Methodology

Investing Basics

Module 2

What is unsystematic risk?

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Commodities & Derivatives

Commodities & Derivatives

If investors are to deal in commodities at all, they are likely to do so on the derivatives market. The only possible exception to this could be when investors buy gold as a hedge for inflation. 

 

The modern commodity markets rely heavily on the use of derivatives to trade goods. If you are not familiar, derivatives are contracts that can be bought and sold on the stock market. Derivatives called futures and forwards are commonly used in the commodities market, setting the price that will be paid for the commodities today, before they are delivered at a later date. For example, an investor may buy a futures contract that locks in the price of $100 for a barrel of oil. If the barrel of oil increases to $120, then the investor may sell the contract, earning a profit of $20.

Why derivatives are used in commodity markets

The derivatives market has been developed for commodities as it ensures that producers are paid, before they even produce their goods. It acts as a type of insurance, giving peace of mind to producers that may have previously worried about whether they would be able to finance their production or whether they would easily be able to sell their commodities.

 

From the perspective of investors, the derivatives market allows them to profit on the changing prices of commodities, without taking physical delivery of them.  Unless the investor is a manufacturer (which is very unlikely), then they probably do not want to actually receive the physical commodities.

 

The market enables investors to sell their orders for commodities, just before the order is finalised. This then allows real producers to come in and buy the commodities order from the investor.

The derivatives used in commodity markets

On the commodity markets, the derivatives that are mostly used are forwards, futures and options.

 

Forwards and futures are essentially the same, as they both involve agreeing on a price today, that will be paid when the commodity is ready for delivery. In order to avoid actually taking delivery of the commodity, investors will sell their contract to another buyer, who will then deal with the physical goods. The main difference between a future and a forward is that a future is a standardised contract that is traded on an exchange, while forwards are customisable contracts that are bought over-the-counter (i.e. at a bank).

 

Options contracts give an investor the option to go ahead with a deal or not. The investor will agree on a price with a seller for delivery of the commodity, but has the option to reject the deal if prices change dramatically in the meantime. For example, if an investor agrees to buy oil at $1.30 a barrel, only for it to decrease in value to $0.30 a barrel, the investor has the option to reject the deal. This would be the best option as the investor would make a loss of $1 on every barrel of oil that they would have purchased.

How much can investor expect to earn from a cash investment?

If an investor lends money to the government, what bills would they buy?

If an investor lends money to the government, what bills would they buy?

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