Commodity Derivative Products And Risk Management Technique

Posted in Finance Articles, Total Reads: 3706 , Published on 25 April 2012
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India’s high GDP value in recent years suggests high income of people and thus high purchasing power. India’s population is increasing rapidly thereby proposing that demand of goods and services will increase substantially. After the dot-com bubble burst in 2000, commodities prices and the level of investment in commodities rose significantly. Derivatives markets hold an immense potential for the economy. They help in stabilizing the amplitude of price variations, bring a balance between demand and supply, act as a price barometer to farmers and the traders besides encouraging competition.

Risk

There has been a significant expansion in commodities investment in recent years, bringing with it a range of new participants. These developments raise various risks and challenges for those involved. Following are the commodities that are traded in the markets: wheat, rice, soya beans, gold, silver, copper, aluminium, gasoline etc. Commodity market is no longer a market where goods are traded for need; it has become more of an investment tool. Commodities can be traded in following ways:

  • Over the counter or Spot Market: In this type of trading commodities are exchanged on the spot. Buyers and sellers meet face-to-face and decide the price of commodity to be traded. Any commodity traded other than on formal exchange such as MCX, NCDEX etc is termed as over the counter transaction. In this kind of trading contract specifications are not standardized.
  • Forward Contract: In this commodities are exchanged at a future date at a fixed price. This type of contract is customized to suit the consumer needs and the receiver of the commodity is defined.
  • Future Contract: This contract is similar to forward contract but with some key differences. This contract is standardized and the receiver of the commodity is not fixed at the time of the contract. It can be resold again and again till actual transfer of goods or services takes place.

Derivative is a security whose price is dependent upon or derived from one or more underlying assets. A derivative instrument is a contract between two parties that specifies conditions under which payments are to be made between parties. Commodity derivatives are investment tools that allow investors to make profit without actually possessing the commodity. The value of derivative depends upon the fluctuations that take place in the value of underlying asset. Some of the examples of underlying asset are stocks, currencies, bonds etc. Some common derivatives used in commodity market are future contracts, forward contracts and options. Commodity trading faces following types of risk:

  • Market risk: This is the risk because of which there is an increase or decrease in the value of a portfolio due to changes in market factors. Some of the commonly known market factors are stock prices, interest rates, foreign exchange, and commodity prices.
  • Operation risk: It is a risk that occurs due to execution of company’s business process. It includes risk arising from people, systems and various processes through which a business carries out it functions.
  • Credit risk: As the name suggests this risk occurs when the borrower goes into default or in other words it occurs when the borrower cannot repay back. It is also called default risk.
  • Geopolitical risk: World’s natural resources are scattered in various continents and the jurisdiction over these commodities lie with sovereign governments. Access to these commodities becomes an issue and therefore a risk for commodities like oil etc.
  • Price risk: It is the risk that occurs due to decline in value of a portfolio. Unpredictability of the price change in future leads to this risk.
  • Quantity risk or yield risk: The unpredictable nature of quantity of output that can be obtained after the production process leads to this risk. For example, produce of any agricultural quantity is dependent on many external factors like weather conditions, amount of rainfall, temperature, insects etc. Not all risks can be hedged and quantity risk is one of them.

Hedging is an investment done in order to offset the losses that may be incurred in other investments. When a firm holds cash for long and then sells in future for protection against downward price exposure in the cash market it is called short hedge. When a firm holds a short cash position and then buys contracts for protection against upward price exposure in the cash market it is called long hedge.

A cross hedge occurs when the asset underlying the contract differs from the product in the cash position. Instruments for managing commodity price risk vary from forward contracts, future markets to option contracts. A key element in any hedging strategy is to determine the desired level in the trade-off between risk and return.

Forward Contract:

These are agreements to purchase or sell a specific amount of commodity on a specified future date at a predetermined price. If the actual price at maturity (spot price) is higher than the price at which forward contract was agreed upon, the buyer makes the profit. Similarly, if the spot price is lower than the price of forward contract, the seller makes the profit. For example, a jewellery manufacturer signs the contract with a gold miner to buy gold at a predetermined rate at 100 Rs. Now suppose at the predetermined date the price of gold becomes 110 Rs. then the buyer gains Rs. 10 In this type of contract actual trading of commodity takes place at the maturity of the contract.

Future Contract:

A future contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities. Future contracts are similar in nature to forward contracts but with some key differences.

  • Future contracts are traded on the exchange whereas forward contracts are generally traded in over the counter market.
  • Future contracts are highly standardized whereas forward contracts are personalized.
  • Future contracts does not specify to whom the delivery of physical asset be made while in forward contracts recipient name is mentioned.
  • Future contracts are settled daily whereas forward contracts are settled at the expiration of the contract.

Swaps:

Swaps were developed on the OTC market as a long-term price risk management instrument. With swaps, producers can effectively fix the prices they receive over the medium to long term, and consumers can fix the prices they have to pay. There is no delivery of commodities in such contracts. In a swap agreement covering a specified volume of a commodity, two prices are involved. One of these prices is variable and is usually expressed in relation to a published price index such as the price of a futures contract. The other is fixed at the time of the swap agreement. The difference between a forward contract and a swap is that swap involves a series of payments in the future, whereas a forward contract has a single future payment.

Options:

Option specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, or a currency) plus a premium based on the time remaining until the expiration of the option.

An option which conveys the right to buy something at a specific price is called a call; an option which conveys the right to sell something at a specific price is called a put. The reference price at which the underlying asset may be traded is called the strike price or exercise price. Thus they help gaining protection against unfavourable price movements.

Diversification:

Another way of managing risk is diversifying investments across a broad spectrum. Diversification spreads out risk over a variety of investment ideas, so that no single idea can be fatal to one’s portfolio. One should invest keeping in mind the portfolio theory which says that one can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated with each other. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets.

Commodity exchange in India has a lot of potential in strengthening Indian economy. Better management of risk that can be incurred can lead to more investments in these markets. They act as an alternative source of investment or investors. These markets should try to expand their base area within India. It should focus on benefiting both the consumers and producers and not only a specific section of people.

This article has been authored by Aakriti Gupta from Welingkar Institute of Management.

Image: jscreationzs / FreeDigitalPhotos.net



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