Description
This is a presentation about risk management at commodity desk report.
RISK MANAGEMENT AT COMMODITY DESK
Member’s perspective
[Type the company name]
[Type the author name]
Table of Contents
Introduction to Commodity markets ............................................................................................................ 3 Members of the commodity exchange ...................................................................................................... 4 Commodity risk management: Member’s perspective ........................................................................... 5 Broker as an intermediary: ........................................................................................................................... 5 Broker as a trader ............................................................................................................................................. 6 Natural Risk .................................................................................................................................................... 6 Man-Made risk ............................................................................................................................................... 6 Developing a Commodity Risk Management Strategy......................................................................... 15 Core elements of a commodity risk management strategy ............................................................... 17 Conclusion............................................................................................................................................................. 18 Bibliography......................................................................................................................................................... 19
Introduction to Commodity markets
Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. The trading of commodities consists of direct physical trading and derivatives trading. The commodities markets have seen an upturn in the volume of trading in recent years. In the five years up to 2007, the value of global physical exports of commodities increased by 17% while the notional value outstanding of commodity OTC (over the counter) derivatives increased more than 500% and commodity derivative trading on exchanges more than 200%.The major commodity markets are in the United Kingdom and in the USA. In India there are 25 recognized future exchanges, of which there are three national level multicommodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: * National Commodity & Derivatives Exchange Limited (NCDEX) * Multi Commodity Exchange of India Limited (MCX) * National Multi-Commodity Exchange of India Limited (NMCEIL) All the exchanges have been set up under overall control of Forward Market Commission (FMC) of Government of India. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say. Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the vital market.
Members of the commodity exchange
A commodity broker is a financial service professional licensed to sell commodity futures and options contracts. Unlike a stockbroker, a commodity broker deals in physical commodities such as foods, metals, energies, building materials, agricultural products, currencies, and stock and bond futures. Commodity trading is regulated by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). The function of a commodity broker is to handle customer accounts, enter customer orders and verify their execution, and report those executions back to the customer. A commodity broker also monitors margin calls, collecting funds from the customer when necessary. In the case of a full-service commodity broker, the broker also suggests and recommends trades to the customer based upon breaking news and the guidance of the brokerage firm's research department. The two types of commodity brokers are full service brokers and discount brokers. The primary difference is in the level of service and the rate of commission. A discount commodity broker is employed to simply enter and verify the execution of customer trades and report those executions back to the customer. Discount brokers do not make recommendations to customers. As the term implies, the commission rate for a discount commodity broker is quite a bit less than that of a full service commodity broker. A full service commodity broker often teaches a customer about the commodity markets and makes trading recommendations. NCDEX and MCX, maintain settlement guarantee funds. The exchanges have a penalty clause in case of any default by any member. There is also a separate arbitration panel of exchanges. Commodity options don't move point-for-point with their underlying futures contract; they do limit the potential downside to the amount invested in the option plus commissions and fees. If an options trade goes the wrong way, the investor will only lose the total investment. If a futures trade goes the wrong way, the investor can lose the entire investment and end up owing more money just to get back to a zero balance in the account.
Commodity risk management: Member’s perspective
As funds seamlessly flow from one market to the other and the Indian commodity market begins to integrate with the global market, the risk perception is beginning to heighten. Adoption of risk management or risk mitigation tools is now sine qua non for success in businesses with exposure to commodities. A serious look at futures trading as a tool for price discovery and price risk management is inevitable. Commodity risk management is very important to provide coverage to all those groups that are related to the commodity market. These groups are exposed to maximum financial risks when there is any natural disaster or man-made disturbance. Commodity market in every country faces some of the common risks. These risks are caused by natural disaster as well as external factors like wars, political instability and so on. If not covered properly, these risks can cause huge financial loss to a number of groups. Proper commodity risk management is essential to provide stability to this sector as well as to make this sector financially secured. The use of commoditylinked financial risk management instruments by commodity producers, traders, consumers, processors, reflects the desire. It is necessary to manage the risk to obtain protection from uncertain adverse price movements and to procure short-term finance. Higher and the more unpredictable the price volatility of a commodity, the greater the possibility of incurring losses or realizing gains on future sales or purchases of a commodity. The greater the share in an enterprise's earnings or in its production costs that a specific internationally traded commodity or commodities represent, the greater that enterprise's exposure to price risks. So its very much important task for the member to keep the safety position of himself and other investors. Broker member can act either as an investor or as intermediary to facilitate the trading for the investors. With these responsibilities there comes risk.
Broker as an intermediary:
When broker member acts as a intermediary between investors and exchange for trading, he faces very little risk. The risk is to maintain the margins with the exchanges and to follow up with the regulation given by them. Margin is important to mitigate risk. For the purpose of computing and levying the margins, MCX uses SPAN® (Standard Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based approach.
The Initial Margin requirement is based on a worst-case loss scenario of portfolio at client level to cover VaR (value at Risk) over a one day horizon, subject to a minimum Base Margin defined by FMC for the respective commodity. The SPAN Risk Parameter File (RPF) is generated by the Exchange periodically at pre-defined timings and RPF files so generated are provided to the members using the FTP service and on the Exchange website. In addition to SPAN margins, MCX levies Additional margins and/ or Special margins whenever deemed necessary considering the volatility and price movement in the commodities. Such margins are also levied as per the directions of FMC Tender Period margins and Delivery Period Margins are levied on contracts nearing expiry to ensure non default in commodity delivery.
