The literature has emphasised the importance of PRM tools, since the availability of PRM tools can be considered as one of the key indicators of the effectiveness of PRM in a particular market. The market that has effective PRM tools available is more likely to be efficient than the market that has not. Moreover, PRM tools are usually related to PRM strategy adoption (Horcher, 2011), as some PRM strategies require a particular PRM tool; for instance, forward selling needs forward or futures contracts to be implemented. In this research, PRM instruments are categorised into five main types: cash market selling, forward, consignment selling, futures and options contracts. These are equivalent to Tomek and Peterson’s (2001) marketing groups: cash market selling in the spot-market group, forward selling in the customised trading-contract group, and futures and options contracts in the standardised derivative-contract group.
Some particular types of PRM tool are available in futures exchange markets such as futures, options and swaps contracts (Adams and Gerner, 2012). However, as Sherafatmand, Yazdani and Moghaddasi (2014) point out, some of them, like futures contracts, may not be effective enough for managing price risk of physical commodity
trading. As a result, the performance of PRM tools available to be used in the NR market will be investigated in this research based on RBIs’ perspective within the thesis findings. Some selected PRM tools, namely cash market selling, forward, futures and options contracts, will be discussed in the rest of this section of the literature review. Their advantages and disadvantages are discussed below.
Cash market selling
One of the advantages of using cash markets in selling products is no or low transaction costs. Another benefit of cash markets is that there is no requirement for specific knowledge like that for futures contract use. However, selling in a cash market means a business is exposed to incurring losses from declining prices of commodities in stock holding. As a consequence of using the cash market, traders have to bear the price risk on their own (Blank, Saitone and Sexton, 2014).
Forward contracts
Marquez and Blanchar (2004, p. 39) define a forward contract as: “a contract to buy or sell at a price that stays fixed for the life of the contract”. The forward contract provides benefits to traders in several ways. It allows traders to deliver physical products as well as manage the price risk (Blank, Saitone and Sexton, 2014). In terms of contract specification, it enables users to customise the contract to meet their specific requirements (Taušer and Čajka, 2014). According to Waldie (2014), farmers can use a forward contract to prevent unfavourable output price movements before crop harvest. Ibrahim and Okeke (2011) add that, apart from output price hedging, farmers can use them for their farm inputs as well. Moreover, Mallory et al. (2014) indicate that the forward contracts allow a commodity business to smooth their revenues over the year with comparatively cheap costs.
In spite of the benefits previously mentioned, there is an issue that dissuades commodity traders from using forward contracts (Jordaan and Grové, 2010). One of them, raised by Banterle and Vandone (2013), is that it does not permit hedgers to gain benefits when prices rise. Tauser and Cajka (2014) point out that forward contracts are often considered expensive to use and difficult to change. Blank et al. (2014) also highlight that trading prices are usually set by buyers, hence to the relative disadvantage of these small business and sold trader as sellers.
So far, informal PRM tools provided by business partners or market intermediaries have been reviewed. Next are the formal PRM tools arranged by derivative markets.
Derivative contracts, such as futures and options relevant to spot trading, may be used as PRM tools, which may potentially result in gratified hedging results (Chung-Chu et al., 2012).
Futures contracts
“A futures contract is a legally binding agreement to buy or sell a specific quantity of the underlying asset at a predetermined date in the future at a price agreed on today” (Brooks, Rew and Ritson, 2001, p. 17). A futures contract specification, such as contract size, date and place of delivery, is considered more standardised than that of a forward contract (Taušer and Čajka, 2014). Williams (2001) points out that a futures contract enables traders to easily offset their contract positions by buying the opposite contracts; as a consequence, it persuades non-physical traders or speculators to facilitate trading activity in the markets. However, various economists question the role of speculators in either supporting or undermining market trading (Williams, 2001), as discussed in Appendix D.
Although futures contracts provide a method to hedge price risk, a considerable amount of literature has been concerned with the effectiveness of futures markets on price risk hedging (Aggarwal, Jain and Thomas, 2014; Sherafatmand, Yazdani and Moghaddasi, 2014). The hedging effectiveness may be undermined by price basis, trading illiquidity, excessive speculation or even governments’ price intervention schemes (Aggarwal, Jain and Thomas, 2014). Yaganti and Kamaiah (2012) highlight the price basis risk, the movement between physical and derivative prices, as a trade-off factor for price hedging. In other words, to eliminate price risk using derivative contracts results in alternative risk, called the basis risk. In their timely research, Revoredo-Giha and Zuppiroli (2013) highlight the occurrence of the basis risk during periods of price volatility. Moreover, like the forward contract, the futures contract does not permit hedgers to gain additional profits from rising prices (Banterle and Vandone, 2013). One another issue in using future contracts in hedging is its costs (Aggarwal, Jain and Thomas, 2014).
There is also an issue of unpopularity of physical product delivery according to futures contracts for some commodities. For example, in the cattle market it is hard to see such a delivery (Blank, Saitone and Sexton, 2014). Other delivery problems include delivery location, warehouse system reliability and commodity specification (Aggarwal, Jain and Thomas, 2014).
Options contracts
Unlike those of forward and futures, options contracts allow users to hedge their price risk as well as enjoy benefits from price movements in their favour (Taušer and Čajka, 2014). “An options contract is a form of insurance that gives the option purchaser the right, but not the obligation, to buy (sell) a contract at a given price.” (Lane, Richter and Sheblé, 2000, p. 204) To gain an options contract, options users have to pay a premium to the sellers (Taušer and Čajka, 2014).
Apart from the problem of availability of options contracts in the market, users have to pay contract premium costs to obtain the contracts (Taušer and Čajka, 2014). Moreover, the contract price tends to be high during the period of price volatility as the premium price is usually derived from market price movements. Shackleton and Voukelatos (2013) criticise that, in such circumstances, the performance of options hedging weakens when users need it the most. Similar to futures contracts, Blank et al. (2014) note that the delivery of physical products according to options contracts has rarely occurred in cattle markets.