Physical Commodities

Unlike other financial assets, commodities have a physical component that introduces additional complexities for valuation and hedging. Physical commodities are broadly classified into energy, metals, agricultural, and livestock with each having unique characteristics. Still, commodities of the same type are subject to varying degrees of quality. Commodity investments typically use futures contracts, as opposed to spot transactions. Most futures transactions are closed before expiration and physical delivery is infrequent. The futures price is rarely equal to the spot price, and the intertemporal difference is related to the carrying costs and benefits of possessing the underlying commodity. Carrying costs include transportation, insurance, storage, and opportunity costs, while benefits are reflected in convenience yield and lease rate. Speculators seek to profit from discrepancies between markets over time. Manufacturers and end users are more likely to conduct hedging transactions, while large-scale financial institutions are more likely to conduct speculative positions.