NISM Series XVI: Commodity Derivative Certification (Set 3)

Explanation:

A hedger seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity.

By hedging, the hedger reduces to a large extent or even eliminates the possibility of a loss from a decline in the price of the commodity. However, he has also eliminated the possibility of a gain from a price increase.

Explanation:

The option premium of an option is made up of Intrinsic Value + Time Value.

Only ‘In the Money’ options have Intrinsic Value.

In the above question, the Call Option is ‘Out of the Money’ as Market Price is lower than Strike Price. So there is no intrinsic value.

So the option premium is entirely due to Time Value.

The option premium is Rs 25 and this is the Time Value

(Note : A Call Option is ‘In the Money’ when Market Price is greater than Strike Price. Its ‘At the Money’ when Market Price is equal to Strike Price and its ‘Out of the Money’ when Market Price is less than Strike Price)

Explanation:

A covered short call position is created by combining a long underlying position ie. holding the commodity stock with a short call option.

A covered call option attempts to enhance the return in a stagnant market and at the same time partially hedge a long underlying position.

Explanation:

Swaps are agreements between two counterparties to exchange a series of cash payments for a stated period of time. The periodic payments can be charged on fixed or floating price, depending on the terms of the contract.

Swap is a pure financial transaction that is used to lock in the long-term price and there is no physical delivery of the commodity and there is net cash settlement on maturity.

Explanation:

An E-registry maintains electronic records of ownership of goods against negotiable warehouse receipts (NWRs) and warehouse receipts (WRs) and effects transfer of ownership of such goods by electronic process.

Explanation:

A futures contract is a legally binding agreement between the buyer and the seller, entered on an exchange, to buy or sell a specified amount of an asset, at a certain time in the future, for a price that is agreed at the time of entering into the contract.

Explanation:

The term “securities” has been defined in the Section 2(h) of the Securities Contract (Regulation) Act, 1956 (SCRA).

The term ‘Securities’ include:

– Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate
– Derivative
– Units or any other instrument issued by any collective investment scheme to the investors in such schemes
– Government securities etc.

Explanation:

The cost of carry determines the differential between spot and futures price and is associated with costs involved in holding the commodity till the date of delivery, it follows that the cost of carry diminishes with each passing day and the differential must narrow and on the date of delivery, the cost of carry becomes zero and the spot and futures price converge. This is known as convergence.

Explanation:

When a person buys a Put option, it means he is bearish on the commodity.

On exercise, the commodity options devolve into commodity futures in India. So, this means on exercise the long PUT option will be short position (bearish) in underlying commodity futures.

Explanation:

A bought CALL option can only be squared up by selling the same CALL option.

Explanation:

Short position means Mr. Suresh has sold the futures contract expecting the prices to fall. He can only make a profit if the futures prices fall.

For eg. Mr. Suresh sells a futures contract at Rs 100. The price falls and on expiry the price is Rs. 90. Here he will make a profit of Rs. 10.

Explanation:

As per the Guidance Note of ICAI – When sales of the hedged inventory occur in the future, the hedging related fair value adjustment to inventory will be released to the statement of profit and loss and can be classified as part of ‘cost of goods sold’.

Explanation:

If the difference between the spot price and futures price is less than the cost of carry, the buyer would be better off buying the commodity in the futures market rather than buying the commodity in the spot market and holding it.

[Conversely, if the differential is greater than the cost of carry, the buyer would be better off buying the asset in the spot market and holding it than buying the futures contract. However, when the difference between the spot and futures prices exactly matches the cost of carry then the buyer would be indifferent as to whether to buy from spot market or from futures market]

Explanation:

Basis risk is defined as the risk that a futures price will move differently from that of its underlying
asset spot price. There is a relationship between the futures price and its underlying commodity spot price and the futures price broadly follow the spot price and the difference between the two tends to become less as the futures approaches its expiry date.

However, other factors can occasionally influence the futures price. The best method of eliminating the basis risk is to hold the futures contract till expiry, since the futures and spot prices converge on expiry.

Explanation:

Hedge Ratio = Coefficient of correlation between spot and futures price * (Standard deviation of change in spot price / Standard deviation of change in futures price)

= 0.66 ( 7.3 / 8.9 )

= 0.66 x 0.82

= 0.541

Explanation:

Credit risk is directly related to the credit worthiness of the buyer and seller and their ability and willingness to honour the contract.

The credit risk / settlement risk on futures is eliminated because the clearing corporation of the exchange
becomes the central counter-party and guarantees settlement of trade.

Explanation:

There are five fundamental parameters on which the option price depends –

1) Price of the underlying asset
2) Strike price of the option
3) Volatility of the underlying asset’s price
4) Time to expiration
5) Interest rates

These factors affect the premium / price of options in several ways.

Explanation:

There are three different ways of closing an option position: offset, exercise and expiration.

Offset is accomplished by selling (purchasing) a call or put identical to the put or call originally bought (sold) by the option holder or option seller.

In Exercise, the option is exercised on the expiry date only if it is in-the-money either for physical delivery or for receipt of cash differential between strike price and settlement price, in case of cash settlement

In Expiration, the option holder abandons the option if it is out-of-the-money and is not profitable to him to exercise.

