How to manage your commodity price risk using Futures contracts
As a business that deals with commodities, either by trading or processing them, you are exposed to a certain amount of commodity price risk. Because commodity markets are generally quite volatile (Creti et al., 2013), it is important to hedge your position (offset the risk) against this commodity price risk. A reminder of why hedging this risk is important, presented itself when the Suez Canal got blocked by a containership. We saw a decreasing supply of coffee beans causing a 2,8% increase of Robusta Futures at the London exchange. This created a risk for companies that process these coffee beans because price fluctuations affect the margins on their deals. The risk could have been mitigated by hedging your position with a futures contract. A futures contract gives you the obligation to buy or sell the underlying commodity at a predetermined price at a specific time in the future. There are multiple variations of futures contracts, for example exchange-traded versus the over-the-counter (OTC). Futures contracts are easily bought and sold through brokers like you would do with stocks. Working with the right commodity trading software is essential.
The ideal CTRM software
CTRM4JDE is an integrated ERP & CTRM solution that supports all your business processes. The software provides you with an overview of your trading, logistics and financial processes in one system. With CTRM4JDE you can record all your physical and derivatives products from contract to cash. This makes it possible for your business to enter, plan, analyze, control and report in one environment. CTRM4JDE is a great software solution for Commodity Traders that wish to have real-time insight in their positions, run mark-to-market and automate settlements.
A complete position overview in CTRM4JDE
In CTRM4JDE you can easily record the necessary information for a futures contract. This information includes (but is not limited to): broker, item, exchange, last trading day, price, quantity, exchange-traded vs over-the-counter traded, and multiple other category codes that can used to further categorize your futures contract in overviews. The advantage of being able to register your futures contracts in CTRM4JDE is that you can create a complete position overview with all your physical & derivate contracts. Both futures and physical contracts will adhere to some status flows in the software. With these status flows, you can determine your approval process, but also which contracts should be eligible for FIFO settlement for example. This ensures that your contracts will move in and out of the position seamlessly, providing an accurate position that is updated automatically.
Full integration with your Financial ERP Modules
Another added benefit of registering your futures contracts in CTRM4JDE is the automated settlement process. The settlement process is fully integrated with the financial modules of Oracle JD Edwards ERP. The CTRM4JDE software checks the current day against the last trading day of all the registered futures contracts. The software will then check if the applicable settlement price is available in JD Edwards. This settlement price can be either entered manually or via an interface with an API connection. It then creates an opposite futures contract with the settlement price as the strike price. These will be matched against each other, which creates a ‘settlement trade’. This is automatically booked in the relevant predefined General Ledger account. Automating this process significantly reduces human errors and increases the efficiency of your operations, moving from executing to a controlling process.
FIFO settle your Futures Contracts in CTRM4JDE
Another great CTRM4JDE feature is the automated FIFO settlement process. This process settles futures contracts that have certain similar specifications against each other, which is common on commodity exchange markets. If futures contracts in CTRM4JDE meet these specified criteria, they will be FIFO settled against each other. As a result, a new futures contract will be created with the results of the FIFO settlement. This process is automated and integrated with the financial modules in JD Edwards. The efficiency gain in your financial processing is enormous. Working with a more automated process makes that the financial department has a more controlling function.
Entering your futures contracts in CTRM4JDE provides you with significant efficiency gains because it automates your financial processes. Additionally, it helps you analyze your position and gives you a great insight into what needs to be hedged. Would you like to know more about our integrated CTRM & ERP solution?
Author: Douwe Disbergen
Junior Finance Consultant at Cadran Consultancy