TYBMS SEM 5 : Finance: Commodity & Derivatives Market (Q.P. November 2018 with Solution)

 Paper/Subject Code: 46006/Finance: Commodity & Derivatives Market

TYBMS SEM 5 : 

Finance:

Commodity & Derivatives Market 

(Q.P. November 2018 with Solution)

Note: 1) All Questions are compulsory subject to internal choice

2) Figures to right indicate full marks

Q.1 (A) State weather the following statement are True or False. (Any 8)

1. It is very difficult to take long or short position in the derivatives & compare to other assets.

Ans: False

2. Forwards are over the counter instrument.

Ans: True

3. Expiration day is the last trading day of the contract.

Ans: False

4. The spot price is the future market price of the underlying assets.

Ans: False

5. Contract price = (Price of each security x contract) / Lot size

Ans: False

6. Payoff on a position is likely profit/ loss that would accrue to a market participant with change in the price of the underlying asset at expiry. 

Ans: True

7. Speculators take large, calculated risks as they trade based on anticipated future price movements.

Ans: True

8. In options, execution of contract can be done any time before the expiry of the agreed date.

Ans: True

9. An option premium is the income received by an investor who holds the option contract.

Ans: False

10. The strike price is specified in the option contract and does change over time.

Ans: False

B) Match the following (Any 7)

Column A	Column B
1 No margin requirement	a Unlimited profit
2 Contract size	b Highly risky
3 Settlement of forward contract	c. Lot size
4 Speculation	d Higher option premium
5 Arbitrage	e Cash or delivery
6 Option writer	f Forwards
7 Option holder	g. Directly proportional to spot price
8 Deep in the money	h. Short position
9 Futures contract	i. Operating leverage
10 Financial risk	J. Symmetrical payoffs

Ans: 

Column A	Column B
1 No margin requirement	f Forwards
2 Contract size	c. Lot size
3 Settlement of forward contract	e Cash or delivery
4 Speculation	b Highly risky
5 Arbitrage	g. Directly proportional to spot price
6 Option writer	J. Symmetrical payoffs
7 Option holder	a Unlimited profit
8 Deep in the money	d Higher option premium
9 Futures contract	h. Short position
10 Financial risk	i. Operating leverage

Q.2 (A) Discuss the Participants in derivative market?

Participants in the derivative market can be categorized into four main groups based on their trading objectives and risk appetite:

1. Hedgers

• Objective: Reduce or eliminate price risk associated with their underlying assets.

• Participants: Businesses, farmers, exporters/importers, and financial institutions.

• Example: A wheat farmer hedges against price drops by selling wheat futures contracts.

2. Speculators

• Objective: Profit from price fluctuations in the derivative market by taking calculated risks.

• Participants: Traders, hedge funds, and high-net-worth individuals.

• Example: A trader buys call options on a stock expecting the price to rise before expiration.

3. Arbitrageurs

• Objective: Exploit price differences between markets to make risk-free profits.

• Participants: Institutional investors, hedge funds, and professional traders.

• Example: Buying a stock in one market at a lower price and simultaneously selling it in another market at a higher price.

4. Margin Traders (Market Makers)

• Objective: Provide liquidity to the market by constantly quoting buy and sell prices.

• Participants: Financial institutions, brokerage firms, and proprietary trading firms.

• Example: A market maker buys and sells options contracts to ensure continuous trading.

Q.2 (B) Distinguish between Forward & Future

	Forward Contract	Future Contract
Definition	A private agreement between two parties to buy or sell an asset at a future date for a predetermined price.	A standardized contract traded on an exchange to buy or sell an asset at a future date for a predetermined price.
Trading Venue	Over-the-Counter (OTC)	Exchange-traded
Standardization	Customized contract terms (quantity, price, expiration date, etc.)	Highly standardized with fixed contract sizes, expiration dates, and specifications.
Counterparty Risk	High, as the contract is private and not regulated by an exchange.	Low, as clearing houses act as intermediaries and guarantee the trade.
Liquidity	Low, as contracts are tailor-made and not easily tradable.	High, as contracts are standardized and actively traded on exchanges.
Margin Requirement	No margin requirement; settlement occurs at maturity.	Requires margin deposits and daily mark-to-market settlements.
Settlement	Settled at the contract’s expiration (physical or cash settlement).	Marked-to-market daily, meaning profits/losses are settled daily.
Flexibility	More flexible in terms of contract terms and conditions.	Less flexible due to standardization.
Example	A farmer agrees with a mill to sell 1000 bushels of wheat at $5 per bushel in 3 months.	A trader buys an oil futures contract on the Chicago Mercantile Exchange (CME) with set expiry and contract size.

