In any market, a commodity is an item that is produced to meet the market needs. The same is true for the derivatives market in economics too. In the commodity market, the goods have the quality of being replaced by one another. A simple example of it is the currency, which you can exchange for the same value. Here, the currency is a commodity. There are other common commodities used in the derivatives markets. Some of them are steel, pure gold, crude oil, and metals.
The value of the derivatives depends on the price of an underlying asset. The price depends on the current or future value of the underlying asset. There are different kinds of commodity Derivatives such as Forwards Futures & Options Contracts.
The forward contract is an agreement between two parties, a buyer and a seller, to sell specific assets in an agreed-upon future time. The price of the asset is decided during the time of the contract.
Imagine any commodity that is priced at INR 50,000 today. When the buyer and the seller decide an exchange on a date two years from now, they set the future price at INR 60,000 and enter a contract accordingly. The profit and loss of the two parties are determined when the actual sale is made two years later. For example, if the price of the commodity at that time is INR 65,000 then the buyer benefits by INR 5,000. However, if the price of the commodity at that time is INR 55,000 then the seller benefits by INR 5,000.
The futures contract is essentially the same as the forward contract. Under the futures contract, a commodity is sold for a pre-decided future price at a future date agreed upon the two parties. However, the futures contract is free of risks of any defaulting. The futures contracts are traded on futures exchanges, which work as the third-party that ensures that the contract is held by both the parties.
Future contracts are most commonly used in India by the agricultural sector. The price of crops can fluctuate between the time they are planted and the time they are sold. For that reason, the farmers use the futures contract to decide upon a fixed selling price for the crops for selling it to the buyer when they are expected to be ready.
Options trading under an options contract is different from the previous two. In the case of the other two contracts, the buyer and seller are obliged to complete the trade on a specific date. In case of the options contracts, the contract holder can buy or sell a certain amount of the commodity at the pre-decided rate before or on the pre-decided date. The right to sell the commodity before the expiration of the contract is called a put option. The right to buy it before or on the date of contract expiry is known as a call option.