Research proposal

Effect of commodity derivative trading on the economy of India

(Effect of having commodity as an asset class)

In partial fulfillment for the requirement of the course

“PhD in Management (finance)”

DPM Full Time (2009-2012)

Submitted to:

Prof. Mallikarjun

Submitted by:

Biswajit kumar (093102)

 Executive summary

Commodities are the physical goods used in the initial phase of the manufacturing process. They are goods that almost everyone in the world uses

on a daily basis, such as oil, natural gas, wheat, soybeans, aluminum, copper, and silver.

In recent times there have been lots of discussions regarding the effect of commodity derivative trading in rising inflation in the country. Dr.

Abhijit Sen committee was set up to find out whether the commodity futures has a role to play in the inflation. The conclusion was inconclusive.

Wheat, Rice, Urad and Tur has been banned from commodity futures trading under the impression that the step will lead to control the inflation

rate.

In this study the main aim would be to test the effect of commodity derivative trading on the economy of India. Though commodity

derivatives are relatively new India, we can bench mark the performance against some of the developed nation and emerging economies. We will

assume that the economic development and financial development of a country are positively correlated.

First of all, we will test the efficiency of the commodity market and check the mean reversal nature of the commodity prices, and then

we will attempt to form a model, based on data from the pre and post ban period, to correlate the derivative market development with economic

development.

The effect of commodity derivative on the stabilization of the spot price of the underlying can be studied.

The effect of incorporating commodity as an asset class in investment portfolio and its correlation with other assets needs to be

considered in depth.

The primary aim of the derivative instruments is to hedge the risk. We will try to understand how speculators and arbitrageurs affect

the hedging process. The financial effect on the different styles of traders with regard to the process will be studied. The role of institutional

investors in rising commodity prices is worth studying.

The various theoretical trends and cycles proposed by chartists will be studied to understand the forecasting potential in the market

and how it will affect the economy in the short and long run.

Consequence of leverage will be measured in detail.

It is often argued that Derivatives Take Money out of Productive Processes and Never Put Anything Back. We will seek to check the

veracity of this statement.

 There are various risks associated with the derivatives. There are credit risks, operating risks, market risks, and so on. We will make

an analysis of these risks and try to find out methods to minimize them.

Finally we will review the regulatory process and study the effect of bringing new commodity derivatives.

Thus the main topics covered in our study will be:

 Critical evaluation of inter-relation between Commodity Futures and Spot Markets.

 Critical examination of Indian Commodity Markets with focus on Agricultural Spot Market.

 Critical evaluation of the performance of Indian Commodity Future Markets and the needs and scope of reforms.

 Efficiency and performance of future trading in agricultural commodities and the impact of government intervention (physical and

future markets) on the growth and development of agricultural commodity futures.

 Regulatory landscape of Indian Commodity Market with special reference to APMC Act and FCR Act: Scope for synergy and

Convergence

 Commodity Markets :Future prospects.

 Impact of government interventions (physical and futures markets) on Growth and Development of Agricultural Commodity Futures.

 The availability of information and its impact on Commodity futures.

 WDRA and the Need for its convergence with FCRA

 Emergence of Commodities as an Investment Class

 We will try to explore the necessity of Commodity Market for the Indian economy, if at all. A study of the Indian Scenario in context

of globalization of Commodity Markets will also be done.

 Volatility and Forecasts of Commodity Markets in India

 Effect of Reforms on the Indian Commodity Futures Markets and Their Integration into the World Economy

 Critical evaluation of the performance of Indian Commodity Exchanges

 Indian Commodity Market: Need for Customer awareness and education

 Forecasting Commodity Futures Prices

 Factors Affecting Commodity Forward Pricing Decisions

 Food Security and Indian Commodity Market

 Impact of Commodity Markets on Production of Agricultural Commodities

 Future Trading Activity and Commodity Cash Price Volatility: Evidence from India

 Price Discovery and Convergence in Futures and Spot Commodity Markets in India

 Impact of Futures Trading on Commodity Prices

 Price Convergence in Agricultural Commodity

We can test Price Convergence in Agricultural Commodity Markets that is the degree to which commodity prices have converged on

world commodity markets over recent decades. Ideally, increases in communications, central bank activities, and globalization would
 suggest that commodity prices in spatially dispersed markets should become similar over time.Convergence, correlation, regression,

cointegration, and vector autoregressive methods can be employed. To measure comparable geographic data can be assembled for

selected commodities covering a reasonable amount of the period.

 Efficiency Analysis of Futures Markets in Indian Agricultural Commodities

 Reforms in Indian Commodity Exchanges: Regulatory Interface between the State and the Market

 Any other relevant research on Commodity Markets

Market Micro-structure and Design

 How do we measure transaction costs? What determines market impact cost? What determines the cross-sectional and time-series

variation of transactions costs in India?

 How does discreteness (tick size, market lot / contract size) matter in price formation? What is the "optimal" discreteness?

 How do price limits and trading halts matter in price formation? How should they be optimised

 How does the pre-opening and post-closing call auction impact on price formation? What is the role for the call auction in market

design?

 Does leverage help or hinder liquidity and market efficiency? What is the evidence about the impact of changing margin regimes on

India's commodity market?

 How does fragmentation of liquidity across trading venues matter?

 How should systems and procedures be constructed for market surveillance? How do we detect manipulative actions and what are

the effective tools for blocking them?

 How should exchanges be governed? What is the empirical evidence about the impact of conflicts of interest in exchange

governance, upon market outcomes?

 How are exchanges financed, and can their financing patterns be improved?

 How has the depository impacted on overall transaction costs? How do transaction costs in India's commodity markets compare

against the lowest levels seen internationally? Is it possible to control market size in this comparison?

 Does location affect transaction costs for investors? Has there been any change over the last five years?

 How does the emergence of bank/custodian depository participants, who are providing comprehensive funds and securities services,

affect the role of traditional brokers?

 To what extent will the emergence of internet-based electronic trading, clearing & settlement affect intermediation?

 How do we evaluate the choices between rolling settlement, account period (with or without badla), and RTGS? How do each of

these impact on liquidity and market efficiency?

 How do anticipated and unanticipated disruptions in trading matter? What is the role for round-the-clock trading?

 How can contingency plans be made to maximise continuity of trading? What is the cost-benefit analysis of contingency plans?

 Can we evaluate the computer and communications systems that are used in India's financial system? What technological

innovations should be applied into improving market design?

The study as a addition to already available body of knowledge:

Although there is a large body of literature which indicates that futures trading is associated with low volatility of spot prices-intra seasonal, inter

year and long term, and help in production planning of these commodities, more recent evidence is mixed even in the US. In view of these

markets having a potentially important role in efficiency of the market in free and liberalized economy, it is important to take steps to contain

potential adverse impact on spot prices and also to dispel the negative perception about the market. With the complete lifting of prohibition on

futures trading in 2003, in the real sense these commodity markets have been opened up only recently. They have yet to make a significant

headway. There are not many empirical studies available so far which have examined the role of these markets in the agricultural economy of the

country.


