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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Commodity Market

What it is:

A commodity market is a place where buyers and sellers can trade any homogenous good in bulk. Grain, precious metals, electricity, oil, beef, orange juice and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets.

According to the New York Mercantile Exchange: "A market will flourish for almost any commodity as long as there is an active pool of buyers and sellers. There is no telling what will lubricate the wheels of commerce -- cat pelts were once a hot item in St. Louis, and today dried cocoons are a major exchange-traded commodity in Japan."

To be considered a commodity, an item must satisfy three conditions: It must be standardized, and for agricultural and industrial commodities it must be in a "raw" state; it must be usable (i.e., have a shelf life) upon delivery; and its price must vary enough to justify creating a market for the item.

How it works (Example):

Buyers and sellers can trade a commodity either in the spot market (sometimes called the cash market), whereby the buyer and seller immediately complete their transaction based on current prices, or in the futures market.

The Commodity Futures Trading Commission (CFTC) regulates commodities futures trading through its enforcement of the Commodity Exchange Act of 1974 and the Commodity Futures Modernization Act of 2000. The CFTC works to ensure the competitiveness, efficiency and integrity of the commodities futures markets and protects against manipulation, abusive trading and fraud.

There are six major commodity exchanges in the U.S.: The New York Mercantile Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, the Chicago Board of Options Exchange, the Kansas City Board of Trade, and the Minneapolis Grain Exchange. The New York Mercantile Exchange Inc. is the world's largest physical commodity futures exchange. When the hours for open outcry and electronic trading are combined, some exchanges are open for nearly 22 hours a day.

Commodities exchanges do not set the prices of the traded commodities. Rather, supply and demand determines commodities prices. Exchange members, who act on behalf of their customers or themselves, engage in open-outcry auctions in pits on the exchange floors. During an open-outcry auction, buyers and sellers announce their bids and offers. When two parties agree on a price, the trade is recorded both manually and electronically. The exchange then disseminates the price information to news services and other reporting agencies around the world.

Commodities exchanges guarantee each trade using clearing members who are responsible for managing the payments between buyer and seller. Clearing members, which are usually large banks and financial services companies, require traders to make good-faith deposits (called margins) in order to ensure they have sufficient funds to handle potential losses and will not default on the trade. The risk borne by clearing members lends further support to the strict quality, quantity and delivery specifications of commodities futures contracts.

Why it Matters:

Commodities are the raw materials used by virtually everyone. The orange juice on your breakfast table, the gas in your car, the meat on your dinner plate and the cotton in your shirt all probably interacted with a commodities exchange at one point. Commodities-exchange prices set or at least influence the prices of many goods used by companies and individuals around the globe. Changes in commodity prices can affect entire segments of an economy, and these changes can in turn spur political action (in the form of subsidies, tax changes or other policy shifts) and social action (in the form of substitution, innovation or other supply-and-demand activity).

Most buyers and sellers trade commodities on the futures markets because many commodity producers, especially those of traditional commodities like grain, bear the risk of potentially negative price changes when their products are finally ready for the market. Futures contracts, whereby the buyer purchases the obligation to receive a specific quantity of the commodity at a specific date, therefore offer some price stability to commodity producers and commodity users.

In general, however, the liquidity and stability of the commodities markets helps producers, manufacturers, other companies and even entire economies operate more efficiently and more competitively.

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