With equity markets soaring to new highs, smart investors are beginning to look for alternative strategies to diversify their risks, should the markets correct further substantially. Prices of most agricultural commodities like pulses and oilseeds, barring rice, have so far been weak this year in India. Although, it can be reasonably expected that these prices are unlikely to keep falling forever, smart investors can choose to invest through bets in anticipation of a bounce back these prices. Thus they can reduce the overall beta and consequently the risk in their portfolio.
One must, however, also consider several other risks associated with commodities trading:
The prices of agricultural commodities are as volatile as the weather – if weather conditions are favourable, there is more supply of a particular commodity thereby keeping prices low while bad weather conditions lead to shortage of supply creating price spikes. This price risk affects producers, consumers, manufacturers as well as traders of commodities. Using historical price analysis and watching key trends may help reduce price risk to some extent.
This is a risk that occurs at the time of hedging strategy execution, when the basis/difference between the spot price and futures price changes within the timeline every time a hedge is placed and when it is lifted. Generally speaking, basis in a commodities future market is fairly stable which helps in estimating the potential for loss or gain.
This risk is based on the quantity of products realised by a producer. If the producer expects high demand, he may want to increase the grain output of a certain commodity or produce more quantity of that grain. However, there is a risk that the eventual demand may, in fact, decline.
The producer may be unable to sell the entire quantity of grain or may have to sell it at a very low price or even at a loss. Quantity risk can also occur while pacing a hedge on a commodity – when the quantity of the underlying commodity in the futures contract does not exactly match the quantity to be hedged or the hedge may cover more quantity than required. This increases leverage and consequently the risk for the producer.
Commodities with higher volatility and high volumes on exchanges are exposed to intense speculation and price manipulation resulting in significant price movements which can lead to large profits or losses. It is important to carefully assess an investment decision considering all factors in order to minimise this risk
Regulatory and geopolitical Risk
There may be times when certain geopolitical tensions rise which may lead to bans on fertilisers or seeds or other crucial elements. Environmental concerns, riots, tax structures, license agreements etc are all factors that may increase or decrease the cost of producing a certain commodity leading to price variations.
In order to manage the above risks, commodity trading and risk management systems have been developed by enterprises across the globe. Smart investors try to mitigate these risks and enhance the diversification of their portfolio.