TYBMS SEM 5 : Finance: Commodity & Derivatives Market (Q.P. April 2019 with Solution)

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

TYBMS SEM 5 : 

Finance:

Commodity & Derivatives Market 

(Q.P. April 2019 with Solution)

Note: 1. All questions are compulsory.

2. Figures to the right indicate full Marks.

3. Working note should form part of your Answer

Q.1. A. Choose the Correct Alternatives: (Any 8)    (8)

1.________ trading is done on margins.

a. Liquidity 

b. Commodity

c. Commodity futures

d. Futures

2. Trading in derivative market ________ price volatility.

a. Reduces

b. Increases

c. Controls

d. None of these

3. The process of the basis approaching zero is called ________.

a. Convergences 

b. Divergences 

c. Cost of carry

d. . None of these

4. An asset cannot have ________ intrinsic value

a. Negative

b. Positive

c. Neutral

d. All of these

5. A _______ order is valid for the day on which it is entered.

a. IOC

b. COZ

c. Limit

d. Day

6. Put option when ruling spot price (S) is less than exercise price (X) then the option is (SX)

a. In the Money

b. Out of the Money

c. At the Money

d. None of these

7. _______ arrays are calculated separately for separate underlying assets.

a. Risk

b. SPAN

c. PC

d. None of these

8. The amount by which an option is In-the-Money is called its ________.

a. Convergences

b. Intrinsic Value

c. Cost of carry

d. Time Value

9. ________ options can be exercised on the expiration date only. 

a. In the Money option

b. European Option

c. American Option

d. Bermudan Option

10. Black Scholes model for calculating the premium of an option was introduced in _______.

a 1971 

b. 1972

c. 1973

d. 1974

B. State whether the statement is true or false: (Any 7)                (7)

1. Commodities future contracts and the exchange they trade in are governed by the forward contracts (Regulation) Act, 1953

Ans: False

2. Forward contracts usually end with deliveries

Ans: False

3. The arbitrage entails two positions on the same contract in two different markets 

Ans: True

4. Strike price is the pre-determined price at which the asset can be bought or sold.

Ans: True

5. open positions, in option contracts, case to exist after their expiration day 

Ans: True

6. VaR gives multiple risk measure aggregating all positions in spot or derivatives market

Ans: True

7. Maintenance margin is the maximum required to be kept by the contracting party at any given point of time 

Ans: False

8. The pay - out of MTM settlement shall continue to be done on a T + 1 day basis. 

Ans: True

9. In Black Scholes model E Exponential terms

Ans: True

10. The SPAN risk parameter files presents a static snapshot of the market at a point in time.

Ans: True

Q.2. A. Explain the history and origin of commodity market?

The commodity market has a long history, dating back thousands of years, when civilizations engaged in trade using barter systems. Over time, these markets evolved into organized exchanges where commodities are bought and sold in a structured manner.

Ancient Commodity Trading (Before 1000 AD)

• Mesopotamia (4500 BC): One of the first recorded commodity trades took place in Mesopotamia, where people exchanged grain, livestock, and metals.

• Egypt & Rome (3000 BC - 500 AD): Agricultural products such as wheat, barley, and spices were traded across civilizations.

• Silk Road (130 BC - 1400s AD): Spices, gold, and textiles were traded between China, India, the Middle East, and Europe.

Example: The ancient Egyptians stored grain in state warehouses and used it for trade.

Medieval and Early Modern Commodity Markets (1000 AD - 1800s)

• Japan (1730s): The first known rice futures market was established in Osaka, known as the Dojima Rice Exchange.

• Europe (1600s):

  • The Dutch East India Company (VOC) and British East India Company started trading commodities like spices, tea, coffee, and gold.

  • The Tulip Mania (1637) in the Netherlands was an early example of speculation in commodity markets.

• United States (1848): The Chicago Board of Trade (CBOT) was founded, formalizing commodity futures trading for corn, wheat, and soybeans.

Example: In medieval Japan, rice futures contracts allowed samurais to secure payments in advance.

