Basic Corportate training tool for Commodities (Futures & Forwards)

1. Commodities:
Fundamentals
Futures & Forwards -

2. Commodities Market
A marketplace for buying, selling, and trading raw materials or primary products.
The Commodity Trader: A commodity trader is an individual or business that focuses on investing in
physical substances like oil, gold, or agricultural products. This buying and selling are often driven by
expected economic trends and/or arbitrage opportunities in the commodities markets. - currently about
50 major commodity markets worldwide that facilitate trade in approximately 100 primary commodities.
• Hard Commodities include natural resources that must be mined or extracted—such as gold,
rubber, and oil,
• Soft Commodities are agricultural products or livestock—such as corn, wheat, coffee, sugar,
soybeans, and pork. - A soft commodity is a grown or agricultural commodity such as coffee, cocoa,
sugar, and fruit.
Most commodity trading involves the purchase and sale of futures contracts, though physical trading
and derivatives trading are also common.
Commodity pools: Funds that buy and sell commodity futures contracts.
Two Broad Categories Of Commodities:

3. Forwards and Futures
A Forward is a contract between two parties: a buyer and a seller.
The buyer of a forward agrees to purchase an underlying asset from the seller on a future date at a
price agreed upon today. - both parties are obligated to participate in the future trade.
Forwards can trade on an exchange or over the counter.
Futures Contracts: exchange-traded forward contracts, thus they have features inherent to all forward
contracts.
Futures are normally classified into two groups based on the type of underlying asset.
• Contracts That Have A Financial Asset such as a stock, bond, currency, interest rate or index – as
the underlying asset are referred to as Financial Futures.
• Contracts That Have A Physical Asset such as gold, crude oil, soybeans and more as the
underlying asset are known as Commodity Futures.
What are “Futures & Forwards Contracts?

4. • Futures are standardized with respect to the amount of the asset underlying each contract, expiration
dates and delivery locations. - the expiration date is set by the exchange on which the contract is
listed.
Commodity futures might require additional standardization for - the quality of the underlying asset and
the delivery location.
Normally, standardization allows users to offset their contracts prior to expiration and provides the
backing of a clearinghouse. – i.e. When commodities are traded on an exchange, they must meet
specified minimum standards, also known as a basis grade.
• The party that agrees to buy the underlying asset holds a long position in the futures contract.
• This party is also said to have bought the futures contract.
• The party that agrees to sell the underlying asset holds a short position in the futures contract, and
is said to have sold the futures contract.
Forwards And Futures

5. The buyer of a futures contract does not pay anything to the seller when the two enter into the contract.
The Seller does not deliver the underlying asset right away.
*The Futures contract establishes the price at which a trade will take place in the future.
As it turns out, most parties end up offsetting their positions prior to expiration, thus few deliveries
actually take place.
But
If a contract is not offset and is held to the expiration date, delivery will occur.
- Longs will have to accept delivery of the underlying asset and make payments to the shorts.
- Shorts have to make delivery of the underlying asset and accept payments from the longs based on
pre-established prices.
Forwards and Futures

6. Types of Commodity Markets
Spot markets are also referred to as “Physical Markets /Cash Markets” where
buyers and sellers exchange physical commodities for immediate delivery.
Derivatives markets involve
• forwards
• futures
• options
Forwards and futures are derivatives contracts that use the spot market as the
underlying asset.
These are contracts that give the owner control of the underlying at some point in the
future, for a price agreed upon today.
Commodities trade either in Spot Markets or Derivatives Markets.

7. Types of Commodity Markets
When the contracts expire physical delivery of the commodity or
other asset will take place, and often traders will ’roll over’ or ‘close
out’ their contracts in order to avoid making or taking delivery
altogether.
Forwards and futures are basically the same, except that forwards
are customizable and trade over-the-counter (OTC), whereas
futures are standardized and traded on the exchange.
Commodities Exchange: an exchange where various commodities
and derivatives are traded. Most commodity markets across the
world trade in agricultural products and other raw materials (e.g.,
wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products,
pork bellies, oil, metals, etc.) and contracts based on them.
These contracts can include spot prices, forwards, futures and
options on futures.
Other sophisticated products may include interest rates,
environmental instruments, swaps, or freight contracts

