YUSI NURLAILI ZAKIYAH

ST10194422

FRKM 202

Question- 2. What is commodity risk? Discuss the distinct characteristics of risks

associated with commodities. Provide an explanation of basic forward and futures
strategies utilized to mitigate commodity risk, Share example.
 Introduction

Nowadays, there are various kinds of investment instrument. There are investment in the
money market, capital market, and also in the commodity market. Commodities are basic raw
materials that are traded with other similar goods. Commodity investment can be done to
maximize profit income from investment. In addition, commodity investments can also be used
to diversity an investment portfolio.

However, keep in mind that commodities are a more volatile investment when compared
to other investment. To be able to invest in commodities there are a commodity market, the
commodity market is where commodities are bought and sold. This commodity market is
influenced by the level of demand and supply.

Commodity investment can be done offline in physical form or online non-physical.

Therefore this paper will discuss in more detail about commodity risk management.

A. Get to know commodity risk management

1. Definition of commodity risk management

Commodity risk is the risk caused by changes in the price of a particular commodity due
to various factors. This type of risk is related to fluctuations in commodity prices and is
influenced by demand and supply (Sofyan, I, 2004, p.5-6). Managing such risk is referred to as
commodity risk management which involves various strategies such as hedging of commodities
through forward contracts, future contracts, and option contracts.

2. Sectors exposed to commodity risk.

Generally, there are 3 sectors are most exposed to prices declines, which means they
receive less revenue for the commodities they produce.

 Mining and mineral sectors such as Gold, steel, coat, and etc.
 Agricultural sectors such as wheat, cotton, sugar, and etc.
 Energy sectors such as oil, gas, electricity, and etc.

Commodity consumers such as Airlines, Transportation companies, Apparel, and food

manufacturers are mainly exposed to price hikes, which will increase the price of the
commodities they produce. Exporters / importers face the risk of the time lags between ordering
and receiving goods and exchange rate fluctuations. In a company, such risk must be managed
appropriately so that they can focus on their core operations without exposing the business to
unnecessary risks (Linda Deelen, Mauricio Dupleich, Louis Othieno, and Oliver Wakelin, 2003,
p.72-74).

3. Commodity risk measurement methods.

Risk measurement requires a structured approach across all strategic business units
(SBUs) such as the production department, procurement department, marketing department,
finance department and risk department. Given the type of commodity risk, many businesses
will not only be exposed to the core commodity risks they face but may also have additional
exposures within the business.

a) Sensitivity analysis, is performed by selecting arbitrary commodity price movements or

based on past commodity price movements.
b) Portfolio approach, companies analyze commodity risks along with a more detailed
analysis of the potential impact on financial and operating activities.
c) Risk value, some organizations especially financial institution, use a probability
approach when conducting sensitivity analysis know as “value at risks”. In addition to
the price change sensitivity analysis discussed above, companies analyze the likelihood
of event occurring (Sofyan, I, 2004, p.27-30).

Therefore, sensitivity analysis is applied using past price history and current exposure to
model the potential impact of commodity price movement on its exposure.

B. Characteristics and methods of commodity risk management.

Commodity risk management involves strategies for dealing with the risk associated with
changes in the price and other terms of a commodity over time. There are several characteristics
and methods associated with commodity risk management (Kountur, R, 2008, p.46-49):

a) Hedging strategy

This is one of the key strategies in commodity risk management. Hedging involves using
futures or options contracts to reduce the risk of price fluctuations. By using these contracts,
businesses can lock in commodity prices at a certain level to avoid losses due to sudden price
changes.
 b) Risk factor analysis

Commodity risk management involves identifying and evaluating risk factors that affect
commodity prices. These factors may include changes in weather, supply, and demand in the
market, and other factors that affect prices (Kountur, R, 2008, p.47).

c) Diversification

In commodity risk management, diversification involves allocating investment across

different commodities. This way, risks can be spread out and reduce the negative impact of price
fluctuations on one type of commodity.

d) Using future and options contracts

Futures and options contracts allow businesses to manage commodity price risk. Future
contracts allow buyers and sellers to lock in future prices, while options provide the right to buy
or sell a commodity at a specified price (Kountur, R, 2008, p.49).

Commodity risk management should be tailored to the needs and characteristics of each
business. Each business can choose the most appropriate strategy to mitigate the risks associated
with the commodities they trade.

C. Hedging strategies for managing commodity risk.

There are 3 kinds of hedging strategies for commodity risk management, but this time I will
discuss in more depth 2 core strategies in risk management (Basyaib, F, 2007, p.158-164).

1) Forward contract.

A forward contract is simply a contract between two parties to buy or sell an asset at a
specific time in the future at an agreed price today. In this case, the risk of price changes is
avoided by locking in the price.

Example: company A and company B on 1st July 2023 entered into a contract whereby
company A sold 100 tons of wheat to company B at USD 400/ton on 1 st January 2024. In this
case, whatever the price on 1st January 2024 company A has to sell company B 100 tons at USD
400/ton (Basyaib, F, 2007, p.159).

2) Futures contract.

In simple terms, futures and forwards are the same expect that futures contracts take
place on a futures exchange, which acts as a marketplace between buyers and sellers. A contract
is negotiated on a futures exchange, which acts as a marketplace between buyers and sellers. The
buyer of the contract to be the position holder, and the selling party is referred to as the short
position holder (Basyaib, F, 2007, p. 163). Since both parties are betting their counterparty away
if the price goes against them, the contract may involve parties filing a margin of the contract
value with a mutually trusted third party.

Example: a farmer wants to sell wheat that will be harvested in 6 months. He buys a
future contract to lock in the selling price of the wheat. By doing so, he protects himself from
fluctuations in the market price of wheat (Basyaib, F, 2007, p.164).

The existence of derivative instruments gives rights or obligations to the parties

involved. By using this strategy, companies can manage risk and protect the value of their assets
from unwanted market fluctuations.
 References

Basyaib, F. (2007). Manajemen risiko (Risk management). Jakarta: PT. Grasindo.

Kountur, R. (2008). Manajemen risiko operasional, memahami cara mengelola risiko

operasional perusahaan (Operational risk management, understanding how to manage
corporate operational risk). Jakarta: PPM.

Linda Deelen, Mauricio Dupleich, Louis Othieno, and Oliver Wakelin. (2003). Leasing
for small and micro entrepises. USA: International Labour Organization.

Sofyan, I. (2004). Manajemen risiko (Risk management). Yogyakarta: Graha Ilmu.