Investing in Basic Commodities

Feb 03

What are Commodities

What is a commodity? Commodities are basic resources that are used every day. They include food products such as sugar and corn, basic products such as steel and aluminum, energy-related resources such as crude oil and natural gas, and precious metals such as gold and silver. Rather than purchase physical quantities of these commodities, you can purchase contracts to buy or same them on the stock market.

Basic Terms related to Commodity Investments
Spot Price of a Commodity: The spot price of a commodity is the price that the commodity is selling for today.

Futures Price of a Commodity: Futures are derivatives - that is, they derive their value from the value of an underlying asset. A futures price of a commodity is a contract for delivery of a set amount of the commodity at a specific time in the future. As it is not practical to trade physical commodities, most people instead trade futures contracts.

Commodities Futures Contracts: These are agreements to buy or sell a fixed amount of a commodity at a fixed date in the future and at a fixed price.

What determines the price of a futures contract
Two main factors affect the price of a futures contract: today’s spot price for the commodity, and the anticipated spot price on the future delivery date.

The spot price of the commodity today is the most important factor that affects the price of a futures contract. Other factors that affect the price of the futures contract: supply and demand factors, interest rates over time.

How to invest in commodities? And why?
The main benefit of investing in commodities is that they are very lowly correlated with other asset classes. They thus fit within the asset allocation Modern Portfolio Theory well. This theory suggests that in order to maximize your returns while minimizing risk, you should try to develop a portfolio with assets that are minimally correlated with one another - should one asset class fail in a financial crisis, another asset class would thus remain a stalwart that would protect your portfolio.

However, investing in commodities as an asset class is generally not advisable, as commodity total return indexes have historically low returns. The risk/reward ratio is far from desirable.

Author: Pak Man Yuen