Commodity trading system which is also called commodity exchange or commodity markets are open and very organized markets where the ownership titles of well defined volumes of commodities at specific prices are bought and sold by members. It is a very organized marketplace where future delivery agreements for measured commodities such as rice, coffee, rubber, cocoa wheat, sugar, crude oil etc are traded.
HOW DID IT START?
The commodity market started with the trading of farm product such as cattle and wheat in the 1800s. Modern market trade far many other products apart from agricultural product.
WHAT MAKE COMODITY EXCHANGE WORK
The sale of commodities not yet delivered to the buyer, at a fixed price at first does not make sense to the first timer. And the reasons are very obvious, what determine the price of farm produce are many, ranging from climatic factors such as rain fall, severity of winter, cost of farm input such as seedlings, pesticides and herbicides to mention a few. One can then reason that with so many things affecting the final outcome how can such a product not yet produced, be sold by the farmer at a specific price. This bring us to an important market tool called hedging
Hedging is like buying insurance, what happens here is that the producer of a commodity, say wheat, agrees to fix the price of a the commodity even before it goes to the market, this locking of the price can help the producer calculate his expected profits. In the same way a big buyer of the commodity can also lock the price at which he will buy from the producer even before the commodity is ready, this provide security to both buyer and seller.
WHAT HAPPEN WHEN THE PRODUCT IS LATER WORTH MORE OR LESS THAN THE CONTRACTED PRICE?
When for instance a big buyer agrees to pay $50000 for a pound of a product, say sugar by December, if by that time the price of sugar rose to $60000, they will still be supplied the ton of sugar at the agreed price of $50000 but the buyer can sell some of the sugar to the open market at a profit. If on the other hand by December, the price of sugar in the open market falls, the big buyer will then buy the commodity from the open market and sell it futures contract with the seller at a loss. But what is interesting is that the buying from the open market and selling of the contract is done in such a way that in the end the buyer ‘evens out’, that is does not end up making a loss.
By knowing in advance the cost of major raw materials, big business can set prices of their product and work towards making a particular profit without bothering the fluctuations of the commodity markets.
It provides security and permits organized planning by both suppliers and buyers.
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