Underlying Commodity

The underlying commodity is the cash commodity underlying a futures contract, forward contract, commodity or futures contract, whereby a commodity option is established and should be accepted or delivered when the option is exercised. The cash commodity is furthermore specified by the minimum quality of the delivered goods and by the delivery location.

Due to this relationship there is a high correlation between the market price of the future/forward contract and the spot market price of the underlying commodity. Deviations from the perfect correlation lead to the so-called basis risk. Indexes can have several underlying commodities, using same commodity classes, for example, grain or different commodity classes like agriculture and energy.

Examples of underlying commodities:

• The IPE Brent crude oil future has the underlying Brent crude oil with delivery location Rotterdam.
• The LME copper futures have copper "Grade A" as underlying.
• CBOT wheat futures and KCBT wheat futures have wheat as underlying, but different deliverable grades: CBOT references to soft red winter wheat, KCBT to hard red winter wheat.
• The Goldman Sachs Commodity Index (GSCI) uses metals, agricultural products, and energy products as underlying commodities.
• The GSCI U.S. grain refers to the underlying commodities like corn, soybean, Chicago wheat, and Kansas wheat.

Underlying Commodity