Forwards, Futures and Options in Commodities

Index of Contents:

• Forwards, Futures and Options
• How commodity derivatives differ from financial market derivatives
• Commodity Derivatives: Understanding the Products
• Commodity Derivatives: Understanding the Participants
• Functions of Commodity Derivatives

While the systematic trading in commodity futures had ushered into India with the formation of the Multi Commodity Exchange (MCX) in 2003, the informal trading of commodity futures has been in existence in India for over 100 years. Let’s begin with understanding commodity futures, forwards and options.

A. 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 1:

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.

Let us look at how futures differ from forward contracts.

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-dividend into lots, both parties can also exit part of 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.

B. HOW COMMODITY DERIVATIVES DIFFER FROM FINANCIAL DERIVATIVES?

Structurally, derivatives in commodities are exactly like derivatives in stocks and indices. However, there are some subtle differences between them.

C. COMMODITY DERIVATIVES: UNDERSTAND THE PRODUCTS

Commodity Futures are available in four broad categories of products as under:

Precious Metals: Owing to their scarce availability in nature, most of the metals that have been categorised as “precious metals” have been historically considered as a form of currency. However, today they are regarded mainly as investment and industrial commodities.

The following are some of the principal products available under the head of precious metal futures in India.

• Gold
• Gold Mini
• Gold Guinea
• Gold Petal
• Silver
• Silver Mini
• Silver Micro

Base Metals: Some of the key base metals on which commodity derivatives are available include:

• Copper
• Copper Mini
• Lead
• Lead Mini
• Nickel
• Nickel Mini
• Zinc
• Zinc Mini

Energy: Of the numerous forms of energy, crude oil and natural gas combined constitute more than half of the total primary energy consumed. The following energy contracts are available in India.

• Crude Oil
• Crude Oil mini
• Natural Gas

Agricultural Commodities: India is predominantly an agrarian economy and ranks second in farm production across the world. The following agricultural commodities are available for trading in futures:

MCX - Black Pepper, Cardamom, Castor Seed, Cotton, Crude Palm Oil, Mentha Oil, RBD Palmolein and Rubber

NCDEX – Barley, Chana, Maize Rabi, Maize Kharif, Wheat, Kapas, 29 MM Cotton, Guar Seed 1MT, Guar Seed 10MT, Guar Gum, Castor seed, Castor seed oil cake, soybean, refined soy oil, mustard seed, crude palm oil, sugar, pepper, turmeric, jeera and coriander.

In the Indian commodity markets, MCX has a leadership position in the trading of precious metals, base metals and energy products while NCDEX has leadership position in trading of agricultural products.

Commodity Options – Products available

Having seen commodity futures, let us also see what are commodity options and the products / contracts available under commodity options. Commodity option is a derivative contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying. For owning this right, the option holder pays a price (called ‘option premium’) to the seller of this right. The seller (writer) of option, on the other hand, bears the obligation to honour the contract should the buyer choose to exercise the option. The option buyer will exercise their option only when the price of the underlying is favourable to them, otherwise they will let the option expire worthless.

As per current regulatory norms, only European style commodity options are available in India at present. (European options can only be exercised on the expiry date as opposed to American options that can be exercised at any time on or before the expiry date). These commodity options, on exercise, devolve into the underlying futures contracts. All such devolved futures positions open at the strike price of exercised options. Commodity options are useful risk management tools, particularly for the small stakeholders, as the option buyer does not generally have to maintain margins. They are akin to price insurance for the hedgers which can be bought by paying only a one-time option premium. Commodity can also be useful to speculators for low cost trading.

MCX offers commodity options on Copper, Crude Oil, Silver, Gold and Zinc. NCDEX offers commodity options on Guar Seeds, Chana, Guar Gum, Soya Bean and Refined Soya Oil.

D. COMMODITY DERIVATIVES: UNDERSTAND THE PARTICIPANTS

Like any market, the commodity market also has its mix of different classes of participants who combine to provide debt, breadth and liquidity to the markets. There are different players in the commodity markets with different needs and different commitments. It is this heterogeneous nature of the participants that creates a rational and objective market for commodities. Broadly there are 3 categories of participants in the commodity markets; each with its own unique risk appetite and return expectations.

