Commodity Valuation

The process of deriving the worth or the “intrinsic value” of a commodity under market conditions described as perfect and/or optimal is known as commodity valuation. In a perfectly competitive market, the price of the goods reflects the intrinsic value of those corresponding goods.

The basic economic theory suggests that to arrive at a price for any commodity, the intersection of its demand and supply curves (better known as the break-even point) needs to be studied, and the process of commodity valuation follows just that.

Because commodity markets are mostly based on demand and supply patterns, the only method for an investor to profit off of speculation is to predict future price changes of those commodities. 

Future contracts account for the vast majority of commodity market investments. They are derivative instruments in which the holders are committed to buying or selling a specific product at a specific price and on a specific date in the future. 

Commodity prices are negotiated pre-facto, i.e., before the goods are delivered. Therefore, a significant risk is associated when negotiating a price for a particular product because spot prices or real market prices may differ significantly from contract prices. 

Due to the seller’s commitment to satisfy the contract’s conditions, the buyer may be protected from price fluctuations. However, the seller may lose money if there is a positive price movement in the future. 

Now, just as predetermined prices help investors or parties to cover themselves against adverse price changes, they also lead to the said investors losing out on positive price movements in the future due to their present-day obligations. 

Therefore, several different pricing models have evolved for determining prices that all the parties can agree upon, some of which are as follows: 

Fixed Price

A fixed price is the most basic form of settling a price for a commodity or a futures contract and is determined at the very start of the contract. It is often based on the price of the futures that have comparable sizes and delivery dates. 

Under the “fixed price” model, the two parties are obligated to trade at predetermined prices, regardless of the real market value of the traded goods at the delivery date. This acts as “insurance” for both parties against unwarranted changes.

But, more often than not, the two concerned parties also agree to revise the prices in the said contract periodically. In this way, they can be assured that their contracts are in line with the exchange prices. 

Advantages of the model

1. Finalized Pricing: Neither party can overcharge or undercharge the other, as the agreement has been laid out since the beginning. 
2. Predictability: The parties do not have to excessively worry about external factors affecting the terms of their contracts because, as mentioned earlier, under this model, pricing is predetermined. The status of the trade becomes easy to monitor.

Disadvantages of the model

1. Rigid terms: Once the contract has been agreed upon, no external factors can be accounted for or implemented within the same contract or agreement. The two parties need to negotiate separately to accommodate the necessary changes. 
2. Long-term planning: These contracts require long-term or in-depth planning. The parties have to discuss every action and every detail, along with the pitfalls associated with the said contract.

Such a model works best when the parties are undergoing a contract with definite deadlines and limited features, when the parties have clear requirements, or when the contract is for a short period.

Floor and Ceiling Price

In the floor and the ceiling price model, we are introduced to two new concepts, price ceiling and price flooring, widely recognized in economics. 

Price floor: This is the minimum price or the value at which the product or the good is allowed to be sold. It keeps the price from falling below a certain point. 

Normally, price floors are associated with agricultural goods. For example, the secretary of agriculture in the United States is responsible for setting a quota and a price floor on necessities sold in the country. 

Many unions impose price floors too. E.g., in the United States, Screen Actors Guild (SAG) imposes a minimum price that needs to be paid, which results in prices being pushed above the level of unconstrained markets.

As an example, let us consider the following illustration. 

Let us say that the demand and supply curves for the wheat market are D and S, respectively. Under the price P1, the two curves intersect at point E1, which is the equilibrium point, and therefore, a total of Q1 is produced and traded. 

Now, to assist farmers, the government imposes a price floor, under which the minimum price that can be charged is P2, which is above the equilibrium level. 

At price level P2, the demand for wheat would fall from Q1 to Q2, and the supply for wheat would increase from Q1 to Q3. Therefore, we can assume that due to the price of flooring, there will be an overproduction of wheat in the market, equal to Q2-Q3. 

Price Ceiling: This is the maximum price or the value at which the product or the good is allowed to be sold. It keeps the price from rising above a certain point.

Normally, price ceilings are associated with the production of demerit goods, i.e., goods that do more harm to consumers than good. E.g., alcohol. Governments would impose a price ceiling to deter the production of alcoholic products. 

Let us consider the following illustration. 

