Commodity Risk- Foreign Exchange Risk and Geographical Risk
This offering is a continuation of the series that examines risk on a granular basis. Two risks that are very important for those trading in the commodity markets are foreign exchange and geographical risks.
Foreign Exchange Risk
Foreign exchange risk is the risk that a change in currency relationships moves beyond acceptable limits. When it comes to commodities, the dollar is the worldwide pricing mechanism for many, if not most, raw materials. That is because the dollar is the reserve currency of the world. Changes in the dollar's value against other currencies often translate into buying or selling pressure in commodity prices.
A weak dollar is often supportive of commodity prices. That is because when the dollar moves lower, commodity prices in other currencies fall. As prices fall two things happen, demand tends to increase and supplies tend to shrink as inventories fall. Conversely, when the dollar strengthens, commodity prices in other currencies move higher stimulating producer selling in an environment where demand suffers due to higher local prices. A strong dollar tends to be negative for commodity prices.
When it comes to producers, a higher dollar results in lower production cost for commodities produced in non-dollar denominated countries. Higher production costs cause the output to eventually slow and sometimes stop. When production costs rise above the market price and stay there for a long period, high-cost producers tend to stop producing. As you can see, there is an inverse correlation between the dollar and commodity prices.
An example of how foreign exchange risk can affect the price of a commodity is the recent rally in the dollar versus the Brazilian currency, the real. Brazil is the world's number one producer and exporter of sugar cane. When the dollar rose during the period between May 2014 and March 2015 the price of sugar dropped from over 18 cents to under 13 cents per pound. The dollar index appreciated by 27% over the period and the price of sugar dropped by the almost the same amount. During that period, the Brazilian currency fell by over 30%.
Therefore, sugar actually did not move lower in Brazilian real terms and the selling from the world's number one producer continued forcing the dollar price lower. This is just one example of how the local price of a commodity actually encouraged selling during a change in foreign exchange rates. The production cost of sugar actually fell for the Brazilians as labor costs dropped in local currency terms with respect to the international price of world sugar that is denominated in dollars.
Foreign exchange levels are an important factor for both commodity production and consumption. When commodity production occurs in one location and consumption is in another, the currency differentials often influence price. Many producers and consumers of commodities, therefore, hedge currency risks that can adversely affect their businesses.
Geographical risk is a very important aspect of commodity values. Different locations around the world have different risks. Those risks vary dramatically. On one level, geographical risk can relate to political risk. Each nation has its own geography and set of rules and regulations and changes in governmental structures that alter these policies can influence prices, as can the outbreak of war or other events in a specific region. On another level, a geographical risk is often associated with the risk of concentrating physical assets in the same geographical area based on the potential for occurrences of natural events in that region.
Natural events can occur because of weather or other acts of nature. This is why many nations or companies that stockpile commodities diversify their holdings in different regions.
An example of this is central bank gold holdings. Central banks around the world hold gold as a foreign currency reserve. While some countries physically store the gold within their own borders, others diversify by storing bullion in other countries. The Bank of England, Federal Reserve Bank in New York, the Reserve Bank of Australia all hold gold on behalf of other nations looking to diversify their geographical risk.
In 2016, volatility in the currency markets around the world increased dramatically. Precious metals prices appreciated in all currencies terms which means that the value of paper money issued by governments fell. We are trained to value currencies against one and other. Foreign exchange rates measure the value of one currency against another, like the dollar versus the euro or the pound sterling against the yen. However, when the prices of precious metals like gold and silver increase in all currency terms this tells us that the value of paper foreign exchange instruments has declined.
The currency markets became particularly volatile after the British voted to leave the European Union at the end of June 2016. In 2016, foreign exchange risk rose with increased volatility in the currency markets.