Derivatives Trading - Exchange Traded Forward & Futures Contracts in Commodities

Exchange traded derivatives first ushered in the commodities market long ago. The first derivatives exchange in the USA was the Chicago Board of Trade (CBT). While the CBT was originally formed in 1848 as a centralized marketplace for exchanging grain, forward contracts were also negotiated. "The earliest recorded forward contract trade was made on March 13, 1851 and called for 3000 bushels of corn to be delivered in June at a price of one cent per bushel below the March 13th spot price. Forward contracts had their drawbacks, however. They were not standardized according to quality or delivery time. In addition, merchants and traders often did not fulfll their forward commitments. In 1865, the CBT made three important changes to the structure of their grain trading market. First, they introduced the use of standardized contracts called futures contracts. Unlike forward contracts in which the parties are free to choose the terms of the contract, the terms of futures contracts are set by the exchange and are standardized with respect to quality, quantity, and time and place of delivery for the underlying commodity. By concentrating hedging and speculative demands on fewer contracts, the depth and liquidity of the market are enhanced. This facilitates position unwinding. If a party to a trade wants to exit his position prior to the delivery date of the contract, he need only execute an opposite trade (i.e., reverse his trade) in the same contract. There is no need to seek out the counterparty of the original trade and attempt to negotiate the contract's termination.

"The second and third changes were made in an effort to promote market integrity. The second was the introduction of a clearinghouse to stand between the buyer and the seller and guarantee the performance of each party. This crucial step eliminated the counterparty risk that had plagued OTC trading. In the event a buyer defaults, the clearinghouse "makes good" on the seller's position, and then holds the buyer's clearing .rm liable for the consequences. The buyer's clearing firm, in turn, passes the liability onto the buyer's broker, and ultimately the buyer. Note that, at any point in time, the clearinghouse has no net position since there are as many long contracts outstanding as there are short. The third was the introduction of a margining system. When the buyer and seller enter a futures position, they are both required to deposit good-faith collateral designed to show that they can fulfll the terms of the contract."
[Source online article on "Derivatives" by Robert E. Whaley, Faculty Fuqua School of Business, Duke University - URL -http://faculty.fuqua.duke.edu/~whaley/pubs/ch19.pdf]

"The butter and eggs dealers of Chicago Produce Exchange joined hands in 1898 to form the Chicago Mercantile Exchange for futures trading. The exchange provided a futures market for many commodities including pork bellies (1961), live cattle (1964), live hogs (1966), and feeder cattle (1971). The International Monetary Market was formed as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. In 1982, it introduced a futures contract on the S&P 500 Stock Index. Many other exchanges throughout the world now trade futures contracts. Among them are the Chicago Rice and Cotton Exchange, the New York Futures Exchange, the London International Financial Futures Exchange, the Toronto Futures Exchange and the Singapore International Monetary Exchange. They grew so rapidly that the number of shares underlying the option contracts sold each day exceeded the daily volume of shares traded on the New York Stock Exchange.

"In the 1980's, markets developed for options in foreign exchange, options on stock indices, and options on futures contracts. The Philadelphia Stock Exchange is the premier exchange for trading foreign exchange options. The Chicago Board Options Exchange trades options on the S&P 100 and the S&P 500 stock indices while the American Stock Exchange trades options on the Major Market Stock Index, and the New York Stock Exchange trades options on the NYSE Index. Most exchanges offering futures contracts now also offer options on these futures contracts. Thus, the Chicago Board of Trades offers options on corn futures, the Chicago Mercantile Exchange offers options on live cattle futures, the International Monetary Market offers options on foreign currency futures, and so on. However in India options trading in commodities is not permitted".
[Source:Website of NSE]

A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts. Futures Contract is specie of forward contract. Futures are exchange - traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose. Futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures contracts; but they merely accept terms of contracts standardized by the Exchange. As distinguished from this all Forward contracts (other than a futures) are customized. In other words, the terms of forward contracts are individually agreed between two counter-parties.

Futures contracts perform two important functions of price discovery and price 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:

1. 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.

2. Leads to integrated price structure throughout the country.

3. Facilitates lengthy and complex, production and manufacturing activities.

4. Helps balance in supply and demand position throughout the year.

5. Encourages competition and acts as a price barometer to farmers and other trade functionaries.

Futures 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:

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

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

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

4. Minimum/maximum prices to be prescribed to prevent future prices from falling below the levels that are un remunerative and from rising above the levels not warranted by genuine supply and demand factors

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5. 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.

A "Futures Contract" is a highly standardized contract with certain distinct features. Some of the important features are as under :

1. Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Bye-laws of the association.

2. It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tenderable varieties".

3. The units of price quotation and trading are fixed in these contracts , parties to the contracts not being capable of altering these units.

4. The delivery periods are specified.

5. The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centres.

6. In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place.