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  • Risk considerations

    Chapter 4 - Cotton trading - Hedging and market systems 


    The most important risk considerations are price, basis and counterparty risk. Secondary risks are currency, financial and government (i.e. tariffs and trade).

    Price risk

    Price risk is probably the most volatile risk to which merchants are exposed. Cotton prices can, and will, fluctuate over a wide range from time to time (see figure 4.4), and therefore some manner of price protection must be practised. The most accessible form of price hedging today is a futures contract. There are several cotton future exchanges available to hedgers, but most are very regional and are used to hedge local trade.

    Figure 4.4: Yearly high and low prices



    ICE offers the best available all-round cotton futures contract providing full or partial price hedging opportunities. United States cotton can be hedged fully, while growths outside the United States can be partially hedged. Non-United States prices tend to follow the New York futures price, but lag behind (see figure 4.5).

    Figure 4.5: Cotlook A Index vs futures



    Trade can be conducted up to 24 months in the future and hedged with New York cotton futures. This allows merchants to be able to buy from growers when growers want to sell and sell to textile mills when the mills want to buy.

    Basis risk

    The basis is defined as the difference between the cash price and the future price. The basis cannot be hedged unless a simultaneous purchase and sale can be transacted, and this is rarely available to traders. The basis changes at a much slower rate than futures, but becomes greater the farther out a contract runs.

    Counterparty risk

    Counterparty risk has to do with the reliability and credibility of trading partners. It is most important to know with whom you are doing business: with the possibility of trading cotton 24 months out into the future it is important to know whether the counterparties will be able to complete the transaction as contracted.

    Currency risk

    Most global cotton trade is transacted in United States dollars, but there are risks possible in cases where currency translations are likely. Sometimes these risks can be hedged by buying or selling the currencies involved in the transaction. There is always the possibility, too, that a country may revalue its currency after transactions have been contracted.

    Financial risk

    Bank financing varies from country to country. While it is rare these days for a bank to fail, it sometimes does happen. When it does happen the affected traders may have to arrange financing with a new institute that may not offer the same terms as the failed bank.

    Government risk

    While most countries are trading according to World Trade Organization (WTO) guidelines, there is always the chance that a country will impose higher tariffs on trade. Also, a country may impose import or export taxes before contracts can be fulfilled.