Modern Commodity Markets (1900s - Present)

• 1900s: Expansion of organized exchanges like New York Mercantile Exchange (NYMEX) and London Metal Exchange (LME).

• 1970s: Oil became a key commodity after the 1973 Oil Crisis, leading to increased trading in energy futures.

• 2000s-Present:

  • Technological advancements led to electronic commodity trading.

  • Countries like India (MCX, NCDEX), China (Dalian Commodity Exchange), and Brazil (BM&F Bovespa) emerged as major commodity markets.

  • Cryptocurrency and carbon credits were introduced as new commodity-like assets.

Example: The Multi Commodity Exchange (MCX) in India was established in 2003, allowing trading in metals, energy, and agriculture.

B. What are the Reasons for Investing in Commodity Market?

Investing in commodities can be a strategic way to diversify a portfolio and hedge against various economic risks. Here are the key reasons why investors participate in the commodity market:

1. Diversification of Portfolio 

• Commodities have a low correlation with stocks and bonds.

• Helps reduce overall risk in an investment portfolio.
  Example: If stock markets crash, gold prices usually rise, balancing losses.

2. Hedge Against Inflation 

• Commodities, especially gold, oil, and agricultural products, tend to rise in value during inflationary periods.

• Protects purchasing power as currency values decline.
  Example: During high inflation, crude oil prices increase, benefiting investors.

3. High Return Potential 

• Due to supply-demand fluctuations, commodities can experience sharp price movements, offering high returns.

• Especially beneficial in times of global economic shifts.
  Example: A sharp rise in gold prices during economic crises benefits commodity investors.

4. Hedge Against Currency Fluctuations 

• Since commodities are globally traded, they can act as a hedge against currency depreciation.

• Useful for countries dependent on imports or exports.
  Example: If the Indian Rupee depreciates, gold and crude oil prices rise in INR terms.

5. Protection from Geopolitical Risks 

• Wars, trade restrictions, and supply chain disruptions affect commodity prices.

• Investors can benefit from price movements in uncertain times.
  Example: The Russia-Ukraine war impacted oil and wheat prices, benefiting early investors.

6. Liquidity & Ease of Trading 

• Commodity markets offer high liquidity, making it easy to buy/sell contracts.

• With the rise of electronic trading platforms (MCX, NYMEX, LME), participation is now easier.
  Example: Investors can trade gold futures on MCX with minimal capital.

7. Leverage & Margin Trading 

• Commodity futures allow trading with margins, meaning investors can take large positions with less capital.
  Example: A trader can buy silver futures worth ₹5 lakh by paying only ₹50,000 as margin.

8. Growing Demand for Commodities 

• Rising global population and industrial growth increase demand for metals, energy, and food grains.

• Long-term investment in commodities can benefit from increasing consumption.
  Example: Copper is in high demand due to the shift toward electric vehicles (EVs).

9. Availability of Various Instruments 

• Investors can choose from spot markets, futures contracts, ETFs, and mutual funds.
  Example: One can invest in gold ETFs instead of buying physical gold.

10. Regulated & Transparent Markets 

• Commodity exchanges (MCX, NCDEX, NYMEX, LME) are highly regulated.

• Provides transparency, fair pricing, and security to investors.
  Example: SEBI regulates the commodity markets in India for investor protection.

C. Explain the features of derivative market

The derivative market plays a crucial role in financial markets by allowing investors to trade contracts based on the value of underlying assets. Here are the key features:

1. Derived from Underlying Assets 

• Derivatives derive their value from underlying assets such as stocks, commodities, currencies, bonds, or indices.
  📌 Example: A gold futures contract derives its price from the market value of gold.

2. Hedging Against Price Risk 

• Helps investors and businesses protect themselves from price volatility.
  Example: A farmer uses a wheat futures contract to lock in a price before harvest to avoid losses due to price drops.

3. Speculation & Profit Potential 

• Traders use derivatives to speculate on price movements and earn profits from fluctuations.
  Example: A trader buys Nifty 50 futures expecting the index to rise, making a profit if it does.

