A commodity is a raw material or agricultural product with economic value. Common commodities include:
If you want to explore further, here’s a list of traded commodities.
Commodity prices fluctuate regularly, much like stock prices. That price movement creates both opportunity and risk:
You can use forwards and/or futures for either speculation or hedging. Test questions usually focus on the characteristics of these derivatives and how they’re similar and different.
Futures contracts lock in a transaction price today for a commodity that will be delivered in the future. Futures share several similarities with options, including:
Like stock options, which typically represent 100 shares per contract, futures contracts cover a specified number of units based on the commodity. For example, a milk futures contract covers the delivery of 200,000 pounds of milk. Every milk futures contract covers the same amount, which is what it means for futures to be standardized.
In a futures contract, both sides have obligations:
Unlike an option contract, the buyer doesn’t have a choice (there’s no “right without obligation”). A futures contract commits both parties to a future transaction at a fixed price.
For example:
Futures contract for 20 tons of live cattle at $3.
This futures contract would result in:
The futures buyer is bullish, meaning they benefit if the price of live cattle rises. If the market price rises above $3/pound, the buyer has locked in a lower purchase price, creating a gain. If the market price falls below $3/pound, the buyer is forced to buy at an above-market price, creating a loss.
Although the buyer could hold the contract through delivery and actually purchase 20 tons of live cattle, most futures contracts are closed out before delivery. In practice, the buyer typically sells the contract before the delivery date. By closing out the position, the buyer is relieved of the obligation to buy. It’s estimated that more than 95% of futures contracts do not result in an actual commodity transaction.
The futures seller is bearish, meaning they benefit if the price of live cattle falls. If the market price falls below $3/pound, the seller has locked in a higher sale price, creating a gain. If the market price rises above $3/pound, the seller is forced to sell at a below-market price, creating a loss.
As with buyers, most sellers don’t deliver the commodity. Instead, the seller typically closes out the position by buying back the contract before the delivery date. That removes the obligation to sell.
Because most futures traders close out positions before delivery, futures are often used primarily for speculation. That said, futures can also be used to hedge. For example, an investor holding a significant amount of oil company stock could sell oil futures. If the stock declines due to falling oil prices, the short oil futures position (bearish on oil) may gain value and help offset the stock losses.
Futures trade on exchanges and typically have low liquidity risk. Standardization helps liquidity: when contracts have consistent terms, market participants can trade them more easily. If every contract were customized (different quantities, dates, and terms), buyers and sellers would need much more review before trading, and active markets would be harder to maintain.
In summary, here are the important futures test points to be aware of:
Forward contracts also lock in a future transaction price for a commodity. They’re similar to futures in several key ways:
So the purpose (a future delivery at a set price) and the buyer/seller obligations are the same. The differences are:
Unlike futures, forward contracts are customized to fit the needs of the buyer and seller. For example, suppose a corn farmer expects a harvest of 2.5 metric tons and plans to deliver the corn to a cereal distributor. Both parties may be concerned about price changes:
To hedge against price fluctuations before the harvest, the farmer and distributor could enter into a forward contract. Because it’s non-standardized, they can set:
Since forward contracts are customized, it’s very difficult to create an active trading market for them. As a result, forwards generally don’t have a secondary market. Unlike futures, most forward contracts do result in delivery of the commodity. Therefore, forwards are subject to high levels of liquidity risk.
In summary, here are the important forwards test points to be aware of:
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