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What is Commodity Futures& Forwards?

What is Commodity Futures& Forwards?


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A Contract to buy/sell specific quantity of a particular commodity at a future date on an exchange platform is known as commodity futures. 

These are identical to the Index futures and Stock futures. The difference here is the commodities instead of Stocks and indices.

Commodity derivatives: A new avenue for retail investors and traders to participate is now open BY Indian markets.

Commodities are the suitable choice for those who want to transform their portfolios beyond shares, bonds and real estate

Retail investors had little choice to invest in commodities such as gold and silver or oilseeds in the futures market previously. This was due to lack of retail avenue for shoving in commodities.

Retail investors can now trade in commodity futures without holding physical stocks. This was made possible with the emergence of three multi-commodity exchanges in the country. 

For market-savvy investors & speculators, commodities offer great opportunities to become asset class. It may be considered immeasurable market by retail investors who understand equity markets in their own perspective. 

The basics of demand and supply can be easily grasped with respect to commodities. 

It is necessary to understand the risks and advantages of trading in commodities futures before getting into it by retail investors.

When compared with equity and bonds, commodity futures pricing is less resilient. This helps in capable portfolio diversification. 

In India, the size of commodities market is powerful. About 58 % of commodities related (and dependent) industries contribute to the country’s GDP of Rs.13,20,730 crore ( Rs. 13,207.3 billion. 

The annual turnover of various commodities globally is amounted to Rs 1,40,000 crore (Rs 1,400 billion) now. It is expected that the futures market introduction will increase the size of the commodities market many times. 

The market is made much more liquid, as the market helps interaction between buyers and sellers of commodities and this creates decision making in terms of storage and consumption of commodities. 

BREAKING DOWN Commodity Futures Contract

Commodities futures contracts can be utilized to make directional price bets on raw materials by speculators other than hedgers. 

The inexperienced could find it risky to trade in futures market. The high amount of leverage involved in holding futures contracts is the reason for the primary risk

Let’s look into the example below: 

For an initial margin of about $3,700, an investor can enter into a futures contract for 1,000 barrels of oil valued at $45,000 (with oil priced at $45 per barrel).

We can see that there is large amount of advantage given. 

Compared to the initial margin, large gains or losses could result with a very small move in the price of a commodity. 

Futures are the obligation of the purchase or sale of the underlying asset, unlike options. 

An inexperienced investor could result in taking delivery of a large quantity of an unwanted commodity by failing to close an existing position. 

Unlimited losses may occur when short position in futures is used by speculation. 

Commodity Futures Hedging Example

The purchase of sale prices can be locked for weeks, months or years in advance by buyers and sellers with the help of commodity futures contracts. 

Let’s look into the example below for a better understanding. 

A farmer expects to produce 1,000,000 bushels of soybeans in a period of next 12 months. 

Soybean futures contracts include the quantity of 5,000 bushels.

Let us assume that the farmers break-even point on a bushel of soybeans is $10 per bushel.

He sees that one-year futures contracts for soybeans are currently priced at $15 per bushel.

It might be right for him to lock in the $15 sales price per bushel by selling enough one-year soybean contracts to cover his harvest.

Here, in this example: 1,000,000 / 5,000 = 200 contracts

After completion of one year: 

Irrespective of the price, the farmer:  

Delivers: 1,000,000 bushels

Receives $15 x 200 x 5000, or $15,000,000.

This price is locked in. But unless soybeans are priced at $15 per bushel in the spot market that day, the farmer has either received less than he could have or more.

Let us assume the soybean was priced at $13 per bushel: 

The farmer receives a $2 per bushel benefit from hedging, or $2,000,000.

Let us assume the soybean was priced at $17 per bushel: 

The farmer misses out on an additional $2 per bushel profit.

1. Organized:

Commodity Futures contracts always trade on an organized exchange, e.g. NCDEX, MCX, etc in India and NYMEX, LME, COMEX etc. internationally.

2. Standardized:

Commodity Futures contracts are highly standardized with the quality, quantity, and delivery date, being predetermined.

3. Eliminates Counterparty Risk:

Commodity Futures exchanges use clearing houses to guarantee that the terms of the futures contract are fulfilled. The Clearing House guarantees that the contract will be fulfilled, eliminating the risk of any default by the other party.

4. Facilitates Margin Trading:

Commodity Futures traders are required to post a margin that is roughly 4 to 8% of the total value of the contract. They do not have to put up the entire value of a contract. (This margin varies across exchanges and commodities) This facilitates taking of leveraged positions.

5. Closing a Position:

Futures markets are closely regulated by government agencies, e.g. Forward Markets Commission (FMC) in India, Commodity Futures Trading Commission in (CFTC) USA, etc. This ensures fair practices in these markets.

6. Regulated Markets Environment:

Commodity Futures contracts are highly standardized with the quality, quantity, and delivery date, being predetermined.

7. Physical Delivery:

Actual delivery of the commodity can be made or taken on expiry of the contract. Physical delivery requires the member to provide the exchange with prior delivery information and completion of all the delivery related formalities as specified by the exchange.

What is a Forward Contract?

It is a personalized contract between two parties which enables them to buy or sell an asset at a specified price on a future date.

Even though the forward contract is non- standardized in nature, it can be used for hedging or speculation. 

A forward contract can be customized to any commodity, amount and delivery date unlike standard futures contract. 

A forward contract settlement can occur on a cash or delivery basis.

Forward contracts are considered as over-the-counter (OTC) instruments as they do not trade on a centralized exchange

The absence of a centralized clearinghouse gives rise to a higher degree of default risk. 

As they are OTC in nature, it becomes easier to personalize terms. 

Forward contracts are not available to retail investors as easily when compared to futures contracts. 

BREAKING DOWN Forward Contract

Let’s look into the below example for a clear understanding. 

Let’s consider that an agricultural producer has 2 million bushels of corn to sell six months from now. 

He is concerned about a potential decline in the price of corn. 

He signs a forward contract with its financial institution to sell 2 million bushels of corn at a price of $4.30 per bushel in six months with settlement on a cash basis. 

The following are the possibilities in 6 months. 

1.     Exactly $4.30 per bushel:  No money is owed by the producer or financial institution to each other and the contract is closed.

2.     Higher than the contract price, say $5 per bushel: The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.

3.     Lower than the contract price, say $3.50 per bushel: The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

The world’s biggest corporations use forward contracts to hedge currency and interest rate risks.

The size of the market is not easy to evaluate. This is because the details of forward contracts are restricted to the buyer and seller, and are not known to the general public. 

The large size and unregulated nature of the forward contracts market means that it may lead to defaults in the worst-cases. 

Banks and financial Corporations handle the risk by being careful in their choice of counter party. 

The non-standard nature of forward contracts is that they are only settled on the settlement date, and are not marked-to-market like futures. 

What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?

The financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client. 

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