Commodity Derivative Contracts - Exotic Products - Relevance for India PDF
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Dr. V. Shunmugam
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These lecture notes discuss commodity derivative contracts, focusing on exotic products and their relevance for India. They cover weather derivatives, including their introduction, business sectors affected by weather risks, and the basics of weather derivatives. The document also touches upon the salient features of weather derivatives and their implications.
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Commodity Derivative Contracts – Exotic Products – Relevance for India By Dr. V. Shunmugam Weather Derivatives -Weather Introduction affects almost all types of business activities....
Commodity Derivative Contracts – Exotic Products – Relevance for India By Dr. V. Shunmugam Weather Derivatives -Weather Introduction affects almost all types of business activities. In the last few years, the Besides agriculture, weather monsoons have played also affects many other truant with us on more activities. than one occasion. Even in our advanced, Companies involved in technology based society, we still live largely at the agriculture, energy, aviation, mercy of the weather. construction, mining event It influences our daily lives management, tourism, etc. and choices, and has an face revenue risk due to enormous impact on adverse weather. corporate revenues & Earnings. Weather risk is the risk of uncertainty in revenue, profit and cash flow due to unfavourable weather conditions. Weather conditions can be temperature, rainfall, humidity, snowfall, windspeed, etc. 2 Business Sectors and Weather Risks Business sector Weather Business risk variables Air conditioner Temperature Drop in sales during Winter months Agriculture plantation Temperature, Drop in production volume as well as poor rainfall, snowfall quality of production Aviation Fog Cancellation of flights due to fog Beverages Temperature, Drop in consumption due to mild summer or ice creams rainfall winter Construction Rainfall, snowfall Delay in construction due to excessive rainfall of snowfall Temperature, Drop in demand for electricity due to warmer Electricity generation winter and colder summer rainfall Drop in production due to inadequate rainfall Drop in traffic and sales if cool or humid Tourism, Temperature, summer entertainment, theme rainfall, snowfall Drop in traffic in ski resorts with insufficient park snowfall Horticulture Temperature Increased energy consumption to keep greenhouse warm Textile, woollen Temperature Drop in consumption due to warmer winter garments and colder summer Weather Derivatives - Basics Weather Derivatives are financial products that allow companies to manage or “hedge” their weather related risk exposures. Until recently, there were very few Like Financial derivatives, Weather financial tools offering derivatives are used to “hedge” companies‘ protection against the erratic risk. nature of the weather. The value of a Financial derivative However, “Weather depends on the value of an Derivatives” have changed all this by underlying asset, index or providing protection commodity. against the uncertainties of the The value of a Weather option weather. depends on the value of an underlying weather statistic. Weather Derivatives protect against abnormal weather outcomes. Weather Derivatives – Salient Features Weather derivatives help companies hedge volumetric risk-risk associated with the decline in sales volume due to unfavorable weather condition. Other types of commodity derivatives help to mitigate price risk. Weather derivatives are used to hedge weather risks that are non-catastrophic in nature. Weather risks emanate from ordinary variations in climatic conditions— temperature, rainfall, humidity, snowfall, etc. 5 Advent of Weather Derivatives Weather derivatives industry is relatively young. This derivatives sector began to develop in 1997, as a result of the severe weather events of El Niño. Growth was limited due to the credit risk associated with an over-the-counter market Chicago Mercantile Exchange (CME) introduced the first exchange-traded, temperature-related weather futures and options on September 