NISM Series - XVI Commodity Derivatives Cert. Mock Test -3

Principal risk arises when the buyer/seller has not received the goods/funds but has fulfilled his obligation of making payment/delivery of goods. This is eliminated by having a central counterparty such as a clearing corporation.

Volatility is the magnitude of movement in the underlying asset’s price, either up or down. It affects both calls and puts option+s in the same way. The higher the volatility of the underlying stock, the higher the premium.

In commodities futures, there are two types of settlement price: the daily settlement price (DSP), which is known as the closing price, and the final settlement price (FSP), which is known as the Due Date Rate (DDR). The daily settlement price calculates the daily mark-to-market profit or loss.

The final settlement price is used for a “delivery default penalty” in case of non-delivery of the short sell quantity. Prescribed methodologies are used to arrive at the delivery default penalty and calculate compensation to the buyer in such cases using FSP.

Cash-and-carry arbitrage refers to buying a physical commodity with borrowed funds and simultaneously selling the futures contract. The physical commodity is delivered upon the expiry of the contract. This opportunity arises when the futures price of the commodity is more than the sum of the spot price and the cost of carrying it till the expiry date.

The hedge ratio indicates the number of lots/contracts that the hedger is required to buy or sell in the futures market to cover his risk exposure in the physical / spot market. It helps to neutralize the volatility difference between Spot and Futures.

An ‘In the Money’ (ITM) option would give the holder a positive cash flow if it were exercised immediately. ( A profitable situation)

A put option is said to be ITM when the spot price is lower than the strike price.

A call option is said to be ITM when the spot price is higher than the strike price.

Futures relating to currency rates (currency futures), interest rates (bond futures), and equity prices (stock or equity index futures) are known as financial futures.

Futures on crude oil, metals like Gold, etc., agriculture products, etc are known as Commodity futures.

An option seller cannot demand an exercise of the option. He can only square off his position before the expiry date. Only an option buyer can exercise the option.

A forward contract is an agreement for the delivery of goods or the underlying asset on a specific date in the future at a price agreed on the date of the contract.

The Daily Price Range is 7%.

7% of Rs. 300 is Rs. 21

So the price range will be 300 – 21 and 300 + 21 = Rs. 279 to Rs.321

By buying a futures contract, he will lock his buying price. Any rise in prices will not affect him.

At the future date when he wants to buy the commodity in the spot market, he will sell the futures contract and buy in the spot market.

A commodity exchange will introduce a commodity having due regard to key factors such as demand for the introduction of a particular commodity from the market players, demand and supply dynamics, price volatility, inventory level, stock utilization, price elasticity, liquidity level of commodity markets, production of a commodity, the political sensitivity of commodity, homogenous nature, durability/expiry period of commodity, storability, government regulation, and control, etc.

The cost of carry has two components – Interest cost (for 180 days) and storage cost (for 180 days)

Interest Cost = 35000 x .09 (Interest rate) x ( 180 /365) for 180 days

= 35000 x .09 x 0.4931

= 1553.26

Storage Cost = 35000 x .02 (Storage cost) x (180/365) for 180 days

= 35000 x .02 x 0.4931

= 345.17

So the total cost of carrying will be 1553.26 + 345.17 = 1898.43

The daily settlement price calculates the daily mark-to-market profit or loss.

MTM profit/loss is calculated by marking all the positions in the futures contracts to the daily settlement price (DSP) of the futures contracts at the end of each trading day.

Buyer of an option: The buyer of an option has a right but not an obligation in the contract. For owning this right, he pays a price to the seller of this right called ‘option premium’ to the option seller.

The buyer of an option is said to be “long on the option”. He/she would have a right and no obligation about buying (in case of a call) / selling (in case of putting) the underlying asset in the contract.

A short position means Ms. Reshma has sold the futures contract expecting the prices to fall. She can only make a profit if the futures prices fall or make a loss if future prices rise.

For eg. Ms. Reshma sells a futures contract at Rs 100. The price rises and on expiry, the price is Rs. 120. Here she will make a loss of Rs. 20.

Generally, the longer the maturity of the option ie. the higher the time to expiry, the greater the uncertainty, and hence the higher premiums for both calls and put options.

Arbitrageurs simultaneously buy and sell in two markets where their selling price in one market is higher than their buying price in another market by more than the transaction costs, resulting in a riskless profit to the arbitrager.

Buying a spread is an intra-commodity spread strategy. It means buying a near-month contract and simultaneously selling a far-month contract. This strategy is adopted when the near-month contract is underpriced or the far-month contract is overpriced.

A trader of the above strategy buys the near-month contract and sells the far-month contract when the spread is not fair and squares the positions when the spread corrects and the contracts are traded at the fair spread.

Premium is the cost of the option paid by the buyer to the seller and is non-refundable. Since the buyer is paying the premium to the seller, he has the right to exercise the option when it is favorable to him but has no obligation to do so.

