70

CHAPTER-04

COMMODITY RISK MANAGEMENT

–AN OVERVIEW

4.1 INTRODUCTION TO COMMODITY RISK MANAGEMENT

4.2 VOLATILITY OF COMMODITY MARKETS

4.3 TRADITIONAL APPROACHES TO COMMODITY RISK MANAGEMENT

4.4 MARKET FOR RISK

71

4.1 INTRODUCTION TO COMMODITY RISK

MANAGEMENT

In any market, the equilibrium between supply and demand may be constant for

reasonable time. Or, if they are not, the economic agents take decisions based on

expected values. If the demand and supply can be predicted by decision makers, and

if the realized value equals the expected value, rational decision making economic

agents feel vindicated and the process is repeated period after period. However,

both supply and demand are functions of many variables which may follow different

stochastic processes. For example, consumer taste may change; their future income

may be different than expected, and so on. The most important variable is of course

the price of the product.

For the real markets, in general. Except for some input prices (e.g., crude oil),

incremental change in most major input prices, the incomes, and technology for the

product and for the substitute (complement) products, may be predicted with

reasonable certainty. The income and price elasticity may be assumed to be

constant over a small interval of time. If so, we can estimate the demand and supply

with high confidence.

In financial markets both demand and supply could have large variation over a small

period of time. For the financial markets, demand and supply for financial products

is a function of expected returns and risk over a near term and midterm period.

Since all the financial products are substitutes of each other, change in return and

risk even in one market has effect on all the other markets since the buyers of

financial products would try to change their portfolio to maximize utility. Since

demand and supply can change rapidly, the price movements of the financial assets

could be large even over a small period. In real markets, these could be due to large

72

changes in underlying supply .As a result, for commodity products, the price can

vary considerably over a small period of time. This is especially true for agricultural

commodity products since one of the major input, weather, and especially,

rainwater, is highly unpredictable. With irrigation facility, the variation in supply of

water input can be reduced. However, in absence of adequate irrigation

The volatility of the financial markets and real markets has different implications. In

financial markets, higher volatility implies less demand for the product. As long as

the long term returns are above risk-less rates, the demand for such products, for

long term investment will exist. Hence, the supplier of financial products has no

other welfare loss. The supplier of financial product earns from spreads (bonds) or

supply of real products using financial resources obtained by selling financial

product (shares).

Whereas, in the real markets, the supplier of product earns from the product itself.

Hence, he faces variable returns. Higher the variance of returns, lower is the utility

derived, since most producers of real resources are risk averse i.e., he faces price

risk and hence income risk. Thus he faces negative incentive for production.

At a macro level, high price variability could impair exports which in turn could

have an effect on growth and employment.

4.2 VOLATILITY OF COMMODITY MARKETS

Commodity markets are highly volatile. The markets have shown both short term

volatility and long term volatility. The table below is an overview of the kind of

volatility observed in world commodity markets.

73

TTAABBLLEE--44..11

WWOORRLLDD PPRRIICCEE TTRREENNDDSS AANNDD PPRRIICCEE IINNSSTTAABBIILLIITTYY OOFF MMAAJJOORR

CCOOMMMMOODDIITTIIEESS

N

O

PRODUCT PRICE INSTABILITY

INDICES

PRICE TRENDS,

CURRENT DOLLARS

PRICE TRENDS,

FIXED DOLLARS

(2000)

