Prof Prabina Rajib (Commodity Derivatives and Risk Management) - Lecture 3

Summary

This session on commodity derivatives and risk management explores key aspects of futures contract specifications. The discussion covers the roles of commodity exchanges, clearing houses, and trading members, with examples from the Indian Commodity Exchange (MCX). It explains important terms such as novation, margin calculations, contract expiration, and delivery processes. The example of cotton futures provides a detailed understanding of contract standardization, price limits, and settlement procedures. The session concludes with a focus on how clearing houses manage counterparty risks and ensure smooth transaction settlements.

Takeaways

• 📈 The session focuses on futures contract specifications and the entities involved in commodity exchanges, including the regulatory body SEBI.
• 🏢 Commodity exchanges like MCX and NCDEX are mentioned, along with the roles of clearing houses, clearing banks, and warehouses in facilitating trades.
• 👤 Traders must go through trading members, such as brokers, to engage in derivatives contracts on an exchange platform.
• 🔄 Clearing members play a crucial role in ensuring trades are cleared smoothly and are part of the clearing house's structure.
• 💼 The clearing house acts as a facilitator for processing delivery and payment, mitigating counterparty risk in futures contracts.
• 📋 The script outlines the responsibilities of trading and clearing members, highlighting the differences in their roles within the commodity exchange ecosystem.
• 📊 The concept of novation is introduced, where the clearing house becomes the counterparty to each buyer and seller, reducing risk.
• 💵 The clearing house maintains a Settlement Guarantee Fund to cover potential defaults by trading parties.
• 📝 The session discusses the standardization in futures contracts, including quality, quantity, maturity date, and delivery margin.
• 📉 The script provides an example of a cotton futures contract, detailing its specifications such as trading unit, maximum order size, tick size, and daily price limits.

Q & A

What is the role of the Securities Exchange Board of India (SEBI) in commodity exchanges?

SEBI acts as the regulator for commodity exchanges, having merged with the Forward Markets Commission. It oversees the functioning and ensures compliance with regulations.

What are the key entities involved in a commodity exchange ecosystem?

The key entities involved in a commodity exchange ecosystem include commodity exchanges, clearing houses, clearing banks, warehouses, trading members, and clearing members.

How do trading members function in the context of commodity exchanges?

Trading members function as brokers, facilitating the buying and selling of derivatives contracts on behalf of buyers and sellers. They are the intermediaries through which trades are channelized.

What is the primary responsibility of a clearing house in a commodity exchange?

The primary responsibility of a clearing house is to act as a facilitator for processing delivery and payment between clearing members, trading members, and participants, ensuring timely payments and reducing counterparty risk.

What is the concept of Novation in the context of commodity derivatives?

Novation is a process where the clearing house becomes the counterparty to each buyer and seller in a derivatives contract, thereby taking away the counterparty risk and ensuring the smooth execution of trades.

Why is the Settlement Guarantee Fund important for clearing houses?

The Settlement Guarantee Fund is important for clearing houses as it serves as a financial buffer to cover potential defaults by any of the counterparties, ensuring the stability and integrity of the market.

What are the differences between forward contracts and futures contracts as discussed in the script?

Forward contracts are non-standardized, bilateral agreements with flexibility in terms of underlying, quantity, delivery date, and location, but they carry counterparty risk. Futures contracts, on the other hand, are standardized and traded on exchanges, with the clearing house managing counterparty risk.

What is a contract launch calendar and how does it relate to futures trading?

A contract launch calendar is a schedule that outlines the availability of contracts for trading based on their maturity dates. It allows traders to enter into contracts that mature on specific dates, providing a structured framework for trading.

What is the significance of the trading unit in a futures contract specification?

The trading unit specifies the minimum quantity of the underlying asset that must be traded in a single contract. For example, in the case of cotton futures, the trading unit is 25 bales, which sets the standard quantity for trading.

How are daily price limits (DPL) applied in futures contracts, and what is their purpose?

Daily price limits are set to restrict the fluctuation of futures prices within a certain percentage range to prevent extreme market volatility. They act as circuit breakers to maintain market stability.

What is the purpose of initial margins in futures trading, and how are they calculated?

