NISM Series XVI – Commodity Derivatives: Chapter 2 – Commodity Futures Explained (Short Notes)

NISM Series XVI – Commodity Derivatives: Chapter 2 – Commodity Futures Explained (Short Notes)

This is Part 2 of 7 in our complete NISM Series XVI Commodity Derivatives short notes series. In this chapter, we cover everything you need to know about commodity futures — what they are, how they differ from forwards, the cost-of-carry model, convergence, fair value, and the payoff profile. All concepts are explained simply for exam preparation.

Missed Part 1? Read Chapter 1: Introduction to Commodity Markets first.

1. What Is a Commodity Futures Contract?

A futures contract is a legally binding agreement between a buyer and a seller, entered on a recognized exchange, to buy or sell a specified quantity of an asset at a price agreed today, for delivery at a specified future date.

• The buyer has an obligation to buy on the agreed date.
• The seller has an obligation to sell on the agreed date.
• Futures contracts are standardized in terms of quantity, quality (grade), lot size, and delivery time — every contract on an exchange has identical specifications.
• The exchange acts as a central counterparty (CCP), guaranteeing settlement and eliminating counterparty default risk.

2. Difference Between Futures and Forwards

3. Cost-of-Carry Model

The cost-of-carry model explains how the futures price of a commodity is determined.

According to this model, the futures price equals the spot price plus the cost of carrying the commodity from today to the delivery date.

What makes up the cost of carry?

• Storage costs
• Insurance costs
• Transportation costs
• Cost of financing (interest on borrowed funds to purchase the commodity)
• Any other costs related to holding the commodity until delivery

Basic Formula:

F = S + C

Where:
F = Futures Price
S = Spot Price
C = Cost of Carry

With Annual Compounding:

F = S × (1 + r)^n

Where:
r = annual interest rate (financing cost)
n = time period (in years)

With Convenience Yield Included:

F = S + C – Y

Where:
Y = Convenience Yield (explained below)

4. Convenience Yield

Convenience yield is the monetary benefit that comes from physically owning a commodity rather than holding a futures contract on it.

• It reflects the value of having actual physical inventory available — for example, a refinery that holds crude oil inventory can immediately use it for production without waiting for futures contract delivery.
• This is one of the key differences between commodity derivatives and financial derivatives — financial instruments do not have a convenience yield.
• When convenience yield is high, the futures price tends to be lower relative to the spot price.

5. Convergence of Spot and Futures Prices

As a futures contract approaches its expiry date, the cost of carry decreases day by day. On the delivery date itself, the cost of carry becomes zero, and the spot price and futures price must be equal. This narrowing and eventual meeting of the two prices is called convergence.

Market Conditions Based on Futures vs Spot Price:

6. Basis

Basis is a core concept in futures trading and risk management.

Formula:

Basis = Spot Price – Futures Price

• When futures price > spot price → Basis is negative → Contango market
• When futures price < spot price → Basis is positive → Backwardation market

Basis Risk: The risk that the futures price will not move exactly in line with the spot price. Even when hedging with futures, the hedger is still exposed to basis risk — i.e., the risk that the basis will change unexpectedly.

Long Hedge vs Short Hedge and Basis:

• Long Hedgers (long in futures, short in spot) benefit from a weakening of basis — futures price rising and spot price falling.
• Short Hedgers (short in futures, long in spot) benefit from a strengthening of basis — spot price rising and futures price falling.

7. Fair Value of a Futures Contract

The theoretical (fair) price of a futures contract can be calculated if you know the spot price and cost of carry:

Fair Value = Spot Price + Cost of Carry

If the actual traded futures price differs from the fair value, arbitrage opportunities arise:

• If the futures price is less than the fair value, a buyer would prefer to buy in the futures market rather than buying in the spot market and holding the commodity.
• If the futures price is more than the fair value, arbitrageurs can buy in the spot market and sell in the futures market to lock in a riskless profit.