1980

-

1989

1990

-

1999

2000

-

2009

1980

-

1989

1990

-

1999

2000

-

2009

1980

-

1989

1990

-

1999

2000

-

2009

1 Food And

Tropical

Beverages

15.4 9.8 9.3 -3.4 -0.1 9.8 -6.8 0.1 5.7

2 Food 19.0 9.2 9.5 -3.4 -0.7 9.9 -6.8 -0.5 5.7

3 Wheat 11.0 15.5 13.5 -2.7 0.1 10 -6.1 0.2 5.8

4 Maize 9.6 12.7 13.6 17.4 0.0 9.1 13.2 0.2 5.0

5 Rice 21.9 10.9 16.8 -4.9 -0.5 14.1 -8.3 -0.3 9.9

6 Sugar 50.6 19.5 20.6 -7.5 -2.7 8.8 -10.9 -2.6 4.7

7 Beef 7.1 6.8 5.8 -0.6 -5.3 3.6 -4.0 -5.1 -0.5

8 Banana 13.3 16.6 16.0 1.5 -1.7 7.2 -1.9 -1.5 3.1

9 Pepper 31.7 17.6 25.2 12.0 19.6 6.0 8.6 19.8 1.9

10 Soybean

Meal

15.2 13.2 15.3 -0.8 -0.6 8.9 -4.2 -0.4 4.8

11 Fish Meal 18.4 16.8 10.3 -1.1 2.8 12.8 -4.5 3.0 8.6

12 Tropical

Beverages

12.7 19.2 9.7 -3.9 5.1 8.9 -7.3 5.3 4.8

13 Coffee 14.5 26.6 14.6 -2.1 6.7 9.5 -5.5 6.9 5.4

14 Cocoa 14.9 12.3 15.4 -4.9 2.6 10.2 -8.3 2.7 6.1

74

15 Tea 17.2 11.2 13.3 -2.2 2.7 3.5 -5.6 2.8 -0.6

16 Vegetable

Oil Seeds

And Oil

18.0 10.1 15.4 -4.1 3.8 11.0 -7.5 4.0 6.8

17 Soybean 13.7 9.8 13.8 -1.2 -0.1 9.8 -4.6 0.1 5.6

18 Soybean

Oil

19.2 11.7 16.4 -3.9 2.2 12.5 -7.3 2.3 8.3

19 Sunflower

Oil

18.3 12.1 17.9 -4.7 2.9 10.6 -8.1 3.1 6.5

20 Groundnut

Oil

24.8 14.0 19.8 -3.6 0.9 9.0 -7 1.0 4.9

21 Copra 27.7 15.5 21.9 -3.3 6.8 11.3 -6.7 7.0 7.1

22 Coconut

Oil

29.5 15.2 20.2 -3.7 7.6 11.0 -7.1 7.7 6.9

23 Palm

Kernel Oil

28.0 15.2 21.0 -4.9 7.6 10.5 -8.3 7.7 6.4

24 Palm Oil 22.2 14.7 18.1 -6.2 6.7 11.3 -9.6 6.9 7.2

25 Cotton Oil 14.0 9.7 25.2 -2.1 -0.3 9.4 -5.6 -0.1 5.3

26 Agricultur

al Raw

Materials

10.0 9.4 8.5 -0.2 -1.6 7.9 -3.6 -1.4 3.8

27 Linseed Oil 22.9 17.3 23.6 -2.3 1.9 12.9 -5.7 2.1 8.7

28 Tobacco 5.5 9.0 8.8 2.2 -0.5 3.5 -1.2 -0.3 -0.6

29 Cotton 14.0 16.5 12.5 -3.5 -1.6 2.7 -6.9 -1.4 -1.4

30 Wool 19.6 18.4 12.9 5.3 -0.3 3.3 1.9 -0.1 -0.8

31 Jute 25.5 19.1 15.6 0.1 -2.1 7.7 -3.3 -1.9 3.2

32 Sisal 6.3 11.2 9.0 -1.0 4.7 3.2 -4.4 4.8 -1.0

33 Hides 11.8 8.7 11.1 9.7 -0.9 -4.9 6.3 -0.7 -8.9

34 Non

Coniferous

9.7 7.8 3.9 1.4 3.6 5.4 -2.0 3.8 1.3

75

Woods

35 Tropical

Logs

15.8 6.6 10.2 3.2 -3.9 7.7 -0.2 -3.7 3.6

36 Tropical

Sawn

Woods

11.2 7.9 0.0 0.1 0.7 2.5 -3.3 0.8 -1.6

37 Ply Woods 14.3 20.0 8.1 4.8 1.5 5.2 1.4 1.7 1.1

38 Rubber 17.0 26.6 17.4 -2.1 -0.5 16.5 -5.5 -0.3 12.4

39 Minerals,

Ores And

Metals

17.6 10.3 21.0 2.3 -2.3 16.3 -1.1 -2.1 12.2

40 Phosphate

Rock

11.5 9.1 49.3 -2.5 0.6 15.9 -5.9 0.7 11.8

41 Manganes

e Ore

18.8 12.1 36.2 2.1 -9.1 16.4 -1.3 -8.9 12.3

42 Iron Ore 5.1 5.2 14.6 -2.1 -1.4 20.2 -5.5 -1.2 16.0

43 Aluminum 23.2 13.1 16.6 4.3 0.6 5.8 0.9 0.7 1.7

44 Copper 22.7 14.8 26.3 3.3 -3.9 18.8 -0.1 -3.7 14.6

45 Nickel 35.8 16.8 34.1 6.7 -3.8 14.5 3.3 -3.7 10.4

46 Lead 26.0 16.8 22.3 -1.9 -1.1 20.1 -5.3 -1.0 16.0

47 Zinc 19.3 11.8 35.9 5.9 -1.9 11.9 2.5 -1.8 7.7

48 Tin 14.8 6.9 22.7 -10.1 -0.7 15.8 -13.6 -0.5 11.6

49 Tungsten

Ore

14.0 15.7 28.8 -12.5 -1.4 17.9 -15.8 -1.2 13.7

50 Gold 14.3 8.0 7.2 -2.6 -2.6 15.2 -6.0 -2.4 11.1

51 Silver 21.7 9.1 16.3 -10.7 2.7 15.8 -14.1 2.9 11.6

52 Crude

Petroleum

12.8 15.2 20.4 -10.7 -1.6 14.7 -14.4 -1.5 10.6

(Source: World Bank, worldbank.org

76

4.2.1 REASONS FOR VOLATILITY

In financial markets both demand and supply could have large variation over a small