 Executive summary.............................................................................................................................2
Market Micro-structure and Design.............................................................................................................4
Testing market efficiency..........................................................................................................................10
GOVERNMENT CONTROL...................................................................................................................13
PRICING OF FUTURE CONTRACTS....................................................................................................13
HEDGING, SPECULATION, ARBITRAGE...........................................................................................14
VOLATILITY...........................................................................................................................................15
TRADING.................................................................................................................................................17
Behavioral Patterns....................................................................................................................................18
Commodities as an asset class and its impact on the economy..................................................................28
CORRELATION WITH OTHER ASSET CLASS...................................................................................29
INFLATION..............................................................................................................................................30
RATIONAL EXPECTATION AND PRICE DETERMINATION, NEWS..............................................32
EFFECT OF COMMODITY DERIVATIVES ON THE ECONOMY OF THE COUNTRY...................33
SPOT PRICE DETERMINATION...........................................................................................................35
Regulatory measures.................................................................................................................................36
Effect of margin trading (leverage)............................................................................................................39
Risk Management Lessons in Leveraged Commodity Futures Trading.....................................................39
A computational approach to modeling commodity markets.....................................................................40
Risk management through Commodity derivatives...................................................................................41
Mark to market..........................................................................................................................................44
Settlement..................................................................................................................................................49
Commodity price forecasting....................................................................................................................51
Price discovery...........................................................................................................................................52
Investor Protection....................................................................................................................................53
The future prospects.................................................................................................................................54
Bibilography..............................................................................................................................................56
Economic Benefits of the Derivative Trading in Commodities and its Prospects:

Futures contracts perform two important functions of price discovery and risk management with reference to the given commodity. It is useful to

all segments of economy. It is useful to producer because he can get an idea of the price likely to prevail at a future point of time and therefore

can decide between various competing commodities, the best that suits him. It enables the consumer get an idea of the price at which the

commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. The

futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in

quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to

hedge his risk by operating in futures market. Other benefits of futures trading are:

(i) Price stabilization-in times of violent price fluctuations - this mechanism dampens the peaks and lifts up the valleys i.e. the amplititude of

price variation is reduced.

(ii) Leads to integrated price structure throughout the country.

(iii) Facilitates lengthy and complex, production and manufacturing activities.

(iv) Helps balance in supply and demand position throughout the year.

(v) Encourages competition and acts as a price barometer to farmers and other trade functionaries.

Testing market efficiency

In financial markets, investors have access to common information sets and may employ similar techniques in evaluating this information.

Therefore, agents may behave in a similar manner, not through consciously following the actions of others, but through acting upon the same

information. However, such behavior, if deliberate, comes under the category of market manipulation and would lead to inefficiency in the

market

Origins of market efficiency and liquidity

Efficient market hypothesis can be evaluated by examining the revisions in the forecasts of prices, volatility and trading activity after new

information is released. If those revisions are equal to zero then the Efficient Market Hypothesis holds. These can be modeled through a VAR. If

the price discovery mechanism in the centralized exchange is efficient then the future prices are unbiased forecasts of spot market prices.

What could be interesting to study are:

(i) Has the efficiency of the commodity exchanges improved over the years?
The commodity market in India has gone through a series of reforms over the years that are likely to result in structural breaks during this period.

It would be interesting to see if some of these events have made the market more or less efficient. (ii) Has the speed of adjustment to news

changed over the years? The analysis using daily, weekly, and monthly data can be motivated by this question. If inefficiency of earlier years

based on longer frequencies (say weekly) disappears in the later period, some potential conclusions can be drawn.

(iii) Comparison with the US and the Chinese market is a potentially interesting exercise. However, given that government control is dominant in

the Chinese market, it may be worthwhile to add other emerging markets like Brazil and Mexico into the analysis .One could then study

“integration/contagion” of these markets.

In the recent times, the Indian stock market has witnessed increased volatility. One explanation of this has been the integration of the Indian stock

market with rest of the world wherein global shocks/news gets quickly absorbed not only in the country where the shocks originate but in other

countries as well. This angle can be explored by studying the co-movement of market indices of different countries.

1. How is news incorporated into prices in India? To what extent, do prices reflect forecasts of future risk and return, and nothing but

future risk and return? Can we measure the speed with which markets incorporate news into prices?

2. What is the evidence on returns forecasting in India? To what extent are the observed pathologies related to under-estimation of

transaction costs and data-mining biases? Does the picture change substantially if we use intra-day data?

3. Do returns forecasting strategies become less useful when they become widely known? Does economic research improve market

efficiency?

4. Why do we see persistence in volatility models? Is news auto co-related or are markets slow in absorbing information?

5. How do disclosure laws impact on market efficiency? In the past, when disclosure laws (or rules of information publication at the

exchange) were changed in India, how did it impact on market efficiency?

 6. When the same product is traded on two or more markets, what drives the joint movement of both prices? Are there lead-lag

relationships? What is the "no-arbitrage band", and what are its components? What is the "information share"? Does fragmentation of

markets help or hurt?

7. How does trading of Indian securities outside India impact upon price formation in India?

8. How does our understanding about the interplay between transactions costs and market efficiency generalise with costs in clearing and

settlement?

We can look at the sources, empirical evidence and implications of mean reversion in asset prices. As for the sources of mean reversion, there are

three aspects to be discussed. Firstly and most importantly, the correlation between the convenience yield and spot prices accounts for mean

reversion. Secondly, spot price level dependent time-varying risk premia have a mean-reverting impact on prices and thirdly, a negative relation

between interest rates and prices induces mean reversion. We will tackle the link between mean reversion and convenience yields as well as with

time-varying risk premia. The understanding will lead us to understand the optimal hedging ratio for the mean reverting commodities.
GOVERNMENT CONTROL

Commodity exchange commission and act

We will try to assess the effectiveness of the ban on curbing inflation in certain agricultural commodities. Given that the futures prices were

almost always higher than the spot prices as far as agricultural commodities are concerned, the ban is likely to bring down the prices of food

grains.

However, whether the ban will help in curtailing overall inflation or merely act as a stopgap measure bringing down prices of agricultural

commodities alone, leaving the farmers faced with lower incomes and higher price levels for nonagricultural commodities is a question that can

be answered only by an examination of real causes of the current inflation phenomenon. Between 2004-05 and 2005-06 there has been an

acceleration in growth of broad money (M3) from 12.3% to 17%.. This rapid growth cannot be attributed merely to the presence of future traders.

There are and fiscal factors like increased credit availability which are at the root of the phenomenon. Banning futures trading without attending

to these real causes will merely bring down price of agricultural products without causing a corresponding deflation for non-agricultural products.

This will lead to a highly inequitable result, leaving the farmers at a worsened position.

We will try to study the impact of the ban on the volatility of the commodities and also its impact on Farmers

It has been pointed out in the previous section how ban on futures trading in agricultural commodities, without initiating steps to attend to the real

causes of inflation will leave the farmers in a worsened situation. However, it is to be noted here that

Crop insurance, support price

PRICING OF FUTURE CONTRACTS

HEDGING, SPECULATION, ARBITRAGE

How much of speculative capital is involved in the market?

Why is liquidity good?

We will try to find out how the strategies of different fund managers taking positions according to their own portfolio needs add to the market

liquidity. Sometimes when the demand and supply situation clearly point in the same direction the large market participants deliberately or

coincidentally act together. We will try to find out the net effect of such moves. We will also try to see how the role of passive investors such as

index funds is different from traditional hedgers and speculators.

Assume a hedge carried in a future from time t 1 to time t 2 (where the future specifies delivery at t 3 ) against x units of inventory purchased at

t 1 and sold at t 2. Let s1 and s2 denote the spot price and f1 and f2 denote the price of the future that exists at t1and t2 respectively. The hedge

will make a total gain (loss) arising from price movements from t 1 tot 2 equal to the positive (negative) value of x[(s2-s1) – (f2 – f1)]. The hedge

is perfectly effective if [(s2-s1) – (f2 – f1)] is equal to zero.

VOLATILITY

Establishing causality between Speculation, hedging, arbitrage and Price volatility

We will try to establish whether there is any observation of causal relationship between the speculative activity and the price volatility .If at all it

is there is this due to different speed with which market participants react to new market information. Speculators seem to anticipate and react

quicker than any other futures market participant, and they are considered to be the reasons that trigger a particular market event which would

have occurred in any case. We will try to test the hypothesis that if future prices move away from fundamentals, the speculative activity of

arbitrageurs would soon restore the efficient conditions in futures market.

The study of the causality will help us decide that it is the trading activity that drives the volatility or the opposite.

 Effect of speculation on distortion of price discovery mechanism in the short run and long run.

 Effect of arbitrage forces in assuring that market fundamentals will be fully reflected in futures prices.

 The effect speculators have on forward premium (the difference between forward and expected spot prices).