8. Advantages of Commodity Futures Over Commodity Forwards

• Efficient Price Discovery: Brings together buyers and sellers with diverse needs and expectations, creating a transparent pricing mechanism.
• No Counterparty Credit Risk: The exchange and clearing corporation act as the central counterparty, guaranteeing settlement.
• Open to All Market Participants: Both large institutional players and small individual traders can participate.
• Standardized Products: Standardization increases clarity and participation, resulting in greater liquidity compared to forward markets.
• Transparent Trading Platform: All trades are executed on an open electronic trading system with publicly visible prices.

9. Payoff Profile for Futures Contracts

A payoff is the profit or loss from a trade. In futures trading:

• A positive payoff means the trade resulted in a profit.
• A negative payoff means the trade resulted in a loss.
• The payoff on a futures contract at expiry depends on the spot price of the underlying commodity at that point and the original contract price.

Long Futures Position (Buyer):

• Profit when spot price at expiry > futures purchase price
• Loss when spot price at expiry < futures purchase price
• Both profit and loss are potentially unlimited

Short Futures Position (Seller):

• Profit when spot price at expiry < futures sale price
• Loss when spot price at expiry > futures sale price
• Both profit and loss are potentially unlimited

10. Contract Specifications — What They Include

Every commodity futures contract listed on an exchange has a detailed contract specification. Key elements include:

• Contract start date and expiry date
• Trading unit and lot size
• Maximum order size
• Tick size (minimum price movement)
• Daily price limit (circuit filter)
• Initial margin, additional/special margin
• Maximum permissible open positions (client-wise and member-wise)
• Delivery centres
• Delivery logic (compulsory delivery, both options to deliver, seller's option)
• Quality specifications
• Tender period, delivery period, delivery margin
• Delivery default penalty provisions

Tick Value Formula:

Tick Value = (Lot Size ÷ Quotation Factor) × Tick Size

Tick value tells you how much profit or loss occurs for a one-tick (minimum price movement) change in the commodity futures price.

11. Selection Criteria for Commodities Suitable for Futures Trading

Not every commodity is suited for futures trading. A commodity must meet these criteria:

• Large demand and supply with sufficient marketable surplus
• Prices must be volatile enough to create a genuine need for hedging
• Relatively free from government price controls and supply restrictions
• Homogeneous — or capable of being standardized by grade/quality
• Storable — if a commodity cannot be stored, arbitrage is impossible and there will be no meaningful relationship between spot and futures prices

Quick Revision Table – Key Formulas

Practice Questions (NISM XVI Pattern)

1. What is the formula for calculating the fair value of a futures contract?
   Answer: Fair Value = Spot Price + Cost of Carry
2. When the futures price is higher than the spot price, what is the market condition called?
   Answer: Contango (Negative Basis)
3. What happens to the cost of carry as the futures contract approaches its expiry date?
   Answer: It diminishes to zero, causing spot and futures prices to converge.
4. What is convenience yield?
   Answer: The monetary benefit (in rupee terms) of physically owning a commodity rather than holding a futures contract — the value of having stock immediately available.
5. A futures contract expires with the spot price at ₹5,200, and the original purchase price was ₹5,000. What is the payoff for the long (buyer)?
   Answer: +₹200 (profit)
6. Which entity eliminates counterparty credit risk in exchange-traded futures?
   Answer: The Clearing Corporation (which acts as the central counterparty)

Continue Your NISM Series XVI Preparation

• ⬅️ Part 1: Introduction to Commodity Markets
• ➡️ Part 3: Commodity Options – Call, Put, Greeks, Pricing Models
• ➡️ Part 4: Commodity Indices – AGRIDEX, iCOMDEX
• ➡️ Part 5: Hedging, Speculation, Arbitrage & Spread Trading
• ➡️ Part 6: Trading Mechanisms
• ➡️ Part 7: Clearing, Settlement, Accounting & Regulation

🎯 Test your knowledge now! Take a free NISM Series XVI Mock Test on PassNISM and see where you stand.