Handling Commodity Price Risk While Trading
According to the legal definition of a commodity, it is a tangible item that can be purchased or sold, and it is something produced for commerce. Hence, commodities are considered marketable goods or wares, like raw or partially processed materials, jewelry, or farm products. If you are dealing with commodity, you must know about its price risk and hedging.
What is Commodity Price Risk?
Commodity price risk refers to the financial risk on an entity’s financial performance or profitability upon fluctuations in the commodity prices that go out of control of the entity as they are driven by the external market forces primarily. Sharp fluctuations in commodity prices create significant business challenges that may impact production costs, pricing of the products, credit availability, and earnings. The volatility of the price makes it imperious for an entity to manage the effect of commodity price fluctuations across its value chain to manage its financial performance and profitability effectively.
Understanding Commodity Price Risk Hedging
Hedging is a method to use financial assets strategically to avoid the dangers of any adverse price movements. It plays a key role in risk management to protect shareholder value. Investors and shareholders assess companies based on the strength of their hedging strategy. Derivative assets like futures, options, swaps, and forwards are examples of some of the assets used by companies to hedge the physical position or asset and mitigate the risk.
You can conduct hedging by holding a short or long position against the instrument or physical product. Usually, manufacturers or producers of the commodity take the long hedge position strategy to protect from the rise of the price in the future when they must source the asset at a future price. On the contrary, a short hedge is chosen when you own the asset already, and you have to protect it from the prices falling in the future. In both cases, the hedge offsets the loss of rising and falling markets and protects the company from having diminished margins.
An Example of Hedging Using Options
Assume that a company needs to purchase aluminum as raw material. There is a risk of price increases at a specific future date that the company has to face. This is the commodity price risk on procurement. As a result, the company can decide to purchase a plain vanilla call option for hedging this exposure for that course of events. As the prices rise, they must pay the producer more for the aluminum raw material, although the gain offsets the loss, they realise on the long call aluminum option. The overall impact of all these would be buying aluminum at a specific price that the company had envisaged.
If hedging is conducted in an efficient way, it can lead to real value addition to the company. However, there is a risk involved that must be considered cautiously and monitored. The tenor of the hedge is an essential part. Corporates must revise the hedges close to expiry. Another important aspect is the liquidity and transparency of the asset that is being used for hedging. This leaves an impact on the cost of hedging.
Benefits of Commodity Price Risk Hedging
There are two major benefits of hedging against the commodity price risk. Let us see what they are.
Cash Flow Benefits
Working capital is the most important thing for running any business. However, almost every company finds it difficult to manage cash flow. Due to this reason, business owners remain vigilant to maintain the financial stability of the business. Commodity price fluctuations, especially on a significant part of the value chain, can lead to cash flow fluctuations in the business. Therefore, it is very important to forecast and protect future cash flow.
One of the benefits of commodity price risk hedging is the ability to minimize cash flow fluctuations attributed to commodity price movements. Hedging insulates the companies from this kind of volatile price movements and creates an offsetting effect to stabilize cash flow volatility in case of commodity price fluctuations with the objective of achieving almost a zero-sum game for the commodity exposures that are covered under the hedge.
Companies that are exposed to similar pricing benchmarks on their expenses and revenue side may use a net exposure approach in its hedging program. If it is done the right way, it helps in mitigating the overall exposure to commodity price fluctuation with the hedging of the net exposure. Hence, it additionally protects that portion of the impact of the exposure from commodity price fluctuation.
P/L Offset and Accounting Benefits
Let us look at these advantages in an example. The advent of Ind AS allows Indian companies to realize the impact of their hedges and exposures on the P/L by offsetting the impact on the P/L. As a result, it helps the company in reducing P/L volatility attributed to commodity price fluctuations.
Moreover, Ind AS allows undertaking hedges against highly probable forecasted exposure. Those who are off-balance sheet items cannot have their MTM impact realized on the P/L. This is for the time until the exposure is recognized as a balance sheet item. Hence, the long-term impact on hedges like earlier is now moved away from the P/L. As a result, it adds extra stability to the P/L volatility attributed to fluctuating commodity prices. However, it is important that the hedge-exposure relation is based on the offset. It must not be on the same side.
Using exchange-traded derivative contracts for commodity price risk hedging lowers the cost of hedging. It is more effective than undertaking an over-the-counter derivative contract for hedging – especially when the traded derivative contract is highly liquid. Compared to the over-the-counter market that does not require additional negotiation, and the true cost is attributed primarily to margin maintenance; this is largely attributed to the lower spreads on the quoted derivative prices. Companies that cannot pass on the expenses of commodity price fluctuation and hedges on the customer find this essential because of market pressures and competition.
Risk management is the most important factor in the financial markets. So, make sure to learn about commodity price risk hedging well before you get involved in commodities.