What is Commodity Risk?

As specialists in foreign exchange risk management, Bound helps businesses (both large and small) to deal with the issue of rising and falling exchange rates. Foreign exchange risk (or currency risk as it’s otherwise known) is the risk that a business will lose money as a result of fluctuating exchange rates.

Another significant risk that many businesses face is commodity risk. Commodity risk arises from rising and falling commodity prices. With most commodities traded in US dollars, commodity risk is often managed alongside foreign exchange risk.

As with foreign exchange risk, it’s important for a business that is affected by commodity risk to understand exactly how they are affected and what they can do about it.  

What is Commodity Risk?

Commodity risk (also known as commodity price risk) is the risk that a change to commodity prices will cause a company that either produces or consumes commodities to lose money. Most importantly, a change in commodity prices can affect a company’s profitability and/or market value.

How are Businesses Affected by Commodity Risk?

The two groups that are most at risk from a change to commodity prices are the businesses that produce commodities and businesses which buy those commodities to use in production. However, as well as producers and buyers, a change to commodity prices can also have serious implications for commodity exporters.

The effect that changes to commodity prices has on producers and buyers is usually straightforward.

Producers

An increase in commodity prices will cause an increase in revenue for commodity producers. As well as increasing profitability in the short term, this can also increase the market value of a company. In some cases, however, demand will fall as a result of an increase in prices, causing a curtailment of the benefits. In other cases, market competition can increase as the general level of supply increases.

A decrease in commodity prices, on the other hand, will cause a fall in revenue for commodity producers, which could affect both the short-term profitability and the market position of a company. In some cases, there can be long-term effects on the level of production.

Buyers

For commodity buyers, an increase in commodity prices will obviously have a negative effect. Where a business has not dealt with the issue in advance or is unable to do so when the time comes (such as bypassing the price increase to customers), short-term profitability will be reduced and a company’s market value could also be affected.

A fall in commodity prices, on the other hand, will cause an increase in the short-term profitability of a company and could also increase its market value.  

How is Commodity Risk Managed?

Approaches to commodity risk management can be thought of as taking two basic forms. A company can either seek the help of an outside organisation or they can aim to manage their commodity risk by adapting the way that they do business.

When a company chooses to seek outside help, they will approach a firm similar to Bound (but which deals with commodity risk, rather than foreign exchange risk). Often, this firm will offer financial products that allow a company to fix prices in advance when either buying or selling commodities.

There are various approaches that can be taken when a company chooses to adapt the way that it does business instead.

Using Forward, Option, and Futures Contracts to Manage Commodity Risk

The main financial products that are on offer for a company that is looking to manage commodity risk with the help of specialist outside assistance are forward trades, option trades, and futures trades. These financial products create an agreement over the future price of a commodity.

With a forward or a futures trade, a company will agree to either buy or sell a specific quantity of a specific commodity on or before a certain date in the future. With an option trade, a company will effectively insure itself against either buying or selling a commodity at an unfavourable price in the future by giving itself either a minimum or maximum price.

As well as forwards, options, and futures trades, commodities swaps are also available.  

Modern Changes

While there is an initial barrier due to the inherent level of complexity associated with them, forwards, options, and futures trades are usually the most straightforward way for a business to protect itself from many types of financial risk. Forward and option trades are particularly useful in risk management as (unlike with futures trades) they can be individually tailored to the exact risks that a business faces.

Traditionally, the use of forward and option trades have been confined to only the biggest businesses with the time investment and costs associated with them, as well as their complicated nature, making their use prohibitive.

Nowadays, however, largely as a result of improvements to technology as well as increased demand from smaller businesses, forward and option trades are much more widely available. Small and medium-sized enterprises can now use forward and option trades as well.

Bound, for example, provides forward and option trades for use in foreign exchange risk management to businesses of all sizes.

