By Rahul Guhathakurta
Commodity market risks are the unknowns and possible losses that can happen when you invest in things like crude oil, gold, wheat, etc. These risks can be broadly categorized into two types: market risks and operational risks.
Market risks include price volatility, supply and demand imbalances, geopolitical instability, and currency fluctuations. These risks can affect the price of commodities, resulting in losses for investors.
On the other hand, operational risks include those associated with commodities' production, transportation, and storage. These risks can lead to disruptions in supply, affecting the price of commodities.
Derisking techniques
Supply chain optimization, hedging techniques such as diversification, derivative instruments like futures and options, and forward contracts are some ways investors can reduce the risk of investing in commodities. Diversification means putting money into several different commodities to spread risk while hedging means taking positions on the market that make up for possible losses.
Using derivative instruments like futures and options can also help investors manage risk by letting them lock in prices, reduce their exposure to market volatility, and protect themselves against downside risk. Other ways to reduce risks are to watch market trends, do thorough due diligence, and develop risk management plans.
Supply Chain Optimization
An optimized supply chain can derisk commodity markets by minimizing risks associated with the transportation and storage of the commodity. This involves managing the flow of the commodity from its origin to its final destination, including storage, handling, and transportation. Also, it can help protect against losses and ensure that the commodity is delivered to the market promptly and efficiently.
There are several ways to use supply chain management to derisk commodity markets, including:
- Demand forecasting: Accurately predicting demand for the commodity to optimize production and transportation schedules, reduce inventory levels, and minimize waste.
- Contract management: Developing strong relationships with suppliers, managing contracts effectively, and selecting suitable suppliers to reduce costs and improve the quality of the commodity. Also, ensuring that contracts with transporters and other parties in the supply chain are adequately negotiated, reviewed, and managed to minimize risks.
- Quality control: Ensuring that the commodity meets the required quality standards at each stage of the supply chain, including during transportation and storage.
- Warehouse optimization, including storage and handling: Optimizing the layout and operations of warehouses to reduce the time required for loading and unloading, improving order accuracy, and reducing handling costs. Also, ensuring the commodity is stored and handled correctly to minimize the risk of damage, spoilage, or theft.
- Logistics and inventory management: Managing transportation logistics to ensure that the commodity is delivered on time and at the correct location and simultaneously optimizing inventory levels to ensure that the right amount of commodity is available at the right time and in the right location, reducing storage costs and minimizing the risk of stock-outs.
- Risk assessment: Regularly assessing the risks associated with the supply chain, including risks related to transportation, storage, and handling.
- Compliance management: Ensuring that all regulatory requirements related to the transportation and storage of the commodity are met.
Hedging
Diversification
Diversification involves investing in various assets to reduce risk. The idea behind diversification is that if one asset performs poorly, the losses can be offset by gains in other assets.
For example, investors concerned about the risks of investing in a single stock can diversify their portfolio by investing in stocks from different sectors and bonds, commodities, and other asset classes. This can reduce the impact of market volatility and the portfolio's overall risk.
Diversification can be achieved through various strategies, including investing in index funds or exchange-traded funds (ETFs) that track a broad range of assets. It can also involve investing in assets with a low or negative correlation with each other, meaning they tend to move independently.
While diversification can help reduce risk, it does not eliminate it entirely. The performance of different assets can be affected by various factors, such as economic conditions, geopolitical events, and other market forces. But, diversification can also lead to missed opportunities if a particular asset class performs exceptionally well.
As a hedging technique, diversification is often used in conjunction with other strategies, such as using derivative instruments such as options and futures, to further reduce risk and protect against market volatility.
Futures and Options
Derivative instruments such as futures and options are financial contracts whose value is derived from an underlying asset, such as a commodity, currency, or stock.
Futures contracts are agreements between two parties to buy or sell a specific asset at a future date and a predetermined price. They are used to hedge against future price movements and can be settled through physical delivery of the underlying asset or cash settlement.
For example, an investor concerned about the price of crude oil falling in the future can enter into a futures contract to sell a specific quantity of crude oil at a predetermined price. If crude oil prices fall below the predetermined price, the investor will be protected from losses.
On the other hand, options contracts give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price, known as the strike price, before or at a specific date in the future. They are used to hedge against adverse price movements or to speculate on the future direction of prices.
For example, an investor who expects the price of gold to rise in the future can buy a call option on gold, giving them the right to buy gold at a predetermined price. If gold prices rise above the strike price, the investor can exercise the option and make a profit.
Both; futures and options contracts can be used to manage risk and gain exposure to various asset classes. However, they involve leverage and can be complex instruments, requiring a good understanding of the underlying assets and market conditions.
Forward Contracts
Entering into a forward contract is a hedging strategy used by investors to manage risk in the future price of an underlying asset, such as a commodity or a currency. A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price and date in the future.
For example, a farmer concerned about the future wheat price can enter into a forward contract to sell a specific quantity of wheat at a predetermined price on a specific date. This will protect the farmer from potential losses if the price of wheat falls.
Similarly, a company that needs to purchase a large amount of foreign currency in the future can enter into a forward contract with a bank to buy the currency at a predetermined exchange rate on a specific date. This will protect the company from losses if the exchange rate changes unfavorably.
Forward contracts are typically traded over the counter, meaning they are customized agreements between the parties involved. They can be used to manage both market risk and credit risk, as the parties involved can agree to collateralize the contract or use other forms of credit protection.
One disadvantage of forward contracts is that they are less liquid than exchange-traded instruments such as futures contracts, meaning they cannot be easily bought and sold on a secondary market. They also carry counterparty risk, meaning the parties involved are exposed to the risk of default by the other party.
About the Author:
Rahul Guhathakurta (ORCID: 0000-0002-6400-6423) is a strategic management consultant. A primary investor in IndraStra Global — a US-based publishing company.
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