A PROJECT REPORT ON

STUDY OF COMMODITY MARKET

For

Marwadi Shares & Finance Ltd.

SUBMITTED TO PUNE UNIVERSITY IN PARTIAL FULFILLMENT OF 2 YEARS FULL TIME COURSE MANAGEMENT OF BUSINESS ADMINISTRATION (MBA)

Submitted By: ROHIT PARMAR (Batch 2006-08)

Guided By:Prof. MAHESH HALALE

BRACTs Vishwakarma Institute of Management, Kondhwa Pune- 411014

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ACKNOWLEDGEMENT It is great pleasure for me to acknowledge the kind of help and guidance received to me during my project work. I was fortunate enough to get support from a large number of people to whom I shall always remain grateful. I would like to express my sincere gratitude to Mr. Pratik Tanna and Mr. Ravi Tandon for giving me this opportunity to undergo this lucrative project with Marvadi Finance Pvt. Ltd. and also for their great guidance and advice on this project, without which I will not be able to complete this project. I am very thankful to our Director Sir Dr. Sharad Joshi for giving me valuable suggestion and encouragement to bring out good project. I am very thankful to my mentor Prof. Mr. Mahesh Halale for him inspiration and for initiating diligent efforts and expert guidance in course of my study and completion of the project and I am very thankful to my project guide for giving me timely and concrete guidance for making this project successful. I would like to thankful to customers and staff members of Marwadi Shares & Finance Pvt. Ltd. For helped me during the project report and providing me more and more valuable information for my project report. I would thank to God for their blessing and my Parents also for their valuable suggestion and support in my project report. I would also like to thank our friends and those who have helped us during this project directly or indirectly.

Rohit Parmar .

CONTENT

Sr. No. 1 2 3 4 5 6 7 8 9 10 11

Particulars EXECUTIVE SUMMARY OBJECTIVE AND SCOPE OF THE PROJECT INTRODUCTION COMPANY PROFILE ABOUT THE COMMODITY RESEARCH METHODOLOGY DATA ANALYSIS RESEARCH FINDING AND CONCLUSION QUESTIONNAIRE SUGGESTION AND RECOMMENDATION BIBLIOGRAPHY

Page No. 4 5 6 8 16 62 64 75 77 79 80

1. EXECUTIVE SUMMARY
One of the interesting developments in financial market over the last 15 to 20 years has been the growing popularity of derivatives. In many situations, both hedgers and speculators find it more attractive to trade a derivative on an asset, commodity than to trade asset and commodity itself. Some commodity derivatives are traded on exchanges. In this report I have included history of commodity market. Than I have included commodity market in India. And after that I have discussed the mechanism of trading in commodity market in India. In this report I have taken a first look at forward, futures and options contract and other risk management instruments. Than after I have discuss the main components of future commodity trading like contract size, what actual margin is and delivery system etc. There are mainly three types of traders: hedgers, speculators and arbitrageurs. In the next section I discuss about the two major commodity exchanges in India that is MCX AND NCDEX. How they are worked for developing this commodity market in India. And I have also given the list of other commodity exchanges in India. Put / call ratio (P/C Ratio) is a market sentiment indicator that shows the relationship between the numbers of put to calls traded. One can use put/call ratio as market indicator .Then after I have discussed about the present scenario of commodity market in India. In the next I have tried to analyze the trading pattern and investment pattern of commodity traders and other investors. This I have done through the help of QUESTIONER, which contains 15 questions. On the basis of different charts prepared, I have at the end given the research findings and conclusion. And on the basis of my findings I have given suggestion and recommendation

2. OBJECTIVE AND SCOPE OF THE PROJECT

2.1 OBJECTIVE OF THE PROJECT REPORT To analyze the view of commodity traders. To make understand the process of future commodity trading in India. To know the investment pattern of commodity traders and people.

2.2 SCOPE OF THE PROJECT REPORT For analyze the trading pattern and investment pattern of commodity traders and government servants, I have taken data from the local area of the Rajkot city.

3. INTRODUCTION
Instability of commodity prices has always been a major concern of the producers as well as the consumers in an agriculture dominated country like India. Farmers direct exposure to price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise profitable activities. There are various ways to cope with this problem. Apart from increasing the stability of the market, various factors in the farm sector can better manage their activities in an environment of unstable prices through derivative markets. These markets serve a risk -shifting function, and can be used to lock -in prices instead of relying on uncertain price developments. There are a number of commodity-linked financial risk management instruments, which are used to hedge prices through formal commodity exchanges, over -the-counter (OTC) market and through intermediation by financial and specialized institutions who extend risk management services. (See UNCTAD, 1998 for a comprehensive survey of instruments) These instruments are forward, futures and option contracts, swaps and commodity linked -bonds. While formal exchanges facilitate trade in standardized contracts like futures and options, other instruments like forwards and swaps are tailor made contracts to suit to the requirement of buyers and sellers and are available over-the counter. In general, these instruments are classified based on the purpose for which they are primarily used for price hedging, as part of a wider marketing strategy, or for price hedging in combination with other financial deals. While forward contracts and OTC options are trade related instruments, futures, exchange traded options and swaps between banks and customers are primarily price hedging instruments. In the case of swaps between intermediaries and producers, and commodity linked loans and bonds (CL&BS) price hedging are combined with financial deals. Forwards contracts are mostly OTC agreements to purchase or sell a specific amount of a commodity on a predetermined future date at a predetermined price. The terms and conditions of a forward contract are rigid and both the parties are obligated to give and take physical delivery of the commodity on the expiry of contract. The holders of forward contracts face spot (ready) price risk. When the prevailing spot price of the underlying commodity is higher than the agreed price on expiry of the contract, the buyer gains and the seller looses. The futures contracts are refined version of forwards by which the parties are insulated from bearing spot risk and are traded in organize exchanges. A detailed discussion on the futures contracts is presented in the next chapter.

Both forwards and futures contracts have specific utility to commodity producers, merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgers and from hedgers to speculators, futures markets also play a major role in price discovery.

Typology of risk management instruments

The price risk refers to the probability of adverse movements in prices of commodities, services or assets. Agricultural products, unlike others, have an added risk. Many of them being typically seasonal would attract only lower price during the harvest season. The forward and futures contracts are efficient risk management tools, which insulate buyers, and sellers from unexpected changes in future price movements. These contracts enable them to lock-in the prices of the products well in advance. Moreover, futures prices give necessary indications to producers and consumer s about the likely future ready price and demand and supply conditions of the commodity traded. The cash market or ready delivery market on the other hand is a time-tested market system, which is used in all forms of business to transfer title of goods.

4. COMPANY PROFILE
4.1 NAME OF THE COMPANY MARWADI SHARES & FINANCE LTD. 4.2 LOGO OF THE COMPANY

4.3 VISION OF THE COMPANY To be a world class financial services provider by arranging all conceivable financial services under one roof at affordable price through cost-effective delivery systems and achieve organic growth in business by adding newer lines of business.

4.4 COMPANY PROFILE: Marwadi Sales and Finance P. Ltd. started in the year 1994 when acquired membership of National Stock Exchange of India Ltd. That was the time when Govt. had just started liberalization. Capital market being at the base of every thing else was among the first few sectors taken up for liberalization and alignment with global benchmarks. NSE was therefore a result of Governments policy to modernize stock market and give our investors a cost - effective trading and settlement system. They enter into the stock market coincided with Government's initiative to give a modern Stock exchange. Marwadi had then very presciently felt that this development would change the very structure and content of the market. Then, when Depository system was introduced to automate the settlement system, we became the first Corporate DP in 1998 to bring this concept to investor's doorstep in Saurashtra. Marwadi had very early on seen that the future lay in the ability to network and use technology to its fullest possible extent. 8

Relying on your judgment, we used technology extensively which resulted in efficient client servicing. It also saw the synergy that lay in providing a bouquet of services under one roof. It is this realization that led us in the year 2003 to go for membership of National Level Commodity Exchanges, which were set up as part of Govt's policy to bring commodity market on par with the capital market in terms of integrity and practices. They bold initiatives starting with our journey from capital market up to commodities market has given us synergies in operations, enabling us to pass on the advantage to customers. As an organization, have achieved a leader's position by ensuring total satisfaction of customers through world class services. Utilize ultra modern technology for timely, seamless and accurate data processing. Proactively seek customers feedback in improving upon our service delivery modes. Promptly respond to customer issues in order to maximize clients satisfaction.

Products & Services offers: Equity & Derivatives: Can look for an easy and convenient way to invest in equity and take positions in the futures and options market using their research and tools. To start trading in Equity, all you need to do is open an online trading account. You can call them and they will have their representative meet you. You can get help opening the account and get guidance on how to trade in Equity.

Commodity: You can enter the whole new world of commodity futures. Investors looking for a fast-paced dynamic market with excellent liquidity can NOW trade in Commodity Futures Market. The Commodity Exchange is a Public Market forum and anyone can play in these vital Commodity Markets. Marwadi Commodity Broker (P) Ltd can certainly be your point of entry to the Commodity Markets. Marwadi is a registered trading-cum-clearing member of NCDEX and MCX. Internet Trading: Making the right trade at the right time! E-Broking service, which brings you experience of online buying and selling of shares with just a click.

A detail resource like live quotes, charts, research and advice helps you take proper decisions. Their robust risk management system and 128 bit encryption gives you a complete security about money, shares, and transaction documents.

IPO: An active player in the primary market with waste customer base and reaching distribution network spread through out the lands. Then breathe Saurashtra peninsula. Marwadi offer bidding for all booked bills IPOs being floated through NSE network. Marwadi offer services to customer such as advises on the minimum lot to applied in case of refer and details and data to be furnished into IPO form. Marwadi scripts even fill up the form for related clients. Marwadi offer bidding services at all major location in Saurashtra and Kutch there by enabled the interline investors to subscribes qualitative IPOs.

Mutual Funds: Transact in a wide range of Mutual Funds. Mutual Funds are an attractive means of saving taxes and diversifying your investment portfolio. So if you are looking to invest in mutual funds, Marwadi offers you a host of mutual fund choices under one roof; backed by in-depth information and research to help you invest smartly.