Explanation:

Delta measures the sensitivity of the option value to a given small change in the price of the underlying asset.

Delta for put option buyer is negative. The value of the contract increases as the underlying price falls.

Explanation:

‘Pay in’ means funds have to be paid and ‘Pay out’ means funds will be received by the clearing member for the trades done by him, his clients etc.

Clearing banks play an important role in the smooth transfer of funds between the clearing members and clearing corporation to effect settlement of funds. The commodity exchange requires every clearing member to open a dedicated and exclusive clearing account with one of the empanelled clearing banks. The clearing corporation computes and advises the clearing member’s obligation and the clearing member makes funds available in the clearing account for the pay-in and receives funds in case of a pay-out.

Explanation:

Basis is a measure of the difference between the spot and the futures prices.

Strengthening of basis happens when basis becomes more positive or less negative and weakening of basis happens when basis becomes less positive or more negative.

Basis = Spot Price – Futures Price

In the above question the Basis on 1st July was Rs. 2000 – 2400 = – 400

On 15th July the basis is Rs. 2100 – 2550 = – 450

The basis has become more negative from -400 to -450. So the basis has weakened.

Explanation:

By taking the difference between the closing price of a contract on that particular day and its previous day’s closing price

REPORT
Explanation:
There are two types of positions on which Mark to Market margin is calculated – 1. New Positions of that day and 2. For carry forward positions.

Mark-to-market (MTM) margin is calculated on each trading day by taking the difference between the closing price of a contract on that particular day and the price at which the trade was initiated (for new positions taken during the day) or is based on the previous day’s closing price (for carry forward positions from previous day).

Explanation:

Interest rates impact the commodity prices and are the key determinants in commodity price movements.

A decrease in real interest rates lowers the cost of carrying inventories, and raising commodity prices. Lower interest rates decrease the incentive to extract mine-based commodities, increase the incentives to maintain inventories, and stimulate the demand for commodity derivatives, all of which raise the prices of basic commodities.

Explanation:

Selling futures is often called “going short,” or establishing a short position. Since he has sold the futures, which means he is expecting the Copper prices to fall so that he can buy the contract back at a lower price and make profits.

Explanation:

In the case of a long hedge, the hedger does not own the underlying commodity, but he needs to acquire it in the future. He can lock-in the price that he will be paying in the future by buying, or going long in futures contracts. In effect, he is already naturally short on the underlying commodity because he must buy it in future and he offsets this naturally short position by taking a long position in futures.

Explanation:

Taking a long position (i.e. buying) in a commodity futures contract in expectation of an increase in price before the expiry of the contract without any corresponding short positions in the spot market is called a Long speculative transaction.

If the price of the futures contract increases before the expiry of the contract, then the trader makes a profit by squaring off the position, and if the price of the futures contract decreases then the trader incurs a loss.

Explanation:

Pay-off refers to profit or loss in a trade. The commodities futures contracts have a linear payoff. The pay-off chart implies that if the price of the underlying commodity rises, the futures’ buyer makes profit and if the price of the underlying commodity falls, the futures’ buyer makes losses.

Explanation:

For any business or value chain participant, they are naturally short on raw materials and long on finished goods. It means, they gain if raw material prices reduce while they lose when raw material price increases.

Similarly, on finished goods, they gain when its prices gain and they lose when its prices fall. Hence, hedgers generally hedge by buying raw materials in derivatives markets or by selling finished goods in derivatives markets or both.

Hedgers include – Farmers, Merchandisers, Food processors, Exporters, Importers etc.

Explanation:

In a market order, the trade is executed at the immediately available current market price, prevailing at the time of placing the order.

Explanation:

A long straddle is an option strategy where the trader buys a call and a put with the same strike price and same expiry date by paying premium. The market view is to profit from increase in volatility.

(A long strangle involves the purchase of a call and a put with the same expiry date but with different strike prices.)

Explanation:

The term “securities” has been defined in the Section 2(h) of Securities Contract Regulation Act.

The term ‘Securities’ include:

– Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities

– Derivative

– Units or any other instrument issued by any collective investment scheme to the investors in such schemes

– Security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act)

– Units or any other such instrument issued to the investors under any mutual fund scheme

– Any certificate or instrument issued to an investor by any issuer being a special purpose distinct entity

– Government securities

– Such other instruments as may be declared by the Central Government to be securities

– Rights or interests in securities

(Monsoon etc. has not been included in this list)

Explanation:

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

Taking a long position (i.e. buying) in a commodity futures contract in expectation of an increase in price before the expiry of the contract without any corresponding short positions in the spot market is called a long speculative transaction.

If the price of the futures contract increases before the expiry of the contract, then the trader makes a profit by squaring off the position, and if the price of the futures contract decreases then the trader incurs a loss.

Explanation:

Client level position limits and member level position limits are set by the Exchange to avoid concentration risk and market manipulation by a trading member or group acting in concert.

Its not a part of KYC and anti-money laundering control procedures / laws.

Explanation:

Commodity options in India devolve into Commodity Futures. That means, buyers of commodity options would get a right to have a position in underlying commodity futures.

