over Rs.3,500 Crore and Rs.800 Crore under non-fund based limits as of 31-Mar-2008.

The portfolio grew by 21% (fund based) over the previous year. Apart from regular working capital facilities, the Bank also offers structured products to cater to the needs of clients. This segment has contributed Rs.1,050 Crore towards the priority sector advances of the Bank. The clear focus, strategy and strong relationship teams and distribution, has helped ensure strong growth. This segment continues to be a priority, with a focus on new bank customer acquisition, product innovation, customer service and relationship deepening.

Agricultural and Rural Banking (ARB)

ARB provides a wide range of products and services to the rural sector and is one of the main contributors for the achievement of the priority sector targets of the Bank. During the year 2007-08, this segment focused on improving the performance of rural branches. ARB assets crossed Rs.1,400 Crore for the period ended March 2008 and the number of borrowers financed surpassed 1,11,000. Micro Finance lending, through both Self Help Groups (SHGs) and Micro Finance Institutions (MFIs), was one of the key focus areas. The Micro finance portfolio touched Rs.377 Crore registering a growth of over 100% during the year. The Bank also partnered with Central Warehousing Corporation for Andhra Pradesh and Karnataka to finance Produce Loans to farmers and also partnered with Escorts Ltd. for financing Tractor Loans to farmers. The Bank surpassed the

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regulatory target of 40% under Priority Sector Advances and achieved the level of 42.68% of adjusted Net Bank Credit as of 31-Mar-2008.

Private Banking

The Bank has a vision to be the advising bank of first choice for Private Banking clients. In 2007-08 three new equity portfolio opportunities were identified. These were delivered to clients under our Portfolio Management Services. This has delivered good returns and helped increase the client base. Assets under management grew by more than 100%.

Private Banking has also provided Trust and Estate Planning Services through an institutional partnership in order to help clients create portfolios and pass on the wealth to their beneficiaries. A second partnership has been established for the distribution of Real Estate Funds. Private Banking continues to do research and introduce new products as new opportunities arise.

The Bank also increased its distribution network to do this business with the addition of Kolkata, Chennai and Hyderabad. Private Banking continues to proactively monitor and advise its clients on their investment in the light of the continuing volatility in financial markets.

Wholesale Banking

Wholesale Banking business headquartered in Mumbai provides a range of banking products and services to Indias leading corporates and fast growing businesses. The fund-based products include working capital finance (cash credit and bills discounting), term finance (long term and short term) and structured finance facilities. The non-fund based products mainly consist of letters of credit, financial and performance guarantees. Other fee-based services such as cash management services, trade services, payment services and debt syndication are also offered. The advisory services focus on mergers and acquisitions, capital restructuring and capital raising. The Bank also accepts rupee Page | 17

and foreign currency deposits with fixed or floating interest bases from its corporate customers. The commercial banking products and services are delivered to corporate customers through a combination of Wholesale Banking offices located in Mumbai, Delhi, Chennai, Bangalore, Kolkata and Hyderabad and the retail branches.

Wholesale fund based assets grew by 15% during the year to close at Rs.6,508 Crore. During the same period, Wholesale deposits grew by 32%. Fee Income grew above expectation and contributed significantly to the Banks profits.

Corporate and Investment Banking Group (C&IB)

The C&IB Group is responsible for managing relationships with large corporates (typically with sales turnover greater than Rs.400 Crore) in both the private and public sector. The primary focus of the C&IB relationship managers is to market products and services, like lending products, fee based products, treasury services and advisory services and also cross-border products from ING Bank N.V. and cross-selling of Retail Banking products and services of the Bank to corporate clients and their employees. In addition to the above, they cross-sell the products offered by other ING Group managed entities in India such as ING Vysya Life Insurance Company Limited (IVL) and ING Vysya Mutual Fund (IVMF).

Emerging Corporates (EC)

The Emerging Corporates group is serviced from ten cities within the Banks extensive network and focuses on managing relationships for manufacturing, processing, and services sector companies with an annual sales turnover between Rs.150 Crore and Rs.400 Crore. A wide range of products are offered to meet the needs of this business segment, with special focus on export credit, regular working capital finance, cash management services, term loans, non-fund based facilities like letters of credit, guarantees and structured finance products in addition to the cross-selling of ING group

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products. The EC segment contributes 75% of the Banks export credit advances. This business segment remains a key focus of growth for Wholesale Banking.

Banks and Financial Institutions (B&FI)

The Banks and Financial Institutions Group, headquartered in Mumbai, is a dedicated group created to leverage the business opportunities with private and public sector banks and financial institutions across India. The group has primary responsibility for origination of transactions and product & service delivery to the Bank/FI client base including funding products, correspondent bank relationships, treasury products, asset purchase & sale and deposit products.

Financial Markets (FM)

The Financial Markets department of the Bank continued to grow strongly. It consists of four key units - Trading & Market Making, Sales, Structuring and Asset Liability Management (ALM). The Trading and Market Making unit of financial markets provides liquidity and prices both to the Sales teams as well as to other market participants. The unit has contributed well to information dissemination as well as analysis of the markets so that the trading unit as well as our clients benefit from our expertise in the area. The unit has also been able to effectively and profitably exploit the opportunities that have been available in the markets, within the defined risk framework. The geographically distributed sales teams help corporate clients manage currency and interest rate risks within their risk management practices. The sales teams are guided by prudent and transparent approach to client deals, adhering to approved appropriateness and documentation policies. The sales unit is supported by a centralized structuring unit that assists in product structuring, pricing and execution. The product capability of the financial markets unit has grown significantly in the last year with the introduction of state-of-the-art systems and process improvements to enable efficient execution. The ALM unit of financial markets has played a key role in managing liquidity and market risks, compliance with reserve requirements and facilitating balance sheet growth. The Page | 19

ALM unit also manages the Banks investment portfolio and has managed volatility in this book in keeping with regulatory requirements. The financial markets unit is in the process of further developing the platform that has been built over recent years. A major upgrade and improvement to core systems is underway which will greatly enhance efficiency and improve the processes further. The strategy continues to be one that will leverage on the customer franchise that is developing strongly.

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PART B

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What is a Commodity?
Commodity includes all kinds of goods. Goods are defined 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, many goods and products of agricultural (including plantation), mineral and fossil origin are allowed for futures trading. Trading is permissible in commodities that include precious (gold & silver) and non-ferrous metals, cereals and pulses, crude oil and oil products, etc.

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: Precious Metals: Gold, Silver, Platinum etc Other Metals: Nickel, Aluminum, Copper etc Agro-Based Commodities: Wheat, Corn, Cotton, Oils, and Oilseeds. Soft Commodities: Coffee, Cocoa, Sugar etc Live-Stock: Live Cattle, Pork Bellies etc Energy: Crude Oil, Natural Gas, Gasoline etc

Indian Scenario
Although India has a long history of trade in commodity derivatives, this segment remained underdeveloped due to government intervention in many commodity markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the state and forwards and futures trading are selectively introduced with stringent controls. While free trade in many commodity items is restricted under the Page | 22

Essential Commodities Act (ECA), 1955, forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952.

The first commodity exchange was set up in India by Bombay Cotton Trade Association Ltd., and formal organized futures trading started in cotton in 1875. Subsequently, many exchanges came up in different parts of the country for futures trade in various commodities. Options are though permitted now in stock market, they are not allowed in commodities. The commodity options were traded during the pre-independence period. Options on cotton were traded until they along with futures were banned in 1939 (Ministry of Food and Consumer Affairs, 1999). However, the government withdrew the ban on futures with passage of FCRA in 1952. The Act has provided for the establishment and constitution of Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers assigned to it by the Act. Later, futures trade was altogether banned by the government in 1966 in order to have control on the movement of prices of many agricultural and essential commodities.

After the ban of futures trade all the exchanges went out of business and many traders started resorting to unofficial and informal trade in futures. On recommendation of the Khusro Committee in 1980 government reintroduced futures on some selected commodities including cotton, jute, potatoes, etc. As part of economic liberalization of 1990s an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra was appointed by the government of India in 1993. Its report submitted in 1994 recommended the reintroduction of futures that were banned in 1966 and also to widen its coverage to many more agricultural commodities and silver. In order to give more thrust on agricultural sector, the National Agricultural Policy 2000 has envisaged external and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk arising from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading.