Broker as a trader
When broker member is himself trading with the exchanges then he faces all the risk which a investor exposed to. Following are some of the major commodity risks, broker member needs to counteract. Basically there are different types of commodity risk that are faced by the commodity markets across the world. These risks are as follows: • • Natural Risks: Natural disasters Man-Made Risks: Liquidity risk, Market risk, Operational risk, Political risks, Currency
risk, Price risks, Interest risk,
Natural Risk
Weather Risk Management: The weather risks are very important for the farmers, plantation companies and the exporters. Heavy rain, drought, cyclones or other types of natural disaster cause huge harm to several groups. These groups need sufficient coverage against the natural disasters to remain financially secured. There are a number of insurance products offered to cover these risks. These are self insurance, crop insurance, index based insurance and many more.
Man-Made risk Liquidity Risk:
Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Usually it gets reflected in a wide
bid-ask spread or large price movements. In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk. Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:
? ? ?
Widening bid/offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations
Funding liquidity - Risk that liability:
? ? ?
Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to broker member of commodity exchange who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets. Broker member should try to invest in highly traded commodities. Trading liquidity risk (an area which overlaps with market and credit risk) is another field in which broker should consider introducing a more consistent approach to monitoring, measuring and managing risk. If liquidity falls when an energy trading member is carrying out a transaction, and the participant buying cannot unwind or hedge the position fast enough, businesses should ensure that similar types of tools and techniques are employed, across all types of risk liquidity risk is created.
Traders should manage liquidity risk by monitoring the market bid-ask spreads and build this into their market making and pricing models. Energy companies and participants need to consider this aspect and build a charge into their pricing models, both to avoid falling into a liquidity trap and to manage trading liquidity risk more efficiently.
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risk are:
? ? ?
Equity risk, the risk that stock prices and/or the implied volatility will change. Interest rate risk, the risk that interest rates and/or the implied volatility will change. Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
?
Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.
Although risk managers at commodity trading companies have attained a considerable degree of sophistication in relation to market risk, firms tend to be skilled mostly at monitoring and measuring market risk. Commodity businesses need to adopt a much more dynamic approach towards the management of market risk and efficient utilization of risk capital. Firstly, trading companies and members should identify any risks not captured in their current risk management or VaR framework and include these in the programmed list for prioritization. Having all risks flowing through the VaR framework improves the completeness and quality of risk management, as well as reducing the requirement for manual intervention. In order to manage market risk more dynamically, energy companies and broker members should make greater use of stress testing. Stress testing must become a regular part of their risk modeling process and not simply be used as a standalone measure. It should incorporate varying probability weights, so that firms gain a better understanding of the risk range, and include historical scenarios, for example, the oil price crash of 2008, as well as user-defined scenarios. Running sensitivity tests can be useful
too, for example, to discover the impact of an event such as a 50% drop in oil prices, breakdown of price correlations etc. In addition, members could consider the introduction of Black Swan testing, i.e. stressing a portfolio with a risk factor previously ignored or considered to have little likelihood of occurring. Examples could include the euro losing its currency status or Russian gas supplies to Europe being cut off. What type of scenarios should commodity and energy companies model? The scenarios chosen should be unique to each company, as firms need to understand what factors are most critical to their own business model. Oil companies could ask themselves what would happen if the crude oil price fell to US$10/bbl, liquidity within the oil market completely dried up or the consequences if oil assets were seized by local governments. For power companies, a comparable scenario might be the discovery of a type-fault in a nuclear power station or the failure of the TSO’s control centre. Members active in the gas markets might wish to understand the effects of a significant trading disruption at a gas hub or the loss of a large storage facility. Importantly, whatever stress scenarios are used, these should be reviewed regularly and adjusted to reflect changes to the company’s circumstances. Stress testing must become a regular part of their risk modelling process and not simply be used as a standalone measure. The scenarios outlined above may be thought of as extreme situations but they are worth planning for. Until recently, few would have thought that a cloud of volcanic ash could have caused such disruption and heavy financial losses to the aviation industry. Importantly, stress testing enables businesses to determine their readiness to deal with (increasingly) extreme events. It allows them to understand more accurately the risks they face, to be better prepared and to provide investors with a clearer picture of the risks involved in the business operation. Finally, regular back-testing should be carried out, ideally on a daily basis. This involves comparing the previous day’s actual P&L with daily VaR numbers. This is important from a regulatory ensure management confidence in risk management processes. Steps should be taken to ensure that the number of exceptions – losses larger than estimated by the VaR model in frequency and size – are understood and corrective actions incorporated into the risk management model. Back-testing of expected tail loss can also provide an indication of how well the model captures the size of expected loss beyond the traditional 95% or 99% VaR confidence levels.