Initial margins are required deposits by traders when entering into a futures contract to cover potential losses. They are calculated as a percentage of the total contract value and serve as a form of risk management.

Outlines

00:00

Introduction to Commodity Derivatives and Market Entities

05:02

Roles and Responsibilities in Commodity Exchange Trading and Clearing

10:03

Forward Contracts vs. Standardized Futures Contracts

15:05

Understanding Cotton Futures Contract Specifications

20:11

Margins, Open Position Limits, and Delivery Specifications

25:14

Due Date Rate and Contract Settlement Process

Keywords

💡Commodity Exchange

A commodity exchange is a centralized marketplace where various commodities are traded. In the context of the video, it is mentioned that commodity exchanges are regulated by bodies like the Securities Exchange Board of India (SEBI), and they play a crucial role in facilitating the trading of commodity derivatives. Examples of commodity exchanges in the script include MCX and NCDEX.

💡Futures Contract

A futures contract is a legal agreement to buy or sell a commodity or financial instrument at a predetermined price at a specified time in the future. The video discusses futures contracts in detail, explaining how they are standardized and traded on commodity exchanges, contrasting them with forward contracts which are more flexible but carry counterparty risk.

💡Clearing House

The clearing house is a critical entity within a commodity exchange that ensures the integrity of trades and manages counterparty risk. It acts as an intermediary between buyers and sellers, guaranteeing the fulfillment of contracts. The script explains that the clearing house facilitates processing, delivery, and payment, taking on the role of the counterparty in each trade to mitigate risk.

💡Settlement Guarantee Fund

The Settlement Guarantee Fund is a financial reserve maintained by the clearing house to cover potential defaults by trading parties. The video script references the fund, highlighting its importance in maintaining market stability and ensuring that all parties receive their due payments even if a counterparty fails to meet their obligations.

💡Trading Member

Trading members, similar to brokers in the stock market, are entities through which buyers and sellers must channel their trades on a commodity exchange. The script mentions that trading members like Kotak Securities or Sharekhan provide the platform for trading derivatives and are the interface between the exchange and the traders.

💡Clearing Member

Clearing members are part of the clearing house and are responsible for ensuring that all trades are cleared smoothly. They play a role in the settlement process, helping to manage and mitigate risks associated with trading activities. The video script distinguishes the roles of trading members and clearing members within the exchange ecosystem.

💡Standardization

Standardization in the context of futures contracts refers to the process of setting uniform terms for contracts such as quality, quantity, maturity date, and delivery terms. The video emphasizes that futures contracts are standardized, which facilitates trading and reduces complexity for market participants, as opposed to the more flexible but less standardized forward contracts.

💡Initial Margin

Initial margin is the minimum amount of funds that a trader must deposit with the broker when entering into a futures contract. The script explains that both parties in a futures contract, whether long or short, are required to deposit this margin to ensure the fulfillment of their contractual obligations.

💡Daily Price Limit

The daily price limit, also known as a circuit breaker, is a mechanism in futures trading that restricts the price movement of a contract within a single trading day to a certain percentage. The video script mentions a 4 percent daily price limit for cotton futures, which helps to prevent excessive volatility and protect market participants.

💡Delivery Period Margin

Delivery period margin is an additional margin requirement that traders must meet as the contract approaches its delivery date. The script specifies that this margin is set at 24-25 percent of the contract value, ensuring that traders are financially capable of fulfilling their delivery or settlement obligations.

💡Due Date Rate

The due date rate, also referred to as the final settlement price, is the spot price used for settling futures contracts on their maturity date. The video script describes how this rate is calculated as the simple average of the last three trading days' spot prices, providing a fair and transparent method for final settlement.

Highlights

Commodity exchanges are regulated by the Securities Exchange Board of India (SEBI) since the Forward Markets Commission has merged with it.

Entities associated with a commodity exchange include trading members, clearing houses, clearing banks, and warehouses.

Parties interested in derivatives contracts must go through a trading member, such as brokers like Kotak Securities or Sharekhan.

Clearing members ensure that all trades are cleared smoothly and are part of the clearing house.

The clearing house acts as a facilitator for processing delivery and payment, ensuring timely payments between parties.

