Companies across a range of sectors from manufacturing to packaging and construction are exposed to rising commodity prices. Their operating margins depend on the spread between raw material costs and sales prices. Most companies operate as price takers in highly competitive industries underlining the importance of cost control.

Managing volatile commodity costs is the responsibility of both purchasing and treasury departments. Effective supply chain management can provide companies with an important competitive advantage. Effective risk management is equally important.

The standard approach to managing the risk of rising input costs is the establishment of a long hedge. A long hedge refers to the purchase of futures contracts to offset a short position in the underlying cash commodity. Losses incurred in the cash market from higher commodity prices will be offset by gains from the long hedge.

An alternative hedging strategy involves the establishment of a price cap through the purchase of call options. Call options grant the right but not the obligation to buy an underlying futures contract for a specific (strike) price over a particular period of time. The buyer of a call option is shielded from rising prices while retaining participation in falling prices. This flexibility is a major advantage of options-based hedging strategies.

Companies can also employ collars to establish a price range for their input costs. The sale of a put option in conjunction with the purchase of a call option sets both a price floor and a price cap for the commodity in question. Consumers are able to reduce the cost of the price cap by sacrificing some of their participation in lower commodity prices.

These are just a sample of the risk management strategies available to commodity consumers. The suitability of different strategies depends on companies' specific requirements and the prevailing market environment. It is essential that companies do not rely exclusively on their trading counterparties for risk management strategies. Independent, third-party consultation is integral to best practice CPRM.