tahir khan abdali
Many commodities are bought in a volatile market, where the purchasing price changes constantly. Sometimes price changes are relatively rapid, in markets like money, stock or oil markets; sometimes they are rather lengthy, in markets like the steel market. Most of these commodities are needed at a high and fairly constant (or at least well predictable) level by buying organizations. In these situations the price paid for the commodity is often the major determinant of the total costs of ownership for these commodities. It is imperative to adopt a proactive approach to minimize risks which are associated with financial, operational, confidential, legal and reputational aspects while undergoing contractual obligations. If risk is managed properly, it positively impacts profitability and operations of any organization.
Fixed price contracts and variable price contracts can differ in their allocation of risk. These differences in risk influence the prices paid for the commodity. In the vast body of literature on hedging we find the description of risks for the buyer and seller in these situations. When buying under fixed price contracts, the buying organization is protected against the fluctuations of the market price and is mostly completely assured of delivery. In this case, the broker bears the risks of higher commodity prices on the spot market than the contract price. The buyer bears the risks of lower commodity prices on the spot market.
When buying under a variable price contract the buyer is provided with prices in line with the market. Accordingly the buying organization takes the risk of uncertain cost and profit levels, due to the fluctuating commodity prices. This shows that the contracts differ in how the risks are distributed over the buying organization and the broker. A variable price contract is only preferable over a fixed price contract when the broker is more risk averse than the buying organization. The fixed prices in the forward contract electricity market, a typical volatile commodity market, are higher than the spot market prices. This is because of the fact that the buyers are more risk averse than the sellers, boosting the demand for safe long-term contracts. The more risk averse the buyer will be, the higher price he will accept for a long-term (fixed price) contract.
This shows that the difference in risk avoidance between the buying organization and the broker can influence the market prices for different contract forms. In a volatile market the risks are higher and so is the risk premium. In a stable market risks are lower and so is the risk premium. When using a variable price contract form the inherent price risks may be high, but there are no risk premium costs. With a fixed price contract form there are no inherent price risks, but the risk premium costs may be high. Therefore, the costs of variable price contracts are on average smaller than the costs of fixed price contracts.