Hedging
FAQs |
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| If
your business depends
on the purchase or sale
of commodities, can you
afford to stay resigned
to wild fluctuations in
commodity prices? In a
marketplace where prices
fluctuate dynamically
due to various price moving
factors like demand and
supply. We bring you a
trade mechanism –
hedging -- that allows
you to lock-in your price
by judiciously using the
commodity futures market.
Considered a pillar
of commodity exchanges,
hedging is easy to understand.
Here’s what it’s
all about:
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- What is 'hedging'?
- Why should we hedge?
- When does one need to hedge?
- Who needs to hedge?
- What is the role of MCX in hedging?
- Why hedge on MCX?
- How does hedging on MCX work?
- Do the buyers and the sellers on MCX know each other?
- What if either party to a transaction on MCX fails to fulfill his obligation of delivery or payment?
- What is the maximum duration for hedging available currently on MCX?
- To what extent can price risk be covered by hedging on MCX?
- Which commodities are covered by hedging on MCX?
- How do I go about hedging on MCX?
- Is there a fee for hedging on MCX?
- What is the legal status of MCX?
- Who is a member of MCX?
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| 1) |
What is 'hedging'?
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Hedging is an internationally well-established trade mechanism that protects businesses from the adverse effects of temporal price volatility in the commodity markets. It is somewhat comparable to the concept of insurance in the sense that insurance offers financial cover against specified risks just as hedging offers cover against the risk of price fluctuations impacting business income. |
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| 2) |
Why should we hedge?
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Profitability of a commodity-dependent business is largely influenced by the price at which it sells or buys the particular commodity. However, commodities are vulnerable to price volatility, which can adversely affect the profitability of business. Companies that opt for hedging can do their costing on firmer grounds. This leads to better management of cost, profits and selling price. |
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| 3) |
When does one need to hedge?
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Every large buyer, seller and processor of commodities needs to hedge against price volatilities throughout the year. Though seasonal price fluctuations can be anticipated, the intensity of volatility cannot be predicted. Besides, there are many factors other than the seasonality that cause price volatility. Therefore, there is constant need for hedging. |
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| 4) |
Who needs to hedge?
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All large buyers, sellers and processors and users of commodities need to hedge because they all stand vulnerable to price volatility. They include: commodity producers, large consumers, manufacturers for whom a commodity is major raw material, processors of commodities, importers, exporters, traders, and so on. |
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| 5) |
What is the role of MCX in hedging?
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As a commodity exchange, MCX provides a transparent and neutral platform for buyers and sellers to trade with each other under the rules and regulation of the exchange and the overall regulation of Forward Markets Commission (FMC). MCX's biggest strengths are its neutrality, technology, transparency, settlement guarantee, and an efficient dispute redressal mechanism.
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| 6) |
Why hedge on MCX?
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Hedging
against price volatility
in the commodity
markets is done
on commodity exchanges
and MCX is India's
biggest commodity
exchange based on
turnover in terms
of value for FY
07 (Source: FMC
website: www.fmc.gov.in).
MCX can be reached
through a vast network
of more than 1,700
registered members,
and over 7,000 trading
terminals located
across 384 locations
in India as of June
30, 2007. The size
of its user-base
and the volume of
trading in many
commodities give
a high degree of
liquidity to the
MCX trading platform.
Usually, the commodity-dependent
companies in the
developed economies
hedge against price
risks on similar
exchanges globally
as Indian users
do it on MCX in
India for many commodities.
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| 7) |
How does hedging on MCX work?
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Hedging is a method by which a buyer, who requires a commodity at a future date, protects himself from the risk of a possible price rise, by agreeing to buy the same commodity on the MCX platform at a pre-determined price. Alternatively, a seller who plans to sell a commodity at a future date but fears a potential price fall can agree to sell the same commodity on the MCX platform at a pre-determined price. Thus, both buyer and seller can avail of the hedging mechanism on MCX to protect themselves from adverse price movements. Trades done in such manner are assured of completion and settlement by MCX. |
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| 8) |
Do the buyers and the sellers on MCX know each other?