The data sets needed like information on commodity prices volume for the five nearest future contract etc. can be acquired from the websites of

MCX and NCDX.

The daily volatility in the market will be calculated using the

 ‘Corrected’ Parkinson Scaled Range Measure.

Simulation of the release of news can be done by use of

 Price Shock mechanism.

The results from this study will help us establish if the new market in information is incorporated instantaneously. If it is so, nobody can forecast

commodity exchange prices using all public available information and hence, traders cannot profit from any trading mechanism attempting to

forecast prices.

We will try to study the impact of futures trading in three or four important commodities which were banned by the government from trading in

futures and their impact on spot prices. The study will use

 simple linear regressions,

  correlation

 Granger Causality tests

The study will also try to find if the seasonal/cyclical fluctuations in these commodities prices have been affected by the introduction of futures in

those commodities.

To differentiate the general trend and seasonal/cyclical fluctuations in prices we will use

 Hodrick-Prescott filter

We will try to find out if the effect is same on all the commodities. The study will determine if the introduction of futures in selected commodities

have helped in reducing seasonal/cyclical fluctuations in prices. It will also find whether futures have increased the volatilities in the spot market

for some of the commodities.

TRADING

The winners and losers of the Zero-sum game: The origins of trading profits, Price efficiency and market liquidity. Lawrence Harris.

1 Who wins and who loses in the trade

2 Types of traders

3 Scope or manipulation
Behavioral Patterns

Some of the known behavioral patterns are:

Herding commodity index investors tend to behave like herds, subject to irrational manias when commodities are on the rise and inclined to

panic fire sales when commodities start declining (see the chart representing inflows to commodity indices above). This type of attitude

inevitably creates systemic risk in commodity markets. As excessive price volatility hits large segments of the industry, threatens the livelihoods

of billions of poor farmers or consumers in the developing world and endangers the political and social stability of vulnerable commodity-

producing or importing countries, a fierce regulatory response is to be expected.

Interference effect –booking profits prematurely out of anxiety even when they book a gain, though good at taking (appropriate) loss.

Overtrading due to feeling of internal pressures to make money without considering the conditions- Trading when volatility is low, trading

outside one’s trading plan or strengths, trading to make up a loss, and trading imprudently large size are examples of overtrading.

Traders comfortable at one level of size (e.g., 5 contracts) frequently re-encounter it once they meaningfully increase their size (50 contracts).  

We generally calibrate our emotions by the dollar amounts we make or lose.  This makes a fifty contract trade much more difficult for traders

than a five contract trade, even though the setups may be identical.

Takes Advantage of Mass Psychology:

Markets, which are always changing, are only our subjective expectations reflected objectively. Interestingly, people's reactions to change always

remain the same (i.e., they bet wrong as a group). Trend following takes advantage of 'panicky sheep' behavior to make money.

Strict discipline minimizes behavioral biases. It solves our eagerness to realize gains and reluctance to crystallize losses. Too many people believe

what pleases them and social conformity means that even if the group is wrong, we go along. Most behaviors are simply driven by the impulsive

moment of now. They aren't purposeful, thought-out choices. Trend following wins because of that.

A structured questionnaire can be prepared to test the various types of behavioral patterns prevalent among the traders (market participants). Then

we can analyse as to how the trend following affects the overall dynamics of the market.
Stylized traders Description Speed and Trading goal Information resources Effect on price Effect on Trading style profits Trading loses

turnover efficiency liquidity from to

Panel A- The winners. If skilled, these traders will profit in the long run.
Value-motivated Speculate on Slow acting Expected The available stock of Causes price to reflect Supply depth to Uninformed traders Informed

traders opinions about Low turnover profits fundamental valuation fundamental values dealers and traders with

 Informed value obtained data rendered into uninformed more current

investors from analysis of information by traders at the information.

 Stock pickers micro- and analysis outside spread Value-

 Asset macroeconomic motivated

allocators fundamental traders with

 Value information superior

investors analyses

Inside informed traders

 Headline

traders

 Event studies

traders

 Risk

arbitrageurs

 Inside trader
Market-makers

Dealers

Scalpers

Day traders
Upstairs position traders
Block positioners

Block facilitator
Parasitic traders

Quote matchers

Front runners
Electronic proprietary

traders
Pure arbitrageurs

Index enhancer
Statistical arbitrageurs

Pair traders
Technical traders

Chartists

Contrarians

Momentum traders

Trend traders
Bluffer market

Manipulators

“Pure traders”

Stylized traders Description Speed and Trading goal Information resources Effect on price Effect on Trading style profits Trading loses

turnover efficiency liquidity from to

Panel B- Traders who expect to lose in the long run from trading. They trade for other reason.
Uninformed investors

Indexes

Passive traders
Exchangers
Hedgers
Gamblers
Fledglings
Cross-subsidisers
Stylized traders Description Speed and Trading goal Information resources Effect on price Effect on Trading style profits Trading loses

turnover efficiency liquidity from to

Panel C- Losers who expect to profit from trading but will not. These traders cannot recognize or refuse to recognize the contraction
Inefficient traders

Unskilled traders

Poorly informed traders

Pseudo informed traders

(a notable type of

inefficient traders)
Victimized traders
Trading styles

Role of information in trading

Psychology of traders

government control, correlation, inflation, hedging, speculation , arbitrge

efficiency, volatility, inflation, trading,technical,trends and waves,as an asset class and impact on economy,rational expectation and price

determination, news
TECHNICAL ANALYSIS

(Trend-following trading strategies in commodity futures: An examination)

In this trading strategy study, we ask three questions. First, does momentum exist in commodity exchange markets? Second, what is the impact of

transactions costs on excess returns? And, third, can a consolidated trading signal garner excess returns and, if so, what is the source of such

returns?

We will examine the performance of trend-following trading strategies in commodity futures markets using a monthly dataset spanning 4 years

and in main exchange markets and see if they yield positive mean excess returns net of transactions cost. We can then pool our results across

markets, and see if all of the trading rules earn hugely significant positive returns that prevail over most subperiods of the data as well.

The types of trading strategies that may be studied include:

 Scalping

 Fading

 Daily pivot

 Momentum

 Turtle trading

 Long Term Investing

 Position / Trend Trading

 Swing Trading

 Day Trading

 Futures Day Trading

These trading strategies may be based on:

 Basic Technical Analysis

 Dow Theory

 Elliott Wave Theory

 Japanese Candlestick

 Multiple Time Frame

 Trading activity and price reversals in futures markets

We will try to find out whether trend-following trading systems were profitable on average over the chosen markets and that there is an

exploitable trend component in market price action. It is said that by using a more sophisticated trading system and trading it in a more carefully

chosen selection of markets, one can improve results substantially. We will try to check if it’s true.

As regarding what price components should to use to construct the indicator, there are four choices: the open, high, low and close. They can be

used separately or in combination.

Our research can help determine whether one or more price components does a better job of indicating trend than the others? Or are they all

equivalent in trend-identifying ability?

Momentum

It uses only the closing price in its calculation.

To calculate Momentum, first the time period over which we want to measure trend needs to be determined. Then we compare today's close with

the close at the beginning of our chosen time period (say, 34 days). If today's close is lower, the trend is down. If today's close is higher, the trend

is up. If today's close is the same, the trend is the same as it was the previous day.

Using the Momentum-based trading system we will try to find out whether the market was profitable

Directional Movement

This method of identifying trend was created by Welles Wilder and described in his 1978 book, New Concepts in Technical Trading Systems.

Unlike Momentum, which uses only the closing price, Directional Movement uses only the high and the low price. It is fairly complicated

mathematically, and therefore, we cannot eyeball it on charts.

