A future contract is an agreement for buying or selling a commodity for a predetermined delivery price at a specific future time. Futures are standardized contract that are traded on organized facture exchanges that ensure performance of the contract and remove the default risk. The commodity futures have existed since the Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together the major function of future market is toe transfer price risk from hedger to speculators. For example suppose a farmer who is expecting the crop of wheat to be ready in three months time, but is worried that the price of wheat may decline in this period, in order to minimize his risk, he can enter into a future contract to sell his crop in three months time at a price determined now.
Just take an another example. All we know that woolen garments demand
picks up in winter season. A garment factory owner can by a factory
contract of cotton to get the raw material for his products as predetermined price. This way both time is able to hedge their risk arising from a possible adverse change in the price of theirs commodity or raw material.
Like futures, option are also financial instruments used for hedging and speculation. The commodity option holder has the right, but not the obligation to buy (or sell) a specified quantity of a commodity at specified price on or before a specified date. Option contract involve two parties – the seller of the option writes the option in favour of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options. A ‘call’ option gives the holder a right to buy a commodity at an agreed price, while a ‘put’ option gives the holder a right to sell a commodity at an agreed price on or before a specified date which is called expiry date.
The option holder will exercise the option only if it is beneficial to him,
otherwise he will let the option lapse. Suppose a farmer buys a put
option to sell 10 MT of wheat of Rs. 13000/- MT and pays a
‘premium’ of Rs. 500/- MT. If the price wheat decline, to say Rs. 1000/-
MT before expiry, the farmer will the exercise his option and sell his
wheat at the agreed price of Rs. 1300/- MT. However, if the market price
of wheat increases by Rs. 1000/-MT, it will be better for the farmer to sell
it directly in the open market at the spot price, rather than his option to
sell at Rs. 13000/- MT.Future and options trading therefore helps in hedging the price risk and
also provide investment opportunity to speculators who are willing to
assume risk for a possible return. Future trading and the ensuing
discovery of price can help farmers to deciding which crops to grow.Thus future and options market perform important functions
that cannot be ignored in modern business environment. At the same
time, it is true that too much speculative activity in essential commodities
would destabilize the markets and therefore, these markets are normally
regulated as per the law of the country.
Commodity Options trading is not permitted in India till now.