All You Need to Know about Commodity Derivatives

History of commodity derivatives. Where did they start? How are they used now? What are the benefits of commodity derivatives and how are they bought, sold and in general, exchanged?

Commodity derivatives were first created for farmers, to offer them protection against crop values falling below the cost of growing the crop. This protection comes in the form of derivative contracts, and these contracts cover commodities such as white pepper, wheat, rice, coffee, cotton, and many others. Commodity derivatives started out as the first risk management options for commodities, but now they have become an important investment tool. Commodity derivatives are now commonly invested in by investors who have nothing to do with agriculture, or who do not need the actual commodity. Investors in commodity derivatives speculate on which direction commodity prices will take, making money if the price moves towards their favor. The commodity market and commodity derivatives allow investors to put their money in commodities without having to actually take possession of the commodity. Those that want to take possession of a commodity can, but usually commodity derivatives are used to make money on the commodity without ever having it physically. These instruments allow investors to put money in the commodities, instead of companies.

Commodity prices are much simpler and more accurate than company prices, because a company price and value includes many more factors than commodity prices, which depend on only supply and demand of the commodity. Commodity derivatives also offer the benefit of requiring a low minimum investment, unlike many other investment options. This means almost anyone can invest in commodity derivatives. These investment offer enormous potential returns if the market is favorable, but also very large losses if the market turns in the opposite direction. In some markets, such as those in India, commodity derivatives are not legal and can not be bought, sold, or traded on the markets and exchanges. A commodity derivatives exchange is the place where trades are settled and cleared, and these exchanges usually have a clearinghouse that deals with trade settlements.

The first exchange created that had trades for commodities was in Chicago. This is the oldest exchange and one of the largest in the world, and is the Chicago Board of Trade, also called CBOT. This exchange has numerous contracts on various commodities traded frequently, and it was fonded in the year 1848. Another commodities exchange is the Chicago Produce Exchange, which is one of the largest commodity exchanges globally and was opened in the year 1874.

Commodity derivatives derive their value from commodity prices, with investors speculating and betting on which way the market will turn in order to get good returns on their investment. A commodity derivative is a contract and legal agreement between two people for one of them to either buy or sell the commodity or have the option to buy or sell the commodity, which would be the underlying asset in this case, to the other person at a specific price within a specific time limit. The specific price is called the exercise price, and the specific length of time is shown by the expiration date on the contract. Most commodity derivative contracts are good for between three and twelve months, although they can be made shorter or longer if both parties to the contract agree. Investors use commodity derivatives to try and predict the commodity prices for the future correctly, and get a return on their investment. These investments offer high returns and high risks, so they are not for all investors, especially conservative ones.

The information supplied in this article is not to be considered as medical advice and is for educational purposes only.