So a buying position in a call option will devolve into long position in the underlying commodity futures on exercise.

Explanation:

An intra-commodity spread is made up of a long position in futures contract and a short position in another month contract of the same underlying or another contract of the same commodity with different lot size.

In a bull spread, the investor buys a lower strike and sells the higher strike of the same commodity. It attempts to profit from the directional movement in the underlying commodity.

(An inter commodity spread is made up of a long position in one commodity and a short position in a different but economically related commodity)

Explanation:

Goods and Services Tax (GST) is a destination based tax on consumption of goods and services which is levied at all stages right from manufacture up to final consumption with credit of taxes paid at previous stages available as setoff. In other words, only value addition will be taxed.

Explanation:

Theoretical future price or 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.

Explanation:

Commodity indices are different from equity indices as commodity indices in India are constructed from futures prices of commodities instead of the underlying spot prices of the commodities.

Explanation:

Minimum support price is not associated with commodities derivatives trading.

Minimum Support Price (MSP) is declared by the Government for its procurement of agricultural commodities like Wheat, Maize etc.

Explanation:

Diagonal spreads attempt to profit from market view and changes in volatility. Diagonal spreads are implemented by buying and selling options with different strike prices and different expiry months.

Explanation:

The order matching on an Exchange is done on a price-time priority basis.

Highest priced buy orders and lowest priced sell orders are matched first for trade, after which next highest buy order or next lowest sell order comes up for trade match. It indirectly means that reducing buy order limit will delay execution while increasing buy order price will speed-up its matching for trade.

For Eg. If the market price of an commodity is Rs. 65 and there is a buy order at Rs 60. If this price of buy order is reduced from Rs. 60 to Rs. 55, the order execution will delayed until the price falls to Rs. 55.

Explanation:

Limit order: In a limit order, the buyer or seller specifies the price at which the trade should be executed. It is sent in the system and is either executed immediately or later or remains in the system till the end of day if not executed.

A stop loss order is generally placed after entering into a trade. This is used in order to limit a probable loss if the price moves in the opposite direction. The stop loss level is a trigger for sending the stop loss order into the system.

Explanation:

There are two main types of commodities that trade in the spot and derivatives markets

– Soft commodities: These are the perishable agricultural products such as corn, wheat, coffee, cocoa, sugar, soybean, etc.

– Hard commodities: These are natural resources that are mined or processed such as the crude oil, gold, silver, etc.

Explanation:

Swaps are agreements between two counterparties to exchange a series of cash payments for a stated period of time. The periodic payments can be charged on fixed or floating price, depending on the terms of the contract. One of the commonly used commodity swaps is “fixed-for-floating swaps”

In a “fixed-for-floating commodity swap”, one party known as the “fixed price payer” makes periodic payments based on a fixed price for a specified commodity that is agreed upon at the execution of the swap, while the other party known as the “floating price payer” makes payments based on a floating price for such commodity that is reset periodically.

Explanation:

Normally for At-TheMoney Options, intrinsic value is zero (or in practice, it is a very small amount), while option price mainly comprises of Time value. Both Call and Put At the Money will have the same time value.

Therefore, generally, At the Money Call and Put options will have same or very similar option premiums.

Explanation:

Maximum order size is represented in terms of quantity.

For eg. The Maximum order size for Gold futures is 10 Kg.

Explanation:

After the Forward Contracts (Regulation) Act, 1952 (FCRA) was repealed by the Government, SEBI took over the regulation of the commodity derivatives market on September 28, 2015 as a result of merger of FMC (Forward Markets Commission) with SEBI.

Explanation:

A put option is said to be n the money (ITM) when current market price is lower than strike price.

In the above question, the market price (Rs 1400) is lower than the strike price (Rs 1500). So it’s a In the Money Put option

For put option which is in-the-money, intrinsic value is the excess of strike price (X) over the spot price (S). Thus, intrinsic value of put option can be calculated as X-S

= 1500 – 1400 = 100

Explanation:

The Dow Jones Industrial Average (DJIA) is a widely-watched benchmark index in the U.S. for blue-chip stocks. It is a stock index and not a commodity index.

The Dow Jones-AIG Commodity Index is a benchmark index for the commodities markets that is composed of futures contracts on physical commodities and was introduced in 1998.

The Rogers International Commodity Index (RICI) is a broad index of commodity futures designed by Jim Rogers in 1996/1997.

The S&P GSCI (formerly the Goldman Sachs Commodity Index) is a tradable index to market participants of the Chicago Mercantile Exchange.

Explanation:

Future price = Spot price + Cost of Carry

Here the cost of carry will have two components – Interest cost for 180 days and storage cost for 180 days.

Interest cost = 20000 @ 7% = 1400

For 180 days the interest cost will be 1400 / 365 x 180 = 690.40

Storage cost = 20000 @ 1% = 200

For 180 days the storage cost will be = 200 /365 x 180 = 98.63

So the Total Cost of Carry will be 690.40 + 98.63 = 789.03

Future price = Spot price + Cost of Carry

Future price = 20000 + 789.03 = Rs. 20789.03