 

OR

Q.2(C) Write note on different types of derivative traded in India.

In India, derivatives are actively traded on exchanges like the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). The Indian derivative market includes various financial instruments that help investors hedge risks, speculate on price movements, and engage in arbitrage. The key types of derivatives traded in India are:

1. Futures Contracts

Definition: A standardized agreement to buy or sell an asset at a predetermined price on a specified future date.
Markets: NSE and BSE offer futures on stocks, indices, and commodities.
Examples:

• Stock Futures (e.g., Reliance, TCS)

• Index Futures (e.g., Nifty 50, Bank Nifty)

• Commodity Futures (e.g., Gold, Crude Oil on MCX)

🔹 Usage: Used for hedging, speculation, and arbitrage.

2. Options Contracts

Definition: A contract that gives the buyer the right (but not the obligation) to buy (call option) or sell (put option) an asset at a predetermined price before or on the expiry date.
Markets: NSE and BSE for stock and index options, MCX for commodity options.
Examples:

• Stock Options (e.g., Infosys Call Option)

• Index Options (e.g., Nifty 50 Put Option)

• Commodity Options (e.g., Gold Call Option on MCX)

🔹 Usage: Used for hedging and speculation with limited risk.

3. Forwards Contracts (OTC Market)

Definition: A customized contract between two parties to buy or sell an asset at a specific price on a future date.
Markets: Over-the-counter (OTC) – Not traded on an exchange.
Examples:

• Currency Forwards (e.g., INR/USD contract between an exporter and a bank).

🔹 Usage: Mainly used by businesses to hedge currency and commodity risks.

4. Swaps (OTC Market)

Definition: A derivative contract where two parties exchange cash flows based on a pre-agreed formula.
Markets: OTC – Traded between banks and financial institutions.
Examples:

• Interest Rate Swaps (IRS): Exchanging fixed interest rate payments for floating-rate payments.

• Currency Swaps: Exchanging cash flows in different currencies to hedge forex risk.

🔹 Usage: Used by corporates and banks for risk management.

Q.2(D) Define Commodity Market. Explain its history & growth in India

A commodity market is a marketplace where raw materials or primary products (such as gold, oil, agricultural produce, metals, etc.) are bought and sold. These markets facilitate trading in physical commodities (spot market) and commodity derivatives (futures & options) to help producers, traders, and investors manage price risks.

History of the Commodity Market in India

1. Early Trading (Before Independence)

• Commodity trading in India dates back to 1875, when the Bombay Cotton Trade Association was established for cotton futures trading.

• By the early 20th century, futures trading expanded to other commodities like wheat, jute, and oilseeds in different regions of India.

• In 1939, the Indian government temporarily banned forward trading in certain commodities due to price fluctuations during World War II.

2. Post-Independence Era & Ban (1950s-1990s)

• In the 1950s, due to food shortages and inflation, the government imposed strict regulations on commodity trading, leading to a ban on futures trading in most commodities.

• From 1952 to the 1990s, only limited spot trading was allowed in some commodities like cotton, pepper, and jute.

3. Liberalization & Revival (2000s Onwards)

• In 2003, the Government of India revived commodity derivative trading by allowing futures trading in multiple commodities.

• The Forward Markets Commission (FMC) regulated the market until 2015, when it merged with SEBI (Securities and Exchange Board of India) for better oversight.

• Multi Commodity Exchange (MCX) and National Commodity & Derivatives Exchange (NCDEX) were established as major exchanges for commodity trading.

Growth of the Commodity Market in India

1. Establishment of Commodity Exchanges

• MCX (Multi Commodity Exchange) – Leading exchange for metals, energy, and agriculture commodities.

• NCDEX (National Commodity & Derivatives Exchange) – Focuses on agricultural commodities.

