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Interest in commodities as an asset class has been rising in recent years in the wake of a surge in commodity prices, particularly gold, and volatility in other asset classes e.g. stocks and bonds. Commodities offer investors diversification as well as a hedge, not only against inflation but also against volatility in stock markets.

In Pakistan, the Commodity Exchange and its futures contracts are in its development stages. Pakistan Mercantile Exchange Company (PMEX) currently offers contracts in gold, silver, crude and palm oil, rice, sugar, wheat and KIBOR (interest rate) futures.

Pakistan Mercantile Exchange

Pakistan Mercantile Exchange (PMEX) is the first technology driven, web-based, demutualized Commodity Exchange in Pakistan. It started operations in May 2007 as a fully electronic exchange with nationwide reach. PMEX is licensed and regulated by the Securities and Exchange Commission of Pakistan and its shareholders are National Bank of Pakistan, Karachi, Lahore and Islamabad Stock Exchanges, Pak Kuwait Investment Company (Pvt) Ltd and Zarai Taraqiati Bank Ltd. The Exchange operates 21 hours daily.

PMEX is the first Exchange in Pakistan to employ modern risk management techniques based on Value-at-Risk with a pre-trade risk check in real time. The Exchange acts as a central counterpart to both buyers and sellers through a novation process providing clearing & settlement on a T+0 basis using on-line bank transfer mechanism.

Futures Contract

A futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a Futures Exchange. The party agreeing to buy the underlying asset in the future, the “buyer” of the contract, is said to be “long”, and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be “short”. The terminology reflects the expectations of the parties – the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease.

In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.

While the futures contract specifies a trade taking place in the future, the purpose of the Futures Exchange is to act as intermediary and minimize the risk of default by either party. Thus the Exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The Exchange will draw money out of one party’s margin account and put it into the other so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.