What is fungibility in commodity markets?

To grasp what fungibility is, we just need to think about cash. If you have a R$20 note, you can easily exchange it for two R$10 notes, and the value remains the same. Commodities follow the same logic: they can be readily exchanged if they belong to the same so-called species and have equal quality and quantity.

However, if you want to exchange a real work of art for a replica, you know the prices will be different. In this case, works of art are non-fungible goods, as they have exclusive attributes that lead to price differences.

Do you want to better understand how the logic of fungibility applies to commodity markets and hedging? Then keep reading!

Commodities: Why are they considered fungible goods?

Fungibility is a concept that refers to the ability to replace one unit of a product with another of the same product. In other words, if something is fungible, it means that its individual units are basically identical and interchangeable, regardless of who owns them.

Commodities are basic products, such as soybeans and coffee. With global marketing and prices that depend on international supply and demand, fungibility becomes especially relevant because every kind of commodity has common aspects for each of its units, such as density, size, and weight.

Let´s summarize the five main points showing how commodities are associated with fungibility here.

• Standardization: Commodities traded on exchanges follow standardized specifications that define characteristics such as quality, size, and weight. This ensures that the units are equivalent, even in the most diverse operations.
• Trading: Traders can buy and sell commodity contracts without considering the specific origin of the units. Hence, it doesn’t matter where the product was grown; it will have the same monetary value as long as it presents the same characteristics and quality conditions.
• Prices: Fungibility also affects the formation of commodity prices. One unit of a given type of commodity has the same value as another unit of the same type, regardless of where it was produced or stored.
• Futures and Derivatives Markets: Fungibility is essential in futures and derivatives markets where contracts are based on underlying commodities. This allows for the efficient settlement and clearing of such transactions.

How is the fungibility of commodities related to hedging?

The fungibility of commodities is closely linked to hedging in financial markets. Hedging is a tool used by companies and investors to protect themselves from the potentially extreme volatility of commodity prices.

For example, let´s imagine a company that produces and sells popcorn. It clearly needs corn as the raw material for its products. To protect itself from rising prices, the company can resort to the use of derivatives, such as futures contracts, in order to lock in a favorable purchase price two months from now. Corn is a fungible item, thus eliminating the need to assess its specific origin.

Thus, the fungibility of commodities allows companies and investors to use futures contracts as effective hedging tools, without worrying about the unique characteristics of each product. This is fundamental to the risk management process and contributes to greater stability of the transactions carried out.

Fungibility: Why is it important to grasp this topic?

Knowing about the fungibility concept makes all the difference in making well-informed decisions in negotiations. In relation to commodities, it´s possible to adopt basis strategies, for instance, to gain advantages regarding the purchase and sale of these assets in the spot or futures markets.

Fungibility allows you to determine commodity prices in a more reliable and transparent way. If all units of a commodity are considered equivalent, the price will be set based on global supply and demand, rather than on each unit´s specific details.

This also increases liquidity, as the units are interchangeable, and naturally there´s a larger number of potential buyers and sellers.

hEDGEpoint: Transforming risks into opportunities

Fungibility is a concept that must be better understood for traders to act strategically in commodity markets.

hEDGEpoint fully understands all the factors that influence this sector. With market intelligence, data analysis, and a multidisciplinary team, we operate globally while offering sophisticated hedging tools.

With the hEDGEpoint HUB, it´s also possible to deepen your knowledge of fungibility and other vital concepts needed to manage risks in agricultural and energy commodities. You can turn risks into opportunities and be better prepared to make more informed decisions.

Talk to a hEDGEpoint professional today and discover how we can help you now!