• ICEX (Indian Commodity Exchange) – Known for diamond and rubber trading.

2. Introduction of Commodity Futures & Options

• Futures contracts were reintroduced in 2003, allowing traders to hedge against price volatility.

• In 2017, SEBI introduced commodity options trading, starting with gold.

3. Increased Participation

• Growth in participation from farmers, traders, investors, and institutions due to better technology, transparency, and regulatory oversight.

• Electronic trading platforms have made commodity trading more accessible to retail investors.

4. Integration with Global Markets

• Indian commodity markets are now linked with international benchmarks for price discovery.

• Agreements with foreign exchanges like CME (Chicago Mercantile Exchange) and LME (London Metal Exchange) improve liquidity.

Q.3(A) Explain the following Terminologies:

1. Initial Margin

Definition:

• The minimum deposit required by an investor to open a futures or options position.

• It acts as a security deposit to cover potential losses.

Example:

• Suppose a trader wants to buy Nifty futures worth ₹10,00,000, and the exchange requires a 10% margin.

• The trader must deposit ₹1,00,000 as the initial margin before trading.

Purpose:

• Ensures financial stability in the market.

• Reduces default risk by requiring traders to commit capital upfront.

2. Contract Size

Definition:

• The total quantity of the underlying asset specified in a derivative contract.

• It determines the notional value of the contract.

Formula: 

$$\text{Contract Size}=\text{Lot Size }\times \text{Price per Unit}$$

Example:

• In Nifty futures, the lot size is 50 units.

• If Nifty is trading at ₹20,000, then:

  $$\text{Contract Size}=50\times 20,000=₹10,00,000$$

Purpose:

• Standardizes the trade size in derivative markets.

• Helps investors and traders determine their exposure.

3. Settlement Price

Definition:

• The official price used to calculate gains and losses, determine margin requirements, and settle contracts.

• It is usually the closing price of the contract on a trading day.

Types of Settlement:

1. Mark-to-Market (MTM) Settlement: Futures positions are adjusted daily based on the latest settlement price.

2. Final Settlement Price: The price at which the contract expires and is settled in cash or physical delivery.

Example:

• A trader holds a crude oil futures contract at ₹6,500 per barrel.

• At the end of the day, the settlement price is ₹6,520 per barrel.

• The trader gains ₹20 per barrel, which is credited to their account.

Purpose:

• Ensures fair price determination and prevents manipulation.

• Helps in the daily mark-to-market adjustments.

4. Option Premium

Definition:

• The price paid by the buyer of an option contract to the seller (writer) for the right to buy or sell the underlying asset.

• It represents the cost of the option.

Formula:

$$\text{Option Premium}=\text{Intrinsic Value }+\text{Time Value}$$

Example:

• A trader buys a Nifty 20,000 Call Option for ₹200.

• The total premium paid = ₹200 × 50 (lot size) = ₹10,000.

Purpose:

• Represents the risk and reward potential of an options contract.

• Higher premiums indicate high volatility or deep in-the-money options.

Q.3(B) What is imperfect hedge? what are the reasons for imperfect hedge?

An imperfect hedge occurs when a hedging strategy does not completely eliminate the risk of price fluctuations in the underlying asset. In such cases, there remains some residual risk, known as basis risk.

Example:

• A farmer hedges wheat prices using wheat futures, but due to differences in contract size or expiration dates, the hedge does not fully protect against price changes.

Reasons for Imperfect Hedge

1️⃣ Basis Risk

• The difference between the spot price and the hedging instrument's price (e.g., futures price) leads to incomplete risk coverage.

• Example: If a company hedges crude oil prices using futures, but oil prices fluctuate differently in the spot and futures markets, the hedge remains imperfect.

2️⃣ Mismatched Contract Sizes

• The lot size of a derivative contract may not match the exact exposure of the underlying asset.

• Example: A company needs to hedge 12,000 barrels of crude oil, but futures contracts are available in lots of 10,000 barrels, leaving 2,000 barrels unhedged.

3️⃣ Different Expiry Dates (Maturity Mismatch)

• The hedging contract's expiration date may not align with the actual risk exposure period.

