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Commodity and Currency Trading Explained

In this episode of Dhan ki Baat, Chintan Modi, Executive Vice President, IIFL, explains the process of Commodity and Currency trading.

1093 views  5 Feb 2018

Understanding Commodity and Currency Trading

Commodity trading:

Commodities, whether they are related to energy, metals or agri, are an essential part of everyday life. They also form an important component of running a business. For instance, a hotelier would be affected by a decline or rise in agri prices.

Commodities are also used to diversify a portfolio against market risk. In volatile or bearish stock markets, investors transfer money to precious metals such as gold and silver that have been historically viewed as precious metals. Commodities can also be used as a hedge against high inflation or during periods of currency devaluation.

Today, tradeable commodities fall into four categories. These are:

  • Bullions (gold and silver)
  • Metals (copper, lead, zinc, nickel, aluminium)
  • Energy (crude oil, heating oil, natural gas and gasoline)
  • Agricultural (guarseed, soybeans, jeera, cotton and sugar)

Commodity market:

Derivatives such as Future & Option are traded on the commodities exchange. Future contract is an agreement between the buyer and the seller to buy or sell a particular asset of specific quantity and at a predetermined price at a specific date in future.

The underlying asset in a future contract could be a commodity, stocks, currencies, or bonds. It helps to transfer the prices risk from hedgers to speculators.

Benefits of trading in commodity market:

Commodities market is mainly driven by demand and supply. It is easy to understand and easy to trade. Margin requirements to trade the future contract is very low i.e. 5-8%. Trading hours are longer in commodity market; it starts from 10 am and is open till 11.30 pm, and extended till 11.50 pm, in accordance with the daylight saving timings schedule.

Further, trading in the commodity market is beneficial as it is difficult to manipulate prices in a commodities contract as it is derived from global markets.

Commodity exchanges in India:

Multi-Commodity Exchange of India Limited (MCX), National Multi-Commodity & Derivatives Exchange of India Limited (NCDEX)

Currency trading:

Currency trading is defined as the buying and selling of international currencies. In general,banks and financial trading institutions are engaged in currency trading. However, individual investors can also participate and make capital gains from variations in the exchange rate of the currencies.

Currencies are frequently traded in the forex market globally are as follows:

Euro/US dollars (EUR/USD)
US dollar/Japanese yen (USD/JPY)
British pound/dollar (GBP/USD)
US dollar/Swiss franc (USD/CHF)
Australian doller/US dollar (AUD/USD)
US dollar/Canadian dollar (USD/CAD)

Benefits of currency trading:

Portfolio diversification
Hedging (specially for importers/exporters)
Low margin-high leverage
Limited scripts to track
Serves as a separate asset class for market savvy investors, arbitrageurs and speculators
Far from manipulation

Currency derivatives:

In terms of market share, currency market is internationally very mature and bigger than equity and commodity markets. Currency derivatives are a contract between the seller and buyer, whose value is to be derived from the underlying asset i.e. the currency value. A derivative based on currency exchange rate is an agreement that two currencies can be exchanged in a specific quantity of a particular currency pair at a future date.

Indian currency markets have noticed heightened activities and extreme volatilities in last couple of years. The developments taking place in the Indian forex market have brightened the prospects for investors and traders.

Currency derivatives can be Future and Options contracts, which are similar to the stock Futures and Options, but the underlying asset happens to be a currency pair (i.e. USDINR, EURINR, JPYINR OR GBPINR) instead of stocks. Currency derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options are currently available on US Dollars.

Participants in commodity and currency market:

Hedgers: They try to reduce the risk associated with uncertainty. Hedgers involve taking an offsetting position in a derivative in order to balance any gains and losses to the underlying assets.
Speculators: They are typically seen as risk takers and they love volatility. They bet against or with the movements of the market to try make profit from the fluctuation in the price of the underlying assets.

Factors affecting different commodities and currency trading:

There are a number of factors that affects commodities and currency trading. Besides geopolitical issues, factors such as US economic data ((nonfarm payroll data), Federal Reserve interest rate, GDP data, new home sales/pending home sales, crude oil/Natural gas inventories data and oil rig count data impact commodities and the currency market. Chinese economic data such as GDP, export and import also affects the market.

Speaker's Profile

Chintan Modi

Chintan Modi

Mr. Chintan Modi is the Executive Vice President with IIFL and handles Commodity and Currency. He has more than 17 years of experience and is an MBA (Finance) and Cost Accountant.

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FAQs

Who regulates commodity markets?

Since 2015, SEBI has been regulating the Commodity Derivative Markets. Previously, the Forward Market commission, overseen by Ministry of Consumer Affairs, regulated Commodities.

What are the trading hours?

The trade timings of the Exchange from Monday to Friday are IST 10:00 a.m to 11.30 pm/11.55 pm.(during US day light saving period).

What are standardized contracts?

Futures contracts are standardized, which means that the parties to the contracts do not decide the terms of futures contracts, they merely accept terms of contracts standardized by the Exchange.

What is 'basis'?

It is normally calculated as cash price minus the futures price. Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.

What is cash settlement?

It is the process of performing a futures contract by payment of money difference rather than by delivering the physical commodity.

What is convergence?

The difference between spot and futures contract theoretically should have declining trend over the life of a contract and tend to become zero on the date on maturity.

How are currency prices determined?

Currency prices are affected by a complex inter-play of economic and political conditions, but probably the most important factors impacting it are interest rates, international trade, inflation, and political stability.

What are benefits of spread contract?

Spread contract give users the benefit to enter two calendar contracts simultaneously without the risk of partial (one leg) execution and at a lower impact cost.

What are the risks involved in currency futures market?

Risks in currency futures pertain to movements in the currency exchange rate. There is no rule of thumb to determine whether a currency rate will rise or fall or remain unchanged. A judgement on this will depend on the knowledge and understanding of the variables that affect currency rates.

What are currency trading hours?

Trading in currency futures is on all working days from Monday to Friday and is between 9.00 am to 5.00 pm.

What is the need of currency futures?

Currency futures are needed if your business is influenced by fluctuations in currency exchange rates. For instance, assume you are in India and are importing something; you have done the costing of your imports on the basis of a certain exchange rate between the Indian Rupee and the relevant foreign currency. By the time you actually import, the value of the Indian Rupee may have gone down and you may lose out on your income in terms of Indian Rupees by paying higher. On the contrary, if you are exporting something and the value of the Indian Rupee has gone up, you earn less in terms of Rupees. Currency futures help you hedge against these exchange rate risks.