What is a Commodity Exchange
Posted on June 22, 2009 | What at mybiginfo.com | What is a Commodity Exchange | | View all What | |
Commodity Trading
A commodities exchange is an exchange where various commodities and derivatives products are traded. Most commodity markets across the world trade in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or ocean freight contracts.
Commodities exchanges usually trade futures contracts on commodities, such as trading contracts to receive something, say corn, in a certain month. A farmer raising corn can sell a future contract on his corn, which will not be harvested for several months, and guarantee the price he will be paid when he delivers; a breakfast cereal producer buys the contract now and guarantees the price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises.
Speculators and investors also buy and sell the futures contracts to make a profit and provide liquidity to the system.
A commodity exchange is conceptually comparable to a Stock Exchange. The difference between the two is that on a Stock Exchange,securities are traded and on a Commodity Exchange, commodity futures are traded.
Why a Commodity Exchange
The purpose of a commodity exchange is to provide an organized marketplace in which members can freely buy and sell various commodities in which they have an interest. The exchange itself does not operate for profit. It merely provides the facilities and ground rules for its members to trade in commodity futures, and for non-members also to trade by dealing through a member broker and paying a brokerage commission.
Commodity Market
Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.
Working of a Commodity Exchange
First, a commodity futures market (or exchange) is, in simple terms, nothing more or less than a public marketplace where commodities are contracted for purchase or sale at an agreed price for delivery at a specified date. These purchases and sales, which must be made through a broker who is a member of an organized exchange, are made under the terms and conditions of a standardized futures contract.
The primary distinction between a futures market and a market in which actual commodities are bought and sold, either for immediate or later delivery, is that in the futures market one deals in standardized contractual agreements only. These agreements (more formally called futures contracts) provide for delivery of specified amount of a particular commodity during a specified future month, but involve no immediate transfer of ownership of the commodity involved. In other words, one can buy and sell commodities in a futures market regardless of whether or not one has, or owns, the particular commodity involved.
When one deals in futures one need not be concerned about having to receive delivery (for the buyer) or having to make delivery (for the seller) of the actual commodity, providing of course that one does not buy or sell a future during its delivery month. One may at any time cancel out a previous sale by an equal offsetting purchase, or a previous purchase by an equal offsetting sale. If done prior to the delivery month the trades cancel out and thus there is no receipt or delivery of the commodity. Actually, only a very small percentage, usually less than two percent, of the total futures contracts that are entered into are ever settled through eliveries. For the most part they are cancelled out prior to the delivery month in the manner just described.
Determination of Prices in a Commodity Exchange
A common misconception is that commodity exchanges determine, or establish, the prices at which commodity futures are bought and sold. This is totally incorrect. Prices are determined solely by supply and demand conditions. If there are more buyers than there are sellers, prices will be forced up.
If there are more sellers than buyers, prices will be forced down. Buy and sell orders, which originate from all sources and are channeled to the exchange trading floor for execution, are actually what etermine prices. These orders to buy and sell are translated into actual purchases and sales on the exchange trading floor, and according to regulation this must be done by public outcry across the trading ring or pit and not by private negotiation. The prices at which transactions are made are recorded and immediately released for distribution over a vast telecommunications network.
Probably the best way to visualize how purchases and sales are made on the floor of a commodity exchange is to think in terms of what happens at a public auction. The principle is the same, except in the futures market a two-way auction is continuously going on during trading hours. This two-way auction is made possible because of the standardized futures contract, which requires no description of what is being offered at the time of sale. Also, the two-way auction is made practicable because the inflow of both buying and selling orders to the exchange floor is normally in sufficient volume to make buying and selling of equal importance. In a public auction the accent is on selling.
What makes commodity trading attractive?
* A good low-risk portfolio diversifier
* A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate.
* Less volatile, compared with, equities and bonds.
* Investors can leverage their investments and multiply potential earnings.
* Better risk-adjusted returns.
* A good hedge against any downturn in equities or bonds as there is little correlation with equity and bond markets.
* High co-relation with changes in inflation.
* No securities transaction tax levied.
Growth of commodity trading
A soft interest rat regime and a weak US dollar has increased the demand for the commodities. In a short span of over a year, online commodity markets are witnessing good growth in India. The daily volume of trading of Rs.2500 crore at NCDEX alone has surpassed that of Rs.2000 crore on the Bombay Stock Exchange (BSE). It registered a record daily traded volume of Rs.2617 crore on 8 December 2004. Commodities like chana, urad, soya bean oil, sugar, pepper, mustard seeds and wheat contributed to the balance trading volume. MCX, on the other hand, has achieved a peak daily turnover of Rs.1889 crore. Though the most popular commodities for trading in India are gold, silver, soya bean and guar gum, the market is divided equally between bullion and agricultural commodities in terms of trading volumes.
Expecting the turnover on the three online commodity exchanges to spurt to Rs.10000 crore per day, banks are keen to tap the commodity trade-financing front. Commercial banks are chasing the commodity industry with attractive lending rates between 8% and 8.5% as against the normal lending rate between 11% and 14%.
» Filed Under What