Commodity Exchange – SS1 Commerce Lesson Note (Third Term)

Commodity exchange is a formal, organised market where standardised raw materials and primary commodities are bought and sold.

Behavioural objectives

By the end of the lesson, students should be able to:

1. define commodity exchange;
2. state the requirements for trading on a commodity exchange;
3. describe the two methods of trading;
4. explain the types of commodity market;
5. list the benefits of and constraints facing commodity exchange;
6. differentiate between commodity and stock.

What is a commodity exchange?

A commodity exchange is a self-regulatory organisation that provides facilities for trading commodities, options and futures under agreed rules.

• Organised market: members trade ownership titles to commodities under set rules and regulations.
• Trading place: trading is done through physical means (a trading floor) or virtual means (computers).
• Products traded: raw materials or primary commodities, such as cocoa, cotton, maize and gold.
• Markets covered: it includes both the spot market and the forward market.
• Link to stock exchange: it works like a stock exchange, but the product traded is different.

Key terms

• Commodity: a raw or primary product that can be bought and sold, such as cocoa or palm oil.
• Spot price: the price at which a commodity is paid for and delivered on the spot date.
• Hedging: protecting against loss from future changes in price.
• Pit: the trading floor where traders shout their bids and offers.
• Dividend: a share of company profit paid to shareholders.

What are the requirements for trading on a commodity exchange?

There are five main requirements: a grading system, a clearing system, a warehousing system, standardisation and market information.

1. Grading system: a system that gives official certification of the quality, size and weight of commodities.
   • It is based on standards developed for each product.
   • It measures the level of quality and value of commodities.
   • Weight and grading rules should be enforceable and trade-friendly.
2. Clearing system: a clearing and settlement system that guarantees payment to sellers.
   • It reduces the risk that one party fails to meet its side of the deal.
   • Payment is guaranteed when deliveries are made.
   • Financial institutions are members of the clearing system.
3. Warehousing system: warehousing is the keeping of goods in a warehouse until delivery.
4. Standardisation: making sure all similar commodities have the same features and acceptable levels of quantity.
   • It gives a means of measuring product quality.
   • It provides a basis for domestic and international trade.
   • It promotes efficiency in marketing and procurement.
5. Information requirement: reliable and timely market information on prices, supply and demand, imports and exports.

What are the methods of trading on a commodity exchange?

There are two methods of trading: open outcry and the electronic system.

Open outcry

Open outcry is the manual method, in which bids and offers are shouted on the trading floor.

• Communication: traders shout and use hand signals to pass on buying and selling orders.
• Place: trading takes place on the floor, called the pit.
• Openness: all offers and trades are made out loud, so everybody on the floor can follow them.

Electronic system

The electronic system is trading in commodities through computer networks.

• Networks: they transmit data and information on offers and trades.
• Place: traders do not need to meet on a physical floor.

Open outcry compared with electronic trading

What are the types of commodity market?

There are four types of commodity market: spot, future, option and forward.

Spot market

The spot market is the buying and selling of commodities for payment and delivery on the spot date.

• Spot price: the settlement price.
• Basis: transactions are on a cash-and-carry basis.
• Delivery: participants trade at agreed current prices and delivery is immediate.

Future market

A future is a standardised contract to buy or sell a commodity on a future date at a price agreed today.

• Parties: two parties agree on a specified commodity of standard quantity.
• Delivery and payment: both take place on a specified future date.
• Purpose: it protects against future price changes and reduces risk.
• Payment: on the date, the buyer pays the agreed sum whether the real price has fallen or risen.

Option market

An option is a contract giving the holder the right, but not the obligation, to buy or sell a commodity at a pre-agreed price.

• Right: the holder may buy or sell a certain commodity at a set price.
• Date: the trade is on a specified future date.

Forward market

A forward is a non-standardised contract between two parties to buy and sell at a future time at a price agreed today.

• Price: agreed now for a commodity delivered on a future date.
• Purpose: it is used for hedging and to reduce risk.

Summary of the four markets

What are the benefits of commodity exchange?

Commodity exchange has twelve main benefits for producers, investors and the economy.

• Investment mobilisation: it links production to demand and helps raise funds for production through financial institutions and investors.
• Increase in agricultural production: high demand for farm commodities encourages more output and better quality.
• Adequate returns and income: it helps to guarantee returns on investment for a prudent investor.
• Basis for risk management: participants hedge against expected price changes using futures and options.
• Stabilisation of agricultural product pricing: it reduces price volatility and provides a forum for efficient pricing.
• Investment in solid minerals: it encourages investment in the search for minerals like gold, silver and aluminium.
• Foreign exchange earning: an efficient market attracts foreign investment and raises farmers’ export prices and incomes.
• Improved market information: prices are set through a transparent process and information flows among contracting parties.
• Guaranteed delivery: the exchange’s guarantee reduces the risk that participants fail to carry out contracts.
• Means of exchange of commodities: it brings sellers and buyers together to transact.
• Access to finance: more inventory finance lets exporters stockpile goods and ensure regular supply and delivery.
• Transparency in transactions: lenders can sell collateralised commodities if the owner defaults.

What constraints face commodity exchange?

Seven constraints limit the growth of commodity exchange.

• Inadequate supply: too little produce reaches the market to meet demand.
• Poor storage: weak storage facilities cause spoilage and loss of quality.
• Lack of formal quality and grading standards: without standards, buyers cannot trust the quality of goods.
• Bad weather: it affects farm output and so reduces supply.
• Middlemen: they stand between producers and buyers and can reduce what producers earn.
• Inadequate knowledge of commodity exchange: many farmers and traders do not know how it works.
• Price volatility: frequent price changes make planning difficult.

What are the differences between commodity and stock?

A commodity is a raw or primary product, while a stock is a share of ownership in a company.

• Commodity: a raw material such as cocoa, cotton or gold that is bought and sold.
• Stock: a share that gives the holder part ownership of a company.

Evaluation

1. Define commodity exchange.
2. State four requirements for trading on a commodity exchange.
3. Explain the difference between open outcry and electronic trading.
4. Describe the spot market and the future market.
5. State three differences between commodity and stock.

Assignment

1. List five benefits and four constraints of commodity exchange, with one line of explanation for each.