8. Cash-settled Futures Contract
Many financial futures are based on underlying assets that are difficult or even impossible to deliver.
For these types of futures, delivery involves an exchange of cash from one party to the other based on
the performance of the underlying asset from the time the futures contract was entered into until the
time that it expires.
These futures are known as Cash-Settled Futures Contracts. E.g., equity index futures contracts
A person who is ‘long’ a stock index futures contract is not obligated to accept delivery of the stocks
that make up the index, nor is one who is ‘short’ required to make delivery of the stocks.
Rather, if the position is held to the expiration date, either the long or the short will make a cash
payment to the other based on the difference between the price agreed to in the futures contract and
the price of the underlying asset on the expiration date.
• If the price agreed to in the futures contract is greater than the price of the underlying asset at
expiration, prices have fallen, and the long must pay the short.
• If the price agreed to in the futures contract is less than the price of the underlying asset at expiration,
prices have risen, and the short must pay the long.
As with all other futures contracts, cash-settled futures can be offset prior to expiration.

9. Margin Requirements And Marking-to-market
Buyers and sellers of futures contracts must deposit and maintain adequate margin in their futures
accounts. Unlike margin on stock transactions (which are the counterpart to the maximum loan value
that a dealer may extend to its clients), futures margins are meant to provide a level of assurance that
the financial obligations of the contract will be met.
In effect, futures margins represent a good-faith deposit or performance bond.
There are two levels of margin used in futures trading: initial margin and maintenance margin.
• Initial or Original Margin is required when the contract is entered into.
• Maintenance Margin is the minimum account balance that must be maintained while the contract is
still open.
Minimum initial and maintenance margin rates for a particular futures contract are set by the exchange
on which it trades, although investment dealers may impose higher rates on their clients. Dealers,
however, may not charge their clients less than the exchange minimums.
An important feature of futures trading is the daily settlement of gains and losses.

10. This process is known as marking-to-market.
At the end of each trading day, those who are
long a contract make a payment to those who are
short, or vice versa, depending on the change in
the price of the contract from the previous day.
If either party accumulates losses that cause their
account balance to fall below the maintenance
margin level, they must deposit addition margin to
their futures accounts.
Margin Requirements and Marking-to-
Market

11. Futures Strategies: Investors
2 basic positions with futures contracts – long and short.
BUYING FUTURES
• Investors buy futures either to profit from an expected increase in the price of the underlying asset
i.e. Speculation - traders who trade in the commodities markets for the sole purpose of profiting from
the volatile price movements. These traders never intend to make or take delivery of the actual
commodity when the futures contract expires.
• To lock in a purchase price for the asset on some future date i.e. Risk Management / Hedging
Commodity prices typically rise when inflation accelerates, which is why investors often flock to them
for their protection during times of increased inflation—particularly unexpected inflation.

12. Strategy #1: Buying Futures to Speculate
Suppose an investor buys 10 December gold futures at a price of US$575 an ounce. Since each gold
futures contract has an underlying asset of 100 ounces of gold, the investor has agreed to buy 1,000
ounces of gold from the futures seller on a specific date in December for a total cost of US$575,000
($575 × 100 ounces × 10 contracts).
If the investor bought the futures to profit from the expectation of a higher gold futures price, the
investor probably has no intention of actually buying 1,000 ounces of gold. Rather, the investor wants
to sell the 10 December gold futures, preferably at a higher price than what was paid for them.
The chances of this happening depend primarily on the price of gold in the spot or cash market.
If the spot price of gold rises, then the price of gold futures will rise, too.
Of course, the investor faces the risk that the price of gold will fall. If this happens, the price of gold
futures will fall as well, and the investor may be forced to sell the contracts at a loss.

13. Strategy #1: Buying
Futures to Speculate
E.g., if in early November the price of December
gold futures have risen to $600 in response to a
rising gold spot price, the investor could choose to
sell the futures at $600 and realize a profit of $25
an ounce, or $25,000 total ($25 × 100 ounces ×
10 contracts).
If, however, December gold futures were trading at
$550, the investor would have to decide whether
to sell the futures or hold on in the hope that the
price recovers before the expiration date.
If the investor decided to sell at this price, a loss
equal to $25 an ounce, or $25,000 total ($25 ×
100 ounces × 10 contracts), would result.

14. Strategy #2: Buying Futures to
Manage Risk
Suppose a different investor buys 10 December gold
futures at a price of US$575 an ounce with the
intention of actually buying 1,000 ounces of gold in
December.
The gold purchase may actually be a speculative
decision, but the purchase of futures to lock in a
purchase price is considered a risk management
decision.
In this case, all the investor needs to do is not offset
the contract. At expiration, the investor will be
required to take delivery of 1,000 ounces of gold for a
payment of US$575,000.
The purchase of the futures contracts locks the
investor in to a purchase price of US$575 an ounce
regardless of what happens to the price of gold in the
spot market.

