Question

Discuss three strategies used in managing commodity price risk.

Answer 1

Three strategies used in managing commodity price risk

1. Forward contract: This instrument can be used for managing commodity price risk by locking in future price and fixed date for the transaction. Commodity producer stays on short side of the contract as they are long on the commodity via producing the commodity. This requires the physical settlement of the commodities

2. Futures: This instrument is also used to hedge the price risk but without requiring physical settlement. Futures are tradable on exchanges. Futures are easy to handle as these are structured instruments with no counterparty risk

3. Options: These are the instruments which give the right not the obligation to buy or sell the asset. Price risk can be managed by hedging through options. Options are less expensive and volatile.