PMS: Can you analyze the prices of 1,500 shares every morning? Can you afford to gamble only on the recommendations from your friends and the information overload from magazines and financial dailies? And, of course, more importantly, if you happen to be a High Net worth Individual, do you have the time to judge which advice is reliable, authentic and has the least chance of failure? With Marwadi PMS, you can be assured that your investments are in safe hands! Give your portfolio the expert edge to smoothly steer towards wealth creation. Cash Market Services: Marwadi also F & O market to all clients in to entire Saurashtra and Kutch region, which they cover through, distributed cover. Marwadi offer cash market trading services for the both retail and in station clients at all the certain Saurashtra and Kutch where placed either a branch or franchise or sub broker

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4.5 HIRARCHY STRUCTURE

Board of Director

General Manager

DP Front

Trading

Account

Technology

DP Back

Audit (Compliance)

Software

4.6 COMPANY INFORMATION: Name: Marwadi Shares & Finance Ltd.

Head Office

Marwadi Financial Center Nr. Kathiawad Gymkhana Dr. Radhakrishnana Road Rajkot 360 001 Mr. Jeyakumar A. S.

C.E.O.:

Directors:

Mr. Ketan Marwadi Mr. Deven Marwadi Mr. Sandeep Marwadi

General Manager:

Mr. Hareshbhai Maniar

E-Mail:

smarwadi@hotmail.com

Web Site:

www.marwadionline.com

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4.7 COMPANYS MILESTONE: 1992: Marwadi Shares And Finance Pvt. Ltd. was incorporated 1996: Became a corporate member of national Stock Exchange of India. 1998: Became a member of Saurashtra Kutch Stock Exchange. 1999: Launched Depository services of Depository Participant under National Depository Ltd. Securities

2000: Commenced Derivative Trading after obtaining registration as a Clearing and Trading Member in NSE 2003: (MCBPL) became a corporate member of The National Commodity and Derivatives Exchange of India Ltd. 2004: Became a corporate member of The Stock Exchange, Mumbai. 2004: Launched Depository Services of Depository Participant under Central Depository Services (India) Ltd. 2006: MSFPL converted to Public Limited (Marwadi Shares And Finance Limited)

4.8 MEMBERSHIP:

Capital Market: National Stock Exchange of India Ltd. Bombay Stock Exchange Ltd. Saurashtra-Kutch Stock Exchange Ltd. Over-the-Counter Exchange of India Ltd.

Commodities Derivatives: National Commodity & Derivatives Exchange Ltd. Multi Commodity Exchange of India Ltd.

Depository Operations: National Securities Depositories Ltd. (NSDL) Central Depository Services (India) Ltd.

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4.9 SERVICES OF MARWADI:

Stock broking: Cash Market Derivatives Trading Margin Trading Internet Trading

Commodities Broking: Commodities Futures Financing Against Commodities Depository Service: NSDL CDSL IPO Subscription Services Mutual Fund Products Portfolio management Insurance Services Qualitative Research in Stock & Commodities

FUTURE SERVICES: Private Banking Sector Forex Market Commodities Demat Service Product Enhancement in commodity market

4.10 THE COMPLETE INVESTMENT DESTINATION:

It provides comprehensive range of investment services. Thats advantage of having all the services investor need under one roof.

Stock broking: It offers complete range of pre-trade and post-trade services on the BSE and the NSE. Whether an investor come into its conveniently environment, or issue instruction over the

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phone, its highly trained team and sophisticated equipment ensure smooth transactions and prompt services. E-Broking and Web-Based Services: It is one of the offers online trading on site www.marwadionline.com, high bandwidth leased lines, secure services and a customs-built user interface give you an international standards trading experience. It also gives regular trading hours, and access to information, analysis of information, and a range of monitoring tools.

Trading Terminals-Money pore Express: It offer its sub-broker and approved/authorized user fully equipped trading terminalsMoney pore Express, at the location of investors choice. It is fully functional terminal, with a variety of helpful features like market watch, order entry, order confirmation, charts, and trading calls, all available in resizable windows. And it can be operated through the keyboard using F1 for buy, F2 for sell. Depository Participant Services: It offers DP services mean hassle-free, speedy settlements. participants with NSDL and CDSL. It is depository

Premium Research Services: Its research team offers a package of fee-based services, including daily technical analysis, research reports, and advice on clients existing investments. It is research beyond desk and company-provider reports. If you have an equity portfolio, you know that the pace of life in the world of stocks and shares is frantic. Managing your portfolio means you have to take firm, informed decisions, and quickly!

4.11 BRANCHES: Marwadi has spread throughout Gujarat state with our 28 branches and now taking on Pan - India mantle with branches, now having come up in Hyderabad, Chennai Bangalore, Pune, Nasik, Kolhapur and Delhi. More out-of-Gujarat branches are on the anvil in order to be a conspicuous player at national level. As on today they are serving about 75,000 clients spread out over 554 pin code locations through a network of about 300 intermediaries such as sub-brokers, franchisees and authorized persons.

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Also other branches of Marwadi in different cities like..

Ahmedabad Amreli Anand Baroda Bhavnagar Bhuj Delhi Dhoraji Dhangadhra Gondal Gandhidham

Jamnagar Junagadh Keshod Manavadar Mithapur Mumbai Okha Porbandar Surat Surendranagar Veraval

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5. ABOUT THE COMMODITY

5.1 INTRODUCTION Keeping in view the experience of even strong and developed economies of the world, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments which allow fund managers to better manage or reduce these risks. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

5.2 COMMODITIES Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab. A three-pronged approach has been adopted to revive and revitalize the market. Firstly, on policy front many legal and administrative hurdles in the functioning of the market have been removed. Forward trading was permitted in cotton and jute goods in 1998, followed by some oilseeds and their derivatives, such as groundnut, mustard seed, sesame, cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy, issued in July, 2000 by the government that futures trading will be encouraged in increasing number of agricultural commodities was indicative of welcome change in the government policy towards forward trading. 16

Secondly, strengthening of infrastructure and institutional capabilities of the regulator and the existing exchanges received priority. Thirdly, as the existing exchanges are slow to adopt reforms due to legacy or lack of resources, new promoters with resources and professional approach were being attracted with a clear mandate to set up dematerialized, technology driven exchanges with nationwide reach and adopting best international practices. The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all the commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets. Of the country's total GDP, commodities related (and dependent) industries constitute about roughly 50-60 %, which itself cannot be ignored. Most of the existing Indian commodity exchanges are single commodity platforms; are regional in nature, run mainly by entities which trade on them resulting in substantial conflict of interests, opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. But with the strong emergence of: National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai (NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will be addressed rapidly. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges. The current mindset of the people in India is that the Commodity exchanges are speculative (due to non delivery) and are not meant for actual users. One major reason being that the awareness is lacking amongst actual users. In India, Interest rate risks, exchange rate risks are actively managed, but the same does not hold true for the commodity risks. Some additional impediments are centered on the safety, transparency and taxation issues. 5.3 WHY COMMODITIES MARKET? India has very large agriculture production in number of agri-commodities, which needs use of futures and derivatives as price-risk management system. Fundamentally price you pay for goods and services depend greatly on how well business handle risk. By using effectively futures and derivatives, businesses can minimize risks, thus lowering cost of doing business. 17

Commodity players use it as a hedge mechanism as well as a means of making money. For e.g. in the bullion markets, players hedge their risks by using futures Euro-Dollar fluctuations and the international prices affecting it. For an agricultural country like India, with plethora of mandis, trading in over 100 crops, the issues in price dissemination, standards, certification and warehousing are bound to occur. Commodity Market will serve as a suitable alternative to tackle all these problems efficiently. 5.4 COMMODITY FUTURES: Commodity futures are simply the standard futures contracts traded through exchange. These contracts have their respective commodity as underlying asset and derive the dynamics from it. Such contracts allow the participant to buy and sell certain commodity at a certain price for future delivery. Futures trading is a natural outgrowth of the problem of maintaining a year-round supply of seasonal products like agriculture crops. The best thing about a commodity futures contract is that it is generally leveraged giving opportunity to all types of investors to participate. Characteristically, such a contract has an expiry and delivery attached with it. 5.5 WHY TRADE IN COMMODITIES? 1. Big market-diverse opportunities India, a country with a population of over one billion, has an economy based on agriculture, precious metals and base metals. Thus, trading in commodities provides lucrative market opportunities for a wider section of participants of diverse interests like investors, arbitragers, hedgers, traders, manufacturers, planters, exporters and importers. 2. Get to the sore Commodity trading has been a breakthrough in expanding the investment from investing in a metal company to trading in metal itself. 3. Huge potential Commodity exchanges see a tremendous daily turnover of more than Rs.15,000 cores. This gives a lunge potential to market participant to make profits. 4. Exploitable fundamental The fundamental for commodity trading is simple price is a function of demand and supply so is hedging, by taking appropriate contract. This makes things really easy to understand and exploit. 18

5. Portfolio diversifier Commodity futures derive their prices from the underlying commodity and commodity prices cannot become zero. Commodity has a global presence and their prices move with global economics and hence, its a good portfolio diversifier.

5.6 ADVANTAGE OF FUTURES TRADING

Futures trading remove the hassles and costs of settlement and storage for traders who do not want custody. Though, the most lucrative element of futures trading is that it allows investors to participate and trade at nominal costs at a much lesser amount: No longer need to put the whole amount for trading; only the margin is required. No sales tax is applicable if the trade is required off. Sales tax is applicable only if a trade results in delivery. Traders can short sell. If a trader buys an equivalent contract back before the contract expires, he will be able to profit from a falling price. This is difficult in spot marketers because it requires the seller to borrow the commodity. It is next to impossible for retail investors in case of something like gold. All participants trade exactly the same notional right i.e. those defined on the standard contract, so the market grows deeper and more liquid in the standard futures contract than in spot bullion where different qualities of bullion exit, each of which has different prices. Greater liquidity provides a reliable real-time price something which is absolutely not available in the OTC bullion market.

5.7 CHARACTERISTICS OF FUTURES TRADING

A "Futures Contract" is a highly standardized contract with certain distinct features. Some of the important features are as under: Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Bye-laws of the association. It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tenderable varieties". The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units. 19

The delivery periods are specified. The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers. In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place.