period of time. In real markets, volatility could be due to large changes in

underlying supply. As a result, for commodity products, the price can vary

considerably over a small period of time.

Input Variability

Specific amount of inputs are required for specific output. However, for certain

inputs it may not be easy to control the quantity. This is especially true for

agricultural commodity products since one of the major input, weather, and

especially, rainwater, is highly unpredictable. With irrigation facility, the

variation in supply of water input can be reduced. However, in absence of

adequate irrigation, the output is heavily dependent on supply of rainfall at the

right time in right quantity. Unlike other production processes, where amount of

input used is controllable, rainfall may be timely but could be much in excess of

requirement thereby causing the output to fall.

Uncertain Demand

Another major reason for price variability is the demand side. Large temporary

changes in demand can result in fluctuations of prices. For example, electricity

use is high at certain times of the day and low at other times. Oil and sugar

demand increases during festival seasons. The increasing integration of world

economies can have an adverse impact on stability of demand. For example, a

crop failure in Germany will, in such scenario, have an impact on demand on

Indian produce and thereby causing price fluctuation.

For normal manufactured goods, production processes of short duration and

inputs are controlled. For agricultural commodities, production processes are of

several month duration and where amount of input required and given are not

fully controllable by the producer. Water is only one example. Pests are another.

77

In fact amount of food loss due to pest attack could be high if pesticides are not

used.

4.2.2 CONSEQUENCES OF PRICE VARIABILITY

Increased uncertainty and risk has negative influence on supply response of the

primary producers, i.e., farmers.

Adverse impact on consumers (especially the poor since a large share of their

expenditure is on food)

The volatility of the financial markets and real markets has different

implications. In financial markets, higher volatility implies less demand for the

product. As long as the long term returns are above risk-less rates, the demand

for such products, for long term investment will exist. Hence, the supplier of

financial products has no other welfare loss. The supplier of financial product

earns from spreads (bonds) or supply of real products using financial resources

obtained by selling financial product (shares)

Whereas, in the real markets, the supplier of product earns from the product

itself. Hence, he faces variable returns due to variability of his produce. Higher

the variance of returns, lower is the utility derived, since most producers of real

resources are risk averse. i.e., he faces price risk and hence income risk. Thus he

faces negative incentive for production. Thus one most important result is

diversion of real resources from commodity production. This is especially true of

agriculture commodity and of products which are used by poorer sections of the

society. Thus, there is a direct loss of social welfare.