Novation is a process where the clearing house becomes the counter party to each buyer and seller, reducing counter party risk.

Clearing houses maintain a Settlement Guarantee Fund to cover potential defaults by counter parties.

Forward contracts offer flexibility but carry counter party risk, unlike futures contracts.

Futures contracts are standardized in quality, quantity, maturity date, delivery, and margin.

The contract launch calendar dictates when contracts are available for trading on the exchange.

Trading units for futures contracts, such as cotton, are standardized, with a minimum of 25 bales per contract.

Maximum order size is limited to 1200 bales in a single order, corresponding to 48 contracts.

Tick size is the minimum price fluctuation allowed and is set at multiples of 10 rupees.

Daily price limits, similar to circuit breakers, are set at 4 percent for cotton futures prices.

Initial margin requirements for futures contracts are set at 4 percent of the total contract value.

Maximum Allowable Open Position for individual clients is capped at 150,000 bales across all contracts.

Delivery Unit for cotton futures is in multiples of 100 bales, with a delivery period margin of 24-25 percent.

The Due Date Rate, or final settlement price, is determined by the average of the last three trading days' spot prices.

Delivery logic for cotton futures is compulsory, ensuring that contracts result in physical delivery of the commodity.

Transcripts

Welcome to the third session on commodity derivatives and Risk Management. In this session

we will be discussing more about futures contract specifications, that is different aspects

of futures contract specification.

But before I go to that discussion, I would like to discuss little more on little bit

on which are the which are the entities which are associated with the commodity exchange.

Let us say a commodity exchange is regulated by a commodity exchange regulator. Of course

now we do not have a commodity exchange regulator persuade forward market commission has been

merged with security exchange board of India. So we have Security Exchange Board of India

(SEBI) as a regulator, we have commodity exchanges in the commodity exchanges. We can have, you

know MCX, NCDEX or regional commodity exchange. And Beside a commodity exchange you also have

other entities such as, clearing house, clearing banks and different warehouses which are associated

with a commodity exchange for delivering the underlying goods.

Now, whenever a party who is interested to take derivatives contract in an exchange platform

it cannot do so on its own. It has to go through a trading member. Let us say let us say Kotak

securities or Share khan or Relicare Security, different brokers which provide us the platform

for buying and selling derivatives contract. So buyers and sellers have to go through a

trading member and these trading members also have to be have to go through another set

of entities called Clearing members. And, in the next slide I will discuss little

more on what is the difference between or what are the responsibilities of trading members

and a clearing members.

Trading members are exactly; provide the same function as that of the brokers in a stock

market. So, whenever any party is interested to take long or short futures contract, they

have to channelize that trade through the broker. In fact for stock exchange we you

know if I am interested to buy or sell derivative contracts, I do not you know, the exchange

does not recognize me exchange recognizes me through the broker, through my broker.

Now, besides the trading member, each exchange also has a clearing house and clearing members

are the members of the clearing house. And the clearing house provides a very very important,

function for the commodity exchange. So, what exactly a clearing house does? This particular

quote unquote which I have mentioned in the slide, it is the from NCDEX frequently asked

question. So, clearing house means a division of an

exchange or a agency identified by the relevant authority or any independent entity, such

as clearing corporation setup and empowered suitably to act as a facilitator for processing

deliveries and payment between clearing members, trading members and the participants for trades

effected by them on the exchange. So here, I would like all of you to focus

little on those set of words. “It acts as a facilitator for processing delivery and

payment”. So the responsibility of ensuring that the buyers and sellers of derivative

contracts are paid in timely manner or whatever they are supposed to pay to the exchange.

Or whatever they are supposed to pay or receive pay to the exchange or receive from the exchange

that is you know done on a orderly manner, and that responsibility lies with the clearing

house. 04:55)

This particular table clearly identifies, what are the different responsibilities of

of or what are the different activities under the trading category and clearing and settlement

activities category. Trading activity under trading activity you have order receipt so

whenever buyers or sellers are giving any order, so that comes under the trading activity

order that comes under trading activity. So receipt of order, order matching once the

order gets matched that means for every buyer seller buyer and seller order gets matched.

