Commodity Risk Management Essay Example | Topics and Well Written Essays - 4000 words

Commodity Risk Management - Essay Example Commodities with higher price volatility subject the consumer or the producer to greater probability of incurring loses or attaining gains on the future sales and buying of the product. Commodities with greater share in enterprise earning or production costs are faced with greater exposure to price risks. Various commodity risk management instrument are available and are mostly used by large producing firms, large consuming firms, trading firms, marketing firms or departments and other business ventures. The current market trends have led to the limitation of middlemen and traders and the transactions between the producer/ manufacture and final consumer have increased considerably. When the world commodity prices fall, the producer is at risk as he is not able to cover for his production costs. Also, a commodity dealer who buys products and keeps them in a warehouse is faced by the risk of not recovering his original purchasing costs. Those who process the goods are faced by double r isks due to the inputs and outputs. The final consumer only experiences the problem of increased prices. Price risks also affect traders, importers and exporters (Rutten and Blarel, 1996) The are several methods that are adopted for the management of commodity price risks, These include the adoption of marketing strategies that help time sales and purchases, Forward contracts, futures long term contracts, the use of over the counter markets. Commodity linked bonds and the use of swaps (Kolb, 1991).The choice of the instrument to use is difficult as the over the counter market is not open and transparent. The price determination depends on the bargaining strength and the availability of vital information. There is also the counterpart risk if he fails to fulfill the obligations imposed on him. Types of instruments used Forwards contracts; this involves the formation of an agreement to deliver a given quantity of goods at a given future date. The agreed forward price is paid when the product is delivered. The contract contains the price of the commodity and the quantity specified for delivery at a given date in the future. The 'long position' or the buyer receives the commodity and pays the forward price and the 'short position' or the seller delivers the commodity (UNCTAD, 1998). Futures contract: this is an agreement to deliver a given commodity in the future. The price is paid at a specified future date and at a future price payable at the time of delivering the commodity. They differ from the forward markets since they are 'marked to the market' this means that the contracts are settled each trading day. Future prices are either greater or less than the forward price. Due to the evaluation of the prices per given trading day, future contracts are usually preferred. Forward contacts are usually traded in exchanges. Futures may require settlement on daily basis if the are market to market. They are safer because the clearing house guarantees the fulfillment of the contract terms by all parties (Morgan, 1992) Cash market The behavior of most commodities in the market is determined by the cash and storage markets. The term spot price is used to refer to the immediate purchase of commodities. That means the products are bought and delivered at that time. The cash market is greatly