Commodities Market
What is a market?
A market is conventionally defined as a place where buyers and sellers meet to exchange goods or services for a consideration. This consideration is usually money. In an Information Technology-enabled environment, buyers and sellers from different locations can transact business in an electronic marketplace. Hence the physical marketplace is not necessary for the exchange of goods or services for a consideration. Electronic trading and settlement of transactions has created a revolution in global financial and commodity markets.
What is a commodity?
A commodity is a product that has commercial value, which can be produced, bought, sold, and consumed. Commodities are basically the products of the primary sector of an economy. The primary sector of an economy is concerned with agriculture and extraction of raw materials such as metals, energy (crude oil, natural gas), etc., which serve as basic inputs for the secondary sector of the economy.
To qualify as a commodity for futures trading, an article or a product has to meet some basic characteristics:
- The product must not have gone through any complicated manufacturing activity, except for certain basic processing such as mining, cropping, etc. In other words, the product must be in a basic, raw, unprocessed state. There are of course some exceptions to this rule. For example, metals, which are refined from metal ores, and sugar, which is processed from sugarcane.
- The product has to be fairly standardized, which means that there cannot be much differentiation in a product based on its quality. For example, there are different varieties of crude oil. Though these different varieties of crude oil can be treated as different commodities and traded as separate contracts, there can be a standardization of the commodities for futures contract based on the largest traded variety of crude oil. This would ensure a fair representation of the commodity for futures trading. This would also ensure adequate liquidity for the commodity futures being traded, thus ensuring price discovery mechanism.
- A major consideration while buying the product is its price. Fundamental forces of market demand and supply for the commodity determine the commodity prices.
- Usually, many competing sellers of the product will be there in the market. Their presence is required to ensure widespread trading activity in the physical commodity market.
- The product should have adequate shelf life since the delivery of a commodity through a futures contract is usually deferred to a later date (also known as expiry of the futures contract).
Commodity Market: A Perspective
A market where commodities are traded is referred to as a commodity market. These commodities include bullion (gold, silver), non-ferrous (base) metals (copper, zinc, nickel, lead, aluminium, tin), energy (crude oil, natural gas), agricultural commodities such as soya oil, palm oil, coffee, pepper, cashew, etc.
Existence of a vibrant, active, liquid, and transparent commodity market is normally considered as a sign of development of an economy. It is therefore important to have active commodity markets functioning in a country.
Markets have existed for centuries worldwide for selling and buying of goods and services. The concept of market started with agricultural products and hence it is as old as the agricultural products or the business of farming itself. Traditionally, farmers used to bring their products to a central marketplace (called mandi / bazaar) in a town/village where grain merchants/ traders would also come and buy the products and transport, distribute, and sell them to other markets.
In a traditional market, agricultural products would be brought and kept in the market and the potential buyers would come and see the quality of the products and negotiate with the farmers directly on the price that they would be willing to pay and the quantity that they would like to buy. Deals were struck once mutual agreement was reached on the price and the quantity to be bought/ sold.
In traditional markets, shortage of a commodity in a given season would lead to increase in price for the commodity. On the other hand, oversupply of a commodity on even a single day could result in decline in price—sometimes below the cost of production. Neither farmers nor merchants were happy with this situation since they could not predict what the prices would be on a given day or in a given season. As a result, farmers often returned from the market with their products since they failed to fetch their expected price and since there were no storage facilities available close to the marketplace. It was in this context that farmers and food grain merchants in Chicago started negotiating for future supplies of grains in exchange of cash at a mutually agreeable price. This type of agreement was acceptable to both parties since the farmer would know how much he would be paid for his products, and the dealer would know his cost of procurement in advance. This effectively started the system of forward contracts, which subsequently led to futures market too.
Cash Market
Cash transaction results in immediate delivery of a commodity for a particular consideration between the buyer and the seller. A marketplace that facilitates cash transaction is referred to as the cash market and the transaction price is usually referred to as the cash price. Buyers and sellers meet face to face and deals are struck. These are traditional markets. Example of a cash market is a mandi where food grains are sold in bulk. Farmers would bring their products to this market and merchants/traders would immediately purchase the products, and they settle the deal in cash and take or give delivery immediately. Cash markets thus call for immediate delivery of commodities against actual payment.
Forwards and Futures Markets
In this case, the agreements are normally made to receive the commodities at a later date in future for a pre-determined consideration based on agreed upon terms and conditions. Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered on a particular future date. Forwards and Futures markets allow delivery at some time in the future, unlike cash markets that call for immediate delivery. These advance sales help both buyers and sellers with long-term planning. Forward contracts laid the groundwork for futures contracts. The main difference between these two contracts is the way in which they are negotiated.
For forward contracts, terms like quantity, quality, delivery date, and price are discussed in person between the buyer and the seller. Each contract is thus unique and not standardized since it takes into account the needs of a particular seller and a particular buyer only. On the other hand, in futures contracts, all terms (quantity, quality, and delivery date) are standardized. The transaction price is discovered through the interaction of supply and demand in a centralized marketplace or exchange.
Forward contracts help in arranging long-term transactions between buyers and sellers but could not deal with the financial (credit) risk that occurred with unforeseen price changes resulting from crop failures, inadequate storage or bottlenecks in transportation, factors beyond human control (floods, natural calamities, etc.), or other economic factors that may result in unexpected changes, and hence counterparty default risks for parties involved. This, in turn, led to the development of futures market. As mentioned above, since futures are standardized contracts that are traded through an exchange, they can be used to minimize price risk by means of hedging techniques. Since the exchange standardizes the quality and quantity parameters and offers complete transparency by using risk management techniques (such as margining system with mark-to-market settlement on a real-time basis with daily settlement), the counterparty default risk has been greatly minimized.
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