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Recently, rice, wheat and pulses - urad and tur - are banned from futures trading in India owing to the huge price rise in the commodities. For this purpose, the government had set up the five-member expert committee, headed by planning commission member Abhijit Sen, to study the extent of impact, if any, of futures trading on wholesale and retail prices of agricultural commodities as per the announcement made by finance minister P Chidambaram while presenting the budget for 2007-08. The committee submitted its report on 12 May 2008. Other than examining the extent of the impact of futures trading, the committee had to suggest ways to minimize the impact and make recommendations for increased association of farmers in the futures market/trading so that farmers are able to get the benefit of price discovery through commodity exchanges. The report has found that though there was volatility, they were triggered, except for rice, by supply shortfall, high global prices and seasonal factors, and not so much due to futures trading. The data for rice were not enough to prove any volatility. In fact, the report argues that the futures contracts were not able to stabilize prices because of lacunae in the system and lack of strong farmer participation. The spot market in these commodities is not efficient and there is no grading of commodities without which the cash-futures link cannot be strengthened. Also, there is still no system of warehouse receipts. The report also found that farmer participation in the futures market is minimal, due to high margins, demat trading and mandatory use of permanent account numbers. Overall, it feels, that a reformed futures market would go a long way in arresting price volatility in staples. The repeated extensions have obliquely meant that future contracts in these commodities remain suspended, although the impact of the ban has not been significant. But, exchanges, which want the government to lift the ban, argue that after the ban, neither wheat nor pulses prices have come down significantly. The price trend of wheat and pulses in the physical market (since January) has proved that the forward market had been giving the correct indication of future price movement. Prices of both wheat and tur have actually gone up in the physical market due to shortage. Even though Abhijit Sen committee has given its view that there is no direct linkage between price rise and future trading of food items, due to its failure to curb inflation, the government is planning to ban future trading in more commodities. The government is

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thinking of an immediate ban on future trading in some commodities like oil and sugar. Even after taking several steps to check inflation, the inflation has inched further to 7.57 per cent (as on April 23).

Segments in Commodities Market

Commodity market is an important constituent of the financial markets of any country. It is the market where wide ranges of products 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.

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.

Commodity Derivatives
The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features that are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying assets are concerned. However in the case of commodities, the Page | 25

quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. The major issues in commodity derivatives are as follows:

Physical settlement: Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. They are: o Limits on storage facilities in different states. o Restrictions on interstate movement of commodities. o State level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities.

Delivery notice period: Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period'. The intention of the notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to Page | 26

produce a verification report from these laboratories along with delivery notice. Some exchanges accept warehouse receipts as quality verification documents while others have independent grading and classification agency to verify the quality.

Assignment: Whenever the seller gives delivery notices, the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method. Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first in first out basis. In some exchanges, the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The clearing house before introduction of the contract publishes the discount/ premium for quality and freight costs. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day.

Delivery: After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity Page | 27

of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts.

Warehousing: One of the main differences between financial and a commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. In case of commodity derivatives however, there is a possibility of physical settlement. Which means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity. In India, the warehousing system is not as efficient as it is in some of the other developed markets.

Quality of underlying assets: A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of Page | 28

prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.

Commodity Futures
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. The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying assets are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. Futures trading perform two important functions of price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It is useful to the producer because he can get an idea of the price likely to Page | 29

prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him. It enables the consumer, in that he gets an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. Futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to hedge his risk by operating in futures market.

Types of Future Contracts

Future contracts are broadly of two types: Specific delivery contracts: Specific delivery contracts are essentially merchandising contracts, which enable producers and consumers of commodities to market their produce and cover their requirements respectively. These contracts are generally negotiated directly between parties depending on availability and requirement of produce. During negotiation, terms of quality, quantity, price, period of delivery, place of delivery, payment term, etc. are incorporated in the contracts. Specific delivery contracts are of two types: o Transferable specific delivery contracts (T.S.D.) o Non-transferable specific delivery contracts (NTSD).

In the TSD contracts, transfer of the rights or obligations under the contract is permitted while in NTSD it is not permitted. Other than specific delivery contracts: Though this contract has not been specifically defined under the act, these are called as future contracts. Futures contracts are forward contracts other than specific delivery contracts. These contracts are usually entered into under the Page | 30

auspices of an Exchange or Association. In the futures contracts, the quality and quantity of commodity, the time of maturity of contract, place of delivery etc. are all standardized and contracting parties have to negotiate only the rate at which contract is entered into. Forward trading in TSD and NTSD contracts is regulated by the government. As per the section 15 of the FCRA, 1952, every forward contract in notified goods that entered into except those between members of a recognized association or through or with any such member is treated as illegal or void. The section 18(1) of the Act exempts the NTSD contracts from the regulatory provisions.

Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

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However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

Forward/futures trading involves a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc. Hence there is a need for the regulatory functions to be exercised by an exchange that is the Forward Markets Commission (FMC). FMC is a regulatory authority, which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. It is a statutory body under the Forward Contracts (Regulation) Act, 1952.

Limitations of Forward Markets

Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Page | 32

Illiquidity, and Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradeable.

Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

Options
Futures contracts are similar to Options. Both represent actions that occur in future. But Options are contract on the underlying futures contract where as futures are either to accept or deliver the actual physical commodity. To make a decision between using a futures contract or an options contract, producers need to evaluate both alternatives. An option on futures gives the right to but not the obligation on the part of the holder to buy or sell the underlying futures contract by a certain date at a certain price.

Types of Options
There are two types of options A call option is a contract that gives the owner of the call option the right, but not obligation to buy the underlying asset by a specified date and a specified price. A put option is a contract that gives the owner of the put option, the right, but not obligation to sell the underlying asset by a specified date and a specified price. Page | 33

A Commodity option gives the owner a right to buy or sell a commodity at a specified price and before a specified time. Options can be traded either in an exchange or over the counter. Over the counter option contracts are tailor-made contracts matching the specific needs of investors. The initial cash transfer (premium) is to be paid by the buyer of the option to the seller (option writer). The purchase of an option limits the maximum loss and at the same time allows the buyer to take advantage of favorable price movements. Sellers of option contracts (option writers) are exposed to margin requirements. Commodity options are exercisable into the corresponding future contracts of the commodity rather than the physical commodity. Based on the exercise mode, there are two types of options that are currently traded: American Style Options: In an American option, the buyer of the option can choose to exercise his option at any given period of time between the purchase date and the expiry date of the underlying futures contract. European Style Options: In a European option, the buyer of the option can choose to exercise his option only on the date of expiration of the underlying futures contract. Since the American option provides greater degree of flexibility to the investor, the premium paid to buy an American Style Option is equal to or greater than the European Style Option. However in India options have still not been introduced as necessary legal formalities are yet to be completed.

Pricing Commodity Futures

The process of arriving at a figure at which a person buys and another sells a futures contract at a specific expiration date is called price discovery. In an active futures market, the process of price discovery continues from the market's opening until its close. The prices are freely and competitively derived. Future prices are therefore considered to be superior to the administered prices or the prices that are determined privately. Further, the Page | 34

low transaction costs and frequent trading encourages wide participation in futures markets lessening the opportunity for control by a few buyers and sellers.

In an active futures markets the free flow of information is vital. Futures exchanges act as a focal point for the collection and dissemination of statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates and other pertinent information. Any significant change in this data is immediately reflected in the trading pits as traders digest the new information and adjust their bids and offers accordingly. As a result of this free flow of information the market determines the best estimate of today and tomorrow's prices and it is considered to be the accurate reflection of the supply and demand for the underlying commodity. The cost-of-carry model explains the dynamics of pricing that constitute the estimation of fair value of futures.

The cost of carry model

This model uses arbitrage arguments to arrive at the fair value of futures. For pricing purposes, it treats the forward and the futures market as one and the same. A futures contract is nothing but a forward contract that is exchange traded and that is settled at the end of each day. The buyer who needs an asset in the future has the choice between buying the underlying asset today in the spot market and holding it, or buying it in the forward market. If he buys it in the spot market today, it involves opportunity costs. He incurs the cash outlay for buying the asset and he also incurs costs for storing it. If instead he buys the asset in the forward market, he does not incur an initial outlay. However the costs of holding the asset are now incurred by the seller of the forward contract who charges the buyer a price that is higher than the price of the asset in the spot market. This forms the basis for the cost-of-carry model where the price of the futures contract is defined as: F= S + C Where: F = Futures price S = Spot price Page | 35

C = Holding costs or carry costs

The fair value of a futures contract can also be expressed as: F = Se r T Where: r = Percent cost of financing T = Time till expiration

In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased.

Storage costs add to the cost of carry. If U is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to F = (S + U) e r T Where: r = Cost of financing (annualized) T = Time till expiration U = Present value of all storage costs

Participants of Commodity Derivatives

The structure of commodity markets dictates that there are several types of participants active in the trading of commodities and commodity derivatives. The structure of the participants and the nature of their activities/motivations are more complex than in other asset classes.

The major participants in commodity markets include:

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Commodity Producers/Consumers: These participants have natural underlying outright long (producers) and short (consumers) positions in the relevant commodity. The inherent risk-exposure drives the use of commodity derivatives by producers and users. The application of commodity derivatives in frequently driven by the pattern of cash flows. Producers must generally make significant capital investments (sometime significant in scale) to undertake the production of the commodity. This investment must generally be made in advance of production and sale of the commodity. This means that the producer is exposed to the price fluctuations in the commodity. If prices decline sharply, then revenues may be insufficient to cover the cost of servicing the capital investment (including debt service). This means that there is a natural tendency for producers to hedge at levels that ensure adequate returns without seeking to optimize the potential returns from higher returns. This may also be necessitated by the need to secure financing for the project. Consumer hedging behavior is more complex. Consumer desire to undertake hedges is influenced by availability of substitute products and the ability to pass on higher input costs in its own product market. In many commodities, producer and consumer deal directly with each other. The form of arrangement may include negotiated bilateral long term supply or purchase contracts between the producers and consumers. The contracts may include fixed price arrangements to reduce the price risk for both parties. These arrangements create a number of difficulties. These include lack of transparency, low liquidity and exposure to counterparty credit risk. The bilateral structure also creates potential adverse performance incentives. This reflects the fact that the contracts combine supply/purchase obligations and price risk elements in a single contract.

