The Indian economy is witnessing a mini revolution in commodity derivatives and risk management. Commodity options trading and cash settlement of commodity futures had been banned since1952 and until 2002 commodity derivatives market was virtually non-existent, except some negligible activation an OTC basis. Now in September 2005, the country has 3 national level electronic exchange and 21 regional exchanges for trading commodity future derivatives. As many as 103 commodities have been allowed for derivative trading. In this article we will discuss the various aspects of Commodity Market.
Modern Commodity market
The modern commodity markets have their roots in the trading of agricultural products. While wheat and corn, cattle and pigs, were generally traded using standard instruments in the 19th century in the United States, other basic foodstuffs such as soybeans were only added quite recently in most markets. For a commodity market to be established there must be very wide consensus on the variations in the product that make it acceptable for one purpose or another.
The economic impact of the growth of commodity markets is hard to misjudge. Through the 19th century "the exchanges became effectual spokesmen for, and innovators of, improvements in transportation, warehousing, and financing, which paved the way to expanded interstate and international trade.
Fundamental factors affecting the commodity Market
Commodity trading is trading in commodity derivatives that include a range of commodities from Petals, Precious metals, Energy and Agricultural commodities.
- Risk & Return
- Trading, Clearing and Settlement
- Demand & supply
- Demand Curve
- Global and domestic economy
- Economic growth
- Geo-political concerns
- Extra-ordinary events
Risk & Return
High return is followed by high risk. Based on an investor’s appetite to take risk and his expectation of return he can prepare his portfolio. Commodity trading is not like trading shares at spot prices. It is futures trading process. The uncertainty and risk involved are part and parcel of the commodity market. Though futures’ trading of commodity market is same as the futures trading in equity market the only differences is that supply demand estimates in commodity market may not be as tough.
Trading, Clearing and Settlement
Trading is when two or more parties negotiate to exchange goods with cash at a specific date and price.
There may be two types of investors in the commodity market. One are the delivery based investors and other the cash (non-delivery) based investors. Exchanges clear the trade in sense that both the negotiating parties are capable of respecting the contract and the settlement agency take care of the settlement of goods against cash.
Except for these basic fundamentals of trading there are various other fundamentals that drive the commodity markets. These fundamentals may be different for different commodities based on its characteristics. There are certain important fundamentals that apply to all commodities either directly or indirectly.
Demand & supply
Demand and supply are basic factors that affect the movement of any commodity prices. The law of demand and supply is same for equity as well as commodity markets. However demand and supply of all commodities vary during different time periods depending upon seasons, domestic and global conditions and various other major factors influencing its characteristics.
It is refined form of demand analysis. Demand curve in a laymen’s term is a graphical representation of demand over a period of time. Price is represented on y-axis and demand on the x-axis. The graph is a line graph representing demand at particular prices over a period of time. It gives a clear understanding of the demand situation over a period of time at various price levels.
Global and domestic economy
Economic scenario significantly affects the prices of a commodity. Demand and supply of any commodity has a direct relationship with economic condition in the state. Depending upon the nature of the commodity, global and domestic economic scenarios affect the commodity prices. For e.g.; Steel prices highly depend on global economic factors as this is a globally and massively used commodity. However as far as a commodity like Kapas (cotton beans) is concerned global factors affect less when compared to domestic factors.
Economic growth of the world as well as the domestic economy is an important fundamental that will affect the demand and supply positions in a country. If the country is growing at a fast rate the consumption level will also be at a higher rate. This will increase the demand on one hand but supply may not increase at the same rate as it takes time to set up new industries and increase production. This drives the commodity prices of all major commodities.
Commodities are considered as hedge against inflation because unlike equity, commodity prices move in direction of inflation. With increase in inflation the prices of major commodities tend to increase and it is true the other way as well.
Political factors have a direct as well as indirect effect on commodity prices. For example if we take the case of Potato when one year back it was barred from trading on the exchanges. However at time political factors can have positive effects as well.
There may be certain extra-ordinary factors that do not occur very frequent. Wars, natural calamities, depression etc. are such events that affect the commodity prices in a dramatic way.
Speculators bring information into system at times fake or over hyped in-order to trigger the price movement in a particular direction. Speculators are though a part of technical analysis but it is important in the matter of fact that speculation may be of some fundamental factors. However they are an important part of the market’s price discovery mechanism.