Derivative markets exist for most major commodities, with diamonds standing out from the crowd as a shining exception. The derivative markets for oil, corn, soybeans and other staples of the global economy are well established, with robust trading in financial contracts that derive their value from the underlying asset. Notably, while a derivative's value is based on an asset, ownership of a derivative doesn't require ownership of the asset. Commodity producers often use derivatives to lock in the prices of the items they will bring to market or purchase from the market at some point in the future. (For more detailed insight into how the derivative markets work, read The Barnyard Basics Of Derivatives to follow the tale of a fictional chicken farm.)
Tutorial: Commodities 101

The Reality of the Marketplace
For many years, diamonds and iron ore were two major commodities that many groups had been trying to create exchange-traded instruments for. Those in favor of the creation of derivative markets tout the market as a way for commodity products to hedge risk by locking in prices. While this is a valid argument, the reality is that a large part of the derivatives markets are fueled by speculators. The derivative market is often larger than the market for the actual commodity. This is because speculators don't want to take physical delivery of the commodity, they want to trade contracts and make money.

Iron Ore Joins the Crowd
Iron ore provides an interesting example of how a derivative market can be established. For approximately 40 years, iron ore producers had long-term contracts with the customers in the steel industry. In 2008, two large banks launched iron ore swaps. This created a short-term market based on securities linked to the current price of iron ore. Speculators began trading in the hope of making a profit. Other banks soon entered the market and the market grew. (Read An Introduction To Swaps to learn how these derivatives work and how companies can benefit from them.)

Why Not Diamonds?
The diamond market was largely a monopoly controlled by the De Beers Family of Companies from the mid 1800s through 2000. De Beers regulated the flow of diamonds to control prices. They were marketing and selling what many industry pundits view as a consumer product as opposed to a commodity.

No Standards
While the monopoly has ended, the reality remains that diamonds are primarily sold as jewelry. Unlike all other commodities, they have little value from an industrial application perspective. They also lack standardization or a benchmark.

For example, oil is sold by the barrel. Gold is sold by the ingot. These items have standard sizes and are homogeneous in nature, making is easy to compare one to another. Diamonds, on the other hand, are unique. Each diamond is different than the next one, making them difficult to value. At present, there is no spot price for diamonds, which means that would-be investors have no way to gauge the price, as prices vary from vendor to vendor.

Overcoming Hurdles
Those in favor of its creation envision trading baskets of polished stones (finished diamonds as opposed to uncut, rough diamonds) in set weights and qualities. Since most speculators in the derivatives market never actually take delivery of a physical commodity, this arrangement may be suitable, although delivering the appropriate diamonds may be a challenge should an investors wish to receive them. While this could be addressed by cash payments or rebates designed to make the buyer whole should the delivery not match what was promised, it would result in an unhappy buyer if the buyer had a specific reason for needing the exact diamonds set forth in the contract.

Past Attempts
Efforts to create a derivatives market for diamonds have been underway for decades. According to the Diamond Registry, 194 diamond contracts traded in 1972 on the West Coast Commodities Exchange. The effort failed after two weeks. In 2007, an effort was made to create a diamond index in order to have set pricing. It did not take hold in the marketplace.

Looking to the Future
As of 2009, interest in creating a derivatives market for diamonds is being pushed by several major banks. While diamond producers are unlikely to support the effort, eventually a market will be created because diamond producers and buyers would want to hedge risk and speculators want to make profits. Companies in India and China may be supporters of the effort, as the demand for jewelry in these two countries exceeds the demand of most nations. Middle-Eastern countries are also possible buyers. Initial efforts are apt to focus on derivative contracts that do not result in physical delivery.

In the meantime, investors can gain limited access to the market via investments in publicly traded mining companies that have diamond mines. Investing in the publicly traded stock of jewelry purveyors also provides some exposure. Other than that, it is just a waiting game.

For related reading, take a look at Does It Still Pay To Invest In Gold?

Related Articles
  1. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  2. Stock Analysis

    What Exactly Does Warren Buffett Own?

    Learn about large changes to Berkshire Hathaway's portfolio. See why Warren Buffett has invested in a commodity company even though he does not usually do so.
  3. Home & Auto

    5 Mistakes That Make House Flipping A Flop

    If you're just looking to get rich quick, you could end up in the poorhouse.
  4. Entrepreneurship

    Top 10 Features Of a Profitable Rental Property

    Find out which factors you should weigh when searching for income-producing real estate.
  5. Markets

    Are EM Stocks Finally Emerging?

    Many investors are looking at emerging market (EM) stocks and wonder if it’s time to step back in, while others wonder if we’ll see further declines.
  6. Markets

    What Slow Global Growth Means for Portfolios

    While U.S. growth remains relatively resilient, global growth continues to slip.
  7. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  8. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  9. Investing Basics

    Explaining the Liquidity Preference Theory

    According to the liquidity preference theory, investors demand interest in return for sacrificing their liquidity.
  10. Professionals

    Alternatives: Will a Market Correction Lift Them?

    When were are surging, advisors and their wealthy clients asked why they should bother with lagging alternatives. Will that change with a correction?
  1. Is the law of supply and demand a law or just a hypothesis?

    The law of supply and demand is actually an economic theory that was popularized by Adam Smith in 1776. The principles of ... Read Full Answer >>
  2. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  3. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  4. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  5. Can hedge funds outperform the market?

    Generating returns that exceed those provided by the broader market is the goal of nearly every investor. However, the methods ... Read Full Answer >>
  6. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center