Commodity Processors: These participants have limited outright price exposure. This reflects the fact the processors have a spread exposure to the price differential between the cost of the input and the cost of the output. For example, oil refiners are exposed to the differential between the price of the crude oil and the price of the refined oil products (diesel, gasoline, heating oil, aviation fuel, Page | 37

etc.). The nature of the exposure drives the types of hedging activity and the instruments used. Commodity Traders: Commodity markets have complex trading arrangements. This may include the involvement of trading companies (such as the Japanese trading companies and specialized commodity traders). Where involved, the traders act as an agent or principal to secure the sale/purchase of the commodity. Traders increasingly seek to add value to pure trading relationship by providing derivative/risk management expertise. Traders also occasionally provide financing and other services. Commodity traders have complex hedging requirements, depending on the nature of their activities. A trader as a pure agent will generally have no price exposure. Where a trader acts as a principal, it will generally have outright commodity price risk that requires hedging. Where traders provide ancillary services such as commodity derivatives as the principal, the market risk assumed will need to be hedged or managed.

Financial Institution/Dealers: Dealer participation in commodity markets is primarily as a provider of finance or provider of risk management products. The dealers' role is similar to that in the derivative market in other asset classes. The dealers provide credit enhancement, speed, immediacy of execution and structural flexibility. Dealers frequently bundle risk management products with other financial services such as provision of finance.

Investors: This covers financial investors seeking to invest in commodities as a distinct and a separate asset class of financial investment. The gradual recognition of commodities as a specific class of investment assets is an important factor that has influenced the structure of commodity derivatives markets.

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Economic Functions of Commodity Futures Market

The two major economic functions of a commodity futures market are price risk management and price discovery. Among these, the price risk management is by far the most important. The need for price risk management, through what is commonly called "hedging", arises from price risks in most commodities. The larger, the more frequent and the more unforeseen is the price variability in a commodity, the greater is the price risk in it. Whereas insurance companies offer suitable policies to cover the risks of physical commodity losses due to fire, pilferage, transport mishaps, etc., they do not cover similarly the risks of value losses resulting from adverse price variations. The reason for this is obvious. The value losses emerging from price risks are much larger and the probability of the recurrence is far more frequent than the physical losses in both the quantity and quality of goods caused by accidental fires and mishaps, or occasional thefts. Commodity producers, merchants, stockists and importers face the risks of large value losses on their production, purchases, stocks and imports from the fall in prices. Likewise, the processors, manufacturers, exporters and other market functionaries, entering into forward sale commitments in either the domestic or export markets, are exposed to heavy risks from adverse price changes. True, price variability may also lead to windfalls, when prices move favorably. In the long run, such gains may even offset the losses from adverse price movements. But the losses, when incurred, are, at times, so huge that these may often cause insolvencies. The greater the exposure to commodity price risks, the greater is the share of the commodity in the total earnings or production costs. Hence, the need for price risks management or hedging through the use of futures contracts.

Price Discovery The buyers and sellers at Futures Exchange conduct trading based on their assessment of inputs regarding specific market information, expert views and comments, the demand and supply equilibrium, government policies, inflation rates, weather forecasts, market dynamics, hopes and fears which transforms into a continuous price discovery mechanism. The execution of trades between buyers and sellers leads to assessment of Page | 40

the fair value of a particular commodity that is immediately disseminated on the trading terminal. Futures exchanges do not act as a mode for setting the prices of commodities. These are free markets that act as a platform to bring together, in open auction, all forces that influence the pricing of the commodity. When these markets keep on assimilating and absorbing new information on a continuous basis throughout the trading day, this information gets transformed into a single benchmark figure. This figure is the market price agreed upon by both the buyer and seller. It is for this reason that rational market participants and commodity traders view futures as a lending price indicator.

Margins for trading in Commodity Futures

Margin is the deposit money that needs to be paid to buy or sell each contract. The margin required for a futures contract is better described as performance bond or good faith money. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract.

With respect to the contracts that are transacted in the exchanges, buyers and sellers will be required to maintain a certain amount as initial margin, including special margin (as applicable) on their respective future positions. These margins vary for each commodity and for different contract months depending upon factors such as market volatility, government policies, macro-economic factors, international price movements, etc.

Margin provisions, subject to margin requirements, are determined by applying the methodology as specified by the exchange and are settled by the clearing house of the exchange. For example, the exchange can levy an initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as prescribed. Additional margins are levied for deliverable positions on the basis of VaR from the expiry of the contract till the actual settlement date, including a mark-up in case of default. The Page | 41

estimated margin (based on the prescribed methodology) may be on gross position basis, net position basis, client level basis or in any other manner determined by the exchange.

Every clearing member is also required to maintain an appropriate margin account with the clearing house of the exchange against the aggregate open positions cleared by the clearing member in respect of (i) the clearing members own account, (ii) for other members of the exchange with whom the clearing member has an agreement and, (iii) clients, where applicable.

Margin accounts of all exchange members are marked daily to the market and the exchange members are required to pay the amount prescribed by the clearinghouse. The entire days trades and open positions on the exchange are marked to closing price for the respective futures contract, on the basis of which the hypothetical gain or loss is estimated. The investor is required to collect or make compensation for this amount at the end of each trading day. The exchange also prescribes additional or special margins as may be considered necessary during the delivery period and emergencies. Every member of the exchange executing transactions on behalf of clients is required to regularly (time interval is exchange specified) collect the margins from their clients against their open positions.

So, in the futures market, there are different types of margins that a trader has to maintain. Different types of margins as they apply on most futures exchanges are:

Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. This margin is meant to cover the largest potential loss in one day. The margin is a mandatory requirement for parties who are entering into the contract.

Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative, a maintenance margin, which is somewhat lower Page | 42

than the initial margin, is set. If the balance in the margin account falls below the maintenance margin, the trader receives a margin call and is requested to deposit extra funds to bring it to the initial margin level within a very short period of time. The extra funds deposited are known as a variation margin. If the trader does not provide the variation margin, the broker closes out the position by offsetting the contract.

Additional margin: In case of sudden higher than expected volatility, the exchange calls for an additional margin, which is a preemptive move to prevent breakdown. This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis.

Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted to reflect the trader's gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day's movement. Based on the settlement price, the value of all positions is marked-to-market each day after the official close i.e. the accounts are either debited or credited based on how well the positions fared in that day's trading session. If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades.

Risks Associated
For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. Banks using portfolio strategies involving forward and derivative contracts are exposed to a variety of additional risks, which may well be larger than the risk of a change in spot prices. These include:

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Basis Risk: The risk that the relationship between the prices of similar commodities alters through time.

Interest Rate Risk: The risk of a change in the cost of carry for forward positions. Forward Gap Risk: The risk that the forward price may change for reasons other than a change in interest rates.

In addition banks may face credit counterparty risk on over-the-counter derivatives. It should also pay attention to the risk of surprise events such as crop reports, freezes, floods, currency interventions and wars. One should not overtrade in markets where these kinds of events are possible.

Regulation of Commodity Futures/Forwards

In general, commodity futures trading, merchandising and stockholding of many commodities in India have always been regulated through various legislations such as the Essential Commodities Act (ECA), 1955, Forward Contract (Regulation) Act (FCRA), 1952 and Prevention of Black-marketing and Maintenance of Supplies of Commodities Act, 1980. The FCRA, 1952 envisages a three-tier regulation for commodity futures trading in India. These are (a) an association recognised by the Government of India on the recommendation of the FMC, (b) the FMC and (c) the central government. As per the act, the exchange that organizes forward trading in regulated commodities can prepare its own rules (Articles of Association) and bylaws and regulate trading on a day-to-day basis. The FMC approves those rules and byelaws and provides a regulatory overview. The ECA, 1955 came into powers to control production, supply, distribution, etc. of essential commodities for maintaining or increasing supplies and for securing their equitable distribution and availability at fair prices. Using the powers under the ECA, 1955, various departments of the central government have issued control orders for regulating production, distribution and quality of products, movements, etc. pertaining to the commodities that are essential and administered by them.

