Price Risk in Commodities
Equity risk, interest rate risk and exchange rate risk have already been discussed, but this chapter examines commodity price risk. The commodity price risk deals with uncertainty about future earnings resulting from changes in commodity prices.
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7.1
Basic Concepts
Equity risk, interest rate risk and exchange rate risk have already been discussed, but this chapter examines commodity price risk. The commodity price risk deals with uncertainty about future earnings resulting from changes in commodity prices. As is well known, all production processes require “inputs” or commodities which are transformed into other products through industrial techniques. These products may well be the commodities of another production process to be sold in the retail market. In this case, when the product is sold in the final retail market, its price is set by marketing strategies that are beyond the scope of this book. Conversely, commodities are generally used by various companies, industries and sectors that produce different products which are usually sold in organised wholesale markets, for example the Chicago Mercantile Exchange. These commodities always have a market price and therefore, when dealing with them, the investor is subject to the commodity price risk defined in the previous paragraph. The share price fits very naturally into the definition of a random walk, as it follows the principle that at any given moment in time all © The Author(s) 2017 F.J. Población García, Financial Risk Management, DOI 10.1007/978-3-319-41366-2_7
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Financial Risk Management
information is incorporated in the price, and therefore the best prediction of the price tomorrow will be the price today plus a noise which represents the information that enters the market between today and tomorrow. Therefore, when dealing with the commodity price risk, a first approach could be to equate it to equity market risk and apply the same principles. The problem is that this would not be suitable because commodities have two features that shares do not: storage costs and convenience yield. These two features of commodities cause prices to behave in a specific way that is reflected in the way the prices of their associated derivatives behave, especially the price of futures at different maturities, that is, the forward curve, which in some cases presents phenomena as distinct as seasonality.
7.1.1 Storage Costs At present, the shares of a company are electronic entries in value markets and/or depositary entities and thus, except for administration and custody costs, which are not usually material, they incur no costs. Of course, the owner of the shares is subject to market risk and if the market price rises, they make profits while if it falls, they lose profits, but under no circumstances must they bear any cost. It is, therefore, reasonable to assume that at any given point in time all the information is incorporated into the price and, consequently, the best prediction of the price tomorrow will be the price today plus a noise which represents the information that will enter the market between today and tomorrow. Otherwise, if all the market information is not included in the price, it will mean that the asset is overvalued or undervalued because there is information that is not incorporated i
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