Hedging instruments: Futures

It helps with price risk management and facilitates effective competition

Hedging is a risk-management strategy used to offset or limit any loss from fluctuations in prices of not only commodities but also currencies and securities. There are various instruments for commodities hedging, and the widely popular ones are futures and options. In this classroom, we will look at futures.

History

Before we delve into the futures market, a little history into its evolution will help. The Cotton Trade Association started the first organised trade in commodity futures in India in 1875.

However, commodity futures trading was later discontinued and remained dormant due to macro-economic factors such as World War II and natural disasters. Post-liberalisation, initiatives were taken to revive commodities futures trading in India. By 2002, the country had nearly 20 commodities exchanges regulated by the erstwhile Forwards Markets Commission (FMC), which was later merged with Securities and Exchange Board of India (SEBI) that now regulates the commodities market along with other securities exchanges.

Market speculations, reports of scams and competitive environment have brought down the number of exchanges to three — MCX (Multi Commodity Exchange), NCDEX (National Commodity and Derivatives Exchange) and ICEX (Indian Commodity Exchange).

Each of these exchanges is known for trading in certain commodities. In MCX, futures contracts are available for bullion (gold and silver) base metals (aluminium, brass, copper, lead, nickel and zinc and energy) crude oil and natural gas. It also offers eight agri commodity futures contracts including cardamom, crude palm oil and cotton. NCDEX and ICEX are known for their agri commodities (such as caster seed, turmeric, soy bean) and diamond contracts, respectively.

Recently, the NSE and the BSE also joined in offering commodity futures contract.

Commodities futures

Commodities futures are contracts between two parties to buy or sell an underlying (commodity) at a specific date in the future at a particular price. The transactions in the futures market are based on transparent rules governing the exchanges, which means the market is organised.

Futures market helps in not only price risk management but also facilitating effective competition and price discovery of the underlying commodities. Here, market parties include participants such as traders, dealers, companies, institutions and farmers.

For the buyers of a commodity, futures contracts helpavoid the risks associated with the price fluctuations of the underlying asset. Similarly, for sellers, commodity futures provide guaranteed prices for their commodities. Consider the case of a wheat farmer. He enters into a futures contract with a seller, say a baker, to sell about 500 kg of wheat post-harvest at ₹200 per kg. Here the farmer’s motive is to secure a selling price for his next season’s crop and the baker can pin down a buying price for his raw material. Both can make profit through futures contract.

Upon maturity, the futures contract executed can be physically settled or cash settled.

Each contract represents a specific quantity of the underlying commodity. For instance, MCX crude oil contract has a trading unit of 100 barrels, while the exchange’s crude oil mini contract has a trading unit of 10 barrels. Market participants can choose a contract based on their requirement and risk appetite.

The parties on a futures exchange place their bid and ask price. This is based on their assessment of demand and supply, and other information such as those they have on government policies, inflation, global trade and weather forecasts. This is how the future price of a commodity is discovered.

Things to know

Before you start trading in futures market, there are certain aspects about futures trading that you should note, such as lot size, contract expiry, delivery and margins. In futures contract, everything is predetermined. For instance, for MCX aluminium contract, one lot size is 5 tonnes, and you can order for a maximum of 150 tonnes. The contract specifications vary with exchanges and one should read the contract specifications of the commodities available with the exchange for clarity.

Consider the same aluminium contract of MCX. The trader has to pay an initial margin of 4 per cent minimum and an extreme loss margin of 1 per cent. If you opt for physical delivery of aluminium, you have to pay a delivery margin also.

Physical delivery is executed with a minimum of 10 tonnes at exchange-designated warehouses. In MCX’s case, it is at Bhiwandi, Maharashtra. Note that not all contracts are compulsorily deliverable.

Sellers have to meet certain quality specifications to trade via commodity exchanges. For instance, in the said aluminium contract, only primary aluminium of 99.7 per cent purity in the form of ingots, t-bars or sows are accepted.

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