What Is a Commodity?
A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers.
When they are traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade. They tend to change rapidly from year to year.
What's a Commodity?
The basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer. A barrel of oil is basically the same product, regardless of the producer.
By contrast, for electronics merchandise, the quality and features of a given product may be completely different depending on the producer. Some traditional examples of commodities include the following:
- Natural gas
More recently, the definition has expanded to include financial products, such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace. For example, cell phone minutes and bandwidth.
- A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type.
- Commodities are most often used as inputs in the production of other goods or services.
- Investors and traders can buy and sell commodities directly in the spot (cash) market or via derivatives such as futures and options.
- Owning commodities in a broader portfolio is encouraged as a diversifier and a hedge against inflation.
Commodities Buyers and Producers
The sale and purchase of commodities are usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. For example, the Chicago Board of Trade stipulates that one wheat contract is for 5,000 bushels and states what grades of wheat can be used to satisfy the contract.
There are two types of traders that trade commodity futures. The first are buyers and producers of commodities that use commodity futures contracts for the hedging purposes for which they were originally intended. These traders make or take delivery of the actual commodity when the futures contract expires. For example, the wheat farmer that plants a crop can hedge against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and guarantee a predetermined price for the wheat at the time it is harvested.
The second type of commodities trader is the speculator. These are traders who trade in the commodities markets for the sole purpose of profiting from the volatile price movements. These traders never intend to make or take delivery of the actual commodity when the futures contract expires.
Many of the futures markets are very liquid and have a high degree of daily range and volatility, making them very tempting markets for intraday traders. Many of the index futures are used by brokerages and portfolio managers to offset risk. Also, since commodities do not typically trade in tandem with equity and bond markets, some commodities can also be used effectively to diversify an investment portfolio.
Commodities as a Hedge for Inflation
Commodity prices typically rise when inflation accelerates, which is why investors often flock to them for their protection during times of increased inflation—particularly unexpected inflation. As the demand for goods and services increases, the price of goods and services rises, and commodities are what's used to produce those goods and services. Because commodities prices often rise with inflation, this asset class can often serve as a hedge against the decreased buying power of the currency.
Frequently Asked Questions
What are commodities?
The term “commodities” refers to basic goods and materials that are widely used and are not meaningfully differentiated from one-another. Examples of commodities include barrels of oils, bushels of wheat, or megawatt-hours of electricity. Commodities have long been an important part of commerce, but in recent decades the trading of commodities has become increasingly standardized. Today, most commodities trade on electronic exchanges such as the Chicago Board of Trade by way of futures contracts and other derivative products.
What is the relationship between commodities and derivatives?
The modern commodities market relies heavily on derivative securities, such as futures contracts and forward contracts. Through these contracts, buyers and sellers can transact with one-another easily and in large volumes without needing to necessarily exchange the physical commodities themselves. In fact, many of the buyers and sellers of commodity derivatives do not intend to make or take physical delivery of the commodities. Instead, they speculate on the price movements of the underlying commodities for purposes such as risk hedging and inflation protection.
What determines commodity prices?
Like all assets, commodity prices are ultimately determined by supply and demand. For example, a booming economy might lead to increased demand for oil and other energy commodities. If the supply of those commodities did not increase sufficiently prior to this increase in demand, the price of those commodities would increase. Conversely, economic shocks that temporarily suppress demand for a particular commodity can cause the price of that commodity to fall rapidly, especially if the producers of that commodity were unable to reduce their supply beforehand. All else being equal, commodity prices tend to also rise when investors expect more inflation on the horizon, as commodities are often seen as an inflation hedge.