When you start dealing with physical commodities there are a lot of risks you need to be aware of! The difficulty comes from the fact that most of them are insidiously hidden and difficult to fully grasp.
Below, I categorized 7 type of risk. Please have in mind that each one of them are not in silo, the boundaries are quite blurry between each of them. The aim of this blog post is not to make you a specialist in commodity risk management but just to give you an idea of the risks involved with the activity.
Operational : This categorie includes every kind of risk within the delivery of a physical product. Shipment delay, paperwork issue, crops failure, quality problems, etc… This is the one that operators fight to minimize. Clear processes and proactive attitude from the operator in charge of the delivery are the 2 keys to handle this risk.
Country : The export/import business is ruled by the regulation from the country of import AND export, it’s twice the amount of pain. What do you think happened when Russia banned the import of food from EU on the 7th of August 2014? Containers, trucks, vessels, about to arrive/load to Russia had to be rerouted! Imagine the hassles & losses (I lived it) !
Basis : The basis is the difference between the cash price and the future price of a commodity.
CASH PRICE – FUTURE PRICE = BASIS
Lot of traders hedge 100% of their trades and only speculate on the basis movement. An unexpected movement of the basis can be devastating for the margin.
Illiquidity : Liquidity is the ability to convert capital into cash. In our case, capital could be contracts on the future market or stock of physical products. In other words, an illiquidity risk is basically the inability to sell. A liquidity/illiquidity event could literally bring down trading companies.
Performance : When you purchase or sale a commodity on the physical market, you automatically inherit from a performance risk. The risk that your counterparty doesn’t fulfill his side of the contract. Imagine, your buyer goes bankrupt & the market price is 25% less than what you concluded with your buyer at the time….
Flat price: For most of the minor commodities or special qualities, there is no way to hedge the price on a future exchange. Therefore, you are at the mercy of any movements in the price.
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Damien W.