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The provisions of FCRA, 1952 govern all types of forward contracts in India. The act categorized commodities into three groups based on the extent of regulation: (a) the commodities in which futures trading can be organized under the auspices of a recognised association (b) the commodities in which futures trading is prohibited (c) the free commodities which are neither regulated nor prohibited. However, options in goods are prohibited by the FCRA, 1952 but the ready delivery contracts remain outside its purview. The ready delivery contract, as defined by the act, is the one that provides for the delivery of goods and payment of a price, either immediately or within a period not exceeding 11 days after the date of the contract. All ready delivery contracts where the delivery of goods and/or payment for goods is not completed within 11 days from the date of the contract are defined as forward contracts. The act classifies forward contracts into twospecific delivery contracts and those excluding specific delivery contracts or futures contracts. Specific delivery contracts are forward contracts that provide for the actual delivery of specific qualities or types of goods during a specified time period at a price fixed thereby or to be fixed in the manner thereby agreed and in which the names of both the buyer and the seller are mentioned. Specific delivery contracts are distinguished as transferable and non-transferable. The distinction between the transferable specific delivery (TSD) contracts and non-transferable specific delivery (NTSD) contracts is based on the transferability of the rights or obligations under the contract. Forward trading in TSD and NTSD contracts are regulated by FCRA, 1952. As per section 15 of the act, every forward contract in notified goods (currently 103 commodity items), which is entered into except those between members of a recognised association or through or with any such member, is treated as illegal or void. As per the section 17(1) of the act, 82 items are prohibited from entering into forward contracts. Section 18(1) of the act exempts NTSD contracts from regulatory provisions. However, over the years, regulatory provisions of the act were applied to the NTSD contracts, and 79 commodity items are currently prohibited from NTSD contracts under section 17 of the act. Moreover, another 15 commodity items have been brought under the regulatory provisions of section 15 of the act, out of which trading in NTSD contracts has been suspended for 12 items. At present, the NTSD contracts in cotton, raw jute and jute goods are permitted only

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between, through or with the members of the associations specifically recognised for the purpose.

The main features of the act are as follows:

The Act applies to goods, which are defined as any movable property other than security, currency, and actionable claims. The very preamble of the Act announces the intention of the legislature to prohibit options in goods. By a specific provision, section 19, such agreements are prohibited. (The proposal to regulate options in goods is under consideration of Government)

The Act classifies contracts/agreements into two broad categories, viz., ready delivery contract and forward contract. Ready delivery contract are those where delivery of goods and full payment of price therefore is made within a period of eleven days. (The proposal to extend the period to thirty days is under consideration of Government). It is further clarified that notwithstanding the period of performance contract, if the contract is performed by payment of money difference it would not be a ready delivery contract

The Act defines forward contract as the contract for delivery of goods that are not a ready delivery contract. Forward contracts are implicitly classified into two broad categories, viz., specific delivery contract and non-specific delivery contract or standardized contract. Though, de-facto, the focus of the regulation are standardized contracts i.e., futures contracts, these are not defined in the present Act (it is proposed to introduce definition of "futures contract" in the Act)

Specific delivery contracts (where the terms of the contracts are specific to each contract - customized contracts) in which, the buyer does not transfer the contract by merely transferring document of title to the goods and exchanging money difference between the sale and purchase price, termed as Non-transferable Specific Delivery Contract are normally outside the purview of the Act, but there is an enabling provision empowering the Government to regulate or prohibit such contracts.

The Act provides for either regulation of the other forward contract in specified commodities or prohibition of specified commodities. Such contracts in the Page | 46

commodities that do not figure in regulated or prohibited categories are outside the purview of the Act, except when they are organized by some Exchange. The Act envisages three-tier regulation. The Exchange that organizes forward trading in regulated commodities can prepare its own rules (articles of association) and byelaws and regulate trading on a day-to-day basis. The Forward Markets Commission approves those rules and Byelaws and provides regulatory oversight. It also acquires concurrent powers of regulation either while approving the rules and byelaws or by making such rules and byelaws under the delegated powers. The Central Government - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution - is the ultimate regulatory authority. Only those associations, which are granted recognition by the Government, are allowed to organize forward trading in regulated commodities. Presently the recognition is commodity-specific. Government has original powers to suspend trading, call for information, require the Exchanges to submit periodical returns, nominate directors on the Boards of the Exchanges, supersede Board of Directors of the Exchange etc. Most of these powers are delegated to the FMC; otherwise the role of FMC is recommendatory in nature. (The Government has full control over the FMC, which is the subordinate office of the Department of Consumer Affairs, depending upon the budget allocation for its existence. The FMC also is subject to the rules and regulations relating to all matters including appointment of staff and officers, incurring office expenses and conducting tours etc. as are applicable to any Government Department.) Only police authorities have powers to enforce illegal trading in prohibited commodities and options in goods. FMC can merely forward information and render technical assistance to police. The penalties provided under the Act are nominal and does not have deterrent effect. Since judicial magistrate first class has jurisdiction to try offences under this Act, the fine cannot exceed Rs.10, 000. The minimum fine prescribed for the second offence is Rs. 1,000 only. There is no provision to relate the penalty to the amount involved in the offence. (The Government is considering amending the Act to raise the fine to Rs.5000).

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The Forward Contract Regulations Act (1952) has been amended over the years. Various committees have worked on and reshaped the act in varying capacities. An example is the Kabra Committee in 1993, which proposed strengthening of the FMC and a few amendments to the Forward Contracts (Regulation) Act, 1952. The major amendments included allowing options in goods, increase in outer limit for delivery and payment from 11 days to 30 days for the contract to remain as a ready delivery contract and registration of brokers with the FMC. The government accepted most of these recommendations and futures trading have been permitted in all recommended commodities.

The FMC has imposed several regulatory measures that are implemented in developed markets such as daily mark to market margining, time stamping of trades, innovation of contracts and creation of a trade guarantee fund, back office computerization for the existing single commodity exchange and online trading for the new exchanges, demutualisation for the new exchanges, one-third representation of independent directors on the boards of existing exchanges, etc. Though these measures were intended to promote financial integrity, market integrity and transparency, most of these have met with strong resistance from the trade.

The government has taken a landmark decision to deregulate long duration margining contracts (non-transferable specific delivery contracts) from the purview of the Forward Contracts (Regulation) Act, 1952. There is a need for radically pruning the negative list of commodities in which futures trading is not allowed. The reasons, whether right or wrong, which led the government to ban a large number of commodities no longer exist today. Prior to 1960, futures trading used to be conducted in traditional commodities at the conventional places of trading as per the set terms and conditions. When futures trading in these traditional commodities were prohibited, either non-transferable specific delivery contracts or futures trading in the commodities of minor nature, which had no tradition of futures trading were used as a guise for conducting futures trading in traditional commodities. Most of these minor commodities were included in the negative list to prevent such disguised trading. Now that most of these conventional commodities Page | 48

such as edible oil and cotton are legally allowed, the need for using minor commodities as a guise has disappeared.

Secondly, futures trading can generally be conducted only in commodities, which have competitive markets. It is necessary that the market forces of demand and supply largely determine the prices. India has already made a transition from being a food importing country to a food surplus country. The Government will have to substantially dilute the administered price mechanisms and integrate the internal food grains market with the global markets. The shortage conditions have changed, in addition to the perception that futures market is volatile, aggravating the impact in a shortage situation. It is appreciated in the policy circles that even in a shortage situation, futures markets help to balance the demand for the commodity and has a salutary impact of reducing intra-seasonal pricespread.

LIST OF COMMODITIES NOTIFIED UNDER SECTION 15 OF THE F.C.(R.) ACT 1952.

Fibers and Manufactures

Art Silk Yarn

Cotton Cloth

Cotton pods

Jute goods (Hessian and Sackings and cloth and /or bags, twines and/or yarns Indian Cotton (Full pressed, half pressed Cotton Yarn or loose) manufacturers of whatever nature made from jute) mfd by any of the mills and/or any other

Kapas

Raw Jute (including Mesta)

Staple Fiber Yarn

FOODGRAINS AND PULSES

Arhar Chuni

Bajra

Barley

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Gram

Gram Dal

Guar

Jowar

Kulthi

Lakh (Khesari)

Maize

Masur

Moth

Mung

Mung Chuni

Mung dal

Peas

Ragi

Rice or Paddy

Small Millets (Kodan Kulti, Kodra, Korra, Vargu, Sawan, Rala, Kakun, Samai, Vari & Banti) Tur Dal (Arhar Dal) Tur(Arhar)

Urad (Mash)

Urad dal

Wheat

Metals

Copper, Zinc, Lead or Tin

Gold

Silver

Silver Coins

Oilseeds and Oils

Celeryseed

Copra Oil/Coconut Oil

Copra Oilcake/Coconut Oilcake

Copra/Coconut

Cottonseed

Cottonseed Oil

Cottonseed Oilcake

CPO Refined

Crude Palm Oil

Crude Palm Olive

Groundnut

Groundnut Oil

Groundnut Oilcake

Linseed

Linseed oil

Linseed Oilcake

Rapeseed Oil/Mustard Oil

Rapeseed Oilcake/ Mustardseed Oilcake

Rapeseed/Mustardseed

RBD Palmolein

Rice Bran

Rice Bran Oil

Rice Bran Oilcake

Safflower

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Safflower Oil

Safflower Oilcake

Sesamum (Til or Jiljilli)