Operational Risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks. Operational risk management is, generally speaking, in an immature state at most commodity trading companies: businesses tend not to have dedicated operations risk managers, nor is operational risk understood to a sufficient level. Companies are only now beginning to monitor trading operational risk, while its measurement is still in its infancy. Indeed, the industry is only just becoming aware of the need to use benchmarks or metrics to measure and understand operational risk. As with other types of risk, there can be no proper management if companies have no adequate means of monitoring and measuring it. One example of particular weakness is trade confirmation. The process is riddled with delays and, even at large companies, can take up to a few weeks, depending on the complexity of the transaction and issues encountered in the contract terms and so forth. If counterparty fails in the intervening time, the impact is likely to be significant and may involve hardship. In contrast, a number of investment banks are now able to process confirmations quite rapidly. Commodity members should aim to emulate financial institutions in this respect – measuring confirmation times against industry benchmarks, both to improve efficiency and to reduce the risk of being unable legally to enforce an unconfirmed trade, in the event of counterparty bankruptcy. An understanding of the potential financial impact might focus attention. Invoicing constitutes another problem area. Here, similar delays can occur to those encountered in the confirmation process, with complex pricing terms and delivery quality issues often being the root cause of the delay. Again, commodity businesses would do well to put in place metrics to measure and monitor operational processes such as invoice generation. This, in turn, would allow firms to identify weak spots and to take remedial action. Finally, for members operating in the physical commodities arena, other types of operational risk need to be considered. In particular, businesses need to assess the efficiency with which physical assets operate. In this respect, metrics aimed at measuring the commercial availability of an asset can also play an important role. Indeed, some large energy firms already make use of these metrics. For businesses that do
not yet carry out these assessments, forming partnerships with agencies which undertake benchmarking exercises of operational processes will prove beneficial.
Political Risk
Political risk refers to the complications businesses and governments may face as a result of political decisions. It is any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives. Any announcement at the political level affects widely the price of the commodity. Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of 1. Nonmarket factors as macroeconomic and social policies like fiscal, monetary, trade, investment, industrial, income, labor, and developmental 2. Events related to political instability like terrorism, riots, coups, civil war, and insurrection At the time of war or any political instability in the country affect the commodity prices indirectly. As this has greater impact on the import and export of the country. Moreover it will affect the capital inflow in the country from other country in form of FIIs. Investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the most authoritarian. Longterm assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world. Understanding risk as part probability and part impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an
expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns. There are both macro- and micro-level political risks. 1. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, and also includes financial and economic risks. 2. Micro-level risks focus on sector, firm, or project specific risk
Impact the import/export and capital inflow
Political Risk
Affect the currency
Affect the Commodity
For mitigating the risk, At the macro-level largely involves understanding political uncertainties of the operating environment and the risks faced by all business operations in individual countries. Such information can come in the form of 1. Customized analysis 2. In-depth subject matter reporting 3. Information that can enable an investor or firm to calibrate their risk appetite 4. Contingency planning, intellectual property safeguards, risk diversification and sound exit planning to guard against uncertainty. At the micro level, it can be mitigated by transferring risk to other party like Insurer or Hedger.
Currency risk
Currency risk is a sudden fall in the value of a particular currency. This happens due to unexpected shifts in the currency exchange rates. Currency risks are related to the floating exchange rates. Nowadays, cross border commercial activities are growing at a rapid pace. Almost everything starting from goods to technologies are exchanged between the traders of different countries. These transactions are subjected to currency risk because floating exchange rates are minimizing the chances of fixing the value of a particular currency.
Change in currency by .01Rs, can change the commodity price by Rs 2 or even Rs 4. So fluctuation in currency creates deviation in the prices of commodity in Indian market. On the other hand, there are the forex market traders who are involved in trading of currencies of different countries. These traders participate in the activities of one of the most liquid world financial markets. One of the most common currency risk management tool is the forward exchange contract. According to these contracts that are signed between the potential seller and purchaser of a particular currency, the exchange rates are fixed before the actual transaction. The transaction takes place in the future but due to the contract, if the exchange rate of that currency changes at the time of transaction, the purchaser and the seller are not affected. There should also be a definite trading strategy that can be very helpful in hedging the currency risks. These strategies should be developed after analyzing the market averages or market indexes properly. On the other hand, there are certain theories regarding the trading process in the currency market. These are also very helpful for currency risk management. All these are specialized things and one may seek professional assistance from the currency risk management firms for the purpose.
Price Risk
Price risk is the risk of declination of the value of a security or portfolio of securities in the future. Basically, it's the risk that investor will lose money due to a fall in the market price of a security that he owns. Following are the risk management member broker should consider. Hedging strategies:
Unhedged Risk ? ? ? Changes in prices on unhedged volumes Changes in the basis differentials (location and grade) between chosen hedge and actual purchases Changes in consumption patterns
Interest rate risk
Interest risk is the major economic indicator. It plays an important role in affecting the price of commodity. When there is increase in employment rate, this leads to increase in the earning power of people resulting in increase in the price of the commodity so the price of commodity is dependent on demand and supply. To control the inflation there is increase in
interest rate. So the rise or fall in interest rate is the indicator of rise and fall in price of commodity. Risk can be minimized by investments in interest rate futures.
