- Commodity can be defined as food or other agricultural products such as wheat or cocoa and natural resources such as oil, or gas and metal such as gold or silver. It can also be standardized goods which are traded in bulk and whose units are interchangeable. They are mostly output of the primary sector that is, agricultural and mining. Commodities are traded in an exchange called commodity exchange.
Table of Contents
TYPES OF TRADABLE COMMODITIES
- Agricultural produce: These include cash and food crops. The following are some of the commodities traded on the exchange.
- Soya beans
- Palm produce
- Oil and gas: These include crude oil, natural gas, propane, gasoline, purified, terepthalic, acid, and heating oil.
- Financial Instrument: These are currencies, bonds, and other tradable instrument like swap.
- Solid Minerals: Precious metals are also traded on the exchange. These commodities include gold, copper, platinum, silver, lead, zinc, tin, aluminum, and nickel.
This is a formal market where regulated and standardized raw materials or primary commodities are bought and sold. It is an organized market where ownership titles to commodities are traded by its members through physical or virtual means. Simply put, it is a self regulatory organization which provides physical facilities for trading commodities, options and future according to rules and regulation governing the market.
Commodities exchange resembles the stock exchange market but the kind of product traded differs. It includes both spot market and forward market.
REQUIREMENT FOR TRADING
- Grading System: There should be a system which provides grading and official certification of the quality, size and weight of commodity. This system is based on standard developed for each product. Grading product provides means of measuring the level of quality and value for commodities. There should be enforceable and trade friendly weight and grading.
- Clearing System: A clearing and settlement system that ensures payment to sellers as well as minimizes over exposure of counter parties is essential. This ensures that payment is guaranteed when deliveries are made. Financial institutions are members of the clearing system.
- Warehousing System: Warehousing is the act of keeping goods in the warehouse until delivery.
- Standardization: Commodity standardization provides means of measuring quality of products. It provides a basis for domestic and international trade and promotes efficiency in marketing and procurement. It has to do with ensuring that all similar commodities have same features and acceptable level of quantity.
- Information requirement: Another basic requirement is provision of reliable and timely market information on prices supply and demand, import and export.
METHODS OF TRADING
The method may be by open outcry or electronics.
- Open Outcry: This is also referred to as the manual system. The method of communication among the participants is through shouting and using of hand signals to transfer information about buying and selling orders on the floor (called pit). Here, trade is conducted verbally with all offers and trades done out loud so that competitors on both sides of the market can follow what is happening. Simply put bidding and offer are made through outcry to the hearing of everybody on the floor.
- Electronics System: This is trading in commodities through the use of computer networks. The networks transmit data and information on offers and trade.
TYPES OF COMMODITY MARKET
- Spot: This is the buying and selling of commodities for settlement (payment and delivery) on the spot date. The settlement price is called spot price. Here transactions are conducted on cash and carry basis. The participants buy and sell commodity at agreed current price ad delivery takes place immediately.
- Future: This is a contract to buy and sell commodity on a future date at a price decided when the contract is made. It is a standardize contract between two parties to buy and sell a specified commodity of standardized quantity for a price agreed upon today while delivery and payment accrued at a specified future date. It is to protect against future change in price of commodities. On the said date, the buyer pays the specified sum regardless of whether the real price has fallen or risen. It is used to reduce risk.
- Option: This is a contract giving the holder the right but not the obligation to trade in a commodity on some future date at a pre-agreed price. It gives the holder the right to sell or buy a certain commodity at a set price at a specified date.
- Forward: This is a non-standardized contract between two parties to sell and buy at a specified future time at a price agreed upon today. Here, price is agreed for commodity to be delivered at a future date. It is used for hedging and to reduce risk.
BENEFITS OF COMMODITY EXCHANGE
- Investment mobilization: The establishment of exchange market will ensure a link between production process and demand and with direct participation of financial institutions and investment this can help to mobilize fund for production in order to meet demand.
- Increase in agricultural production: High demand for agricultural commodities can encourage increase in agricultural output and quality.
- Adequate returns and income: This market helps to guarantee returns on investment. A prudent investor can take advantage of the potential in investing in commodities.
- Basis for risk management: It affords the participants to hedge against the expected price fluctuation of their commodities. Investors can balance their portfolio in such a way as to reduce risk instrument like future and option are useful for hedging.
- Stabilization on agricultural product pricing: It reduces price volatility and its attendant effect to the barest minimum. It is a forum for facilitating efficient pricing.
- Encourage exploration of solid minerals: It encourages investment in the exploration of solid minerals like gold, silver and aluminum. Once investors are sure of adequate returns then they will invest in commodities.
- Foreign exchange earning: A well organized and efficient commodity market will attract foreign investment. This will increase the earning capacity of the participants. The farmer’s export price and incomes are also increased.
- Improvement in collection and dissemination of market information: Exchange trading improves collection and dissemination of market information to all players. Prices on the exchange are set through transparent process. There is tree flow of information among contracting parties.
- Guaranteed delivery: The guarantee of delivery by the exchange reduces the risk of non-performance of trade contracts by the participants.
- Means of exchange of commodities: The system is a means by which sellers and buyers are bought together to transact commodities.
- Access to finance: There is increase availability of inventory finance. This will enable exporters to stockpile goods thereby assuring regular supply and delivery of commodities.
- Provides transparency in transactions: It represents a transparent and reliable means by which lenders can liquidate collaterized commodities in the event of default by the owner.
CONSTRAINTS FACING COMMODITY EXCHANGE
- Inadequate supply.
- Poor storage.
- Lack of formal quality/grading standards.
- Bad weather.
- Inadequate knowledge of commodity exchange.
- Price volatilities.
DIFFERENCES BETWEEN COMMODITY AND STOCK
|1||Ownership of raw unprocessed goods.||Ownership of company.|
|2||They are tangible items.||They are intangible items.|
|3||They are not entitled to dividend.||They are entitled to dividend.|
|4||They are non-financial instruments.||They are financial instruments.|
|5||Trading is on price fluctuation.||Trading is simply on performance of the company and prevailing conditions in the market.|
|6||Most commodities are not bought or held in a portfolio because some are perishable.||They are bought and held in a portfolio.|