Using a Forward Trade to Manage Commodity Risk

With a forward trade, a company can go to a firm to create a bespoke deal for a future sale of a commodity. This firm will agree with the company to either buy or sell a specific quantity of a specific commodity on or before a future date and, crucially, at a fixed price.

The company is then guaranteed to receive this price in the future and is not affected by changes to the normal market rate that takes place in the intervening period.

Using an Option Trade to Manage Commodity Risk

With a forward trade, both parties are committed to completing the arranged deal. With an option trade, however, a company that goes to an option trade providing firm does not make this commitment.

By paying a premium, a company will be guaranteed to be able to either buy or sell a specific quantity of a specific commodity on or before a certain date, again, at a fixed price. However, they are not committed to doing so and can choose whether to use the option trade or not.

If, when the time comes to either buy or sell the commodity, the current market rate is unfavourable, the company can use the option trade. If, on the other hand, the current market turns out to be favourable at that time, they can choose not to use it and trade at the favourable market rate instead.

Using a Futures Trade to Manage Commodity Risk

Futures trades are similar to forward trades, except that rather than being able to arrange a bespoke deal with one they are sold as standardised products on an exchange. The same deal is available, in that a specific quantity of a specific commodity is arranged to be sold on or before a certain date for a fixed price. However, the exchanges on which they are sold regulate the amounts, commodity types, dates, and prices for these arrangements.

With a forward trade, it is possible to negotiate a bespoke deal, but with a futures trade, it is not.

Adapting the Approach to Business

Instead of seeking the help of an outside firm (or exchange as is more accurate with a futures trade), a company that faces commodity risk can look to manage this risk by adapting the way that they do business.

The approach varies depending on whether the company is a producer or buyer of commodities.

Producers

With the various commodities markets being relatively simple, diversification is often key for producers when looking to manage commodity risk without outside assistance.

As in many types of business, diversification can help to spread risk around and to reduce the overall likelihood of a change in prices having a negative effect. While, to many commodity producers, it will not be possible to produce new commodities in order to spread risk where it is possible it will be likely to help. A recycling company, for example, may be able to begin to recycle a wider range of materials to avoid being dependent on the price of one material or a few.

Where diversification is not carried out in advance of potential risks, some firms aim to be able to diversify when price changes take place.

Similar to forward trade contracts, producers can negotiate production contracts directly with buyers. These will be more variable in nature than forward trades but will usually allow for the fixing of the price of a commodity over a period of time. As well as negotiating deals with commodity buyers, producers can also often group together and negotiate deals with commodity exchanges for future prices.

Buyers

Often, buyers of commodities who experience an increase in costs are able to pass this on to their customers in the form of higher prices. Where this is possible, this is often the chosen method because it is simple and completely avoids the firm being negatively affected by the price change.

Unfortunately, however, simply passing the price change on isn’t always possible.

Production contracts, as well as being helpful for producers, can also be helpful for buyers with a pre-arranged price allowing both parties to have certainty about what the future price of a commodity will be. Often in business, certainty is more important than anything else because it allows things to run smoothly.

If it is not possible to fix the price of a commodity in advance, other approaches are available. It may be possible, for example, for a business to alter production processes so that less of the commodity is used in production or so that savings are made in an alternative way. Alternatively, if an expensive commodity is used in the manufacture of one particular product that is sold as part of a range it may be possible to review the strategy behind the whole range so that share of the affected product has of that range is reduced.

Another alternative approach is to consider the use of an alternative commodity. It may be that an alternative commodity can be used appropriately in production at a lower price.

How is Currency Risk Managed?

Currency risk is managed in a similar way to commodity risk with it being possible for a company that is affected by it to either seek the assistance of a specialist foreign exchange risk management firm or to adapt the way that they do business.

Where companies, whether they be large or small, choose to seek the help of a specialist firm they will often choose to negotiate either a forward or option trade for currency exchange. Bound are specialists in this field and can be used by businesses of all sizes to set currency exchange rates in advance so that money is not lost simply to changes in the exchange rate.