Commodity Derivatives

After understanding the concept of currency derivatives, which provide a hedge against the risk of floating exchange rates, we now turn our attention to commodity derivatives. In much the same way that currency derivatives provide hedging and speculative opportunities, commodity derivatives enable firms and investors to deal with price variability in such commodities as gold, oil, and agricultural products. These instruments play a vital role in India's commodity-based economy.

Commodity derivatives are gaining much importance in the country. It may be a business dealing with raw materials, a farmer, or an investor that needs commodity derivatives to protect themselves from risk and optimize their profits.

What are commodity derivatives?

Commodity derivatives are financial contracts in which the value depends upon the price of a commodity. Examples of derivatives include the following:

1. Commodity futures: A standardized contract to buy/sell a definite quantity of any commodity with a view to delivering at a future date at a prescribed future price is traded in exchanges like MCX and NCDEX.
   

2. Commodity options: These give you the right (but not the obligation) to buy or sell a particular commodity at a given price sometime before the given date. Compare that with futures, where options allow room for maneuvering.
   

3. Commodity Swaps: These are customized contracts for the exchange of the future price movements of commodities. These are widely used by institutional investors for hedging.
   

Commodity derivatives Importance

The Indian economy is highly reliant on commodities, both for domestic consumption and international trade. Prices of these commodities tend to be very volatile due to weather, geopolitical events, and market demand. It is commodity derivatives that help in the management of such price risks for businesses and investors.

1. Hedging against price fluctuations: A farmer and businesspeople hedge the risk of prices through the use of futures contracts. For example, a farmer can lock in a price for crops using futures to protect against a drop in price at harvest time. Businesses that rely on crude oil or metals can hedge against price increases.

2. Commodity price speculation: The speculation on gold or oil prices in buying futures or options in those commodities could yield profits. As a matter of fact, however, it carries the risk of commodity prices determined by various unpredictable global factors.

3. Portfolio diversification: It has proved to be one of the best diversifiers for an investment portfolio, as commodities tend to go their own way in relation to stocks and bonds. Adding commodities in a portfolio can reduce overall risk in times of market volatility.

In India, commodity derivatives are traded on MCX and NCDEX. The exchanges facilitate the desired levels of liquidity and transparency, and efficient price discovery, helping market participants manage risks and make informed decisions.

Therefore, the commodity derivatives are regulated by the Security and Exchange Board of India (SEBI) that enforces a code of fair practices, including protection of the rights of investors. Besides, policy measures like GST and electronic trading have been responsible for increasing volumes in the Indian commodity market.

Conclusion:

Commodity derivatives represent a fundamental tool for businesses concerned with the management of price risks pertaining to agricultural and energy-and-metal price volatility. Businesses ensure their price, reducing risk, which, in turn, makes planning financial goals more feasible. Going forward, it is important to understand the tools of risk measurement in the broader range of financial risk management. Indeed, the tools of the risk measurement allow business and investors to gauge and measure the extent of risks from different financial derivatives segments.