• Example: A company hedges using a three-month futures contract, but its exposure lasts for four months, leading to a gap in protection.

4️⃣ Liquidity Constraints

• Some derivatives markets may have low trading volumes, making it difficult to execute a perfect hedge.

• Example: If an investor wants to hedge a mid-cap stock, but no liquid futures contracts exist for it, the hedge may not be effective.

5️⃣ Correlation Risk

• A hedge may be placed using a related asset (proxy hedge), but if the correlation weakens, the hedge becomes imperfect.

• Example: A gold jewelry manufacturer hedges gold price risk using silver futures due to a strong historical correlation, but if gold and silver prices diverge, the hedge fails.

6️⃣ Regulatory & Market Restrictions

• Trading restrictions, margin requirements, or market disruptions (such as price limits on futures contracts) can prevent a hedge from being fully executed.

• Example: A government-imposed ban on wheat futures trading can make it impossible for a farmer to hedge wheat price fluctuations.

OR

Q.3 (C) The spot price of gold is Rs 31,000/- the locker rent is Rs500 and the insurance charges are Rs 750. The interest rate on the borrowed funds is 14% p.a. compounded on monthly basis. What will be the fair value of futures after 3 months?            (08) 

Q.3(D) Naman shorts a call option of VST Ltd at an exercise price of Rs 1020 with a premium of Rs 50. Calculate the profit or loss for Naman if the spot price on expiry is as follows: Rs. 970, Rs. 980, Rs. 990, Rs. 1000, Rs. 1010, Rs. 1020, Rs. 1030, Rs. 1040, Rs. 1050. Also draw the payoff diagram for the same.                             (07)

Q.4 (A) Explain what is meant by intrinsic value or moneyness of an option contract (07)

1. Intrinsic Value of an Option

Definition:

• Intrinsic value is the real value of an option if it were exercised immediately.

• It represents the difference between the spot price of the underlying asset and the strike price of the option.

Formula:

• Call Option:

  $$\text{Intrinsic Value}=\max (0,\text{Spot Price}-\text{Strike Price})$$

• Put Option:

  $$\text{Intrinsic Value}=\max (0,\text{Strike Price}-\text{Spot Price})$$

Example:

• Suppose a Nifty 50 Call Option has a strike price of ₹20,000 and Nifty is trading at ₹20,500.

  $$\text{Intrinsic Value}=20,500-20,000=₹500$$

• If the Nifty trades below ₹20,000, the intrinsic value is ₹0, as the option would expire worthless.

🔹 An option's premium consists of intrinsic value + time value.

2. Moneyness of an Option

Definition:

• Moneyness describes the financial state of an option—whether it has intrinsic value or not.

Types of Moneyness:

Type	Call Option Condition	Put Option Condition	Meaning
In the Money (ITM)	Spot Price > Strike Price	Spot Price < Strike Price	Option has positive intrinsic value.
At the Money (ATM)	Spot Price = Strike Price	Spot Price = Strike Price	No intrinsic value, only time value.
Out of the Money (OTM)	Spot Price < Strike Price	Spot Price > Strike Price	No intrinsic value, expires worthless.

Example: (Assume Nifty 50 is trading at ₹20,500)

• Call Option ₹20,000 (ITM) → Intrinsic Value = ₹500

• Call Option ₹20,500 (ATM) → Intrinsic Value = ₹0

• Call Option ₹21,000 (OTM) → Intrinsic Value = ₹0

• ITM options have intrinsic value.

• ATM & OTM options have only time value.

Q.4 (B) Distinguish between Binomial Option Pricing Model & Black Scholes Option Pricing Model             (08)

	Binomial Option Pricing Model	Black-Scholes Option Pricing Model
Approach	Uses a step-by-step method (discrete time) to estimate option price.	Uses a continuous-time formula to derive option price.
Mathematical Basis	Based on repeated up/down movements in the underlying asset’s price over time.	Uses stochastic calculus (lognormal distribution of asset prices).
Time Framework	Multi-period model that breaks time into small intervals.	Single-period model, assuming continuous price movement.
Hedging	Assumes dynamic hedging at each step.	Assumes continuous hedging.
Flexibility	More flexible, allowing for American & European options.	Best suited for European options (not ideal for early exercise).
Assumptions	Assumes price moves in a binomial tree structure (up/down at each step).	Assumes constant volatility, no arbitrage, and no dividends.
Complexity	Computationally intensive but useful for real-world scenarios.	More mathematically complex but faster to compute.
Application	Used for pricing American, European, and exotic options.	Used for pricing European options on stocks, indices, and currencies.

