FINANCIAL DERIVATIVES

Use of financial derivatives in the global commodities market



Use of financial derivatives in the global commodities market

History of Commodity Markets

According to studies, commodity markets in Sumer were known as the oldest and the primitive form of today's commodity markets. Small baked clay tokens in the shape of sheep or goats were used in trade. Sealed in clay vessels with a certain number of such tokens, with that number written on the outside, they represented a promise to deliver that number of sheep and/or goat. Moreover, a promise included time and date of delivery. So that, the clay vessels were like a modern future contracts.

In ancient Greece and Rome, The Agora and The Forum were served as distributions centers for commodities brought from different edges.

Objectives of Hedger, Speculators and Arbitrageurs

The two major categories of traders are hedgers and speculators. Although these two groups trade in the futures market, they are trying to accomplish very different objectives.

Hedgers trade not only in futures contracts but also in the commodity, equity, or product represented by the contract. They trade futures to secure the future price of the commodity of which they will take delivery and then sell later in the cash market. By buying or selling futures contracts, they protect themselves against future price risks. Speculators bet on the price change potential for one reason only — profit.

The interaction between speculators and hedgers is what makes the futures markets efficient.

This efficiency and the accuracy of the supply-and-demand equation increase as the underlying contract gets closer to expiration and more information about what the marketplace requires at the time of delivery becomes available.

A hedger may try to take the speculator's money, and vice versa. A speculator, for example, may buy a contract from a hedger at a low price, anticipating that it will be worth more. The hedger sells at that low price because he expects the price to decline further. Hedgers transfer the risk of price variability to others in exchange for the cost of the hedge.

Speculators assume price variability risk, thus making the transfer possible in exchange for the potential to gain. A hedger and a speculator can both be very happy from the outcome of price variability in the same market.

How a Commodity Market Works

In this section, two distinct forms of commodity markets and their characteristics, and also trading processes are held in order to explain that how commodity markets work. Moreover, two main type of investors are compared for better understanding of commodity exchanges. The two distinct forms of commodity markets are OTC (Over-the-Counter) Markets and Exchange Based Markets (Standardized Markets).

Firstly, an OTC market that is also called spot market has specific, small range of commodities depending on its geographical location; since OTCs are regional markets and participants are usually local people like wholesellers, farmers, processors, etc. Participants; for example, farmers or wholesellers; cannot trade in OTCs by themselves. Instead, broker of a farmer negotiates quantity, quality and price of a commodity with broker of a ...