Ever wondered how the price of gold or oil is determined? No? Well let’s discuss it because you should know it anyway. The prices of these and other goods are determined within large exchanges such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), but let’s first establish what makes a commodity a commodity.
A commodity is a basic good which is nearly identical to other commodities of the same type and is commonly traded on exchanges.
Common commodities include metals, agricultural goods, and energy products.
Commodity prices are determined on commodity exchanges.
Trading commodities is much closer to speculation than investing.
What is a Commodity?
A commodity is a commonly traded good that is interchangeable with other goods of the same type. For example wheat grown in Iowa is for the most part indistinguishable from wheat grown in Kansas. Agricultural products with their nearly perfect similarities are a great example of commodities. Whether the corn is grown in Iowa or Kansas it is still corn. Though commodities are interchangeable, different grades or quality of the commodity can be traded. For example, there are varying qualities of oil and natural gas traded.
Types of Commodities
The common classifications of commodities traded are metals, agricultural goods, and energy products.
Metals: This group is composed both industrial and precious metals. Industrial metals include metals such as zinc, copper, and nickel that are commonly used in the construction of many goods. Precious metals include metals such as gold and silver that derive their value not by their industrial applications, rather for their intrinsic rarity.
Agricultural Goods: This group is composed of both food products and livestock. Food products includes foods such as corn, wheat, sugar, milk, and orange juice. Livestock is comprised of lean hogs, live cattle, and feeder cattle. (The difference between feeder cattle and live cattle? Feeder cattle is cattle that will be placed on a feedlot, fattened, then slaughtered to produce delicious steaks or burgers).
Energy Products: This group is the most diverse of the three major groups. It includes products such as ethanol, natural gas, propane, and gasoline. Energy products have various uses including construction of petrochemical products to providing fuel for homes and vehicles.
Like stocks or bonds, commodities trade on long standing markets (most of which predate the largest stock and bond markets). The largest commodity market in the U.S. is the Chicago Mercantile Exchange (CME) followed by the New York Mercantile Exchange (NMEX) which together account for the majority of commodity trades made in the U.S.A. There are also many large international commodity exchanges such as the London Metal Exchange (LME) based in London, UK and Euronext which is based in several major European cities.
How does an exchange ensure that the wheat or livestock being traded is actually worthwhile grain or animals and not disease ridden goods? Exchanges establish a basis grade which establishes a minimum accepted standard that a tradable commodity. Also called a “par grade” or “contract grade” the purpose of the basis grade is to ensure that when trading commodities it is truly “apples to apples” trades.
There are two primary ways to trade commodities: spot and futures markets.
Spot Markets: When trading commodities in the spot market an investor is buying or selling the commodities at that very moment. This trading is done at the spot price, which is simply the market price of the goods at that time. A different way to look at spot markets is that when trading in the spot market you are truly trading “on the spot”.
Futures markets: When trading commodities in the futures market an investor is not buying or selling the commodities directly but is instead trading futures contracts. For now just know that a futures contract is a highly standardized contract that obligates the holder to buy or sell a set amount of goods at a set price. These contracts tend to greatly fluctuate in price based on the perceived value of the underlying assets and predictions of future market circumstances.
Speculation vs. Investing
Now that you are more informed about commodity trading here is where I throw my $0.02 in.
I DO NOT recommend commodity trading for the average everyday investor.
Commodity trading is a highly specialized field in which highly savvy and well informed traders and investors operate and seize on market opportunities. In addition most trades are made “on margin”. This means that losses and gains become greatly magnified as the transactions are highly leveraged. A final reason is simply the speculative nature of commodity trading. There are limitless variables which can alter commodity prices and result in enormous volatility in the prices of commodity.
If as an investor you really want to invest in commodities, my recommendation is to get exposure through ETFs or mutual funds based in commodity-related businesses. For example an oil and gas mutual fund would own stock in different companies directly involved in the production and distribution processes.
Commodity: A commonly traded good that is interchangeable with other goods of the same type.
Basis grade: The minimum quality of a commodity that must be met in order to be traded and is established by the commodity exchange on which it will trade.
Spot market: A market in which commodities or securities are traded for cash and settlement is immediately effective.
Spot price: The current market price at which an asset is bought or sold for immediate payment and delivery.
Futures market: A market in which commodities or securities are traded via futures contracts for delivery on a specified future date.
The term money market is actually a great example of a misnomer. One might think that “money” in the form of currencies (Euros, U. S. dollars, Chinese Yen, etc.) are traded in this market. This is incorrect. Instead the money market consists of highly liquid, short term debt investments. The money market is the alternative to the capital markets which consist of longer term bonds and stocks. An easy way to remember the difference is that if the asset is short term (it matures in one year), you are in the money market. If the asset is long term (stocks, bonds, etc.) you are in the capital markets.
The money market is where short term debt instruments are traded.
Some of the key players in the money market include the U.S. Treasury, Federal Reserve, large companies, and individuals.
One of the main purposes of the money market is to house surplus funds and meet short term needs of funds.
Some of the securities traded in the money market include T-bills, commercial paper, federal funds, negotiable CDs, Eurodollars, and repurchase agreements.
The money market (mainly in the trading of T-bills) is where short term interest rates are determined.
What is the Money Market?
