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Managing Risk with Commodity Derivative

Commodities such as metals, agricultural products and energy products, are exposed to risk with their physical stock movement due to their fluctuating prices. This risk can be mitigated depending on timing of purchase or sale, marketing strategies, adjusting to production process and hedging.

Most of the companies mitigate the risk through hedging via financial market institutions.

Hedging allows one to mitigate risk associated with the physical stock of commodity by taking opposite position in market by means of financial instrument in a time bound manner and get benefited from position taken on market that squares off the loss arise with the physical commodity stock.

There are various types of financial instruments available for the purpose, also known as Commodity Derivatives.

Let’s try and understand from an example on how the risk can be managed by the way of hedging using a commodity derivative i.e. Futures contract on CME (Chicago Mercantile Exchange).

Example

Gold Turtle is a company into jewelry design business receives an order with specifications on 1st July, 2020 to deliver gold jewelry in three month’s time i.e. by 30th September, 2020. It would require 500 troy ounce(ozt)** of gold for the finished jewelry but only by around mid-September.

Prices can go either way up or down, but let’s consider here that the prices are to go up.

In such case, Gold Turtle to suffice the need if purchases the gold in September then it may incur loss of $9,96,500 because of the price rise.

To minimize the losses or eliminate the price risk, Gold Turtle decides to appoint a trading consultant who suggested Gold Turtle to take up long position on the Commodity Exchange.

On 1st July 2020, Gold Turtle invested $10,40,000 ($2080 * 500 ozt) to buy Gold Futures on exchange, sold them later on 15th September for $10,90,000 with Futures price as $2180.

Thus, making a gain of $50,000  ( $10,40,000 – $10,90,000 ) due to price rise in futures.

Because the Gold is needed physically to make jewelry now on 15th September 2020, Gold Turtle purchases it from physical market for $11,00,000 with spot price $2200.

Due to gain on exchange via Gold Futures, the effective cost to buy Gold is:

$10,50,000 (Effective Cost)  =    $11,00,000 (Gold Purchase) – $50,000 (Gain from trade)

i.e. Effective price for Gold Purchase is $2100, whereas the price of Gold price may have increased to $2200 in the current example.

Thus Gold Turtle has been able to minimize losses here and save $100 per troy ounce of gold.

 

Taking opposite position in market is the key that helps squaring off the losses due to price change. In the example above we just saw that how taking opposite position in market has saved significant amount of money.

Now, for the customers to take decisions on certain aspects like:

  • When one must go for hedging and for what commodities?
  • What position is to be taken in market, should go long or short?
  • How much quantity must be hedged?

To enable answer all such questions there is a need to have precise and accurate information available which can be analyzed and used to make business decisions.

SAP Commodity Risk Management provides analytics, that helps achieve above objectives by providing real time view of the consolidated commodity position (both financial and physical). Provides the insights for commodity price risk exposures across the business operations while ensuring compliance and complete audit support with single source of truth.

** 1 OZT ( Troy Ounce)  =  31.1035 grams

References:

https://help.sap.com/saphelp_pserv472/helpdata/EN/cd/6aba34d7653f75e10000009b38f83b/content.htm?no_cache=true

https://www.cmegroup.com/trading/metals/precious/gold_contract_specifications.html

https://www.mcxindia.com/docs/default-source/education-training/occasional-papers/benefits_of_hedging.pdf?sfvrsn=ce8aac93_2

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