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Commodity

–°ommodityGenerally speaking, a commodity means literally anything that can be bought and sold. However, it has a more specific meaning in the finance industry.

What Is a Commodity?

Commodities are economic goods, mostly raw materials, and products coming out of the earth, which are actively traded on organized markets and have the following features:

  • standardized consumer properties;

  • interchangeability (fungibility);

  • storability;

  • transportability;

  • fragmentation of batches.

Some specific instances of commodities are easily interchangeable (or equal in quality) and it does not always matter who produced them (e.g. oil, paper, milk, copper, etc.) These goods are typically traded on commodities exchanges, also in the form of derivatives.

An important feature of commodities is their pricing mechanism. The stock exchange creates conditions that are close to ideal competition. The price of such goods depends primarily on global supply and demand. The wide availability of commodities leads to smaller profit margins and reduces the importance of non-price factors such as brand name.

Commodities are traded mostly by large companies and not individuals. Over 100 commodities are currently traded on global exchanges, with a 20% market share. They can be divided into the following groups:

  • Energy raw materials: oil, diesel fuel, gasoline, fuel oil, propane.

  • Non-ferrous and precious metals: copper, aluminum, lead, zinc, tin, nickel, gold, silver, platinum, etc.

  • Cereals: wheat, corn, oats, rye, barley, rice.

  • Oilseeds and their products: flaxseed and cottonseed, soybeans, beans, soybean oil, soybean meal.

  • Livestock and meat: cattle, live pigs, bacon.

  • Food products: raw sugar, refined sugar, coffee, cocoa beans, potatoes, vegetable oils, spices, eggs, orange juice concentrate, peanuts.

  • Textile raw materials: cotton, jute, natural and artificial silk, washed wool, etc.

  • Industrial raw materials: rubber, lumber, plywood, sulfuric acid.

Commodity Trading

Together with bonds, real estate, stocks, and other assets, commodities form one of the major asset classes. They are typically traded through futures contracts on exchanges that standardize the and minimum quality and quantity of the commodities being traded.

There are three main types of commodity trading participants: buyers, producers, and speculators.

Buyers and producers actually make or accept the delivery of a certain commodity when the futures contract expires. For example, a farmer that plants a crop can hedge against the risk of losing money if the price of the crop drops down before it is harvested. The farmer can sell futures contracts at the time they plant the crop and guarantee a predefined price for the crop when they harvest it. One more example: an airline may use a futures contract to buy fuel at a fixed rate using in order to avoid fluctuations in the gasoline and crude oil market.

Speculators trade in the commodities markets only for the purpose of profiting from price fluctuations and are not interested in the delivery of the commodity. They can also trade commodities to diversify their investment portfolio.

It is also possible to get indirect exposure to commodities by investing in mutual funds, exchange-traded funds, or stocks that work with specific products. For example, if you are not planning to buy gold directly, you can buy shares of a gold mining company. This approach is less risky and easier to understand for the average investor.

Commodity Exchange

A commodities exchange (CE) is a permanent wholesale market of pure competition for trading qualitatively homogeneous and easily fungible goods according to certain rules. The first CE appeared in Bruges, Belgium in 1409. In the US, the CEs started emerging in the early 19th century. In general, there are two types of CEs: universal and specialized.

Universal Commodity Exchanges

These are international CEs that have the largest volume of transactions, for example, the Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), and the Tokyo Commodity Exchange (TOCOM). Each of these exchanges specializes in a wide variety of commodity types, such as:

  • CBOT: Wheat, corn, oats, soybeans, soybean meal, soybean oil, gold, silver, and securities.

  • CME: Livestock, bacon, gold, lumber, securities, foreign currencies.

  • TOCOM: Gold, silver, platinum, rubber, cotton yarn, and wool yarn.

Specialized Commodity Exchanges

These are exchanges with narrow specialization, typically by groups of goods, for example, The London Metal Exchange (LME); Coffee, Sugar, and Cocoa Exchange (CSCE); New York Cotton Exchange (NYCE). The following cities are also the center of exchange trade for goods:

  • Cotton: Alexandria, Sao Paulo, Bombay, Sydney.

  • Rice: Milan, Amsterdam, Rotterdam.

  • Wool: Antwerp, Melbourne, Sydney.

  • Jute — Calcutta, Karachi.

  • Coffee - Paris, Rotterdam, Le Havre, Hamburg, Amsterdam.

Here is a list of the world’s largest CEs:

  • CME Group (USA)

  • Tokyo Commodity Exchange (Japan)
  • Euronext (France, Belgium, Netherlands, Portugal, UK)

  • Dalian Commodity Exchange (China)

  • Multi Commodity Exchange (India)

  • Intercontinental Exchange (USA, Canada, China, UK)

Key Functions of a Commodity Exchange

International commodities exchanges (ICE), which are recognized centers of world trade in a particular commodity, perform the following main functions:

  • Pricing. The results of trading on an ICE are instantly known worldwide thanks to modern means of communication and information. ICE pricing indicates the current global supply-demand ratio for a specific product.

  • Hedging. This is the insurance of the price at which the product is sold or purchased in the future.

  • Delivery. Delivery of real goods traded on the stock exchange is guaranteed by the presence of a sufficient amount of goods available in the stock exchanges. It is also ensured by the creation of a special settlement system, development of transaction rules on the stock exchange, and control over the stock exchange activities by authorities.

Summary

Commodities are raw materials and goods that are traded on exchanges. They have the following characteristics:

  • standardized consumer properties,

  • interchangeability (fungibility),

  • storability,

  • transportability,

  • fragmentation of batches.

They can be divided into the following groups:

  • energy raw materials,

  • non-ferrous and precious metals,

  • cereals,

  • oilseeds and their products,

  • livestock and meat,

  • food products,

  • textile raw materials,

  • industrial raw materials.

There are three main types of commodities trading participants: buyers, producers, and speculators. Buyers and producers actually make or accept the delivery of a certain commodity when the futures contract expires while speculators trade in the commodities markets only to profit from price fluctuations. Commodities are typically traded on global commodity exchanges that are either universal or specializing in specific types of commodities.