Chapter 1: Forwards, Futures and Options in Commodities

WHAT ARE COMMODITY FUTURES, FORWARDS AND OPTIONS?

Commodity futures are available on four broad categories of products in India:

• Base Metals (Aluminium, copper, tin, zinc)
• Precious metals (Gold and silver)
• Energy products (Crude oil and Natural Gas)
• Agricultural products (cotton, pepper, mentha oil etc)

To understand the concept of forwards as distinct from futures and options, let us look at a hypothetical illustration.

Example

A farmer grows tomatoes during the season and supplies it to the ketchup factory which is situated about 60 KM away. The ketchup factory arranges to pick up the tomatoes from the farm and transports to the factory directly. The price at which the tomatoes are supplied is determined by the prevailing market prices on the date of supply. The contract is for 5000 kg of tomatoes. However, this opened up a price risk to both the farmer and the ketchup factory as neither were sure about the prevailing market prices on the day of supply. That is where a basic forward contract can come into existence.

A forward contract is an agreement to buy or sell an underlying commodity at a fixed price determined in advance for a particular date in the future.

Can a forward contract come into existence in the above case? Let us take a look.

• The farmer can sell tomatoes forwards to the ketchup factory at a minimum price of price of Rs.30/kg exactly 3 months from now. The farmer needs a minimum price of Rs.30/kg to cover his costs and make a profit.
• The Ketchup factor can buy tomatoes from the farmer at Rs.33/kg at the end of 3 months. That is the price at which the ketchup factory can cover all costs including transportation and also make a margin.

Now the farmer and the ketchup factor can enter into a forward contract as under:

• The farmer and the ketchup factory enter into a 3-month forward contract under which the farmer will supply 5000 kg of tomatoes to the ketchup factory at the end of the 3 month period at a price of Rs.31.50/kg.
• This forward price suits the farmer because it is Rs.1.50 better than the minimum price that he is expecting to be profitable in the market.
• The forward price of Rs.31.50/kg also suits the ketchup factory because it is Rs.1.50 lower than the cost at which the factory can be profitable.
• Under the forward contract, the farmer is obligated to delivery 5000 kg of tomatoes on the designated date at the price of Rs.31.50/kg, irrespective of whatever is the price prevailing in the market at that point of time.
• Similarly, the forward contract also stipulates that the ketchup factory is obliged to buy 5000 kg of tomatoes on the designated date at the price of Rs.31.50, irrespective of the prevailing price of tomatoes at that point of time.

What happens on the date of maturity of the forward contract at the end of 3 months? There are 3 possibilities in this case.

• On the contract maturity date the price of tomatoes in the market may be around Rs.31.50. In this case, both the farmer and the ketchup factory will just execute their ends of the contract.
• What if the price of tomatoes has fallen sharply? Say, the price has fallen to Rs.27/kg. The farmer will be happy because under the forward contract he will get Rs.31.50/kg instead of the market price of Rs.27. The farmer makes a profit of Rs.4.50/kg. However, that will be a loss for the ketchup factory as they have to honour their part of the forward contract at Rs.31.50, when they could have bought it in the open market at Rs.27/kg.
• What if the price of tomatoes has risen sharply? Say, the price has risen to Rs.35/kg. The farmer will be obviously unhappy because under the forward contract he will get only Rs.31.50/kg instead of the market price of Rs.35. The farmer makes notional loss of Rs.3.50/kg. However, that will be a profit for the ketchup factory as, under the forward contract, it can procure the tomatoes at Rs.31.50, for which they would have had to otherwise pay Rs.35/kg.
• What is important here is that the forward contract is the right and the obligation for both the farmer and the ketchup factory. The profits or losses can be unlimited to both the parties in a forward contract. What is important is that it gives a degree of certainty to the farmer and the ketchup factory. The farmer is assured of his income irrespective of market conditions and the ketchup factory knows its costs of procurement and can plan its budgets accordingly.

How futures can be an improvement over forwards?

The above example of forwards sounds very good on paper, but there are a lot practical difficulties. What happens if the farmer or the ketchup factory is unable to honour their side of the contract? It could be a deliberate default or it could be a genuine reason. Either ways, the other party will be put through a lot of pain. Of course, forward contracts are regulated under the Contracts Act and hence the contract can be enforced in the court of law. But, that is a very long and cumbersome process and the parties to a forward contract may have neither the time nor the wherewithal to pursue prolonged legal recourse.

There is another possibility. After entering into a forward contract, either the farmer or the ketchup factory may want to exit the contract for genuine reasons. However, they are obligated to the contract and they cannot exit the contract unless they can find another similar party who is able to honour their side of the contract. Since forward contracts are very unique to the specific circumstances, they tend to become illiquid. It is to address these problems that the concept of futures transaction came about.

How futures differ from forward contracts?

Let us look at how futures differ from forward contracts.

TABLE GOES HERE

As seen from the above table, the futures contract and forward contract are structurally the same. Both entail a contract to buy or sell an underlying commodity at a future date at an agreed price. In case of futures and in case of forwards, the buyer and the seller have unlimited profit and loss potential. However, futures differ from forwards on the following counts.

• Futures are traded on a recognized exchange and hence it is bound by the rules and by-laws of the exchange. To that extent it is different from a forward contract, which is an over the counter (OTC) contract entered between two parties privately based on mutually agreed terms and conditions.
• Futures are standardized. Unlike forwards, futures standardize the contract quantity, lot size, product definition and the expiry. For example, an exchange can define that tomatoes can only be bought and sold in minimum lot size of 500 kg. In the above case, the farmer will sell 10 lots of tomatoes. The expiry date of the contact is also standardized and since these futures are listed there is a ready secondary market. Also, since the contract is now sub-divided into lots, both parties can also exit part of the contract instead of the full contract. This enhances liquidity for the farmer and the ketchup factory.
• The last difference is most important. Futures contracts typically carry a counter guarantee by the clearing house of the stock exchange. These clearing houses (clearing corporations) guarantee each futures trade executed on the stock exchange and act as the counter party to each trade. In case of forward contracts, it is still a private contract between two parties and there is no neutral counterparty. On the expiry date if either party defaults on the commitment, then the only recourse that the aggrieved party is the legal route under the aegis of the Indian Contracts Act.

What are the costs in case of futures and forwards?

Do futures and forward contract entail a cost? Basically, forwards are private contracts so they operate on good faith. However, you get a real idea of costs when you get into an exchange traded futures contract. When you enter into a futures contract, there is an upfront margin that the exchange collects. The margins are defined by the exchange and are called the initial margin and it consists of VAR margin and Extreme Loss Margins (ELM). In addition, the exchange also collects mark-to-market (MTM) margins, in case the prices move against the parties. The initial margins are similar, irrespective of whether you are buyer or a seller in the futures contract. It is only the MTM margins that differ based on which side of the contract you are in. Like in the case of financial derivatives, commodity derivatives are also subject to trading and statutory costs. The only difference is that the exchanges charge commodity transaction tax (CTT) instead of STT in case of equity and index futures.

Understanding commodity options

Commodity options are a recent addition to the Indian commodity markets repertoire. While trading in commodity futures began in 2003 on base metals, precious metals, energy and agricultural commodities, options were only permitted from 2017 onwards. While future and forwards are a right and an obligation, options are a right without an obligation. Thus the option buyer has the right to buy (in case of call option) and the right to sell (in case of put option). On the other hand, the seller of the option has the obligation to buy or sell without the right. For this risk, they are paid the option premium.

Originally posted on school.5paisa.com