COMMODITIES

Commodities are bulk goods and raw materials, such as grains,

metals, livestock, oil, cotton, coffee, sugar, and cocoa which are used to
produce consumer products. The term also describes financial products, such
as currency or stock and bond indexes. Commodities are bought and sold on
the cash market, and they are traded on the futures exchanges in the form
of futures contracts. Commodities are part of the national and international
marketplace. The products are traded on exchanges, and the prices are
based on supply and demand.



How to invest in Commodities
Futures Market
Futures market is an auction market in which participants buy and sell
commodity/future contracts for delivery on a specified future date. Trading is
carried on through open yelling and hand signals in a trading pit. Volume in the
futures market usually increases when the stock market outlook is
uncertain. Most of the participants in the futures markets are commercial or
institutional users of the commodities they trade. These hedgers may use the
commodity markets to take a position that will reduce the risk of financial loss
due to a change in price. Other participants, mainly individuals, A popular way
to invest in commodities is through a futures contract, which is an
agreement to buy or sell a specific amount of a commodity at the designated
time in the future at a given price.

Investing in a futures contract will require you to open up a new brokerage
account, if you do not have a broker that also trades futures, and to fill out a
form acknowledging that you understand the risks associated with futures
trading.

Most futures contracts will also have options associated with them. Options on
futures contracts still allow you to invest in the futures contract, but limit your
loss to the cost of the option. Options are derivatives and usually do not move
point-for-point with the futures contract.

Advantages:
It's a pure play on the underlying commodity.
Leverage allows for big profits if you are on the right side of the trade.
Minimum-deposit accounts control full-size contracts that you would normally
not be able to afford.
You can go long or short easily.



Stocks
Many investors looking for a commodity play use stocks, which are less
prone to volatile price swings than the futures market. Stock options are
another way to invest in commodities. While risk is limited to the cost of the
option, the price movement will not usually directly mirror
the underlying stock.
Advantages:
Investors usually already have a brokerage account, so trading is easier.
Public information on a company's financial situation is readily available.
The stocks are often highly liquid.
Disadvantages:
A stock is not a pure play on commodity prices.
Its price may be influenced by company-specific factors as well as market
conditions.

Exchange Traded Funds and Exchange Traded Notes
Exchange traded funds (ETFs) are securities that tracks an index, a commodity
or a basket of assets like an index fund, but trades like a stock on an exchange.
Exchange traded notes (ETNs) are unsecured debt designed to mimic the price
fluctuation of a particular commodity or commodity index, and are backed by
the issuer. A special brokerage account is not required to invest in ETFs or
ETNs.


Advantages:
Because they trade like stocks, there are no management or redemption fees to
worry about.
They provide an easy way to participate in the price fluctuation of a commodity
or basket of commodities.
Disadvantages:
A big move in the commodity may not be reflected point-for-point by the
underlying ETF or ETN.
Not all commodities have an ETF or ETN associated with them.
ETNs have credit risk associated with the issuer.

Mutual Funds and Index Funds
While mutual funds cannot invest directly in commodities, they can invest
in stocks of companies involved in commodity-related industries, such as
energy, agriculture or mining. Like the stocks they invest in, the fund shares
may be affected by factors other than commodity prices, including stock market
fluctuations and company-specific risks.
A small number of commodity index mutual funds invest in futures contracts
and commodity-linked derivative investments, thus providing more direct
exposure to commodity prices.

Advantages:
Professional money management
Diversification
Liquidity
Disadvantages:
Management fees may be high, and some of the funds may have sale
charges as well.
Because most commodity mutual funds invest in stocks, they are not a pure
play on commodity prices.


Managed Futures
A commodity pool operator (CPO) is a person or limited partnership that
gathers money from investors, combines it into one pool and invests it in
futures contracts and options
CPOs will employ a commodity trading advisor (CTA) to advise them with the
trading decisions for the pool. They usually have a system to trade futures and
use it to advise commodity-pool trades.

Advantages:
Professional advice
A pooled structure that provides more money for a manager to work with
Closed funds require all investors to put in the same amount of money
Disadvantages:
It may be difficult to evaluate past performance, and you may want to look at
the CTA's risk-adjusted return from previous investments.
Investors should also read CTA disclosure documents and understand the
trading program, which may be susceptible to drawdowns.

Commodities and Financial Futures


Futures Contract
An agreement that provides for delivery
-of a specific amount of a commodity
-at a designated time in the future
-at a given price
Almost all commodities futures contracts closed out (reversed) before actual
transaction occurs
Tremendous volume of activity but,
Few actual items ever change hands
Hedge
Futures markets originally set up to allow grain & livestock producers &
processors to hedge (protect) their positions in a given commodity.

