Commodity
What is Commodity?
Commodity papers are a special type of loan or advance that is made using commodities in the possession of the borrower as collateral for the transaction. In general, the lender does not take possession of the physical commodities as part of the loan agreement. Often, documents such as bills of lading, verified inventory lists, and warehouse receipts are used to establish the status of the commodities and allow the lender to prepare a commodity paper.
The nature of commodities is different from many other investments, in that the commodity is a physical substance that has to be produced before it can be sold on an exchange. For example, food products and grains are raised by farmers and then stored, all in the hope that the products will sell at a good price when the time comes. The commodity paper is one of the ways that the owner of produced commodities can benefit from the stored goods prior to the point of sale.
Loans and advances that are transacted with the use of a commodity paper are otherwise very similar to any other type of loan. There is normally a fixed or variable rate of interest applied by the lender. Repayment of the loan balance plus interest can be structured into monthly installments of a series of balloon payments. In the event that the borrower defaults on the loan, the lender has the right to assume control of the commodities as a means of settling the remaining debt on the commodity paper.
Generally, the lender and borrower will work together in structuring the terms so that the borrower can obtain permission to sell the pledged commodities when the sale price is attractive. The terms will often involve a commitment on the part of the borrower to use a portion of the sale to settle a part of the outstanding balance on the commodity paper. This type of arrangement makes selling the commodities at the highest market price possible a goal for both the lender and the borrower.
Commodity-product spread involves the purchase of a given commodity and a subsequent sale of products derived from commodities of the same type. Generally, these two transactions take place simultaneously. However, if there is a relatively small amount of time between the execution of the two transactions, the strategy is still considered to be a commodity-product spread.
It is also possible for a commodity-product spread to be conduced in reverse sequence. That is, the purchase of commodities may take place after the sale of products made with the same type of commodity. In both cases, there is generally no more than a thirty-day window in between the two transactions that compose the spread.
Under the broad classification of a commodity-product spread are a number of specialized spreads. One common transaction of this nature is known as the crack spread. Essentially, a crack spread is a commodity-product spread that has to do with commodities such as crude oil. An example of a crack spread would be the purchase of crude oil coupled with the sale of such products as heating oil or gasoline.
Another type of commodity-product spread is the crush spread. Crush spreads usually have to do with foodstuffs, such as corn or soybeans. Like all versions of the commodity-product spread, an investor may choose to purchase soybean futures and then sell any futures associated with soybean oil, meat substitutes made with soybeans, or dairy substitute products such as soy milk.
The purpose of a commodity-product spread is to allow the investor to ride a commodity market that is currently experiencing an upswing. The purchased component will often be acquired at a good price, with the component sold earning a return that covers the cost of the acquired commodity futures contract. By watching the market and continually rolling over investments within the commodities market, it is possible to earn a substantial return using this strategy. In general, the application of a commodity-product spread is expected to carry a low risk in comparison to other investments.
Contract grades are standards that are associated with various types of investment commodity situations. Essentially, the contract grade helps to establish the status of a futures contract based on a given commodity as being deliverable within the terms outlined in the contract. Contract grades help to ensure that investors who deal in commodities get what they pay for.
Contract grades or standards are usually established on two fronts. First, the government of jurisdiction where the particular commodities exchange is located will provide relatively broad rules and regulations that apply to any commodity traded on the market. In addition, the actual market or exchange will also have some input into whether or not a given commodity offering meets the standards for trading set by the exchange. In both instances, the intent of the laws and regulations is to establish contract grades that are reasonable, help to represent the underlying value of the commodity realistically to potential investors, and in general make sure that all transactions are conducted with honesty and integrity.
In some markets, contract grades are known as deliverable grades. This designation reflects the fact that the standards set for the commodities must be of a nature that will ensure the investor receives a final product that is at least as good as indicated in the original futures contract. In the event that the deliverable grade does not meet the terms of the contract for some reason, there are usually some mechanisms that can be employed to reverse the transaction.
While contract grades tend to be consistent, they are subject to change from time to time. Factors such as a change in the availability of the commodity may impact contract grades, as well as political and environmental factors that may inhibit or stimulate the creation of the commodities. However, both government regulations and the rules of the commodity exchange proper usually tend to amend contract grades in a manner that still keeps the investor aware of the current status of any given commodity, making it easier to determine whether investing in the commodity is viable or not.
Commodity exchanges are trading organizations that engage in transactions that involve the buying and selling of futures and options related to the commodities market. Generally, the commodity exchange will maintain a physical location where trading activity takes place. Increasingly, a commodity exchange will also provide online access to trading activity, including the ability to trade on the exchange by electronic means.
Perhaps one of the most well known commodity exchanges in the world today is Commodity Exchange, Inc. located in the Manhattan area of New York City. Known simply as COMEX, the particular commodity exchange has been around for decades and has a solid reputation throughout the investment community. This exchange is particularly well known for metal futures, although COMEX does engage in other commodity options trading.
The basic structure of any commodity exchange will involve creating a platform of standards, rules, and processes that will govern the trading activity of the exchange. All regulations and procedures must be in compliance with the national laws relating to investment trading within the jurisdiction where the commodity exchange is physically located. This means that COMEX is subject to the federal laws and regulations in force in the United States. At the same time, the laws of the nation of Japan govern the Tokyo Commodities Exchange.
While a commodity exchange is free to engage in trading and futures activity involving any commodities, some exchanges tend to specialize in the types of transactions they support. In some cases, a commodity exchange may focus more on precious metals such as gold or silver.
Other exchanges may lean more toward grain and grain products. Still other exchanges may tend to focus more on a broad range of food products as the commodities of choice.
Participation as an investor with a commodity exchange may be done on an individual basis, if the investor can meet the margin requirements set in place by the exchange. Smaller investors may choose to participate by means of a commodity pool, wherein a group of investors pool their resources for trading purposes. Brokers may also be engaged to execute orders on behalf of the individual or pool of investors.