Context: The Indian government has permitted derivatives trading in 11 more commodities including skimmed milk powder, cement, apple, bamboo and timber based on a recommendation from the Securities and Exchange Board of India (SEBI).
A Derivative is a financial instrument whose value is based upon the value of an underlying asset like equities, currency or commodities or other financial assets. A derivative contract, which has a commodity as its underlying, is known as a ‘commodity derivative’ contract. Most common types of derivative instruments are forwards, futures, options, and swaps.
Agricultural commodity derivatives, have the underlying asset as an agricultural commodity, such as cereals (wheat, rice), pulses (chana, tur), spices (jeera, pepper) and oilseeds (soybean, castor).
Non - Agricultural commodity derivatives, have the underlying asset as a non- agricultural commodity, such crude oil, gold, silver, Aluminium, Iron, etc. The non- agricultural commodities are generally natural resources that are mined, extracted or processed.
Futures and Options are two important derivative instruments that are traded in the commodity derivative market. In future contract, the buyer has the obligation to buy/sell the assets. Whereas, in option contract, customers have no obligation to buy/sell the assets.
Benefits of commodity derivative markets
- Hedging: It is a price risk management tool adopted by actual users such as processors, miners, exporters, importers, manufacturers, etc. Hedging means taking a position in the derivatives market with an objective of reducing or limiting risks associated with price changes.
- Price discovery: Speculation is the practise of trading in order to profit quickly from price changes. Speculators never use the item for physical purposes because their goal is to benefit quickly from price fluctuations. This contributes to transparent price discovery in the underlying commodity markets.
Commodities that are suitable for derivative trading:
- The commodity should have relatively large demand and supply.
- Prices should be adequately volatile.
- The commodity should be free from substantial control from Govt.
- Regulations in terms of supply, distribution and prices.
- The commodity should preferably have a long shelf-life.