Let us say that for the market of alcohol, the demand and supply curves are D and S, respectively. Under the price P1, the two curves intersect at point E1, which is the equilibrium point, and therefore, a total of Q1 is produced and traded. 

Now, to deter production, the government imposes a price ceiling, under which the maximum price that can be charged is P2, which is below the equilibrium level. 

At price level P2, the demand for alcoholic products would increase from Q1 to Q3, and the supply for the same would fall from Q1 to Q2. Therefore, we say that due to the price ceiling, there will be an underproduction of alcohol in the market, equal to Q2-Q3. 

We have understood the concepts of price flooring and price ceiling. Therefore, let us briefly understand the floor and ceiling price model of commodity valuation using a similar illustration.

Under this illustration, the model will allow the values of commodities to fluctuate between prices P2 and P3. This window provides some flexibility to both parties. Huge price fluctuations under this model would lead to higher benefits for both parties. 

If the market price of the particular commodity falls within this window on P2 and P3, then that spot price becomes the price of the good on the delivery date. 

Suppose the spot price is above the equilibrium level. In that case, the seller of the commodity will gain at the buyer’s expense, and if the spot price is below the equilibrium level, then the buyer of the goodwill benefit. 

In the above illustration, as P4 is within this window, it will become the commodity’s price on the delivery date. If the market price on the delivery date is P6, both parties will share profits. 

Floating Price

A floating price is another pricing mechanism for determining a price for a commodity contract. It is the average of a reference price over a specified time. This strategy lowers the chances of a momentarily too high price at the delivery time. 

A quick spike will only have a minor impact on the total price of the commodity when using averages. Because the chance of a price fluctuation grows with the contract’s length, this pricing is especially beneficial for long-term contracts. 

The reference price for such a contract is set at the beginning of the contract and is frequently the spot price of a commodity on a major exchange.

Another method of floating price is to agree to pay the spot price at the time of delivery or a date close to the delivery date. But, again, the parties must agree on the exchange rate as the reference price. 

Due to the uncertainty of the price in the future, this pricing strategy is particularly dangerous as it can fluctuate either way. Typically, both the participants will use an exchange to hedge their pricing risks to protect themselves against price volatility.

The floating price in a swap contract, however, is the leg determined by the level of a variable, such as an interest rate, currency exchange rate, or asset price. Most swaps involve a floating and a fixed leg, though both legs can be floating. 

The party paying the floating rate anticipates a decrease in the rate over the life of the swap. In a swap, one party agrees to pay the second party a predetermined, fixed interest rate on a spurious principal on specific dates over a specified period. 

Concurrently, the second party agrees to make payments to the first party on the same notional principal on the same specified dates for the same specified period based on a floating interest rate.

Speculative Trading

The various traders that operate the market can have a significant impact on the commodity market’s volatility.

Speculative trading, often known as speculation, is buying or selling a stock based on supposition. You profit or lose based on whether your prediction is true or false. 

Speculators (also known as traders) profit by buying and selling stocks. They look for price differences, market fluctuations, and news to identify profit opportunities, like betting on whether a company will succeed or fail. 

Speculation necessitates paying close attention to short-term factors that can shift quickly, where even experts are frequently mistaken.

The end product can either be incredibly gratifying or extremely hazardous. While some speculators gain their fortunes on a successful trade, others lose everything.

Various strategies and ideas can be used to engage in various types of trading. Because it involves taking significant risks in exchange for large profits, this is commonly referred to as stock market speculation. 

These speculative traders do not adhere to normal market cycles. Instead, they develop systems to forecast when stocks will rise or fall in value. New variations on day trading or swing trading (trading over a single day) can earn you large payouts if executed correctly.

Speculative trading is simply betting on price fluctuations in securities. Traders do not typically own stock but buy and sell contracts based on their value. Futures, options, and spread trading are a few types of speculative trading.

Advantages

1. It may yield great returns if done correctly. 
2. Over the long term, index funds frequently outperform other funds, lowering risk more significantly than diversification.
3. Individuals who speculate often provide liquidity and absorb risks. 

Disadvantages

1. Requires thorough prior research about investing, sectors and companies. 
2. The research tends to be time-consuming for individuals speculating on a risky investment.

Researched and Authored by Sara Malwiya | LinkedIn

Reviewed and Edited by Abhijeet Avhale | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Call Option
• Eurex Exchange
• Herd Mentality
• Margin
• Put Option