Essentials of Financial Risk Management by Horcher Karen A

Author:Horcher, Karen A. [Horcher, Karen A.]
Language: eng
Format: mobi, epub, pdf
Publisher: John Wiley & Sons, Inc.
Published: 2011-07-20T22:00:00+00:00

CHAPTER 6

Commodity Risk

After reading this chapter you will be able to

Describe the unique aspects of commodity-related risks

Evaluate basic forward and futures strategies for managing commodity risk

Identify additional strategies for managing commodity price risk

Not all financial risk arises directly from financial securities prices and rates. Commodity prices are a source of market risk and an important consideration for many organizations. Commodity price risk management is enhanced considerably by a variety of hedging products, while new frontiers in related risk management products include weather risk contracts, environmental credits, and derivatives on economic indicators.

Commodities are somewhat unusual in the risk management world. Unlike financial securities, commodities are physical assets with unique attributes. Commodities must be stored, and in many cases spoilage or deterioration is a concern. As a result, there are risk management considerations that do not apply to purely financial securities.

In some cases, commodity exposures are difficult to hedge effectively. There are several reasons why this might occur. There may be weak correlation between the exposure and the available hedge. Alternatively, the market for a particular commodity may not be large or liquid enough to warrant actively traded derivatives, and therefore underlying exposure may be difficult to hedge given the hedging products available. In certain markets, it may be difficult to sell commodities short, since short selling requires the ability to borrow the product.

In some markets, major participants may offer fixed prices to their customers that are similar to forward contracts. Other alternative risk management mechanisms exist, such as crop insurance for agricultural products that may provide a recovery of 25 to 50 percent of losses.

Commodity risk management permits producers to hedge against declining prices. Similarly, manufacturers and other users reduce the risk of rising prices by hedging. The final consumer benefits from price stability as a result of the ability to hedge price risk.

Managing commodity price risk requires an understanding of the nature of the commodity risk to which an organization is exposed and the products available to assist in developing a risk management strategy. A strategy can then be considered in light of the organization’s priorities and risk tolerance.

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