Sesamum Oil

Sesamum Oilcake

Soy meal

Soy Oil

Soybean

Sunflower Oil

Sunflower Oilcake

Sunflower Seed

Spices

Aniseed

Betelnuts

Cardamom

Chillies

Cinnamon

Cloves

Coriander seed

Ginger

Methi

Nutmegs

Pepper

Turmeric

Others

Camphor

Castor seed

Crude Oil Chara or Berseem (including Gram Husk (Gram Chilka) charaseed or berseemseed) Gur

Khandsari Sugar

Polymer

Potato

Rubber

Seedlac

Shellac

Sugar

Furnace Oil

Ethanol

Coking Coal

Electricity

Mentha oil

Natural Gas

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The Forward Contract (Regulation) Amendment Bill, 2008

The Forward Contract (Regulation) Amendment Bill, 2008 introduced in the Lok Sabha seeks to make the following amendments:

To transform the role of the FMC from a government department to an independent regulator. The powers and responsibilities of FMC with regard to regulating commodity forward and derivatives market similar to that of SEBI in the Securities Market. Permits trading in commodity derivatives that derive their value from differences in prices of goods or services, activities or events. An increase in the maximum number of members of FMC from four to nine out of which three should be whole time members and a Chairman Conferring powers upon the FMC to levy fees The constitution of FMC General Fund to which all grants, fees and all sums received by the FMC shall be credited except penalty and application of such funds for meeting the expenses of the Commission.

Making provisions for corporatization and demoralization of recognized associations in accordance with the scheme to be approved by the FMC. Making provisions for registration of members and intermediaries. Allowing trading in options. Making provision for investigation, enforcement and penalty in case of contravention of the provisions of the FCR Act, 1952. Securities Appellant Tribunal (SAT) would be designated as the appellate tribunal for the purpose of FCR Act. The Bill provides for an appeal from the order of Forward Market Commission and adjudication officer to SAT. Dissatisfied over the SAT order, an appellant can move the Supreme Courtunder proposed new Section 24A, no civil court would have any jurisdiction to entertain any suit under FCR Act.

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Apart from The Forward Contract (Regulation) Amendment Bill, 2008, many more bills (e.g. Amendment Bill, 2006) were introduced in the Lok Sabha but none were passed. The Amendment Bill, 2008 is also yet to become an Act.

RBI Guidelines
Apart from FMC, the RBI also has a role to play if banks are to deal in future/forward contracts in commodities. The regulation a bank may have to follow in order to deal in forward is as follows:

Regulation by RBI Commodity Derivatives Commercial bank ADs, authorized by Reserve Bank, can grant permission to companies listed on a recognized stock exchange to hedge the price risk in respect of any commodity (except gold, silver, petroleum and petroleum products other than aviation turbine fuel) in the international commodity exchanges/ markets. ADs may grant permission to Corporates only after obtaining approval from the Reserve Bank that also retains the right to withdraw the permission granted to the bank, if considered necessary. Commercial bank ADs interested in extending this facility to their customers should satisfy the minimum norms as given below: 1. Continuous profitability for at least three years 2. Minimum CRAR of 9% 3. Net NPA at reasonable level but not more than 4 per cent of net advances 4. Minimum net worth of Rs 300 crore. Corporates to undertake hedge transactions should submit a Board resolution to the ADs indicating 1. The Board understands the risks involved in these transactions

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2. Nature of hedge transactions that the corporate would undertake during the ensuing year, and 3. The company would undertake hedge transaction only where it is exposed to price risk. ADs may refuse to undertake any hedge transaction if it has a doubt about the bonafides of the transaction or the corporate is not exposed to price risk. It is clarified that hedging the price risk on domestic sale/purchase transactions in the international exchanges/markets, even if the domestic price is linked to the international price of the commodity, is not permitted. Banks which have been granted permission to approve commodity hedging may submit an annual report to the Chief General Manager, Reserve Bank of India, Foreign Exchange Department as on March 31 every year, within one month, giving the names of the corporates to whom they have granted permission for commodity hedging and the name of the commodity hedged. Applications from customers to undertake hedge transactions not covered under the delegated authority may continue to be forwarded to Reserve Bank by the Authorised Dealers Category-I, for approval.

Commodity Hedging for Domestic Transactions - Select Metals As announced in the Annual Policy Statement for the year 2007-08 (para 139), it has been decided that AD Category I banks may, henceforth, permit domestic producers / users to hedge their price risk on aluminium, copper, lead, nickel and zinc in international commodity exchanges based on their underlying economic exposures. Hedging may be permitted up to the average of previous three financial years' (April to March) actual purchases / sales or the previous year's actual purchases / sales turnover, whichever is higher, of the above commodities. Further, only standard exchange traded futures and options (purchases only) may be permitted.

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Commodity Hedging for Domestic Purchases Aviation Turbine Fuel (ATF) AD Category I banks, may also permit actual users of aviation turbine fuel (ATF) to hedge their economic exposures in the international commodity exchanges based on their domestic purchases. If the risk profile warrants, the actual users of ATF may also use OTC contracts. AD Category I banks should ensure that permission for hedging ATF is granted only against firm orders and the necessary documentary evidence should be retained by them. The following points are to be noted in the above two cases: 1. AD Category I banks should ensure that the entities entering into hedging activities above should have Board approved policies which define the overall framework within which derivatives activities should be conducted and the risks controlled. 2. Applications from customers to undertake hedge transactions not covered under the delegated authority may continue to be forwarded to Reserve Bank by the AD Category I banks, for approval as hitherto. Oil Refining and Marketing Companies As announced in the Mid Term Review of Annual Policy Statement for the Year 200708 (para 135), it has been decided to permit domestic oil marketing and refining companies to hedge their commodity price risk to the extent of 50 per cent of their inventory based on the volumes in the quarter preceding the previous quarter. The hedging may be undertaken through AD Category I banks, which have been authorised by Reserve Bank. The hedges may be undertaken using over-the-counter (OTC) / exchange traded derivatives overseas with the tenor restricted to a maximum of one-year forward. AD Category I banks should ensure that the entities hedging their exposures should have Board approved policies which define the overall framework within which derivatives activities should be undertaken and the risks contained. AD Category-I banks should approve this facility only after ensuring that the Boards approval has been Page | 55

obtained for the specific activity (i.e. hedging of inventories) and also for dealing in OTC markets. The Board approval must include explicitly the mark-to-market policy, the counterparties permitted for OTC derivatives, etc. The entities must put up the list of OTC transactions to the Board on a half yearly basis, which must be evidenced by the AD before permitting continuation of hedging facilities under this scheme. The AD Category I banks should also carry out due diligence regarding "user appropriateness" and "suitability" of the hedging activity of the customer.

Procedure for application for approval for hedging of commodity price risk (According to Foreign Exchange Management (Foreign Exchange Derivative Contracts) (Second Amendment) Regulations, 2006) 1. A person resident in India, engaged in export-import trade, who seeks to hedge price risk in respect of any commodity, excluding gold, silver, petroleum and petroleum products (but including ATF), in the international commodity exchanges/markets may submit an application to the International Banking Division of an authorized dealer giving the following details. a. A brief description of the hedging strategy proposed namely: i. Description of business activity and nature of risk ii. Instruments proposed to be used for hedging iii. Names of commodity exchange and brokers through whom the risk is proposed to be hedged and credit lines proposed to be availed. The name and address of the regulatory authority in the country concerned may also be given iv. Size/average tenure of exposure and/or total turnover in a year, together with expected peak positions thereof and the basis of calculation b. Copy of the Risk Management Policy approved by the Management covering: i. Risk identification ii. Risk measurements Page | 56

iii. Guidelines and procedures to be followed with respect to revaluation and/or monitoring of positions iv. Names and designations of the officials authorized to undertake transactions and limits c. Any other relevant information. 2. Authorised dealer after ensuring that the application is supported by documents indicated in paragraph 1, may forward the application with its recommendations to Reserve Bank where applicable. In all other cases, the application may be forwarded by the company concerned to an authorized dealer bank authorized to grant permission under sub-regulation (ii) of regulation 6, for consideration.

Regulation 6 of Foreign Exchange Management (Foreign Exchange Derivative Contracts) (Second Amendment) Regulations, 2006 (i) Reserve Bank may, on an application made in accordance with the procedure specified above, permit subject to such terms and conditions as it may consider necessary, a person resident in India to enter into a contract in a commodity exchange or market outside India to hedge the price risk in a commodity. (ii) Notwithstanding anything contained in sub-regulation (i), an authorized dealer bank specially authorized in that behalf by the Reserve Bank may permit a company, resident in India and listed on a recognized stock exchange, to enter into contracts in a commodity exchange or market outside India, to hedge the price risk in a commodity imported/exported by it subject to such terms and conditions as may be stipulated by the Reserve Bank from time to time. Provided that such authorized dealer bank shall exercise such authority subject to the directions and guidelines issued to them by the Reserve Bank in that behalf.