Directional movement compares the portion of today's price bar that moves beyond yesterday's. If today's high and low are greater than

yesterday's, the portion of the today's bar that extends above yesterday's is the up directional movement. If today's high and low are less than

yesterday's, the portion of the today's bar that extends below yesterday's is the down directional movement. For an inside day (where today's high

is lower and today's low is higher than yesterday's), there is no directional movement. For an outside day (where today's high is higher and today's

low is lower than yesterday's), the day's directional movement is the larger of the up or down directional movement as defined above. Up

directional movement is positive; down directional movement is negative.

To calculate the indicator, we need to find the total directional movement over the time period we selected for measurement. If it is positive, the

trend is up. If negative, the trend is down. Just as with Momentum, the concept makes intuitive sense. If price is trending up, one would expect

the preponderance of daily bars to have higher highs than the day before, and vice versa.

Open/Close Indicator

It looks at the relationship between the opening price and the closing price on the same day.

In an uptrending market, the close is most often higher than the open. In a downtrending market, the close tends to fall below the open. By

comparing the sum of the closes with the sum of the opens over the trend time period you have selected, we get a good indication of the trend

based on the relationship of the opens and closes.

Combination Indicator

The last test attempts to use all four available data points (open, high, low and close) to determine trend. Its indicator is the combination of

Momentum, Directional Movement and Open/Close. When all three indicators (measured over 34 days) point up at once, the Combination trend

is up. It stays up until all three indicators point down at once. At that point, the trend changes to down.

From the results of these tests we will see if there is any indication of which one is the best trend indicator.

We can use the standard contrarian portfolio approach to examine short-horizon return predictability in the Indian commodity futures markets.

We will try to find out if there is any evidence of weekly return reversals, similar to the findings from equity market studies. We will look at the
interaction between past returns and lagged changes in trading activity (volume and/or open interest), and try to find out the nature of association

of the profits to contrarian portfolio strategies with lagged changes in trading volume and to lagged changes in open interest. Our study will help

to establish whether futures market overreaction exists, and both past prices and trading activity contain useful information about future market

movements. These findings will have implications for futures market efficiency and are useful for futures market participants, particularly

commodity pool operators.

TRENDS AND WAVES

It has been reported in various literature that when the market is moving upwards, the movement of the security is in form of five waves which

are as follows:

Wave 1

The security makes its initial move up. Generally due to it being undervalued and traders believe its time to buy.

Wave 2

After a rise, some people now start taking profits. This causes the price to go down. As more people start to see the security still being

undervalued, the price does not drop to its prior low.

Wave 3

This is generally the longest wave. It has become a "popular" security, and more people want in and they buy it for a higher and higher price. This

wave exceeds the peaks created at the end of wave 1.

Wave 4

At this point people again take profits and some people may start seeing the security overvalued. This wave tends to be weak because there are

usually more people that are still bullish on the security and after some profit taking comes wave 5.

Wave 5

This is where most people jump on the bandwagon, and is mostly driven by emotion. People will carelessly purchase the security trying to catch

the wave. This is where the security becomes the most overpriced. As more people jump in trying to ride the wave, the price drives up and gets

even more overpriced. Then the security will move into either one of two patterns; an correction, or starting again with wave 1.

An correction is when the security is overpriced, in the mindset of current investors. Some people will take their profits now, thinking a reversal

is overdue. This drops the price. Yet, some people will still buy, driving the price back up, especially if they still consider the stock a good value

or undervalued. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the

market is taking a pause while fundamentals catch up.

The above description applies to a market moving upwards. In a down market generally the same types of behavior in reverse is seen.

There may be more than one ABC correction or if the security is overvalued it could reverse and start a 5 wave down cycle. In general, an odd

number of corrections indicate a continuance to the uptrend while an even number of corrections indicate a reversal and a downtrend starting.
Commodities as an asset class and its impact on the economy.

Using commodities to diversify and improve efficiency of the portfolio.

The benefits of commodities in a portfolioInstitutional investor interest in commodities has increased significantly during this decade. In our view

this reflects a much lower investmentreturns environment in this decade compared to the 1990s as well as powerful cyclical andstructural forces

working in favour of commodities.

As an asset class, commodities have historically displayed a low or negative correlation withstocks and bonds, delivering naturally

occurringreturns and providing protection in the event of geopolitical or inflationary shocks. As a result, these unique properties of commodities

can make them an attractive addition to an investor portfolio.

Commodities are fundamentally different from stocks and bonds. While they are investable assets, they are not capital assets. Commodities do

not generate a stream of dividends, interest payments, or other income that can be discounted in order to calculate a net present value. The

Capital Asset Pricing Model does not apply to a bushel of corn. Rather, commodities are valued because they can be consumed or transformed

into something else which can be consumed.

What has changed significantly during this decade is the growing popularity of commodities as a distinct asset class. However, there have been

many routes investors have used to gain commodity exposure. The most common approach historically has been via equity investment in major

exchange-listed commodity producing companies. Other vehicles have included owning physical assets such as forests, pipelines or royalty trusts

or investing in resource-economy currencies such as the Australian and Canadian dollars. However, the emergence of commodity index products

as well as

Exchange Traded Funds including Exchange Traded Commodities over the past years has increased the

popularity of commodity exposure via these routes.

One of the benefits of investing in commodities via an

index is that an investor can gain exposure to a broad

range of commodities, which tends to enhance

diversification, reduce volatility and maximise the Sharpe

ratio. In addition, index investment can exploit the

benefits of downward sloping forward curves, which

delivering a positive return. Equity investment,

meanwhile, has tended to be unable to give broad

exposure to the entire commodity complex. Rather, it

provides an investor exposure to just one sector or simply

one commodity. In this article we outline the properties

of commodities and how the inclusion of commodities in

a portfolio can enhance returns, reduce volatility and

hence enhance risk adjusted returns.

Commodities are a unique asset class that can provide valuable diversification benefits to an investment portfolio. Used in combination with

traditional assets like stocks and bonds, they can potentially reduce overall portfolio long-term risk while increasing upside potential.

Whether commodity derivatives act as a hedge against event risk can be tested by examining the cumulative returns for bonds, equities and

commodities during periods of either fixed income or equity market distress, which we define as a month where returns are negative.

There are two primary reasons for adding commodities to a portfolio:

 Diversification and

 Inflation protection.

Diversification

Commodity prices and prices for stocks and bonds respond differently to changes in market and economic conditions. The difference in how they

respond to these global events and the timing of those responses can provide commodities with valuable benefits when combined with other

financial assets. While diversification may not necessarily protect against market risk, the historically low correlation between commodities and

financial assets means that commodities may perform well in neutral or negative years for stocks and bonds. As such, commodities, while

historically volatile in terms of their returns, can actually lower the overall volatility of a portfolio. The Importance of Correlations to Portfolio

Risk and Return When thinking about building a diversified portfolio, remember the old adage, “Don’t put all your eggs in one basket.”

Diversification is not only about the number of investments in your portfolio, it’s also about the relationships among those investments. Adding

one more technology stock to a portfolio comprising only 15 other technology stocks is not a particularly diversifying move. If the technology

sector faces a downturn, the portfolio value will decrease no matter how many different technology stocks are in it. A better approach is to build a

portfolio whose individual elements tend not to move in lockstep in response to changing market conditions, so that there is built-in “buffers” if

certain asset classes, sectors, or styles should suffer.

CORRELATION WITH OTHER ASSET CLASS

Correlation values range between -1 and +1. Assets that have an inverse relationship, or move in exact opposite directions, will have a correlation

of -1, while those that move in the same direction in tandem will have a correlation of +1. A correlation of 0 implies that there is no relationship.

If commodities have low historical correlations to stocks and bonds, they can be a good choice to lower your overall portfolio risk while

enhancing your potential for better long-term risk adjusted returns .

Inflation Protection

(Inflation as a hedge against Inflation)

We can look at the performance of stocks and bonds during times of inflations and compare it with the performance of commodities.

Commodities should perform well because they are closely liked to rising prices in essential goods. If it is found that during inflation periods

from 1990-2009 stocks and bonds have generally moved in the opposite direction from inflation while commodities moved in the same direction

then we can conclude that investors can use commodities as part of an inflation hedging strategy.