The second important implication is the welfare loss of the consumers. For

majority of consumers, percentage spends from income, on agricultural

commodities and power is significantly large. A large variance, even with same

expected value, would imply:

78

Distortion in savings-consumption decision ,resulting in temporary

savings, and increased transaction cost

Consumers’ inability to smoothen the consumption pattern ,directly

impacting welfare

More frightening consequence could be decline in productive capacity for certain

commodities in an irreversible fashion. If the decline is due to reduction in

demand, then it is not welfare decreasing. However, if the demand is unchanged

–or even increased- but the productive capacity has declined, due to price

variability, it directly decreases consumer welfare.

At a macro level, high price variability could impair exports which in turn could

have an effect on growth. It would also have long term impact on employment.

4.3 TRADITIONAL APPROACHES TO

COMMODITY RISK MANAGEMENT

Historically, several methods are employed for managing risks inherent in

commodity markets. Traditionally the focus is on stabilization of the commodity

prices.

4.3.1 PRICE STABILIZATION

Price stabilization is maintaining constant price or price within a band. The

governments initiate, implement policies which induce private players to participate

in the suitable markets and/or create institutions which help stabilize the prices and

/or directly participate in the price stabilization. Since stable price is welfare

increasing, all governments try to stabilize the price by specific policy measures.

4.3.1.1 Methodologies for Price Stabilisation

Need for price stabilization was first explicitly recognized during 1930s. Several

approaches were then suggested for reducing the price variability and stabilizing

the price. These approaches relied on government’s direct intervention, either in

79

terms of price, quantity or market access. Keynes was proponent of price stability as

a major policy goal to be achieved through fiscal measures. He endorsed policy of

maintaining buffer stocks to achieve price stability. He felt that the private players

would not keep sufficient stocks , or did not have means to do so and hence the

government had a direct role in storage. Several governments collaborated and

International commodity Agreements (ICA) were signed between nations to

stabilize the price for several commodities. These agreements ware for coordinated

policy measure to maintain buffer stocks and control prices. These agreements were

abandoned in 1980s as disagreements among different nations grew.

The government interventionist policies can be summarized as:

1. Support price policy to protect producers

2. Use of buffer stocks and canalized trade

3. Food prices are maintained within a price band of a floor and a ceiling price with

the help of public stocks and imports/exports

4. If the economies are integrated, then additional interventionist policies, viz.,

tariffs and restrictions on export/imports are also followed.

The interventionist policies helped reduced long term cyclicity. However, they also

resulted in increased intra-year cyclicity. The longer production cycles in the long

run and increased volatility in short run reduced price instability in the long run but

increased short term volatility. Hence, concern shifted from price stability to price

volatility. This led to gradual replacement of interventionist policy by market based

methods. Academic research (Gemmell (1985), Gilbert (1985)) at the time also

showed that market methods were more welfare enhancing then interventionist

policies. It was also realized that the government intervention was not sufficient to

manage the risk if the output itself was fluctuating widely.

Hence the need for market for risk. This has resulted in popularity of derivative

markets.

80

With opening up of the economy, the scenario has changed over the last decade.

Now, the world markets are integrated. With formation of World Trade organization

(WTO), the trade is, both, less restrictive and less costly. The rules of the trade are

universally framed and are applicable to all. This has resulted in lower barriers to

trade. There is a progressive reduction in tariff and elimination of quantity

restrictions. Shocks are globally transmitted almost instantaneously. Traditional

policies, hence, have limited effectiveness in maintaining price level.

4.3.1.2 Categories of Price Stabilization

Price stabilization policies of the government can be categorized as:

Partial Price Stabilization

Perfect Price Stabilization

Optimal Price Stabilization

If intertemporal price difference is nil, resulting from following of certain policies,

one can say that the said policies lead to perfect price stabilization. If the said

policies reduce the difference in intertemporal prices, but done not make it zero,

then they are said to lead to Partial Price Stabilization.

