Commodity derivatives are investment tools that allow investors to profit from certain commodities without possessing them. The buyer of a derivatives contract buys the right to exchange a commodity for a certain price at a future date. The buyer may be buying or selling the commodity. The buyer does not have to pay the full value of the amount of the commodity in which investment is made. He only needs to pay a small percentage, known as the margin price. On agreement, the seller gives the owner the ownership of the commodity at the agreed future date along with the physical delivery. Based on the spot price of the commodity the buyer makes profit or loss. Exchanges facilitate the contract settlements and clearing.
An understanding of hedging requires an understanding of the elements of the theory of asset holding. Individuals will hold inventories of assets only in the expectation of increases in the value of those assets by at least enough to cover the costs of carrying the assets. In the case of financial assets, these carrying costs are largely the costs of the money tied up. In the case of physical inventories, there will also be costs of storage and spoilage or deterioration. Set against these costs will be certain benefits from the inventory: for merchants, for example, the inventory may be the means to increased sales or commissions.
The net costs of carrying inventory may be positive or negative, but in economic equilibrium the marginal cost of a unit of inventory must be equal to the expected price appreciation of that unit of inventory (Working 1933; Brennan 1958). This introduces an asymmetry into the behavior of expected changes in prices of storable assets. At no time can the expected price one period from now be greater than the current price by more than the marginal cost of storage for that period. Once the difference becomes equal to the costs of storage, an increase in expected future price will increase today’s price as well. On the other hand, there is no similar lower limit on the extent of expected price decreases: if prices are expected to fall, current prices will be depressed by a reduction in the amount of inventories held until the marginal value of those inventories is equal to the expected price decline. But while inventories can be accumulated indefinitely, they can be reduced only to zero.
When inventories are increased, the holder exposes himself to increased capital risk from fluctuations in the price of the goods being held. If the merchant is a risk averter, increasing his inventory increases his subjective costs of storage. To reduce that risk, he may hedge by selling for future delivery at some fixed price some or all of the inventory he owns. By doing so, he passes the risk to the speculator who buys the futures contracts.
Every trade is based on the expectation of the investor. The markets function only because someone is willing to buy and someone on the other end is willing to buy. The seller generally expects the price to fall and sells to monetise his profit, while the buyer expects the price to rise and hence enters the counter to generate returns. Speculation is the broad term for trading based on expectation, assumption or hunch. The speculation involves considerable risk of loss. The primary driver of speculation is the probability of earning significant profits. Speculation is not limited to financial instruments; it is common in other assets also. For instance, speculation is common in the real estate market. Extreme speculation leads to the formation of asset bubbles like the dot com bubble in the early 2000s and tulip bubble in medieval times. The profit margin can be high in speculative trades, so even small traders can trade based on speculation.
Arbitrage is the act of buying and selling an asset simultaneously in different markets to profit from a mismatch in prices. Arbitrage opportunities arise due to the inefficiency of the markets. Arbitrage is a common practice in currency trade and stocks listed on multiple exchanges. For instance, suppose the shares of company XYZ are listed on the National Stock Exchange in India as well as the New York Stock Exchange in the US. On certain occasions, there will be a mismatch in the share price of XYZ on the NSE and NYSE due to currency fluctuations. Ideally, after considering the exchange rate, the share price of XYZ on both the exchanges should be the same. However, stock movements, the difference in time zones and exchange rate fluctuations create a temporary mismatch in prices. Seizing the opportunity, arbitrage traders buy on the exchange where the share price is lower and sell the same quantity on the exchange with the higher share price.
Arbitrage opportunities are very short-lived as markets have been designed to be highly efficient. Once an arbitrage opportunity is used, it quickly disappears as the mismatch is corrected. While arbitrage is more common in identical instruments, many traders also take advantage of a predictable relationship between instruments. Generally, the price of a mismatch is exceedingly small. To profit from a small price differential, traders must place large orders to generate adequate profits. If executed properly, arbitrage trades are relatively less risky, however, a sudden change in the exchange rate or high trading commission can make arbitrage opportunities unfeasible.
Arbitrage vs Speculation
Arbitrage and speculation are two different financial strategies. The major differences between arbitrage vs speculation are the size of the trade, time duration, risk and structure. Only large traders can take advantage of arbitrage opportunities as they are short-lived, and the profit margin is small which requires scale. Speculation doesn’t have any such limitations; even small traders can place bets based on speculation. Speculative trades can last anywhere from a few minutes to several months, but the same cannot be said about arbitrage trades. Arbitrage opportunities arise due to market inefficiencies and disappear as soon as someone utilises it. Arbitrageurs buy and sell the same asset simultaneously. The simultaneous nature of arbitrage trade limits the risk for the trader. On the other hand, the risk of loss remains high in the case of speculative trade as speculative price movements are based on the assumption of many people.