NISM Series XVI: Commodity Derivative Certification (Set 1)

Explanation:

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

The Final settlement price is the price used for “delivery default penalty” in case of non-delivery of short sell quantity. There are prescribed methodologies to arrive at delivery default penalty and working out compensation to the buyer in such cases, using FSP.

Explanation:

Volatility is the magnitude of movement in the underlying asset’s price, either up or down. It affects both the Call and Put options in the same way. Higher the volatility of the underlying stock, higher the premium.

Explanation:

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 clearing corporation

Explanation:

Cash-and-carry arbitrage refers to buying of 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 spot price and the cost of carrying it till the expiry date.

Explanation:

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.

Explanation:

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

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

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

Explanation:

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.

Explanation:

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.

Explanation:

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.

Explanation:

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

Explanation:

Buy 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 future contract and buy in the spot market.

Explanation:

A commodity exchange will introduce a commodity having due regard to key factors such as demand for 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 commodity, political sensitivity of commodity, homogenous nature, durability / expiry period of commodity, storability, government regulation and control, etc.

Explanation:

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 carry will be 1553.26 + 345.17 = 1898.43

Explanation:

Daily settlement price is used to calculate 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.

Explanation:

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 rise and on expiry the price is Rs. 120. Here she will make a loss of Rs. 20.

Explanation:

Buyer of an option: The buyer of an option is one who has a right but not the 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.

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

Explanation:

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

Explanation:

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 off the positions when the spread corrects and the contracts are traded at fair spread.

Explanation:

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 riskless profit to the arbitrager

Explanation:

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 favourable to him but no obligation to do so.

In 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.

Explanation:

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

Explanation:

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

Explanation:

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.

Explanation:

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

Explanation:

Complaints against trading members on account of the following can be taken by an Exchange for redressal :
– Non-receipt of funds / securities
– Non- receipt of documents such as member client agreement, contract notes, settlement of accounts, order trade log etc.
– Non-Receipt of Funds / Securities kept as margin
– Trades executed without adequate margins
– Delay /non – receipt of funds
– Squaring up of positions without consent
– Unauthorized transaction in the account
– Excess Brokerage charged by Trading Member / Sub-broker
– Unauthorized transfer of funds from commodities account to other accounts etc.

Explanation:

Importers and exporters of commodities face –

1. Foreign exchange rate risk – Most commodities are priced and traded in US dollars (USD) and any adverse movement in the foreign currency carry foreign exchange rate risk that impacts revenue and profits.

2. Commodity price risk – arises on account of adverse fluctuations in the prices of commodities.

3. Geopolitical risk – Commodities that have a global demand (e.g., crude oil) are prone to price fluctuations due to political tensions in some parts of the globe and these may lead to disruptions in supply.

Explanation:

Future Price = Spot Price + Cost of Carry

Here the cost of carry will have two components – Interest cost for 90 days and storage cost for 90 days

Interest Cost = 40000 x .06 (Interest) ( 90 /365) for 90 days

= 40000 x .06 x 0.246

= 590.4

Storage Cost = 40000 x .01 (Storage cost) ( 90/365) for 90 days

= 40000 x .01 x 0.246 = 98.4

So the total cost of carry will be 590.4 + 98.4 = 688.80

Future Price = Spot Price + Cost of Carry

= 40000 + 688.80 = 40688.80

Explanation:

The Securities Contracts (Regulation) Act, 1956 (SC(R)A), provides for direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges. It prevents undesirable transactions in securities by regulating the business of securities dealing and trading.

Explanation:

Exchange Traded Derivatives (Futures) are standardized in terms of size, quantity, grade and time, so
that each contract traded on the exchange has the same specification.

Commodity Futures contracts are highly uniform and are well-defined. These contracts explicitly state the commodities (quantity and quality of the goods) that have to be delivered at a certain time and place (acceptable delivery date) in a certain manner (method for closing the contract) and define their permissible price fluctuations (minimum and maximum daily price changes).

Explanation:

Rho is the change in option price given a one percentage point change in the risk-free interest rate.

Rho measures the change in an option’s price per unit increase in the cost of funding the underlying.

Explanation:

The Parliament passed the Forward Contracts Regulation Act in 1952 to regulate the forward contracts in commodities across the country.

However, the Forward Contracts Regulation Act was repealed and regulation of commodity derivatives market was shifted to the Securities and Exchange Board of India (SEBI) under Securities Contracts Regulation Act (SCRA) 1956 with effect from 28th September, 2015.

Explanation:

Each commodity has its own delivery logic that is clearly specified in the contract specification. The tendering of deliveries is permitted by the exchange on specific tender days during delivery period as indicated in the contract.

The buyer will be obliged to take delivery within such period as may be specified by the Exchange.