22, 1999. CME offers Heating Degree Day (HDD) and Cooling Degree Day (CDD) futures contracts and options on futures for monthly and seasonal temperature related events. HDD futures and options are traded on the fall and winter months of October through April. CDD futures and options are traded on the spring and summer months of April through October. CME contracts are based on indexes of HDDs and CDDs and are traded on selected cities throughout the United States, Europe, and Asia-Pacific. Utility industry in the United States has found that 65 degrees Fahrenheit is a benchmark temperature to differentiate between transactions in the heating and cooling seasons. 6 HDD is calculated by subtracting the daily average temperature from 65 degrees Exchange Traded Weather Derivative Contracts at CME Temperature based Derivatives Contracts o CDD/HDD Futures contracts Contract size is USD 20 times the respective CME Degree Days (HDD/CDD) Index. o CDD/HDD Seasonal and Seasonal Strip Futures o CDD/HDD Monthly Options o CDD/HDD Seasonal and Seasonal Strip Options Hurricane Index o Hurricane Index Futures o Hurricane Index Options Futures Contracts on Frost Futures Contracts on Snowfall Index Rainfall Index o Rainfall Index Futures 7 o Rainfall index Options Weather Risks Average Temperature - HDDs/CDDs Abnormal Temperature Rainfall Precipitation or snowfall Snowfall Humidity Wind speed River flow Combinations of the above 8 Weather Derivative Customers Any derivative Utilities and energy companies product derives its value from some underlying asset. Agricultural companies / producers Weather derivatives use weather Municipalities conditions-such as city temperature, Seasonal Clothing Manufacturers rainfall and wind speed and so on— Airlines to create different kinds of derivative instruments. Ski/Beach Resort Operators Golf Course Management Companies Beverage Companies & Distributors 9 Prospects of Weather Derivatives in India Pros Variability in Indian Monsoon Increased water-intensive cultivation Rapid commercialization of agriculture Necessary amendments (SCRA) post-merger of FMC with SEBI Cons Farmers are covered under crop insurance schemes—most of them government-sponsored—to hedge against weather risks. Regional variation in weather Small and marginal farmers Weather Derivatives – Developments MCX and Rainfall Index NCDEX tied up with Skymet for Weather Indices 10 Emission Trading What is Emission Trading? Differences in Emission Instruments Emissions trading (ET) is a mechanism EUA – European Union Allowances that enables countries with legally – Granted by the EU to member nations binding emissions targets to buy and sell – Acts as caps for emissions in each emissions allowances among country themselves. – Surplus allowances can be traded in the EU ETS Emission Trading – Bird’s Eye View – Potentially Risk Free CER – Certified Emission Reductions – Earned by projects that reduce emissions (pollution) – Used by nations that pollute beyond their caps – Inherent project risk The new treaty—what would become the Paris Agreement—was to fully replace the Kyoto Protocol by 2020. 11 Risk Elements in CDM Delivery risk - Project risk - Regulatory risk o Risk of certification o Cap in European National Allocation Plan o Implementation of ITL - Risk of contract fulfillment Market price risk (Fuel prices, weather, economic growth, EUA, etc.) 12 Price Influencing Factors EUAs Price Influencing Factors Price Influencing Factors - CERs Policy issues Supply-demand mismatch CO2 emissions Policy issues Weather/Fuel prices Crude oil prices CERs Coal prices Foreign exchange fluctuations CO2 emissions Weather/Fuel prices Pricing of CERs is based on Prices of European Union Allowances Fixed contract (EUAs) Index linked contract - to get high Foreign exchange fluctuations prices of EU market Global economic growth Correlation between Brent Crude Oil and EUAs – 78.05 % (2007) Correlation between Electricity and EUAs – 49 % (2007) Price Volatility of EUAs – 4.04 % (from inception on ECX platform to 14 th November 2007) Note: Brent crude oil and Electricity prices were from Intercontinental Exchange, while EUA prices are from ECX traded on ICE platform. 