Importance and Types of Commodity Derivatives

India is one among the top-5 producers of most of the commodities and to being a major consumer of bullion and energy products. Agriculture contributes about for about 22% to the GDP of the Indian economy. It employees for about 57% of the labor force on a total of 163 million hectares of land. Agriculture sector is a significant factor in achieving a GDP growth of 8-10%. All this point out that India can be promoted as a main center for trading of commodity derivatives.

It is regrettable that the policies of FMC during the most of 1950s to 1980s suppressed the markets. But in fact it was supposed to encourage and nurture to grow with times. It was a mistake and other emerging economies of the world would want to avoid such instance. However, it is not in India alone those derivatives were suspected of creating too much speculation that would be damaging the healthy growth of the markets and the farmers. Such suspicions may generally arise due to a misunderstanding of the characteristics and role of derivative product. It is significant to understand why commodity derivatives are necessary and the role they can play in risk management. It is general knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The opportunity of adverse price changes in future creates risk for businesses. Derivatives are used to diminish or eliminate price risk arising from unforeseen price changes. A derivative is a financial contract whose price depends on, or is resultant from, the price of another asset.

Two important types of Commodity Derivatives

• Commodity Futures Contracts: A futures contract is a contract for buying or selling a commodity for a predetermined delivery price at a specific future time. Futures are standardized agreements that are traded on organized futures exchanges that ensure performance of the contracts and therefore eliminate the default risk. The commodity futures had existed ever since the Chicago Board of Trade (CBOT) was established in 1848, in view to bring farmers and merchants together. The main function of futures markets is to transfer price risk from hedgers to speculators. For instance, suppose a farmer is expecting his crop of wheat to be ready in two months time, but is worried that the price of wheat may turn down in this period. In order to minimize his risk, he can penetrate into a futures contract to sell his crop in two months’ time at a price determined now. In this way he is able to hedge his risk arising from a probable adverse change in the price of his commodity.

• Commodity Options contracts: options are also financial instruments like hedges, which are used for hedging and speculation. The commodity option holder has the right, except he don’t have the obligation, to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date. Option agreements involve two parties, namely the seller of the option writes the option in favor of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two kinds of commodity options. First one is a ‘call’ option gives the holder a right to buy a commodity at an agreed price and the other one is ‘put’ option gives the holder a right to sell a commodity at an agreed price on or before a specified date (called expiry date).

The option holder will exercise the option only if it is advantageous to him; or else he will let the option lapse. For instance, presume a farmer buys a put option to sell 100 Quintals of wheat at a price of Rs 1250 per quintal and pays a ‘premium’ of Rs. 25 per quintal (or a total of Rs. 2500). If the price of wheat reduces to say Rs. 1000 before expiry, the farmer will exercise his option and sell his wheat at the agreed price of rs. 1250 per quintal. Nevertheless, if the market price of wheat amplifies to say rs. 1500 per quintal, it would be beneficial for the farmer to sell it directly in the open market at the spot price, instead of exercise his option to sell at rs. 1250 per quintal. Futures and options trading for that reason helps in hedging the price risk and also provide investment opportunity to speculators who are keen to assume risk for a possible return. In addition to this, futures trading and the ensuing discovery of price can help farmers in deciding which crops to cultivate. They can also help in building a competitive edge and enable businesses to smoothen their earnings since non- hedging of the risk would boost the volatility of their quarterly earnings. Thus futures and options markets perform essential functions that can not be ignored in modern business environment. At the same time, it is factual that too much speculative activity in vital commodities would destabilize the markets and hence, these markets are normally regulated as per the laws of the country.