5.8 COMMODITY DERIVATIVES IN INDIA Commodity derivatives have a crucial role to play in the price risk management process especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed and developing countries in the world. The Chicago Mercantile Exchange; Chicago Board of Trade; New York Mercantile Exchange; International Petroleum Exchange, London; London Metal Exchange; London Futures and Options Exchange; Marche a Terme International de France; Sidney Futures Exchange; Singapore International Monetary Exchange; The Singapore Commodity Exchange; Kuala Lumpur Commodity Exchange ; Bolsa de Mercadorias & Futuros (in Brazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China Commodity Futures Exchange; Beijing Commodity Exchange, etc are some of the leading commodity exchanges in the world engaged in trading of derivatives in commodities. However, they have been utilized in a very limited scale in India 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 government controls the production, supply and distribution of many agricultural commodities and only forwards and futures trading are permitted in certain commodity items. Free trade in many commodity items is restricted under the Essential Commodities Ac, 195, and forward and futures contracts are limited to certain commodity items under the Forward Contracts (Regulation) Act, 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. The Gujarati Vyapari Mandali came into existence in 1900, which has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively for futures 20

trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association. Many exchanges came up in the agricultural centers in north India before world war broke out and engaged in wheat futures until it was prohibited. The exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this period. The futures trade in spices was firs organized by IPSTA in Cochin in 1957. Futures in gold and silver began in Mumbai in 1920 and continued until the government prohibited it by mid-1950s. 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. 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 the along with futures were banned in 1939. However, the government withdrew the ban on futures with passage of Forward Contract (Regulation) Act in 1952. After the ban of futures trade many 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. Further in 1993 the government of India appointed an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra and the report of the committee was submitted in 1994 which recommended the reintroduction of futures already banned and to introduce futures on many more commodities including silver. In tune with the ongoing economic liberalization, 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 emerging from price fluctuations. In line with the proposal many more agricultural commodities are being brought under futures trading. In India, currently there are 15 commodity exchanges actively undertaking trading in domestic futures contracts, while two of them, viz., India Pepper and Spice Trade Association (IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been recently upgraded to international exchanges to deal in international contracts in pepper and castor oil respectively. Another 8 exchanges are proposed and some of them are expected to start operation shortly. There are 4 exchanges, which are specifically approved for undertaking forward deals in cotton. More detailed account of these exchanges has been presented.

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The proposed study is primarily based on the visit of seven leading exchanges viz., IPST Cochin, which deal in domestic and international contracts in pepper; BCE Ltd., a multy-commodity international exchange where futures in castor oil, castor seed, sunflower oil, RBD Palmolein etc are traded; The East India Cotton Association (EICA) Ltd., Bombay, which is a specialized exchange dealing in forwards and futures in cotton; South India Cotton Association (SICA , Coimbatore which deals in forward contracts in cotton; Coffee Futures Exchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading; Kanpur Commodity Exchange (KCE) which deals with futures contracts in mustard oil and gur; and The Chamber of Commerce, Hapur which undertakes futures trading in gur and potatoes. 5.9 MECHANICS OF FUTURES TRADING Futures are a segment of derivative markets. The value of a futures contract is derived from the spot (ready) price of the commodity underlying the contract. Therefore, they are called derivatives of spot market. The buying and selling of futures contracts take place in organized exchanges. The members of exchanges are authorized to carryout trading in futures. The trading members buy and sell futures contract for their own account and for the account of non-trading members and other clients. All other persons interested to trade in futures contracts, as clients must get themselves registered with the exchange as registered non-members.

5.10 WHAT IS A COMMODITY FUTURE EXCHANGE?

Exchange is an association of members, which provides all organizational support for carrying out futures trading in a formal environment. These exchanges are managed by the Board of Directors, which is composed primarily of the members of the association. There are also representatives of the government and public nominated by the Forward Markets Commission. The majority of members of the Board have been chosen from among the members of the Association who have trading and business interest in the exchange. The chief executive officer and his team in day-to-day administration assist the Board. There are different classes of members who capitalize the exchange by way of participation in the form of equity, admission fee, security deposits, registration fee etc.

a. Ordinary Members: They are the promoters who have the right to have own account transactions without having the right to execute transactions in the trading ring. They have to place orders with trading members or others who have the right to trade in the exchange. 22

b. Trading Members: These members execute buy and sell orders in the trading ring of the exchange on their account, on account of ordinary members and other clients. c. Trading-cum-Clearing Members: They have the right to trade and also to participate in clearing and settlement in respect of transactions carried out on their account and on account of their clients. d. Institutional Clearing Members: They have the right to participate in clearing and settlement on behalf of other members but do not have the trading rights. e. Designated Clearing Bank: It provides banking facilities in respect of pay-in, payout and other monetary settlements. The composition of the members in an exchange however varies. In so me exchanges there are exclusive clearing members, broker members and registered non -members in addition to the above category of members.

5.11 WHAT IS COMMODITY FUTURES CONTRACT?

Futures contracts are an improved variant of forward contracts. They are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. While forward contracts are mainly over-the-counter and tailor-made which physical delivery futures settlement standardized contracts whose transactions are made in formal exchanges through clearing houses and generally closed out before delivery. The closing out involves buying a different times of two identical contracts for the purchase and sale o the commodity in question, with each canceling the other out. The futures contracts are standardized in terms of quality and quantity, and place and date of delivery of the commodity. The commodity futures contracts in India as defined by the FMC has the following features: (a) Trading in futures is necessarily organized under the auspices of a recognized association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules and Bye-laws of the association. (b) It is invariably entered into for a standard variety known as the basis variety with permission to deliver other identified varieties known as tender able varieties. (c) The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units. (d) The delivery periods are specified.

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(e) The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers. (f) In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. The terms and specifications of futures contracts vary depending on the commodity and the exchange in which it is traded. The major terms and conditions of contracts traded in six sample exchanges in India. These terms are standardized and applicable across the trading community in the respective exchanges and are framed to promote trade in the respective commodity For example, the contract size is important for better management of risk by the customer. It has implications for the amount of money that can be gained or lost relative to a given change in price levels. I also affect the margins required and the commission charged. Similarly, the margin to be deposited with the clearing house has implications for the cash position of customers because it blocks cash for the period of the contract to which he is a party the strength and weaknesses of contract specifications are discussed under constraints and policy options.

5.12 WHO ARE THE PARTICIPANTS IN FUTURES MARKET?

Broadly, speculators who take positions in the market in an attempt to benefit from a correct anticipation of future price movements, and hedgers who transact in futures market with an objective of offsetting a price risk on the physical market for a particular commodity make the futures market in that commodity. Although it is difficult to draw a line of distinction between hedgers and speculators, the former category consists of manufacturing companies, merchandisers, and farmers. Manufacturing companies who use the commodity as a raw material buy futures to ensure its uninterrupted supply of guaranteed quality at a predetermined price, which facilitates immunity against price fluctuations. While exporters in addition to using the price discovery mechanism for getting better prices for their commodities seek to hedge against their overseas exposure by way of locking-in the price by way of buying futures contracts, the importers utilize the liquid futures market for the purpose of hedging their outstanding position by way of selling futures contracts. Futures market helps farmers taking informed decisions about their crop pattern on the basis of the futures prices and reduces the risk associated with variations in their sales revenue due to 24

unpredictable future supply demand conditions. Above all, there are a large number of brokers who intermediate between hedgers and speculators create the market for futures contracts.

5.13 COMMODITY ORDERS

The buy and sell orders for commodity futures are executed on the trading floor where floor brokers congregate during the trading hours stipulated by the exchange. The floor brokers/trading members on receipt of orders from clients or from their office transmits the same to others on the trading floor by hand signal and by calling out the orders (in an open outcry system they would like to place and price. After trade is made with another floor broker who takes the opposite side of the transaction for another customer or for his own account, the details of transactions are passed on to the clearing house through a transaction slip on the basis o which the clearinghouse verifies the match and adds to its records. Following the experiences of stock exchanges with electronic screen based trading commodity exchanges are also moving from outdated open outcry system to automated trading system. Many leading commodity exchanges in the world including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International Petroleum Exchange (IPE), London, have already computerized the trading activities. In India, coffee futures exchange, Bangalore has already put in place the screen based trading and many others are in the process of computerization. To add to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated for a common electronic trading platform connecting all commodity exchanges to conduct screen based trading. In electronic trading, trading takes place through a centralized computer network system to which all buy and sell orders and their respective prices are keyed in from various terminals of trading members. The deal takes place when the central computer finds matching price quotes for buy and sell. The entire procedural steps involved in electronic trading beginning from placing the buy/sell order to the confirmation of the transaction have been shown in figure -2.1 below.

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Order and Execution flows in electronic future trade Confirmation BUYER SELLER Comfirmation

Order Output COMPUTER Verifaction of Order CREDIT RISK

Order Input COMPUTER Verifaction of Order CREDIT RISK

Legitimitate Order Are Trasferred

ELECTRONIC TRADING

Legitimate Order are Transferred

Orders are matched EXECUTION Transfer of Position CLEARING HOUSE

CLEARING MEMBER

CLEARING MEMBER

Position and margin settlement

5.14 ROLE OF CLEARING HOUSE Clearinghouse is the organizational set up adjunct to the futures exchange which handles all back-office operations including matching up of each buy and sell transactions, execution, clearing and reporting of all transactions, settlement of all transactions on maturity by paying the price difference or by arranging physical delivery, etc., and assumes all counterparty risk on behalf of buyer and seller. It is important to understand that the futures market is designed to provide a proxy for the ready (spot) market and thereby acts as a pricing mechanism and not as part of, or as a substitute for, the ready market. The buyer or seller of futures contracts has two options before the maturity of the contract. First, the buyer (seller) may take (give) physical delivery of the commodity at the delivery point approved by the exchange after the contract matures. The second option, which distinguishes futures from forward contracts is that, the buyer (seller) can offset the contract 26