Regulatory risk
Commodity exchanges and organizations along with the trading participants face a range of legal and compliance risks within commodity risk management. Compliance oversight is required to manage training, policy-making, and monitoring of commodity sales, marketing, and business operation/transaction activities. This frequently requires understanding and adherence to a complex array of international regulations governing commodities which often focus on: monitoring and documenting trade flows, order routing/execution, and trade reporting functions for compliance as well as irregularities; maintaining the commodities compliance policies and procedures and appropriate training; and documenting, categorizing, and tracking of error trades and error trading policies. Example: GE was forced to restate earnings from 2001-2005 because of noncompliance with FAS 133. As the result of a regular audit review, GE discovered that it was in non-compliance to FAS 133 (regulations governing accounting for derivative instruments and hedging activities) for certain transactions used to protect from changes in interest and currency exchange rates.
Developing a Commodity Risk Management Strategy
Commodity risk management requires that broker members provide an integrated view across commodities that rolls-up into a broader risk management program. Developing a strategic and integrated approach to commodity risk management are aiming to achieve . . . Sustainability: Risk managers require a sustainable process and infrastructure for ongoing management of commodity risk on a continuous basis – commodity risk is highly volatile and requires continuous monitoring and validation. The dynamic nature of business, supply chains, and commodity prices and availability demands that an organization develop a sustainable commodity risk management program. Consistency: Commodity risk has historically and ineffectively been managed across silos that do not integrate into a holistic view of enterprise risk. The complexity of business requires that commodity risk management be part of an integrated enterprise risk management framework.
Efficiency: The line-of-business is fighting back because of redundant and non-integrated risk processes that handicap the business. It should be aimed at to ease the burden on business by leveraging common control monitors, processes, assessments, and information. Transparency: Ultimately commodity risk management is needed to require greater transparency into key-risk indicators so that the investors can monitor its financial health, take advantage of commodity opportunity, avoid fraud, and avert or mitigate disaster. Accountability: In the end, someone is accountable to manage commodity risk. The organization brings all of this together to measure the effectiveness of commodity risk management and to provide accountability (whether positive or negative) to those who oversee it.
Core elements of a commodity risk management strategy
Risk intelligence: Risk management is about reducing uncertainty so that the business is not caught by surprise and is prepared for any situation it confronts. Good information – intelligence – is what reduces uncertainty. Organizations need to understand their commodity price and supply risk (and market) at a detailed level. This involves making sourcing strategies that reflect risk. The organization needs to be able to assess the commodity market, identify potential Conditions/uncertainties, and define key risk indicators to manage uncertainty and predict outcomes impacting the organization. Risk collaboration: Risk management that operates in a silo is not effective. To be effective, commodity risk management requires a range of stakeholders that can provide their input and insight into commodity risk issues and provide for the transparency the organization needs. Good collaboration also provides integration and oversight with both accounting and compliance scrutiny to avoid issues with regulators. Risk modeling: Risk management requires that the organization build commodity risk models and scenarios. This defines where points of failure or uncertainty are and predicts what can happen to the business. Risk calculation: Risk management then uses the models to calculate and score the risk across a range of models. Model your commodity risk exposure. This can be done across a range of value at risk (VaR) models utilizing analyses such as Monte Carlo simulations. Risk strategy: Risk management then impacts business strategy. The commodity risk valuations and business impact should turn into decisions to accept, avoid, transfer, or mitigate risk. This allows the organization to effectively react to uncertainty and market fluctuations. All five of these elements – risk intelligence, collaboration, modeling, calculation, and strategy – tie together to effectively manage commodity risk as an ongoing process and component of strategy. This often results in hedging, and it is only through these five elements that trader can feel secure in their hedging efforts. Otherwise hedging is really gambling. The goal of hedging is to insure against commodity risk and it requires intelligent risk strategy decisions to be effective. The goal is to provide predictability and not be surprised by changes.
Conclusion
Individual commodity trading exchanges and members have attained differing levels of sophistication in relation to the monitoring, measuring and managing of market, credit and operational risk. Nevertheless, we think that, the bulk of members should consider taking a far more consistent and holistic approach to risk management. In particular, members must abandon old attitudes which view market, credit and operational risk as separate heads and operational risk as the ‘poor relative’ of the other two. In contrast, exchanges and members need to establish where the risks overlap in their businesses and quantify these interactions in a consistent manner. They must become more sophisticated in the measurement of risk, as well as active in its management. They can also gain valuable insights from investment banks many of which must tighten up risk management procedures in the wake of recent financial crisis. risk managers spent most of their time monitoring risk, less time measuring it, and an even smaller amount of time actively managing it. This should be avoided as in future there is strong growth in seen in this market. Impact of new regulations to increase options, inclusions of banks, FIIs will be tremendous in terms of volume traded in commodity market. So if risk management strategies have not been applied consistently, it will adversely impact the growth of commodity market. Broker member being important function of the commodity market should understand the risk and take proper mitigation steps. Finally, members should ensure that similar types of tools and techniques are employed, across all types of risk, in order to ensure its consistent management and help provide a more enterprise-wide view of risk.
Bibliography
www.google.com www.investopedia.com www.mcxindia.comhttp://in.reuters.comhttp://www.ism.wshttp://www.economictimes.comhttp://www.mypptsearch.comhttp://www.nseindia.com
modeling risk basis risk call risk systemic risk interest risk volatility risk
doc_805670225.docx
This is a presentation about risk management at commodity desk report.