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No, they don't. They don't need to. To avoid the risk of influential buyers and sellers impacting the market, it is imperative for anonymity to be maintained. Apart from anonymity, there are other risk management instruments on MCX that helps it avoid any group of buyers or sellers influencing the prices discovered on its platform. |
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| 9) |
What if either party to a transaction on MCX fails to fulfill his obligation of delivery or payment?
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Respective contracts have penal clauses in cases of default. Besides, MCX ensures settlement of obligations without any counterparty risk through its Settlement Guarantee Fund. While MCX takes care of settlement at the member level, at the client level, MCX provides an efficient dispute resolution mechanism of arbitration to protect members and clients. |
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| 10) |
What is the maximum duration for hedging available currently on MCX?
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Currently, hedging against price volatilities in India can be done from many days upto 6 months and as the market matures, we will have contracts ranging upto or more than one year. |
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| 11) |
To what extent can price risk be covered by hedging on MCX?
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Hedging generally is done to cover as much price risk as possible taking into account a host of factors affecting prices in the market and the users. At the outset, it is has to be noted that you are minimizing your price risk through hedging, NOT eliminating it. Extent of coverage would vary with the commodity specifications and markets that a hedger is exposed to compared with the specifications of the contract traded on MCX. |
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| 12) |
Which commodities are covered by hedging on MCX?
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Hedging
on MCX can be done
for all commodities
that are traded
on its platform.
These include precious
metals, base metals,
energy, agriculture
and emissions. MCX
website- www.mcxindia.com
- has an exhaustive
list of the commodities
and available contracts.
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| 13) |
How do I go about hedging on MCX? |
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Hedging for the commodities listed on MCX can be done by buying or selling a futures contract through a member of MCX or by themselves becoming members of MCX.
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| 14) |
Is there a fee for hedging on MCX?
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Yes. As a member, one has to pay a security deposit, pay the margin, and a nominal transaction fee for trading on MCX. As a client, one has to pay brokerage fee and margin money to the member of MCX through whom you do your transaction. Besides, the member/client will also need to manage their daily cash flow for Mark to Market (MTM) differences which will be payable or receivable on daily basis from the exchange/member. |
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| 15) |
What is the legal status of MCX?
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MCX enjoys permanent recognition of the Government of India and its operations are governed by the rules of the Forward Markets Commission (FMC), Ministry of Consumer Affairs, Food and Public Distribution. |
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| 16) |
Who is a member of MCX?
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A member is an entity registered with MCX and FMC who trades (buys and sells) on the MCX platform, on his own behalf, or for his clients. |
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Are
the commodity prices
you trade on, the best
prices you should be
trading on? Or are they
reflecting the vested
interests of dominant
players of the market
or do the prices display
inefficiency of fragmented
markets? In a marketplace
that has had lack of
transparency on pricing,
we bring to the market
an additional mechanism
that discovers right
prices of commodities
reflecting their fundamentals
and that too ahead in
time before actually
physical transactions
could happen.
Considered a pillar of commodity exchanges, Price Discovery is easy to understand. Here's what it's all about:
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- What exactly is Price Discovery?
- Who are the participants in the Price Discovery process?
- What is the need for Price Discovery?
- How does Price Discovery work?
- Which are the commodities whose prices are discovered by the Price Discovery process?
- What is the role of MCX in Price Discovery?
- Since MCX is located in the Indian time zone, what is its relevance to internationally referenced commodities such as crude oil, base metals, bullion, etc?
- How does the Indian economy benefit from price discovery?
- Where do I get information on the prices 'discovered' for products I'm interested in?
- What would be the charges I would need to pay for this information?
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| 1) |
What exactly is Price Discovery?
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Price discovery is the process by which most-likely prices of commodities that will prevail at a future point in time are arrived at the exchange market place in advance by virtue of the trading between a large number of buyers and sellers each with different sets of information about the fundamentals of the commodities and its effect on likely future prices. The buyers and sellers communicate this information through prices at which they intend to take or provide delivery of respective commodities at a future date. These prices indicate the most likely price scenario of respective commodities at a future point in time. Being transparent, exchange discovered prices help stakeholders of the economy like producers, consumers and traders take efficient economic decisions such as what to sow, when to sell, when to buy or when to hold, etc. |
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Who are the participants in the Price Discovery process? |
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The participants in the price discovery can be broadly categorised into hedgers (like farmers, producers, consumers, processors, etc), investors, arbitrageurs and speculators depending on the purpose behind their participation. |
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What is the need for Price Discovery?
