Subject 3. Commodity market participation

There are several ways to participate in commodity markets.

Buying the Physical Good

It requires handling delivery and storage of the commodity. Not practical for most investors.

Commodity Stocks

Comparing to buying commodities directly, this approach offers the following advantages:

  • Easier to trade stocks.
  • Public information on a company's financial situation is readily available.
  • The stocks are often 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.

Commodity Funds

Mutual funds can invest in stocks of companies involved in commodity-related industries, such as energy, agriculture or mining.

Advantages: professional money management, diversification, and liquidity.

Disadvantages: management fees; not a pure play on commodity prices.

Commodity Future Indexes

Two types:

  • ETFs on commodity indexes.
  • Commodity index certificates: unsecured debt designed to mimic the price fluctuation of a commodity index.

    • The have credit risk associated with the issuer.
    • They often use excess return indexes as the underlying instrument, leading to lower returns during periods of high interest rates.
    • They can only consider short-term futures contracts.

Commodity Futures

A commodity futures contract is an agreement to buy or sell, in the future, a specific quantity of a commodity at a specific price. Participants can choose to close out their positions before the contract is due and never take actual delivery of the commodity itself.

Advantages:

  • It's a pure play on the underlying commodity.
  • Leverage and low capital requirements (buying on margin).
  • Easy to go long or short.
  • Very liquid, low transaction costs.

Disadvantages:

  • The futures markets are very volatile and risky.
  • Leverage magnifies both gains and losses.

Practice Question 1

Researchers find that commodity stocks are ______ commodity prices.

A. highly correlated with.
B. only slightly correlated with.
C. not correlated with.
Correct Answer: B

Stocks reflect other price-relevant factors.

Practice Question 2

For commodity futures, which form of settlement do most participants take?

A. delivery of the commodity at maturity.
B. closing the futures position.
C. rolling of futures contracts.
Correct Answer: B

A typical participant will buy or sell the same amount of contracts before maturity in order to settle with the counterparty.

Practice Question 3

Mr. Nathan is considering to invest in the commodity market. However, he does not want to deal with storage requirements associated with commodities. Which investment category will give the most direct exposure to commodities for Mr. Nathan?

A. Commodity stocks.
B. Commodity funds.
C. Commodity futures.
Correct Answer: C

Commodity futures are directly based on commodity future prices.