4. Leverage & Margin Trading 

• Derivative markets allow traders to take large positions with less capital (trading on margin).
  Example: A trader can buy a crude oil futures contract worth ₹10 lakh by paying only ₹1 lakh as margin.

5. Standardized Contracts 

• Exchange-traded derivatives (futures & options) are standardized in terms of contract size, expiration date, and settlement terms.
  Example: An MCX Gold Futures contract has a fixed lot size of 1 kg.

6. High Liquidity

• Derivative markets, especially for major assets like stocks, indices, and commodities, have high trading volumes, ensuring easy buying and selling.
  Example: S&P 500 futures are among the most liquid derivatives in the world.

7. Arbitrage Opportunities

• Arbitrageurs earn risk-free profits by exploiting price differences between different markets or exchanges.
  Example: If gold is priced at ₹60,000 on MCX and ₹60,200 on another exchange, an arbitrageur buys low and sells high.

8. Different Types of Derivatives

• The market includes:

  • Futures: Contracts to buy/sell an asset at a future date.

  • Options: Right, but not an obligation, to buy/sell.

  • Swaps: Agreements to exchange cash flows (e.g., interest rate swaps).

  • Forwards: Customized contracts traded over-the-counter (OTC).
    Example: A company may use a currency swap to manage foreign exchange risk.

9. Settlement Methods 

• Derivative contracts can be cash-settled or physically settled.
  Example: Stock options in India are cash-settled, while commodity futures can be delivered physically.

10. Regulatory Oversight & Risk Management 

• SEBI (India), CFTC (USA), and other regulators oversee derivative trading to prevent manipulation and excessive speculation.
  Example: SEBI regulates NSE & MCX derivatives trading to protect investors.

OR

D. Who are the participants of derivative market

The derivative market consists of different participants who trade contracts based on the underlying asset's future value. The participants are:

1. Hedgers (Risk Managers)

• Use derivatives to protect against price fluctuations in the underlying asset.

• Aim to reduce risk, not generate profit.
  Example: A wheat farmer sells wheat futures to lock in a price and protect against falling prices.

2. Speculators (Risk Takers)

• Trade derivatives to profit from price movements in the market.

• Take high risks for high returns.
  Example: A trader buys Nifty 50 call options, expecting the index to rise and make a profit.

3. Arbitrageurs (Price Exploiters)

• Take advantage of price differences in different markets to make risk-free profits.

• Buy low in one market and sell high in another.
  Example: If gold futures are cheaper on MCX than on another exchange, an arbitrageur buys from MCX and sells at the higher price elsewhere.

4. Margin Traders  (Leverage Users)

• Trade derivatives using borrowed funds (margin trading) to take larger positions with smaller capital.

• Can make big profits but also face big losses.
  📌 Example: A trader pays ₹50,000 as a margin to buy a ₹5 lakh crude oil futures contract.

5. Market Makers (Liquidity Providers)

• Institutions or individuals who ensure continuous buying and selling of derivatives.

• Maintain liquidity and reduce price volatility.
  Example: A financial firm places buy and sell orders on the stock exchange to ensure smooth trading.

6. Institutional Investors  (Big Players)

• Large financial institutions, such as mutual funds, pension funds, banks, and hedge funds, that trade derivatives for hedging or profit.
  Example: A mutual fund might use index futures to hedge against market downturns.

Q.3. A. Explain the following terms:

1. Future Price

The Future Price is the agreed-upon price for buying or selling an asset at a future date through a futures contract. It is determined based on the spot price of the asset plus various cost and risk factors.

Formula for Future Price

$$\text{Future Price}=\text{Spot Price }+\text{Cost of Carry}$$

where:

• Spot Price = Current market price of the asset

• Cost of Carry = Interest costs, storage costs, insurance, and other holding costs

📌 Example: If the current price of gold is ₹60,000 per 10g and the cost of carry is ₹500 per month, the 3-month gold future price might be:

$$60,000+(3\times 500)=61,500$$

Factors Affecting Future Price

1️⃣ Spot Price Movement – If the current price increases, the future price generally rises.
2️⃣ Cost of Carry – Includes storage, interest rates, and insurance.
3️⃣ Demand & Supply – More demand for futures leads to higher prices.
4️⃣ Time to Expiry – The longer the contract, the higher the future price.
5️⃣ Market Expectations – Anticipation of economic changes impacts pricing.

