What is Commodity Market?

Types of Commodity Market

The commodity market can be categorized under two major categories based on the commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more type. These two categories are:

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#1 – Hard Commodities

Hard commodities consist of the commodities that are required by the manufacturing industries. These should be mined and manually extracted from the land or the ocean. They have limited reserves and are most affected by geopolitical and economic conditions. Examples of such commodities are Gold, Oil, silver, rubber, copper, etc. The major part of the pricing is because of the process of extracting them.

#2 – Soft Commodities

Soft commodities constitute the commodities that are mainly Agri related or livestock. Unlike hard commodities, they are not mined or extracted but are produced through proper procedures. They have virtually unlimited reserves and are not affected by geopolitical conditions but by the weather or natural occurrences. Possible examples of such commodities are corn, wheat, barley, sugar, pork, coffee, tea, etc.

Example of How Commodity Market Works

If the price of a traded commodity fluctuates, the price of the corresponding future contracts changes in sync. Consider the case of crude oil, whose prices are decided ideally by demand and supply. Middle East countries, the major oil-producing nations, tried to control crude oil prices by controlling the supply. However, in a practical world, oil prices are affected by other factors, too- the major geopolitical consideration.

For example, in the 2008 economic crisis, global growth was down, so oil futures prices should have crashed big time. However, that was hardly the case, and oil futures were at a lifetime high of $ 145 per barrel. This was mainly because investors worldwide took out their money from equity and bought commodities and futures contracts. This increased money flow led to a surge in the oil and gold futures.

Advantages of Investing in a Commodity Market

  • Hedging Mechanism: The biggest advantage of investing in the commodity market is for the producers, importers, and exporters, as it provides them with a mechanism to hedgeHedgeHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more price fluctuations. For example, a farmer can protect himself from the price fluctuations in wheat by selling his futures contract with an expiry date three months later. A retailer, on the other hand, can protect itself by buying a futures contract.Fewer Manipulations: Compared to the financial marketFinancial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more, commodity markets deal in proper tangible products that are raw materials for the manufacturing industries. Hence the commodity markets are governed by demand and supply and are less prone to manipulations than financial markets.

Disadvantages

  • Risky: Commodities investments are risky as geopolitical factors play an important role in pricing. For example, any suspicion of a political crisis in the middle east leads to a sudden spike in crude oil prices. Because of such a systematic riskA Systematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more, commodity markets are prone to operational failures and must be regularly monitored to avoid unfavorable circumstances.Leverage: Unlike financial markets, commodity markets thrive on low margin requirements and high leverage. Though it helps in better potential profit, high leverage ratiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.read more during an economic recessionEconomic RecessionEconomic recession is defined as the phase in which economic activities of a country become stagnant, leading to a disturbance in the business cycle and affecting the overall demand-supply balance. read more or unexpected volatile movements can lead to increased losses.

Important Points

  • The commodity market is much older than the financial money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more and has evolved. The first trading known to humanity was barter trading, where commodities like food grains would be traded between farmers and consumers. The earliest known full functional commodity market was set up in Amsterdam in early 16thThe pricing of commodities traded in the commodity market is quite complex and depends on individual characteristics. For example, for goods like wheat and barley, a storage cost is involved in addition to the forces of demand and supply. The storage cost is required as these commodities require proper storage mechanisms to save them during transportation or from natural calamities.There are certain criteria that a commodity must possess to be fit for trading in commodity exchanges. These characteristics are homogeneity, price fluctuations, open supply, and durability.The commodity market differs from money markets in terms of the underlying instrument; the underlying concepts of trading are pretty much the same. The concept of spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more, future price, expiry, and strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more are pretty much the same.The commodity market, though, in general, trade-in generic commodities like coffee or wheat, but with time it has evolved to include certain differentiated products too. These differentiated products are generic commodities but with certain peculiar characteristics. Example of high octane gasoline for which a generic commodity would be gasoline.Commodities are highly volatile assets compared to financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more. They are governed not only by geopolitical tensions, economic expansions, and recessions but also by natural forces like floods or calamities.     The major commodity exchanges worldwide are the London Metal Exchange, Dubai mercantile exchange, Chicago Board of Trade, Multi Commodity exchange, etc.

Conclusion

Commodities trading and hence the commodity market can be traced to when human civilizations started to evolve. They are just another class of assetsClass Of AssetsAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more, just like equity or bonds. The difference lies in the origins, as they are more tangible. The similarity is that both have complex, evolved derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more that act as hedging mechanisms for hedgers and quick money for speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more. The commodity market provides a medium for these different participants to come together and play a role in the eventual pricing of these commodities.

This has been a guide to What is the Commodity Market and its Meaning. Here we discuss how commodity markets work along with their types, an example, advantages, and disadvantages. You can learn more about excel modeling from the following articles –

  • List of Financial MarketsCommodity DerivativesCash Settlement vs. Physical SettlementBest Commodities Trading Books