Investing 101

## TL;DR

- Raw materials which can be consumed (like food) or used to create other products, and traded in financial markets
- Spot commodities and derivative commodities markets 
- Hard commodities and soft commodities 

## What are commodities? 

Commodities are raw materials such as copper or coffee, that can be bought and sold. These commodities can be traded on the commodity market: a place where buyers and sellers of raw materials come together to transact. These people come together to ensure present production through current orders or future orders for later consumption. The commodity market can be split into 2: spot orders that involve immediate delivery or derivative orders that involve future delivery. Investors can get directly involved in the commodities market through a range of investment vehicles. 

There are 2 categories of commodities: hard and soft. Hard commodities refer to natural resources that are extracted from our planet, like coal or gold. On the other hand, soft commodities are usually products used in our food (agricultural or livestock) like corn or chicken. Since prices of commodities move opposite to stock prices, investors rely on commodities for diversification and hedging their portfolio against inflation risk. For example, the value of the dollar is dependent on monetary policy and fiscal policy but precious metals like gold derive their value from different factors, isolating them from inflation. 

## Types of Commodity Markets

Commodities either trade in the spot or derivatives markets. The spot market is where buyers and sellers trade physical commodities and these will be delivered to the respective party immediately.

Derivatives markets involve derivative securities: forwards, futures and options. Forwards and futures are contracts to transact at a future date with a predetermined price. Forwards and future contracts are the same except forwards can be customized and traded over the counter. On the other hand, futures are standardized and only traded on exchanges, guaranteeing the transaction with a clearinghouse. 

## Benefits and drawbacks

Investing in commodities provides exposure to growth opportunities with good potential returns. For example, this year, lumber saw its price rise as high as 370% as homeowners used money saved up from the COVID pandemic for home renovations. As mentioned earlier, commodity prices also have a low correlation with stocks and therefore great to diversify one’s portfolio - reducing their risk. Essentially, this hedges an investor’s portfolio against inflation. 

On the other hand, while prices can drastically rise, prices can dramatically fall too. It is said that investing in commodities is twice as volatile as investing in stocks. At the start of the COVID pandemic, when lockdowns began and demand for oil vanished, oil producers had no one to sell their supply to. As a result, production continued, storage filled up but nothing was being sold. No one wanted to buy oil when the future was so uncertain. As a result, in April 2020, oil prices went negative, forcing sellers to pay people to take oil. Lastly, unlike stocks that generate income in capital or dividend gains, commodities do not provide investors with any income. 



Commodities are raw materials such as copper or coffee, that can be bought and sold. 

What are Commodities?

Types of Assets

## TL;DR

- Options, forwards, futures and swaps are types of derivative instruments 
- Derivative contracts track the performance of an “underlying” asset. 
- Majority trade in the OTC markets but some trade on standardized exchanges 
- Good source of return and portfolio diversification 
- High risk and highly unregulated 

## What are derivative contracts? 

Derivative contracts began in the agricultural industry where one party to a contract agreed to sell goods to the other party at a specified price on a specific date. 

Derivative contracts allow parties to transact an option of a security, either immediately or at a later date. The security is referred to as the “underlying” as it drives the value of the derivative contract. This allows holders to hedge risk (in terms of price fluctuations) and accelerate returns. Similar to alternative investments, derivative contracts are also leveraged, so as high as the gains can be, the losses can be deep too. 

Most derivatives are traded in the over-the-counter market but as mentioned above, some options and futures are traded only on standardized exchanges. This allows the clearing house to guarantee the transaction occurs. 

## Benefits and drawbacks 

By investing in derivative contracts, the holder can “hedge” against the underlying asset i.e. gain protection against the price moves of the asset.

For example, if a producer of sugar likes the price today and is worried that it would go down in a few months, he can hedge his position by selling sugar at today’s price, thus effectively betting that the price would fall tomorrow. This transaction would protect the producer from any fluctuation in price in the future. A speculative trader would take the other side of the bet if she believed that the price of sugar would instead increase in the future.

In another example, interest rate swaps allow users to lock in favorable rates relative to the interest rate from directly borrowing. 

Did you know that credit-default swaps, a type of derivative contract, led to the collapse of financial institutions and eventually the Global Financial Crisis? The volatility involved in trading derivatives is very high, exposing investors to potentially large losses. The unregulated nature of derivatives also make them very complex and difficult to fairly value. As a result, these contracts are made available only to institutional or experienced investors. In addition to downside risk, there is a chance that the counter-party you are doing business with might default on their payment. 



What are Derivative Contracts?

TL;DR

What are derivative contracts?

Benefits and drawbacks

What are Commodities?