The reporting of the executed trades to the buyers and sellers of the derivative contract,

all these activities are the part of the trading activities. Post trading the old activities,

remaining activities like margin calculation, margin collection, margin reporting margin

payment and receipt, delivery payment and receipt on the expiration all these become

the responsibility of the clearing house. And this clearing house appoints clearing

members and the members are responsible for ensuring that all trades are cleared smoothly.

Clearing house also provides very important important role in the whole ecosystem of commodity

derivative trading that is the Novation. So what exactly is Novation?

06:32)

Novation is a process in which the clearing house becomes the counter party to each buyer

and each seller and basically it takes away the counter party risk.

All of you know and we have also discussed that the forward contracts have significant

amount of counter party risk, however, futures contract do not have that counter party risk.

This risk is taken away by the clearing house. So, whenever let us say, today I am interested

to take long futures contract on a on a underlying, let us say, let us say black pepper black

pepper, I am interested to take a long futures contract. I give my price quotation and the

somebody is interested to take a short futures contract I my order matches and I get a confirmation

from the exchange through my trading member that is my broker that my order has been executed.

So I have now a long futures position and some counter party has a short futures position.

But, I do not need to know who is my counter party? Whatever I am obligated to pay or whatever

I am supposed to receive will be effected through the clearing house and the clearing

members. Even if my counter party defaults whatever I am supposed to receive form the

exchange, I am going to receive. So, this is a very very important function

provided by the clearing house which brings the order and also maintains the market integrity.

Now how does these clearing houses ensure that they are able to take care of all the

counter party risk each and every clearing house has to maintain something called as

Settlement Guarantee fund. Basically a corpus, in case one counter party or few counter parties

default, these clearing houses can dip into that corpus and pay to the counter party.

08:50)

Now, this particular detail, this particular you know slide which I am showing, this shows

the details of the settlement guarantee fund maintained by NCDEX as on December 31 2015.

So as on December 31, 2015 the total amount of fund available in the settlement guarantee

fund comes to about 127 crore that is 12798 lakhs of rupees. And how this settlement guarantee

fund has been created and who has contributed this amount. This is mentioned in this table

and if time permits or you are interested to learn more about settlement guarantee fund

you can spend some time on it. 09:47)

Now let us our todays agenda that is futures contract specification, but before we go to

the futures contract specification I would like to make a little you know spend may be

half a minute on forward contract specific forward contracts. In case of your forward

contracts it is taken, forward contracts are agreed between two parties the non-standardized,

bilateral contracts it could be on any underlying that is the flexibility of forward contracts.

Like, let us say if two parties enter agree one party can deliver mango pulp, one party

can deliver brass which is let us say alloy of copper and tin, one party can also you

know deliver bamboo poles. So I mean it could be any any any any product as long as both

parties agree to it, and it can be any quantity, it can be any delivery or any maturity date,

it can be at any delivery location. So this is great deal of there is a great

deal of flexibility associated with forward contract. However, forward contract as you

know has a counter party risk. Now let us go to understand more about a futures contract

specifications, so as we have read many times that futures contracts are standardized. So

when we are talking about the standardization so we mean by quality, quantity, maturity

date, delivery margin all these details are standardized.

Now I will take you through the contract specifications given by Indian Commodity Exchange. Just for

an example I have downloaded the cotton futures contract of multi commodity exchange so let’s

go to understand the more on this particular. At this point I would like to mention something

from my experience as a teacher of Commodity Derivatives and Risk Management at IIT Kharagpur,

I have initially when I was offering this particular subject to MBA students and dual

degree financial engineering students, I did not spent you know I did not elaborate in

detail different aspects of this contract specification and students use to come to

me and ask for clarifications at a later point of time. So, I realized that I need to spend

little longer in explaining the forward contract, sorry the details given in the futures contract

specification. 11:53)

So today you know we will be spending in this particular session we will be spending the

remaining part of this session and understanding various aspects or various details in this

futures contract specification. So this as you can see you know from the screen, this

is the contract specification for cotton and its not for any cotton it is 29 MM. So, what

is the description, this is cotton MMYY, contract listing so contract listing is contracts are

available as per the contract launch calendar.