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(iii) An authorized dealer bank may apply to the Reserve Bank of India, Foreign Exchange Department for grant of authority to grant permission under sub-regulation (ii) to its customers. (iv) Notwithstanding anything contained in this regulation a unit in the Special Economic Zone (SEZ) may enter into contracts in a commodity exchange or market outside India to hedge the price risk of the commodity of export/import, subject to the condition that such contract is entered into on a 'stand-alone' basis (The term standalone means that the unit in the SEZ is completely isolated from financial contracts with its parent or subsidiary in the mainland or within the SEZ(s) as far as its import/export transactions are concerned).

Conditions/ Guidelines for undertaking hedging transactions in the international commodity exchanges/ markets The focus of hedge transactions shall be on risk containment. Only offset hedge is permitted. All standard exchange traded futures and options (purchases only) are permitted. If the risk profile warrants, the corporate/firm may also use OTC contracts. It is also open to the Corporate/firm to use combinations of option strategies involving a simultaneous purchase and sale of options as long as there is no net inflow of premium direct or implied. Corporates/firms are allowed to cancel an option position with an opposite transaction with the same broker. The corporate/firm should open a Special Account with the authorized dealer category-I. All payments/receipts incidental to hedging may be effected by the authorized dealer category-I through this account without further reference to the Reserve Bank. A copy of the Brokers Month-end Report(s), duly confirmed/countersigned by the corporates Financial Controller should be verified by the bank to ensure that all offshore positions are/were backed by physical exposures. Page | 58

The periodic statements submitted by Brokers, particularly those furnishing details of transactions booked and contracts closed out and the amount due/payable in settlement should be checked by the corporate/firm. Unreconciled items should be followed up with the Broker and reconciliation completed within three months.

The corporate/firm should not undertake any arbitraging/speculative transactions. The responsibility of monitoring transactions in this regard will be that of the authorized dealer category-I.

An annual certificate from Statutory Auditors should be submitted by the company/firm to the authorized dealer category-I. The certificate should confirm that the prescribed terms and conditions have been complied with and that the corporate/firms internal controls are satisfactory. These certificates may be kept on record for internal audit/inspection.

Constraints and Major Challenges of Commodity Futures Market

Commodity futures markets are the strength of an agricultural surplus country like India. Commodity exchanges play a pivotal role in ensuring stronger growth, transparency and efficiency of the commodity futures markets. This role is defined by their functions, infrastructure capabilities, trading procedures, settlement and risk management practices. Indian commodity market is still at a nascent stage of development as there are numerous bottlenecks hampering its growth. The institutional and policy-level issues associated with commodity trading have to be addressed by the government in coordination with the FMC in order to take necessary measures to pave the way for a significant expansion and further development of the commodity markets. Some of the major problems associated with commodity markets in India are discussed below: Infrastructure: The lack of efficient and sophisticated infrastructural facilities is the major growth inhibitor of the Indian commodity markets. Though some exchanges occupy large premises, they are deficient in terms of the necessary

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institutional infrastructure, including warehousing facilities, independent and automated clearing houses, transparent trading platforms, etc. Trading System: Though the operations of national exchanges are carried out through the electronic trading system, a majority of the regional exchanges continue to trade via the open outcry system. In order to attract a greater number of investors towards sector-specific commodities, regional exchanges must introduce the electronic trading system to assure the investors of transparency and fairly priced commodities. Controlled Market: Price variability is an essential pre-condition for futures markets. Any deviation in the market mechanism or where the free play of supply and demand forces for commodities does not determine commodity prices will dilute the variability of prices and potential risk. For a vibrant futures market, it is imperative that commodity pricing must be left to market forces, without monopolistic government control. However, in India, scores of commodities in which futures trading is permitted are still protected under the ECA, 1955. Integration of Regional and National Exchanges: From a wider standpoint, it is essential to integrate the regional exchanges with the national exchanges to achieve price discovery for regional exchanges to be driven by broad-level prices prevailing at the national exchanges. Secondly, this integration will facilitate the creation of more efficient markets as price discovery will become dependent on domestic demand and supply of commodities. Integration of the Spot and Futures Markets: The integration of the spot and futures market is another critical factor for the expansion of the commodity futures market in India. The spot market in commodities is largely controlled by the state governments. Restrictions exist on stockholding, turnover, and movement of goods, and variations persist in the level of duties levied by the different state governments.

In spite of these constraints, Foreign Institutional Investors (FIIs), mutual funds and banks may soon become active participants in the Indian commodity derivatives markets. The Reserve Bank of India (RBI), along with the Ministry of Finance and Consumer Page | 60

Affairs, is considering a proposal to grant permission to overseas institutional investors to hold stakes in the Indian commodity derivatives markets (Business Line, 23 February 2005). If these institutional investors are permitted to operate in the Indian commodity derivatives markets, they could provide for the much required breadth and depth to these markets. Moreover, since such a move would warrant the convergence of the commodity derivatives markets with the financial derivatives markets, the commodity derivatives markets could reap better gains. The convergence of commodity futures markets with other derivatives markets will induce eminent economies of scale and would help in the utilization of capital and institution building, which has already taken place for the derivatives markets for the purposes of Indias agricultural sector.

Major Commodities Traded in India

Gold
Indian Gold Market

Gold is valued in India as a savings and investment vehicle and is the second preferred investment after bank deposits.

India is the world's largest consumer of gold in jewellery as investment. In July 1997 the RBI authorized the commercial banks to import gold for sale or loan to jewellers and exporters. At present, 13 banks are active in the import of gold.

This reduced the disparity between international and domestic prices of gold from 57 percent during 1986 to 1991 to 8.5 percent in 2001.

The gold hoarding tendency is well ingrained in Indian society. Domestic consumption is dictated by monsoon, harvest and marriage season. Indian jewellery offtake is sensitive to price increases and even more so to volatility.

In the cities gold is facing competition from the stock market and a wide range of consumer goods. Page | 61

Facilities for refining, assaying, making them into standard bars in India, as compared to the rest of the world, are insignificant, both qualitatively and quantitatively.

Market Moving Factors

Above ground supply from sales by central banks, reclaimed scrap and official gold loans

Producer / miner hedging interest World macro-economic factors - US Dollar, Interest rate Comparative returns on stock markets Domestic demand based on monsoon and agricultural output

Aluminium
Supply and Demand: Global Scenario

Aluminium ore, most commonly bauxite, is plentiful and occurs mainly in tropical and sub-tropical areas - Africa, West Indies, South America and Australia. There are also some deposits in Europe

The leading producing countries include the United States, Russia, Canada, the European Union, China, Australia, Brazil, Norway, South Africa, Venezuela, the Gulf States (Bahrain and United Arab Emirates), India and New Zealand; together they represent more than 90 percent of the world primary aluminium production.

The largest aluminium markets are North America, Europe and East Asia. The global production of aluminium is about 27.7 and 28.9 million tons in 2003 and 2004 respectively.

China, Russia, Canada and United States produced about 6.1, 3.6, 2.64 and 2.5 million tons of aluminium in year 2004 respectively.

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Indian Scenario

India is considered the fifth largest producer of aluminium in the world. It is estimated at about 3037 million tonnes for all categories of bauxite (proved, probable and possible). With the present level of consumption of aluminum, the identified reserves would have an estimated life of over 350 years. India's reserves are estimated to be 7.5 per cent of the total deposits and installed capacity is about 3 per cent of the world.

In terms of demand and supply, the situation is not only self-sufficient, but it also has export potential on a competitive basis. India's annual export of aluminium is about 82,000 tonnes.

Indias annual consumption of Aluminum is around 6.18 lakh tons and is projected to increase to 7.8 lakh tones by 2007.

About a decade back, the primary Indian aluminium producers were BALCO, NALCO, INDAL, HINDALCO and MALCO. Of the five, two (BALCO and NALCO) were in the public sector while the other three were in the private sector

As a result of the process of liberalization of trade in aluminium, India has emerged as a net exporter of aluminium, on competitive terms. Government monopoly, in terms of aluminium production, removal of price and distribution control over aluminium, has been diluted in favour of private sector. The ownership pattern in private sector has undergone changes. With the takeover of INDAL by the HINDALCO, it has emerged as the major producer of aluminium in the country.

World Aluminium Markets

LME, TOCOM, SHFE and NYMEX are the important international markets that provide direction to the aluminium prices.