Say a company wants to build a new building or make a long term investment in a new product. A bond would be a perfect way for the company to raise a large amount of funds and pay it back over many years. What if a company needs a smaller amount of cash for a quick payment (say to fill a small gap in the weekly payroll)? As the process for issuing bonds is very costly in terms of both dollar amount and time, it would be ineffective to issue bonds to address this small need of funds. Thus in this case and others the money market instruments arose to fulfill the need of short term funds.
There are three common characteristics of money market instruments:
Money market instruments mature in less than one year. Unlike bonds or stocks, money market instruments mature in less than one year than issue date whereas bonds mature in 5-10 years and stocks theoretically never mature.
Money market instruments are highly liquid. The instruments in the money markets have high liquidity due to the large amount of participants and the large amount of funds that flow through the market.
Money market instruments have low risk relative to the average risk of stocks and bonds. With their short maturities and high liquidity money market instruments in general possess very low risk when compared to their capital market counterparts.
Key Participants in the Money Market
The major participants in the money market include the U.S. Treasury, the U.S. Federal Reserve, large public companies, institutional investors, and individual investors.
U.S. Treasury: Remember those Treasury bonds that we mentioned in the bond market lesson? Well the U.S.
Treasury also issues T-bills. We will discuss T-bill specifics later, but for now just now that the U.S. Treasury is the largest borrower of money market instruments which it uses to fund the federal debt.
Federal Reserve: The U.S. Federal Reserve (Fed) is the most influential player in the U.S. money market. It buys and sells vast amounts of T-bills to influence the money supply and short term interest rates in America.
Large Public Companies: Large companies participate in the money markets through buying and selling of securities. One instrument associated with large companies in the money market is commercial paper which will be discussed later.
Institutional Investors: Due to their low risk many institutions (insurance companies, pension funds, etc.) will hold large amounts of money market instruments to generate investment returns while maintaining minimum risk.
Individual Investors: Primarily through the use of mutual funds (which we discuss in the next lesson) individual investors are able to participate in the buying and selling of the large dollar denomination securities in the money market.
Purpose of the Market
The primary purpose of the money markets is to provide a market that matches large amounts of excess funds from financial institutions to other firms and governments in need of short term funds. Imagine a firm, let’s say Apple, has over $1 billion in excess cash. What should Apple do with these funds? Furthermore let’s assume that the market for stocks and bonds has been volatile and therefore unusually risky lately. One option is to buy money market instruments to generate higher return than the return that cash offers. (It is important to note that the return on cash is zero. Another way of thinking of this is cash in your wallet generates no return for you). The money market allows Apple to invest in short term liquid securities that do not put Apple at significant risk and provides short term funds to other firms that need it.
Another way to think about the money market is imagine you as an individual have excess cash. One option you have is to go to a bank and put the money in a savings deposit. The return on this account will be quite low. Now imagine there is a market where you can invest and get a slightly higher return with a corresponding slightly higher risk profile. You will provide the funds to institutions and businesses who have a short term need for funds and will compensate you with a higher rate for doing so. This is the purpose of the money market.
Types of Money Market Instruments
T-bills: Treasury bills are issued by the U.S. Treasury Department and are used to finance the federal debt. The U.S. Treasury bill is arguably the most liquid and widely traded security in the world. As a result the interest rate offered on T-bills is used as a proxy for the short term risk-free rate. T-bills do not pay interest and are instead sold at a discount and later matures at par value. (Similar to the zero-coupon bonds discussed last chapter)
Federal Funds: Federal funds are short-term funds transferred between large financial institutions (usually larger commercial banks). Because banks must have minimum reserves relative to the amount of deposits they have, some banks need quick, overnight funds to avoid legal repercussions. As an investor you may hear the “federal funds rate” mentioned. This is the interest rate charged on these overnight bank loans.
Commercial Paper: Commercial paper are money market securities that are issued by corporations and mature in less than 270 days. Commercial paper is offered directly from issuer to buyer and is used to fund the issuing companies’ activities.
Negotiable CDs: Negotiable certificates of deposit (CDs) are large, bank issued securities that range in value from $100,000- $10 million. Most individual investors will have little interaction with negotiable CDs, but it is worth noting that a negotiable CD is not the same instrument as the certificate of deposit that an individual can get at a consumer bank.
Repurchase agreements: Repurchase agreements (repos) occur when a firm sells Treasury securities and agrees to buy back the securities at a later date. In essence a repo is a short-term loan. One firm sells the securities for quick funds and promises to rebuy the securities at a later date. Repos are used by the Federal Reserve in conducting monetary policy.
The Risk Free Interest Rate
As mentioned above the T-bill is one of the most important securities within the financial markets. The interest rate on the 3 month Treasury bill is commonly used as the “interest-free rate”. The interest free rate represents the return an investor should expect to earn on an investment with no risk. The T-bill is used for this theoretical rate because of its unparalleled liquidity and the ability of the U.S. Federal government to create more money to pay off the T-bill obligations as they come due.
Money market: The market for short term debt obligations used to facilitate short term borrowing and lending of excess funds.
Interest free rate: The theoretical return an investor should earn on a security with zero risk. The interest rate on the 3-month Treasury bill is commonly used as a proxy for this theoretical rate.