 

OR

Q.4 (C) The spot price of copper is Rs 4,600 per kg, the store room rent is Rs6,000 paid semi annually. The interest rate on the borrowed funds is 12% p.a. compounded on monthly basis. What will be the fair value of futures after 3 months?                    (07)

Q.4 (D)An investor takes position in the futures market through the following transactions                                                             (08)
a. Buys 6 contracts of Tata Steel Ltd at Rs 3125 with a lot size of 200, which expires at a final settlement price of Rs 3150

b. Sells 7 contracts of Canara Bank at Rs 675 with a lot size of 100 which expires at 665 Determine the net profit or loss for the investor from both the positions draw payoff diagram for respective positions

Q.5 (A) What are the types of Order?

In trading, an order is an instruction given by a trader to buy or sell a security. Different types of orders help traders manage execution speed, price, and risk.

1. Market Order

Definition:

• An order to buy or sell immediately at the best available price.

• Guarantees execution but not the exact price.

Example:

• A trader places a market order to buy 100 shares of TCS.

• The order executes at the current market price, say ₹3,500 per share.

Best For:

• Fast execution when price certainty is not a priority.

2. Limit Order

Definition:

• An order to buy or sell at a specific price or better.

• Buy Limit Order: Executes at or below the limit price.

• Sell Limit Order: Executes at or above the limit price.

Example:

• A trader places a buy limit order for 100 shares of Reliance at ₹2,500.

• If Reliance falls to ₹2,500 or lower, the order executes.

• If the price stays above ₹2,500, the order remains pending.

Best For:

• Controlling execution price but with the risk of no execution.

3. Stop-Loss Order

Definition:

• An order that becomes a market order once the stock reaches a certain price (stop price).

• Buy Stop Order: Placed above the current market price (for short positions).

• Sell Stop Order: Placed below the current market price (for long positions).

Example:

• A trader holds Infosys at ₹1,600 but wants to limit losses.

• Places a sell stop-loss order at ₹1,550.

• If Infosys falls to ₹1,550, the order converts to a market order and sells.

Best For:

• Preventing large losses by automatically exiting a position.

4. Stop-Limit Order

Definition:

• A combination of stop-loss and limit order.

• Triggers a limit order when the stop price is reached.

Example:

• A trader places a sell stop-limit order at ₹1,550 with a limit of ₹1,540.

• If the stock drops to ₹1,550, a limit order is placed at ₹1,540.

• If the price falls too quickly below ₹1,540, the order may not execute.

Best For:

• Controlling execution price while setting a safety trigger.

5. Day Order & Good Till Canceled (GTC) Order

Day Order:

• Expires if not executed by the end of the trading day.

GTC Order:

• Remains active until executed or manually canceled.

Best For:

• Day Order: Short-term trades.

• GTC Order: Long-term investment strategies.

6. Bracket Order

Definition:

• A combination of entry, stop-loss, and target orders.

• Automatically exits at profit or loss levels.

Example:

• A trader buys Bank Nifty at ₹45,000, sets:

  • Stop-loss at ₹44,500

  • Target at ₹46,000

• Order automatically exits at either level.

Best For:

• Automated risk management in volatile markets.

7. Iceberg Order

Definition:

• A large order divided into smaller visible parts to hide actual order size.

Example:

• A mutual fund wants to buy 1,00,000 shares of HDFC Bank.

• Instead of placing one big order, it places 10 orders of 10,000 shares each.

Best For:

• Institutional investors minimizing market impact.

8. Fill or Kill (FOK) & Immediate or Cancel (IOC) Orders

FOK Order:

• Must be executed immediately in full or canceled.

IOC Order:

• Executes immediately for available quantity; remaining part is canceled.

Best For:

• High-frequency traders seeking immediate execution.