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Copper
Supply and Demand: Global Scenario Economic, technological and societal factors influence the supply and demand of copper. As society's need for copper increases, new mines and plants are introduced and existing ones expanded. Land-based resources are estimated at 1.6 billion tons of copper, and resources in deep-sea nodules are estimated at 0.7 billion tons. The global production of refined copper is around 15 million tons. The major copper-consuming nations are Western Europe (28.5%), the United States (19.1%), Japan (14%), and China (5.3%). Copper and copper alloy scrap composes a significant share of the world's supply. The largest international sources for scrap are the United States and Europe. Chile, Indonesia, Canada and Australia are the major exporters and Japan, Spain, China, Germany and Philippines are the major importers. Indian Scenario The size of Indian Copper Industry is around 4 lakh tons, which as percentage of world copper market is 3 %. Birla Copper, Sterilite Industries are two major private producers and Hindustan Copper Ltd the public sector producers. India is emerging as net exporter of copper from the status of net importer on account of rise in production by three companies. Copper goes into various usage such as Building, Cabling for power and telecommunications, Automobiles etc. Two major states owned telecommunications service providers; BSNL and MTNL consume 10% of country's copper production. Growth in the building construction and automobile sector would keep demand of copper high. Page | 64

World Copper Markets LME and NYMEX are the two international markets, which provide direction to the copper prices. The eight leading refining nations, viz., United States,Japan, Chile, Canada, Zambia, Belgium, and the Federal Republic of Germany account for 67% of total refined metal production. Factors Influencing Copper Markets Copper prices in India are fixed on the basis of the rates that rule on LME the preceding day. World copper mine production through exploration of new mine and expansion of existing mine. Economic growth of the major consuming countries such as China, Japan, Germany etc. Growth and development in the Building, electronics and electrical industry.

Lead
Supply & Demand Scenario Domestic Scenario Lead production equaled approximately 82,000 tons in 2004, mostly from secondary sources. The main constraint in lead production in the country is the lack of lead ore reserves, which necessitates large-scale imports and recycling. Lead demand in India was estimated at 150,000 tons for 2004. Due to huge gap in demand-supply, India imported nearly about 50% of its domestic demand.

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The major suppliers for the imports were China, the Republic of Korea and Australia: 54%, 15% and 10% respectively. The domestic industry is characterized by the presence of only a few players in the primary segment. The primary lead industry in India is divided between the following main players: Binani Industries Limited and Sterlite Industries (India) Ltd. (Hindustan Zinc Ltd.). Due to increasing use of lead in domestic market both players are expanding their smelting capacities for lead.

World Scenario USA, Japan, China, EU and India are the major consumers of Lead Supply is controlled by Australia and China. Lead in the global market is traded as soft lead, animated lead, lead alloys and copper-base scrap. Factor influencing demand and supply Changes in inventory level at LME warehouses Economic growth rate of major consuming countries Global growth and demand in major consuming industries Prices of the alternative metal(s) Participation of funds

Nickel
Characteristics of World Nickel Market Nickel world market is characterized by rising demand and constrained supply. More than 54% if world total supply comes from only five companies. Global nickel consumption is growing by an average 3.1 per cent a year.

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Supply and Demand Major producers of Nickel are Russia, followed by Australia, Canada, New Caledonia and Indonesia, which represents over 65% of total world production. World primary nickel consumption is about 1 million tons. Consumption centers are Japan 2 lakh tons and European Union 3.74 lakh tons. Rapid expansion of global stainless steel production is fuelling demand for primary nickel. Important World Nickel Markets London Metal Exchange.

Indian Nickel Market Nickel market in India is of total import dependent. India imports around 30,000 tons of Nickel. Import duty on Nickel is 15%. With growth in the stainless steel sector Nickel import demand is expected to increase in the coming years. India in World Nickel Industry India meets its Nickel Requirement through import.

Factors Influencing Nickel Markets Above ground supply from scrap. New mines discovery. Nickel demand is derived demand thus the situation in the various industries. Growth in consumption of Stainless steel.

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Tin
Global Scenario The world tin production fluctuates between 2.4 to 3.1 lakh tons. The production in 2001, is estimated at 2.49 lakh tons. China (80000 - 1,00,000 tons), Indonesia (54000-90000 tons), Peru (50000 - 70000 tons), Bolivia (12000 - 15000 tons) and Brazil (12000 to 14000 tons) are the major producers of tin in the world. These five producers account for around 91% of the world's total production. The other important producers are Australia, Vietnam and Malaysia are the other major producers. United States is believed to be the world's largest producer of secondary tin. World tin consumption is estimated to have exceeded supply by 15000 tons in 2003. Japan is estimated to be the largest consumer of tin in the world. The other major consumers are China and USA. Globally, the demand is estimated to be above the supply.

Major Tin Markets The London Metal exchange is the major referral market for futures trading in tin.

Indian Scenario India's tin production is a meager 10 tons. India meets most of her tin requirements through imports. It is estimated that India imports around 4000 tons of tin and its alloys (including scrap). Tinplate packaging is picking up in the country. The market size of tin plate packaging is estimated to be around 3,00,000 tons. In India, tin plate is mainly used for packaging in three categories: edible oil & cashew, processed food and non-food.

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Zinc
Domestic Scenario The Indian zinc industry entered its transformation phase with the privatization of the largest zinc producer, Hindustan Zinc Ltd, in favor of the Sterlite group in April 2002. The domestic zinc industry is now completely under the private sector and is in the midst of a serious expansion program. By 2010, India is expected to attain complete self-sufficiency in meeting its zinc demand. Thereafter, the process of India becoming an important zinc supplier to the world would be initiated, provided that another phase of capacity expansion is effected. The country's zinc demand, which stood at 3.5 lakh tonnes in 2003-04, is expected to rise to 4 lakh tonnes in 2004-05, including imports 65,000 tonnes. Over the next five-six years, zinc demand is likely to grow at 12-15 per cent annually, against the global average of 5 per cent. Even if one assumes that zinc demand grows by 10 per cent till 2010 and at slower 7 per cent thereafter, India would require zinc capacity of 14 lakh tpa by 2020, in order to be self-reliant. The next round of large capacity additions would, therefore, be warranted from 2008 onwards. Buoyancy in domestic zinc demand primarily emanates from the boom in the steel industry, given that over 70 per cent of zinc is used for galvanizing. The steel industry has bright prospects with demand drivers being the construction industry and exports. Other sources for demand would be die-casting, guard rails for highways and imported-substituted zinc alloys. Global Scenario Substitutes: Aluminum, steel, and plastics substitute for galvanized sheet. Aluminum, plastics, and magnesium are major competitors as diecasting materials. Plastic coatings, paint, and cadmium and aluminum alloy coatings replace zinc for corrosion protection;

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aluminum alloys are used in place of brass. Many elements are substitutes for zinc in chemical, electronic, and pigment uses. Factors Influencing Zinc Market Changes in inventory level at LME warehouses Economic growth rate of major consuming countries Global growth and demand in major consuming industries Prices of the alternative metal(s) Participation of funds

Crude Oil
Global Scenario

Oil accounts for 40 per cent of the world's total energy demand. The world consumes about 76 million bbl/day of oil. United States (20 million bbl/d), followed by China (5.6 million bbl/d) and Japan (5.4 million bbl/d) are the top oil consuming countries.

Balance recoverable reserve was estimated at about 142.7 billion tones (in 2002), of which OPEC was 112 billion tones.

OPEC fact sheet OPEC stands for 'Organization of Petroleum Exporting Countries'. It is an organization of eleven developing countries that are heavily dependent on oil revenues as their main source of income. The current Members are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.

OPEC controls almost 40 percent of the world's crude oil. It accounts for about 75 per cent of the world's proven oil reserves. Page | 70

Its exports represent 55 per cent of the oil traded internationally.

Indian Scenario

India ranks among the top 10 largest oil-consuming countries. Oil accounts for about 30 per cent of India's total energy consumption. The country's total oil consumption is about 2.2 million barrels per day. India imports about 70 per cent of its total oil consumption and it makes no exports.

India faces a large supply deficit, as domestic oil production is unlikely to keep pace with demand. India's rough production was only 0.8 million barrels per day.

The oil reserves of the country (about 5.4 billion barrels) are located primarily in Mumbai High, Upper Assam, Cambay, Krishna-Godavari and Cauvery basins.

Balance recoverable reserve was about 733 million tones (in 2003) of which offshore was 394 million tones and on shore was 339 million tones.

India had a total of 2.1 million barrels per day in refining capacity. Government has permitted foreign participation in oil exploration, an activity restricted earlier to state owned entities.

Indian government in 2002 officially ended the Administered Pricing Mechanism (APM). Now crude price is having a high correlation with the international market price. As on date, even the prices of crude bi-products are allowed to vary +/- 10% keeping in line with international crude price, subject to certain government laid down norms/ formulae.

Disinvestment/restructuring of public sector units and complete deregulation of Indian retail petroleum products sector is under way.

Market Influencing Factors

OPEC output and supply . Terrorism, Weather/storms, War and any other unforeseen geopolitical factors that causes supply disruptions.

Global demand particularly from emerging nations. Dollar fluctuations.

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DOE / API imports and stocks. Refinery fires & funds buying.

Exchanges dealing in crude futures

The New York Mercantile Exchange (NYMEX) . The International Petroleum Exchange of London (IPE). The Tokyo Commodity Exchange (TOCOM).

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Conclusion
Commodity derivatives play a pivotal role in the price-risk management process especially in any agricultural surplus country. Unique hedging instruments derivatives such as forwards, futures, swaps, options and exotic derivative products are extensively used in the global market. However, Indian market is limited to commodity futures and forwards only.

