Commodity Linked Securities

Refers to a type of financial instrument linked to one or more commodity prices, in which coupon payments are based on the price of the underlying commodity.

Commodity-linked securities are a type of financial instrument linked to one or more commodity prices, in which coupon payments are based on the price of the underlying commodity.

Commodity linked securities

Most securities have a fixed value determined when the bond is issued. The bond's total value is composed of the bond's face value and the coupons, given by the interest rate computed on the face value. 

Commodity-linked securities are issued at the moment in which the initial value or coupon payments have the chance of changing with the market price of the linked commodity. This causes commodity-linked securities to have highly volatile prices, increasing or decreasing the actual price of the underlying commodity. The security's value will change with the commodity's price, which will be decided beforehand by the security issuer. 

Understanding Commodity-Linked Securities and Their Risks 

Commodity-linked securities provide traders with a highly speculative financial product that will give them benefits. Depending on the contract, investors will profit when the underlying commodity increases, decreases or maintains value. 

Moreover, these products have multiple functions. For example, they can provide investors with a passive source of income and a way to hedge their investments against inflation

Candlestick Graph

Usually, commodity-linked securities are likely to have long maturities, meaning they are long-term assets. 

These securities often have a lower coupon rate compared to regular ones. This is because traders have the chance to increase their profits if the commodity increases in value. 

Commodity-linked securities are typically issued by corporations that produce the underlying commodity. For example, particular securities, such as SPDR Gold Shares (GLD), are linked to gold. In addition, these kinds of securities can have a call option in the contract.

This means that the issuer has the chance to redeem the deposit before the maturity date. 

Coins

This option is crucial for the company that issues the bond because it protects them from paying large installments to investors in the event of a significant increase in the price of the underlying commodity. 

Since commodities are very volatile, their fluctuations can be an excellent opportunity for traders. 

Essentially, commodity-linked securities are more likely to have a higher level of risk when compared to ordinary securities like bonds, which have a lower degree of risk and a determined rate of return. 

These features are not included in commodity-linked securities, mainly used for speculative purposes. 

Investors are comfortable with having a higher level of risk due to the higher potential return.

However, given the high volatility, these commodities can see their initial value and coupon rate decrease dramatically. 

Key Takeaways
  • Commodity-linked securities are financial instruments linked to one or more commodity prices. For example, coupon payments are based on the price of the underlying commodity.
  • The security's total value is composed of its face value and the coupon payments until maturity. 
  • Commodity-linked securities can provide investors with a passive source of income and give them a way to hedge their investments against inflation. 
  • These securities have a lower coupon rate than regular bonds. This is because traders have the chance to increase their profits if the commodity increases in value.
  • Commodity-linked securities may have a call option in the contract. This means the issuer can redeem the security before maturity if prices rise significantly.
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Researched and authored by Alessandro Davì | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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