No investment channel is 100% risk-free. The difference of the market commodity derivatives is that investors and market participants can be protected by a special type of insurance – commodity insurance.
What is cargo insurance? What are the benefits of participating parties and investors when participating in commodity derivatives insurance? Invite investors to learn more details through the article of DCV Invest.
1. What is Cargo Insurance?
Cargo insurance is a form of conditional commitment. When participating in cargo insurance, if there is a risk or damage to the goods, we will be compensated. The prerequisite is that the goods have been listed in the policy of insurance.
For underlying commodity market participants, cargo insurance helps market participants protect their interests in physical goods.
In the commodity derivatives market, transactions are based on the price index of the underlying commodities. Therefore, commodity insurance is the price insurance for the items participating in the market. Thanks to this commodity price insurance policy, investors can be assured of the transparency and safety of the market.
Insurance of physical goods in the underlying commodity market is clearly regulated by law and contract when the units sign to buy and sell goods with each other.
2. The necessity of commodity price insurance
In the commodity derivatives market, the underlying commodities include agricultural products, industrial products, energy, and metals. In particular, agricultural products are the group with the most volatile prices, depending on many objective factors such as weather, world political situation…
Commodity derivative price insurance will help businesses buy with peace of mind, easily control market prices, and quantify expected profits. And farmers are assured of production. Because of this need, commodity derivatives insurance is a solution to help market participants feel secure in fulfilling their obligations, increasing transparency and efficiency for the market.
3. Subject matter of commodity derivatives insurance
Commodity derivatives insurance, especially commodity price insurance, brings many benefits to the parties involved. Specifically, the subject matter of insurance is as follows:
– Investors are assured of price transparency, market commitment, and are assured of making transactions regardless of whether the market rises or falls.
– Farming and livestock farmers use commodity insurance to prevent risks when the price of agricultural products decreases and the price of animal feed increases, with peace of mind in production.
– Business people will reduce the fear of abnormal commodity price drops during the time they hold goods, and store them with peace of mind.
– Buyers and agro-processing factories are more secure about the price of input materials, feel secure to buy raw materials and reduce inventories.
– Exporters and importers are more secure about the stability of the export and import prices of agricultural products, thereby having appropriate import and export policies.
– Consumers can buy processed agricultural products at stable prices.
4. Commodity derivative price insurance example
Enterprise X is an instant coffee producer that needs to buy raw coffee – a product being traded in the commodity derivatives market. Enterprise X needs to buy 100 tons of coffee.
– Expected purchase price is 40,000 VND/kg
In these 6 months, enterprise X does not want the price of raw rubber to increase abnormally compared to the price they had expected. Therefore, company X goes to the trading floor to buy 100 tons of coffee with a term of 6 months on the exchange (future contract) at the price of 40,000 VND/kg.
=> Thus, 6 months later, enterprise X will still receive enough goods, at the expected cost, regardless of the price of coffee increases.
On the other hand, if the market price drops to 35,000 VND/kg, businesses can short sell this futures contract to get the necessary protection (lock in the selling price). Thus, the loss incurred by the enterprise in the underlying market is equal to the profit the company earns through the derivatives market. Thanks to the price insurance policy, enterprise X can safely plan the cost of buying input materials for 6 months of production without worrying about market fluctuations.
5. How to calculate the cost of commodity derivative price insurance
Investors can refer to the calculation of commodity price insurance as follows.
5.1 Cost of goods insurance of the buyer
Costs will be based on the following price indexes:
– Futures contract price at the time of starting price insurance (time of buying futures contract) – F1
– Futures contract price at the time of closing, making goods purchase (time of selling futures contract) – F2
– Price of purchased goods at the time of purchase on the underlying market: S2
– Profit from derivatives market = F2-F1
– Net cost of investors = S2 – (F2-F1)
For example:
In May 2022, the price of soybean meal on the base market was $1,400/bu. Company A wants to buy soybean meal with the expectation that soybean price will be stable at around $1,500/bu in October 2022 – when the company starts to produce the new crop.
The Company carries out price insurance as follows:
– In May, the company purchased soybean meal futures contract with the quantity corresponding to the actual quantity they need and the maturity date in November 2022 for $1,300/bu.
– By October 2022, the company bought soybean meal in the base market at S2 and sold soybean futures contract in November 2022 on the derivatives market for $1,600/bu.
– By October 2022, the price of soybean meal on the basic market S2 = $1,800/bu
=> Net cost of investors = 1,800 – (1,600 – 1,300) = $1,400
Thus, the purchase cost of company A’s goods remains stable within the desired range.
5.2 Calculating the cost of insuring the seller’s goods
– Futures contract price at the time of starting price insurance (time of selling futures contract) – F1
– Futures contract price at the time of closing, selling goods (time of buying futures contract) – F2
– Price of purchased goods at the time of sale of goods on the underlying market: S2
– Profit from derivatives market = F1-F2
– Net selling cost = S2 + (F1-F2)
For example: March 2022, it is not yet the time for the wheat harvest, but the seller wants to sell at an expected price of about $6.15 per bushel when the wheat is harvested in June 2022.
The seller carries out price insurance as follows:
– In March 2022, they sell wheat futures contracts with a term of July 2022, the number of contracts is equivalent to the output they expect to be able to produce, the selling price is $ 6.50 / bush
– By June 2022, wheat is in the autumn crop, farmers harvest and sell real wheat on the underlying commodity market at S2 = $ 5.60/ bushel and buy wheat futures on the commodity derivatives market. maturity in July 2022 at $6.00 per bushel.
=> Net selling cost to farmers = 5.60 + (6.50 -6.00) = $6.10.
Thus, the selling price of farmers is still within the desired range.