India is rapidly doing away with its barriers on commodity imports and exports, opening up the countrys commodity sector to foreign competition. In order for the domestic industry to be able to compete on an equal footing to its counterparts in other countries, India must develop its commodity market to meet international standards. Unless these standards are met, exchanges will make only minor contributions to the growth and stability of the Indian economy, and international firms and large domestic firms with significant hedging needs will not use these exchanges.

The thirty-year ban on futures exchanges has had an adverse repercussion on the growth and functioning of Indian commodity exchanges. It has forced people, skills and money to flow to other international markets. While commodity exchanges have done remarkably well in the face of adverse conditions, these conditions have now changed. What was appropriate for the exchanges in the mid-1990s is no longer so today. The FMC has been trying to modernize the exchanges by requiring them to implement changes and using the withdrawal or even suspension of approval for trading in some commodities. Many of the commodity exchanges are now responding and have been making efforts to deal with their problems and imperfections.

In its Annual Report 1993, the RBI suggested granting of industry status to commodity futures. This would have provided enhanced access to institutional funds. RBI also observed Participation in futures market needs to be enlarged by including mutual funds, financial institutions and Foreign Institutional Investors (FII), under appropriate regulatory supervision. The banks and financial institutions can play the vital role of Page | 73

price discovery and price risk management. Somehow, for some extraneous reasons the initiatives did not take shape as the nascent phase of futures market could not encourage the Central Government to take bold steps. The traditional hawala markets continued to occupy the pivotal position in the market. But, there appears to be a strong case for allowing banks to participate in futures market. This boosts liquidity and turnover volumes. Indirectly banks would have got a cover against fluctuations in commodity security values of financing. The possible arrangement would be to encourage lending by banks to farmers or cooperatives with a condition that they should sell their commodities in the market under futures contracts.

The commodity futures market in India is facing the test of efficacy due to strong and extreme views of political parties. In March 2007 India banned futures trading in wheat and rice in the wake of uproar over import of wheat. The ban which is driven by political risk is posing challenge to the new players to enter the market. The government decides the maintenance of buffer stocks, price fixation and import-export trade of sensitive commodities. This approach has not helped either the farmer or the consumer in the long run. It is in this context the role of futures market appears crucial for leveling the price fluctuations with wider range extending beyond domestic market. Having recognized the commodity futures market as an essential integral part of liberalization this new alternative must have been allowed to the willing players including banks. If major commodities are not allowed for trading through hasty interventions of government, India will end up with small gains.

The apprehensions over misuse of futures market are misplaced as physical delivery in most cases tones down the undue speculation and futures market in fact can break the power of vested interests operating in private and fragmented markets. A transparent electronic exchange with wider access to new players can be the right answer as futures market can be made more competitive by allowing the participation of mutual funds, banks and other financial institutions. Banks are getting used to playing with the derivatives which are facilitating the reallocation and mitigation of credit risks for banks. RBI is already functioning as an effective regulator by laying down policies and issuing Page | 74

directions to banks operating in securities and derivatives. RBI can also be empowered to regulate the futures trading in commodities by banks. Banks as main suppliers of food credit and major financiers of trading in commodities can play a significant role in stabilizing the futures market.

RBI has taken steps towards the same and has issued the guidelines to be followed by banks and its clients to hedge their risk using commodity futures/ forwards contract. Thus, ING should look into this section of derivatives market so as to spread its risk among various asset classes. This would also help in its portfolio diversification. Today, the commodity derivative market is multiplying and many financial institutions are trying to take advantage of this and a bank like ING Vysya should stay ahead in the race. The government is playing its role and is relaxing terms for players to enter the commodity market. If the amendment bill 2008 is passed, Options in commodities will also be allowed in India and this would offer huge potential for a bank like ING which already deals in many derivative products effectively and efficiently.

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Learning from the Project

The experience at ING Vysya Bank was very enriching. I came to know how exactly a treasury of a bank operates, what all tools they use, how they deal with their clients and how they react to the market volatility i.e. how they react when a news hits the market and the forex rates fluctuate. There I also learnt the basics of forex trading, how the exchange rates are determined and computed, how the bank gives the trading rates to their clients, how they deal with the bid/ask spread and how they make money on each forex derivative contract (be it with the exporter or the importer). The banks main treasury is at Mumbai (I worked at Delhi office), so the Delhi office had to close their books each day. For this purpose, they used the inter bank rates for selling or buying currency (mainly USD, EUR, JPY, CHF, etc) from the main treasury and thus booked their profits or loss.

During my training, I also learned a lot about derivatives. I had the access to the Bloomberg terminal wherein I could try my hand at all kind of derivatives be it swaps, options or other derivatives. After gaining knowledge about few of the derivatives, I switched on to study commodity derivatives wherein I gained a lot of knowledge as to what regulations bank will have to follow in order to float commodity forward contract and how exactly are commodity derivatives dealt around the globe. I also got to interact with the employees of ING Vysya bank and came to know about the functioning and coordination between the different sections of the bank.

Apart from this, I came to know that how difficult it is to dig information from treasuries of banks or corporate. The strategy they follow to hedge their price risk is very confidential to the company and only two to three managerial level employees in the company know about it. Thus, they are reluctant to share information with the outsiders or even other employees of the firm because of its possible negative use like competitors copying it.

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ANNEXTURES

ANNEX 1

Questionnaire on OTC Commodity Derivative Trading

Bank: Identification of the Respondent: Phone: Email: 1. OTC Commodity Products covered by your bank (Multiple Options can be ticked): a) Precious Metals: Gold, Silver, Platinum etc. b) Other Metals: Nickel, Aluminum, Copper etc. c) Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds, etc. d) Soft Commodities: Coffee, Cocoa, Sugar etc. e) Livestock: Live Cattle, Pork Bellies etc. f) Energy: Crude Oil, Natural Gas, Gasoline etc.

2. Please provide the percentage each product contributes to your OTC trading in Commodity Derivatives (e.g. Oil contributes 35% of your total OTC commodity trading, etc.): Commodity Percentage a) b) c) d) e)

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3. With which counterparties do you engage in OTC trading in Commodity Derivative. Please specify the main OTC commodities traded with them (e.g. power with large industrial companies or energy trading companies, etc.):

4. Do you give importance to the credit rating (long term) of the counterparty you deal with in OTC Commodity Derivatives (Yes/No): ______ If yes, then what is the minimum acceptable rating considered as credit worthy (e.g. BBB): ______

5. Is the rating of the counterparty Commodity specific (e.g. you trade in power with a counterparty only if his minimum rating is say A) (Yes/No): ______ If yes, please specify the minimum acceptable credit rating for each commodity traded by you: Commodity Minimum Acceptable rating a) b) c) d) e)

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6. Is your OTC trading in Commodity Derivative state specific (e.g. Surendranagar is the major center for Cotton, etc.) i.e. do you trade a certain commodity mostly in a certain state (Yes/No): _____ If yes, please specify the states (along with the kind of Commodity Derivative traded in that state) for the major Commodity Derivatives you trade in (e.g. Gold in Mumbai, etc.): Commodity State a) b) c) d) e)

7. What do you think are the risks associated with OTC trading in Commodity Derivatives (Multiple options can be ticked) a) Credit risk b) Market risk c) Operational risk d) Liquidity risk e) Legal risk f) Settlement risk g) Reputation risk h) Others (Please specify): ______________ Which is the most important risk associated with OTC trading in Commodity derivatives: _____________________ 8. What is the risk management methodology (for each of the risks ticked above) used by your company (e.g. VaR, etc.)? Please specify.

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9. What is the usual margin percentage you ask for while booking a forward contract? Is it different for different customers (Yes/No): ______ 10. If yes, what is the usual percentage you demand: _____

11. A change in price of the Commodity Derivative could be caused due to (Multiple options can be ticked): a. The model or style of pricing b) Packaging c) Components d) Labor e) Suppliers or manufacturers prices f) Exchange rates g) Competition h) New tax structure i) Adjustments to profit margins 12. Has any counterparty ever failed to fulfill a Commodity Derivative contract (Yes/No): _____ If yes, in the event of failure of counterparty to fulfill the contract, how would your bank unwind its position (e.g. your bank engages in agreements with counterparties, etc.)?

13. Have you ever faced a major crisis while trading in Commodity Derivatives (OTC)? If yes, what was the cause of this crisis and in what way were you affected by it?

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14. In your opinion, do you see any major crisis happening in OTC market of Commodity Derivatives in the near future (like the imposition of Commodity Transaction Tax (CTT) may drive the share of unofficial commodity trading (i.e. DABBA) thus leading to a lower usage of commodity derivatives, etc.)?

15. What all documents do you ask for while booking an OTC commodity derivative contract?

16. OTC Commodity Derivatives your company is planning to trade in the future and are not being traded presently:

17. OTC Commodity Derivatives your company do not intend to handle in the near future (Please state the reason for not trading the commodity in short if possible):

18. Which bank you think gives the toughest competition to you in OTC traded Commodity Derivatives: _____________________________ Page | 81

References

www.mcxindia.com www.ncdex.com www.fmc.gov.in www.rbi.org.in www.commodityonline.com www.sify.com MCX Basic Reference Material NSEs Commodity Market Module

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