In recent years, there has been an increasing interest in PRM as a consequence of the volatility of commodity markets (Zsidisin and Hartley, 2012; Revoredo-Giha and Zuppiroli, 2013). As a result, price risk has become one of the main issues, if not the most important issue, in agricultural commodity trading, ranging from producers (Banterle and Vandone, 2013; Broll, Welzel and Wong, 2013; Sherafatmand, Yazdani and Moghaddasi, 2014), to commercial traders (Berling and Rosling, 2005), to financial investors (Deng, Zhang and Zhao, 2009), to users (Tang, 2015) and consumers (James, 2007). A significant issue is how stakeholders who are exposed to risk manage it (Morgan, Cotter and Dowd, 2012). In this section of the review, some important literature in relation to PRM strategies will be assessed.
PRM strategies play a crucial role in commodity trading as they are the key determinant of business performance (Newman, 2009; Ni et al., 2012). There are a variety of PRM strategies that supply chain players may be able to select from, for instance, stocking, back-to-back selling, forward selling, or a mix of these to create a portfolio management. However, the formation of management strategies in small business tends to be not explicit (d'Amboise and Muldowney, 1988). Therefore, to investigate it is considered a challenging task.
Different PRM strategies may have different advantages and disadvantages. Therefore, adopting a particular strategy may lead to different consequences for business performance. In other words, selecting appropriate management strategies from the trade-off of costs and benefits of possible alternatives is a difficult job (Tomek and Peterson, 2001). Neyhard et al. (2013) point out that traders need to know the information relating to different PRM strategies, especially their costs. Tang (2015) adds that a particular strategy’s performance tends to fluctuate depending on the business circumstance. Therefore, this section discusses both the advantages and limitations of given PRM strategies.
Types of Price Risk Management Strategy
This section reviews the five selected PRM strategies. The advantages and limitations of each individual strategy will be clarified.
Stock Holding
One of the common trading methods used in commodity markets is holding the stocks for reselling later (Joseph, Irwin and Garcia, 2015). Stock holding is the obvious strategy
chosen by physical commodity traders and their main business activity is sourcing and supplying. When they buy commodity products from their suppliers without hedging the price risk, they are considered to be stock holders. As a result, the stock holding strategy is one of the main commodity trading strategies.
Advantages
The obvious benefit of stocking commodity products is that there is no need for PRM tools in its implementation. Traders are able to balance supply when there is plenty, such as harvest or peak producing seasons, and then resell during times of less supply. With this strategy, stock holders may gain the advantage of better prices. Therefore, they may gain profits from price differences subtracted from costs of storage (Joseph, Irwin and Garcia, 2015).
Disadvantages
Apart from the storage costs of the stock-holding strategy (Rampini, Sufi and Viswanathan, 2014), there are other issues that also need to be considered. The first issue is the need for warehouse capacity to maintain the quality of products in the physical holding (Anastassiadis et al., 2013). Moreover, this may include warehouse insurance for safety reasons. Finally, there is one of the most important issues in commodity trading, that is merely price volatility. There is no guarantee of a better price after the period of buying and storing commodities (Ramanujam and Vines, 1990). Back-to-back selling
The ideal PRM strategy for a risk-averse trader is back-to-back selling or full hedging. In order to prevent future price changes, commodity market participants are able to use a natural hedge (sell their stock holding) or PRM tools to fix prices. As a consequence, using PRM tools in hedging is considered a provisional trading mechanism for a physical market (Taušer and Čajka, 2014).
Advantages
One of the advantages of managing price risk by back-to-back selling is to lock in a profit of trading. This is practical when the price is higher than what is expected, relative to the known producing costs (Kim, Brorsen and Anderson, 2010). As a consequence, the business is able to capture the selling opportunity if the trading is profitable.
unable to be resold immediately, hedging the price risk via PRM tools in futures exchanges is one of the potential ways to transfer the risk to other parties. This is because the price of derivative contracts, such as futures or options contracts, are related to those in cash markets (Chung-Chu et al., 2012).