13 Emission Markets Participants / Platforms Global Exchanges Providing Emission Participants Trading Platform Hedgers Nord Pool Exchange – Electricity & CERs Producers European Energy Exchange (EEX) – Intermediaries in Spot Markets Electricity, Coal, Natural Gas & EUAs Ultimate Consumers _ Annexure I European Climate Exchange (ECX)* – Investors EUAs & CERs Chicago Climate Exchange (CCX)* – Arbitragers – ECX Participants VERs Speculators Portfolio Managers * - ICE acquired ECX & CCX Diverse participants with wide participation objectives Commodity Financers – OTC Traders Funding agencies Corporates having risk exposure in energy products – Clean Technology Developers 14 Physical Markets for Freight Freight - Bulk Transportation of Goods – Truck. Ships, Railways Charterer - Uses a ship to transport a cargo from one place to another place Voyage Charter Contracts Contract of Affreightment Time Charter Contracts 15 Main Vessel Types Dry Bulk Carriers Handysize: about 20/35,000 dwt, four holds/hatches or five holds/hatches Handymax about 36/49,000 dwt, five holds/hatches Supramax/Ultramax about 50/66,000 dwt Panamax/Kamsarmax about 65/82,500 dwt, seven holds/hatches Post Panamax/Mini Cape about 87/120,000 dwt, seven holds/hatches Capesize about 120/200,000 dwt, nine holds/hatches Valemax, Chinamax about 220/400,000 dwt, seven holds/hatches Tankers Handysize about 10/37,000 dwt MR (Medium Range) MR1 35,000-44,999 dwt MR2 45,000-54,999 dwt Panamax about 60/80,000 dwt (also called an LR1 if coated tanks for refined products) Aframax about 90/120,000 dwt (also called an LR2 if coated tanks for refined products) Suezmax about 120/160,000 dwt VLCC (Very Large Crude Carrier) about 240/320,000 dwt Container Vessels Ultra Large Container Ship (ULCS) - carrying capacity of 18,000-23,000 TEU Very Large Container Ship (VLCS) - carrying capacity of 14,500-17,999 TEU Neo-panamax - carrying capacity of 10,000-14,499 TEU Post-Panamax - carrying capacity of 5,200-9,999 TEU Panamax - carrying capacity of 3,000-5,199 TEU 16 Causes of Volatility in Freight Rates Supply & demand - how many ships are available for charter at any one time General economic conditions and the state of global trade Seasonal trading patterns/industrial cycles Strikes and port delays which will tie up ships Vessel speed – slow steaming ties up more ships Vessel orderbook – lots of new ships can swamp the market Vessel recycling – lots of scrapping decreases supply Floating storage – storing commodities at sea will decrease vessel supply 17 Baltic Freight Indexes Started publishing the BFI – January 4, 1985. 13 Voyage Routes – Cargoes from 14k Tons to 120K tons Dry Cargo – Coal, Grain, Iron Ores, etc. Wet Cargo – Crude Oil, Chemicals, LNG, etc. Freight Indexes and Futures Committee (FIFC) Geographical Balance: The chosen routes should not be concentrated in one geographical location. Liquidity: The chosen routes should have significant shipping activities. A route which remain closed in a specific season are not chosen. Standard preferred voyage terms: Routes where business is done standard terms are given preference – Baltic Handysize Index (BHI) – Baltic Panamax Index (BPI) – Baltic Supramax Index (BSI) – Baltic Capesize Index (BCI) – Baltic Dirty Tanker Index (BDTI) – Baltic Clean Tanker Index (BCTI) – Baltic Dry Index (BDI) 18 The Baltic Code 2020 Guidance to Shipbrokers and Principals on Ethical Conduct in Physical Freight and Freight Derivatives markets. Baltic Code key principles Integrity of Markets Market Participants shall act to uphold the integrity of the physical freight and freight derivatives markets and avoid any action or omission that may adversely affect these markets or bring the Baltic Exchange and its membership into disrepute. Fairness and Competition Market Participants to act fairly and avoid anti-competitive agreements and practices. Ethical Business Market Participants shall do business in an ethical manner, eschew corrupt practices nts shall treat their customers fairly, compete and comply at all times with any and all applicable laws including those related (but not limited) to money laundering, sanctions and tax evasion. Good Market Conduct Market Participants shall comply with applicable laws in respect of their activities in the freight and freight derivatives markets, maintain authorisations