XYZ Ltd. is manufacturing electric wires. To ensure smooth production it buys and hold the inventory of copper. Explain what types of risk XYZ Ltd. is exposed to and how it can hedge these risks.

If XYZ Ltd. buys and keeps copper as inventory, it takes the following risks: Price risk: Copper prices may go up or down due to any specific reasons. If it goes down, value of our inventory goes down. Liquidity risk: If our position is very large, we may not be able to cover our position at the prevailing price (called impact cost). Liquidating the position may cause loss in value as price goes down. Counterparty (credit risk): It may happen that after negotiating the deal and receiving the prices, the supplier goes bankrupt or even after the delivery, we realize that the quality is significantly different. Once it has the physical copper with it, it can hedge by going short on the copper futures. The credit risk will be absorbed by the exchange in this case. In the case of a hedger seeking to offset the price risk on his holding of inventory of commodities by selling futures in the copper. But what in real markets do not happen is the quantity matching. There is always a gap between expected and actual output. This is defined as a quantity risk. If the output on the maturity is lesser, the quality mismatch may affect the hedge. Besides, it will also affect the final revenue that the producer generates. Even with the hedging plan using futures contract, the producer is not able to cover the losses. But unfortunately, such risk cannot be hedged using the commodity derivative.