Perfect Price Stabilization:

Let the demand function for a product be P = f (Q), where P is the price and Q is the

quantity. f (Q) is a decreasing function of Q. Thus, if Q increases P will decrease.

Assume a two period model and assume that the demand function remains

unchanged. Then, if quantities produced are Q1 and Q2 in two periods, the prices will

be P1 and P2.

81

Thus stabilized price will be such that P* is same in both period.

P Demand Function

p1

P2

Q1 Q* Q2 Q

Quantity

FFIIGGUURREE--44..11 PPEERRFFEECCTT PPRRIICCEE SSTTAABBIILLIIZZAATTIIOONN MMOODDEELL

The prices in two periods are maintained same by creating a buffer stock or

borrowing from other markets to be repaid in the next period. Thus, consumption

and price are maintained in both the periods. Assume that the quantity produced in

the first period is Q1 and in the second period, Q2.

Then amount of buffer storage = (Q1-Q*) The cost of creating buffer storage is the

cost of the investment made. If the interest rate is r,

cost = (r)*(P*)*(Q1-Q*). -------- (4.1) (ignoring transaction and storage costs).

(Assumption is that the supply curve is such that the producer is profit neutral. This

would be satisfied if the point (Q*, P*) lies on the supply curve, and

P1Q1+P2Q2=2*(P*)*O*. The condition of (Q*, P*) lying on the supply curve is

necessary which means as if the producer is producing Q* in both the periods and

selling at price P* in both periods and hence he is indifferent between the two

outcomes. (However, indifference implies risk neutrality; otherwise this is true even

for risk averse producer since risk is purchased away.) .

82

The buffer will be liquidated in the next period at price P*. The cost of creating

buffer, (4.1), is the social cost of price stabilization.

If, the costs of perfect price stabilization are high, then the possible solution is

partial price stabilization. In partial price stabilization, price is kept within a narrow

band.

P1

P1*

Price P2*

P2

Q1 Q1* Q2* Q2 Q

FFIIGGUURREE--44..22 PPAARRTTIIAALL PPRRIICCEE SSTTAABBIILLIIZZAATTIIOONN MMOODDEELL

Suppose quantity produced in two periods are Q1 and Q2. Without price

stabilization, prices in the two periods will be P1 and P2.

If perfect price stability is desired, costs could be high. Instead, a price band is

chosen. The price would be stabilized in this price band. Supposing price band is

(P2*, P1*). Then, in the first period, amount (Q1*-Q1) will be borrowed and repaid in

the next period of bounty. In the next period the price is kept at a lower band, P2*.

Obviously, quantity (Q1*-Q1) = (Q2-Q2*)

The cost will of course depend on the supply curve. However, costs would be lower

compared to complete price stabilization since buffer stocks are lower in quantity as

also the lower price differential.

4.3.2 BUFFER STOCKS

83

The government maintains buffer stocks for several key commodities in many

developing countries. This is necessary since the markets may not have been

adequate mechanism and the welfare consequences of high prices are high. Even in

advanced countries government may maintain stocks of key commodities, e.g.,

mineral oil, Private traders do maintain stocks of commodities. However, that could

be for a short period, at best one production cycle, and that too only if it is

profitable. Hence, public sector must be involved in creating and maintaining

commodity storage facility. Such storage not only helps price stability but also

creates security.

4.4 MARKET FOR RISK

4.4.1 CROP INSURANCE

Insurance is widely used for compensation for loss, if suffered, by the holder of an

asset. This ensures that the owner is protected and hence would take risk of owning

and optimal utilization of the asset. However, traditional insurance schemes have

inherent problems of moral hazard and adverse selection. Both result in inefficient

outcomes.

4.4.2 COMMODITY DERIVATIVES

As it became evident that the price stabilization and market for risk by way of

insurance and other methods are not efficient and have inherent deficiency,

derivative markets for commodities developed. In these markets derivative

products could be bought and sold. Derivative products are products whose value is

linked to the underlying asset and could be freely traded.

Some authors had tried to compare the impact of futures markets in comparison to

buffer stock schemes (for example, Gemmell (1985) and Gilbert (1985)). These

authors concluded that derivative markets are more effective and welfare

increasing method compared to stabilization policies to manage price volatility.

