What's commodities exchange?

A commodity exchange serves the same purpose as a stock exchange, that is, to buy and sell items

July 23, 2014 01:19 pm | Updated 01:22 pm IST

Commodities that can be traded on exchanges come under any of the following four categories – energy (like crude oil, natural gas), agricultural products (wheat, rice, coffee, cotton, pulses, sugar), animal products and metals (gold, silver, aluminium, copper).  Photo: K.K. Mustafah

Commodities that can be traded on exchanges come under any of the following four categories – energy (like crude oil, natural gas), agricultural products (wheat, rice, coffee, cotton, pulses, sugar), animal products and metals (gold, silver, aluminium, copper). Photo: K.K. Mustafah

One of the biggest shocks in markets and trading last year in India had to do with an exchange called the NSEL, or the National Spot Exchange Ltd. Investors and traders in the NSEL lost nearly Rs 5600 crore because the exchange was mismanaged.

While you might be unfamiliar with the scam, you might find the idea of a commodities exchange slightly intriguing and definitely different from the stock exchanges that are usually discussed in this space.

Jog your memory a little and you will remember that a stock exchange is a trading platform where investors can buy and sell shares in a company. A share isn’t a tangible good – what it represents is a right on the company’s assets and liabilities. A commodity exchange serves the same purpose as a stock exchange, that is, to buy and sell items. These items, however, can range from rice and wheat to crude oil, pork and natural rubber. In commodities exchanges, traders take bets on the future prices of these items (just like in a stock exchange, traders take bets on the future prices of shares).

What commodities?

Commodities that can be traded on exchanges come under any of the following four categories – energy (like crude oil, natural gas), agricultural products (wheat, rice, coffee, cotton, pulses, sugar), animal products and metals (gold, silver, aluminium, copper).

Essentially, there are two kinds of investors who are active on a commodities exchange. The first kind are people who are keen on acquiring or selling the specific commodity. For instance, a sugarcane farmer may want to sell his produce over a commodity exchange. This way, he can finalise the trade over an exchange and then deliver the sugarcane to his buyer. Or McDonalds may want to make sure that it has enough supply of wheat flour available at a specific price over the next six months. It can do this by entering into an agreement with wheat farmers to buy their produce at a specific price at a specific time in the future.

Guessing the future price

The second kind of trader is the speculator who makes intelligent guesses on the future prices of products. He may, for example, buy 10 barrels of crude oil at today’s price and sell the same 10 barrels on Friday for a higher price. And a commodity exchange allows him to do all this without actually physically taking charge of the crude oil at all. (unlike the first kind of traders who actually physically deal in their products). Since these exchanges deal with physical products, which can sometimes be perishable, there are strict quality standards that items traded on commodity exchanges must meet.

What influences prices?

Just like with a stock exchange, anybody can participate in a commodity exchange, provided you understand how the item you are interested in is traded. You can be a student speculating on the future price of concentrated orange juice or a jeweller wanting to buy 50 tonnes of gold at a certain price. The rules to trading are the same as with any other market – it depends solely on demand and supply. However, prices of commodities can be strongly influenced by external factors. For example, an unexpected war in the Middle East can send the price of crude oil shooting up. A recession in China may cause a sudden fall in demand for metals like copper and aluminium (used so commonly in industry) that the prices of these metals may fall internationally.

If you look around carefully, you can surely find a commodity market in your vicinity. The wholesale vegetable and fruit market or the flower bazaar in your city are prime examples of how a commodity market works.

The really big exchanges are, however, in the US, UK – like the Chicago Mercantile Exchange and the London Metal Exchange.

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