Commodity is an economic good or service that has monetary utility and does not generate cash. There are two types of commodities which are:
- Hard commodities: include gold, silver, nickel, copper, steel, lead, oil, natural gas, coal etc.
- Soft commodities: are agricultural products including coffee, tea, sugar, wheat, rice etc.
Factors affecting commodity prices: Supply and Demand effect plays an important role in determining the commodity pricing. Let’s understand this effect with a simple formula:
Supply and Demand effect:
- Demand > Supply = Higher Prices of the commodities.
- Supply > Demand = Lower Prices of the commodities.
Weather, economic & political conditions, currency movements, interest rates and inflation also affect the prices of commodities.
Commodities are traded on commodity exchanges such as Multi Commodity Exchange (MCX), New York Mercantile Exchange (NYMEX), Chicago Mercantile Exchange (CME), Singapore Exchange Limited (SGX), Intercontinental Exchange (ICE) and London Metal Exchange (LME).
The difference between spot and futures price is known as basis.
The difference between the futures price of a nearer maturity and the futures price of a more distant maturity is known as the calendar spread.
When futures prices are higher than spot prices, the market is in contango. In contango market, the calendar spread and basis are negative.
When futures prices are lower than spot prices, the market is in backwardation. In backwardation market, the calendar spread and basis are positive.
Contango and backwardation are signal of supply and demand.
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Commodity Market Participants
- Hedgers are informed investors because they either produce or consume the commodity. Example: a wheat producer, will hedge by selling wheat futures, since it is exposed to the risk of falling wheat prices.
- Speculators take on commodity risk in futures market and may act as informed investors, seeking to exploit an information or information processing advantage to profit from trading with hedgers. Speculators can also earn profits by providing liquidity to markets: buying futures when short hedgers are selling and selling futures when long hedgers are buying.
- Arbitrageurs are traders who buy and sell the same commodity in different markets with different prices to make profit. These are risk free transactions.
Components of commodities future returns
- The spot return is change in spot prices.
- Roll return is closing out expiring contracts and reestablishing the position in longer dated contracts.
- Collateral return is the yield on securities the investor deposits as collateral for the futures positions.
Theories of Commodity Future Returns
- Insurance theory states that future returns compensate contract buyers for providing protection against price risk to futures contract sellers. The positive return to contract buyers is given as they provide insurance against price uncertainty to producers. According to this theory backwardation is a normal condition.
- The hedging pressure hypothesis expands on Insurance theory by including long hedgers as well as short hedgers. This theory suggests future markets will be in backwardation when short hedgers dominate and in contango when long hedgers dominate.
- The theory of storage states that spot and future prices are related through storage costs and convenience yield. The market is in contango, when supply of the commodity is high and the market is in backwardation, when supply of the commodity is less. Convenience yield is inversely related to supply of commodities.
Valuation of Commodities
Current spot price is discounted value of the expected selling price at some future date.
A swap can be used to increase or decrease exposure to commodities risk. Swaps are created for which the payments between the two parties are based on various risk factors including excess return on a commodity, total return on the commodity or a measure of price volatility.
- Total return swap: swap buyer will receive periodic payments based on the change in commodity price, in return for a series of fixed payments.
- Excess return swap: party may make a single payment at the initiation of the swap and then receive periodic payments of any percentage by which the commodity price exceeds some fixed or benchmark value, times the notational value of the swap.
- Basis swap: the variable payments are based on the difference between the prices of two commodities.
- Commodity volatility swap: the underlying factor is volatility of the commodity’s price. If the volatility of the commodity’s price is higher than the expected level of volatility specified in the swap, the volatility buyer receives a payment. When actual volatility specified is lower than the specified level, the volatility seller receives a payment.
Investment in commodities offers inflation hedge, liquidity, diversification, leverage and higher returns.