NISM Series XVI: Commodity Derivative Certification (Set 5)

Explanation:

If a gold futures contract is bought for Rs 50,000 per 10 grams of gold with a quality specification of .995 fineness and on the delivery date, if .999 fineness gold is delivered, the price is recalculated as follows:

Gold price = 50000 x 999/995 = Rs 50,201. The buyer will pay Rs 50,201 as against the original contract price of Rs 50,000 per 10 grams.

Explanation:

Most commodities follow a certain schedule of production cycle, which impacts the price trend. For example, in agricultural commodities, during the harvesting season, due to an increased supply, prices tend to come down, whereas during the sowing season the overall supply (availability) remains lower, which leads to an increase in prices.

Explanation:

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

Explanation:

Algorithmic trading is defined as trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as initiation of order, timing, price or quantity, managing the order post submission with / without limited human intervention.

Any order that is generated using automated execution logic is known as algorithmic trading. Algorithmic trading permits the use of programs and computers to generate and execute orders in markets with electronic access and do not require human intervention.

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 and is valid for both call and put options.

The rate at which the time value of the option erodes (time decay) is not linear and the erosion speeds up as expiry date approaches. This means that time decay is slower in the initial days and speeds up as expiry approaches.

Explanation:

The difference between the Spot price and the Futures price is the Cost of Carry. The main components associated with cost of carry include finance cost (interest), storage cost and insurance

The cost of carry diminishes with each passing day and on the date of delivery, the cost of carry becomes zero and the spot and futures price converge. This is known also known as convergence.

Explanation:

When a person is selling a Put, he will receive the option premium.

If the prices rise, he gains on the option but loses on the actual commodity purchases

If the prices falls, he loses on the option but gains on the actual commodity purchases

So in both the cases he is not affected by the price rise or fall. But he will gain by the option premium he has received thus lowering his purchase price.

Explanation:

If the farmer didn’t want to deliver his soya bean, he could pass on his contractual obligation to another farmer. The price of the contract would increase or decrease depending on what was happening in the soya bean market.

Explanation:

The exchange traded commodity options in India devolves into their futures contracts.

Explanation:

In a Forwards commodity contract, the terms of the contract are decided by the buyer and the seller and there is no commodity exchange involved. So there is an inherent credit or default risk since the counter-parties of the forward transaction may fail either to deliver the commodity or to pay the agreed price at maturity.

(A futures contract is a legally binding agreement between the buyer and the seller, entered on an exchange. The exchange guarantees the delivery/payment even if the parties defaults)

Explanation:

Options Theta values are either positive or negative.

All long stock options positions have negative Theta values, which indicates that they lose value as expiration draws nearer.

All short stock options positions have positive Theta values, which indicates that the position is gaining value as expiration draws nearer.

Explanation:

In case a person owns an asset and wants to protect against falling prices in future, he will adopt the strategy of Short Hedge.

Short hedge involves sale of futures to offset potential losses from the falling prices.

Explanation:

Quotation factor is ‘Rupees per 10 Kilograms’
Lot size = 10 MT (10000 kilograms)
Tick size = Rs 0.05

The formula for calculating tick value is :

Ticket Value = (Lot size / Quotation factor) X Tick size

Tick value = (10000 / 10) x 0.05 = Rs 50

Explanation:

Speculation is a practice of doing trading to make quick profits from fluctuations in prices. It includes buying, selling (short selling) of securities, commodities or any financial asset. Speculators never utilize the asset for physical usage as their objective is to get quick profits from change in prices.

In this example, Mr. Avinash is a ‘long speculator’. Long speculators are those who buy first and expect the price to increase from current level.

Explanation:

Vertical Spreads (Bull or Bear spreads) attempts to profit from the directional movement in the underlying commodity. Unlike an outright purchase of call/put option, the vertical spreads are used when the market view of the investor is moderately bearish/bullish.

In a bull spread, the investor buys a lower strike and sells the higher strike. Conversely, the investor sells the lower strike and buys a higher strike in a bear spread.

Explanation:

In the commodity Pay in process the clearing member of the buyer will transfer funds to the clearing corporation and the clearing member of the seller will transfer the warehouse receipt to the clearing corporation.

Explanation:

A commodity futures contract would be settled on mark to market criteria (MTM) on daily basis and on the expiry, at the settlement price.

Explanation:

Future Price = Spot Price + Cost of Carry

Here the cost of carry will have two components – Interest cost for 60 days and storage cost for 60 days

Interest Cost = 3000 x .06 (Interest) ( 60 /365) for 60 days

= 3000 x .06 x 0.164

= 29.52

Storage Cost = 3000 x .02 (Storage cost) ( 60/365) for 60 days

= 3000 x .02 x 0.164 = 9.84

So the total cost of carry will be 29.52 + 9.84 = 39.36

Future Price = Spot Price + Cost of Carry

= 3000 + 39.36 = 3039.36

Explanation:

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

Delta for call option buyer is positive. This means that the value of the contract increases as the underlying price rises.

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
– Derivatives
– Units or any other instrument issued by any collective investment scheme to the investors in such schemes
– Government securities etc.

Explanation:

In commodity derivatives, we see arbitrage play between Futures / Options – Spot or within Futures when we see huge backwardation.

Explanation:

If a gold futures contract is bought for Rs 47,000 per 10 grams of gold with a quality specification of .995 fineness and on the delivery date, if .999 fineness gold is delivered, the price is recalculated as follows:

Gold price = 47000 x 999/995 = Rs 47,189. The buyer will pay Rs 47,189 as against the original contract price of Rs 47,000 per 10 grams.

