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Difference between Commodity and Financial Derivatives

Posted by : NIFM
25 October, 2013, 4:33 PM
The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Since financial assets are not bulky, they do not need special facility for storage, transport even in case of physical settlement. On the other hand, due to the bulky nature and physically existence of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying are concerned. However, in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. Physical Settlement Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. The period available for the buyer to take physical delivery is stipulated by the Exchange.


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