What is commodity pice risk?

What is commodity pice risk?

Agricultural and mining businesses are exposed to commodity price risk, which is the possibility that the price of the commodity will change unfavorably by the time the commodity is ready to be delivered.

They avoid unnecessary risk by using futures contracts, forward contracts, and possibly other derivative instruments. Commodity price risk means that an agricultural or mining business might not be able to predict the revenue that they can generate from the production or extraction of commodities.

This poses a big problem that is somewhat unique to the commodities sector — no other business is likely to be at the mercy of such unpredictable and uncontrollable price swings. Because commodities are fungible, and any one unit of a commodity can be reasonably replaced by a similar one from another producer, branding does not help a company control their bottom line.

What they can do is use futures and forward contracts that lock in prices well in advance. This allows the company to set a budget that can be relied upon because they will no longer be subject to fluctuations in the price of commodities.

This could mean that in some cases the company will miss out on the ability to collect more revenue, but the safety that comes with knowing how much will be paid for their goods is too important to be cast aside.

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