Structuring of Derivative Contracts

Index of Contents:

• Structuring of derivatives contracts on strike price, delivery and benchmarks
• Structuring of Contracts – Focus on Precious Metals
• Structuring of Contracts – Focus on Base Metals
• Structuring of Contracts – Focus on Energy Products
• Structuring of Contracts – Focus on Agri Products

Like in every derivative contracts, the commodity derivative contracts also have a fixed expiry date, benchmarks for the spot price, strike prices in case of options, etc. More or less, all these factors are standardized to the extent possible. There is a small difference on the concept of spot price of the underlying in each of these commodities. While equities have a standard method of using the stock price, the commodity futures and options use the spot commodity underlying with clear standards of quality and grading defined. Unlike in the case of equity futures and options, there is no standard contract cycle that expires on the last Thursday of the month. Instead, each commodity has its own unique contract cycle. Before we get into the specifics of various classes of contracts, let us quickly look at how deliveries are handled in case of commodity futures.

Concept of delivery against futures in commodities

Index options and currency options and futures are necessarily settled in cash. There is no underlying spot that is exchanged. It is just the profit and loss that gets adjusted. However, commodities are used by genuine hedgers and hence they either need to take delivery or give delivery at a future date. Hence commodity markets offer the dual facility of either trading and squaring up the futures position or actually taking or giving physical delivery against the contract.

There are some basic things you need to understand about delivery. Trading unit is different from delivery unit. Trading unit represents the minimum size that can be traded while delivery unit is the minimum size that can be delivered. For example, In the case of Gold Petal contract, trading unit is 1 gram but delivery unit is 8 grams. Deliveries shall always take place at the warehouses accredited/approved as designated delivery centres, typically through warehouse receipts (WRs). Warehouse receipts represent a document whether in physical or electronic form evidencing a commodity being held in the in the accredited/approved warehouses and is considered tantamount to physical delivery.

There are four different types of delivery contract available on the MCX at the current point of time. They are as under:

Compulsory Delivery: In this case, all open interest position of the members at expiry of the contract will necessarily result in physical deliverable obligations.

Seller Option: In case of delivery based on seller option contract it is based on the seller’s choice. If the seller gives valid intention to give delivery within the stipulated time limit, the MCXCCL will mark the delivery to the Buyer Member. Rest of the open positions on expiry of the contract, will be closed out at the Due Date Rate (DDR)

Both Option: When intentions of both Buyer and Seller Member to give/take delivery match on or before the expiry of the contract, then the delivery will be marked to the extent of matched quantity on expiry of the contract. If the intentions are not received, all open interest position of the Members get closed out at DDR (Due date rate).

Cash Settled: Contracts specified as Cash settled shall be settled by way of Funds settlement and no physical delivery settlement will take place for such contracts.

Structuring of Contracts – Focus on Precious metals

Precious metals broadly consist of gold and silver in the Indian context. Of course, they are further broken up into specific commodity contracts, based on size of the contract, like Gold, Gold Mini, Gold Guinea, Gold Petal, Silver, Silver Mini etc. Let us look at the structuring of the contracts of each of these sub-segments.

Most of the features for the mini and smaller gold contracts are the same and hence we shall not be covering the sub contracts individually. We shall only cover the gold and the silver broad contracts.

Are options on gold and silver available? Yes there are options available on gold and silver with the following characteristics.

Underlying: Gold Futures and Silver Futures contract respectively. Options are based on futures price underlying and not on spot price.

Option Type: European calls and puts

Expiry Date: 3 business days prior to the first business day of tender period

Margins: Upfront premium margin for buyer and normal futures margining for seller

Mode of settlement: Long calls and short puts will devolve into long futures. Long Puts and short calls shall devolve into short futures.

Structuring of Contracts – Focus on Base metals

Base metals include a number of lower value metals with substantial industrial uses. These include aluminium, copper, zinc, nickel and each of the versions also a major contract and a mini contract. These are more synced with industrial demand cycles.

Apart from aluminium, another important base metal is copper, details as under.

Lead is another important base metal with extensive applications in batteries.

Nickel is a base metal with extensive applications in manufacture of stainless steel.

The last of the major base metals on which futures is available is Zinc, which is known for its anti-corrosive properties make it useful in ships, automobiles and construction.

In all the base metals, futures and options contracts are available. Options are European in nature and devolve into futures on the option expiry date.

Structuring of Contracts - Focus on Energy Products

Globally, energy is a major trading product. Like in other markets, even in India, trading in crude oil and natural gas are among the most liquid contracts in the market. The need for hedging energy products arise from their volatile nature and the multifarious factors that have an impact on the price of these commodities. Broadly, there are two categories of energy products available in India viz. Crude oil and Natural Gas with mini variants too.

While crude oil continues to be the biggest source of energy, it has its downsides in the form of the environmental costs. An alternative is natural gas, which is environmentally friendlier and is extensively used across Western countries for winter heating.

Structuring of Contracts - Focus on Agricultural Products

Agricultural products are not only volatile but price are generally regulated and demand supply situation is constantly monitor as they are politically subjects. Also the government endeavours to protect the interests of its farmers by ensuring that they get remunerative prices for their crop. While NCDEX clearly has the leadership position in trading agri product futures, MCX has also been building volumes in select products. Let us look at some of the details of products on MCX.

Like Pepper, Cardamom is also extreme region specific and is vulnerable to the vagaries of the weather and the monsoons.

Castor seed is crushed to make oil which does not have edible applications but has extensive uses in chemicals, paints, varnishes and certain drug formulations.

Cotton is available in different grades with the Egyptian cotton considered to be of an extremely superior grade. Cotton is an important input for the textile industry.

Crude Palm oil is now emerging as an important and healthy alternative to traditional edible oil. The futures are a popular trade on Indian futures bourses.

Mentha Oil is predominantly produced in India and has extensive applications in flavouring, essences, perfumes etc.

Finally, Rubber has emerged as a key input for automobile and aeronautic industry. Kerala State is a leader in the production of rubber in India.