Introduction

In the realm of commodity trading, understanding risk is paramount. This chapter delves into the nuanced concepts of systematic and nonsystematic risk and their profound influence on both current futures prices and the expected future spot prices of commodities. As traders and investors navigate the complex world of commodity forwards and futures, grasping the distinction between these two types of risks becomes essential for informed decision-making. This chapter will elucidate the impact of these risks on the pricing dynamics of commodity derivatives, allowing practitioners to develop strategies that effectively manage risk exposure.

Systematic Risk and Nonsystematic Risk

Systematic risk

Systematic risk, often referred to as market risk or undiversifiable risk, is the risk that affects the entire market or a specific segment of the market. It stems from external factors such as macroeconomic conditions, geopolitical events, interest rate fluctuations, and global market trends. Systematic risk cannot be eliminated through diversification and is inherent to the broader market environment. For instance, a sudden spike in crude oil prices due to geopolitical tensions would impact all commodities within the energy sector.

Nonsystematic Risk

Nonsystematic risk, also known as idiosyncratic risk or diversifiable risk, pertains to risks that are specific to a particular asset, company, or industry. These risks can often be mitigated through diversification. For instance, a company-specific issue, like a labor strike at a mining company affecting metal production, would predominantly impact that specific metal’s market but might have limited impact on other commodities.

Impact on Current Futures and Expected Future Spot Prices

Systematic risk significantly influences futures prices across a range of commodities. If a major geopolitical event results in uncertainty in global oil supply, crude oil futures prices are likely to rise due to increased perceived risk. Similarly, a broader economic recession can lead to decreased demand for various commodities, causing futures prices to decline.

Nonsystematic risk, while less broad-reaching, can still have notable effects. For instance, a localized drought affecting a specific agricultural region can lead to reduced crop yields, resulting in higher prices for that particular agricultural commodity’s futures contracts.

Risk Management Strategies

Commodity traders and investors employ various risk management strategies to mitigate the impacts of both systematic and nonsystematic risk. Diversification across commodities and industries helps mitigate nonsystematic risk by spreading exposure. Hedging with derivatives, such as futures contracts, allows market participants to manage price risk associated with systematic events.