Commodities Explained

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Sometimes investment banking can seem abstract – you have to pay attention to how the "market" reacts to events or you are betting on which way interest rates will go. You're not trading real things you can touch and hold, and sometimes that can be hard to wrap your brain around. But one section of an investment bank that does away with all that is commodities.


What is a commodity?

Commodities are products or goods with a uniform quality and price across the market. These can range from everyday items such as coffee, cocoa or cotton to other goods that may or may not be part of your daily life such as gold, oil and coal. Generally all commodities are grouped as either hard commodities – ones that are extracted, such as minerals – or soft commodities – ones that are cultivated by man. Commodities trading can be fascinating and can cover a range of products and issues such as agriculture, energy and precious metals. If you work in commodities you could be selling sugar to Cadbury or buying copper on behalf of a manufacturing giant. It may not get the press that the bond market or corporate finance does, but it is just as rewarding and challenging.


How are commodities traded?

Commodities are traded on commodities exchanges, so that the goods can be regulated. When a trade is made, there is a contract produced that details the trade. Sometimes a commodities trade can be for spot price, meaning that the buyer agrees to a certain price for the good and the seller will transfer that good to the buyer immediately. More often, though, commodities deals are done as forward or futures contracts. A forward or future is when a contract is written up that states that a good will be sold in the future for an already determined amount of money. So if a company that makes soy milk needs to buy soya beans to make their product, the soya bean farmer may say that his crop will not be ready for another five months, but they will enter into a futures contract where they agree the amount that the soy milk company will pay the farmer and they pay it now. The company likes this because if the price of soya beans rises in those five months, they won't have to pay anything extra as they've already locked in the price. The farmer also benefits from a futures contract because if the price of soya beans goes down, he won't suffer a hit as he has already negotiated his price.


What's the difference between a future and forward?

Though a future and forward is basically the same thing, they cannot be used interchangeably. A future is more regulated than a forward. Futures contracts go through the exchange so they are very strict and there is no way either party can get out of or default on the contract. A forward is less formal and more of a personal agreement between the buyer and the seller. Though you don't have to go through the exchange, which can be beneficial, you also don't have the exchange to back you if the other side decides they want out of the contract. But it does mean that you can call off the trade too if it becomes clear that it will no longer be in your interest.

Another difference between a future and forward contract is that forwards, because they are less formal, are set up so that the entire order is settled at the agreed upon forward date. But futures contracts can actually be settled over more than one date and also at daily marked-to-market rates. This means that the fair value of the commodity is calculated at the end of each day, no matter what rates the commodity was trading at throughout the day.


Options

Options are also a popular contract in commodities. This is a contract similar to a future except that each side has to option not to go ahead with the contract. Every option has an expiration date so if neither side wants to enter into the option before that date, the contract ends. Analysts often work on complex models to try to predict how values will move and if an option will be profitable or not as trying to determine volatility is an important part of commodities trading.

Commodities trades don't work in a bubble and you'll have to pay attention not only to the product you are trading but also things like weather (if there is a major drought in the American mid-west, how will that affect corn prices?), the environment/advances in alternate energies and how many worldwide products include things like copper. You'll also need to think practically – if you buy a large amount of oil, where are you going to store it? – which can make for a very interesting career.


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