When one speaks about investing, bonds and equities initially come to mind. Rightly so, these are the most popular constituents of an investment portfolio. Commodities, alternatively, are also investment tools investors consider.

Energy, industrial metals, grains, precious metals and livestock amongst others are all examples of daily commodities traded worldwide which contribute to the functioning of the broader economy.

Investing directly in commodities is uncommon for the typical investor. Users of raw inputs for production purposes would most likely resolve to holding physical assets and consider hedging price changes from market movements, by entering into forward contracts.

A forward contract involves no cash outflow and is an agreement between two parties (Generally the commodity user and producer) to enter into a transaction at a pre-determined price at a future date.

For example, a construction company anticipating an upturn in the real-estate market would want to lock in a good price for the industrial metals required. The company, to rationally reduce costs, can enter into a forward contract with say a steel producer to buy an amount of steel at a pre-determined price at a future date.

If the anticipation of a market upturn was correct, the construction company would have obtained steel prices at prices below the market average. Alternatively, a downturn in the economy would have resulted in the company purchasing steel at prices above the market average.

Evaluating market movements is therefore essential prior to entering into forward contracts.

Precious metals, such as gold, are often the exception when it comes to average investors not holding physical commodities. Gold can be physically stored or traded on an exchange. Gold is perceived as a safe haven during downturns in the economy, and is often used as a hedge to global currencies; given the metal’s less-than-perfect correlation with the economy.

Yet, although gold can be stored and held physically, nowadays more complex investment tools such as futures allow investors to be exposed to gold, or any other commodity for that matter, without actually receiving a physical asset at maturity.

Futures contracts, although similar to forward contracts, are traded on an exchange and do not generally result in delivery of the underlying commodity. Futures are often used for hedging and/or speculative purposes amongst other uses, and can be used by producers, commodity users and investors.

A producer may enter into selling futures contracts as insurance to protect their future sales against downturns in market prices. Similarly, users of raw materials can enter into long futures contracts to lock in favourable purchase prices if they anticipate demand to increase. Higher demand usually results in higher prices.

Investors can also benefit from commodity price fluctuations and volatility without actually purchasing or requiring the underlying physical commodity. There are numerous methods to trade commodities.

Generally, futures prices tend to converge to spot (current) prices with the passage of time. Hence, under this presumption profits can be made in the interim, whether an investor goes long or short a futures contract, only when the right market call is taken.

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

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