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Terms Related to Commodities Market


Investment Returns



It is generally agreed that commodities have an expected return of 5% in real terms which is based on the risk premium for 116 different commodities weighted equally since 1888. It is general for investment professionals to mistakenly claim there is no risk premium in commodities.

Spot trading



Spot trading is any transaction where delivery either takes place immediately/with a minimum lag between the trade and delivery due to technical restraints. Spot trading usually involves visual inspection of the commodity or a sample of the commodity, and is carried out in markets such as wholesale markets. Commodity markets, on other hand, require the existence of agreed standards so that trades can be made without visual inspection.

Forward contracts



A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price.

Futures contracts



A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Commodity and Futures contracts are based on what is termed "Forward" Contracts. Early on these "forward" contracts (agreements to buy now, pay and deliver later) were used as a way of getting products from producer to the customer. These typically were only for food and agricultural Products. Forward contracts have developed and have been standardized into what we know today as futures contracts. Although more complex today, before days “Forward” contracts for example, were used for rice in seventeenth century Japan. Modern "forward", or futures agreements, began in Chicago in the 1840s, with the appearance of the railroads. Chicago, being centrally located, materialized as the hub between Midwestern farmers and producers and the east coast consumer population centers.

Hedging



"Hedging", a practice of farming cooperatives insures against a poor harvest by purchasing futures contracts in the same commodity. If the cooperative has significantly less of its product to sell due to weather or insects, it makes up for that loss with a profit on the markets, since the on the whole supply of the crop is short everywhere that suffered the same conditions.

All developing nations may be especially vulnerable, and even their currency tends to be tied to the price of those particular commodity items until it manages to be a fully developed nation. For instance, one could see the nominally fiat money of Cuba as being tied to sugar prices, since a lack of hard currency paying for sugar means less foreign goods per peso in Cuba itself. In effect, Cuba needs a hedge against a drop in sugar prices, if it wishes to preserve a steady quality of life for its citizens.

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