Hedgers – Participants with an underlying exposure to the commodity:

Hedgers are commercial producers or consumers of a traded commodity. Examples are copper smelters, oil companies, farmers, and jewellers. A copper smelter may want to protect against higher copper prices. Jewellers may want to protect against a sharp rise in the price of gold. Farmers may want to ensure that they get a good price for their produce. Similarly, downstream oil companies may look to hedge their risk on input and output. Hedgers are normally exposed to commodity price volatility in the spot market and use futures or options to protect or reduce the risk. For example, if a jeweller has a requirement of 50 kg of gold after 3 months to cater to wedding season demand, the jeweller can hedge the risk by buying gold in the 3 month futures market. Similarly a pepper farmer can sell pepper futures to effectively lock in a profitable price, irrespective of the volatility in price movements later. Hedgers typically take delivery on the underlying and are low risk participants in the commodity markets.

Speculators – On the lookout for trading opportunities:

Speculators may not have any exposure to the spot market. To them, commodity futures are an investment and trading avenue, like the stock market. They try to make money by speculating on commodity prices. As a result, speculators never receive delivery of the physical commodity. They take a position in commodity futures and square it off before expiry. This means, they settle by buying or selling a contract that is exactly the opposite of the contract they currently hold. This only involves payment in cash and no delivery of the underlying commodities. Speculators can be on the short side or the long side i.e. sellers or buyers in the futures market. Speculators may either look at trading for a few days or may look to roll over positions for a couple of months or more. But these speculators are important as they provide liquidity and finer pricing in the commodity markets.

Arbitrageurs – The spot–futures people

The term arbitrage refers to profiting from price differentials or price inefficiency in two different markets. For example, a stockist holding commodities in spot can sell futures at a premium and lock in the profits. A person with idle stock can also do a reverse arbitrage by selling spot and buying in futures and then rectifying the position to take advantage of mispricing. Arbitrageurs try to profit from the difference in the prices of the same commodity in two different markets. The difference between the two prices is their profit. Arbitrage transactions are usually risk-free. Constant arbitrage reduces the price in the market where it is higher and increases it in the market where it is lower. Arbitrage stops when prices become similar in both markets. These arbitrageurs play a very important role in ensuring that the futures price and the spot price converge over a period of time. Most pricing anomalies are removed by the arbitrageurs and they make the market safer in the process.

Within each of the above categories there are many sub categories but their broad intent is the same. It is the combination of speculators, hedgers and arbitrageurs that makes the market a genuinely price discovery tool. The different categories of participants respond differently to a market development because of their differing risk-return preferences. These differing responses determine how the market price of a commodity will move.

E. FUNCTIONS OF COMMODITY DERIVATIVES

Like any market place, the commodity markets also bring buyers and sellers together. To summarize, these commodity markets perform 4 key functions.

Assists in price discovery

Commodities markets facilitate the trading in bullion, base metals, energy products, agricultural products, and others. These markets help to establish prices for products in a scientific and systematic manner. The unique facet about commodities is that the prices are determined by the market forces of supply and demand. Prices reported from the commodities exchanges are communicated to all market participants and are used as the basis for numerous economic and political decisions. The presence of multi factor approach to pricing ensures that the price discovered is as close to the real situation as possible.

Commodity derivatives help in organizing markets

Forwards represent the unorganized markets where the contracts are largely over the counter and illiquid. Futures exchanges take commodities one step forward. They fulfil an essential economic function by providing organized marketplaces with standardized contracts. Each futures exchange maintains its own clearinghouse that fulfils all transactions and also provides a counter guarantee to eliminate the counterparty risk. This provides stability to the market as the clearinghouse acts as the other party in all transactions.

Gives the opportunity to hedge and manage the risk of the underlying commodity

Merchants, farmers and international firms use the futures exchanges to hedge future transactions. Take the case of a farmer who plans to sell his pepper produce 3 months down the line but is not sure of the price prevailing at that time. To remove the risk of price changes, he sells pepper futures contracts at planting time. When he sells his actual crop (spot) a few months later, he buys back the futures contract. This protects the farmer from any adverse price movements. Today traders and businesses with long commodity positions in the stock can hedge against a price fall by either selling equivalent futures or even by purchasing a put option entailing a much lower cost.

Trading and speculating makes the market function

Speculators fill the important economic function of providing liquidity to an exchange. With the money that speculators bring to the exchanges, the spread between bid prices and ask prices is much narrower than it otherwise would be. Had it not been for the speculators, commodity prices would fluctuate more erratically and in a much wider range. In a nutshell, the commodity markets bring in a greater degree of pricing genuineness to the entire commodity markets through more a scientific and democratic process of price discovery.