Speculators in the Futures Market
Take purely long or short positions without intent to hedge actual ownership
Each contract has its own specifications which include:
The product
The exchange on which the contract is traded
The size of the contract (and in what units: bushels, pound, etc.)
The pricing unit (such as cents per pound)
The delivery month
Settle price is the closing price (last price of the day) for commodities and
financial futures
Open interest is the number of contracts currently outstanding on a
commodity or financial future


Types of Commodities
Categories of Commodities and Financial Futures
1. Grains and oilseeds:
o Corn
o Soybeans
o Wheat
o Oats
o Barley
o Rye

2. Livestock and meat:
o Cattle- feeder
o Cattle- live
o Hogs- live
o Pork bellies
o Turkeys
o Broilers

3. Food and fiber:
o Cocoa
o Coffee
o Cotton
o Orange juice
o Potatoes
o Sugar
o Rice
o Butter




4. Metals and petroleum:
o Copper
o Gold
o Platinum
o Silver
o Mercury
o Oil

5. Financial Futures:
a. Foreign exchange:
Euro, yen, peso, etc.
b. Interest rate futures:
Treasury bonds
Treasury bills
Municipal bonds
Eurodollars
c. Stock index futures:
S&P 500
Value Line
Dow Jones
Industrial Average

Commodity Exchanges
Manila Commodity Exchange (MCX) is a commodity and derivatives
exchange located in Ayala Avenue, Makati City, Philippines. MCX currently has
84 registered members throughout the Philippines. MCX provides a platform for
trading of commodities, futures contracts and options contracts on various base
metals, agriculture commodities, energy, and currencies. The monthly volume
on all contracts is around US$12.6 million.



Margin Requirements
*Commodity trading uses
Margins
NOT actual cash dollars
Typically 2% to 5% of the value of the contract
o There are no borrowed funds as such, the margin is to protect any loss in a
contract's market value due to adverse price movements
o The initial deposit is the amount an investor must deposit with the broker at
the time of the futures transaction. It is also pointed out that a customer
may need a minimum account balance of $5000 or greater to open a
commodity account.

Margin requirements may vary
Over time
Among exchanges for a given commodity
Margin Maintenance Requirement
60 to 80% of the value of initial margin
If initial margin is reduced due to losses on contract
MUST deposit more money to cover margin position if not position will be closed out
(resulting in loss)


Maintenance Deposit
The maintenance deposit is the minimum amount of margin which must be
kept in the margin account at all times
If the margin falls below this deposit, the investor will receive a margin call
to deposit enough cash to bring the deposit back to the required level

Market Conditions
-Market conditions affect price of commodities
What key variables influence value of contract?
o For wheat, factors could be
Weather
Crop conditions in the Midwest
Price of corn as a substitute product
Carryover of supply from last year
o Market Conditions
Export of wheat to other countries
Imports from other countries
Currency fluctuations
Mark-to-market is a daily check of an investor's margin position, determined
at the end of each session, at which time the broker debits or credits the
account as needed.

Price Movement Limitations
o High risk of gains/losses in commodities
Limit maximum daily price movements in commodity


Price Movement Limitations
o Daily limits affect efficiency of the market
If market conditions indicate price of wheat should decline by $0.30 but daily
limit is $0.20, then,
price of wheat not in equilibrium as it opens next morning
Desire to stop market panics tends to override desire for total market
efficiency
Potential intraday trading range is still large


The Cash Market and the Futures Market
Many commodity futures exchanges provide areas where
Buyers and sellers negotiate cash (or spot) prices
Cash price
actual dollar paid for immediate transfer of a commodity
Must be a transfer of physical possession of goods
Prices somewhat dependent on prices in futures market



The Futures Market for Financial Instruments
-Ideal for speculators because of Low margin requirements & Wide swings in
value

Currency Futures
Futures are available in
Euro Japanese yen
Australian dollar
Mexican peso
Canadian dollar
Russian ruble
Currency Futures
The currency futures market has
Standardized contracts &
Strong secondary market
Marked-to-market daily
Interest-Rate Futures
GNMA certificates
Treasury notes
Treasury bills
Municipal bonds
Federal funds
Eurodollars
Hedging with Interest-Rate Futures
1. Corporate treasurer
Awaiting new debt
Borrowing under a floating prime rate
2. Mortgage banker
3. Pension fund manager
4. Commercial banker for loans
Options As Well As Futures
Futures contract requires initial margin
Options require payment of option premium
Interest-Rate Swaps
A deal between banks or companies where borrowers switch floating-rate
loans for fixed rate loans
One company may have access to a lower fixed rates and another company
may have access to lower floating rates so they trade.
Commodity Prices
Move up and down in relation to economic, political and international
pressure, as well as the weather
These pressures cause the prices of the underlying commodities to change
The large size of commodity contracts magnify small changes in the price of
an underlying commodity into substantial changes in the commodity futures
price
To restrict daily price movements on commodity futures, a daily price limit
has been established
The maximum daily price range represents the maximum a price can change
within a day-it is twice the daily price limit