9.5 Commodities - 9.5 Commodities Explained

Key Concepts

• Commodities
• Physical Commodities
• Financial Commodities
• Commodity Derivatives
• Commodity Markets
• Commodity Risk Management

Commodities

Commodities are basic goods used in commerce that are interchangeable with other goods of the same type. They are often the raw materials that are essential inputs for manufacturing and production processes. Common examples include metals, energy products, and agricultural goods.

Example: Crude oil, gold, and wheat are all examples of commodities. Crude oil is used as an energy source and in manufacturing, gold is a precious metal used in jewelry and electronics, and wheat is a staple food crop.

Physical Commodities

Physical Commodities refer to the actual goods that are traded in the market. These include tangible items like oil, gold, and agricultural products. Investors can buy and store physical commodities, although this often requires significant logistics and storage costs.

Example: A refinery may purchase physical crude oil to process into gasoline. The refinery takes delivery of the oil and stores it until it is ready to be refined.

Financial Commodities

Financial Commodities are financial instruments whose value is derived from the price of physical commodities. These include commodity futures, options, and exchange-traded funds (ETFs) that track commodity prices. Financial commodities allow investors to gain exposure to commodity markets without taking physical delivery.

Example: An investor buys a futures contract on gold, which gives them the right to purchase gold at a specified price in the future. This allows the investor to speculate on gold prices without needing to store physical gold.

Commodity Derivatives

Commodity Derivatives are financial contracts whose value is based on the future price of a commodity. These include futures, options, and swaps. Derivatives are used for hedging against price volatility, speculation, and arbitrage.

Example: A farmer uses futures contracts to lock in the price of wheat at harvest time, protecting against potential price declines. If the price of wheat falls, the farmer can sell the futures contract at a profit, offsetting the lower market price.

Commodity Markets

Commodity Markets are platforms where physical and financial commodities are traded. These markets include exchanges like the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), as well as over-the-counter (OTC) markets. Commodity markets facilitate price discovery and liquidity.

Example: The CME Group operates futures markets for a variety of commodities, including energy, metals, and agricultural products. Traders and investors can buy and sell contracts on these exchanges, with prices determined by supply and demand.

Commodity Risk Management

Commodity Risk Management involves strategies to mitigate the risks associated with commodity price volatility. These strategies include hedging using derivatives, diversification, and operational adjustments. Effective risk management helps businesses protect their profitability and manage their exposure to market fluctuations.

Example: An airline company hedges against rising jet fuel prices by purchasing futures contracts. If fuel prices increase, the gains from the futures contracts offset the higher costs of purchasing fuel, protecting the company's profit margins.