by selling (buying) the same amount of commodity and squaring off his position. For squaring of a position, the buyer (seller) is not obligated to sell (buy) the original contract. Instead, the clearinghouse may substitute any contract of the same specifications in the process of daily matching. As delivery time approaches, virtually all contracts are settled by offset as those who have bought (long) sell to those who have sold (short). This offsetting reduces the open position in the account of all traders as they approach the maturity date of the contract. The contracts, if any, which remain unsettled by offset until maturity date are settled by physical delivery. The clearinghouse plays a major role in the process explained above by intermediating between the buyer and seller. There is no clearinghouse in a forward market due to which buyers and sellers face counterparty risk. In a futures exchange all transactions are routed through and guaranteed by the clearinghouse which automatically becomes a counterpart to each transaction. It assumes the position of counterpart to both sides of the transaction. It sells contract to the buyer and buys the identical contract from the seller. Therefore, traders obtain a position vis --vis the clearing house. It ensures default risk-free transactions and provides financial guarantee on the strength of funds contributed by its members and through collection of margins (discussed in section 2.3), marking-to-market all outstanding contracts, position limits imposed on traders, fixing the daily price limits and settlement guarantee fund. The organizational structure and membership requirements of clearinghouses vary from one exchange to the other. The Bombay Commodity Exchange and Cochin pepper exchange have set up separate independent corporations (namely, Prime Commodities Clearing Corporation of India Ltd, and First Commodities Clearing Corporation of India Ltd., respectively) for handling clearing and guarantee of all futures transactions in the respective exchanges. While coffee exchange has clearing house as a separate division of the exchange, many other exchanges like Chamber of Commerce, Hapur; Kanpur Commodity Exchange and cotton exchange in Bombay run in-house clearinghouse as part of the respective exchanges. The clearing and guaranty are managed in these exchanges by a separate committee (normally called the Clearing House Committee). The membership in the clearinghouse requires capital contribution in the form of equity, security deposit, admission fee, registration fee, guarantee fund contribution in addition to net worth requirement depending on its organizational structure. For example, in the Bombay Commodity Exchange the minimum capital requirement for membership in its clearinghouse as applicable to trading-cum-clearing members is Rs.50,000 each toward equity and security deposit, Rs. 500 as annual subscription, and additionally, members are 27

required to have net worth of Rs.3 lakhs. Similarly, coffee exchange prescribed Rs.5 lakh each towards equity and guarantee fund contribution and Rs.40,000 towards admission fee for a trading-cum-clearing member. However, in exchanges where clearing house is a part of the exchange the payment requirements are lower. For example, Kanpur Commodity Exchange prescribed only Rs.25,00,000 Rs.1000 and Rs.500 respectively towards security deposit, registration fee and annual fee for a clearing cum-trading member. For ensuring financial integrity of the exchange and for counterparty risk -free trade position (exposure) limits have been imposed on clearing members. These limits which are stringent in some cases and are liberal in other cases are normally linked to the members contribution towards equity capital or security deposit or a combination of both and settlement guarantee fund. In Bombay Commodity Exchange the exposure limit of a clearing member is the sum of 50 times the face value of contribution to equity capital of the clearinghouse and 30 times the security deposit the member has maintained with the clearinghouse. While coffee exchange prescribes the limit of 80 times the sum of members equity investment and the contribution to the guarantee fund, the cotton exchange, Bombay, has stipulated a liberal exposure limit on open positions. It has a limit of 200 and 1500 units (recall that one contract unit is equivalent to 93.5 quintals respectively for composite and institutional members. The Cochin pepper exchange has fixed a net exposure limit of 60 units (equivalent to 1500 quintals) for domestic contract and 90 units (equivalent to 2250 quintals) for international contract. Moreover, setting up of settlement guarantee fund ensures enough financial strength in case the clearinghouse faces default. The Kanpur Commodity Exchange maintains a trade guarantee fund with a corpus of Rs.100 lakhs while the coffee exchange in addition to a guarantee fund the exchange has substituted itself as party to clear all transactions. Yet another check on the possible default is through prescribing maximum price fluctuation on any trading day, which helps limit the probable profit/loss from each unit of transaction. The relevant data on permitted price limit has been presented. Its clear from the table that the maximum profit/loss potential from trade in each contract unit varies from as low as Rs. 800 for potato futures in Chamber of Commerce, Hapur to as high as Rs. 15,000 in pepper exchange, Cochin. Similarly, given the permissible open position of 200 units for a trading-cum-clearing member and maximum price fluctuation of Rs. 150 per 100 kg for cotton futures in the cotton exchange, Bombay, the maximum potential loss/profit in a trading day works out to be Rs.28.05 lakhs!

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Margins Margins (also called clearing margins) are good -faith deposits kept with a clearinghouse usually in the form of cash. There are two types of margins to be maintained by the trader with the clearinghouse: initial margin and maintenance or variation margins. Initial margin is a fixed amount per contract and does not vary with the current value of the commodity traded. Margins are deposited with the clearing house in advance against the expected exposure of the trading member on his account and on account of the clients. The member who executes trade for them in turn collects this amount from the clients. Generally, the margin is payable on the net exposure of the member. Net exposure is the sum of gross exposure (buy quantity or sale quantity, whichever is higher, multiplied by the current price of the contract) on account of trades executed through him for each of his clients and gross exposure of trades carried out on his own account. However, for squaring-off transactions carried out only at the clients level, fresh margins are not required. The margin is refundable after the client liquidates his position or after the maturity of the contract. Maintenance margin which usually ranges from 60 to 80 per cent of initial margin is also required by the exchange. Variation margin is to compensate the risk borne by the clearinghouse on account of price volatility of the commodity underlying the contract to which it is a counterparty. A debit in the margin account due to adverse market conditions and consequent change in the value of contract would lead to initial margin falling below the maintenance level. The clearinghouse restores initial margin through margin calls to the client for collecting variation margin. In case of an increase in value of the contract, markingto-market ensures that the holder gets the payment equivalent to the difference between the initial contract value and its change over the lifetime of the contract on the basis of its daily price movements. If the member is not able to pay the variation margin, he is bound to square off his position or else the clearinghouse will be liquidating the position. The margins have important bearing on the success of futures. As they are noninterest bearing deposits payable to the clearinghouse up-front working capital of any trading entity gets blocked to that extent. While a higher margin requirement prevents traders from participating in trading, a lower margin makes the clearinghouse vulnerable to any default due to its weak financial strength otherwise. Internationally, many developed exchanges maintain a low margin on positions due to their better financial strength along with massive volume of trade resulting in large income accruing to them. However, this has not been the case with many exchanges in India. For example, as shown in table 2.2 the initial margin liability for transacting the minimum lot size in pepper is 29

Rs.30, 000 for domestic contracts and US$ 312.50 for international contracts .Similarly, the volume of transactions. These clearinghouses deal in many exchanges in India is abysmally low making their existence financially unviable. Most of the exchanges in additions to keeping mandatory margins maintain a settlement guarantee fund. The fund set up with the contribution from members of clearing house is used for guaranteeing financial performance of all members. This fund absorbs losses not covered by margin deposits of the defaulted member. The clearinghouse ensures this by settling the default transactions by properly compensating the traders paying the amount of difference at the closing out rate.

How does futures contract facilitate hedging against price risk? The futures contracts are designed to deal directly with the credit risk involved in locking-in prices and obtaining forward cover. These contracts can be used for hedging price risk and discovering future prices. For commodities that compete in world or national markets, such as coffee, there are many relatively small producers scattered over a wide geographic area. These widely dispersed producers find it difficult to know what prices are available, and the opportunity for producer, processor, and merchandiser to ascertain their likely cost for coffee and develop long range plans is limited. Futures trading, used in the Midwest for grains and similar farm commodities since 1859, and adapted for coffee in 1955, provides the industry with a guide to what coffee is worth now as well as todays best estimate for the future. Moreover, since all transactions are guaranteed through a central body, clearing house, which is the counter party to each buyer and seller ensuring zero default risk, market participants need not worry about their counterparts creditworthiness. Hedge is a purchase or sale on a futures market intended to offset a price risk on the physical (ready) market. It involves establishing a position in the futures market again ones position or firm commitments in the physical market. The producers who seek to protect themselves from an expected decline in prices of their commodity in future go for short hedge (also called sell hedge). He undertakes the following operations in the market to lockin the price in advance which he is going to receive after the product. I ready for physical sale. We assume that the producer anticipates a harvest of 5 metric tones (equivalent to 2 units of contracts in Cochin pepper exchange) of pepper in March, the futures price for March delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per unit, and the prevailing (say, October) ready market price is Rs.8100 per quintal. a) In October, the producer goes short (sells) in the futures market selling 2 March futures contracts at Rs.8400 per quintal. This is called price fixing. 30

b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the producer sells pepper in the ready market for Rs.8200. c) Simultaneously, he closes out his short position in futures by buying (long position) 2 March futures contracts at Rs.8200 per quintal. The result is that the producer sold futures contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal making a net gain of Rs.200 per quintal or Rs.5000 per contract. For the physical sale, the producer received the market price of Rs.8200 prevailing on the day of the sale and the gain of Rs.200 per quintal from closing-out of futures contracts makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If the price realized in the ready market is lower than the price in future contract, the loss on the physical market is compensated by the higher price realized on the future contract. On the other hand, if the price in the ready market is higher than in futures contract, the gain in the ready market is offset by the loss on the repurchase of the futures contract. Since futures market prices move in tandem with the ready market prices over the course of time tending to converge as the contract matures, a gain in the futures market in a developed commodity market under normal conditions, will be offset by a loss in the ready market, or vice versa. However, market imperfections will lead to the basis risk emerging from the mismatch between the gain/loss from the futures market not compensated by loss/gain in the ready market. Meaning of Derivatives

The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived". A derivative is a financial instrument, which derives its value from some other financial price. This other financial price is called underlying. The most common underlying assets include stocks, bonds, commodities, currencies, livestock, interest rates and market indexes. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying. The terms derivative contract, derivative product, or derivative are used interchangeably.

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Examples of Derivatives

Consider how the value of mutual fund units changes on a day-to-day basis. Dont mutual fund units draw their value from the value of the portfolio of securities under the schemes? A very simple example of derivatives is cloth, which is derivative of cotton. The price of cloth depends upon the price of cotton, which in turn depends upon the demand, and supply of cotton... Arent these examples of derivatives? Yes, these are. And you know what, these examples prove that derivatives are not so new to us.

There are two broad types of derivatives: Financial derivatives: - Here the underlying includes treasuries, bonds, stocks, stock index, foreign exchange etc. Commodity derivatives: Here the underlying is a commodity such as wheat, cotton, peppers, turmeric, corn, soybeans, rice crude oil etc.