INFLATION

We will try to establish if there is any direct correlation between future trading and inflation. It is proposed that the inflation is brought about by

the presence of basis (the difference between spot and future prices). In usual cases, the futures prices are higher than spot prices (In support of

this proposition, see market data for different commodities and different dates available at www.ncdex.org). The cause of this phenomenon is the

presence of speculation and positive expectations. However, in certain commodities where speculation is negative, futures prices are lower than

the spot prices. This difference in spot and futures prices is capable of causing a shit in the demand-supply mechanisms in favour of a particular

time period to the prejudice of the other. For instance, when futures prices are higher than spot prices for an agricultural commodity, the farmers

would like to sell the commodity in future, bringing down the supply levels at present. However, the lower prices at present compared to future

prices prompts a high demand for the commodity at present. This mechanism causes excess demand in the present time period and pushes up the

price of the commodity in question, thereby causing higher levels of inflation.

Subject to the futures market being inefficient and the subsequent mispricing leading to a social loss in terms of welfare, regression for testing the

hypothesis that mispricing of commodity futures contracts leads to inflation can be performed. For this wholesale price index inflation can be

regressed on the growth in volumes of trade in leading two future exchanges in India NCDEX and MCX, growth in money supply (M3) and

growth in oil price index. The latter two are perceived to be important determinants of inflation in an economy. The null hypothesis that inflation

is caused by the growth in volumes of trade in futures market can be rejected in case the co-efficient corresponding to the same is significant in

the regression.
Why In vest in Commodities as opposed to Commodity Producers?

Some investors think they are gaining exposure to commodities when they invest in the common stocks of commodity producers. However, for a

number of reasons, the performance of producer stocks and commodities often diverge, so it is a bit of a misconception to think that when you

invest in a company like Exxon Mobil or Starbucks that you have direct exposure to oil or coffee prices. Buying a company’s equity securities

exposes an investor to a variety of factors, including their specific financial and operational risk. In addition, companies may hedge their

commodity exposure, thereby minimizing the impact changes in commodity prices have on their bottom line. The most effective way for an

investor to add commodity exposure to their portfolio is by directly investing in commodities, or a product that seeks to track a pure commodity

index. The chart in Figure 3 shows the annual returns of a hypothetical investment in oil directly, as represented by the S&P GSCI® Crude Oil

Total Return Index, and exposure to the stocks of oil companies, as represented by the Dow Jones U.S. Oil & Gas Index. As you can see,

historically these two indexes have not moved in lockstep and may have moved in different directions.

How do I get exposure to commodities?

Below is a brief summary of some common strategies for gaining commodity asset class exposure.

 While providing pure asset class exposure, owning physical commodities outright typically entails high transportation and storage

costs and is not cost effective or practical for most investors.

 Managed futures eliminate the transportation and storage costs but are best suited for institutional investors with the resources to meet

investment minimums and manage derivatives contracts.

 Commodity-indexed mutual funds provide a viable alternative for the individual investor, offering broad-based commodity exposure

with relatively low investment minimums.

 Commodities can be appropriate for investors looking for new ways to diversify their portfolio and who have a long-term time horizon

for investment. They can be an exciting asset class in which to invest, but also can be volatile. Speak with your financial professional

about how much exposure you may allocate based on your investment objectives, and how to select the most-appropriate investment

vehicle.

It is often argued that as popular as commodities may have been as investment assets, they cannot be called an asset class since much

of the total return is linked to the shape of the forward curve. By definition, an asset class consists of a portfolio of homogeneous

assets delivering a positive excess return above the risk-free rate in the long-run, corresponding to a “risk premium” or a reward for

the risk associated to the so-called “buy-and-hold” strategy. Obviously this property is not satisfied for a wide range of renewable

commodities, from agriculture to livestock markets.

 As regards depletable resources like metals and energy commodities, a price rise is certainly expected in the long-run as the result of

increasing extraction costs and the necessity of leaving a part of these resources to the use of future generations (see Hoteling’s

seminal paper The Economics of Exhaustible Resources). But, as illustrated by the recent booms and busts in the oil and metal prices,

commodity investors will have to ride across cycles of increased magnitude and frequency, due to supply rigidities and demand’s

ample variations in emerging countries.

When investors fully realize the harm inflicted by the contango and the reality of these regulatory threats, they will necessarily look

for alternatives to Commodities indices.

Two strategies make sense to gain exposure to commodities prices: active futures commodities management (potentially long or short

according to the contango, prices dynamics and macro fundamentals) or investment in the stocks of metals and energy producing

companies, which follow commodities price moves in the long run.

http://www.riskelia.com/blog/2010/02/do-commodities-represent-an-asset-class/

RATIONAL EXPECTATION AND PRICE DETERMINATION, NEWS

The purpose of this paper is to examine the implications of the rational expectations hypothesis for the econometric modeling of primary

commodity markets. Muth's Rational Expectations Hypothesis (REH) revolutionized economic theory and modeling on price formation in a

simple agricultural market. The author studied the results of the few econometric models of primary commodity markets that have incorporated

the REH. In a commodity price model, it is useful to distinguish between application of the REH to the physical production and consumption

relationships and its application to how intertemporal stockholding affects short term price determination. In practice, most econometric work has

concentrated on the implications of the REH for stock and price relationships.
EFFECT OF COMMODITY DERIVATIVES ON THE ECONOMY OF THE COUNTRY.

“Derivatives are financial weapons of mass destruction” Warren Buffet

The basic architecture of each derivative product (forward, future, options, swap ) is the same, whether it is “derived” from currencies,

commodities, interest rate products, or stock markets. Derivatives allow for economic agents –households, financial institutions, and

noneconomic firms – to avail themselves of the benefits of division of labor and comparative advantage at risk-bearing; but are derivatives

indeed value creating and contribute to the wealth of the nations?

Derivatives are Zero-sum games and what one side of a derivative contract loses the other side gains. There are examples of institutions,

which played in the derivative markets and lost big. For some of these unfortunate organizations, it was honest but flawed financial

engineering which brought them havoc. For others it was unbridled speculation perpetrated by rogue traders, whose unchecked fraud

brought their house down.

We will try to find out how commodity derivative trading affects the speculators (big and small), arbitrageurs and hedgers along with the

nation at large in the long and short run.

The primary aim to develop commodity derivative market is to help in hedging process. The price discovery and risk allocation functions of

derivative hedge instruments can help reduce price distortions by lowering transactions and agency costs and information asymmetry in the

spot capital markets, resulting in efficient allocation of resources and economic growth.

Data and test methodology

Our study will be based on the assumption that a sound financial system is vital for economic growth.

We will look at the data before and after introduction of the commodity futures in India. Based on Levine’s (1997) functional approach, our

study will hypothesize a positive relationship between derivative market developments with economic growth through increases capital

formation over a period of time. In other words, with well functioning commodity derivative markets the growth rate should be higher.

We will test the relationship between derivative market development and economic growth from three perspectives of direct liquidity,

capitalization channel and indirectly with the effects of derivative markets on their underlying spot market development. We will also

attempt to analyze critical economic and financial factors creating the demand for derivative markets indicating the readiness of these

markets to start derivative products. The dependence of the derivative market as a risk-reducing agent for the spot market economy will also

be looked at in our study.

Model development

In order to assess the relationship of economic growth and derivative markets, we will evaluate the correlation of derivative market

development indicators with economic growth in the regression equation. The proxy for the economic growth indicator and the various

control variables associated with economic development and for derivative market development has to be chosen.

The liquidity and efficiency impacts of derivative market on economic growth is routed through their underlying spot markets. In order to

capture this indirect relationship of derivative markets with economic growth, it will be assumed that capital formation is a channel through

which derivative markets effect the economic growth. The effect of spot market needs to be analyzed first. Then to substantiate the expected

positive effects of derivative markets through their underlying spot market, we will develop a regression model to test the liquidity impact

of derivative market on their respective spot market. The proxy for capital formation needs to be determined.

