Commodity price risk reflects changes in commodity markets. A company is exposed to commodity price risk due to fluctuations in the cost of materials used in the supply chain or if the company is a manufacturer or reseller in a commodity market. There are four commonly used ways to reduce or mitigate commodity risk.
- The company is not applying hedging practices and trying to mitigate this risk by supply managing techniques. For example, the company can accept the inventory policy to keep sufficient raw material inventory according to market conditions, initiate the forward purchases during the low price periods, etc.
- The company hedges fluctuations in commodity prices using derivative exchanges traded contracts. The company used offset methods, where a futures contract is offsetting before expiration and purchases or sales of a commodity in the local market. In this case, the company is exposed to margin and basis risks.
- Deliverable hedge in the local market. The company enters into a fixed-price contract with a supplier or customer. This contract is due for delivery at the end of the term.
- Non-deliverable OTC commodity contract. The company enters into a fixed-price contract with a commodity operator or financial institution. At the end of the term, settle any difference between the market price and the contract price.