15. Strategy #1: Selling Futures to Speculate
Suppose an investor sells 5 December Government of Canada ten-year bond futures at a price of 105.
(Just like prices in the bond market, the price of a bond futures contract is always quoted on a “per
$100 of face value” basis.)
Since each bond futures contract has a $100,000 face value bond as its underlying asset, the investor
has agreed to sell a $500,000 face value bond to the buyer on a specific date in December for total
proceeds of $525,000 ([105 ÷ 100] × $100,000 bond × 5 contracts).
The investor in the above scenario could have sold the futures simply to profit from an expectation of a
lower bond futures price.
The investor probably has no intention of actually selling $500,000 of bonds. Rather, the investor will
want to buy back the 5 December bond futures in the market, preferably at a lower price than what they
were sold for. The chances of this happening depend primarily on the price of ten-year Government of
Canada bonds in the spot or cash market. If bond prices fall in the cash market, then the price of bond
futures will fall, too.
Of course, the investor faces the risk that bond prices will rise. If this happens, the price of bond futures
will rise as well, and the investor may be forced to buy back the contracts at a loss.

16. Strategy #1: (Selling)
Speculating with Futures
E.g., if in early November the price of December bond
futures have declined from 105 to 100, the investor
could choose to buy back the futures at 100 and realize
a profit of 5 points, or $25,000 total ([5 ÷ 100] ×
$100,000 face value × 5 contracts).
If, however, December bond futures were trading at
107.50, the investor would have to decide whether to
buy the futures or hold on in the hope that the price
falls before the expiration date. If the investor decided
to buy them back, a loss equal to 2.5 points, or $12,500
total ([2.5 ÷ 100] × $100,000 face value × 5 contracts),
would result.

17. Strategy #2: Using Futures to
Manage Risk
Suppose a different investor sells 5 December
Government of Canada ten-year bond futures at a
price of 105 and that, for whatever reason, the investor
actually wanted to sell $500,000 of bonds
in December.
In this case, all the investor needs to do is ‘not’ offset
the contracts. At expiration, the investor will be
required to make delivery of $500,000 of bonds and in
return will receive
$525,000.
The sale of the futures contracts locks the investor in
to a sale price of 105 regardless of what happens to
bond prices.

18. FUTURES STRATEGIES FOR
CORPORATIONS
Corporations use futures to manage risk in the same
way that investors do. When a company
needs to lock in the purchase price of an asset, they
may decide to buy futures on the asset.
Similarly, when a company needs to lock in the sale
price of an asset, they may decide to sell
futures on the asset.
Even though they take futures positions consistent
with their risk management needs, many
companies offset their positions before expiration
rather than actually making or taking delivery
of the underlying asset, as the investor examples
illustrated. But the futures can still satisfy a
company’s risk management needs by providing
price protection.

19. Examples of Commodities
Markets
The major exchanges in the U.S., that trade commodities,
include:
• Chicago Board of Trade (CBOT) - Commodities traded on
the CBOT include corn, gold, silver, soybeans, wheat, oats, rice,
and ethanol.
• Chicago Mercantile Exchange (CME) - trades commodities
such as milk, butter, feeder cattle, cattle, pork bellies, lumber,
and lean hogs.
• New York Board of Trade (NYBOT) commodities
include coffee, cocoa, orange juice, sugar, and ethanol trading on
its exchange.
• New York Mercantile Exchange (NYMEX) trades
commodities on its exchange such as oil, gold, silver, copper,
aluminum, palladium, platinum, heating oil, propane, and
electricity.
• Kansas City Board of Trade (KCBT) and Minneapolis Grain
Exchange (MGE).
These exchanges are primarily focused on agricultural
commodities.

