The document provides a comprehensive overview of commodities and commodity derivatives, explaining what commodities are, their categories, and their role in economic exchanges. It discusses the differences between spot and futures trading, the risks involved, and the significance of commodities in investment portfolios, especially during inflationary periods. Additionally, it outlines the structure of futures markets, ways to invest in commodities, and the importance of global commodity indices.

1. Commodities and
Commodity Derivatives
An Introduction

2. What are Commodities?
 A commodity is anything for which there is a demand.
 They can be traded in a commodities market.
 They are supplied to the market in all varieties and quality grades.
 They can be divided into 8 basic categories:
Grains
Oil & Meal
Livestock
Food Stuffs
Textiles
Forest Products
Metals
Energy
 Soft Commodities – Commodities which are grown by farmers are known as soft commodites
which are distinguished from mined commodities.

3. Commodities as a separate “Asset Class”
 Capital based assets like “Bonds”, “Equity Stocks”, “Foreign Currencies”, etc. give returns
for the time value of the money put upfront, as well as the risk he is holding.
 Commodity pricing is driven by factors like demand, supply, inventory, transportation,
seasonality etc. Hence, commodities are treated as a different asset class.
 Commodities are lucrative for investment during times of high inflation as they usually
outpace inflation.
 Commodities are traded in a Commodities Exchange like NYMEX, ICE, NYCE, LIFFE, CBOT,
WTI, LME, WCE.
 Commodities are usually traded as futures contracts. OTC trading of Commodities also take
place as Forward contracts or Spot trading.

4. Spot Trading of Commodities
 Commodities trading is an integral and indisposable part of economies of all nations. Usually the developing nations are
producers of commodities (as raw materials), and developed nations are marketers and manufacturers (of finished goods).
 These commodities can be spot traded among parties usually through an intermediary party which purchases FOB out of dock or
warehouse and maintains inventory and waits for an importer to purchase FOB out of dock or warehouse. The intermediary
hedges its spot position by taking up futures position in the market. If the intermediary is responsible for delivering the
commodity then he is exposed to Transportation risk. He has to take a forward position for freight charges to hedge against
price risk of transportation.
 Risks involved in Spot Trading:
Price Risk – Commodities are highly volatile assets as they are governed by demand and supply.
Transportation Risk – Deterioration of commodity, Partial/Total and fluctuation in Freight charges.
Delivery Risk – The quality and grade of delivered commodity may change.
Credit Risk – The importer may always default.
 Due to the presence of the above risks in spot trading various exchanges were started for commodities trading and Futures
Trading became the most common way of Commodities trading through these Commodity Exchanges.

5. Futures vs Forwards Trading
Investors usually trade in the commodities market through forward contracts or
futures contracts, the latter being more popular. The forward and futures prices
for the same underlying asset with the same time to expiry struck at the same
time are different because of difference in custom taxes, transaction costs, credit
risk, stochastic interest rates etc. between the two contracts. However, in
practice, the forward and futures prices remain very close to each other, the
underlying commodity being the most important guiding factor.
Futures contracts are always more lucrative. It is because:
 They are standardized (Quantity, Quality, Variety, maturity of contract etc.)
 Absence of counterparty risk as they are traded in an exchange and both parties have to
deal with the clearing house of the exchange which is in principle trust worthy.
 Credit risk is nullified as both parties can go into a contract.
 The contracts are Marked to Market daily and the margin balance needs to be
maintained by both parties.

6. The Players in Futures Markets
 Hedgers
Market players who want to hedge their position against price risk (fluctuation in price of a commodity).
E.g. Farmers, Airline Companies, Refineries, etc. They usually take a long or short position in a futures
contract with an underlying which is perfectly correlated with a commodity they are buying or selling
spot.
 Speculators
Speculators are investors who take long or short position in the commodities market according to their
market perspective. Commodities are becoming increasingly attractive investment instruments as they
reduce the financial risk of a portfolio consisting of capital based assets; and add to the overall
expected return. Liquidity in the commodities market is increased by the combined activity of
speculartors and hedgers.
 Arbitragers
There are a small group of investors interested in the commodities market looking for opportunities to
make arbitrage out of the futures and options market.

7. Futures vs Forwards Trading
Forward Contracts
 Bilateral agreement.
 Flexibility in contract with respect to
delivery date, quality, quantity, etc.
 No mechanism or regulation for pricing or
delivery.
 Presence of Counterparty Credit Risk.
 Pricing is fixed by trading parties.
 Less liquid.
 Transaction, storage, customs may cost
very high.
Futures Contracts
 Standardized commodities.
 Necessity of a physical delivery with strict
quality regulations.
 Central clearing mechanism generating
“Market Practices”.
 Absence of Counterparty Credit Risk
 Transparent Pricing.
 High Liquidity.
 Low transaction costs.

8. Commodities in a Portfolio
Commodities have a low to negative correlation with other asset classes like stocks
and bonds. This can be explained as follows –
Commodities are basic raw materials for manufacturing industries providing finished
products and services. In case of unexpected inflation, the price of the commodities will
rise and the equity stocks and bond values will fall as a company’s profits will be curbed
by rising salaries and increased cost of production.
The negative correlation between commodities and other capital based asset classes help
in hedging the portfolio against inflation.
However commodities are risky assets as they have high volatility but small investors are
always interested in commodities for the opportunity of arbitrage as they give high returns.
However, an intelligent addition of commodities to a portfolio consisting of equity
stocks and bonds that are less volatile than commodities, decreases the overall
risk of the portfolio and in most cases increases the overall expected return.

