What are Commodity Derivatives?
The term “derivative” refers to the financial instrument whose value depends on the value of the underlying asset, such as equities, currency or commodities. A financial instrument is known as a “commodity derivative” when the underlying asset of the contract is a commodity. In a commodity market, the primary economic sector products are traded instead of manufactured products. The list of underlying commodities includes metals, gas, agricultural products, oil, minerals, freight rates, emissions trading credits, weather, etc.
Explanation of Commodity Derivatives
Most of the commodity markets around the globe primarily trade in oil, metals, and agricultural products, such as barley, wheat, maize, sugar, cocoa, coffee, cotton, milk products, etc. These commodity derivative contracts include spot prices, futures, forwards, and options. Examples of some of the other more sophisticated underlying assets include environmental instruments, interest rates, freight contracts, swaps, etc.
Examples of Commodity Derivatives
Now, let us look at some of the examples of commodity derivatives to understand how they work.
Let us assume that a trader entered into a contract in the month of November 2020to deliver 100 tons of steel at $500/ton in the month of January 2021. Here, the trader is assured that he has a buyer at an acceptable price, while the buyer can plan in advance as he knows the raw material cost in advance with certainty. Determine the profit or loss made by the buyer if in the month of January 2021
- the spot price of steel goes up to $525/ton
- the spot price of steel becomes $450/ton
If the spot price of steel goes up to $525/ton, then the buyer will make a profit of $2,500 [= 100 tons * ($525 – $500)/ton].On the other hand, if the spot price of steel becomes $450/ton, then the buyer will incur a loss of $5,000 [= 100 tons * ($450 – $500)/ton].
Let us assume that a farmer, in September 2020, entered into a futures contract with a miller to sell 10,000 bushels of wheat at $4.50/bushel in December 2020. On the day of the expiration of the contract, the market price of wheat fell to $4.45/bushel. However, the miller is obligated to purchase 10,000 bushels at $4.50/bushel, which is higher than the current market price of $4.45. Effectively, the miller will pay $500 more [= 10,000 bushels * ($4.50 – $4.45)/bushel], while the farmer will benefit from the transaction as he will recoup a higher-than-market price.
Types of Commodity Derivatives
The commodity derivative products can be classified into four major types:
- Commodity Future: It is an agreement to either buy or sell a particular amount of a commodity on a pre-decided date at a pre-determined price.
- Commodity Forward: It is an agreement between two parties who agree to exchange a certain quantity of a commodity at a pre-determined price on a fixed future date.
- Commodity Option:This type of contract gives the holder the right but not obligation to execute the transaction on the expiration date. The put option gives the right to sellwhile the call option gives the righttobuy.
- Commodity Swap: In this type of agreement,the floating price of an underlying asset is traded for the fixed price over a particular period of time.
Functions of Commodity Derivatives
In a commodity derivative, if the price of the underlying commodity goes up then the buyer of the contract benefits as he/ sheis able to get the commodity at a lower-than-market price and can sell in the market at a higher price. On the other hand, if the price goes down then the seller of the contract benefitsas he/ she can purchase the commodity at a lower price in the market and sell it to the buyer of the contract at a higher-than-market price.
What are Commodity Derivatives Used For?
The prices of commodities fluctuate over time and adverse movement in the price results in future business risk. Thus, traders use commodity derivatives in the form of future or options contracts to hedge the price risk. On the other hand, some of the investors enter the commodity derivative market to earn possible returns based on speculations.A large number of investors, who participate in the commodity derivative market, don’t actually hold any of the physical commodity because traders are allowed to invest in non-financial assets without the actual possession. These investors primarily predict the fluctuations in the commodity value based on its market demand and supply.
Some of the major advantages of commodity derivatives are as follows:
- The prices of commodities increase even during times of inflation owing to the growing demand. Hence, investors prefer investing in commodity derivatives to safeguard their capital from the adverse impact of inflation.
- Investment in commodity derivatives can be helpful in stemming the losses of an investment portfolio in the case of an adverse geopolitical event.
- Trading of commodity derivatives is done on an electronic trading platform that accessible to all market participants, which facilitates the discovery of a fair price.
Some of the major disadvantages of commodity derivatives are as follows:
- Given that a large number of commodity derivative transactions are leveraged, even a small change in the price can have a colossal impact on the portfolio gains.
- The prices of commodities are largely dependent on their market demand and supply, which results in inhigh volatility. Hence, the price movement of the commodities requires extensive monitoring.
- Investment in commodities may not be ideal for portfolio diversification purposes as they exhibit a negative or low correlation with the prices of stocks.
So, it can be seen that commodity derivatives can be useful for traders and investors in multiple ways. These alternative investment avenues have the potential to earn profits in the long run if the investors execute the trades in a systematic way.
This is a guide to Commodity Derivatives. Here we also discuss the introduction and functions of commodity derivatives along with advantages and disadvantages. you may also have a look at the following articles to learn more –