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What is Commodity Market

  • Commodity Market Commodity market organized trader’s exchange in which standardized, graded products are bought and sold.
  • Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts
  • Market in which goods or services are bought and sold. Commodities are raw materials such as tea, rubber, tin or copper, which generally need processing to reach their final state. The actual commodities are seldom present, and what is traded is their ownership.
  • The oldest existing commodity exchange in the world isCBOT in Chicago established in 1848.

Definition of a "Commodity"

  • Any product that can be used for commerce or an article of commerce which is traded on an authorized commodity exchange is known as commodity.
  • Commodity includes all kinds of goods. Forward Contracts (Regulation) Act (FCRA), 1952 defines “goods” as “every kind of movable property other than actionable claims, money and securities”.
  • The national commodity exchanges, recognized by the Central Government, permits commodities which include precious (gold and silver) and non-ferrous metals; cereals and pulses; ginned and un-ginned cotton; oilseeds, oils and oilcakes; raw jute and jute goods; sugar and gur; potatoes and onions; coffee and tea; rubber and spices. Etc.

List of Traded Commodity

  • Agricultural (Corn, Oat, Soya bean, Wheat, Coca etc)
  • Energy (WTI Crude Oil, Brent Crude, Natural Gas, Heating Oil, Gulf Coast Gasoline, Uranium)
  • Industrial metals (Copper, Lead, Zinc, Tin, Aluminium, Aluminium alloy, Nickel)

Why are Commodity Derivatives Requried

India is among the top-5 producers of most of the commodities, in addition to being a major consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian economy. It employees around 57% of the labour force on a total of 163 million hectares of land. Agriculture sector is an important factor in achieving a GDP growth of 8-10%. All this indicates that India can be promoted as a major centre for trading of commodity derivatives.

What Commodity Futures Markets Do

  • A well-developed and effective commodity futures market, unlike physical market, facilitates offsetting the transactions without impacting on physical goods until the expiry of a contract.
  • Futures market attracts hedgers who minimize their risks, and encourages competition from other traders who possess market information and price judgment.
  • While hedgers have long-term perspective of the market, the traders, or arbitragers as they are often called, hold an immediate view of the market.
  • A large number of different market players participate in buying and selling activities in the market based on diverse domestic and global information, such as price, demand and supply, climatic conditions and other market related information.
  • All these factors put together result in efficient price discovery as a result of large number of buyers and seller transacting in the futures market.

There are Three Types of the Traders in the Derivatives Markets Namely

Hedgers

Hedging means taking a position in the future market that is opposite to position in the physical market with the objective of reducing or limiting risk associated with price changes.

For instance, if the hedger is going to buy a commodity in the cash market at a future date, he buys a future contract now and when he buys the commodity in cash market, the future contract is squared off to reduce or limit the risk of the purchase price.

They are in the position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk.

For example, a farmer may use futures or options to establish the price for his crop long before he harvests it. Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. The farmer can watch the prices discovered in trading at the [COMMODITY EXCHANGE] CBOT and, when they reflect the price he wants, will sell futures contracts to assure him of a fixed price for his crop.

Speculators

Speculators wish to bet on the future movement in the price of an asset. They use derivatives to get extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.

Arbitrators

Arbitrage means locking in a profit by simultaneously entering in to transactions in two or more markets. If the relationship between spot prices and future prices in terms of basis or between prices of two future contracts in terms of spread changes, it gives rise to arbitrage opportunity.

Difference in the equilibrium prices determined by the demand & supply at two different markets also gives opportunities to arbitrage.

Arbitrage, involves buying and selling a security and taking advantage of prices differences that may exists on different markets. While rare, this does happen from time to time.

For example, suppose you find on eBay that someone is selling a brand new iPod for Rs 11500 while the local store is buying the same iPods for Rs12000. In theory, you can buy all the iPods available on eBay and sell them all to the local store, pocketing Rs500 per music player. Taking advantage of this price inequality is the essence of true arbitrage.

Cash VS Futures Market Trading

  • In cash market, a physical commodity is exchanged in a buy and a sell agreement.
  • In futures market, you are paper trading and don’t take physical possession of the commodity in most cases.

Future Contract

  • Commodity and Futures contracts are similar as "Forward" Contracts.
  • Early days "future" contracts (agreements to buy now, pay and deliver later) were used as a way of getting products from producer to the consumer.
  • These typically were only for food and agricultural Products.
  • Now it is used for every metal.
  • Future contract for commodity trading and for share trading is all different from one another
  • Futures are traded in certain contract months
  • Contracts are at specified and pre-determined amounts
  • Owner doesn’t take physical possession of commodity

Futures VS Forwords

    Futures

    • Futures are traded on a stock exchange
    • Futures are contracts having standard terms and conditions
    • No default risk as the exchange provides a counter guarantee
    • Exit route is provided because of high liquidity on the stock exchange
    • Highly regulated with strong margining and surveillance systems

    Forwords

    • Forwards are non tradable, regotiated instruments
    • Forwards are contracts customized by the buyer and seller
    • High risk of default by either party
    • No exit route for these contracts
    • No such systems are present in a forward market.




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