Question

What are some ways that financiers hedge against commodity price risk? explain it with an in-depth example.

Answer 1

Commodity price risk can be defined as the probability that the commodity prices will change and that will cause financial losses for the buyers or producers of a commodity. Buyers are at the risk that commodity prices will be higher than what is expected and producers are at risk that the commodity prices will get lower.

Hedging against the commodity price risk is important to reduce the risk from commodity price fluctuation. Mostly all the big companies use techniques to hedge the commodity price risk so that their loss is minimum. Various methods are avilable to hedge -

One way to hedge is with commodity futures and options contracts. These contracts are traded on the country's stock/ mercantile exchanges and can provide a very economic option to benefit the commodity buyers and producers by reducing price uncertainty up to a certain level. Suppose, the buyer and seller have agreed upon a price of $500/ unit; so in order to hedge against the risk a future trading at price higher and lower than $500/ unit can be brought by the buyer and sellers.

Another waycan be to develop strategic methods of diversification of the commodity to reduce the risk and uncertainty related to the commodity. Diversifying the commodities shall increase the flexibility and give an edge to the buyer and seller to protect from loss of one commodity to gain from another one.