Commodity Price Risk

INTRODUCTION

Commodity price risk is the potential threat that a change in a production input price will unfavourably affect the producer of a commodity. Influences of commodity prices comprise political and regulatory changes, seasonal variations, climate, technology and market conditions. Providentially, producers can protect themselves from fluctuations in commodity prices by the use of derivative instruments to minimise uncertainty and minimise potential losses.

WHAT IS A COMMODITY

A commodity is an item that is interchangeable in commerce for another item of the same value or monetary figure. Most commodities are used as input in the production of goods ands and services. Commodities should meet certain minimum standard to add value in

Their performance depends on how another asset performed. They are financial securities whose value depends on the value of other securities underlying assets.

Derivatives are used for risk management, income generation and financial engineering. They are used widely by professional investors and many individuals. The benefits of derivatives are numerous, with their uses being; to lower funding costs by borrowers, to efficiently alter the proportions of fixed to floating rate debt, to enhance the yield on assets, to quickly modify the assets’ payoff structure to correspond to the firms market view, to avoid taxes and skirt regulations, and most importantly to transfer market risk (hedge).

FORWARD CONTRACTS

An agreement to purchase or sell a given commodity at a future date at a predetermined price is known as a forward contract. On the day of delivery, the buyer will make a profit if the spot price is higher than the predetermined price. Conversely, if the spot price is lower than the predetermined price, the buyer realises a loss. The payoff for the seller is the opposite (Varangis, P & Larson, D.

In return for the option, the buyer will then forego a small portion of the value of the underlying commodity called the premium price.

There are two types of options, namely put and the call option

A put option gives the right to a short position in the futures; this means that the holder of this option is bearish toward the price of the commodity. Suppose that the price of feeder cattle’s is currently R85per hundredweight and the anticipated decline in price is R10per hundredweight, In order for a producer to avoid the future loss due to anticipated decline in commodity prices, the producer will buy the R85put option feeder cattle futures on the SAFEX. If the producer’s projections are correct, then the increase in value of the contract will offset the decline in commodity prices. However if the price increase beyond R85per hundredweight then the producer is out of the money and will let the option lapse and the maximum loss realized, is the initial premium forgone to acquire the put option called the put