What it means
Commodities are goods that are largely interchangeable, whoever produced them, such as a barrel of crude oil or a bushel of wheat of a given grade. Because they are uniform, they can be traded in standard contracts, which is what an exchange offers.
Most trading is in futures, which are agreements to buy or sell a set quantity at a fixed price on a future date. Each contract specifies the quantity, quality, delivery month and delivery place, so buyers and sellers know exactly what is being traded.
The exchange acts as a referee and a safety net. A clearing house stands between buyer and seller, collects deposits called margin and settles gains and losses daily, which greatly reduces the risk that one party fails to pay.
Different people use the market for different reasons. A farmer can sell a futures contract to fix the price of next season's crop, a bakery can buy one to fix the price of flour, and a speculator can take a view on price without ever wanting the physical goods.
For non-specialists, the key value of an exchange is price discovery. The published prices reflect the combined views of thousands of participants, and companies often link their own supply contracts to these benchmark prices.
Risks should be noted. Margin means a small price move can create a large gain or loss relative to the money deposited, and a hedge that is poorly designed can leave a company worse off than before.
In practice
Real-world examples
Example 1
A cereal manufacturer worries about wheat prices rising before winter. It buys wheat futures on an exchange, so that if the market price rises, the gain on the futures offsets the higher cost of physical wheat. The company still buys the physical wheat from its usual miller.
Example 2
A gold mining company sells futures on part of its expected output for the coming year. The company fixes revenue for the planned volume, which lets the lender approve a loan with confidence. The company accepts that it gives up the benefit if gold prices rise sharply.
Example 3
An airline buys oil-linked futures to cap its fuel costs for the next six months. Management accepts that it will miss out if prices fall, in return for budget certainty. The treasury team reports the hedge position to the board every month.
Think of it
A commodity exchange is like a giant farmers market for raw materials, but instead of buying apples for today, buyers and sellers agree on standard prices and quantities for deliveries months into the future.
Formula
Calculation
Contract value = Price per unit x Contract size
Initial margin = Contract value x Margin percentage
Assume a corn futures contract covers 5,000 bushels and the price is $6.00 a bushel. Contract value = $6.00 x 5,000 = $30,000. With an initial margin requirement of 10%, margin = $30,000 x 0.10 = $3,000. If the price rises by $0.40 to $6.40, the contract value becomes $32,000, a gain of $2,000 for the buyer, which is a 66.7% return on the $3,000 of margin.Case study
Seen in the real world
Sunvale Coffee Roasters is an illustrative, fictional business that buys green coffee beans and sells roasted coffee to cafes on fixed-price contracts. A sharp rise in bean prices one year cut its gross margin from 35% to 20%.
The finance manager asked her bank about hedging. After training, the company bought coffee futures on an exchange covering about half of the next year's needs, posting margin of $40,000.
In this illustrative year prices rose again, and the futures gained $75,000 while the physical beans cost $90,000 more than budget. The hedge covered most of the extra cost, and the owners decided to make hedging a formal part of the annual budget, with clear limits set by the board. The finance manager also agreed to report the hedge result against the original budget at each quarter end, so the board could judge whether the programme was doing its job.
Watch out
Common mistakes
- Treating a hedge as a way to make money, when its purpose is to reduce uncertainty.
- Forgetting that margin calls can require extra cash at short notice if prices move against you.
- Hedging a larger quantity than the business really needs, which turns the hedge into speculation.
Questions
People also ask
What is the difference between a spot and a futures price?
The spot price is for immediate delivery, whereas the futures price is for delivery at a set date in the future and reflects storage costs and market expectations. Traders compare the two prices to judge whether the market expects prices to rise or fall.
Do I need to take physical delivery?
Most futures positions are closed out before delivery, so the physical goods are never received by the trader. The gain or loss is settled in cash through the clearing house.
Who regulates commodity exchanges?
Each country has its own regulators, and they set rules on reporting, position limits and the conduct of market participants. They also publish information on large positions, so the public can see how concentrated the market is.