Managing trading risk
A London International Financial Futures and Options Exchange case study

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Page 1: Introduction

London International Financial Futures And Options 4 Image 1This case study examines the importance of futures trading and focuses more specifically on commodity futures trading. The futures market plays a key role in the modern economic system because it enables investors to trade in a cost efficient way and to eliminate some of the risk from their trading activity.

Commodities lie at the heart of modern industrial society and include a wide range of primary products ranging from foodstuffs, such as rice, grain and coffee, to industrial raw materials, such as oil and iron ore. Commodities are subject to price fluctuations over time - due to changing supply and demand conditions in the market place.

Demand and buying patterns can change - for example, more oil than normal may be consumed during a particularly cold winter and so demand increases. The commodity supply chain can also vary considerably for a variety of reasons - frosts may destroy olive trees in Southern Italy, potato blight may wipe out a crop in the East of England, political upheavals in the Middle East may prevent the free flow of oil.

There is an element of risk in any activity when the outcome cannot be predicted with certainty, or when the outcome is known but its full consequences are not. Individuals have widely different attitudes towards taking risks. It is possible to identify three different positions:

  • The risk lover - someone who enjoys a gamble, even when mathematical analysis shows that the odds are unfavourable.
  • The risk-neutral person – will only speculate if the odds on a gain are favourable. The person will not be concerned with the range of possible outcomes, only with the odds being in their favour.
  • The risk-averse person - will not leave anything to chance and only speculates if the odds are strongly favourable.

In business, organisations also take risks. Some are prepared to take large risks which can make or break the organisation but more typically, organisations aim to manage their risks.

London International Financial Futures and Options Exchange | Managing trading risk