Types of Future Prices

📍 Contango Market – Future price is higher than the spot price (common in commodities).
📍 Backwardation Market – Future price is lower than the spot price (common in perishable goods).

📌 Example: If crude oil is ₹7,000/barrel today but expected to be ₹7,500 in 3 months due to rising demand, the market is in Contango.

ii. Contract Cycle

A contract cycle refers to the lifetime of a derivative contract, from its listing to its expiration. Futures and options contracts are available for multiple expiration months, and they follow a predefined contract cycle.

Features of a Contract Cycle

1. Duration: Contracts are available for different periods, such as near-month, next-month, and far-month contracts.
2. Expiration Date: Every derivative contract has a fixed expiry date, after which it ceases to exist.
3. Renewal: Once a contract expires, a new contract for a later expiry month is introduced.
4. Rolling Over: Traders can roll over positions by closing an expiring contract and opening a new one.

Types of Contract Cycles

1. Monthly Contract Cycle (Most Common) 

• Futures and options contracts have three-month trading cycles:
  Near Month (Current Month)
  Next Month (Following Month)
  Far Month (Third Month)

Example: In April, contracts available would be:

• April (Near Month)

• May (Next Month)

• June (Far Month)
  At the end of April, a new July contract is introduced, maintaining the three-month cycle.

2. Weekly Contract Cycle 

• Used mostly in index options (Nifty, Bank Nifty, etc.)

• Shorter expiry periods provide traders with more frequent trading opportunities.
  Example: Bank Nifty options have weekly expiries every Thursday.

Contract Expiry Dates

• Stock and Index Derivatives (NSE, BSE) → Expire on the last Thursday of the month

• Commodity Futures (MCX, NYMEX, etc.) → Have different expiry rules depending on the commodity

Example: If April 25 is the last Thursday, then the April Nifty Futures contract expires on April 25, 2024.

ii. Initial Margin

Initial Margin is the minimum amount of money that a trader must deposit with the exchange to enter a futures or options contract. It acts as collateral to cover potential losses and ensures smooth trade execution.

Features of Initial Margin

1. Mandatory Requirement – Traders must deposit it before entering a derivative position.
2. Determined by Risk – Higher volatility means higher margin requirements.
3. Calculated by SPAN Method – Exchanges use SPAN (Standard Portfolio Analysis of Risk) or VaR (Value at Risk) models to determine the margin.
4. Protects the Market – Reduces counterparty risk by ensuring traders have enough capital.

Initial Margin Calculated?

Initial Margin = Lot Size x Futures Price x Margin

Example:

• Nifty 50 Futures Price = ₹22,000

• Lot Size = 50

• Margin Requirement = 15%

$$\text{Initial Margin }=22,000\times 50\times 15\%=₹1,65,000$$

The trader must deposit ₹1,65,000 to take a position in Nifty Futures.

Initial Margin Important

Prevents Default – Ensures traders have funds to cover losses.
Controls Excessive Leverage – Stops traders from taking oversized positions.
Maintains Market Stability – Reduces systemic risk in volatile markets.

iv. Mark to Market Margin

Mark-to-Market (M2M) Margin is the daily settlement of profits and losses in futures and options (F&O) trading. It ensures that traders maintain enough funds in their accounts to cover potential losses.

🔹 Applicable to: Futures contracts (mandatory) & sometimes options.
🔹 Purpose: To reduce counterparty risk and maintain financial stability.

How M2M Works?

1️⃣ At the end of each trading day, the futures contract is revalued at the closing market price.
2️⃣ Profits are credited to gaining traders.
3️⃣ Losses are debited from losing traders, who must deposit additional margin if required.
4️⃣ This process repeats until expiry or position closure.

Example of M2M Settlement 

Suppose you buy 1 lot of Nifty Futures at ₹20,000. The lot size is 50.

