Commodity price risk

Commodity price risk cuts both ways. A rise in the price of steel raises costs for a car maker who uses it. A fall in the price of a crop hurts the farmer who grows it.

The booklet is careful to make this a two-sided risk: it "adversely impacts the financial position of those who both use and produce commodities." A producer worries about prices falling; a consumer of the same commodity worries about prices rising. Both are exposed to the same underlying uncertainty, just from opposite directions.

The booklet also lists what actually moves commodity prices — political and regulatory changes, seasonal variations, weather, technology and market conditions — and notes that farmers in particular face extra layers of risk: poor storage, the need for finance at sowing time, dependence on middlemen, small holdings with little bargaining power, and opaque or manipulated mandi prices.

The booklet's worked case: "If crop prices are low one year, a farmer may plant less of that crop. If prices subsequently rise next year, the farmer will miss out on a potentially profitable crop." That is commodity price risk working on the producer side; on the user side, "as the price of steel rises, this increases the cost of automobile production and can negatively impact that producer's profit margins."

The protection mechanism is hedging through a commodity derivatives exchange — "the process of protecting against financial loss or price risk." A hedge locks in a price today for a transaction that will actually happen later: it "will guarantee a consumer the supply of a required commodity at a set price and a producer the known price for commodity output."

India's two major commodity derivatives exchanges are MCX (predominantly non-agricultural: gold, silver, base metals, crude oil, natural gas) and NCDEX (predominantly agricultural: pulses, cereals, sugar). Trading happens through forward contracts (privately negotiated, over the counter) or futures contracts (standardised, exchange-traded, and guaranteed by the exchange's clearing house).

A cotton farmer, A, expects to harvest 10 bales in a year. He is exposed to the risk that cotton prices fall by the time he harvests.

Today, cotton trades at a price that would earn him a comfortable margin. He enters a futures contract with buyer B, agreeing now to sell his 10 bales at that price a year from today, regardless of where the market price actually goes by then.

A year later, suppose the market price of cotton has fallen sharply. A still receives the price he locked in — he has hedged his price risk and protected his income. B, who agreed to buy at that fixed price expecting prices to rise, now pays more than the prevailing market rate — B took the other side of the same risk, betting the price would move up. Neither party removed the underlying price risk from the market; they simply transferred it between themselves at an agreed price.

Chapter 5 (Investment in Securities Market) covers commodity price risk inside its broader Commodity Derivatives Market section, right after listing the seven general investment risks. Expect the exam to test the two-sided nature of the risk (affects producers and consumers differently), the definition of hedging, and which exchange (MCX or NCDEX) trades which broad category of commodity.

• Commodity price risk hits producers and consumers in opposite directions — a rising price hurts the buyer/user and helps the seller/producer, and vice versa. A question may test which side benefits from a given price move.
• MCX is predominantly non-agricultural (gold, silver, metals, energy); NCDEX is predominantly agricultural (pulses, cereals, sugar). Do not swap them.
• Forward contracts are over the counter and privately negotiated; futures contracts are exchange-traded and standardised, with the exchange's clearing house guaranteeing settlement — only futures remove counterparty default risk this way.
• Diversification, not hedging, is the tool the booklet names for volatility risk generally — hedging through commodity derivatives is the specific tool named for commodity price risk.