Explanation:

Advantages of commodity futures over commodity forwards:

– Efficient price discovery as the market brings together buyers and sellers of divergent needs

– Elimination of counterparty credit risk as exchanges interposes as central counter-party

– Access to all types of market participants, big or small

– Standardized products: Standardisation increases the clarity and number of participants in Future trades which results in increased liquidity than the forward markets

– Transparent trading platform

Explanation:

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

When actual spread between two futures contracts of the same commodity widens, trader buys the near-month contract because it is underpriced and sells the far-month contract because it is overpriced. When actual spread between two futures contracts of the same commodity narrows, trader sells the near-month contract because it is overpriced and buys far-month contract because it is underpriced.

Explanation:

If all other factors affecting an option’s price remain same, the time value portion of an option’s premium will decrease with the passage of time. This is also known as time decay.

Of the two components of option pricing (time value and intrinsic value), one component is inherently biased towards reducing in value; i.e., time value. So, if all things remain constant throughout the contract period, the option price will always fall in price by expiry. Thus, option sellers are at a fundamental advantage as compared to option buyers as there is an inherent tendency in the price to go down.

Explanation:

The guidance note issued by the Institute of Chartered Accountants of India (ICAI) comes into effect in respect of accounting periods beginning on or after April 1, 2015. This guidance note requires that all derivatives are recognised on the balance sheet and measured at fair value since a derivative contract represents a contractual right or an obligation.

Explanation:

Under the staggered delivery mechanism, the seller has an option of marking an intention of delivery on any day during the last 10 days of the expiry of the contract. The corresponding buyer will be randomly allocated by the trading system of the exchange and he/she will have to take the delivery on T+2 day from the delivery centre where the seller has delivered the commodity.

This is to ensure confirmation of delivery in the near month contract and to keep the price volatility under check.

Explanation:

Exchanges face legal risk on account of uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations or due to uncertainty and complexities relating to successful delivery of stocks of specified quality.

The legal risk is also high in commodities trading which are subject matter of Essential Commodities Act, FSSI standards in addition to various taxes like GST, CTT, STT, etc.

Explanation:

Hedging means taking a position in the derivatives market that is opposite of a position in the physical market with the objective of reducing or limiting risks associated with the price changes.

Hedging is a process designed to reduce or remove the risk of a position in an asset or a derivative product. Hedger enters into the derivatives contract to mitigate the risk of adverse price fluctuation in respect of his existing position.

Explanation:

Market participants including individual investors, professional traders, manufacturing and trading companies, financial institutions such as hedge funds, exchange traded funds (ETFs), Trading Members and mutual funds can use commodity indices either as a reference benchmark for performance of Indian commodity markets or as the basis of investment products to provide direct exposure to Indian commodities markets.

Explanation:

Dispute resolution mechanism : The investor should first approach the concerned exchange/intermediary against whom there is a complaint.

If the response received is not satisfactory, then investors can approach SEBI through SCORES. SEBI Complaints Redress System (SCORES) is a web based centralized grievance redress system of SEBI. The complaint is forwarded online to the entity concerned for its redressal and the entity concerned uploads an Action Taken Report (ATR) on the complaint. The entity must resolve the complaint within 30 days after receiving intimation from SEBI under SCORE.

If the grievance is not resolved by the exchange due to disputes, it goes to Investor Grievance Resolution Committee (IGRC or GRC).

Explanation:

The fair value of a futures price with continuous/daily compounding can be expressed as:

F = S*e^ (r*n)

where – F: Futures price S: Spot price r: Cost of financing in percentage n: time till the expiry of the contract (number of years) e = 2.71828 = A Constant number used in continuous compounding in mathematics

Explanation:

F = S + C – Y : where F: Futures Price, S: Spot Price, C: Cost of carry and Y: Convenience Yield.

Explanation:

A manufacturer has to either hedge against a price rise of raw materials or against a price fall of finished goods in future.

Selling a Put option is not an appropriate hedging mechanism for a manufacturer.

Explanation:

Once obligations for delivery are assigned, seller will raise the bill on buyer at Final Settlement Price. The bill will be inclusive of appropriate GST levied on Final Settlement Price.

Explanation:

The Black-Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular, relatively simple and fast modes of calculation of option prices.

This model is used to calculate a theoretical price of options using the five key determinants of an option’s price: underlying price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. This model provides the formula to calculate price of options based on cash settlement or physical settlement of Options on goods / securities.

Explanation:

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 off the positions when the spread corrects and the contracts are traded at fair spread.

Explanation:

In Commodity Derivatives, GST is levied by seller of goods on buyer of goods at the time of billing for delivery. It is levied at the point of delivery of goods after assignment of delivery obligations.

Explanation:

There are broadly six types of margins relating to Futures segment: initial margin, extreme loss margin, mark-to-market margin, special/additional margin, concentration margin and tender period/delivery period margin. In addition to that, Option on Futures will have Devolvement Margin (but does not have tender period / delivery period margin).

Explanation:

Convenience yield indicates the benefit of owning a commodity rather than buying a futures contract on that commodity.

Sometimes, due to supply bottlenecks in the market, the holding of an underlying commodity may become more profitable than owning the futures contract, due to its relative scarcity versus huge demand. An oil refiner may enjoy a convenience yield on crude oil inventories and without it, production will be interrupted and the refiner cannot produce any finished product.