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In the absence of price discovery by market forces, as it happens on the futures exchanges, prices can only be guessed. Experience suggests that such guessed prices are often in the interests of a few and not in the interests of the macro economy. Hence, it is necessary that large number of buyers and sellers should converge anonymously on a trading platform to discover the prices based on which important economic decisions can be taken by all stakeholders for commodities market. |
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How does Price Discovery work? |
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Buyers and sellers of different commodities quote their prices based on analyses of the available information on technical and fundamental parameters about a commodity. This, in true economic sense, would reflect the "scarcity value" of the commodity. The trading platform of a futures exchange keeps on matching these price quotes given by buyers & sellers on real time basis on a price and time priority.
MCX provides a platform for buyers and sellers to anonymously sell or buy a contract. When a price offered by a seller is matched with the price of a buyer, the trade is executed on the exchange and it becomes the 'discovered price' at that given time. As large number of sellers and buyers operate through MCX, the price of the commodities keeps getting 're-discovered' on the best possible analysis of the information available at any given point in time on any given day. In other words, it keeps changing according to the views of the market forces from time to time throughout the life of the contract.
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Which are the commodities whose prices are discovered by the Price Discovery process?
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Price discovery occurs in commodities traded on the MCX platform such as, bullion, base metals, energy, petrochemicals, and agricultural commodities. The efficiency of this process for any commodity can be measured by the trading intensity of the contract on the platform. In future, we expect many other commodities including risk related products to be traded on MCX, like, weather indices, freight indices etc, subject to regulatory approvals. |
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What is the role of MCX in Price Discovery?
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MCX provides the trading, clearing and settlement and necessary regulatory support system within which all stakeholders can buy and sell commodities with different maturity for a settlement. Therefore, MCX facilitates above activities subject to its byelaws and provides necessary protection to all users of this market so that they can trade with full regulatory support of MCX as provided in its byelaws. |
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Since MCX is located in the Indian time zone, what is its relevance to internationally referenced commodities such as crude oil, base metals, bullion, etc? |
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MCX's strategic geographic location in India enables Indian market to take price signals from the eastern markets and then to pass them to the western markets through the Indian prices discovered on MCX. The sequence is that, MCX participants begin trading within India while the Tokyo Commodity Exchange (TOCOM) is at the middle of its day's session, and thereafter European markets open by mid afternoon Indian time and MCX closes a little before the end of trading in the US exchanges. Besides passing on the price signals from one time zone to another through information dissemination, the extended trading hours at MCX also enables Indian industry to effectively trade on MCX based on the most current global price information. This information is most useful for global commodities and Indian industry only gets empowered to mitigate its risk on MCX platform where the prices are discovered with almost similar efficiency as in the above markets. |
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How does the Indian economy benefit from price discovery?
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The Indian economy benefits from price discovery in the ways given overleaf:
- The influence of vested interests is neutralised since the Price Discovery process is transparent on an electronic system and is influenced largely by the forces of demand and supply.
- A national online exchange helps bring in spatial integration of the physical markets to resonate to one price point that emerges from the exchange platform and hence integrating them.
- In the absence of the perfect market conditions in the physical markets, price discovery on the futures exchanges provides right prices in advance.
- The supply chain is squeezed out to become more efficient with bulk sellers and bulk buyers trading using minimum level of intermediation.
- In the case of agricultural commodities, price discovery helps efficient resource allocation in the rural economy enabling maximum returns to its growers.
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Where do I get information on the prices 'discovered' for products I'm interested in? |
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Prices discovered on the MCX platform are widely available through various channels of communication including:
- Newspapers (most regional and national)
- Television
- The
MCX website
(www.mcxindia.com)
- SMS (sms MCX <<commodity
code>> to 53456 from an MTNL/BSNL mobile phone or to 58888 from any other mobile phone).
- Toll-free number 126565 dialed from any Tata Indicom mobile phone 1.
And of course, one can always ask a MCX broker too.
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What would be the charges I would need to pay for this information?
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Price information is available free of cost through most of the above mentioned sources. |
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