RISK MANAGEMENT AT COMMODITY DESK
Member’s perspective
[Type the company name]
[Type the author name]
Table of Contents
Introduction to Commodity markets ............................................................................................................ 3 Members of the commodity exchange ...................................................................................................... 4 Commodity risk management: Member’s perspective ........................................................................... 5 Broker as an intermediary: ........................................................................................................................... 5 Broker as a trader ............................................................................................................................................. 6 Natural Risk .................................................................................................................................................... 6 Man-Made risk ............................................................................................................................................... 6 Developing a Commodity Risk Management Strategy......................................................................... 15 Core elements of a commodity risk management strategy ............................................................... 17 Conclusion............................................................................................................................................................. 18 Bibliography......................................................................................................................................................... 19
Introduction to Commodity markets
Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. The trading of commodities consists of direct physical trading and derivatives trading. The commodities markets have seen an upturn in the volume of trading in recent years. In the five years up to 2007, the value of global physical exports of commodities increased by 17% while the notional value outstanding of commodity OTC (over the counter) derivatives increased more than 500% and commodity derivative trading on exchanges more than 200%.The major commodity markets are in the United Kingdom and in the USA. In India there are 25 recognized future exchanges, of which there are three national level multicommodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: * National Commodity & Derivatives Exchange Limited (NCDEX) * Multi Commodity Exchange of India Limited (MCX) * National Multi-Commodity Exchange of India Limited (NMCEIL) All the exchanges have been set up under overall control of Forward Market Commission (FMC) of Government of India. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say. Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the vital market.
Members of the commodity exchange
A commodity broker is a financial service professional licensed to sell commodity futures and options contracts. Unlike a stockbroker, a commodity broker deals in physical commodities such as foods, metals, energies, building materials, agricultural products, currencies, and stock and bond futures. Commodity trading is regulated by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). The function of a commodity broker is to handle customer accounts, enter customer orders and verify their execution, and report those executions back to the customer. A commodity broker also monitors margin calls, collecting funds from the customer when necessary. In the case of a full-service commodity broker, the broker also suggests and recommends trades to the customer based upon breaking news and the guidance of the brokerage firm's research department. The two types of commodity brokers are full service brokers and discount brokers. The primary difference is in the level of service and the rate of commission. A discount commodity broker is employed to simply enter and verify the execution of customer trades and report those executions back to the customer. Discount brokers do not make recommendations to customers. As the term implies, the commission rate for a discount commodity broker is quite a bit less than that of a full service commodity broker. A full service commodity broker often teaches a customer about the commodity markets and makes trading recommendations. NCDEX and MCX, maintain settlement guarantee funds. The exchanges have a penalty clause in case of any default by any member. There is also a separate arbitration panel of exchanges. Commodity options don't move point-for-point with their underlying futures contract; they do limit the potential downside to the amount invested in the option plus commissions and fees. If an options trade goes the wrong way, the investor will only lose the total investment. If a futures trade goes the wrong way, the investor can lose the entire investment and end up owing more money just to get back to a zero balance in the account.
Commodity risk management: Member’s perspective
As funds seamlessly flow from one market to the other and the Indian commodity market begins to integrate with the global market, the risk perception is beginning to heighten. Adoption of risk management or risk mitigation tools is now sine qua non for success in businesses with exposure to commodities. A serious look at futures trading as a tool for price discovery and price risk management is inevitable. Commodity risk management is very important to provide coverage to all those groups that are related to the commodity market. These groups are exposed to maximum financial risks when there is any natural disaster or man-made disturbance. Commodity market in every country faces some of the common risks. These risks are caused by natural disaster as well as external factors like wars, political instability and so on. If not covered properly, these risks can cause huge financial loss to a number of groups. Proper commodity risk management is essential to provide stability to this sector as well as to make this sector financially secured. The use of commoditylinked financial risk management instruments by commodity producers, traders, consumers, processors, reflects the desire. It is necessary to manage the risk to obtain protection from uncertain adverse price movements and to procure short-term finance. Higher and the more unpredictable the price volatility of a commodity, the greater the possibility of incurring losses or realizing gains on future sales or purchases of a commodity. The greater the share in an enterprise's earnings or in its production costs that a specific internationally traded commodity or commodities represent, the greater that enterprise's exposure to price risks. So its very much important task for the member to keep the safety position of himself and other investors. Broker member can act either as an investor or as intermediary to facilitate the trading for the investors. With these responsibilities there comes risk.
Broker as an intermediary:
When broker member acts as a intermediary between investors and exchange for trading, he faces very little risk. The risk is to maintain the margins with the exchanges and to follow up with the regulation given by them. Margin is important to mitigate risk. For the purpose of computing and levying the margins, MCX uses SPAN® (Standard Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based approach.
The Initial Margin requirement is based on a worst-case loss scenario of portfolio at client level to cover VaR (value at Risk) over a one day horizon, subject to a minimum Base Margin defined by FMC for the respective commodity. The SPAN Risk Parameter File (RPF) is generated by the Exchange periodically at pre-defined timings and RPF files so generated are provided to the members using the FTP service and on the Exchange website. In addition to SPAN margins, MCX levies Additional margins and/ or Special margins whenever deemed necessary considering the volatility and price movement in the commodities. Such margins are also levied as per the directions of FMC Tender Period margins and Delivery Period Margins are levied on contracts nearing expiry to ensure non default in commodity delivery.