(B) What are objectives of NSCCL

The National Securities Clearing Corporation Limited (NSCCL) is a wholly owned subsidiary of the National Stock Exchange (NSE). It was established in 1996 to act as a clearing and settlement agency for trades executed on the NSE.

Objectives of NSCCL

1️⃣ Clearing & Settlement of Trades

• Ensures efficient and timely settlement of securities and funds for all trades executed on NSE.

• Reduces counterparty risk by guaranteeing trade settlements.

2️⃣ Risk Management

• Implements a robust risk management system to ensure financial stability.

• Uses margins, collateral requirements, and real-time monitoring to prevent defaults.

3️⃣ Trade Guarantee Mechanism

• NSCCL acts as a central counterparty (CCP) by guaranteeing settlement of trades.

• If a seller defaults, NSCCL ensures the buyer receives securities, and vice versa.

4️⃣ Dematerialized Settlement

• Supports paperless (demat) settlement, improving efficiency and reducing fraud risks.

• Works closely with depositories like NSDL & CDSL.

5️⃣ Regulatory Compliance

• Ensures NSE follows SEBI regulations and maintains transparency in settlement processes.

6️⃣ Market Integrity & Investor Protection

• Enhances confidence in Indian capital markets by reducing settlement risks.

• Provides real-time tracking of trade obligations to prevent manipulation.

7️⃣ Facilitating New Products

• Manages clearing & settlement for derivatives (futures & options), debt instruments, and currency markets.

Q.5 Write short notes on any three of the following

1. Backwardation

Backwardation is a market condition where the futures price of a commodity or asset is lower than its current spot price. It typically occurs when investors expect the price of the underlying asset to decrease over time. In such scenarios, buyers are willing to pay a premium for the immediate delivery of the commodity rather than waiting for a future date, often due to supply shortages or high immediate demand.

Backwardation contrasts with contango, where futures prices are higher than the spot price, reflecting expectations of rising prices over time. Backwardation can benefit traders who hold short positions in futures contracts, as the futures price converges upward toward the spot price as the contract nears expiration.

2. Reverse Cash & Carry Arbitrage

Reverse Cash and Carry Arbitrage is a trading strategy used to profit from the price difference between a commodity's spot price and its corresponding futures price when the market is in backwardation. In this scenario, the spot price is higher than the futures price, providing an opportunity for arbitrage.

To execute this strategy, an investor sells the commodity short in the spot market and simultaneously takes a long position in the futures market. The investor holds the futures contract until maturity, at which point the futures price converges to the spot price. The profit arises from the difference between the higher spot price (at the time of the short sale) and the lower futures price locked in through the purchase.

This approach can yield risk-free profits as long as the costs of carrying the position, such as storage, borrowing, and interest expenses, are less than the price difference between the spot and futures prices.

3. Types of Underlying Assets.

Underlying assets are financial instruments or physical assets upon which derivatives such as options, futures, swaps, or other financial contracts are based. Here are the main types of underlying assets:

1. Equities (Stocks)

• Common stocks or shares of publicly traded companies.
• Derivatives based on equities include stock options, equity futures, and equity swaps.

2. Bonds (Fixed Income Securities)

• Government bonds, corporate bonds, or other fixed-income securities.
• Derivatives based on bonds include bond futures, options on bonds, and interest rate swaps.

3. Commodities

• Physical goods like agricultural products (wheat, coffee), energy (crude oil, natural gas), and metals (gold, silver).
• Commodities are often the basis for futures contracts, options, and swaps.

4. Currencies (Foreign Exchange)

• Currencies of different countries (e.g., USD, EUR, JPY).
• Forex derivatives include currency futures, options, and forward contracts, allowing investors to hedge or speculate on currency movements.

5. Indices

• Stock market indices like the S&P 500, NASDAQ, or Dow Jones Industrial Average.
• Derivatives on indices include index futures and index options, used to gain exposure to broader market movements.

6. Interest Rates

• These are derived from benchmark interest rates such as LIBOR, SOFR, or government bond yields.
• Interest rate derivatives include interest rate swaps, futures, and options, helping institutions manage interest rate risk.

7. Real Estate

• Physical real estate properties or real estate investment trusts (REITs).
• Real estate can be the underlying asset for mortgage-backed securities (MBS) or REIT-based derivatives.