13:31)

Let us go to what exactly a contract launch calendar means. This is a contract launch

calendar. So this particular contract launch month and contract expiry month, this has

got two tables. So, one table has two columns so you have August 2015 and January 2016 respectively

so that means during August 2015 a trader whose interested to take long or short position

can enter into a contract which is maturing on January 2016. Similarly, A trader in the

month of 2015 can enter into a contract which is maturing in February 2016. He is also free

to take a contract on January 2016. So, during September 2015 a trader can enter into January

2016 contract or February 2016 contract. Similarly, let us understand today we are

recording this particular session on 10th June 2016 so today if a trader or I, let us

say I, want to take a cotton take cotton futures contract, I am free to take contracts in the

month of June for the month of June 2016. I can also take a contract on long or short

futures contract depending on my expectations or my interest. I can take July contract,

I can also take October 2016 contract or I can take November 2016 contract or December

2016 contract. So these five contracts are available to me to at this point of time.

And this June contract 2016 contract will come to an end at the last working day of

the month. So from where I got this information so that is last trading day last calendar

day of the contract month, if the last calendar day is a holiday or Saturday then preceding

working day. So this month of June whichever is the last working day this contract will

come to an end. 15:54)

More about trading period Mondays through Fridays. Training sessions again Monday through

Friday 10 AM to 9.30 PM. Trading Unit Trading Unit is 25bales, so, if I am interested to

take long or short futures contract, minimum one contract will have a minimum 25 bales

as a underlying. So it is like a if I want to take futures contract for one unit that

means I am willing to buy or sale cotton for 25 bales. And what is a bale? Bale has consist

of 170 kilograms of cotton and quotation based value. So whenever I will be quoting, when

I will be giving a buy or sell order I will not be giving for 25 bales but I will be quoting

it for 1 bale. What is the maximum order size? Maximum order

size is 1200 bales. So, in a given order I will be able to if at a single point of time

I can order let us so 1200 bales divided by 25, so that comes to 48, so I can order for

maximum 48 contracts at a single order. Minimum Tick size: Tick size is the minimum

difference on quotation so somebody can quote in let us say 12000, 12010, 12020 so on and

so forth. So a trader cannot quote anything in multiply multiplication of 5 or 2 or 1

or 3 so on and so forth. It has to be multiplied by 10 rupees, whatever may be the buy or sell

value a trader is interested to quote. And this price quote, this price quote is

X warehouse Rajkot within 100 kilometer radius excluding all taxes, duties levies charges

as applicable. So this means that whatever price a buyer or seller is quoting that means

the buyer will be as if taking delivery from Rajkot and the seller will be giving delivery

of the cotton at Rajkot. So, if the buyer or seller are interested to take or give,

give or take delivery at any other location will you know in other also some discount

or premium associated with it will discuss later.

17:19)

Daily price limit like circuit breakers in stock exchanges stock markets so you also

have a futures contract of daily price limits. So, this is daily price limit is mentioned

here so it is mention at to be a Daily Price Limit (DPL) of 4 percent, so commodity cotton

prices is cotton future prices is allowed to fluctuate within this range.

This is a very very important understanding, I must highlight at this point of time that

the futures market there is no there is no price limit but this particular price limit

is applicable to sorry in case the spot market there is no price limit so you know buyers

and sellers can agree on any price there is because these are spot markets are not for

exchange traded. So you have no price limit for spot market. Spot market price can go

up or go down depending upon the demand supply situation at that point of time.

But, in case of the futures contract, futures contract have their daily price limit. Initial

margin initial so when a buyer a a trader takes a long or short position short futures

position, they have to deposit the initial margins. So, Initial margin of 4 percent is

mentioned so let us how exactly this initial margin 4 percent let us say this initial margin

let us say a trader took two long a trader took long futures in two contracts that is

50 bales at a price of 19130 rupees per bale. So, total amount he has to pay 4 percent of

this total amount as a initial margin so that comes to around 38260 rupees.