5.15 HISTORY

The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago board of trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralized location to negotiate forward contracts, where forward contracts on various commodities were standardized around 1865.The primary market intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial 32

exchanges of any kind in the world today. From then on, futures contracts have remained more or less in the same form, as we know them today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S & P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France etc. However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments - such as bond, currencies, stocks and stock indiceshas now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desais government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities was allowed to trade on exchanges. In June 2000, National Stock Exchange and Bombay Stock Exchange started trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005

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5.16 TYPES OF DERIVATIVES

A derivative as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few smart finance professionals. In reality it is not so. In fact, a derivative transaction helps to cover risk, which would arise on the trading of securities on which the derivative is based and a small investor, can benefit immensely. A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. An example of a simple derivative contract: Rohan buys a futures contract. He will make a profit of Rs. 1200 if the price of Infosys rises by Rs. 1200. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs. 1000 he will lose Rs. 1000. As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty. There are basically of 3 types of Derivatives and Futures: Forwards and Futures Options Swaps DERIVATIVES

Options

Swaps

Futures

Forwards

Put

Call Interest Rate Currency

Commodity

Securities

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FORWARD CONTRACT

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 assed on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to dell 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 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. it has to compulsorily go to the same counter party, which often results in high price being charged. Limitation of forward market: Forward market world-wide are afflicted by several problems: Lack of centralization Illiquidity 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-tradable. 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 market trade standardized contracts, and hence avoids the problem of illiquidity, still the counterparty risk remains very serious issue. Illustration Sahil wants to buy a Laptop, which costs Rs 30,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of laptop will rise 35

3 months from now. So in order to protect himself from the rise in prices Sahil enters into a contract with the laptop dealer that 3 months from now he will buy the laptop for Rs 30,000. What Sahil is doing is that he is locking the current price of a LAPTOP for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Sahil at the end of three months and Sahil in turn will pay cash equivalent to the LAPTOP price on delivery. FUTURES CONTRACT Futures markets were designed to solve the problems that exist in forward market. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. So, the counter party to a future contract is the clearing corporation of the appropriate exchange. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. Future contracts are often settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transaction is offset this way. The standardized items in a futures contract are: Quantity of the Underlying. Quality of the Underlying. The date and month of delivery. The units of price quotation and minimum price change. Location of settlement. Distinction between futures and forwards contracts: Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. The distinction between futures and forwards are summarized below:

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Futures 1.Trade on an organized exchange 2.Standardized contract terms 3.Hence more liquid 4.Requires margin payments

Forwards 1.OTC in nature 2.Customized contract terms 3.Hence less liquid 4.No margin payment 5.Settlement happens at the end of

5.follows daily settlement

period.

OPTIONS CONTRACT Option means several things to different people. It may refer to choice or alternative or privilege or opportunity or preference or right. To have option is normally regarded good. One is considered unfortunate without any options. Options are valuable since they provide protection against unwanted, uncertain happenings. They provide alternatives to bail out from a difficult situation. Options can be exercised on the happening of certain events. Options may be explicit or implicit. When you buy insurance on your house, it is an explicit option that will protect you in the event there is a fire or a theft in your house. If you own shares of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt. Options have assumed considerable significance in finance. They can be written on any asset, including shares, bonds, portfolios, stock indices currencies, etc. They are quite useful in risk management. How are options defined in finance? What gives value to options? How are they valued? An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. For example, that Rohit discover a bungalow that Rohit love to purchase. Unfortunately, Rohit won't have the cash to buy it for another three months. Rohit talk to the owner and negotiate a deal that gives Rohit an option to buy the bunglow in three months for a price of Rs.20,00,000. The owner agrees, but for this option, Rohit pay a price of Rs.50,000. Now, consider two theoretical situations that might arise:

1. It is discovered that the bunglow is actually having a historical importance! As a result, the market value of the bunglow increases to Rs. 50,00,000. Because the owner sold Rohit the 37

option, he is obligated to sell Rohit the bunglow for Rs.20,00,000. In the end, Rohit stand to make a profit of Rs.29, 50,000. (Rs.50,00,000Rs.20,00,000Rs.50,000).

2. While touring the bunglow, Rohit discover not only that the walls are chock-full of asbestos, but also that it is a home place of numerous rats. Though Rohit originally thought Rohit had found the bunglow of Rohit dreams, Rohit now consider it worthless. On the upside, because Rohit bought an option, Rohit are under no obligation to go through with the sale. Of course, Rohit still lose the Rs.50,000 price of the option.

This example demonstrates two very important points. First, when Rohit buy an option, Rohit have a right but not an obligation to do something. Rohit can always let the expiration date go by, at which point the option becomes worthless. If this happens, Rohit lose 100% of Rohit investment, which is the money Rohit used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives; means an option derives its value from something else. In our example, the bunglow is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Types of Options

There are two types of options:

Call Options: - It gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. Put Option: - It gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market There are four types of participants in options markets depending on the position they take: 1. Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of put

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People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. Here is the important distinction between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. Terminology Associated With The Options Market. Option Price: - Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration Date: - The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike Price: - The price specified in the options contract is known as the strike price or the exercise price. Listed Options: - An option that is traded on a national options exchange such as the National Stock Exchange is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents a predetermined number of shares of company stock (known as a contract). In-the-money Option: - An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money Option: - An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money Option:- An out-of-the-money (OTM) option is an option that would lead to a negative cash flow when exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Depending on when an option can be exercised, it is classified in on of the following two categories: 39

American Options: - American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European Options: - European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

TRADING IN OPTIONS

If one buys an option contract he is buying the option, or "right" to trade a particular underlying instrument at a stated price. An option that gives you the right to eventually make a purchase at a predetermined price is called a "call" option. If you buy that right it is called a long call; if you sell that right it is called a short call. An option that gives you the right to eventually make a sale at a predetermined price is called a "put" option. If you buy that right it is called a long put; if you sell that right it is called a short put. Trading in Call Suppose a call option with an exercise/strike price equal to the price of the underlying (100) is bought today for premium Re.1.

Profit/ Loss for a Long Call.

At expiry, if the securitys price has fallen below the strike price, the option will be allowed to expire worthless and the position has lost Re.1. This is the maximum amount that you can 40

lose because an option only involves the right to buy or sell, not the obligation. In other words, if it is not in your interest to exercise the option you dont have to and so if you are an option buyer your maximum loss is the premium you have paid for the right. If, on the other hand, the securitys price rises, the value of the option will increase by Re.1 for every Re.1 increase in the securitys price above the strike price (less the initial Re.1 cost of the option). Note that if the price of the underlying increases by Re.1, the option purchaser breaks even breakeven is reached when the value of the option at expiry is equal to the initial purchase price. For our call option, the breakeven price is 101. If the price of the security is greater than 101, the call buyer makes money.

Profit/Loss for a short call.

Here profit is limited to the premium received for selling the right to buy at the exercise price - again Re.1. For every Re.1 rise in the price of the underlying security above the exercise price the option falls in value by Re.1. Here again, the breakeven point is 101. Trading in Put: Consider that a put option with an exercise/strike price equal to the price of the underlying (100) is bought today for premium Re.1.

41

Profit/Loss graph for a Long Put.

At expiry the put is worth nothing if the securitys price is more than the strike price of the option but, as with the long call, the option buyers loss is limited to the premium paid. The breakeven for this option is 99, so the put purchaser makes money if the underlying security is priced below 99 at expiry.

Profit/Loss graph for a short put.

Here profit is limited to the premium received for selling the right to sell at the strike price. For every Re.1 fall in the price of the underlying security below the strike price the option falls in value by Re.1. Here again, the breakeven point is 99.

42

Difference between Future and Options

Futures Obligation

Options

Both the buyer and the seller are The buyer of the option has the under obligation to fulfill the right and not the obligation whereas the seller is under obligation to fulfill the contract.

contract.

Risk

The buyer and seller are subject to The seller is subject to unlimited unlimited risk of losing. risk of losing whereas the buyer has a limited potential to lose.

Profit

The buyer and seller have unlimited The seller has limited potential potential to gain. to gain while the buyer has unlimited potential to gain.

Price Behavior

It is one-dimensional as its price It is bi-dimensional as its price depends on the price of the depends upon both the price and the volatility of the underlying. Nonlinear payoff

underlying only. Payoff Linear payoff

Price

and Price is zero and strike price moves

Strike price is fixed and price moves

Strike price Price Price is always zero

Price is always positive

Risk

Both long and short at risk

Only short at risk

SWAP CONTRACT: Swaps are similar to futures and forwards contracts in providing hedge against financial risk. A swap is an agreement between two parties, called counter parties, to trade cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situation. Two most popular swaps are currency swaps and interest-rate swaps. These two swaps can be combined when interest on loans in two currencies are 43

swapped. The development of swaps in the eighties is a significant development. The interest rate and currency swap markets enable firms to arbitrage are differences between capital markets. They make use of their comparative advantage of borrowing in their domestic market and arranging swaps for interest rates or currencies that they cannot easily access. 1. Interest rate swaps: - These entail swapping only the interest related cash flows between the parties in the same currency.

Currency swaps: - These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

COMMODITY FUTURES EXCHANGES THE PROFILE AND REGULATORY ENVIRONMENT

The Profile of Futures Exchanges (mcx and ncdex)

5.17 Overview of MCX

MCX an independent and de-mutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX include Financial Technologies (I) Ltd., State Bank of India (Indias largest commercial bank) & associates, Fidelity International, National Stock Exchange of India Ltd. (NSE), National Bank for Agriculture and Rural Development (NABARD), HDFC Bank, SBI Life

44

Insurance Co. Ltd., Union Bank of India, Canara Bank, Bank of India, Bank of Baroda and Corporation Bank. Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Through the integration of dedicated resources, robust technology and scalable infrastructure, since inception MCX has recorded many first to its credit. Inaugurated in November 2003 by Shri Mukesh Ambani, Chairman & Managing Director, Reliance Industries Ltd, MCX offers futures trading in the following commodity categories: Agri Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & Oilseeds, Energy, Plantations, Spices and other soft commodities. MCX has built strategic alliances with some of the largest players in commodities eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade Association. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Centers, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure, is well placed to tap this vast potential.

5.18 Vision and Mission

The vision of MCX is to revolutionize the Indian commodity markets by empowering the market participants through innovative product offerings and business rules so that the benefits of futures markets can be fully realized .Offering 'unparalleled efficiencies', 'unlimited growth' and 'infinite opportunities' to all the market participants.

