Commodity sourcing in volatile markets

Abstract

The increasing competition in the market has put pressure on the profit margins enjoyed by the firms. The margins are further squeezed by the volatile nature of the commodity prices. Oil, Copper, Aluminum and other commodity prices have exhibited high volatility in the recent years. It is increasingly becoming important for the firms to take measures to ensure a relatively stable, if not decreasing, ratio of raw material costs to the finished products. The volatile prices of the commodities and the development of financial instruments over commodities have led to the involvement of the treasury department of the firm in commodity price risk management. Some firms are accessing the commodity derivatives markets to hedge itself from adverse movements in commodity prices. In this study we aim to develop a framework using which a firm can take a decision on the hedging requirements for its input commodities. We begin by understanding the need and importance of our work, followed by a definition of our objectives. It is followed by the insights from the interviews with the industry people. We then describe both the financial derivatives tools and the operational tools available to a firm to hedge the commodity price risk. Thereafter, we present our framework that would help a firm to decide on its hedging requirements. To provide an overall perspective, we have covered three cases, two cases when the financial markets are available and one case when they are not available. We conclude by giving our observations and certain guidelines for hedging.