Broker as a trader
When broker member is himself trading with the exchanges then he faces all the risk which a investor exposed to. Following are some of the major commodity risks, broker member needs to counteract. Basically there are different types of commodity risk that are faced by the commodity markets across the world. These risks are as follows: • • Natural Risks: Natural disasters Man-Made Risks: Liquidity risk, Market risk, Operational risk, Political risks, Currency
risk, Price risks, Interest risk,
Natural Risk
Weather Risk Management: The weather risks are very important for the farmers, plantation companies and the exporters. Heavy rain, drought, cyclones or other types of natural disaster cause huge harm to several groups. These groups need sufficient coverage against the natural disasters to remain financially secured. There are a number of insurance products offered to cover these risks. These are self insurance, crop insurance, index based insurance and many more.
Man-Made risk Liquidity Risk:
Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Usually it gets reflected in a wide
bid-ask spread or large price movements. In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk. Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:
? ? ?
Widening bid/offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations
Funding liquidity - Risk that liability:
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Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to broker member of commodity exchange who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets. Broker member should try to invest in highly traded commodities. Trading liquidity risk (an area which overlaps with market and credit risk) is another field in which broker should consider introducing a more consistent approach to monitoring, measuring and managing risk. If liquidity falls when an energy trading member is carrying out a transaction, and the participant buying cannot unwind or hedge the position fast enough, businesses should ensure that similar types of tools and techniques are employed, across all types of risk liquidity risk is created.
Traders should manage liquidity risk by monitoring the market bid-ask spreads and build this into their market making and pricing models. Energy companies and participants need to consider this aspect and build a charge into their pricing models, both to avoid falling into a liquidity trap and to manage trading liquidity risk more efficiently.
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risk are:
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Equity risk, the risk that stock prices and/or the implied volatility will change. Interest rate risk, the risk that interest rates and/or the implied volatility will change. Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
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Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.
Although risk managers at commodity trading companies have attained a considerable degree of sophistication in relation to market risk, firms tend to be skilled mostly at monitoring and measuring market risk. Commodity businesses need to adopt a much more dynamic approach towards the management of market risk and efficient utilization of risk capital. Firstly, trading companies and members should identify any risks not captured in their current risk management or VaR framework and include these in the programmed list for prioritization. Having all risks flowing through the VaR framework improves the completeness and quality of risk management, as well as reducing the requirement for manual intervention. In order to manage market risk more dynamically, energy companies and broker members should make greater use of stress testing. Stress testing must become a regular part of their risk modeling process and not simply be used as a standalone measure. It should incorporate varying probability weights, so that firms gain a better understanding of the risk range, and include historical scenarios, for example, the oil price crash of 2008, as well as user-defined scenarios. Running sensitivity tests can be useful
too, for example, to discover the impact of an event such as a 50% drop in oil prices, breakdown of price correlations etc. In addition, members could consider the introduction of Black Swan testing, i.e. stressing a portfolio with a risk factor previously ignored or considered to have little likelihood of occurring. Examples could include the euro losing its currency status or Russian gas supplies to Europe being cut off. What type of scenarios should commodity and energy companies model? The scenarios chosen should be unique to each company, as firms need to understand what factors are most critical to their own business model. Oil companies could ask themselves what would happen if the crude oil price fell to US$10/bbl, liquidity within the oil market completely dried up or the consequences if oil assets were seized by local governments. For power companies, a comparable scenario might be the discovery of a type-fault in a nuclear power station or the failure of the TSO’s control centre. Members active in the gas markets might wish to understand the effects of a significant trading disruption at a gas hub or the loss of a large storage facility. Importantly, whatever stress scenarios are used, these should be reviewed regularly and adjusted to reflect changes to the company’s circumstances. Stress testing must become a regular part of their risk modelling process and not simply be used as a standalone measure. The scenarios outlined above may be thought of as extreme situations but they are worth planning for. Until recently, few would have thought that a cloud of volcanic ash could have caused such disruption and heavy financial losses to the aviation industry. Importantly, stress testing enables businesses to determine their readiness to deal with (increasingly) extreme events. It allows them to understand more accurately the risks they face, to be better prepared and to provide investors with a clearer picture of the risks involved in the business operation. Finally, regular back-testing should be carried out, ideally on a daily basis. This involves comparing the previous day’s actual P&L with daily VaR numbers. This is important from a regulatory ensure management confidence in risk management processes. Steps should be taken to ensure that the number of exceptions – losses larger than estimated by the VaR model in frequency and size – are understood and corrective actions incorporated into the risk management model. Back-testing of expected tail loss can also provide an indication of how well the model captures the size of expected loss beyond the traditional 95% or 99% VaR confidence levels.