and permissions to undertake regulated activities and devote due skill, oversight and resources to these activities. Robust and Credible Benchmarks Members contributing data to the Baltic Exchange benchmarks shall comply at all times with applicable law and the Baltic Exchange Guide to Market Benchmarks. Market Participants using these products shall comply with applicable laws and terms and conditions under which the Baltic Exchange provides these products and at all times recognise the rights of the Baltic Exchange in respect of these products. Within the Code, each of the five principles listed has detailed examples of good and bad practice designed to help market participants understand what is acceptable and unacceptable. 19 Forward Freight Agreements Existed since 1985 with the creation of the BFI (Baltic Freight Index), a basket of individual dry cargo routes Since 1992, the individual shipping routes can be traded “over the counter” (i.e. outside an organized exchange) in the form of FFAs. The underlying market is the freight market of physical transportation of cargo Prices in the freight market are termed freight rates and are expressed in terms of $/day (“time-charter”) or $/tonne (“voyage charter”) The freight market is highly segmented and freight rates are specific to: Vessel type Route Duration of charter agreement 20 Water Derivatives WATER - Considered Almost Free Till We Face Scarcity – Affecting Quality of Life of People, Farming Risks – non-availability of water, deficiency of water and hence higher cost of water Australia – has been a frontrunner in water markets 1994 Reform by – Council of Australian Government – Making water tradeable Separation of Land Ownership – Ownership of Surface/Ground Water Water Corporation of Victoria – Manages water trading issues – State of Victoria Victoria produces 90% Aus Pears, one third of Aus Apples, Tomatoes, Potatoes, Carrots, etc. Also has 60% of Australia’s dairy production. 21 The Water Market Structure Each Farm/Company – State of Victoria in a Particular Geographical Region State of Victoria – 6 Trading Zones – Limits of market boundaries Allocated a specific amount of water – Type of Activity and Historical Consumption Pattern - Level of water reserve Allocation indicated as a percentage of the Historical Consumption Pattern The firm can as per its consumption plan can trade these water rights Closed Auction – Successful Bidders get their water through the waterway and buyers Water drawal would have to happen in a certain no. of days from the purchase. Rainfall – Helps the agriculturists sell or buy their requirements and hedge water costs vis-à-vis loss of crop if it fails Thus emerges a spot price for market – which can form the basis of water derivative trading. 22 CME Group to Launch First-Ever Water Futures California Water Markets Size – Estimated at USD 1.1 Bill – 40% - Agricultural Use – 9 Mill Acres of Crops Futures Contracts - Nasdaq Veles California Water Index NQH2O (2018) – Nasdaq + Veles Water Limited – Oct 31, 2018 - USD. 371.11/Acre Foot – (Excl. Conveyance Cost, water loss) Current valuation of water as determined by water entitlement transactions from California’s surface water market and four adjudicated groundwater basins Data – WestWater Research – Pricing, Valuation, and Transaction Advisory Services for Water Rights – Aggregated from the five largest and most actively traded markets in California – Priced weekly in US$ per Acre Foot ($/AF), the prevailing market price for water transactions – Sourced weekly from Waterlitix™ – a pricing and market information database developed and maintained by WestWater Research Index – Weekly Benchmark Spot Price of Water Rights – VWAP California’s five largest and actively traded water markets NQH2O Index Futures – Contract Unit – 10 Acre Feet X Index Value - Tick Size – USD 1/Acre Foot – Financial Settled Contracts Final Settlement Price - Closing NQH2O price on Final Settlement Day rounded to the nearest $0.01 Contracts to be available - Eight consecutive quarterly contracts (Mar, Jun, Sept Dec) plus nearest two serial months https://www.cmegroup.com/trading/equity-index/us-index/nasdaq-veles-california-water-futures.html?redirect=/wat erfutures 23 Challenges and Issues in