9. Structure of a Futures Market – An
Overview
Exchange
Corporation
Futures
Commission
Merchants (FCMs)
FCM Customers
Clearing House
Clearing
Members
Non-Clearing
Members

10. Structure of a Futures Market – An
Overview
 Clearing
Clearing denotes all activities from the time a commitment is made for a transaction until it is settled. Clearing involves the management
of post-trading, pre-settlement credit exposures, to ensure that trades are settled in accordance with market rules, even if a buyer
or seller should become insolvent prior to settlement. Important processes included in clearing are reporting/monitoring, risk
margining, netting of trades, tax handling and failure handling.
 Clearing House
A clearing house is a financial services company that provides clearing and settlement services for financial transactions, usually on a
Futures Exchange, and often acts as central counterparty. A clearing house may offer novation, debt for an old contract and various
other credit enhancement services to its members. Clearing house in a Futures Exchange is necessary because the speed of trades is
much faster than the cycle time for completing the underlying transaction.
 Central Counterparty
A well capitalised financial institution involved in clearing is known as a CCP or a Central Counterparty. The CCP becomes the market
maker acting as a buyer to market participant sellers, and sellers to market participant buyers.
 Exchange Corporation
Any exchange is a company in itself consisting of it’s members stake holders and board of directors. The exchange corporation provides an
open market for interested participants through its members (clearing members, lawyers, brokers etc.). The Exchange Corporation
may or may not directly involve in Financial activities going on through the exchange. However it must have a Clearing House for
legalities and financial services.
 Futures Commission Merchants (FCMs)
Futures commission merchants handle futures contract orders and sometimes extend credit to customers wishing to enter into such
positions. These include many of the brokerages that investors in the futures markets deal with. So they present an open interface
for interested participants in the Futures contracts.

11. Ways of Investing in Commodities
 Purchasing physical commodity in the cash market
An investor or a hedge fund can in principle buy any commodity in the spot market either by direct transaction with the producer or through an
intermediary. Even if the transportation is organized by an intermediary, the hedge fund manager still has to worry about storage issues like
space, perishability, handling, etc. Soft commodities are often highly perishable and have to be stored in proper environmental conditions.
Natural gas cannot be stored without a salt cavern. Electricity is a commodity whose storage in general is not feasible.
An exception to the above difficulties is provided by precious metals, which do not require much space not care, they cannot however, constitute
the bulk of the diversified commodity portfolio an investor wishes to hold.
 Purchasing stocks of commodity-related companies.
Buying stocks of natural resource companies has always been a traditional way of benefiting from an anticipated rise in the price of a commodity.
To be exposed to oil prices, one buys the stock of major oil firms since most of the revenues of these companies come from exploration, oil
refineries and sales of petroleum products.
In order to avoid currency risk, US investors will buy Exxon or Texaco stocks while UK investors will chose British Petroleum stocks. Such positions
give a chance of high returns to the investor, however they are hold high risk.
These stocks have positive betas and covary positively with the stock market as a whole. There are other issues like decisions on the capital
structure of the firm or governance issues, such as a dividend policy or merger decisions which can have a major impact on the stock price.
Absence of proper risk management activities , or a firm’s poor communication with its share holders can have disastrous consequences.
Hence, one must always keep in mind that buying the shares of a natural resource company certainly introduces a noise component in the desired
exposure to the commodity.

12. Ways of Investing in Commodities
(contd.)
 Purchase of Commodity Futures
A direct way to build targeted exposure to a given commodity is to take a long or short position in Futures written on that commodity. Future
positions in commodities have been discussed in earlier slides.
 Purchase of Commodity Options
Options market is also available in Commodities. Like futures, options with commodities as underlying are standardized by a commodities
exchange. An important characteristic of commodity options is the way the contract can be settled. The buyer of a call option may wish to
take a physical delivery of the underlying upon payment of the strike at maturity (The delivered commodity must be of the exact grade and
quality as written in the contract). Or the option contract may be financially settled.
Options in commodities are available in all forms and features as for other asset classes such as Call Options, Put Options, Straddles, Butterflies,
Risk Reversals, etc. The options can be European as well as American.
Options on Commodities can be priced using the Black-Scholes framework in the same manner as for other asset classes.
A typical and important feature of options where the underlying are commodities can be is in the movement of call option price with respect to a
movement in the underlying price.
If there is a rise in the underlying price S, then the return generated by a Call Option is strictly higher than the return on the stock during the
same time period.
S
S
C
C 



13. Global Commodity Indices
 Commodity Research Bureau (CRB)
 Goldman Sachs Commodity Index (GSCI)
 Dow Jones – American International Group Commodity Index (DJAIGCI)
 S & P Commodity Index (SPCI)
 Deutsche Bank Liquid Commodity Index (DBLCI)
 London Metal Exchange Index (LMEX)

14. Benefits of Indexes in Commodity
Markets
 They provide information about the price of a commodity either worldwide or at a given
location in case of fragmented regional markets. Since commodity prices are important for
consensus such as WPI, CPI and quantifying inflation and economic growth, knowledge of
accurate price values of commodities are critical.
 It allows new players to enter the market. Without price and traded volume transparency and
regulation, the market will be dominated and commodity prices manipulated by players
having dominant position in the market. This would give disincentive to new players willing to
enter the market.
 They make possible the existence of derivative contracts – Futures and Options, as they are
usually financially settled and an index acts as a benchmark for the underlying at maturity.
 They are lucrative investment instruments for interested players who don’t wish to deal with
the physical commodity.

15. Thank You