Purpose of commodity markets

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities.[citation needed] Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

A financial derivative is a financial instrument whose value is derived from a commodity termed an underlier. Derivatives are either exchange-traded or over-the-counter (OTC). An increasing number of derivatives are traded via clearing houses some with central counterparty clearing, which provide clearing and settlement services on a futures exchange, as well as off-exchange in the OTC market.

Derivatives such as futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003-), forward contracts have become the primary trading instruments in commodity markets. Futures are traded on regulated commodities exchanges. Over-the-counter (OTC) contracts are “privately negotiated bilateral contracts entered into between the contracting parties directly”.

Exchange-traded funds (ETFs) began to feature commodities in 2003. Gold ETFs are based on “electronic gold” that does not entail the ownership of physical bullion, with its added costs of insurance and storage in repositories such as the London bullion market. According to the World Gold Council, ETFs allow investors to be exposed to the gold market without the risk of price volatility associated with gold as a physical commodity.

Purpose:

Quality Maintenance

The commodity markets have strict requirements concerning the quality of commodities available for buying and selling. Such policies ensure the goods have superior quality throughout the country, benefitting suppliers as well as consumers.

Price Discovery

These markets allow people to find the real prices of various commodities, including agricultural products in India. These markets ensure that commodities are not sold at a lower price, thereby preventing any losses.

Leverage

Trading in commodity futures is based on leverage through margin maintained with the broker. A big transaction can be performed with a much smaller amount of cash on hand.

Helps in portfolio diversification

The new-age investor is intelligent and on the constant lookout for attractive investment avenues to diversify his portfolio. However, traditional instruments such as equities, FDs, mutual funds, and gold continue to be the top choice for many. Commodity trading provides an excellent opportunity to all investors to explore a new category of assets that includes agricultural products, metals, livestock, and bullion. Trading in commodity markets in India is a great way for investors to diversify their portfolios. As commodities have an inverse relationship with bonds and equities, investing in commodities would safeguard the investor money if other markets fall.

Distributes the risk

The commodity market plays a vital role in minimising the risk that investors usually face. In fact, commodities can be used as hedging instruments as the risk is distributed between a large group of investors. For example, a jewellery manufacturer who is keen to hedge against the price volatility of gold can buy gold futures to lock in the price.

Increases investment in the agri sector

Due to the shortage of strong post-harvest infrastructure, lots of food grains get spoiled. This has a direct impact on the prices which affects both farmers and end-consumers. Thanks to a viable commodity market, it becomes more profitable for farmers, brokers and the middlemen, leading to more investments for the agricultural ecosystem. The investments can be utilised to ensure better warehousing and transport facilities.

Results in predictable pricing

Certain commodities are extremely elastic, and the manufacturers need to ensure stability to protect their market share. Commodity futures can play a critical role in providing more predictability in the prices. In the absence of a commodity market, the manufacturer may face severe short-term price movements.

Organised commodity markets ensure an effective aggregation of agricultural products. Farmers also benefit from the institutional mechanism provided by this market to raise financing and reduces their dependence on the unorganised sector. The sale of agricultural products also takes place in a streamlined fashion due to such markets.

Reduces speculative excess

Speculative demand for commodities such as gold is extremely high. In fact, the demand for gold is often generated for speculative purposes, resulting in high imports and utilization of foreign exchange resources. However, there are no corresponding benefits of such a speculative demand. With a strong gold commodity market in place  it will be easier to absorb the speculative demand and safeguard forex resources.