Mitigating risks without financial instruments

Key takeaways:

• Protect against potential adverse price fluctuations when a derivative market does not exist.
• Customize your risk management strategy using self-insurance.
• Create a commodity hedging process that prioritizes stable cash flows.

Procurement managers and commodity producers are often exposed to price fluctuations, which can significantly impact their profitability and financial stability.

To hedge against adverse commodity price movements, market participants often turn to financial instruments such as futures, swaps, and options.

In some instances, a derivative market might not be available yet.

However, a potential solution exists.

Commodity market participants can opt for self-insurance strategies by setting aside self-insurance premiums equal to the value of a cap or floor. While caps and floors are often embedded in physical contracts, they are frequently a source of complexity in negotiations on how to price an underlying physical contract.

What is a cap and floor?

A cap in commodity trading refers to a price limit placed on a transaction or contract. It represents the maximum price at which the commodity can be bought or sold. Conversely, a floor represents the minimum price at which a commodity can be bought or sold. It acts as a price floor to protect against price declines and ensure a minimum return on investment.

Together, caps and floors provide traders with a range of possible prices for a commodity transaction, creating a level of certainty and protection against extreme price movements.

What is commodity price self-insurance?

Self-insurance is an alternative to physical market caps and floors or using derivatives to mitigate exposure to higher or lower prices. Self-insurance in the commodities market involves the establishment of a fund to cover potential losses resulting from price fluctuations. Companies exposed to commodity price fluctuations can calculate the premium cost for purchasing call or put options and allocate an equivalent amount to their self-insurance fund. This fund serves as a buffer to offset losses that may arise if prices fall below or rise above a certain level.

How self-insurance works

By setting aside self-insurance premiums, companies’ exposure to commodity prices can create a financial cushion that can help mitigate the impact of adverse price movements on their bottom line. Instead of relying solely on financial instruments that might not exist, companies exposed to commodity prices can take control of their commodity price risk management strategy and build internal reserves to protect against unforeseen events. The accounting method to buffer losses can be customized based on company practices.

The benefits of self-insurance

One key advantage of using self-insurance premiums to create a fund for price risk mitigation is the flexibility it offers. Unlike traditional insurance or hedging arrangements, self-insurance allows market participants to tailor their risk management approach to specific market conditions and operational requirements. This customized approach can create a competitive advantage and financial resilience in volatile commodity markets, especially if a derivative market is unavailable.

Another benefit of self-insurance is the potential cost savings that companies can achieve in the long run. Companies exposed to commodity prices can reduce their overall risk management expenses by avoiding premium payments to external insurance providers or financial institutions and retaining more control over their financial resources. Additionally, self-insurance premiums can generate investment income for producers if not immediately used to cover losses, further enhancing their financial position.

Managing commodity price self-insurance

However, it is essential for commodity producers to prudently manage their self-insurance fund and regularly assess its adequacy in light of evolving market conditions. Producers and procurement managers should conduct thorough risk assessments, monitor price trends, and adjust their self-insurance premiums to ensure they have sufficient resources to withstand adverse price movements.

What are the risks?

A self-insurance premium strategy is not without risks. The strategy incorporates forecasted volatility to estimate the appropriate reserve needed for commodity hedging. While it is an alternative to financial instruments and

The bottom line

In conclusion, self-insurance premiums offer commodity-exposed businesses a flexible and cost-effective way to create a fund to offset losses due to adverse price movements instead of a derivatives market. By leveraging self-insurance strategies when no derivative market currently exists, commodity procurement and producers can enhance their risk management capabilities and strengthen their financial resilience during volatile market periods. Embracing self-insurance as part of a comprehensive risk management strategy can help market participants navigate price fluctuations and safeguard their profitability.

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