Every successful idea has history behind it, and trading in commodity derivatives is no exception to this rule. Trading in derivatives was conceptualised to safeguard farmers from the risks of devaluation of their produce. Derivative contracts were offered on products like cotton, rice, coffee, wheat, pepper etc. Later natural resources like crude oil, coal, and precious metals like gold, silver and others were also added to the long list of commodities that can now be traded across the world through commodity exchanges.
The commodity derivatives market started functioning in India through the establishment of Cotton Trade Association in 1875. Fast forward to 2016, there are six national commodity exchanges operational:
National Multi-Commodity Exchange of India (NMCE),
National Board of Trade (NBOT),
National Commodity and Derivatives Exchange (NCDEX),
Multi Commodity Exchange (MCX),
Indian Commodity Exchange (ICEX),
The ACE Derivatives Exchange (ACE).
These exchanges take care of the settlement and clearing of trades, and they have a separate body called the clearinghouse to handle all settlements. The advent of these exchanges and the introduction of commodity futures contract on new commodities triggered significant levels of trade in the country.
How do you invest in commodity derivatives?
The commodity derivatives market is where you directly invest in commodities, and not in the companies that trade in these commodities. It’s easier to forecast the price of commodities based on demand and supply as compared to forecasting the price of shares of a company.
Most of the investors trading in the commodity derivatives market have no need for the commodity in its physical form. They simply speculate on the direction of the price of commodities, hoping to make monies if the price of the commodity moves in their favour. Commodity derivatives are cheaper for trading, as only a small sum of money is required to buy a commodity futures contract. The buyer of a derivative contract is the one who pays an initial margin to buy the right to buy or sell the commodity at a certain price and certain time in the future. Whereas, the seller is the one who accepts the margin and agrees to abide by the terms of the contract by buying or selling the commodity at the agreed price on the date of maturity of the contract.
The investor can opt for settlement in cash instead of taking the delivery of the commodity upon maturity of the contract. The seller of a futures contract can choose to take delivery of the commodity rather than closing his position before maturity. The clearinghouse takes care of possible problems of default by the either of the two parties involved by standardising and simplifying transaction processing between participants and the organisation.
Types of commodity investments
A commodity-linked security is the one whose return is dependent on the price level of a commodity like crude oil, gold, or silver at maturity.
Commodity derivatives include exchange-traded and over-the-counter commodity derivatives like futures and forwards and swaps.
Why should you invest in commodities?
Hedge against inflation: commodity cash prices benefit from periods of inflation, whereas stocks and bonds may suffer. Commodity prices usually rise when inflation is high, while bonds and stocks tend to perform better when the rate of inflation is stable or slowing.
Performance/return: this asset class tends to outperform stocks and bonds.
Enhanced diversification: portfolio diversification is the primary benefit of holding commodities.
What is a commodity futures contract?
It’s an agreement for the purpose of buying or selling a predetermined amount of a commodity at a specific price at a specific time in the future. Buyers use such contracts for avoiding risks associated with the price fluctuations of products or raw material under the futures. Sellers use these contracts to lock in guaranteed prices for their products.
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