These are raw materials such as oil, food, steel etc.
The prices of these products are unpredictable but are often affected by the seasons.
Commodities are usually traded by people who have no need for the actual raw material but are speculating on the future price.
Most trading is done on the futures market making deals to buy and sell a commodity at some time in the future.
Most deals are closed out before the commodity is due to be delivered.
Cash and carry arbitrage is much less common in the commodities market than the financial futures market
The Chicago Board of Trade (CBOT) is the oldest and largest commodity exchange in the world.
Commodities are the raw or partly refined materials which are traded for processing into final products.
Most commodities traded on exchanges are for future delivery.
Types of Commodities
The range of comodities is vast so its best to think of them as falling into four main categories:
Energy - Brent Crude Oil, Natural gas, electricity, Coal
Agricultural - Grains & Oilseeds, Livestock/Meat and Softs
Metals - Base Metals and Precious Metals
How are they traded
Commodity Futures and Options
There are 2 methods
Actual/Exchange - normal exchange of goods for cash
Derivative Contracts - traded in pits or electronically (CBOT has a trading pit)
Unlike other Financial-Markets there are quite a few middle men
Producers - supply and refine the raw materials
Consumers - convert the raw/refined commodities into finished products
Traders - hedging, speculators and arbitrage
Dealers - provide risk management/derivatives or financing services
Two important terms related to futures/forward prices are:
Contango - the market that reflects a positive carrying charge is called a market in contango (or a normal market)
It occurs when future delivery prices for forward/future exceed the spot price.
Backwardation - the opposite to contango (ie an inverted market)
The market reflects a negative carrying charge.
It occurs when future delivery prices are lower than the spot price
This might reflect a tightness of supply or a strong immediate demand for a commodity
Base metals frequently exhibit a backwardation
The difference between the forward/future price and the spot price is called the basis
Trading the basis is a critical concept in the commodities market.
The only way to avoid basis risk is to hold the futures position until delivery.
This is the benefit from holding a physical commodity instead of its corresponding derivative contract.
It describes the adjustment to the forward price of some commodities, such that the forward price tends to be lower than than the spot price.
The convenience yield arises from the fear or:
1) a temporary shortage
2) interruption to the production or refining process
If we assume there is no convenience yield then the forward price should rise at the same rate as the risk free money rate.
Therefore any difference between the spot and forward price can be attributed to convenience yield.
When there is convenience yield, the forward price must rise at a lower rate than the risk free money market rate.
London's main commodity market is divided into 2 parts
1) Metals (non ferrous metals)
Copper, Lead, Zinc, Nickel, Tin, Aluminium, Aluminium Alloy
2) Soft (london commodity exchange)
Cocoa, Coffee, Sugar, Potatoes, Wheat, Barley
The official price on the day in the price at the end of the session
There are 4 sessions a day and each one lasts for 5 minutes
The International Petroleum Exchange (IPE) which is a separate organisation but located in the same building, offers futres and options on futures in various petroleum products of which the main ones are Brent crude and gas oil.