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What is a Commodity Risk?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 15 November 2016
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Commodity risk is a term that is used to describe the level of volatility or risk that is associated with the trading of commodities in the futures market. Investments in commodities like electricity, metals, or grains can and do fluctuate in value based on factors such as supply on hand, the demand for those products, and even events such as the outcome of political elections or shifts in the general economy. The goal of investors is to consider the potential for future events to adversely affect the price of the commodities associated with the futures contracts and structure those contracts so that the level of risk is kept within a reasonable range.

There are several different types of commodity risk that investors will consider very closely before actually entering into a futures contract. One of the more common issues to address is the degree of risk associated with the unit price of the commodity. Here, the investor will weigh the potential for shifts in exchange rates or downward trends in local or world prices that could cause the investment to perform poorly, and determine if the futures contract is likely to yield sufficient returns to justify taking on the risk.

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Assessing commodity risk also calls for considering the degree of quantity risk that is inherent with the deal. The potential for some type of interruption in production will be considered, including the impact of that reduction in available product on the market and the commodity price. At the same time, the possibility of a sudden increase in production that exceeds demand and causes the commodity price to slump is also an important aspect to consider.

Political risk is a third component that must be included when assessing commodity risk. Here, the goal is to accurately project the outcome of elections on the performance of the commodity in the marketplace, at least for the duration of the futures contract. This includes allowing for upsets in which a candidate that was highly unlikely to be elected actually does capture the popular vote as well as determining what would likely happen to the commodity price if favored candidates were to win the elections.

As with any type of investment, commodity risk requires that investors look closely at any factors that could negatively impact the performance of the asset at any point during the futures contract. By accurately assessing the degree of risk and accurately forecasting the outcome of the contract once it is called or reaches maturity, investors can realize a health return for their efforts. Should those projections be faulty or fail to include consideration of relevant information, the potential for failure is increased and the chances of losing money rather than earning a return are higher.

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