What are Commodity Futures and forwards?

A commodity futures contract is a formal arrangement to purchase or sell a set quantity of a commodity at a specified price on a predetermined date in the future. These contracts serve dual purposes – they can be employed for hedging to safeguard an investment position or, alternatively, for speculating on the anticipated direction of the underlying asset's movement.

Commodity derivatives, specifically commodity futures, involve contracts to buy or sell a predetermined quantity of a particular commodity at a future date on an exchange platform. These financial instruments share similarities with index and stock futures, with the key distinction being the involvement of commodities rather than stocks and indices.

Commodity Derivatives: 

In the Indian markets, commodities now present a promising opportunity for retail investors and traders seeking to diversify their portfolios beyond traditional assets like shares, bonds, and real estate. Unlike in the past, retail investors can actively participate in the futures market for commodities such as gold, silver, or oilseeds without the need to physically possess the stocks. The advent of three multi-commodity exchanges has facilitated this accessibility.

Benefits and Considerations for Retail Investors:

Commodities, as an asset class, offer attractive prospects for market-savvy investors and speculators. Understanding the basics of supply and demand in the context of commodities is relatively straightforward compared to the complexities of equity markets. However, it is crucial for retail investors to comprehend the risks and advantages associated with trading in commodity futures.

Compared to equities and bonds, commodity futures pricing exhibits less resilience, providing an opportunity for effective portfolio diversification. In India, the commodities market constitutes a robust portion of the economy, contributing significantly to the GDP. With an annual turnover of about Rs. 1,40,000 crore, the introduction of futures markets is anticipated to substantially amplify the size of the commodities market.

Breaking Down Commodity Futures Contracts: Considerations and Risks

Commodity futures contracts enable speculators, in addition to hedgers, to make directional price bets on raw materials. However, the futures market involves risks, particularly for inexperienced traders, primarily due to the high leverage associated with holding futures contracts. 

For instance, an investor entering into a futures contract for 1,000 barrels valued at Rs. 45,000 with an initial margin of Rs. 3,700 could experience significant gains or losses from even a minor price fluctuation.

Unlike options, futures contracts entail the obligation to buy or sell the underlying asset. Failure to close an existing position may result in an inexperienced investor taking delivery of an unwanted quantity of commodities. Furthermore, speculation using a short position in futures can lead to total losses.

Commodity Futures Hedging Example: Managing Price Risks

Buyers and sellers can utilize commodity futures contracts to lock in purchase or sale prices for weeks, months, or even years in advance. This hedging strategy helps manage price risks and provides a level of certainty for market participants involved in the production and consumption of commodities.

Let's imagine a farmer who expects to produce 1,000,000 bushels of soybeans in the next year. Normally, soybean futures contracts come in units of 5,000 bushels. The farmer needs the price to be at least Rs. 10 per bushel to cover the costs of growing soybeans.

Currently, the farmer notices that a one-year futures contract for soybeans is priced at Rs. 15 per bushel. To secure this selling price, the farmer decides to sell enough one-year soybean contracts to cover the entire harvest. Since each contract is for 5,000 bushels and the farmer needs 1,000,000 bushels, they sell 200 contracts (1,000,000 bushels needed / 5,000 bushels per contract = 200 contracts).

A year later, regardless of the market price, the farmer delivers the 1,000,000 bushels and receives the locked-in price of Rs. 15. This amounts to Rs. 15 x 200 contracts x 5000 bushels, totaling Rs. 15,000,000 in income.

If soybeans were priced at Rs. 15 per bushel in the market on the expiration date, the farmer did well. However, if the market price was lower, like Rs. 13 per bushel, the farmer would gain Rs. 2 per bushel, resulting in a profit of Rs. 2,000,000. On the flip side, if soybeans were trading at Rs. 17 per bushel at expiration, the farmer missed out on an extra Rs. 2 per bushel profit due to the locked-in selling price of Rs. 15.

Features of Commodity Futures Contracts

• Organized Trading Platforms:

Commodity futures contracts are exclusively traded on organized exchanges, such as NCDEX and MCX in India, as well as internationally recognized platforms like NYMEX, LME, and COMEX.

• Standardization for precision:

Commodity futures contracts adhere to high standardization levels, with predetermined specifications for quality, quantity, and delivery dates, ensuring consistency across transactions.

• Risk Mitigation through Clearinghouses:

To eliminate counterparty risk, commodity futures exchanges employ clearinghouses. These institutions guarantee the fulfillment of contract terms, minimizing the possibility of default by any involved party.

• Margin Trading Facilitation:

Commodity futures trading involves posting a margin, typically ranging from 4 to 8% of the contract's total value. Traders are not required to put up the entire contract value, enabling the adoption of leveraged positions (margin requirements may vary by exchange and commodity).