So, and one important understanding is that both long futures and short futures party

have to deposit the margin. It is not that only one party will pay and the other party

will not be depositing. Both initial margin has to be deposited by both parties. There

is also extreme loss margin, another type of margin there is additional and special

margin, I will discuss all this little later. And Maximum Allowable Open Position, so what

is exactly for a individual client 150000 bales. So if I, if I as a as a client I am

interested to take long or short futures position in the cotton futures contract, at a given

point of time I can have that many long and short features contract such that such that

my total, the total underlying will be equal to 15000 bales.

So, as a Individual trader let me make it bigger so on this particular note individual

trader can have maximum long or short position for 125000 bales, so he can have 6000 contracts

for all maturity. Let us say if today I have a, I can take long or short futures contract

on June contract, July contract, October, November, December contract. So, across all

these 5 contracts, both short as well as long position I can I can have maximum I can have

6000 contracts against my name. And, also there is another limit which is

set by the exchange, so for near month delivery for individual client some 37500 maximum are

37500 bales can be kept. So, out of this 6000 open position a trader can have a maximum

long or short position, a long or short position for let us say 1500 contracts that is 37500

bales divided by 25 bales so you can have a maximum 1500 contracts for the near month

contract that the contract which is going to mature immediately.

So, today 10 June the contract which is maturing on June 2016 is the near most or nearest contract,

so that particular contract if I take long futures or short futures , so at a given point

of time I cannot have more than 1500 contracts open against my name or my client code.

Delivery Unit: So, let us say I am interested to deliver I have taken, let us say I have

taken short features and I am interested to deliver the underlying. So I can deliver multiples

of 100 bales and so it has liable margin of plus minus 7 percent, so that means I can

deliver anywhere between 93 bales to 93 bales to 107 bales in multiplication of 93 bales

to 107 bales where I can deliver or where I can take delivery a trader can take, where

trader can deliver the underlying or take delivery that is the place called Rajkot in

Gujarat. A trader can also a trader can also deliver

that is a long futures, sorry short features position holder can also deliver in other

centers that is these are the additional delivery centers. Now we are talking about Quality

aspects. In the 29 MM this particular a panel shows the detailed to which, the underlined

commodity satisfies the detail quality specification who is the underlying commodity has to satisfy

for you know to be traded in this in the exchange. Not only the underlying commodity how the

baling has to be done that is also mentioned and crop condition only current session season

Indian crop is deliverable so only current season Indian crop is deliverable. And if

a particular trader has suppose a has already imported certain cotton from somewhere else

he cannot he cannot use the exchange platform for selling or delivering that cotton. Or

even older last year cotton if they have stored those older cotton that is also not available

for delivery. Delivery Period Margin that is 24-25 percent

so, before the contract comes to an before the contract expiry the contract enters into

a delivery period. So, during that delivery period whichever party has a long or short

futures position, they have to deposit margin that is called your delivery period margin

that is to the tune of 25 percent of the total underlying what they are holding at that point

of time. So, this is the Due Date Rate. This is also

known as final settlement price. So on the contract delivery date sorry contract maturity

date there will be no futures quotation for that contract and the spot price will be used

for all settlement and all you know all payment related calculations so how exactly the spot

price will be arrived on the contract delivery rate delivery date sorry how the spot price

will be calculated on the contract maturity date that is mentioned here as a due date

rate. So basically this is the let me read out the

due date rate shall be arrived by taking the simple average of last three trading days

polled spot prices that is E0, E1, E2 of Rajkot in the in the event of spot price for any

one of the E minus 1, E minus 2 that is let me repeat once again the due date rate shall

be arrived by taking simple average of last three trading days polled spot prices. So

if today let us say 29 of June is going to be the contract maturity date, so 28 June,

27 June and 26 June prices will be used to arrive at the spot price.

And, how this 27 June, 26 June28, 26 June will be collected the exchange will have exchange

sets up a mechanism by which they polls from major cotton traders processors, consumers

etc. from then it collects it does a poll from it does the averaging of it and that

becomes the spot price that becomes a spot price to prevail on the contract maturity

day that is on 29 June 2016. Delivery Logic is compulsory delivery I will come to this

aspect little later. So for this session will wind up understanding

different aspect of the contract specification the in the next session we will discuss the

delivery and settlement procedure of cotton and whatever we have not been able to discuss

as part of the futures contract specification. Thank you all of you.