Day Closing Price Daily Gain/Loss M2M Settlement Day 1 (Buy at ₹20,000) ₹20,200 +₹200 × 50 = ₹10,000 Profit credited Day 2 ₹20,100 -₹100 × 50 = ₹5,000 Loss debited Day 3 ₹20,300 +₹200 × 50 = ₹10,000 Profit credited

If your margin balance is low after a loss, you must add funds to continue holding your position.

Q.3. B. If cost of 10gm gold in the spot market is Rs. 32,000/- and the locker rent for storing the gold is Rs.500 for six months, insurance Rs. 100 and interest rate is 10% p.a. then what is the fair value of a 6 months futures contract?

OR

Q.3. C. Explain the cost of carry model of futures pricing

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

---

Formula for Futures Price (Cost of Carry Model)

F=S× e (r+c−y)T

Where:

• F = Futures Price

• S = Spot Price of the asset

• e = Exponential function (Euler's number)

• r = Risk-free interest rate

• c = Storage and carrying costs (for commodities like gold, oil)

• y = Income from the asset (like dividends on stocks)

• T = Time to maturity (in years)

Explanation of Cost Components

1️⃣ Risk-Free Interest Rate (r) – If an investor buys an asset today, they forgo the interest they could have earned by investing in a risk-free instrument.
2️⃣ Storage & Holding Costs (c) – Commodities like gold, crude oil, and agricultural products have storage, insurance, and transportation costs.
3️⃣ Income or Yield (y) – Some assets provide income (e.g., dividends on stocks, rental income on real estate), which reduces the cost of holding them.

Q.3. D. Sunita feels that the stock price of Reliance will go down. She sells 10 futures contracts 08 expiring after 3 months. The lot size of each contract is 500 shares. The short position is taken at future price of Rs 1050/ calculate the position value. Find out the possible gain or loss on the positions, if after 3 months the spot rate moves to:

1. Rs.1150/-

ii. Rs. 1050/-

iii. Rs.950/-

Q.4. A. Explain the following terms:

1. Call option

A Call Option is a financial contract that gives the buyer the right, but not the obligation, to buy an underlying asset (such as stocks, commodities, or indices) at a specified strike price on or before the expiration date. The seller of the call option (option writer) is obligated to sell the asset if the buyer chooses to exercise the option.

Elements of a Call Option

1. Underlying Asset – The asset that the option contract is based on (e.g., stocks, commodities, currencies).

2. Strike Price – The price at which the buyer can purchase the asset.

3. Premium – The price paid by the buyer to the seller for acquiring the option contract.

4. Expiration Date – The last date on which the option can be exercised.

5. Intrinsic Value – The difference between the market price of the asset and the strike price (if the option is profitable).

6. Time Value – The extra value based on the time left until expiration.

Call Option Payoff

• In-the-Money (ITM): When the market price is higher than the strike price.

• At-the-Money (ATM): When the market price is equal to the strike price.

• Out-of-the-Money (OTM): When the market price is lower than the strike price.

Example of a Call Option

Suppose an investor buys a call option on Stock ABC with:

• Strike Price = ₹100

• Premium = ₹5

• Expiration Date = 1 month

If the stock price rises to ₹120 before expiration, the investor can buy at ₹100 and sell at ₹120, making a profit (minus the premium paid).

ii. Intrinsic Value 

Intrinsic Value (IV) is the real, tangible value of an option if exercised immediately. It measures how much an option is "in the money" (ITM) by comparing the current market price (spot price) with the strike price of the option.

• If exercising the option would result in a profit, the option has intrinsic value.

• If not, IV = 0 (out-of-the-money options have no intrinsic value).

Calculate Intrinsic Value?

1. Call Option (Right to Buy)

For a Call Option, the intrinsic value is:

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

• If the spot price is higher than the strike price, the call option has intrinsic value.

• If the spot price is lower or equal, IV = 0 (since no one would buy at a higher price when they can buy cheaper in the market).

Example – Call Option:

• Stock Price (Spot Price) = ₹1050

• Strike Price = ₹1000

• IV = ₹1050 - ₹1000 = ₹50
   The Call Option has ₹50 intrinsic value.