Explanation:

Extreme Loss Margin (ELM) is the margin to cover the loss in situations that lie outside the coverage of the VaR based initial margins. ELM is levied or revised when back testing of existing margins falls short of required confidence level.

Explanation:

Securities Contracts (Regulation) Act, 1956 specifies that organized trading of securities can take place only on recognized stock exchanges.

Explanation:

Generally there is a direct relationship between spot and future prices. If the spot prices rise, the future prices will also tend to rise and vise versa.

So a seller of a future contract will tend to lose money if the spot prices rise as the future prices will also rise and he will make a loss.

For eg. If he has sold at Rs 100 and prices rise to Rs 105, he will make a loss of Rs 5 if he squares up the contract.

Explanation:

The National commodity exchanges do not own or hire any warehouse for the purpose of settlement of the contracts that require to be settled by the physical delivery of commodities. Exchanges set the criteria for the warehouses and empanel warehouse service providers (WSPs) who arrange warehousing facilities on the basis of the criteria laid down by the exchanges.

As per SEBI Regulations, only WDRA (Warehousing Development and Regulatory Authority) registered warehouses can be used by exchange-empanelled WSPs for storing goods which are meant for settlement of trades on exchanges.

Explanation:

The formula for calculating a premium is –

C – P = S – [K / (1 + r * t) ]

where C is Call Premium, P is Put Premium, S is Underlying Price, K is Strike Price, r is rate of interest and t is time period. Here time is 3 months ie. 3/12 = 0.25

61.45 – P = 250 – 200 / [ 1+ (0.06 ∗ 0.25) ]
61.45 – P = 250 – (200 / 1.015)
61.45 – P = 250 – 197.04
61.45 – P = 52.96
P = 61.45 – 52.96
P = 8.49

Explanation:

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

Eg. The spot price of commodity is Rs 100 and the cost of carry for three months is Rs 2. The three months futures price is Rs 104.

So it will be beneficial to buy the commodity in spot at Rs 100 and pay Rs 2 as the cost of carry rather than paying Rs 104 for the futures contract. ( 104 – 100 = 4 which is greater than 2 )

Explanation:

In an options transaction, the purchaser pays the seller (the writer of the option), an amount for the right to buy (in case of “call” options) or for the right to sell (in case of “put” options). This amount is known as the “Option Premium”,

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.

Explanation:

For an option, intrinsic value refers to the amount by which option is in the money i.e., the amount an option buyer will realize, before adjusting for premium paid, if he exercises the option instantly. Therefore, only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value.

Time value: It is the difference between premium and intrinsic value, if any, of an option. At-The-Money and Out-of The-Money options will have only time value because the intrinsic value of such options is zero.

Explanation:

Immediate or Cancel (IOC) is an order requiring all or part of the order to be executed immediately after it has been placed. Any portion not executed immediately is automatically cancelled.

Explanation:

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

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

Explanation:

In a market order, the trade is executed at the immediately available current market price, prevailing at the time of placing the order. The buyer or seller will not specify the price. The trade will be executed at the best available current price at that time.

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:

The holder of European option can exercise his right only on the expiry date/day of the contract.

A holder of an American option can exercise his right at any time on or before the expiry date/day of the contract.

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:

An option buyer has limited loss potential (only to the extent of premium paid) and unlimited gain potential. The premium is paid initially when the option is bought. Since the option buyer has rights, but not obligations, the option buyer does not have margin requirements.

Apart from an option buyer, all others like option seller, future buyers, future sellers have unlimited loss potential and so they have to meet the margin requirements as and when it arises.

Explanation:

Vega (ν) is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change (typically 1%) in the underlying volatility.

Vega = Change in an option premium / Change in volatility

(Note – Please memorise the features of all – Delta, Gamma, Rho, Theta and Vega)

Explanation:

From the accounting point of view there are three types of hedges viz., Fair Value Hedge, Cash Flow Hedge and Net Investment Hedge.

Explanation:

If the closing price is lower than the purchase price, the buyer has to pay the Mark To Market (MTM) margin as there is a notional loss.

Explanation:

Depository enables holding of stock in dematerialized form for easy tradability.

Physical (material) shares can be converted into electronic (dematerialized) shares through a depository.

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.

Explanation:

Systemic risk might arise when the default by one of the parties leads to the default of other parties too.

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events such as, error, fraud, outages, etc. in commodity exchanges.

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.

Income tax is a personal tax levied on the income, salary etc. of an individual and is not covered under GST.

Explanation:

Types of INTER COMMODITY spreads:

Crush spreads: It specifically refers to soyabean complex whereas the spread trader buys soyabean and sell soyabean meal and soyabean oil in a specific proportion to locking processing margins.

Crack spreads: It specifically refers to Energy complex whereas trading happens between crude oil and petroleum products extracted from it. This strategy is helps to locking refining margins.

Explanation:

As per SEBI rules on giving investment advice in publicly accessible media –

In case, an employee of the stock broker is rendering such advice, he shall also disclose the interest of his dependent family members and the employer including their long or short position in the said security, while rendering such advice.

Explanation:

Hedging is a two-step process. For instance, if the hedger has plans to sell a commodity in the spot market at a future date, he sells the futures contract now. This is the first step.

Subsequently, on the Futures Expiry date, he may deliver the commodity on Futures expiry date.. Alternately, if the hedger manages to sell the required commodity in the spot market in the interim, then he squares off his futures contract. This is the second step.

Explanation:

The exchange traded commodity derivatives in India devolves into their futures contracts and not into the spot.

The question says ‘Long Call option’ which means the trader has taken a bullish position. So this will devolve as Long futures contract.

Explanation:

Basis risk is defined as the risk that a futures price will move differently from that of its underlying asset.

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.

Explanation:

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.