Commodity derivatives, which were conventionally developed for risk management purposes, are now emerging in popularity as an investment tool. The majority of the trading in the commodity derivatives market is being done by people who have no need for the commodity. They just speculate on the path of the price of these commodities, hoping to make money if the price moves in their favor.
The commodity derivatives market is a direct method to invest in commodities rather than investing in the companies that trade in those types of commodities.For instance, an investor can invest directly in a steel derivative rather than investing in the shares of Tata Steel. It is easiest way to forecast the price of commodities based on their demand and supply forecasts when compared to forecasting the price of the shares of a company -- which depend on many other factors than demand and supply of the products they manufacture and sell or trade in.
Moreover, derivatives are much cheaper to trade in as just small sum of money is required to buy a derivative contract. Let us presume that an investor buys a tonne of soybean for Rs 8,700 in expectation that the prices will rise to Rs 9,000 by June 30, 2009. Thus he will be able to make a profit of Rs 300 on his investment, which is 3.4%. Try to compare this to the scenario if the investor had decided to buy soybean futures as an alternative.
Before we glance into how investment in a derivative contract works, we ought to familiarize ourselves with the buyer and the seller of a derivative contract. An initial margin role is paid by a buyer of the derivative contract to buy the right to buy or sell a commodity at a certain price and a certain date in the future. Alternatively, the seller admits the margin and agrees to fulfill the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract.
Now let us take for an example, the investor buys soybean futures contract to buy one tone of soybean for Rs 8,700 (exercise price) on June 30, 2009. The contract is made available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor requirements to invest only Rs 870 here.
On June 30, 2009, the price of soybean in the market is, say, Rs 9,000 (which known as Spot Price; Spot Price is the current market price of the commodity at any point of time).
The investor can take the delivery of one tone of soybean at Rs 8,700 and instantaneously sell it in the market for Rs 9,000, making a profit of Rs 300. Hence the return on the investment of Rs 870 is 34.5%. In contrast, if the price of soybean drops to Rs 8,400 the investor will wind up making a loss of 34.5%.
If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract.
Presently, the option of cash settlement lies just with the seller of the contract. If the seller decides to make or take delivery on maturity, the buyer of the contract have to fulfill his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract.
In the above instance, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the divergence in the spot price of the commodity and the exercise price. 34.5% is the return on the investment of worth Rs 870.
The above instance shows that with very little investment, the commodity futures market proposes scope to make big bucks. Nevertheless, trading in derivatives is highly risky since as there are high returns to be earned if prices move in favor of the investors, an unfavorable move results in huge losses.
The most crucial function in a commodity derivatives exchange is the settlement and clearance of trades. Commodity derivatives can involve the exchange of funds and goods. The exchanges have a separate body to take care of all the settlements, which called as the clearing house. For instance, the seller of a futures contract to buy soybean may prefer to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organization, in kind of a case, is to take care of possible problems of default by the other party involved by standardizing and also to simplifying transaction processing between participants and the organization.
Despite the surge in the turnover of the commodity exchanges in current years, a lot of work in terms of policy liberalization, setting up the right legal system, creating the essential infrastructure, large-scale training programs, and so on, still needs to be done in order to catch up with the developed commodity derivative markets.
In addition this, trading in commodity options is banned in India. The regulators should look towards introducing new contracts in the Indian market in order to provide the investors with option, plus provide the farmers and commodity traders with extra tools to hedge their risks.
A commodity price index is type of a fixed Mandan weight index or (weighted) average of selected commodity prices, which might be spot or futures prices. It is premeditated to be representative of the broad commodity asset class or a specific subset of commodities, for example energy or metals.
The components in a commodity price index can be generally grouped into the following categories :
Investors can prefer to obtain a passive exposure to these commodity price indices through a total return swap. The benefit of a passive commodity index exposure includes negative correlation with other asset classes such as equities and bonds and also protection against inflation. The disadvantages include a negative roll yield due to contango in certain commodities, even though this can be reduced by active management techniques, such as reducing the weights of certain components (e.g. precious and base metals) in the index.
Following are the major Commodity Derivative Indices in the world
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