• If the Spot Price = ₹950,

  • IV = ₹950 - ₹1000 = -₹50 → IV = 0 (Out of the Money)

2. Put Option (Right to Sell)

For a Put Option, the intrinsic value is:

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

• If the spot price is lower than the strike price, the put option has intrinsic value.

• If the spot price is higher or equal, IV = 0 (no one would sell at a lower price when they can sell for more in the market).

Example – Put Option:

• Stock Price (Spot Price) = ₹950

• Strike Price = ₹1000

• IV = ₹1000 - ₹950 = ₹50
  The Put Option has ₹50 intrinsic value.

• If the Spot Price = ₹1050,

  • IV = ₹1000 - ₹1050 = -₹50 → IV = 0 (Out of the Money)

iii. Strike Price

Definition:
The strike price is the predetermined price at which an options contract can be exercised. It is the fixed price at which the buyer of a call option can buy the underlying asset or the buyer of a put option can sell the underlying asset.

Example in Options Trading:

Suppose you buy a call option for Apple stock with a strike price of Rs. 150 and an expiration date of one month.

• If Apple's stock price rises to Rs.170, you can exercise the option and buy the stock at Rs. 150, making a Rs 20 per share profit (excluding premiums and fees).

• If Apple's stock price stays below Rs. 150, the option expires worthless, and you lose only the premium paid.

Similarly, for a put option with a strike price of Rs.150:

• If Apple's stock falls to Rs. 130, you can sell the stock at Rs. 150, making a Rs.20 per share profit.

• If the stock stays above Rs. 150, the put option expires worthless.

iv. Option Premium

The option premium is the price a trader pays to buy an option contract. It represents the cost of acquiring the right (but not the obligation) to buy (Call Option) or sell (Put Option) an asset at a predetermined price (Strike Price).

📌 Example: If a trader buys a Nifty 50 call option at a premium of ₹200 per lot, the total cost is:

$$\text{Premium}=₹200\times \text{Lot Size}$$

For a lot size of 50, the total cost = ₹10,000 (₹200 × 50).

Components of Option Premium

The premium consists of two key components:

Intrinsic Value (IV) 

• The real value of the option if exercised immediately.

• Formula:

  • Call Option IV = Spot Price - Strike Price (if positive, else 0)

  • Put Option IV = Strike Price - Spot Price (if positive, else 0)

Example: If a stock trades at ₹1050 and a trader holds a Call Option with a Strike Price of ₹1000, the Intrinsic Value = ₹50 (1050 - 1000).

2️⃣ Time Value (TV) 

• The extra amount traders are willing to pay for the option before expiry.

• Formula:

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

• Higher when more time is left before expiry.

Example: If the option premium is ₹80 and Intrinsic Value is ₹50, then Time Value = ₹30 (80 - 50).

Q.4. B. Mrs.X buys a call option on stock of Axis bank Ltd by paying option premium of Rs.28/- having exercise price of Rs.550. Calculate Profit and loss of Mrs X if spot price at expiry will be Rs. 530, Rs.550, Rs. 570 and Rs. 590. and present it graphically.                08

OR

Q.4. C. Explain the difference between futures and options 

	Futures	Options
Definition	A contract to buy/sell an asset at a predetermined price on a future date.	A contract that gives the right, but not the obligation, to buy (Call) or sell (Put) an asset at a set price.
Obligation	Buyer and seller are both obligated to execute the contract at expiry.	Buyer has the right but not obligation to execute. Seller has an obligation if the buyer exercises.
Risk	High risk: Traders can face unlimited losses.	Limited risk for buyers (maximum loss = premium paid). Sellers can have unlimited loss.
Upfront Cost	Requires Initial Margin (higher capital required).	Buyer only pays Option Premium (lower cost upfront).
Profit/Loss Potential	Both buyer and seller have unlimited profit/loss based on price movement.	Buyers have limited loss (premium) but unlimited profit potential.
Expiry Effect	Position is settled at expiry (either cash-settled or physical delivery).	Options expire worthless if not profitable (OTM).
Time Value Impact	No impact of time decay.	Options lose value over time due to time decay (Theta).
Best for Traders Who	Want to hedge or speculate with higher capital and risk appetite.	Prefer a controlled risk approach with limited downside.

