Commodity Markets: Price Discovery, Price Risk Management and Regulation
Futures contracts in commodity markets perform two important functions of price discovery and price risk management with reference to any commodity-irrespective of the fact whether it is a base metal, precious metal or agri-products or even crude oil/ any other form of energy. It is useful to different segments of economy. A seller can get an idea of the price likely to prevail at a future point of time and hence can decide between various competing commodities, the best that suits him. On the other side, it also enables the consumer to 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 cost benefit analysis and also cover his purchases by making forward/ futures contracts. Futures trading is very useful to the exporters as it offers the privilege of providing a advance indicative price likely to prevail and allow the exporter to quote a realistic price in a competitive market. It enables him to hedge his risk by operating in futures market. Other benefits of futures trading are:
Price stabilization-in times of heavy price fluctuations
The mechanism dampens the peaks and lifts the bottom of price, thus reducing the volatility in the market to some extent.
- It leads to integrated price structure throughout the country.
- Facilitates lengthy and complex production and manufacturing activities.
- Helps balance in supply and demand position throughout the year.
- Encourages competition and acts as a price barometer to farmers and other trade functionaries.
Futures trading is also capable of being misused by speculators. In order to safeguard against uncontrolled speculation certain regulatory measures are introduced from time to time. They include:
- Imposition of upside limit on open position of an individual operator to prevent over trading
- Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices
- Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints
- Minimum/maximum prices to be prescribed to prevent future prices from falling below the un-remunerative level and from rising.
During times of short supply of commodity, 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 by regulatory authorities, or the government itself.
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.
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 and by the authorities regulating the commodity exchanges.
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".
The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units.
The delivery periods are specified.
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.
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.
- Defining Commodities
- Commodity Markets - Types of Commodities
- Commodity Traders and Future Value
- Types of Markets for Commodity Trading
- Commodity Markets: Price Discovery, Price Risk Management and Regulation
- Regulation of Commodity Markets
- What is Contango?
- What is Backwardation?
- Backwardation and Contango