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June 16, 2008

Investing in Commodity Derivatives

Trading in derivatives market is booming as investors try to benefit from the high market volatility caused by the never ending crisis in the credit markets, and the heightened food and fuel prices that generally push inflation to unprecedented levels all around the globe. Derivatives in general, are contracts whose value is derived from an underlying asset, which can be anything really from bonds and stocks to loans, currencies, commodities, even the weather!

Traditionally, derivatives were developed for hedging and risk management purposes, but as traders and investors realised their potential to leverage profits, they are now being widely traded for speculation reasons as well.

Now, let’s take a close look to commodity derivatives and the reasons they are now growing in popularity as an investment tool, outperforming both equities and bonds in the current state of the economy.

In earlier years, trading in commodity derivatives markets was driven by people who had the need for the commodity itself, such as farmers. Examples of commodities that can be traded in the commodity derivatives markets are the following:
• Energy (including oil, the most heavily traded commodity of all)
• Precious metals, such as gold, copper, etc
• Agriculture, eg soybeans, corn, etc
• Softs, e.g. orange juice

Bloomberg reports that according to data compiled by the Bank for International Settlements, global trading in commodity derivatives has risen by 52% in the first quarter of 2008, compared to a year earlier. Energy and agricultural derivative products led the race during the first quarter of 2008, but not all major players managed to come up with the appropriate strategy to turn the game in their favor.

Goldman Sachs and Morgan Stanley are making money buying and selling commodities, and the two investment giants together accounted for about half of the $15 billion if revenue that the world’s ten largest investment banks generated from commodities last year, said a financial-services industry consultant in a Bloomberg interview.

However, analysts in the City estimate that JP Morgan has lost around $400 million in energy trading in the past two months, after taking a rather dangerous short position against the oil at $110 per barrel. In plain words, their bet was that the price of the oil will reach the ‘ceiling’ at $110, and then start falling…. In reality, the consumer fears have become the speculators hope and the fact is that oil prices now have no ceiling – only limit is the sky!

3 Responses to “Investing in Commodity Derivatives”

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