The commodity market needs many participants with different investment objectives and risk profiles. This allows the market to function effectively. The participants play different roles in the market by using the commodity futures contract. We have described the latter concept in the previous chapter.
As a commodity market participant, you could take up one of three roles: hedger, speculator, and arbitrageur.
Hedgers are commercial producers or consumers of a traded commodity. Examples are copper smelters, oil companies, farmers, and jewellers. Hedgers are exposed to commodity price volatility in the spot market. They use the futures market to offset (hedge) this risk. Suppose gold prices are unstable. A jeweller would want to offset a possible risk of loss on his monthly gold purchases due to this volatility. If he expects the price to rise next month, he could go long on (buy) a gold futures contract with a one-month expiry period. The contract will let him buy gold at the current price even if the prices rise in a month. But, if the prices fall during this time, he will not profit from it. That is because he still has to buy gold at the price specified in his futures contract.
Speculators may not have any exposure to the spot market. To them, commodity futures are an investment avenue, like the stock market. They try to make money by speculating on commodity prices, just as they would by speculating on stock prices. As such, speculators never receive delivery of the physical commodity. They take a position in commodity futures and square it off before expiry. This means, they settle by buying or selling a contract that is exactly the opposite of the contract they currently hold. This only involves payment in cash and no delivery of the underlying commodities.
Arbitrageurs try to profit from the difference in the prices of the same commodity in two different markets. They take a long position (buy) in the market where the price is lower and a short position (sell) in the market where it is higher. The difference between the two prices is their profit. Arbitrage transactions are usually risk-free. Constant arbitrage reduces the price in the market where it is higher and increases it in the market where it is lower. Arbitrage stops when prices become similar in both markets.
Their varying preference for risk and return distinguishes market participants from each other. The different categories of participants respond differently to a market development because of their differing risk-return preferences. These differing responses determine how the market price of a commodity will move.
Hedgers have the lowest risk appetite of the three categories. They see fluctuations in commodity prices as a risk and use the futures contract to mitigate it. Making a profit on the trade is the least of their concerns.
Speculators enter the market only to make a profit, without caring much for the implicit risk. They make aggressive bets and are fine with losing money along the way.
Arbitrageurs are also driven by the profit motive. But their bets are less risky than those of speculators. Arbitrageurs play the most important role in price discovery. That is because they keep performing arbitrage until prices in the different markets reach parity.
In the next chapter, we will understand why commodity futures are a good investment avenue, given their many advantages. We will also look at the different commodities that trade on the commodity market.