8. Cryptocurrencies

• Digital assets like Bitcoin (BTC), Ethereum (ETH), and others.
• Derivatives based on cryptocurrencies include futures and options, enabling traders to hedge or speculate on price changes in the digital asset space.

9. Other Financial Instruments

• This can include things like exchange-traded funds (ETFs), mutual funds, or other pooled investment vehicles.
• Derivatives like options can be based on these instruments, providing exposure to a basket of assets rather than a single security.

4. MCX

MCX (Multi Commodity Exchange of India Ltd.) is a leading commodity derivatives exchange in India. It was established in 2003 and operates under the regulatory framework of the Securities and Exchange Board of India (SEBI). MCX facilitates the trading of commodity futures contracts, enabling market participants to hedge, speculate, and invest in various commodities.

Features of MCX:

1. Commodities Traded:

   • Metals: Gold, Silver, Copper, Aluminum, Zinc, Lead, and Nickel.
   • Energy: Crude Oil, Natural Gas.
   • Agri-Commodities: Cotton, Mentha Oil, Cardamom, and other agricultural products.

2. Role in the Market:

   • MCX provides a transparent and regulated platform for price discovery and risk management.
   • It allows traders, investors, producers, and hedgers to manage price risk in commodities through futures contracts.

3. Participants:

   • The exchange is used by various market participants, including retail traders, institutional investors, producers, processors, exporters, and importers.
   • These participants use MCX for hedging against price volatility, price discovery, and taking advantage of speculative opportunities.

4. Trading Mechanism:

   • MCX operates on an electronic trading platform that ensures efficient and seamless trade execution.
   • Contracts are settled either through physical delivery or cash settlement, depending on the nature of the contract.

5. Significance in the Indian Economy:

   • MCX plays a vital role in India’s commodity markets by providing a structured environment for commodity trading.
   • It aids in better price transparency and helps in the effective management of risks related to commodity price fluctuations.
   • It also contributes to the stability of India's agricultural, energy, and metals markets.

MCX has become a crucial part of India's financial ecosystem by offering a wide range of commodities for trading, enabling better risk management practices, and providing a reliable platform for price discovery in various markets.

5. Cost of Carry Model

The Cost of Carry Model is used to determine the fair price of a futures contract based on the spot price and the costs associated with holding (carrying) the underlying asset until the futures contract expires.

Formula:

For a non-dividend-paying asset, the futures price is calculated as:

$$F=\mathrm{S }\times {\mathrm{e }}^{(\mathrm{r }+ \mathrm{c }- y)T}$$

Where:

• F = Futures price

• S = Spot price of the underlying asset

• e = Euler’s number (≈ 2.718)

• r = Risk-free interest rate (cost of financing the asset)

• c = Storage and other carrying costs (if applicable)

• y = Income or yield received from the asset (e.g., dividends)

• T = Time to maturity of the contract (in years)

Components of Cost of Carry

1. Financing Cost (r)

• If an investor borrows money to buy the asset, the interest on that loan is a cost.

• Higher interest rates lead to a higher futures price.

2. Storage Cost (c)

• Some physical assets (e.g., commodities like gold, oil, wheat) incur storage and insurance costs.

• These costs increase the futures price.

3. Income from Asset (y)

• Some assets, like stocks, pay dividends, or commodities may provide income (e.g., oil storage earns rental income).

• Higher income/yield reduces the futures price.

Example

Assume:

• Spot price of gold (S) = ₹50,000 per 10g

• Risk-free interest rate (r) = 5%

• Storage cost (c) = 1%

• No income from gold (y = 0)

• Contract maturity (T) = 1 year

Using the formula:

F=50,000×e(0.05+0.01−0)×1

F=50,000×e0.06

$$F\approx 50,000\times 1.0618=53,090$$

So, the fair price of a 1-year gold futures contract is ₹53,090.

Importance of Cost of Carry Model

✔ Determines Fair Pricing: Helps traders identify mispricing between spot and futures prices.
✔ Arbitrage Opportunities: If the actual futures price deviates from the theoretical price, traders can profit from arbitrage.
✔ Risk Management: Helps hedgers understand the impact of financing, storage, and dividends on futures pricing.