Disadvantages
One of the most significant current discussions in PRM is the hedging performance of PRM tools, such as futures contracts. In the case that commodity products cannot be sold immediately, it requires proper price risk hedging tools such as futures markets. Though price movements between cash and derivative markets are expected to be consistent (Chung-Chu et al., 2012), in the real world of trading, the price movements between the two markets may be varied (Dinică and Armeanu, 2014). Therefore, back- to-back selling may not be perfectly implemented in this case. Moreover, using PRM tools means incurring transaction costs. Therefore, the trade-off between advantages and incurred costs needs to be considered in details, particular where margins are small Forward Selling
Forward selling takes place when market participants sell commodity products in advance before they produce or buy them, or use PRM tools to hedge price risk in quantities that are higher than that of their holding. Forward, futures or options contracts are common PRM tools used to employ the forward selling strategy.
Advantages
Forward selling is beneficial during periods of depressed prices. Selling commodity products in advance of such periods of time means the opportunity to sell them in higher prices (Henderson, Hobson and Kentwell, 2002) and buy them later at lower prices to generate extra profits for traders in addition to the usual profit margins. Moreover, traders may gain indirect benefits in business competition by sourcing at above-market prices that their competitors may not be able to compete with.
In addition, forward selling by physical traders may affect price movements in their favour. According to Chen et al. (2014), previous trading may impact on subsequent prices of a particular asset. Therefore, forward selling might result in declined prices in the futures markets if business partners hedge derived price risk from forward contracts by selling in these futures markets.
Disadvantages
Selling in advance without holding physical stocks may expose traders to the risk of making losses from increased prices. Moreover, forward contract arrangements usually come with costs, as their business partners may transfer the price risk to other parties with other financial tools, such as futures or options contracts. Such tools incur transactional costs alongside occasional maintenance costs that are often, in turn, passed to forward contractors.
Negotiation
“Negotiation is a normal approach to determine a purchase price in a supply chain contract. In a bilateral negotiation process, the contract (purchase) price is negotiated between a buyer (retailer) and a seller (supplier)” (Moon, Yao and Park, 2011, p. 413). Negotiation is a PRM strategy employing market power in supply chains or relationships with business partners to gain a competitive advantage in terms of price. Moreover, market information also plays an important part in negotiation (Wilcox and Abbott, 2006).
Advantages
In an emerging market where formal PRM tools are scarce or even non-existent (Capitani and Mattos, 2015), the informal trading or hedging mechanism plays a vital role in PRM. To access such tools, negotiating ability is a key success factor. As a consequence, negotiations both in better trading prices and in gaining PRM tools represent certain of the ways to gain a competitive advantage in trading in such a market.
Disadvantages
Bargaining power is the key factor of the negotiating strategy and, in commodity trading, trading volume tends to relate to such market power. As a result, small or start-up businesses are less likely to be able to adopt this strategy. Therefore, only large traders who have bargaining power are able to adopt the strategy. Moreover, traders require good negotiating skills and comprehensive market information to gain a better position in negotiation (Blount, Thomas-Hunt and Neale, 1996).
Portfolio Management
Rather than using market power or relationships, traders may adopt a portfolio management strategy in managing price risk utilise market-based PRM tools to gain a
understanding market prices as it is seeking to optimise profit or minimise price risk from market movements.
Advantages
Utilising several strategies i.e. a portfolio of activities gives benefits in several aspects. Maximising profits from a variety of price movements is ideal for portfolio management, for example stock holding when prices are rising and forward selling when prices are falling, although it is difficult to implement in practice as price movements are difficult to forecast. The finance industry has paid much attention to seeking the most profitable techniques for many years. For example, Hammoudeh, Malik and McAleer (2011) indicate that traders can be guided by VaR, one of the techniques used to measure price risk, in order to assess the most appropriate PRM strategy for a particular business environment.
Disadvantages
One of the main issues in adopting portfolio management in practice is the lack of PRM tools to facilitate trading. It also requires each tool to work efficiently. This seems to be an issue during price volatility periods where price co-integration between spot and futures seems to be broken up (Taylor, Tonsor and Dhuyvetter, 2013) or forward contract default might have taken place (Jones et al., 2007).