Commodity and Other Price Risk Exposures
Core concepts
Commodity risk includes price risk, basis risk, storage/carry cost, convenience yield, and seasonality. Hedging instruments include futures, forwards, swaps, options, and collars. Candidates must understand contango (futures above spot, normal carry) versus backwardation (futures below spot, often reflecting scarcity or convenience yield), and how these affect roll yield.
Pricing intuition
For storable commodities: F = S × e^((r + storage − convenience yield)T). The convenience yield reflects the benefit of holding physical inventory and can push futures below spot. Roll yield is the gain or loss from rolling expiring contracts and can dominate returns in commodity strategies.
Traps in questions
- Confusing contango with backwardation and mis-signing roll yield.
- Ignoring basis risk between the hedge contract's delivery point/grade and the actual exposure.
- Assuming commodity futures always trade above spot-convenience yield can invert the curve.
- Overlooking margin calls on futures during volatile price moves.
Worked example
A baker needs 100,000 bu of wheat in 6 months. Spot = $5.00/bu; 6-month futures = $5.20/bu (contango). Buying futures locks in $5.20. If spot rises to $5.60 at delivery, the futures gain offsets the higher cash price-net cost ≈ $5.20 plus basis. If the local basis widens, the hedge is imperfect; that residual is basis risk.
Rule of thumb
Hedge the exposure you actually have (grade, location, timing); the closer the hedge contract matches, the smaller the basis risk.