The Three I's - Inflation, Insurance, and Interest Rate Risks

Hand connecting finance jigsaw puzzle pieces
Roy Scott/Getty Images

In another article, I gave an overview of the topic of risk in commodity markets. In that piece, I described the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Three risks that are very important for those trading in the commodity markets are inflation, insurance, and interest rate risks.

Inflation is the rate at which the general level of prices for goods and services is rising as a function of purchasing power. Commodity prices are highly sensitive to the rate of inflation. When inflation moves higher, commodity prices appreciate. In the late 1970's the inflation rate in the United States moved aggressively higher which caused prices of all commodities to rise, many to all-time highs back then. Recently, since the global financial crisis in 2008, central banks around the world have lowered interest rates and used other monetary policy tools including instituting programs of quantitative easing in order to stimulate economic conditions. This resulted in historically low-interest rates or cheap money around the globe. Many analysts believe that this type of monetary policy will eventually lead to increasing inflation as more money chases a finite amount of goods or commodities.

Therefore, one of the upside risks for commodities or the risk of increasing prices of raw materials for consumers is a function of inflationary pressures.

Insurance risk is the risk that a party to a commodity transaction has insufficient insurance coverage to support a transaction, on the part of either the principal or counterparty to a transaction.

An example of an insurance risk would be a consumer who insured the price of a commodity at today's price and then needs to make a claim based on nonperformance or loss at a later date when prices have moved much higher. In this case, the intention of the insurance purchase was to cover the price of the commodity and replace it in the case of an insurable event. However, if the commodity price were to increase significantly, the insurance might not be sufficient to cover replacement cost.  In the 1980s, when I was handling physical commodity shipments, I would often insure cargos for 110% of value to cover this potential. Due to the occasional extreme volatility of commodity prices, even this additional amount may not suffice at times. If one considers that the price of crude oil increased by 100% in a matter of minutes in 1990 when Iraq invaded Kuwait, you can see that it is impossible to cover all of the risks of a commodity trade due to the potential for extreme price volatility.

One of the biggest risks faced by all businesses is interest rate risk. This is the risk that interest rates increase or decrease beyond acceptable limits. Interest rates affect many aspects of a commodity trade.

The forward or future price of a commodity is partially a function of interest rates. When it comes to forward or term structure for commodities, a combination of supply, demand, and interest rates factors determines the degree of the term structure of a commodity market in terms of contango or backwardation. Commodities must compete with other assets, many of which provide a yield or dividend. When it comes to physical or cash commodity transactions owners of raw materials must consider interest rates in that the cost of carrying inventory or supplies is an interest rate sensitive affair. Capital allocated for commodity inventories is an economic choice. One must consider other competing financial vehicles available for investment with respect to the optimization and use of that capital.

There are two components to interest rate risk, inflation and real rates of interest. Together they combine to establish the total nominal interest rate. Therefore, while when the inflation rate increases it is bullish for commodity prices when real interest rates increase, it is bearish. The later increases the cost of carrying or storing commodities. Many interest rate vehicles, short and long term, trade in markets and can serve as a hedge for this type of risk.

Inflation, insurance, ​and interest rates are risks that all commodity traders face, whether they trade in the physical or derivative markets.