We will attempt to gauge the contribution of derivative markets in India by testing the relationship between overall economic activities and

the derivative market liquidity level.

Derivative products have a derived demand which is not only linked with real economic sector but is also directly related to overall

financial development level and with their underlying assets in the spot capital markets. Therefore, both economic and financial variable

will be analyzed as the critical factors creating the demand for derivative market.

Granger’s causality test will be conducted to test whether derivative markets follow demand-following or supply-leading patterns of

development (Patrick, 1966).

Unit root test using Phillips Perron (PP) procedure will be conducted to check the stationarity of the variables and appropriate adjustments

will be made to correct the non-stationary variables. As PP test include a non-parametric allowance for serial correlation and

heterodeskasity, it is preferred over other unit root tests in this study with quarterly data o relatively volatile Indian market.
SPOT PRICE DETERMINATION

 Based on demand and supply

 Based on demand of derivative contact

 Based on absence of derivative contract

 Based on information and expectation

 Based on various technical analyses

 Based on regression models


Regulatory measures

A future trading is also capable of being misused by unscrupulous speculators. In order to safeguard against uncontrolled speculation certain

regulatory measures are introduced from time to time. They are:

a. Limit on open position of an individual operator to prevent over trading;

b. Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices;

c. Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial

restraints;

d. Minimum/maximum prices to be prescribed to prevent future prices from falling below the levels that are unremunerative and from rising

above the levels not warranted by genuine supply and demand factors.

During shortages, extreme steps like skipping trading in certain deliveries of the contract, closing the markets for a specified period and even

closing out the contract to overcome emergency situations are taken. With the gradual withdrawal of the government from various sectors in the

post-liberalization era, the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and

transfer their risks. India's obligation under WTO to open agriculture sector to world trade would require futures trade in a wide variety of

primary commodities and their products to enable diverse market functionaries to cope with the price volatility prevailing in the world market.

The gains that the typical Indian farmer used to reap from futures trading are those that arise as a spill-over effect of futures trading (through the

mechanism mentioned in the previous section) and not from the participation of farmers in forward markets.

Futures trading has been advocated as a tool to solve the market uncertainties by promising the farmers a fixed price for their future output. Given

the market situation and volatility of prices of agricultural products in India, such an assurance is of extreme importance. Thus, futures trading, in

theory, has the potential to solve a number of problems in the agricultural sector. But, in the present scenario, a forward markets are beyond the

reach of a vast majority of Indian farmers. A huge chunk of Indian farmers fall within the category of marginal farmers. It is these farmers who

are the most affected the most by the market fluctuations and the monsoon failures. Hence, it is these farmers who really need to hedge risks

through futures trading. But the present regulations in the Indian commodity exchanges appear to exclude small farmers from the picture

completely. A comparison between the average product per farmer and the minimum lot size to be traded in the commodity exchange throws

some light on the situation. Comparison of minimum lot size that can be traded in commodity exchanges in India with the production data for

small and marginal farmers reveals that the minimum lot size in a commodity market is much larger than the total annual production of a small or

marginal farmer. This keeps future markets outside the reach of marginal and small farmers.

Thus a major part of the gains that critics of the ban accuse the ban of snatching from the farmers, were in fact never enjoyed by the majority of

agrarian community in India. The direct gains of futures trading in India were always cornered by speculators and large farmers who were able to
meet the huge lot size requirements of the Indian commodity markets. Thus what the average Indian farmer stands to lose from the ban is the

higher price lever arrived at as a spillover effect of forward trading and not any direct gain.

Conclusion:

In the light of the above analysis, it can be safely concluded that the current ban on futures trading in certain agricultural commodities is a mere

stopgap measure to curb inflation. It certainly will affect the farmers adversely by lowering the price level of agricultural commodities

unaccompanied by a corresponding lowering in prices of non-agricultural products. However this does not mean forward trading, as it stood

before the ban was helpful to the farmers. It is specially emphasized that the market regulations regarding lot size and other standards prevailing

in the Indian commodity exchanges are not suited for the socio-economic realities of the Indian farming community.

What Should Regulators Do?

Believing the 10 myths presented here, indeed, believing just one or two of them, could lead one to advocate legislative and regulatory measures
[9]
to restrict the use of derivatives. Derivatives-related disasters, such as the Orange County bankruptcy and the collapse of Barings, have led to

questions about the ability of individual derivatives participants to internally manage their trading operations. In addition, concerns have surfaced

about regulators' ability to detect and control potential derivatives losses.

But regulatory and legislative restrictions on derivatives activities are not the answer, primarily because simple, standardized rules most likely

would only impair banks' ability to manage risk effectively. A better answer lies in greater reliance on market forces to control derivatives-related

risk taking, together with more emphasis on government supervision, as opposed to regulation.

The burden of managing derivatives activities must rest squarely on trading organizations, not the government. Such an approach will promote

self-regulation and improve organizations' internal controls through the discipline of market mechanisms. Government guarantees will serve only

to strengthen moral-hazard behavior by derivatives traders.

The best regulations are those that guard against the misuse of derivatives, as opposed to those that severely restrict, or even ban, their use.

Derivatives-related losses can typically be traced to one or more of the following causes: an overly speculative investment strategy, a

misunderstanding of how derivatives reallocate risk, an ineffective internal risk-management audit function, and the absence of systems that

simulate adverse market movements and help develop contingency solutions. To address those concerns, supervisory reforms should focus on

increasing disclosure of derivatives holdings and the strategies underlying their use, appropriate capital adequacy standards, and sound risk-

management guidelines.

For the most part, however, policymakers should leave derivatives alone. Derivatives have become important tools that help organizations

manage risk exposures. The development of derivatives was brought about by a need to isolate and hedge against specific risks. Derivatives offer

a proven method of breaking risk into component pieces and managing those components independently. Almost every organization--whether a

corporation, a municipality, or an insured commercial bank--has inherent in its business and marketplace a unique risk profile that can be better

managed through derivatives trading. The freedom to manage risks effectively must not be taken away.
The exchanges have circuit filters in place. The filters vary from commodity to commodity but the maximum individual commodity circuit filter

is 6 per cent. The price of any commodity that fluctuates either way beyond its limit will immediately call for circuit breaker.
Effect of margin trading (leverage)

However, futures and options are highly geared, or leveraged, transactions and therefore traders/investors are able to assume large positions -

with similar sized risks - with very little up-front outlay.

By their very nature they encourage those higher degrees of speculation. The potential rewards are such that a technique designed to reduce risk is

all too often treated as a gambler's tool.

Risk Management Lessons in Leveraged Commodity Futures Trading

A computational approach to modeling commodity markets

We build an agent based computational framework to study large commodity markets. A detailed representation of the consumers, producers and

the market is used to study the micro level behavior of the market and its participants. The user can control players' preferences, their strategies,

assumptions of the model, its initial conditions, market elements and trading mechanisms. The first part of the paper describes the computational

framework and its three main modules. The later part describes a case study that examines the decentralized market in detail, specifically the

computational options available for matching the buyers and suppliers in a synthetic market. The study illustrates the sensitivity of the outcome

of various economic variables, such as clearing price, quantity, profits and social welfare, to different matching schemes in a bilateral

computational setting. Based on seven different matching orders for the buyers and suppliers, our study shows that the results can vary

dramatically for different pairing orders.

RISK FACTORS, MEASUREMENT AND MANAGEMENT THROUGH COMMODITY DERIVATIVES.

What are the alternative techniques to implement VaR, and how well do they fare?

How can VaR estimators be scaled up to different time intervals, e.g. from one--day VaR to two--day VaR?

Should the models for estimating VaR differ across market regulators and market participants?

What are the VaR estimators applicable to Indian securities market (equities, foreign exchange, fixed income, commodities)? How would we
incorporate derivatives into these implementations?

What is a sound VaR implementation for a portfolio of futures on the Nifty? How can the basis risk of Nifty futures be estimated?

