Commodity derivatives are financial instruments that allow market participants to trade in commodities, such as gold, oil, wheat, and other raw materials, without having to take physical delivery of the underlying asset.
These
derivatives typically take the form of futures contracts or options contracts,
which give the buyer the right (but not the obligation) to buy or sell the
underlying commodity at a specified price and time in the future.
Commodity
derivatives are used by a variety of market participants, including producers,
consumers, traders, and speculators, to manage price risk and to speculate on
price movements in the underlying commodity market.
For
example, a farmer may use commodity derivatives to hedge against a drop in the
price of his crop before it's harvested, while a speculator may buy a futures
contract in anticipation of rising prices. For example, let's assume that in
April 2020 the farmer enters a futures contract with a miller to sell 5.000
bushels of wheat at $4.404 per bushel in July. On the expiration date in July
2020, the market price of wheat falls to $4.350, but the miller has to buy at
the contract price of $4.404, which is higher than the prevailing market price
of $4.350. Instead of paying $21,750 (4.350 x 5,000), the miller will pay
$22,020 (4.404 x 5,000), while the farmer recoups a higher-than-market price.