Derivatives are often used as a tool for managing risk and this instrument originated in the Commodity market itself. As time passed on, derivatives started finding their use in hedging tool in financial markets as well. For a derivative the underlying can be a commodity or a financial asset and the basic concept remains the same. There are however, few distinguishing features of a commodity derivative market. Most of the contracts are cash settled in case of financial derivatives. This feature applies to the physical settlement also.
Commodity derivatives/futures on the other hand are either settled in cash or settled through deliveries, and can be defined as securities whose prices are dependent upon or derived from one or more underlying assets. A derivative is typically a contract between two or more parties, whose value is determined by fluctuations in the underlying asset prices. Stocks, bonds, commodities, currencies, interest rates and market indexes are the most common underlying assets.
Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories – hedgers, speculators, and arbitragers.
Hedgers: Hedging is the process of minimizing risk against unexpected price fluctuations. Hedgers face risk associated with the price of an asset. They use the futures markets to reduce or eliminate this risk.
Speculators: Speculators are participants who willingly bet on future movements in the price of an asset. Futures contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.
Arbitragers: Arbitragers aim for making profits by taking advantage of discrepancy between prices of the same product across different markets. For example, if they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.
There are various derivatives traded in the world, two of the commonly traded are defined below:
Forwards: A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today’s pre-agreed price. A forward is the most basic derivative contract. Taking an example of Chana, suppose the buyer is not interested to buy Cardamom on 1st of July (in spot) but wants to buy one month later. He gets a forward price quote of Rs.5500/qtl. They agree upon the forward price and the buyer pays Rs 5500/qtl, a month later to the trader or seller and collects his delivery.
This is a forward contract, in which two parties with mutual consent agree to settle a trade at a future date, for a stated price and quantity. There is no exchange of money when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract, and the process of trading, clearing and settlement does not happen instantaneously.
Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today’s future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded.
There are three components in all types of transactions i.e. trading, clearing and settlement. Trading is when a buyer and seller come together, negotiate and arrive at a price, while clearing involves working out exactly how much of goods and money the two should exchange. Example, A buys goods worth Rs.3000 from B and sells goods worth Rs.2500 to B. Therefore on a net basis A has to pay Rs.500 to B. Settlement on the other hand is the actual process of exchanging money and goods.
Keep browsing the Agripedia/Commodity sections for getting further insights on commodities and commodity futures/ futures trading