• Regulatory Oversight for Fair Practices:

Futures markets are closely regulated by government agencies, such as the Forward Markets Commission (FMC) in India and the Commodity Futures Trading Commission (CFTC) in the USA. This regulatory scrutiny ensures fair and ethical practices within these markets.

• Structured and Predetermined Markets:

Commodity futures contracts maintain a high degree of standardization, with predefined attributes for quality, quantity, and delivery dates, providing a structured and predictable environment.

• Possibility of Physical Delivery:

Upon contract expiration, actual delivery of the commodity can occur. Members engaging in physical delivery must provide prior delivery information and comply with all formalities specified by the exchange.

What is Forward Contracts:

A forward contract is a personalized agreement between two parties to either buy or sell an asset at a predetermined price on a future date. While a forward contract serves dual purposes for hedging or speculation, its unique feature lies in its non-standardized nature, making it especially well-suited for hedging purposes.

In contrast to standardized futures contracts, a forward contract offers the flexibility to tailor its terms to specific commodities, quantities, and delivery dates. This customization extends to a diverse range of traded commodities, including grains, precious metals, natural gas, oil, and even poultry. Settlement for a forward contract can take place either in cash or through physical delivery.

Unlike futures contracts that trade on centralized exchanges, forward contracts operate over-the-counter (OTC). This OTC nature allows for greater customization of contract terms. However, the absence of a centralized clearinghouse introduces a heightened level of default risk, as there is no intermediary to guarantee the fulfillment of contract obligations.

Breaking Down Forward Contract

Let's consider a practical example of a forward contract. Imagine an agricultural producer with two million bushels of corn to sell in six months harboring concerns about a potential decline in corn prices. To hedge against this risk, the producer enters into a forward contract with a financial institution to sell the two million bushels of corn at a predetermined rate of Rs. 4.30 per bushel, with settlement on a cash basis after six months.

After the stipulated period, the spot price of corn can unfold in three scenarios:

1. If the spot price is exactly Rs. 4.30 per bushel, there are no monetary obligations between the producer and the financial institution, and the contract concludes without any payments.

2. In case the spot price surpasses the contract price, for instance, reaching Rs. 5 per bushel, the producer is liable to the institution for Rs. 1.4 million. This amount represents the difference between the prevailing spot price and the agreed-upon rate of Rs. 4.30.

3. Conversely, if the spot price is lower than the contract price, say Rs. 3.50 per bushel, the financial institution compensates the producer with Rs. 1.6 million. This payment reflects the disparity between the contracted rate of Rs. 4.30 and the actual spot price.

Features of Forward Contracts

• Corporate Risk Management Through Forward Contracts:

Many major corporations employ forward contracts as a strategy to mitigate risks associated with currency and interest rate fluctuations.

• Market Size Challenges:

Assessing the exact size of the forward contract market proves challenging. This difficulty arises from the fact that the specifics of these contracts, limited to the buyer and seller, remain undisclosed to the general public.

• Risk of Defaults in an Unregulated Landscape:

The forward contract market, characterized by its substantial size and lack of regulation, presents the potential for defaults in extreme cases.

• Risk Mitigation by Financial Institutions:

Banks and financial corporations adopt a cautious approach to handling these risks. They meticulously select counterparties to minimize the likelihood of defaults.

• Non-Standardized Settlement Approach:

A key feature of forward contracts is their non-standard nature. Unlike futures contracts, they are settled solely on the designated settlement date and do not undergo continuous marking-to-market assessments.

Forward Contracts vs. Futures Contracts: Key Differences

Both involve buying or selling commodities at set prices in the future. Key differences:

Trading Venue:

• Forward: not traded on an exchange.

• Futures: traded on exchanges.

Settlement Timing:

• Forward: settles at the contract end.

• Futures: Daily settlements.

Customization vs. Standardization:

• Forward: Highly customizable.

• Futures: standardized agreements.

Frequently Asked Questions

1. What is a commodity forward contract?

A commodity forward contract is a personalized agreement to buy or sell a set quantity of a commodity at a specified price on a future date. It's a non-standardized contract tailored to individual needs.

2. What are the features of commodity futures contracts?

Commodity futures contracts are standardized agreements traded on exchanges, featuring predetermined terms for quality, quantity, and delivery dates. They provide a structured platform for buying or selling commodities.

3. How do forwards and futures play a role in commodities trading?

Forwards and futures in commodities trading serve multiple purposes. They help mitigate risks, facilitate price discovery, and provide opportunities for speculation on the future direction of commodity prices.

4. How Can One Trade Commodity Futures?

Trading commodity futures involves navigating markets, understanding contract terms, and managing risks effectively. Traders must be aware of market dynamics and stay informed about factors influencing commodity prices.

5. What is the difference between forward and future contracts?

While both involve buying or selling commodities at set prices in the future, forward contracts are customizable, traded over-the-counter, and settled at the contract end. In contrast, futures contracts are standardized, exchange-traded, and settled on a daily basis.