What are the issues in a VaR estimator for a portfolio of options on Nifty?

What is a sound VaR estimator for a portfolio of shares, which incorporates liquidity risk?

How can the computational cost of VaR estimation be brought down?

How do we measure liquidity risk, and how do we incorporate it into the initial margin of the futures clearing corporation? When the clearing

corporation needs to liquidate a position, how best should it do so?

The market value of the Securities may be influenced by many unpredictable factors, including, highly volatile commodities prices, changes in

supply and demand relationships; weather; agriculture; trade; pestilence; changes in interest rates; and monetary and other governmental policies,

action and inaction. Index components that track the performance of a single commodity, or index components concentrated in a single sector, are

speculative and may typically exhibit higher volatility. The current or “spot” prices of the underlying physical commodities may also affect, in a

volatile and inconsistent manner, the prices of futures contracts in respect of the relevant commodity. These factors may affect the value of the

index and the value of Securities in varying ways.

In addition to factors affecting commodities generally, index components composed of futures contracts on nickel or copper, which are industrial

metals, may be subject to a number of additional factors specific to industrial metals that might cause price volatility. These include changes in

the level of industrial activity using industrial metals (including the availability of substitutes such as man-made or synthetic substitutes);

disruptions in the supply chain, from mining to storage to smelting or refining; adjustments to inventory; variations in production costs, including

storage, labor and energy costs; costs associated with regulatory compliance, including environmental regulations; and changes in industrial,

government and consumer demand, both in individual consuming nations and internationally. Index components concentrated in futures contracts

on agricultural products, including grains, may be subject to a number of additional factors specific to agricultural products that might cause price

volatility. These include weather conditions, including floods, drought and freezing conditions; changes in government policies; planting

decisions; and changes in demand for agricultural products, both with end users and as inputs into various industries.
Derivatives Link Market Participants More Tightly Together, Thereby Increasing Systemic Risks

Financial derivative participants can be divided into two groups: end-users and dealers. As end-users, banks use derivatives to take positions as

part of their proprietary trading or for hedging as part of their asset/liability management. As dealers, banks use derivatives by quoting bids and

offers and committing capital to satisfy customers' needs for managing risk.

In the developmental years of financial derivatives, dealers, for the most part, acted as brokers, finding counterparties with offsetting

requirements. Then dealers began to offer themselves as counterparties to intermediate customer requirements. Once a position was taken, a

dealer immediately either matched it by entering into an opposing transaction or "warehoused" it--temporarily using the futures market to hedge

unwanted risks--until a match could be found.

Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their overall position. That development has changed the

focus of risk management from individual transactions to portfolio exposures and has substantially improved dealers' ability to accommodate a

broad spectrum of customer transactions. Because most active derivatives players today trade on portfolio exposures, it appears that financial

derivatives do not wind markets together any more tightly than do loans. Derivatives players do not match every trade with an offsetting trade;

instead, they continually manage the residual risk of the portfolio. If a counterparty defaults on a swap, the defaulted party does not turn around

and default on some other counterparty that offset the original transaction. Instead, a derivatives default is very similar to a loan default. That is

why it is important that derivatives players perform with due diligence in determining the financial strength and default risks of potential

counterparties.

For banking supervisors in the United States, probably the most important question today is, What could go wrong to engender systemic risk--the

danger that a failure at a single bank could cause a domino effect, precipitating a banking crisis? Because financial derivatives allow different risk

components to be isolated and passed around the financial system, those who are willing and able to bear each risk component at the least cost

will become the risk holders. That clearly reduces the overall cost of risk bearing and enhances economic efficiency.

Furthermore, a major shock that would jolt financial markets in the absence of derivatives would also affect financial markets in which the use of

derivatives was widespread. But because the holders of various risks would be different, the impact would be different and presumably not as

great because the holders of the risks should be better able to absorb potential losses.
MARK TO MARKET

The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance

company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon

the occurrence of some event for which you must pay a premium in advance.

When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the

shares at $50 and the price appreciates to $75, we have made $2500 on a mark-to-market basis. If we buy the shares at $50 and the price

depreciates to $25, we have lost $2500 on a mark-to-market basis.

Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of $50, giving us

the right but not the obligation to purchase ABC stock at $50 in 1 month's time. Instead of immediately paying $5000 and receiving the stock, we

might pay $700 today for this right. If ABC goes to $75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the

stock in the open market, locking in a net profit of $1800.

If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but

before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility

with a different risk/reward profile.

Mark-to-market is a way of accounting for financial products in which an inventory of financial products is revalued a pre-set interval (usually at

the end-of-business on a daily basis) at current market rates. The combination of realized and unrealized profit and loss is booked to the profit-

and-loss account. Mark-to-market accounting is a good practice for the management of any financial portfolio.

It is mandatory for financial institutions to report their financial accounts in this fashion. In the near future, initiatives like the Financial

Accounting Standards Board Statement No. 133 will require mark-to-market accounting from non-institutional end-users, as well.

Notional Amounts
Another aspect of financial derivatives is the fact that they are carried off-balance sheet, generally. When we speak of the size of a particular

derivative contract, we refer to the notional amount. The notional amount is the amount used to calculate the payoff. For example, in our options

example above, the notional amount was 100 shares. However, the potential payoff and the potential loss were both different from the value of

100 shares. Because the payoffs of derivative products differ from the payoffs that their notional amounts might suggest if they were cash

instruments, they are kept off balance sheet. Otherwise, the balance sheet could be distorted and inflated by even a relatively small derivatives

portfolio.

Finally, in terms of the regulatory appeal of derivative products, there are a number of different ways of looking at this issue. Derivative products,

because of their off-balance sheet nature, can be used to clear up the balance sheet. A mutual fund manager who is restricted from taking currency

plays by regulatory requirements can buy a structured note whose coupon is tied to the performance of a particular currency pair.

Credit derivatives can be used to lay off and manage a company's exposure to credit events, such as supplier default. Most importantly, derivative

products enable the end user to tailor their risk profile in order to most closely match their exposure to their view of the financial markets and

their preferences for holding and managing risk.

The Two Types of Derivatives

There are two types of derivatives: linear derivatives and non-linear derivatives. A linear derivative is one whose payoff function is a linear

function. For example, a futures contract has a linear payoff in that every one-tick movement translates directly into a specific dollar value per

contract. A non-linear derivative is one whose payoff changes with time and space.

Space in this case is the location of the strike with respect to the actual cash rate (or spot rate). One example of a non-linear derivative with a

convex payoff profile at some point before the option's maturity is a simple plain vanilla option. As the option becomes progressively more in-

the-money, the rate at which the position makes money increases until it asymptotically approaches the linear payoff of the future. Similarly, as

the option becomes progressively more out-of-the-money, the rate at which the position loses money decreases until that rate becomes zero.

"Delta"
With non-linear derivatives, therefore, it is possible to capture gains from volatility by hedging a portion of the option's value. This is called the

"delta", given by a mathematical formula derived from the formula used to determine price, and rebalancing the hedge as spot moves around and

the delta changes.

In the ABC Inc. example from above, we could have purchased a 1-month $50 call option on ABC giving us the right to purchase 100 shares.

With the spot price at $50, the option is said to be at-the-money. At-the-money options have a delta of 50%, so to "delta-hedge" the option, we

would have sold short 50 shares. If the ABC price proceeded to $25 the next week, we could buy back some of the 50 shares we were short

(realizing a $25 profit on those shares).

Any move back to $50 subsequently and we could sell more shares short again. If the ABC price went to $75 the next week, we could sell more

shares short. This would enable us to buy these shares back if the ABC price went lower before maturity. The more times we can delta-hedge the

option (or "dynamically hedge" the option), the more profit we will realize.

Every time we realize a profit, we help to pay for the option. If you own an option and you delta hedge it, you will make money if the stock price

goes up. You will also make money if the stock price goes down. You have to delta-hedge consistently in order to realize that profit, though. At

the end of the day, you will only make money if you have realized delta-hedging profits that are greater than the premium you paid away for the

option.