Q.4. D. Mr Ajit buys a put option on stock of ICICI bank Ltd by paying option premium of Rs.12/- having exercise price of Rs.310. Calculate Profit and loss of Mr Ajit if spot price at expiry will be Rs. 280, Rs.290, Rs. 300, 310 and Rs. 320. and present it graphically

Q.5. Write Short Notes: (Any 3)

1. Types of Orders.

2. Explain any Two Methods Of Computing VaR

3. Futures V/S Forward

	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.

4. Types of Risk

Risk can be categorized into various types depending on the context. Below are the main types of risk across different domains:

1. Financial Risk

• Market Risk – Risk due to market fluctuations (e.g., stock prices, interest rates, exchange rates).

• Credit Risk – Risk of a borrower defaulting on a loan or credit obligation.

• Liquidity Risk – Risk of not being able to sell assets quickly without significant price changes.

• Operational Risk – Risk from internal failures such as fraud, system failures, or human errors.

2. Business Risk

• Strategic Risk – Risk arising from poor business decisions or market changes.

• Reputational Risk – Risk due to negative public perception or brand damage.

• Regulatory/Compliance Risk – Risk of legal penalties due to non-compliance with regulations.

3. Investment Risk

• Systematic Risk – Risk that affects the entire market (e.g., inflation, economic downturns).

• Unsystematic Risk – Risk specific to a particular company or industry (e.g., bad management, product failures).

4. Operational Risk

• Process Risk – Risks due to inefficient or faulty internal processes.

• Technology Risk – Risks associated with IT failures, cyberattacks, or outdated systems.

• Fraud Risk – Risk of financial loss due to fraudulent activities.

5. Strategic Risk

• Competitive Risk – Risk of losing market position due to stronger competitors.

• Political Risk – Risk arising from political instability, government policies, or trade restrictions.

• Innovation Risk – Risk related to adopting new technologies or business models.

6. Environmental & Social Risks

• Climate Risk – Risks due to climate change, natural disasters, or extreme weather.

• Social Risk – Risk from changing societal attitudes, activism, or ethical concerns.

7. Personal & Health Risk

• Health Risk – Risk of illness, accidents, or disability.

• Life Risk – Risk related to mortality affecting dependents.

• Career Risk – Risk of job loss, career stagnation, or skill redundancy.

5. Settlement of futures

The settlement of futures refers to the process by which futures contracts are finalized, either through physical delivery or cash settlement, at the contract's expiration or during its tenure. There are two main types of settlement in futures trading:

1. Daily Settlement (Mark-to-Market)

• Futures contracts are marked-to-market daily, meaning that profits and losses are settled at the end of each trading day.

• Gains are credited, and losses are debited from the trader’s margin account.

• This ensures that traders always have sufficient margin to cover their positions.

• If margin falls below the maintenance level, a margin call is triggered, requiring the trader to deposit additional funds.

2. Final Settlement (At Expiry)

This occurs when the futures contract reaches its expiration date. It can be settled in two ways:

a) Physical Delivery Settlement

• The actual underlying asset (e.g., commodities, bonds, currencies) is delivered to the contract holder.

• The buyer must pay the full contract value, while the seller delivers the asset as per contract specifications.

• Mostly used for commodity futures (e.g., crude oil, agricultural products).

b) Cash Settlement

• Instead of delivering the actual asset, the difference between the contract price and the market price at expiration is settled in cash.

• Common in index futures, interest rate futures, and some commodity futures.

• Ensures efficiency and avoids logistical challenges associated with physical delivery.

Participants in Settlement

• Clearing House: Ensures all futures trades are settled properly and acts as an intermediary between buyers and sellers.

• Brokers & Exchanges: Facilitate the transaction and margin requirements.

• Traders & Institutions: Engage in futures contracts for speculation or hedging.