20. International CommodityExchange :
• The London Metal Exchange and Tokyo Commodity Exchange are also prominent international
commodity exchanges.
• Bourse de Montréal lists financial futures contracts e.g. index futures, two-year and ten-year
Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate.
Commodities are predominantly traded electronically; although, several U.S. exchanges still use the
open outcry method.
Commodity trading conducted outside the operation of the exchanges is referred to as the over-the-
counter (OTC) market.
Examples of Commodities Markets

21. Commodity Market Trading vs. Stock Trading
• Untenable for most individual investors except via the managed fund structure i.e. mutual funds,
hedge funds etc
• Commodities are considered an alternative asset class, pooled funds that trade commodities futures
(Commodity ETFs - that track a wide range of underlying commodities/ a diversified basket of
commodities), such as CTAs, typically only allow accredited investors.
• ordinary investors can also gain indirect access to commodities via the stock market itself - Stocks on
mining or materials companies tend to be correlated with commodities prices - there are various
ETFs now that track various commodities or commodities indexes.
• Commodity prices tend to be more volatile than stock and bond prices,
• Commodities trading is often most-suited for those with a higher risk tolerance and/or longer time
horizon.
• Many online financial portals will provide some indication of certain commodities prices such as gold
and crude oil.
• ETFs provide more diversification and lower risks while futures are more speculative and the risks
are higher because of margin requirements.
• commodities are normally seen as a hedge against inflation, and gold, in particular they can be a
hedge against a market downturn.

22. Difference: Commodity vs Product
Commodity: e.g. copper, crude oil, wheat, coffee
beans, and gold etc.
• Raw material used to manufacture finished
goods.
• Part of the production and manufacturing
process; - in the early stages of production
• Raw material used in the production process to
manufacture finished goods
• No value is added to a commodity, which can
be grown, extracted, or mined.
• Traded on exchanges through futures contracts,
stocks, and ETFs, and can also be bought and
sold in their physical states.
Product: can be differentiated, and value can be
added by the manufacturer and
through branding and marketing.
• Are made using commodities and are then put
on the market and sold to consumers.
• The finished good sold to consumers.
• Part of the production and manufacturing
process; - products fall at the final stage.
• Product are finished goods sold to
consumers.
• sold on the market for consumption by the
average consumer and can also be found in
investment portfolios.

23. Major Impediments
• The lack of transparency and uniformity of process.
• Competition
• Market information – dissemination through the market to participants.
• Bargaining power of small-scale producers.
• Credit in the industry.
• Poor quality standards – should be strict with enforceable guidelines.
• inadequate volumes of production.
• Widespread warehousing system closely monitored including collection points for the small-scale
farmer.
Major impediments to a fair and efficient commodities market system: The African Experience

24. Intermarket Analysis:
Stocks Versus Bonds
An old adage …, what is good for stocks is bad for bonds,
and vice versa.
Bond prices normally move in the same direction as stock
prices.
Hence falling interest rates are normally favourable for
equities.
A key point to remember here is that the bond market (or
prices) historically peaks and bottoms before the stock
market does.

25. Intermarket Analysis:
Bonds vs Commodities
Inflation is particularly bad for bonds. Analysts closely
follow commodity markets as a leading indicator of
inflation.
When commodity prices begin to trend higher – as
measured for example by the CRB Index, a widely
watched composite of different commodities – market
participants look for emerging inflationary signs, which
can lead to central banks raising interest rates and thus
lower bond prices.

26. Intermarket Analysis:
Commodities vs Currencies
Foreign Currency Exchange (Forex) Trading involves
determining whether a certain nation's currency will go
up or down compared to another major currency.
Commodities (anything found naturally in nature or
planted) you determine if the price of a certain
commodity will go up or down based on whether you
believe there will be a good growing season, increased
mining prospects, a bad growing season, floods, drought,
strikes etc.
Mother Nature plays a much stronger role in trading
commodities than it does in trading currency.

27. Intermarket Analysis:
Commodities vs Currencies
World Events: As mentioned above, the constant
change in weather patterns from year to year can play
havoc on the commodities market. - the possibility of
good sized gains exists in the commodities market, but
the risk of huge losses due to crop failures, etc. is also
present.
Information Accessibility: Information about trading
commodities can be fairly difficult to find, especially
information which is free. There is an ample amount of
information available, but a lot of it is costly to obtain.
Forex information is much more accessible and most of it
is free.
Hours of Operation: The Forex Market is open 24 hours
a day, five days a week. There is no other market open
this long.

28. Intermarket Analysis:
Commodities vs Currencies
Liquidity - Ease of Buying and Selling: Forex Market
does the most volume as compared to all other markets.
If it is going to be easy to buy and sell positions, Forex
will be the easiest with all its volume.
Highly Predictable: Commodity prices can jump all
around the board depending on demand, weather, crop
percentages planted, oil found or not found, etc.
Commission Free Trading and Instantaneous Order
Execution: he Forex Market is an open market and has
no centralized trading floor, when you trade in the Forex,
you don't pay a middleman. In other words, you don't pay
a commission to trade. Money is made by institutions on
the difference between the bid and ask price, but that
occurs with any market.

