What are Commodities Futures Contracts
Commodities traded in the commodity exchanges are required to be delivered at the contracted price, ignoring all the changes in the market prices. Both the participants (Buyers & Sellers) are allowed to liquidate their respective positions by way of cash settlement of price between the contracted and liquidated price, no later than the last trading session of the specified expiry date.
An effective and efficient market for trading in commodities futures requires:
Volatility in the prices of the underlying commodities.
Large numbers of buyers and sellers with diverse risk profiles(hedgers, speculators and arbitrageurs).
The underlying physical commodities to be fungible, i.e. they should be exchangeable.
Features of commodity futures
1. Organized :
Commodity Futures contracts always trade on an organized exchange, e.g. NCDEX, MCX, etc in India and NYMEX, LME, COMEX etc. internationally.
2. Standardized :
Commodity Futures contracts are highly standardized with the quality, quantity, and delivery date, being predetermined.
3. Eliminates Counterparty Risk :
Commodity Futures exchanges use clearing houses to guarantee that the terms of the futures contract are fulfilled. The Clearing House guarantees that the contract will be fulfilled, eliminating the risk of any default by the other party.
4. Facilitates Margin Trading :
Commodity Futures traders do not have to put up the entire value of a contract. Rather, they are required to post a margin that is roughly 4 to 8% of the total value of the contract (this margin varies across exchanges and commodities). This facilitates taking of leveraged positions.
5. Closing a Position :
Futures markets are closely regulated by government agencies, e.g. Forward Markets Commission (FMC) in India, Commodity Futures Trading Commission in (CFTC) USA, etc. This ensures fair practices in these markets.
6. Regulated Markets Environment :
Commodity Futures contracts are highly standardized with the
quality, quantity, and delivery date, being predetermined.
7. Physical Delivery :
Actual delivery of the commodity can be made or taken on expiry of the contract. Physical delivery requires the member to provide the exchange with prior delivery information and completion of all the delivery related formalities as specified by the exchange.
In order to understand the commodity market participants like hedgers, speculators and arbitrageurs, it is essential to first understand all the features, terms and conditions of the commodity futures contract.
In the next chapter we will learn about the various commodity market participants like hedgers, speculators and arbitrageurs.