Risk is an essential part that a businessman or investor should consider while doing any kind of business or while making an investment. In general, it means anticipation variation in business outcomes variables, such as revenue, cost, and profit and market share and so on. The concept of performance inconsistency arising from risk is widely used in finance and strategic management, the term refers to the variation in corporate outcomes or performance that cannot be forecast.
The entrepreneur of this world are doing business after understanding the fact of risk as its associated for the sake of profit. For enterperenerur, risk is a double edged sword i.e. while exposing the business to the possible losses and failures; a business is often faced an opportunity to make profit. Risk is not be avoided or limited from a business: rather, it must be managed and controlled.
Risk is commonly assigned to the factors either external or internal to the firm that have an impact on their performance of the firms. Some common example of risk is political risk and competition risk. Such term links specific uncertain environment variable leading to unpredictability in a firm’s performance.
Firms are exposed to difference source of risk, which are as follows:
1. Operation risks: The risk of loss arising from inadequate or failed internal processes, peoples and system, or from the external event is operation risk. This category can include employee error, system failure, fire, floods, or other losses to physical assets, fraud or other criminal activities.
2. Financial Risks: Operational risks, unexpected change in financial variable-like in interest rates, and exchange rates create financial risk for individual firms. These risk results from the way in which the firm’s capital is obtained and financed or if the firm’s transaction involve an inflow or outflow of foreign exchange.
While the impact of operation risks is limited to a specific firm or industry, financial risk is market-wide risk that can affect the financial performance of firm in the whole economy.
Exposure of firms to operational and financial risk combines to give to operating risk which is the risk to the firm as a business and that includes anything that might advisedly affect either the firm’s market or its profitability. Operating risk comes due to factors such as volatile earning which is less certain or more unstable. Leverage, when added to this operating risk, magnifies its impact on the firm performance. A minor drop in demand, leading to significant reductions in the firm’s bottom line, is the result of higher operating risk.
One type of operating risk is encountered by firm is commodity trading risk. Broadly speaking commodity trading risk arises out of uncertainties caused by the impact of these reflects on the incomes of those who deal with such commodities may be grains, metal, gas, electricity etc.
Commodity risk can come in the form of:
1. Price: the price risk come due to unpredictability of the cost at which commodities price can reach in future or the price at which the price will be sold in future. Price risk reflects risk associated with changes in the price of commodities arising today and tomorrow.
2. Yield: Yield risk arises from the production risk i.e. this risk that arises from the unpredictability of quantity of output that can be obtained from the production process and is most real for farmer or producer. Yield risk occurs due to agriculture affect, mining affect, government policy, price cartel and so on.
Our current interest lies in the specific commodity risk, the source of which is volatile commodity prices. Firms involved in the purchase or sale of commodities may have to take unexpected losses if the commodity price is volatile. This type of risk, despite the fact that it which a business firm operates is often considered as financial risk as well. In financial markets there exist many derivative instruments with commodity price as underlying assets, allowing for the transfer of commodity price risk to it here market participants. Thus commodity price risk is a financial as much as operation risk.
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Commodity risk can make even best laid business vulnerable failure. Unexpected swing in inputs cost or output prices, and supply shortage can hamper production, disrupt cash flows and derail growth plan. If firm’s passes on the cost increase to their customers in the near medium term, then the risk is less of a concern. But very often price hike may not be an available option, mostly due to competition. Therefore, firms that can fix an assured input cost or guaranteed selling price, can minimize their downside risk, boost their margin risk or market shares, and outdo competition.
Derivative can be used for redistribution of risk, such that the party that seeks to minimize the risk and do so by transferring it to another party interested in accepting this risk for the potential of a high return. Derivatives are a tool or an instrument that can eliminate uncertainty and reduce market risks. They are financial instruments whose value is derived from the value of something else. Derivative generally take the form of contracts, traded on or off an exchange, under which the parties agree to make payment between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivative are futures, forwards, options and swaps, or even combination of these products.
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Commodity risk management market is place where unable or unwilling to bear risk exchange them to those who wish to benefit from taking rom taking them on. Many market users take on risk as part of a strategy of portfolio diversification, or because users hope to benefits from accurate anticipation of future price movements. Participation tends to trade standardized futures and option contracts on organized commodity exchanges.
(Reference: This article is written by Mr. Abhishek Gautam (Mr. Gautam is GM of commodity Futures Exchange Limited (CFX) and this article also published in the journal of ICAN)