29. Commodities as Part of an Investment Portfolio
Commodities are a class of ‘Alternative investments’ – i.e., an alternative investment class that offers
diversification benefits when combined with a traditional portfolio containing equities and bonds.
2 primary ways of investing in commodities:
• Directly by buying and selling commodities
• Indirectly through commodity derivatives (that is, options, futures, forwards or swaps)
Although less direct, exposure to commodities can be had by investing in the securities of companies
that produce commodities.
Xteristics as part of an Investment Portfolio
A separate asset class cause they can offer diversification benefits when combined with a traditional
portfolio containing equities and bonds.
Often display high volatility, as well as a negative correlation with equity and bond returns and a
positive correlation with inflation.

30. Commodities as Part of an Investment Portfolio
In portfolios where income is a high priority, direct investment in commodities is generally not suitable,
since commodities do not provide any interim cash flows, unlike bonds, which provide interest income,
or some common equities, which provide dividends.
The only return on a commodity investment comes from changes in the commodity’s price.
One form of indirect investment in commodities is through a structured product design commonly
referred to as a Commodity-linked Note. - generally offers a small amount of periodic income in
addition to realizing, in the form of capital gain, some portion of the underlying commodities’ price
change.
However, these notes do not have a large market share. The most popular method of commodity
investment is through a pooled fund vehicle called a Managed Futures Fund / Commodity pools:
Managed futures funds that are structured and sold as mutual funds. Managed futures funds actively
trade derivatives products as well as physical commodities, financial assets, and currencies.

31. Managed Futures Funds
A Managed Futures Fund invests in listed financial and commodity futures markets and currency
markets around the world. Fund managers are usually called commodity trading advisors (CTAs).
Thus, Managed futures are alternative investments consisting of a portfolio of futures contracts that
are actively managed by professionals. The are used as an alternative to traditional hedge funds to
achieve both portfolio and market diversification.
2 common approaches for trading managed futures:
• Market-neutral strategies look to profit from spreads and arbitrage created by mispricing,
• Trend-following Strategies look to profit by going long or short according to fundamentals and/or
technical market signals. - goal is to capture gains by analyzing various indicators, determining an
asset's direction, and then executing an appropriate trade.
Most managers of managed futures funds apply a systematic approach to trading, using technical
and statistical analyses of price and volume information to determine investment decisions.
Once the manager has developed the system, trading decisions are largely mechanical and little or no
discretion is involved. Other fund managers make discretionary decisions according to current
economic and political fundamentals.

32. Financial Planning: Risk – Return Possibilities
High Risk / High
Returns
Lowest Risk / Lowest
Earning
Commodities, Penny Stocks
Collectibles & Speculative Stocks, Bonds or Mutual Funds
Blue Chip Common Stock, Real Estate and Growth Mutual Funds
Balanced Mutual Funds, High Grade Preferred Stock & High Grade Convertible Bonds
Cash or Cash Equivalents e.g. Money Market Accounts, Some Mutual Funds, High Grade
Municipal Bonds & High Grade Corporate Bonds
Savings & Checking Accounts, Federal Savings Bonds, Certificates of Deposits & Treasury
Issues

33. References:
• Project: New Business Models for Sustainable Trading Relationships, Commodity exchanges and
smallholders in Africa; Peter Robbins in collaboration with Catholic Relief Services
• Investing in Commodity ETFs, MICHAEL CORCORAN, Jan 15, 2021
• Commodity vs. Product: What's the Difference?, NICK LIOUDIS, Jan 13, 2021
• Commodity Trader, JAMES CHEN, Oct 29, 2020
• Investment Management Techniques – CSI Global
• Canadian Securities Course Vol 01 & 02, CSI Global
• Forex Trading Vs. Commodities - See What You Could Be Missing; Chris Murphy
• ValueWalk, HOW TO INVEST IN A VOLATILE MARKET PART 3: DIVERSIFYING IN THE RISK PYRAMID; Michelle Jones, Aug 18, 2019
•

34. Fortuna Favi et Fortus Ltd.,
118 Old Ewu Road, Aviation Estate, Lagos.
+234 703 253 0965 Nigeria, +1 416 262 7271 Can
www.ffavifortus.com info@ffavifortus.com
Compiled and assembled by: Olufemi Feyisitan