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Exposure to absolute price changes is the risk of commodity prices rising or falling. Organizations that produce or purchase commodities, or whose livelihood is otherwise related to commodity prices, have exposure to commodity price risk. IN THE REAL WORLD Some commodities cannot be hedged because there is no effective forward market for the product. Generally, if a forward market exists, an options market may develop, either on an exchange or among institutions in the over-the-counter market.

In lieu of exchange-traded commodities markets, many commodity suppliers offer forward or fixed-price contracts to their clients. Financial institutions may offer similar products to clients, provided that a market exists for the product to permit the financial institution to hedge its own exposure. Financial institutions in some markets are limited by regulation to the types of commodity transactions they can undertake, though commodity derivatives may be permitted.

Commodity Price Risk

Commodity price risk occurs when there is potential for changes in the price of a commodity that must be purchased or sold. Commodity exposure can also arise from non-commodity business if inputs or products and services have a commodity component. Commodity price risk affects consumers and end-users such as manufacturers, governments, processors, and wholesalers. If commodity prices rise, the cost of commodity purchases increases, reducing profit from transactions.

Price risk also affects commodity producers. If commodity prices decline, the revenues from production also fall, reducing business income. Price risk is generally the greatest risk affecting the livelihood of commodity producers and should be managed accordingly. Commodity prices may be set by local buyers and sellers in the domestic currency in order to facilitate local customer business. However, when transactions are conducted in the domestic currency for a commodity that is normally traded in another currency, such as U.S. dollars, the exchange rate will be a component of the total price for the commodity, and the currency exposure continues to be a consideration.

Some companies help their clients manage risk by offering domestic commodity prices. The company may fix the commodity price for a period of time or, alternatively, may pass along commodity price changes but allow customers to use a fixed exchange rate for calculating the domestic price. In the latter case, the supplier is effectively assuming the currency risk. Either scenario may be useful for small organizations or those that are only occasional buyers of a commodity and do not wish to manage the risk themselves.

Commodity Quantity Risk

Organizations have exposure to quantity risk through the demand for commodity assets. Although quantity is closely tied to price, quantity risk remains a risk with commodities since supply and demand are critical with physical commodities.

For example, if a farmer expects demand for product to be high and plans the season accordingly, there is a risk that the quantity the market demands will be less than has been produced. Demand may be less for a number of reasons, all of which are out of the control of the farmer. If so, the farmer may suffer a loss by being unable to sell all the product, even if prices do not change dramatically. This might be managed using a fixed price contract covering a minimum quantity of commodity as a hedge.

Contango and Backwardation

In a normal or contango market, the price of a commodity for future delivery is higher than the cash or spot price. The higher forward price accommodates the cost of owning the commodity from the trade date to the delivery date, including financing, insurance, and storage costs. Although the cash commodity buyer incurs these costs, the futures buyer does not. Therefore, the futures seller will usually demand a higher price to compensate for the higher costs incurred. In general, the longer delivery is delayed, the more expensive the carrying charges. As delivery approaches, the forward or futures price will converge with the cash or spot price.

Markets do not always follow the normal pricing structure.When demand for cash or near-term delivery of a commodity exceeds supply, or there are supply problems, an inverted or backwardation market may result. Market participants bid up prices for immediate available supply, and prices for near-term delivery rise above prices for longerterm delivery.

At least one highly publicized corporate loss occurred as a result of a commodity market that had traded in backwardation for some time. IN THE REAL WORLD The company may have surmised that the backwardation pricing structure would continue, and it developed its hedging and trading strategies accordingly.When the market moved from backwardation back to a normal pricing structure, the company suffered significant losses.

Commodity Basis

The basis is the difference between the cash or spot price and the futures or forward price at any point in time.A shift in the basis, where the difference between cash prices and futures prices has changed, can mean additional gains or losses to hedgers. A forward or futures contract manages price risk but not necessarily basis risk.

Basis disappears as a futures contract reaches the delivery month and futures and spot prices converge, presuming that both the spot and futures prices represent identical product. Changes in the basis can play havoc with hedging.

While the term basis has a specific meaning in futures markets, in the commodities markets it can also refer to differences due to the specifics of a particular commodity, such as its delivery point or local quality. Calculating a local basis involves adjusting market prices (such as those determined from futures exchanges) to reflect local characteristics and prices. The basis will change over time and represents a source of risk to a hedger if an imperfect hedge is used.

Special Risks

Commodities differ from financial contracts in several significant ways, primarily due to the fact that most have the potential to involve physical delivery. With notable exceptions such as electricity, commodities involve issues such as quality, delivery location, transportation, spoilage, shortages, and storability, and these issues affect price and trading activity. In addition, market demand and the availability of substitutes may be important considerations. If prices of potential substitutes become attractive because a commodity is expensive or there are delivery difficulties, demand may shift, temporarily or in some cases, permanently.