Terminology

Oil (/Commodity) Futures

 

Oil futures are part of the derivatives family of financial products as their value 'derives' from the underlying instrument. Futures contracts are financial instruments and carry with them legally binding obligations for the buyer and seller to take or make delivery of an underlying instrument (Oil) at a specified settlement date in the future. These contracts are standardised in terms of quality, quantity and settlement dates. In the case of crude oil, the main futures exchanges are the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange where West Texas Intermediate (WTI) and North Sea Brent crude oil are traded respectively.

 

Participants on futures exchanges include those that have an interest in the instrument for their daily business (for example in the case of oil: a refinery, a utility or an airline company), who typically seek to off-load the risk of volatility in the price of oil and are thus referred to as Hedgers. Insurance offers coverage of the risks of physical commodity losses due to fire, pilferage, transport mishaps, etc., it does not cover similarly the risks of value losses resulting from adverse price variations, which occur with a much higher probability. Hedging is the practice of off-setting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. This technique is very useful in case of any long-term requirements for which the prices have to be firmed so as to quote a sale/purchase price, but, the hedger wants to avoid buying the physical commodity immediately to prevent blocking of funds and incurring large holding costs.

 

On the other side, there are the traders or speculators/ arbitrageurs, typically banks and other financial institutions with a view on the direction oil prices will take. They assume the risk and provide liquidity to the market. The traders or arbitrageurs prefer an immediate view of the market and these diverging views lead to price discovery for the commodity concerned.

 

Commodities are different from financial assets as they involve storage. The flow of benefits to the holder of commodity inventory is termed Convenience Yield; the benefits arise from the use of inventories to reduce production and marketing costs, and to avoid stockouts. Marginal convenience yield is the flow of benefits accruing from the marginal unit of inventory, and is thus equal to the price of storage. Cost of Carry is the total cost of storing a commodity, namely the physical storage cost plus the forgone interest.

 

Futures contracts are traded on regulated futures exchanges. Trading can take place through electronic dealing systems, open outcry around a pit or a combination of both. Only a member of an exchange can trade on that exchange; members can trade on their own account or they can execute orders as brokers for hedgers or speculators. Each futures exchange has a clearing house which ensures that trades are settled in accordance with market rules and that guarantees the performance of the contracts traded. The NYMEX operates its own clearing house. When a buyer and a seller agree to trade on futures exchanges, their transaction is recorded and the clearing house then steps in between them, in effect breaking the 'bond' between the buyer and the seller to become counterparty to both sides - the process of creating a trade in the name of the clearing house to each of the parties is often referred to as novation. In the UK, the London Clearing House (LCH.Clearnet) is a recognised house that clears business for many different exchanges. The ICE exchange as well is recognised as a clearing house by the UK regulator, the Financial Services Authority (FSA). In the US, the equivalent government regulator is the Commodity Futures Trading Commission (CFTC).

 

When market participants buy futures, they do not pay the full amount of value of the contracts they purchase, rather, they pay an initial margin (determined by the clearing house) that acts like an insurance deposit. This initial margin represents a percentage of the value of the transaction. At the end of each trading day, individual positions are evaluated relative to the closing price of the market published by the exchange - participants are then said to be marked to market. If the participant’s position is profitable, the profit will accrue into their account. In contrast, if the position is not profitable, the loss will be deducted from the initial deposit and the participant will be given a margin call (called the variation or maintenance margin) to make up the difference.

 

There are two types of futures contracts, those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. On the settlement date or the expiry of futures contract, the buyer and seller have the obligation to make or take delivery of the instrument. In the case of oil, settlement can be carried out in two ways: through the actual delivery of oil into a predefined location or through a cash settlement. In the case of the NYMEX WTI contract, physical delivery is possible and entails delivery into the oil hub of Cushing, Oklahoma. On the ICE Brent contract, there is no physical delivery but a cash settlement is available - the value of the position is assessed relative to the settlement price and a corresponding financial payment is made. Market participants do not necessarily need to wait for the expiry of their contract to settle their obligation vis-à-vis the exchange. Positions are often closed by taking an offsetting position for an equal and opposite amount of contracts. For example, a buyer of a certain futures can therefore sell an equal amount of that futures, making their net obligation relative to the exchange zero. Open Interest is the total number of outstanding contracts that are held by market participants at the end of each day. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other. Each trade completed on the floor of a futures exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract.

 

Delivery on futures contracts is the exception rather than the rule, however, a delivery provision offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires.

 

Oil futures prices reflect the price that both the buyer and the seller agree will be the price of oil upon delivery. Therefore, these prices provide direct information about investor's expectations about the future price of oil. The tendency of the difference between spot and futures prices to decline continuously, so as to become zero on maturity, is referred to as Convergence. Convergence occurs at the expiration of the futures contract because any difference between the cash and futures prices would then quickly be negated by arbitrageurs.  Basis is normally calculated as spot price minus the futures price. A positive basis indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). When the prices of spot, or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation. It is usual for a contract maturing in the peak season to be in backwardation during the lean period. Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier. It arises normally when the contract matures during the same crop season. In an well-integrated market, Contango is equal to the cost of carry viz. interest rate on investment, loss on account of loss of weight or deterioration in quality etc. As basis volatility (risk) increases the effectiveness of the hedge decreases. Index

                                                                                         
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Market Stabilisation Scheme (MSS)

Forex flows have implications for the conduct of domestic monetary policy and exchange rate management. While intervening in the forex market, the RBI releases rupees for buying dollars to keep the exchange rate within a desirable limit. The rupees so released add to liquidity in the system raising inflationary expectations. To mop up this excess liquidity through OMOs, the central bank uses its stock of government securities. But over a period this stock of securities held with RBI has come down sharply. It is in such a context that a new market stabilisation scheme (MSS) was announced to take care of the shortage of government securities. With sustained surge in capital flows since 1999-2000, RBI's net domestic assets even recorded a decline in absolute terms on account of significant OMOs. Forex reserves increased from US$54 billion as at the end of March 2002 to US $ 103 billion by January 2004, consequently MSS was launched in April 2004.