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Commodities Gold, Gold HNI, Gold M, I-Gold, Silver, Silver HNI, Silver M Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cottonseed, Crude Palm Oil, Groundnut Oil, Kapasia Khalli (Cottonseed Oilcake), Mustard /Rapeseed Oil, Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Sesame Seed, Soymeal, Soy Seeds

Cardamom, Jeera, Pepper, Red Chilli Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Flat, Steel Long (Bhavnagar), Steel Long (Gobindgarh), Tin, Zinc Cotton Long Staple , Cotton Medium Staple, Cotton Short Staple, Cotton Yarn, Kapasii Chana, Masur, Tur, Urad, Yellow Peas, Basmati Rice, Maize, Rice, Sarbati Rice, Wheat Brent Crude Oil, Crude Oil, Furnace Oil Middle East Sour Crude Oil Arecanut, Cashew Kernel, Rubber High Density Polyethylene (HDPE), Polypropylene (PP), PVC
Guar Seed, Guar gum, Gurchaku, Mentha Oil, Potato, Sugar M-30,

46

5.19 Benefits to Participants The mark of a true exchange market is that it provides equal opportunities to all participants without any bias. This is the central belief of MCX and towards that it shall be our endeavor to provide all our participants with equally rewarding opportunities. MCX would harmoniously meet the requirements of all the stakeholders in the commodity ecosystem in the most impartial manner. Benefits to Industry Hedging the price risk associated with futures contractual commitments. Spaced out purchases possible rather than large cash purchases and its storage. Efficient price discovery prevents seasonal price volatility. Greater flexibility, certainty and transparency in procuring commodities would aid bank lending. Facilitate Informed lending Hedged positions of producers and processors would reduce the risk of default faced by banks Lending for agricultural sector would go up with greater transparency in pricing and storage. Commodity Exchanges to act as distribution network to retail agri-finance from Banks to rural households. Provide trading limit finance to Traders in commodities Exchanges.

Benefits to Exchange Members Access to a huge potential market much greater than the securities and cash market in commodities. MCX would leverage on the vast experience of NSE in the capital markets and NABARD for its strong presence in the rural agricultural markets Robust, scalable, state-of-art technology deployment. Member can trade in multiple commodities from a single point, on real time basis. Traders would be trained to be Rural Advisors and Commodity Specialists and through them multiple rural needs would be met, like bank credit, information dissemination, etc.

47

5.20 WINNING EDGE Value Proposition - MCX's most important differentiator and strength is that it is an independent and a de-mutualized exchange since inception. This is further strengthened by participation from different constituents of the market, such as banks, financial institutions, warehousing companies and other stakeholders of the marketplace. Moreover, experienced professionals with deep knowledge of the commodity markets as well as exchange management experience manage MCX. Neutral Image - MCX has de-mutualized status from inception that allows formation of a broad, collaborative business partnership. Strategic Equity Partnerships - MCX has consolidated it base by entering into strategic equity partnership with leading nationalized banks like State Bank of India, HDFC Bank, National Stock Exchange (NSE), National Bank for Agriculture and Rural Development (NABARD), State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank. Trade Support - MCX has already tied up exclusively with some of the largest players in this eco-system, namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of India and India Pepper and Spice Trade Association.

FTIL: Technology Partner - It is here that MCX gets the strategic advantage of having Financial Technologies (India) Ltd. as its technology partner for delivering technologically advanced solutions to market participants. FTIL's proven class of end-to-end Exchange Trading technologies addressing Trading / Surveillance / Clearing and Settlement operations would deliver a cutting-edge to the MCX Trade Life Cycle i.e. Pre-Trade, Trade and Post-Trade operations. In addition to its (technology) technological capabilities, FTIL also brings to MCX its deep engagements with technology giants such as Microsoft / Intel and HP which would be used to gain the competitive edge in gaining foothold in global markets.

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5.21 OPERATION

Trading The trading system of MCX is state-of-the-art, new generation trading platform that permits extremely cost effective operations at much greater efficiency. The Exchange Central System is located in Mumbai, which maintains the Central Order Book. Exchange Members located across the country are connected to the central system through VSAT or any other mode of communication as may be decided by the Exchange from time to time. The Exchange would gradually also consider providing an internet based access. The controls in the system are system driven requiring minimum human intervention. The Exchange Members places orders through the Traders Work Station (TWS) of the Member linked to the Exchange, which matches on the Central System and sends a confirmation back to the Member. Risk Management The macro objective of MCX's Risk Management System is to financially secure the marketplace and its participants at all times, without increasing the operational cost or compliance overheads of market participants. Some of the basic parameters of Risk Management are as follows: Risk Management parameters

Real-time Margining. Quantity (position) limits. Exposure limits linked to value of outstanding positions and the capital deployed. Daily Loss Limits. Daily Price Limits. Special Margins.

Settlement The Clearing and Settlement System of the Exchange is system driven and rule based.

49

Clearing Bank Interface Exchange maintains electronic interface with its Clearing Bank. All Members of the Exchange are having their Exchange operations account with the Clearing Bank. All debits and credits are affected electronically through such accounts only.

Delivery and Final Settlement All contracts on maturity are for delivery. MCX specifies tender and delivery periods. For example, such periods can be from 8th working day till the 15th day of the month - where 15th is the last trading day of the contract month - as tender and/or delivery period. A seller or a short open position holder in that contract may tender documents to the Exchange expressing his intention to deliver the underlying commodity. Exchange would select from the long open position holder for the tendered quantity. Once the buyer is identified, seller has to initiate the process of giving delivery and buyer has to take delivery according to the delivery schedule prescribed by the Exchange.

5.22 TECHNOLOGY EDGE

Exchange markets and operations will undergo a paradigm shift in their behavior and would be increasingly driven for providing integrated processes and services to the trading community. Moreover, Exchanges today need to deliver highest levels of service backed by strong technology to bring increased participation at lowest possible costs .It is here that MCX gets the strategic advantage of having Financial Technologies (India) Ltd. as its technology partner for delivering technologically advanced solutions to market participants. FTIL's proven class of end-to-end Exchange Trading technologies addressing Trading / Surveillance / Clearing and Settlement operations would deliver a cutting-edge to the MCX Trade Life Cycle i.e. Pre-Trade, Trade and Post-Trade operations.

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NCDEX PROFILE

5.23 PROFILE

National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed online multi commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Punjab National Bank (PNB), CRISIL Limited (formerly the Credit Rating Information Services of India Limited), Indian Farmers Fertilizer Cooperative Limited (IFFCO) and Canara Bank by subscribing to the equity shares have joined the initial promoters as shareholders of the Exchange. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nationwide reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has commenced its operations on December 15, 2003.

NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an independent Board of Directors and professionals not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

Forward Market Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. 51

NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India. The reach will gradually be expanded to more centers.

NCDEX currently facilitates trading of 45 commodities - Cashew, Castor Seed, Chana, Chilli, Coffee - Arabica, Coffee - Robusta, Common Parboiled Rice, Common Raw Rice, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Groundnut (in shell), Groundnut Expeller Oil, Grade A Parboiled Rice, Grade A Raw Rice, Guar gum, Guar Seeds, Guar, Jeera, Jute sacking bags, Indian 28 mm Cotton , Indian 31 mm Cotton , Lemon Tur, Maharashtra Lal Tur, Masoor Grain Bold, Medium Staple Cotton, Mentha Oil , Mulberry Green Cocoons , Mulberry Raw Silk , Rapeseed - Mustard Seed, Pepper, Raw Jute, RBD Palmolein, Refined Soy Oil , Rubber, Sesame Seeds, Soy Bean, Sponge Iron, Sugar, Turmeric, Urad (Black Matpe), V-797 Kapas, Wheat, Yellow Peas, Yellow Red Maize, Yellow Soybean Meal, Electrolytic Copper Cathode, Mild Steel Ingots, Sponge Iron, Gold, Silver, Brent Crude Oil, Furnace Oil. At subsequent phases trading in more commodities would be facilitated.

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NCDEX PRODUCTS
Agro Products

Cashew Chana Coffee - Arabica Common Raw Rice Crude Palm Oil Expeller Mustard Oil Grade A Raw Rice Groundnut Expeller Oil Guar Seeds Jeera Lemon Tur Indian Raw Rice Indian 31 mm Cotton Masoor Grain Bold Mentha Oil Mulberry Raw Silk Pepper Rapeseed-Mustard Seed Oilcake Refined Soy Oil Sesame Seeds Sugar Turmeric V-797 Kapas Yellow Peas
Base Metals

Castor Seed Chilli Coffee - Robusta Common Parboiled Rice Cotton Seed Oilcake Grade A Parboiled Rice Groundnut (in shell) Guar gum Gur Jute sacking bags Indian Parboiled Rice Indian 28 mm Cotton Maharashtra Lal Tur Medium Staple Cotton Mulberry Green Cocoons Mustard Seed Raw Jute RBD Palmolein Rubber Soyabean Yellow Soybean Meal Urad Wheat Yellow Red Maize

Electrolytic Copper Cathode Mild Steel Ingots

Precious Metals

Gold Silver

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Regulation of Commodity Futures Merchandising and stockholding of many commodities in India have always been regulated through various legislations like the Essential Commodities Act, 1955 (ECA, 1955) and Forward Contracts (Regulation) Act, 1952, (FCRA, 1952) and Prevention of Black marketing and Maintenance of Supplies of Commodities Act, 1980. The ECA, 1955 gives 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

Ministries/Departments of the Central Government have issued control orders for regulating production/distribution/quality aspects/movement etc. pertaining to the commodities which are essential and administered by them. The FCRA, 1952 provided for 3-tier regulatory system for commodity futures trading in India: (a) An association recognized by the Government of India on the recommendation of Forward Market Commission, (b) The Forward Markets Commission and (c) The Central Government Stock exchanges and futures markets being a part of the Union list their regulation is the responsibility of the central government. All types of forward contracts in India are governed by the provisions of the FCRA, 1952. The Act divides commodities into three categories with reference to extent of regulation. (a) The commodities in which futures trading can be organized under the auspices of recognized association, (b) The commodities in which futures trading is prohibited and (c) The free commodities which are neither regulated nor prohibited. While options in goods are prohibited by the FCRA, 1952, the ready delivery contracts remain outside its purview. The ready delivery contract as defined by the Act is the one which provides for the delivery of goods and payment of a price therefore, either immediately or within a period not exceeding eleven 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 eleven days from the date of the contract are forward contracts.

