How would you explain a commodity market to a simple layman?

A commodity market has its own set of rules and regulations like any other market but it is clearly not a share market as physical form of goods are traded here. It can be said that the weather plays a huge role in this market as most agricultural products are dealt in the commodity market.

Aug 29, 2017 04:08 IST India Infoline News Service

Commodity and commodity market
 
A dictionary would show you the term “commodity” as a product or a raw material which has market value, meaning it can be bought or sold in monetary transactions. The term “commodity market” denotes the place where commodities or products are bought or sold. A commodity market has its own set of rules and regulations like any other market but it is clearly not a share market as physical form of goods are traded here. It can be said that the weather plays a huge role  in this market as most agricultural products are dealt in the commodity market.
 
Types of contracts:
 
Forward contracts and Futures contract:
 
These terms are quite commonly used in the commodity market.
 
Forward contract:  Forward contract is an agreement between two parties to sell or buy a certain commodity at a fixed price in the future. This contract hedges the risk for the buyer against price fluctuations and the seller can get a guaranteed price for his product at a specified date.
 
For example, if A has the has machinery that produces 10 bales of cotton, then he can secure an agreement with B to sell the bales at a certain price after an year irrespective of the price that is trending. This is called hedging the risk. “A” hedges the risk by securing the price and “B” speculates by pre-booking the price expecting that prices would go up in the near future which would benefit him.
 
Futures contract: Futures contract is an agreement between two parties who agree to buy or sell a particular asset at a specified date and at a pre-determined price. The payment and delivery of the asset is made on the future date termed as delivery date. The buyer in the futures contract is known to hold a long position. The seller in the futures contracts is said to be having short position.
 
On reading the meanings of future and forward contract, you may find that the meaning is the same. But there are some points of difference:

  • Forward contracts are traded over the counter, while futures contracts are traded on the exchanges.
  • Forward contracts can be privately negotiated.
 
Futures contract have a standardized way of execution and the transaction is guaranteed by the clearing house which leads to lesser defaults on the agreement.

  • Forward contracts are mostly used by hedgers (they try to eliminate the price risk).
  • Futures contracts are used by speculators. (who predict the way the asset price moves).
 
Major commodity Exchanges in India:

The place where all the transaction or contracts regarding commodities take place is called the exchanges. In India the these are

  • Multi Commodity Exchange of India Ltd, Mumbai (MCX) –Non-agricultural products like gold, silver, aluminum,copper, nickel, lead, zinc and energy products like crude oil and natural gas are traded on this exchange.
  • National Commodity and Derivative Exchange, Mumbai (NCDEX) - in Agricultural products like pulses, cereals, sugar etc are traded on this exchange.

Contracts are executed on the exchanges. MCX is the main exchange where all commodity trading takes place. There is an another type of contract authorized by the clearing house called the Over The Counter (OTC) contract where transaction is done privately by the contracting parties without the need of involving the exchanges.
 
Types of commodities traded in the commodity market:
There are basically two classes of commodities as seen above, the hard commodity and the soft commodity. It is further divided into four categories namely;

  • Energy- natural gas and crude oil.
  • Agriculture –  cereals, pulses, potato, oil and oil seeds, rubber, fibers, sugar, and spices.
  • Metals – Aluminium, Lead, Zinc, Nickel, Copper
  • Bullions – Gold, Silver
 
Caution:
Trading in the commodity market requires a sound working knowledge of the transactions and the trader should make an informed decision while trading. It is always better to enlist the services of a brokerage firm whilst dealing in commodities.

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