The more the stock prices moves up and down, the more likely you are to realize delta-hedging profits. Conversely, if you sell an option and delta

hedge it, you will lose money if the stock price goes up and you will lose money if the stock price goes down. Each time that you delta-hedge,

you are realizing a loss. At the end of the day, you will only make money if your delta-hedging losses are less than the option premium you

earned to sell the option in the first place.

If you can understand delta hedging, then you can understand the way options are priced and what it means to determine good value in a

premium. If we buy an option, then we are arguing that we will make more money dynamically hedging around it than we will pay in premium. If

we sell an option, then we are arguing that we will make more money in premium than we will lose in dynamically hedging the option. One of

the prime determinants of the price of an option is the volatility.

Volatility

Volatility is the measure of how much the spot rate is expected to move around. Obviously, in a high volatility environment, the spot rate will be

expected to move around aggressively and options premiums are very high. In a low volatility environment, the spot rate is expected to move

around very little and options premiums are very low. One of the key factors in making money in options is to understand the nature of volatility.

There are two important characteristics of volatility one needs to understand. First, volatility is not constant. It changes over the course of time.

There might be specific events that will cause volatility to spike higher. For example, the 1992 European Exchange Rate Crisis, triggered by

votes on the Maastricht Treaty, turned a relatively stable environment into a savagely volatile one. Second, volatility is statistically persistent.

That is a fancy way of saying that volatility trends. If it's volatile today, then it should continue to be volatile. If it's calm today, then it should

continue to be calm.

Making money in options often means realizing that the trend in volatility has changed from calm to volatile (in which case you buy options at

the beginning of the volatile period when options volatilities are still low compared to what you expect actual volatility will turn out to be) or

selling options when the trend changes from volatile to calm (and option volatilities are higher than what you expect them to be). In subsequent

articles, we will elaborate on determining good value in options and we will focus on the other key element in making money in options:

understanding the behavioral characteristics of derivative products. The biggest single problem with the use of derivative products today is the

lack of knowledge about these two factors.

Article by Chand Sooran, Principal, Victory Risk Management Consulting Inc.

http://www.finpipe.com/derivatives2.htm

77. What is Mark-to-Market margin?

Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid

by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and

the rate of the contract (if it is enterned into on that day) or the previous day's clearing rate. The Exchange collects these margins from buyers if

the prices decline and pays to the sellers and vice versa.

TOP

78. Why is Mark-to-Market margin collected daily in commodity market?

Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in

one direction. Hence the risk of default is reduced. Also, the participants are required to pay less upfront margin - which is normally collected to

cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position. Alternatively, for

the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity.
Settlement

Daily Mark-to-Market Settlement

The positions in the futures contracts for each member is marked-to-market to the daily settlement price (available in the NSE Web site), of the

futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day's

settlement price, as the case may be, and the current day's settlement price.

The clearing members (CM) who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL, which is in turn passed on

to the members who have made a profit. This is known as daily mark-to-market settlement.

Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in

cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final

settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day's settlement price, as the

case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited on T+1 day

(T= expiry day).

Settlement risk is the risk that a settlement in a transfer system does not take place as expected. Generally, this happens because one party

defaults on its clearing obligations to one or more counterparties. As such, settlement risk comprises both credit and liquidity risks. The former

arises when a counterparty cannot meet an obligation for full value on due date and thereafter because it is insolvent. Liquidity risk refers to the

risk that a counterparty will not settle for full value at due date but could do so at some unspecified time thereafter; causing the party which did

not receive its expected payment to finance the shortfall at short notice. Sometimes a counterparty may withhold payment even if it is not

insolvent (causing the original party to scramble around for funds), so liquidity risk can be present without being accompanied by credit risk.
Buffer stock and price stabilization

Today we have the Food Corporation of India, which is doing a huge job of storage, and it is a system, which -- in my opinion -- does not work.

Futures market will produce their own kind of smoothing between the present and the future. If the future price is high and the present price is

low, an arbitrager will buy today and sell in the future. The converse is also true, thus if the future price is low the arbitrageur will buy in the

futures market. These activities produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there is trade in

agricultural commodities; arbitrageurs on the futures market will use imports and exports to smooth Indian prices using foreign spot markets.
Commodity price forecasting
Forecasting Commodity Markets: Using Technical, Fundamental and Econometric Analysis

By

Julian Roche

(Author)
Price discovery
Investor Protection
The future prospects
We can look at the currency linked bonds and currencies
Harri Toivonen, M.Sc. (Econ), will defend his PhD dissertation at the Helsinki School of Economics (HSE)
on Friday, December 2, 2005. The dissertation is entitled “Modeling, Valuation and Risk Management of
Commodity Derivatives” and is in the field of Finance. The public defense will start at 12:00 in the
auditorium of the Chydenia building (address Runeberginkatu 22-24). The opponent is Professor Petri
Sahlström (Tampere University of Technology) and the custos is Professor Hannu Seristö (HSE).

In his study Toivonen examines modeling, valuation and risk management of commodity derivatives.
According to United Nations International Trade Statistics more than 40% of world trade consists of
primary commodities. Both long-term trends and short-term fluctuations in commodity prices have
important consequences for global economic growth. On the supply side of the market many developing
countries still continue to rely heavily on commodities for their export earnings. On the demand side,
commodity markets play a major role in transmitting business cycle disturbances and consequently
affecting the revenues of corporations and the inflation rates of economies across industrial nations.
Toivonen aims to contribute to the existing literature through four interrelated essays using unique
long-term commodity swap data in Brent crude oil and NBSK pulp commodity markets.

The first essay, Modeling Term Structure of Commodity Prices – Swapping the Convenience, studies the
modeling of long-term commodity forward prices. We find support for the existence of the theory of
storage. There is a statistically significant inverse relationship between the convenience yield, the return
to the holder of the physical commodity, and the level of physical inventories. The paper also finds
support for the so-called maturity effect, i.e. a declining volatility term structure, in long-term
commodity forward markets. This decreasing volatility term structure implies mean-reverting spot
commodity prices in the long-run.

The second essay, Volatility of Commodity Forward Prices, compares alternative multivariate models of
volatility in order to model volatility of commodity forwards. We find that the Multivariate Stochastic
Volatility model (MSV) and the simpler Exponentially Weighted Moving Average (EWMA) method
outperform different Multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH)
models and simpler methods in both markets. The findings also suggest that there is a negative
relationship between the spot volatility and the level of inventories as the theory of storage stipulates.

The third essay, Hedging Long-Term Commodity Forward Price Risk, investigates the problem of hedging
long-term commitments with short-term futures empirically, to our knowledge for the first time in the
existing literature, with actual long-term commodity market data. This problem is also known as the
Metallgeschellschaft problem in the existing literature. Empirical evidence is found that neither simple
time-series-based nor one-factor model-based hedging strategies can sufficiently capture the
characteristics of the term-structure of forward prices.

The fourth essay, Pricing Quanto Commodity Swaptions, presents a formula for pricing quanto
commodity swaptions. Quanto or cross currency effects are particularly common in commodity markets
as most of the markets are US dollar denominated. Toivonen utilizes the forward price based approach
and the change of measure technique to derive a simple closed-form solution for European quanto
commodity swaptions.
 Bibiliography

1 Derivative and the wealth of the nation

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inc.,2000)

3 Chew, L. Managing Derivative Risk: The use and abuse of leverage (John Wiley& sons inc, 1996)

4 Edwards, F.R. and C.W. Ma. Futures and Options (McGraw Hill, 1992)

5 Jorion, P.Value at risk: The new benchmark of financial derivatives (PearsonAddison-Wesley, 2005)

6 Teweles, R.J. and F.J.Jones, edited by Ben Warwick. The future Game: who wins, who loses and why (McGraw Hill, 1999, 3rd edn.)

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