Operational Risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks. Operational risk management is, generally speaking, in an immature state at most commodity trading companies: businesses tend not to have dedicated operations risk managers, nor is operational risk understood to a sufficient level. Companies are only now beginning to monitor trading operational risk, while its measurement is still in its infancy. Indeed, the industry is only just becoming aware of the need to use benchmarks or metrics to measure and understand operational risk. As with other types of risk, there can be no proper management if companies have no adequate means of monitoring and measuring it. One example of particular weakness is trade confirmation. The process is riddled with delays and, even at large companies, can take up to a few weeks, depending on the complexity of the transaction and issues encountered in the contract terms and so forth. If counterparty fails in the intervening time, the impact is likely to be significant and may involve hardship. In contrast, a number of investment banks are now able to process confirmations quite rapidly. Commodity members should aim to emulate financial institutions in this respect – measuring confirmation times against industry benchmarks, both to improve efficiency and to reduce the risk of being unable legally to enforce an unconfirmed trade, in the event of counterparty bankruptcy. An understanding of the potential financial impact might focus attention. Invoicing constitutes another problem area. Here, similar delays can occur to those encountered in the confirmation process, with complex pricing terms and delivery quality issues often being the root cause of the delay. Again, commodity businesses would do well to put in place metrics to measure and monitor operational processes such as invoice generation. This, in turn, would allow firms to identify weak spots and to take remedial action. Finally, for members operating in the physical commodities arena, other types of operational risk need to be considered. In particular, businesses need to assess the efficiency with which physical assets operate. In this respect, metrics aimed at measuring the commercial availability of an asset can also play an important role. Indeed, some large energy firms already make use of these metrics. For businesses that do
not yet carry out these assessments, forming partnerships with agencies which undertake benchmarking exercises of operational processes will prove beneficial.
Political Risk
Political risk refers to the complications businesses and governments may face as a result of political decisions. It is any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives. Any announcement at the political level affects widely the price of the commodity. Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of 1. Nonmarket factors as macroeconomic and social policies like fiscal, monetary, trade, investment, industrial, income, labor, and developmental 2. Events related to political instability like terrorism, riots, coups, civil war, and insurrection At the time of war or any political instability in the country affect the commodity prices indirectly. As this has greater impact on the import and export of the country. Moreover it will affect the capital inflow in the country from other country in form of FIIs. Investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the most authoritarian. Longterm assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world. Understanding risk as part probability and part impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an
expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns. There are both macro- and micro-level political risks. 1. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, and also includes financial and economic risks. 2. Micro-level risks focus on sector, firm, or project specific risk
Impact the import/export and capital inflow
Political Risk
Affect the currency
Affect the Commodity
For mitigating the risk, At the macro-level largely involves understanding political uncertainties of the operating environment and the risks faced by all business operations in individual countries. Such information can come in the form of 1. Customized analysis 2. In-depth subject matter reporting 3. Information that can enable an investor or firm to calibrate their risk appetite 4. Contingency planning, intellectual property safeguards, risk diversification and sound exit planning to guard against uncertainty. At the micro level, it can be mitigated by transferring risk to other party like Insurer or Hedger.
Currency risk
Currency risk is a sudden fall in the value of a particular currency. This happens due to unexpected shifts in the currency exchange rates. Currency risks are related to the floating exchange rates. Nowadays, cross border commercial activities are growing at a rapid pace. Almost everything starting from goods to technologies are exchanged between the traders of different countries. These transactions are subjected to currency risk because floating exchange rates are minimizing the chances of fixing the value of a particular currency.
Change in currency by .01Rs, can change the commodity price by Rs 2 or even Rs 4. So fluctuation in currency creates deviation in the prices of commodity in Indian market. On the other hand, there are the forex market traders who are involved in trading of currencies of different countries. These traders participate in the activities of one of the most liquid world financial markets. One of the most common currency risk management tool is the forward exchange contract. According to these contracts that are signed between the potential seller and purchaser of a particular currency, the exchange rates are fixed before the actual transaction. The transaction takes place in the future but due to the contract, if the exchange rate of that currency changes at the time of transaction, the purchaser and the seller are not affected. There should also be a definite trading strategy that can be very helpful in hedging the currency risks. These strategies should be developed after analyzing the market averages or market indexes properly. On the other hand, there are certain theories regarding the trading process in the currency market. These are also very helpful for currency risk management. All these are specialized things and one may seek professional assistance from the currency risk management firms for the purpose.
Price Risk
Price risk is the risk of declination of the value of a security or portfolio of securities in the future. Basically, it's the risk that investor will lose money due to a fall in the market price of a security that he owns. Following are the risk management member broker should consider. Hedging strategies:
Unhedged Risk ? ? ? Changes in prices on unhedged volumes Changes in the basis differentials (location and grade) between chosen hedge and actual purchases Changes in consumption patterns
Interest rate risk
Interest risk is the major economic indicator. It plays an important role in affecting the price of commodity. When there is increase in employment rate, this leads to increase in the earning power of people resulting in increase in the price of the commodity so the price of commodity is dependent on demand and supply. To control the inflation there is increase in
interest rate. So the rise or fall in interest rate is the indicator of rise and fall in price of commodity. Risk can be minimized by investments in interest rate futures.
