Commodity Prices

Additional details of commodity derivatives, including who buys, sells and the detailed information on risks and profitability.

In order to understand what commodity derivatives are, you must first understand what derivatives are and how they function. The objective of every investor is to minimize his/her risk which is why financial institutions and banks invent various financial instruments in an effort to minimize the risk. Similarly, a derivative minimizes risk by deriving its value from an asset; this asset is simply known as the “underlying”. For example, a derivative deriving its value from the shares of a particular company. The derivative is an agreement through which an investor can either buy or sell its underlying by an agreed future date and at a pre-agreed price. The profit or loss associated with a derivative comes from the increase or decrease in the value of the underlying, because remember the price of the derivative has already been fixed.

In commodity derivatives, as the name states, the underlying is a commodity such as gold, wheat, machinery etc. Originally, commodity derivatives were designed to protect farmers from the risk of under or over production of crops. Commodity derivatives were a financial instrument for investors who traded in the underlying commodity. However, commodity derivatives are now used as an investment tool for managing your risk and are traded in the market most frequently by investors who have no need for the commodity itself (i.e. they never actually are possession of the commodities, they keep trading them in the market.)

It is easier to predict the fluctuations in the value of a commodity derivative, than it is to predict the fluctuations for a company’s share, because the values of the commodities are determined by the forces of demand and supply.

The commodity derivative contract has two parties; the buyer and the seller. The buyer of the commodity derivative has to submit an initial margin (an agreed percentage of the total value of the derivative) with the seller of the commodity. If the seller is satisfied with the initial margin he agrees to give the buyer ownership of the commodity at that agreed future date. The physical delivery of the commodity will take place at a future date. The buyer, depending on the spot price (current price) of the commodity, makes a profit or a loss. Besides the physical delivery, the buyer and the seller can agree to settle the trade in terms of cash instead.

There are exchanges dedicated to the trading of commodity derivatives. The primary function of these exchanges is to facilitate the contract settlement and clearing. The most common commodities to be traded on these exchanges through derivatives include cotton, rice and soybean. The prices prevailing on these exchanges play a very important role in determining the prices of those commodities nationally as well as internationally.

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