The salient features of the MSS are: The Government issues treasury bills and/ or dated securities under the MSS in addition to its normal borrowing requirements, for absorbing liquidity from the system. These have all the attributes of existing treasury bills and dated securities and are issued and serviced like any other marketable government securities. The treasury bills and dated securities are issued by way of auctions conducted by the RBI. The Government, in consultation with the RBI, fixes an annual aggregate ceiling for these instruments.

MSS securities are not treated as part of the Government debt. Instead balances collected through MSS bond issues are held as a separate account with the RBI, which the Government cannot use for its own expenditure. Interest out flows on MSS balances though, are treated as part of the Government revenue expenditure. The amounts raised under the MSS are held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) maintained and operated by the RBI. The amounts credited into the MSS Account are used only for the purpose of redemption and/ or buy back of the treasury bills and / or dated securities issued under the MSS. The payments for interest and discount will not be made from the MSS account. The receipts due to premium and / or accrued interest will not be credited to the MSS account.

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Reserve Bank of India

Main Functions

Monetary Authority:

  • Formulates, implements and monitors the monetary policy.
  • Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system:

  • Prescribes broad parameters of banking operations within which the country's banking and financial system functions.
  • Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Manager of Foreign Exchange

  • Manages the Foreign Exchange Management Act, 1999.
  • Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

  • Issues and exchanges or destroys currency and coins not fit for circulation.
  • Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role

  • Performs a wide range of promotional functions to support national objectives.

Related Functions

  • Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.
  • Banker to banks: maintains banking accounts of all scheduled banks.

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 Budget Special Feature

Through the Budgetary process the parliament authorises the ruling Govt to collect funds by way of taxes, duties, borrowings etc., to meet with approved Govt expenses. In india the Finance Minister prepares the Union Budget; after the Dept of Economic Affairs issues a circular to all States/UTs, Union ministries, the Defence Forces etc., to submit estimates, spending priorities are assessed by the Dept of Economic Affairs ans revenue mobilisation is assessed by Dept of Revenue. The Planning Commission sets overall targets for various ministries and the Controller & Auditor general keeps track of the accounts.

Deficit spending occurs when a government, business, or individual's spending exceeds income. The practice also is called a deficit, or budget deficit.  Governments, companies and households sometimes indulge in deficit spending, but with a plan to repay the debt, plus interest charges, over time. This technique is a standard government and business practice as opposed to having a budget surplus or balancing the budget such that expenditures are exactly matched with revenues.

An accumulated deficit over the years is referred to as the government debt. The government's deficit can be measured with or without including the interest it pays on its debt. The primary deficit is defined as the difference between current government spending and total current revenue from all types of taxes. The total deficit (which is often just called the 'fiscal deficit') is spending, plus interest payments on the debt, minus tax revenues. These measures are mostly expressed as a percentage of GDP, so that they are comparable across the years and even countries. Therefore, if Gt is government spending and Tt is tax revenue, then

Primary deficit = Gt − Tt

If Dt − 1 is last year's debt, and r is the interest rate, then

Total deficit = Gt + rDt − 1 − Tt

Finally, this year's debt can be calculated from last year's debt and this year's total deficit:

Dt = (1 + r)Dt − 1 + Gt − Tt

The expenditure of the government can be classified into plan expenditure and non-plan expenditure. Plan expenditure is an expenditure that the government plans to incur on a scheme to be implemented in a given year. Non-plan expenditure is defined as expenditure committed by the plan expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure. Expenditure on both plan and non-plan front can be categorised into capital and revenue expenditure. Capital expenditure includes that expenditure which leads to creation of assets whereas revenue expenditure does not involve asset creation and is recurring in nature.

Revenue deficit is the difference between the revenue expenditure and the revenue receipts (the recurring income for the government). When a country runs a revenue deficit it means that the government is unable to meet its running expenses from its recurring income.

Economic trends can influence the growth or shrinkage of fiscal deficits in several ways. Increased levels of economic activity generally lead to higher tax revenues, while government expenditures often increase during economic downturns because of higher outlays for social insurance programs such as unemployment benefits. Changes in tax rates, tax enforcement policies, levels of social benefits, and other government policy decisions can also have major effects on public debt.

FRBMA (Fiscal Responsibility and Budget Management Act of 2003):  From a macroeconomic perspective, low levels of budget deficits and public debt are generally considered as key ingredients for economic growth, reducing poverty and improving social outcomes. This owes to the stabilization models attributing resource-expenditure imbalances as thetrigger for economic problems of many emerging/developing economies. The fiscal reforms initiated in India in the 1990s as a part of economic liberalization reflected this view point. Fiscal consolidation began in the early 1990s with fiscal deficit declining from 6.6 per cent of GDP in 1990-91 to 4.1 per cent of GDP in 1996-97; however it faltered and started deteriorating in 1997-98 and reached a level of 6.2 per cent of GDP in 2001-02. It was against this background, that operationalization of the FRMBA assumed urgency leading to the notification of the Rules under the Act in July, 2004. In the post-FRBMA period, progress in fiscal consolidation was more or less close to the targets envisaged there under, till the Global Financial crisis of 2008 derailed the process and the fiscal deficit moved up to an estimated 6.8 per cent of GDP for the fiscal year 2009-10.   

See these:  ET in the classroom - Non tax sources of income for the government.
                 ET in the classroom - Big words in the budget speech.


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