Supply chain inflation can have a knock on effect on prices by driving up supply chain expenses, which in turn drives up inflation and prices. Due to their usage as raw materials in the creation of other products or services, raw materials are an essential component of trade. They can be used interchangeably with other products of the same type and are frequently employed as raw materials in the production of finished goods. The world of commodities, including what they are, how they are traded, and how they relate to derivatives, will be examined in this article.
- In a Nutshell
- Understanding Raw Materials
- Commodity Speculators
- Special Considerations
- Examples of Raw Materials
- Wrap Up
- FAQs
- Article sources
In a Nutshell
- Commodities are basic products that are used in trade and can be exchanged for other goods of the same kind.
- Typically, they are the raw ingredients that are used to make completed goods.
- As financial assets, commodities can be purchased and traded on specialized exchanges.
- Commodity buyers and producers who utilize commodity futures contracts for hedging and speculators who trade in commodity markets only for the aim of benefitting from price volatility are the two categories of commodity futures traders.
- When inflation picks up speed, commodity prices typically climb, making them a popular alternative for investors seeking to hedging against inflation.
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Understanding Raw Materials
Raw materials are inputs used in the production of goods. They can also be commodities, such as certain agricultural products. The important characteristic of a commodity is that there is little, if any, differentiation in that good if it comes from one producer and the same commodity from another. A barrel of oil is basically the same commodity regardless of the producer. The same is true of a bushel of wheat or a ton of ore. On the other hand, the quality and characteristics of a given consumer product will often be very different depending on the producer (e.g., Coca Cola versus Pepsi).
Commodities are the building blocks of civilization.
Dennis Gartman
Traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the definition has been broadened to include financial products such as currencies and indices. Technological advances have also led to new types of commodities being traded in the market. For example, cell phone minutes and bandwidth.
Commodities can be bought and sold on specialized exchanges as financial assets. There are also well developed derivatives markets where commodity contracts (e.g., forwards, futures and options) can be purchased. Some experts believe that investors should hold at least part of a well diversified portfolio in commodities, as they are not highly correlated with other financial assets and can serve as a hedge against inflation.
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Experts recommend allocating 5% to 10% of the portfolio to a combination of commodities. Individuals with lower risk tolerance may consider a smaller allocation. Ordinary investors can turn to one of several commodity ETFs or mutual funds to gain exposure.
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Buyers and Producers of Raw Materials & Inflation
Commodity trading is usually done through futures contracts on exchanges that standardize the minimum quantity and quality of the commodity being traded. For example, the Chicago Board of Trade (CBOT) stipulates that a wheat contract is for 5,000 bushels and establishes which grades of wheat can be used to satisfy the contract.
There are two types of commodity futures traders. The first are buyers and producers of commodities who use commodity futures contracts for the hedging purposes for which they were originally intended. These traders make or take delivery of the actual commodity when the futures contract expires.
For example, the wheat farmer who plants a crop can protect himself against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and guarantee a predetermined price for the wheat at harvest time.
Commodity Speculators
The second type of commodity trader is the speculator. These are traders who operate in the commodities markets for the sole purpose of profiting from price volatility. These traders never intend to make or take delivery of the actual commodity when the futures contract expires.
Many of the futures markets are very liquid and have a high degree of daily fluctuation and volatility, making them very tempting markets for intraday traders. Many index futures are used by brokers and portfolio managers to offset risk. In addition, since commodities do not usually trade in parallel with equity and bond markets, some of them can be used effectively to diversify an investment portfolio.
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Special Considerations
Commodity prices tend to rise when inflation accelerates, which is why investors often turn to commodities for protection in times of rising inflation, especially unexpected inflation. As demand for goods and services rises, so does their price, and commodities are what is used to produce those goods and services.
Since commodity prices tend to rise with inflation, this asset class can often serve as a hedge against declining purchasing power of the currency.
Those interested in learning more about commodities and other financial topics may want to consider enrolling in one of the best investment courses available today.
Examples of Raw Materials
Commodities are basic, widely used goods and materials that do not differ from each other in any significant way. Examples of commodities are barrels of oil, bushels of wheat or megawatt hours of electricity. Commodities have long been an important part of trade, but in recent decades their trade has become increasingly standardized.
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Wrap Up
In conclusion, because they are used as raw materials in the creation of goods and services, commodities play a crucial role in the world economy. They are frequently employed as a hedge against inflation and can be traded as financial assets on specialist platforms. Investors who want to diversify their portfolios and control risk must understand the world of commodities.
FAQs
What is the Relationship between Commodities and Derivatives?
The modern commodities market relies heavily on derivative securities, such as futures and forward contracts. Buyers and sellers can transact with each other easily and in large volumes without the need to exchange physical commodities. Many buyers and sellers of commodity derivatives do so to speculate on the price movements of the underlying commodities for purposes such as hedging and inflation protection.
What determines Commodity Prices?
Like all assets, commodity prices are ultimately determined by supply and demand. For example, a booming economy can lead to increased demand for oil and other energy commodities. Supply and demand for commodities can be affected in many ways, such as economic crises, natural disasters and investor appetite (investors may buy commodities as a hedge against inflation if they expect inflation to rise).
What is the Difference between a Commodity and a Security or Asset?
Raw materials are physical products intended to be consumed or used in the production process. Assets, on the other hand, are goods that are not consumed through their use. For example, money or a piece of machinery are used for productive purposes, but persist as they are used. A security is a financial instrument that is not a physical product. It is a legal representation (e.g., a contract or a receivable) that represents certain cash flows generated by various activities (such as a stock representing the future cash flows of a company).
What types of Raw Materials are there?
Hard raw materials are usually classified as those extracted from the earth. For example, metals, minerals and petroleum products (energy). Soft commodities are those that are cultivated, such as agricultural products. These include wheat, cotton, coffee, sugar and soybeans.
Where are Commodities Traded?
The major U.S. commodity exchanges are ICE Futures U.S. and CME Group, which operate four major exchanges: Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), and Commodity Exchange, Inc. (COMEX). There are also major commodity exchanges scattered around the world.
Article sources
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We take pride in properly citing all of our sources, both primary and secondary, in order to give credit to the original authors and to allow our readers to verify the information for themselves. We appreciate your trust in our website and are committed to upholding the highest standards of financial journalism.
- CME Group – Grain and Oilseed Futures and Options Page 3.
- Vanguard – The Potency of Commodities as an Inflation Hedge
