Managing multiple categories of risk

The commodity trader's challenge: managing multiple categories of risk

Commodity trading involves managing different categories of risk. As risk taking directly links to profit opportunities, traders aim to have the clearest understanding possible of the risks involved with each trade. In turn, traders will seek to limit their exposure by transfering certain risks to third party entities.

Similarly to other business, commodity traders are exposed to a wide range of operational risks that are managed through a combination of approaches, including insurance, IT, and health and safety audits.

Commodity trading is a low margin, high volume activity. Profits are largely based on the volumes traded and the margin between purchase and sale prices. As margins are thin, poor risk management can turn a viable business opportunity into a loss-making trade.

Contrary to a popular belief, commodity trading firms have little exposure to commodity price risk, also referred to as flat price risk. This is due to the fact that traders normally hedge physical commodity transactions with financial derivatives, reducing or offsetting the impact of any sudden commodity price swing.

By hedging, traders transform flat price risk into basis risk, which is the risk of change in the differential between the price of a commodity on the market and the hedging instrument. When there is a timing mismatch between the buying and selling orders for physical commodities and the hedging instruments, traders can also be faced with a spread risk. Commodity traders have significant expertise in managing these risks and can use a number of financial instruments to do so.

Because trading firms operate in a low margin, high volume environment, they face various kinds of liquidity risks. Securing funding for business operations and individual trades is of vital importance. In the same way, illiquid markets can be problematic as traders might not be able to sell or buy a commodity at the time or price point that would turn a profit.

Finally, traders also face other types of risks such as political risk, legal/reputational risk, contract performance ris

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