In the case of both call and put options, the buyer has the right but no obligation whereas the seller, being the receiver of the premium, has no right but an obligation to the buyer.

Clearing Corporation with the help of clearing banks transfers the funds equivalent to the contract value to the clearing member.

Exchange regulations specify codes of conduct related to the commodity derivatives segment. All trading members must comply with these. One of the codes of conduct is :

– No Trading Member or person associated with the Trading Member shall guarantee a client against a loss in any transactions effected by the Trading Member for such client.

The main objective of commodity market regulation is to maintain and promote the fairness, efficiency, transparency and growth of commodity markets and to protect the interests of the various stakeholders of the commodity market and to reduce systemic risks and ensure financial stability.

The three-tiered regulatory framework for commodity markets comprises Government of India, Securities and Exchange Board of India (SEBI) and Exchanges.

When the futures price is less than the spot price, the basis is a positive number. This is known as the backwardation market.

Exchange traded commodity markets facilitates efficient price discovery as the market brings together buyers and sellers of divergent needs in a transparent online system.

The above question implies that if the oil content in castor seed is below 47 percent but within 45 percent, the contracted price will attract discount. For every 1 percent decrease in oil content or part thereof, there will be a discount of 2 percent or part thereof in price.

Contracted price of castor seeds i.e., Rs 6000 will be discounted by 2 percent because the quality content has decreased by 1 percent (from 47 percent to 46 percent).

Contracted price of castor seeds (at discount) = 6000 – 2% of 6000 = 6000 – 120 = Rs. 5880

On a Screen based computerised trading system, the order matching is done on a price-time priority basis. This means that all the orders received are sorted on ‘best-price’ basis

A Member is permitted to modify or cancel his orders. The order can be modified by effecting changes in the order input parameters. Time priority for an order modification will not change due to decrease in its quantity or decrease in disclosed quantity. In other circumstances, the time priority of the order will change.

The Securities Contract (Regulation) Act, 1956 (SCRA) gives SEBI the jurisdiction over stock exchanges through recognition and supervision. It also gives SEBI the jurisdiction over contracts in securities and listing of securities on stock exchanges.

Self Clearing Members (SCM) / Trading cum Clearing Member (TCM): This category of membership entitles a member to execute trades on his own account as well as for his clients and also to clear and settle trades executed by himself as well as of his clients.

Clearing members are members of the clearing corporation. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

In a Mandi, the farmers bring their produce, and the traders or middlemen known as commission agents inspect the quality and bid for the same. The buyer with the highest bid acquires the produce.

Thus mandis are physical spot markets in which the commodities are physically bought and sold by the buyers and sellers respectively for immediate delivery.

Speculation is a practice of engaging in trading to make quick profits from fluctuations in prices.

Long speculators are those who buy first and expect the price to increase from current level.

Short speculators are those who sell first and expect the price to decrease from current level.

If a trader is expecting a large decrease in volatility, he will try to gain from it by selling a call and a put with same expiry dates but with different strike prices. This is known as Short Strangle.

A Trading Member can trade either on their own account or on behalf of the clients. This category of membership entitles a member to execute trades on his own account as well as for clients registered with him.

Mr. Amit has sold Cotton and to hedge his position he has to go long on Cotton(buy).

When he buys the Call Option, he will benefit if prices rise. And if prices fall, he will benefit from his forward sale position. So, by buying a Call Option, he will create a good hedge.

Note –

Buy Call Option – View is bullish / Prices to rise. Maximum profit unlimited and maximum loss limited to premium paid

Buy Put Option – View is bearish / Prices to fall – Maximum profit unlimited and maximum loss limited to premium paid

Sell Call Option – View is bearish / Prices to fall – Maximum profit limited to premium received and maximum loss is unlimited

Sell Put Option – View is bullish / Prices to rise – Maximum profit limited to premium received and maximum loss is unlimited

Convenience yield indicates the benefit of owning a commodity rather than buying a futures contract on that commodity. Convenience yield can be generated because of the benefit from ownership of a physical asset.

Futures Price = Spot Price + Cost of carry

(The cost of carry is the Spot price X interest cost for 4 months)

= 40000 + ( 40000 x 12% x 4/12)

= 40000 + ( 40000 x .12 x 0.3333)

= 40000 + (40000 x 0.04)

= 40000 + 1600

= 41600

Spread refers to the difference in prices of two futures contracts.

Selling a spread is also an intra-commodity spread strategy. It means selling a near-month contract and simultaneously buying a far-month contract. This strategy is adopted when the near-month contract is overpriced or the far-month contract is underpriced.

A trader of the above strategy sells the near-month contract and buys the far-month contract when the spread is not fair and squares off the positions when the spread corrects and the contracts are traded at fair spread.

Fair Value of the Futures Contract = Spot Price + Cost of Carry

The futures price is based on the relevant spot market price that is adjusted for the ‘cost of carry’ associated with the specific commodity.

Stop loss orders are passive until the trigger price is breached. Once this trigger price is reached, the stop loss feature gets activated.