The Act classified forward contracts into two:

(a) Specific delivery contracts and 54

(b) Other than specific delivery contracts or futures contracts. Specific delivery contract means a forward contract which provides 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. The specific delivery contracts are of two types: 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 the government. As per the section 15 of the FCRA, 1952 every forward contract in notified goods (currently 36 commodity items) which is entered into except those between members of a recognized association or through or with any such member is treated as illegal or void (see appendix I for the list). As per the section 17(1) of the Act, 82 items are prohibited for forward contract (see appendix II for the list). The section 18(1) of the Act exempts the NTSD contracts from the regulatory provisions. However, over the years the regulatory provisions of the Act were applied to the NTSD contracts and 79 commodity items are currently prohibited for NTSD contracts under section 17 of the Act (see appendix III for the list). Moreover, another 15 commodity items are brought under the regulatory provisions of the section 15 of the Act out of which trading in the NTSD contract has been suspended in 12 items (see appendix IV for the list). At present, the NTSD contracts in cotton, raw jute and jute goods are permitted only between, through or with the members of the associations specifically recognized for the purpose. Subsequent to the report of the Committee on Forward Markets (known as the Kabra Committee) submitted in 1994 the government has so far permitted futures trading in nearly 35 commodities under the auspices of 23 commodity exchanges located in different parts of the country. The commodities in which futures trading is permitted are: pepper, turmeric, gur, castorseed, Hessian, jute sacking, cotton, potato, castor oil soyabean and its oil and cake, coffee, mustardseed and its oil and oilcake, ground nut and its oil, sunflower oil, copra/coconut and its oil and oilcake, cottonseed and its oil and oilcake, kapas, RBD palmolein, rice bran and its oil and oilcake, sesame seed and its oil and oilcake, safflower seed and its oil and oilcake, and sugar. This list may get enlarged with the repeal of ECA, 1955 and with further liberalization of farm sector as envisaged in the National Agricultural Policy, 2000 and the Union Budget, 2002-03.

55

The exchanges are required to get prior approval of the FMC for opening of each contract in commodities which are notified under the relevant sections in FCRA 1952. Regulation is essential especially in a private ownership and market oriented system to ensure the necessary checks and balances in the system. However, stringent and continuous regulation for long period of time would do no good to the system. The initial stringent regulation should ensure that a foolproof and growth oriented control system in terms of set up of the exchange and its sound management, a clearinghouse which can promote trade and its financial integrity, sound and facilitating contract terms and conditions, etc. is in place. The exchanges are already assumed to be self-regulatory agencies. Their role must get strengthened further along with FMC minimizing its role as a facilitator making the existing regulation an appropriate regulation.

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Table-I. Exchanges and Commodities in which futures contracts are traded. No. 1. 2. 3. 4. Exchange India Pepper & Spice Trade Association, Kochi (IPSTA) Vijai Beopar Chambers Ltd., Muzaffarnagar Rajdhani Oils & Oilseeds Exchange Ltd., Delhi Bhatinda Om & Oil Exchange Ltd., Bhatinda The Chamber of Commerce, Hapur The Meerut Agro Commodities Exchange Ltd., Meerut The Bombay Commodity Exchange Ltd., Mumbai COMMODITY Pepper (both domestic and international contracts) Guar, Mustard seed Guar, Mustard seed its oil & oilcake Guar

5.

Guar , Potatoes Mustard seed Guar Oilseed Complex

and

6.

7.

8.

Rajkot Seeds, Oil & Bullion Merchants Association, Rajkot The Ahmedabad Commodity Exchange, Ahmedabad The East India Jute & Hessian Exchange Ltd., Calcutta The East India Cotton Association Ltd., Mumbai The Spices & Oilseeds Exchange Ltd., Sangli.

9. 10. 11. 12.

* Castor oil international contracts Castor seed, Groundnut, its oil & cake, cottonseed, its oil & cake, cotton (kapas) and RBD palmolein. Castorseed, cottonseed, its oil and oilcake Hessian & Sacking Cotton Turmeric Soya seed, Soyaoil and Soya meals. Rapeseed/Mustardseed its oil and oilcake and RBD Palmolien ( Also granted in-principle approval of Nation wide Multicommodity Exchange Status)See para 8) Copra/coconut, its oil & oilcake

13.

National Indore

Board

of

Trade,

14.

The First Commodities Exchange of India Ltd., Kochi

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15. 16.

Central India Commercial Exchange Ltd., Gwalior E-sugar India Ltd., Mumbai National Multi-Commodity Exchange of India Ltd., Ahmedabad Coffee Futures Exchange India Ltd., Bangalore Surendranagar Cotton Oil & Oilseeds , Surendranagar E-Commodities Delhi Ltd., New

Guar and Mustard seed Sugar Several Commodities (Please see the site of the Exchange at www.nmce.com) Coffee Cotton, Cottonseed, Kapas Sugar (trading commence) yet to

**17

18.#

19 20

21** 22.**

National Commodity & Derivatives , Exchange Ltd., Mumbai Multi Commodity Exchange Ltd., Mumbai

23 24 25

Bikaner commodity Exchange Ltd., Bikaner Haryana Commodities Ltd., Hissar Bullion Association Ltd., Jaipur

Several Commodities (Please see the site of the Exchange at www.ncdex.com) Several Commodities (Please see the site of the Exchange at www.mcx.com) Mustard seeds its oil & oilcake, Gram. Guar seed. Guar Gum Mustard seed complex Mustard seed Complex

4. In-principle approval for trading in the specified commodities has been given to the following Exchanges/proposed Exchanges:Serial. No. 1. 2. 3. Name of the Association M/s. NCS InfoTech Ltd., Hyderabad Unites Planters Association of South India, Connors (u/s 14B) SGI Commodity Exchange, Mumbai Commodities Sugar Tea Soya bean Ground nut their oils and oilcakes.

58

These Associations/Exchanges are at different stages of completing the procedural formalities for setting up the exchange/commencing trading. 5. After assessing the market situation and taking into account the recommendations

made by the Board of Directors of the Exchange, the FMC prescribes various regulatory measures from time to time, for prudential regulation of futures/forward trading. 6. Under a World Bank aided Grant Scheme to support development of commodity

futures markets in India, a number of consultancy assignments, training programmes, study tours, office automation of FMC etc. have been undertaken. The project was successfully completed on 31st October, 2000. A Plan Scheme under the 10th Five Year Plan for generating awareness about the activities, mechanism and benefit of futures trading among farmers is being implemented. 7. Under a USAID Technical Co-operation programmed on Commodity Futures, the

Government of India has entered into an agreement with USAID for capacity building in Indian commodities derivatives market. The capacity building includes training, seminars, consultancy studies and visits to foreign regulators and exchanges. The short term component of this programmes likely to be completed by the end of November, 2004. 8. In enhancing the institutional capabilities for futures trading the idea of setting up

of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. National Status implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of bye-laws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November, 2002, MCX and NCDEX, Mumbai commenced operations in October/ December, 2003 respectively. 9. The Government has proposed to initiate steps to integrate the commodities markets

and securities markets. A Working Group set up in this connection has submitted its report to the Government indicating the road map for convergence of securities and commodities derivatives markets and their regulatory systems.

5.24 COMMODITY FUTURES MARKETS IN INDIA: PRESENT SCENARIO Major reforms have been initiated in commodity futures markets in India since the last few years. An article1 by this author in this Journal compared the growth trajectories being followed by the commodity derivatives market vis--vis the securities derivatives markets in India at the dawn of the millennium. It was observed that though derivatives 59

trading commenced in the securities market only in June 2000 it was growing at great speed while the commodity derivatives markets which were operational for about 48 years by then was only gradually waking up. However, subsequent few years have witnessed major changes in the commodity spectrum despite the several institutional constraints in which commodity derivatives markets still function. Commodity futures trading in India was in a state of hibernation for four decades, which was marked by suspicion on the benefits of futures trading. This is replaced by policy, institutional and market activism in the last few years. This is partly a response to the predominant role being assigned to the market forces in price determination and the consequent need for providing market-based derisking tools. It is also the result of a growing awareness that derivatives trading do perform substantial risk mitigating functions to the stakeholders. This resurgence of interest in commodity derivatives is timely since global commodity cycle is on the upswing, and experts have predicted that we are in the decade of the commodities. Concomitant to the newfound policy initiatives the market has responded by setting up modern institutions (Nation-wide Multi-Commodity Exchanges, (NMCE) and adapting some of the best practices such as electronic trading and clearing.

The projections of commodity derivatives trading, though widely variant in the range of Rs. 30-50 trillion and needs to be calibrated with sound assumptions, indicate the enormous potential of this sector not only in terms of trading but also in terms of the opportunities for developing value-added services in terms of quality warehousing, gradation and certification services, financial intermediation, modern marketing practices, modern clearing and settlement mechanism. Once the market becomes liquid the old complaint, that the Indian commodity derivatives markets do not meet the basic objectives of price discovery (with many studies indicating backwardation common place) and risk management may also vanish. The most important changes that have taken place in the commodity futures space were the removal of prohibition on futures trading in a large number of commodities and the facilitation of setting up modern, demutualised exchanges by the Government of India. These two initiatives together are becoming instrumental in changing the contours of the commodity futures markets in India in terms of both participation and practices. There are, however, still a number of obstacles in fully exploiting the opportunities available to the commodity ecosystem. The views expressed and the approach suggested in this paper is of the author and not necessarily of NSE.