Regulatory risk
Commodity exchanges and organizations along with the trading participants face a range of legal and compliance risks within commodity risk management. Compliance oversight is required to manage training, policy-making, and monitoring of commodity sales, marketing, and business operation/transaction activities. This frequently requires understanding and adherence to a complex array of international regulations governing commodities which often focus on: monitoring and documenting trade flows, order routing/execution, and trade reporting functions for compliance as well as irregularities; maintaining the commodities compliance policies and procedures and appropriate training; and documenting, categorizing, and tracking of error trades and error trading policies. Example: GE was forced to restate earnings from 2001-2005 because of noncompliance with FAS 133. As the result of a regular audit review, GE discovered that it was in non-compliance to FAS 133 (regulations governing accounting for derivative instruments and hedging activities) for certain transactions used to protect from changes in interest and currency exchange rates.
Developing a Commodity Risk Management Strategy
Commodity risk management requires that broker members provide an integrated view across commodities that rolls-up into a broader risk management program. Developing a strategic and integrated approach to commodity risk management are aiming to achieve . . . Sustainability: Risk managers require a sustainable process and infrastructure for ongoing management of commodity risk on a continuous basis – commodity risk is highly volatile and requires continuous monitoring and validation. The dynamic nature of business, supply chains, and commodity prices and availability demands that an organization develop a sustainable commodity risk management program. Consistency: Commodity risk has historically and ineffectively been managed across silos that do not integrate into a holistic view of enterprise risk. The complexity of business requires that commodity risk management be part of an integrated enterprise risk management framework.
Efficiency: The line-of-business is fighting back because of redundant and non-integrated risk processes that handicap the business. It should be aimed at to ease the burden on business by leveraging common control monitors, processes, assessments, and information. Transparency: Ultimately commodity risk management is needed to require greater transparency into key-risk indicators so that the investors can monitor its financial health, take advantage of commodity opportunity, avoid fraud, and avert or mitigate disaster. Accountability: In the end, someone is accountable to manage commodity risk. The organization brings all of this together to measure the effectiveness of commodity risk management and to provide accountability (whether positive or negative) to those who oversee it.
Core elements of a commodity risk management strategy
Risk intelligence: Risk management is about reducing uncertainty so that the business is not caught by surprise and is prepared for any situation it confronts. Good information – intelligence – is what reduces uncertainty. Organizations need to understand their commodity price and supply risk (and market) at a detailed level. This involves making sourcing strategies that reflect risk. The organization needs to be able to assess the commodity market, identify potential Conditions/uncertainties, and define key risk indicators to manage uncertainty and predict outcomes impacting the organization. Risk collaboration: Risk management that operates in a silo is not effective. To be effective, commodity risk management requires a range of stakeholders that can provide their input and insight into commodity risk issues and provide for the transparency the organization needs. Good collaboration also provides integration and oversight with both accounting and compliance scrutiny to avoid issues with regulators. Risk modeling: Risk management requires that the organization build commodity risk models and scenarios. This defines where points of failure or uncertainty are and predicts what can happen to the business. Risk calculation: Risk management then uses the models to calculate and score the risk across a range of models. Model your commodity risk exposure. This can be done across a range of value at risk (VaR) models utilizing analyses such as Monte Carlo simulations. Risk strategy: Risk management then impacts business strategy. The commodity risk valuations and business impact should turn into decisions to accept, avoid, transfer, or mitigate risk. This allows the organization to effectively react to uncertainty and market fluctuations. All five of these elements – risk intelligence, collaboration, modeling, calculation, and strategy – tie together to effectively manage commodity risk as an ongoing process and component of strategy. This often results in hedging, and it is only through these five elements that trader can feel secure in their hedging efforts. Otherwise hedging is really gambling. The goal of hedging is to insure against commodity risk and it requires intelligent risk strategy decisions to be effective. The goal is to provide predictability and not be surprised by changes.
Conclusion
Individual commodity trading exchanges and members have attained differing levels of sophistication in relation to the monitoring, measuring and managing of market, credit and operational risk. Nevertheless, we think that, the bulk of members should consider taking a far more consistent and holistic approach to risk management. In particular, members must abandon old attitudes which view market, credit and operational risk as separate heads and operational risk as the ‘poor relative’ of the other two. In contrast, exchanges and members need to establish where the risks overlap in their businesses and quantify these interactions in a consistent manner. They must become more sophisticated in the measurement of risk, as well as active in its management. They can also gain valuable insights from investment banks many of which must tighten up risk management procedures in the wake of recent financial crisis. risk managers spent most of their time monitoring risk, less time measuring it, and an even smaller amount of time actively managing it. This should be avoided as in future there is strong growth in seen in this market. Impact of new regulations to increase options, inclusions of banks, FIIs will be tremendous in terms of volume traded in commodity market. So if risk management strategies have not been applied consistently, it will adversely impact the growth of commodity market. Broker member being important function of the commodity market should understand the risk and take proper mitigation steps. Finally, members should ensure that similar types of tools and techniques are employed, across all types of risk, in order to ensure its consistent management and help provide a more enterprise-wide view of risk.
Bibliography
www.google.com www.investopedia.com www.mcxindia.comhttp://in.reuters.comhttp://www.ism.wshttp://www.economictimes.comhttp://www.mypptsearch.comhttp://www.nseindia.com
modeling risk basis risk call risk systemic risk interest risk volatility risk
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