84

Commodity derivative exchanges are organized market place where contracts

promising delivery/purchase of underlying goods of specified quality on a specified

future date at a predetermined price are traded. When the contract matures, either

delivery takes place or the transaction is consummated by payment of the difference

between agreed price and spot price. The exchange allows for hedging price risks

faced by the producers and consumers. The exchanges also help in price discovery.

Transaction costs are small and risk is minimized by regulations, e.g., margining.

The exchanges are regulated by the government. These exchanges thus could result

in efficiency and Pareto optimal outcomes. Derivative products are futures and/or

options.

4.4.3 COMMODITY DERIVATIVE EXCHANGES

The exchanges started in an organized manner in 2nd half of 19th century in Chicago,

USA. Derivatives on agricultural products, wheat and corn, were the first to be

traded. Today, the market exists for large number of commodities, for energy

products, for electricity and even for weather is “traded “through weather

derivatives.

Though large scale multiproduct derivative exchanges are less than 10 year old in

India, the derivative trading is more than 130 years old. The first organized futures

market was Bombay Cotton Trade Association Ltd. Established in 1875. Bombay

Cotton Trade Association was established in 1893. Gujarati Vyapari Mandali

established in 1900 started futures trading in groundnut, castor seed and cotton. By

1940, several small futures markets in oilseeds were functioning in Gujarat and

Punjab.

Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment

of the Calcutta Hessian Exchange Ltd., in 1919. East Indian Jute Association Ltd was

set up in 1927 for trading futures in Raw Jute. The Chamber of Commerce at Hapur

85

was established in 1913 for trading in wheat futures. Several other markets were

also set up for local trades. Futures market in Bullion began at Mumbai in 1920 and

later similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and

Calcutta. Over a period, exchanges were created to trade in pepper, turmeric, potato,

sugar and gur (jiggery). After the independence, Forward Contracts (Regulation)

Act, 1952, was enacted and control of all exchanges came under the purview of

Central Government. Forward Markets Commission (FMC) was set up in 1953 to

supervise and control all commodity derivative exchanges.

In the seventies, most of the registered associations became inactive, as futures as

well as forward trading in the commodities for which they were registered came to

be either suspended or prohibited altogether. Several Committees and their reports

later, and as a result of liberalized policies initiated in 1991, the government

introduced several reforms in the policy. Several new commodities were allowed to

be traded in 1993. Notable is the National Agriculture Policy, 2000, which later

resulted, in 2003, in multi commodity exchanges being set up. Three major national

level commodity derivative exchanges were set up and flourished over time. Though

there are more than 20 other exchanges, most of them single product for localized

produce, it is these three exchanges which have revolutionized the derivative

markets. The three exchanges are:

1. National Commodity & Derivatives Exchange Limited (NCDEX),Mumbai

2. Multi Commodity Exchange of India Limited (MCX) ,Mumbai

3. National Multi-Commodity Exchange of India Limited (NMCEIL), Ahmedabad

All these exchanges operate under overall supervision and control of Forward

Market Commission (FMC) of the Government of India. Recently, two more

exchanges have been permitted multi-commodity trading.

National Commodity & Derivatives Exchange Limited (NCDEX) was promoted by

ICICI Bank, LIC, NABARD and NSE, in Mumbai, in 2003. Multi Commodity Exchange

86

of India Limited (MCX), Mumbai was promoted in 2003 by Financial Technologies

(India) Ltd., State Bank of India, Union Bank of India, Corporation Bank, Bank of

India and Canara Bank. National Multi-Commodity Exchange of India Limited

(NMCEIL), Ahmedabad, started in 2002, by Central Warehousing Corporation Ltd.,

Gujarat State Agricultural Marketing Board and Neptune Overseas Limited.

The market for derivatives has grown rapidly in the last few years. Turnover in

these commodity derivative markets was Rs. 78300 billion1 during April 1, 2010 to

December 15, 2010, which was Rs. 77650 billion during 2009-10.2

(1: Times of India, 28th December, 2010, 2: Times of India, 15th April, 2010)