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1. Securities Market and Commodity Derivatives Markets Rush vs. Slow Growth? (NSE News, December 2001). A comparative profile of the commodity derivatives markets with that of the nascent securities derivatives market was made since no comparison of the Indian derivatives markets would be useful with any counter part. This was because of the chequered history of Indian commodity derivatives trading from that of a flourishing market formally started in 1875 with the setting up of the Bombay Cotton Association but which went into disrepute during the scarcity decades of the 1960s and 70s. A comparison revealed that the rapid strides made by the securities derivatives segment in a short span was because of its sound institutional frame work in the spot side while the spot market acted as a drag on the progress of the derivatives markets in commodities. 2. The NMCEs marked a major paradigm shift in the institutional structure and market architecture of commodity futures markets. Drawing heavily from the NSE model in the securities markets these institutions are expected to unleash a chain of value added functions in the commodity derivatives markets as well as in the commodity spot market through a host of extra functions they are expected to perform. These include warehouse receipt based deliveries which would require transferability and negotiability of warehouse receipts and its de-materialization, entry of corporate, banks, financial institutions and FIIs in commodity futures trading, dissemination of information relating to the physical markets and prices, adoption of the best technology in trading, clearing and settlement and so on. The NMCEs have started exhibiting a penchant for innovations as reflected in their attempts at coopting warehousing agencies, bringing about transferability and de-mating of warehouse receipts account, though in a limited manner (because of the absence of a legal frame work) association of banks (for other than trading activities as trading in commodities is still prohibited for banks) polling of price information from the spot markets(from mandies)commencement of evening trading session to align domestic markets with the global markets and so on(see Economic Survey 2003-04). 3. Several studies particularly by Jain & Naik (1999), Thomas (2003), Sahadevan (2002) etal have indicated that only in a few cases the commodity futures markets performed its basic objective of discovering efficient prices. While the studies focus were different the general picture emerging was that only in the case of commodities with reasonable volumes of trading, like castor seed and pepper, the markets achieved the objective of price discovery to some extent. However, since the markets in general were too shallow the results were not unexpected.

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6. RESEARCH METHODOLOGY
6.1 TITLE OF THE PROJECT REPORT

A study of the commodity market

6.2 SAMPLE DESIGN: 6.2.1 SAMPLING TYPE In this project convenient sampling method is used for the selection of customer. 6.2.2 SAMPLING UNIT To define sampling unit, one must answer the question that who is to be surveyed. In this project sampling units are commodity traders and govt. Servants. 6.2.3 Sample size The sample size of the survey was 100 people.

6.3 METHODS OF DATA COLLECTION 6.3.1 PRIMARY METHODS 1. QUESTIONNAIRE 6.3.2 SECONDARY METHODS 1. MAGAZINES. 2. NEWSPAPERS 3. WEBSITES 4. BOOKS

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6.4 FIELDWORK: In order to gather the primary data associated with my survey commodity traders and government servants over a selected hub of areas in Rajkot, i have undergone an extensive fieldwork. The basic purpose of the fieldwork was, obviously, to record responses of target people.

6.4 LIMITATIONS This survey was restricted to Rajkot city. The sample size for the survey of people was limited to 100 respondents, which might not be representing the whole country. The results are totally derived from the respondents answers. There might be a difference between the actual and projected results. Research also depends on surveyors bias & his/her ability to analyze the data & draw conclusion. The time duration to carry out the survey of all the areas of Rajkot was very short.

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7. DATA ANALYSIS (1). Gender Ratio:

MALE 58

FEMALE 42

(2). Age:

Age

20 30 25

30 40 45

Above 40 30

(3). Educational Qualification:

Qualification

Graduate 40

Post Graduate 35

Under Graduate 25

(4). Occupation:

Professional 25

Businessman 30

Employee of Pvt. Sector 14

Employee of Govt. Sector 31

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5. Interested pattern of the people:

Securities Bank Mutual Funds Post Office Insurance Real Assets Govt. Bonds IPO Gold/Silver Stock Market Others

Nos. 74 55 78 68 35 45 42 35 56 58

As above we can see that most of people like to invest in bank, Post Office and Insurance. And also many people prefer to invest in stock market but less than compare to Bank, Post office and insurance. Because of many people scare about their money risk, they scare to invest in stock market.

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6. People prefer category to invest in stock market:

Instruments Equity Derivatives Commodity

No. 64 53 39

When ask the people about investment in stock market most of people give his first preference in Equity and second preference in derivatives and last preference in commodity. Because many people dont know about commodity, so there is lack of awareness about the commodity.

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7. Factors which people take in consideration while they are taking the decision to deal with commodity?

Factors Self Analysis Tips from Export Tips from friends/Relatives Business Channels Newspapers Others

No. of People 22 22 17 14 15 10

When we ask the respondents that how they take decision about investment, most of respondent give his first preference to tips from expert and Self analysis after that other factor which are tips from friends/relatives, Business Channels, Newspapers and Others. So thus respondent reach at their own decision.

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8. Factors which play a crucial role when they make decision to invest in stock market?

Factors Risk Reduction Speculative Motive Leverage Benefit Investment Arbitrage Benefit

No. of People 28 19 25 16 22

After investigating the factors which have been given the maximum importance by investors which trading in commodities we have come up with risk reduction as the first priority with 28 People while 28 people have considered it as a leverage benefit. So in future possibility can be growth in commodity market.

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9. Duration of attachment with commodity market?

Duration Less than 1 year 1 to 5 year 5 to 10 Year Above 10 Year

No. of People 5 14 12 8

After asking about the duration of attachment I know that most of investor is connect with commodity about 1 to 5 Years but not satisfied change in present figure. So first of all try to aware the investor about commodity.

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10. Products which is most of prefer by investor:

Product Metal Crops Oil Cereals & Pulse Spices Energy Bullions Others

No. of People 25 45 29 28 36 44 38 55

Product preferred by people

60 50 40 30 20 10 0 No. of People Metal Spices Crops Energy Oil Bullions Cereals & Pulse Others 25 45 36 29 28 44 38 55

As we see that most of respondent gives first priority to Crops and second priority to Energy. And after that they give priority to Bullions, Spices, Oil, etc. But also some of people give his preference to other product.

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11. People prefer to deal with:

Type of Trading Square up mode Arbitrage Intraday Hedging Delivery Based

No. of People 12 9 11 10 6

After investigate to respondent, I know that most of investor like to square up mode in commodity market and after that their second priority is intraday. So this is the types of trading which is preferred by investor.

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12. Which exchange prefers to deal by people?

Name of the exchange MCX NCDEX

No. of people 21 18

Preferred Exchange of People

NCDEX 46%

MCX 54%

After investigate to respondent, I know that most of investor like to invest in MCX and after that their second priority goes to NCDEX.

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13. How do you view your self?

Investor type Trader Speculator Short Term Investor

No. of People 21 36 40

Investor Type
Short Term Investor 36 Speculator 40

21

Trader 0

10

20

30

40

50

No. of People

After getting response from respondent I see that most of investor view their selves as Short Term Investor and also some view their selves as Speculator and Trader.

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14. In which of the company people prefer to deal more and more time?

Name of the Company Marwadi Kotak Street (online) Motilal Oswal ICICI Direct. Com India bulls Other

No. of people 20 15 15 17 18 15

Company preferred to invest by People

Other, 15 India bulls, 18

Marwadi, 20

ICICI Direct. Com, 17

Kotak Street (online), 15 Motilal Oswal, 15

Marwadi ICICI Direct. Com

Kotak Street (online) India bulls

Motilal Oswal Other

After getting response from respondent I know that most of my respondent prefers company to invest Marwadi. And after that some of prefers India Bulls and ICICI Direct.Com.

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8. RESEARCH FINDING & CONCLUSION

Commodity derivatives have a crucial role to play in the price risk management process. Especially in any agriculture dominated economy. Derivatives like forwards, futures, options, swaps etc are extensively used in many developed as well as developing countries in the world. However, they have been utilized in a very limited scale in India

The production, supply and distribution of many agricultural commodities are controlled by the government and only forwards and futures trading are permitted in certain commodity items.

The most things I have seen are that the awareness of future commodity trading is still not there.

People who knows, they believe that operators and big players in the market drive this future commodity market.

Most of peoples feel that the qualities of the commodities are not as per the requirement.

For the process of taking or giving delivery in future commodity market is lengthy, costly, and required so many documents.

The option trading is still not allowed in commodity market so the risk management process is incomplete. Because we all know that future trading has its own limits.

The account opening process of future commodity trading is lengthy and requires more documents.

The delivery centers of commodities are very less in India compare to other developed countries.

People still considering that to invest in commodity market is very risky. 75

People still considering commodity market for speculation rather than business purpose.

The whole industry is highly sensitive towards national and internationals environmental and political factors.

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9. QUESTIONNARE
(1). NAME: ________________________________________________________________ (2). ADDRESS: _____________________________________________________________ _______________________________________________________________________ (3). CONTACT NO. _________________________________________________________ (4). PROFESSION: _________________________________________________________ (5). SEX: _______________ (6). AGE: ______ (7). EDUCATION: __________________

(6). Where do you invest your saving? Bank Insurance IPO Mutual Fund Real Assets Gold/Silver Post Office Govt. Bonds Stock Market

If Others, Please specify.____________________________________

(7). If you invest in stock market, where do you invest your savings? Equity Derivatives Commodity

(8). How you reach at investment decision? Self analysis Business channels Tips from Experts Newspapers Tips from friends/relatives Other (Specify) _________

(9). Which factor plays a crucial role when you make a decision to invest in stock Market? Risk Reduction Investment Speculative Motive Arbitrage Benefit Leverage Benefit

(10). Duration of attachment with commodity market? Less than 1 year More than 10 year (11). Which of the following product prefer by you for your investment? Metal Cereals & Pulse Bullions Crops Spices Oil Energy 1 to 5 year 5 to 10 year

If others, please specify _____

(12). Which type of trading you prefer to deal with? Square up mode Hedging Arbitrage Delivery based 77 Intraday

(13). Which exchange you prefer to deal with? MCX NCDEX

(14). How do you view your self? Trader Speculator Short term investor

(15). In which of the company you would like to deal more and more time? Marwadi Motilal Oswal Kotak Street (online) India Bulls ICICI direct. Com Others Specify ________

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10. SUGGESTION & RECOMMENDATION

The FMC should allow Option trading in commodity market in India. The FMC has to take some steps to increase the awareness of future commodity trading India. The FMC has to encourage the mutual fund companies and institutional investors to invest in commodity market in India. The government has to allow FIIs to invest in commodity market in India in future market not in option. The FMC should have concrete plan to stop Dabba trading in commodity market in India. The FMC should increase the range of commodities in future commodities in commodity market in India. To motivate the commodity business in India the FMC should come up with some rebate in taxes. The FMC should increase the delivery centers of commodities in India. As commodity market is very potential for business, the angel co. should think about various ways to attract the customers.

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11. BIBLIOGRAPHY www.msfpl.com

www.mcxindia.com

www.ncdex.com

www.commodityindia.com

www.indiainfoline.com

www.fmc.gov.in

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