Types of Commodity Exchanges


Now that we have learnt about the advantages of investing in the commodity market, let us explore the types of commodity markets.

There are two types of commodity markets: the normal futures market and the inverted futures market.

Normal futures market

In a normal market, the prices of futures contracts increase with maturity. The contract with the nearest contract month is priced the lowest. Meanwhile, the contract with the most distant contract month is priced the highest.

Example : Let us assume a normal futures market with contracts maturing in each month from July 2016 to December 2016. Since the market is ‘normal’, contract prices will broadly increase as we move from a July maturity to a December maturity. The contract maturing in July will normally have the lowest price and the contract maturing in December will have the highest price. If you plot a curve of monthly contract prices, you will get an upward-sloping curve.
It is logical for the futures market to be ‘normal’. That is because carrying a commodity involves costs. These costs include insurance cost, storage cost, and interest. Together, these are the cost of carry. As the period of holding a commodity increases, the cost of carry also increases. This cost is built into the price of the futures contract. It results in an increase in the contract price as the term of maturity increases.

Inverted futures market

In an inverted market, the prices of futures contracts decrease with maturity. The contract with the nearest contract month is priced the highest and the contract with the most distant contract month is priced the lowest.

Example : Let us assume an inverted futures market with contracts maturing in each month from July 2016 to December 2016. Since the market is ‘inverted’, contract prices will broadly decrease as we move from a July maturity to a December maturity. The contract maturing in July will normally have the highest price and the contract maturing in December will have the lowest price. If you plot a curve of monthly contract prices, you will get a downward-sloping curve.
The market for a commodity is inverted when a short-term supply disruption creates a shortage of the commodity in the market. The temporary shortage pushes up the commodity’s short-term prices. It also affects the futures prices of nearby months. If the supply is expected to recover over a longer period, the prices of longer-term contracts remain unaffected.

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