Subject 1. Market participants

An efficient market for commodity futures requires a large number of market participants with diverse risk profiles. Ownership of the underlying commodity is not required for trading in commodity futures. The market participants simply need to deposit sufficient money with brokerage firms to cover the margin requirements. Market participants can be broadly divided into hedgers, speculators and arbitrageurs.

Hedgers

They are generally the commercial producers and consumers of the traded commodities. They participate in the market to manage their spot market price risk.

Hedging is a two-step process. For example, if the hedger is going to sell a cash commodity at a later time, his first step is to sell future contracts. The second step occurs when the cash market transaction takes place. If the hedger is initially long, he would offset his position by selling the contract back.

Speculators

They are traders who speculate on the direction of the futures prices with the intention of making money. Thus, for the speculators, trading in commodity futures is an investment option.

Arbitrageurs

They are traders who buy and sell to make money on time- or location-based price differentials across different markets. Arbitrage involves simultaneous sale and purchase of the same commodities in different markets. Arbitrage keeps the prices in different markets in line with each other. Usually such transactions are risk-free.

Storability and Renewability

A storable commodity is defined as a commodity that does not easily spoil and does not cost a large deal of money to store. Examples:

  • Storable: gold, honey, and silver.
  • Non-storable: live hogs, milk, and electricity.

Storable goods can be acquired at the spot price and stored till the expiration of the futures contract, which is the practical equivalent of buying a futures contract and taking delivery at expiration.

A renewable commodity can replenish with the passage of time, either though biological reproduction or other naturally recurring processes.

  • The price of nonrenewable commodities depends strongly on current investor demand.
  • The price of renewable commodities depends more on estimated future production costs.

Practice Question 1

The smallest group of market participants in commodity futures markets is:

A. hedgers.
B. speculators.
C. arbitrageurs.
Correct Answer: C

Practice Question 2

Which group of market participants is subject to huge gains and huge losses?

A. hedgers.
B. speculators.
C. arbitrageurs.
Correct Answer: B

Practice Question 3

In June a farmer expects to harvest at least 10,000 bushels of soybeans during September. In order to protect himself against the possibility of falling soybeans prices in September, the farmer should act as a(n):

A. hedgers.
B. speculators.
C. arbitrageurs.
Correct Answer: A

By hedging the farmer can lock in a price for his soybeans in June.

Practice Question 4

Arbitrageurs try to take advantage of ______ based price differences in commodity futures markets to generate riskless profits.

I. time-.
II. location-.
III. type-.
Correct Answer: I and II

Practice Question 5

Silver is:

I. storable.
II. non-storable.
III. renewable.
IV. non-renewable.
Correct Answer: I and IV

Practice Question 6

Commodity producers are normally ______ and commodity consumers are normally ______.

A. hedgers, hedgers.
B. hedgers, speculators.
C. speculators, hedgers.
Correct Answer: A

Commodity prices are volatile. Commodity consumers and producers? participation in the futures market allows them to hedge or protect themselves against the risk of losses from fluctuating prices. For e.g. a copper smelter will hedge by selling copper futures, since it is exposed to the risk of falling copper prices.

Practice Question 7

The largest group of market participants in commodity futures markets is:

A. hedgers.
B. speculators.
C. arbitrageurs.
Correct Answer: B

They provide liquidity while balancing the long and short hedges in the futures markets.

Practice Question 8

Gold is considered to be a ______ commodity.

A. storable and renewable.
B. storable and nonrenewable.
C. non-storable and renewable.
Correct Answer: B

It is not perishable and storage cost is low.