Commodity Markets COVID and Commodities National Supply Problems Reduction in Demand Wastages in supply chain Inefficient logistics International Volatile Currency Rates Reduction in Demand Uncertain Supplies Reduction in Global Trade Lower Demand – Inflexible Supplies -> Lower Prices Higher Volatility – Global Fundamentals – Economic Data Non-functional markets Lower Liquidity in the markets Enhanced risk management efforts Problems with physical commodities under lockdown Challenging logistics COVID Impact – Energy The Conundrum Demand Slow Down – Tepid Supply Response Limited Storage – Landlocked WTI Futures Delivery Based CME – WTI Contracts The Impact Volatility Surge – Skyrocketing VAR 40 Minutes – Minus 40 Unprepared Intermediaries Widening Spot-Futures Divergence Key Lessons from Negative Crude Oil Prices - Failure in market functioning? An attempt to manipulate markets? - Mechanism of Trading – TAS – Commins /Vega - Bank of China – Treasure Fund - Didn’t Occur to us – USD 52.2 Mill – Retail who accumulated at USD 10-0 levels – Never thought unthinkable can happen – CFTC has been studying Vega Capital (Behavior) - While the international exchanges prepared the market for a possible negative prices –intermediaries did not - None of the geographies had an alternative risk management mechanism – Settlement, Accountability, Price Determination (options) - Roles and responsibilities of intermediaries being questioned. Spate of disputes at various levels across geographies with varied regulatory culture - Decrease in the trust about the market integrity amongst the stakeholders affecting their overall performance - Had its own reverberations on the other asset classes, especially the equities – DJIA 29 - To retail investors – Be on top of the markets and have a watchful eye Negative Crude Oil Prices - The India Story - Rs. 965/B Minus Rs 2884 - On April 15, 2020, CME Clearing announced that its trading and clearing systems had been enabled to trade in zero or negative prices - Initially announced Rs. 1 as the settlement price and thereafter minus Rs. 2884 per barrel - Sanctity of the contract terms? Should there be an exception due to an unprecedented event? - Timings changed – March 26, 2020 with only 5 days notice to the market – in discussion with SEBI vs 30 days - Settlement of contracts executed on an exchange platform are also guaranteed by the clearing corporation and cannot be annulled unless on account of fraud, mistake or wilful misrepresentation – Unconditional Financial Settlement is the Holygrail of traded market places - Motilal Oswal Financial Services Ltd, Religare Securities and PCS Securities Ltd--that jointly moved the Bombay High Court – Apri l 22, 2020. MCX has any provision to trade commodities/stock by assigning a negative value to it. - Automatic Deduction of Broker Accounts – Clients Pay-in ? Dhanera Diamonds - Rajasthan High Court – Ganganagar Commodity - MCX did not have the facility to allow negative trading and truncated trade time at 5 pm The Nickel Short Squeeze on LME – April 2022 Nickel from thUSD 20,000 to 100,000 / Ton – March 4 – 8 , 2022 CAUSE – USD Bill / Economic Sanctions / Tsingshan Co (‘Big Shot’) At the peak of Price – TS – USD 15 Bill At LME, the price spike – generated ‘Margin Calls’ Trade Halted – Retroactively cancelled 9000 trades / USD 4 Bill LME over time – Boozy Lunches – 2019 – LME Ban 30,000 LME – 120,000 Tons on OTC Russia provides about 20% of all top-grade nickel Making hedge funds go long and benefit One among them is – AQR – AUM USD 124 Bill Trading to start the next day with a price limit of – 10% Curiously, Xiang remains confident that nickel’s price will fall and wants to remain short even after the bailout To Xian JM Keynes ‘ “Markets can remain irrational longer than you can remain so” The Global Spillover Effect Trade cancellation - broken a cardinal market rule The retroactive cancellation of trades for such like-minded free-market Dwindling Nickel Volumes on advocates amounts to a cardinal sin. Its rule-book grants the exchange wide-ranging powers to act in MCX "emergencies". 6000000 Those powers are exercised through the "Special Committee", a body 5000000 established to remove any conflict of interest from LME market 4000000 interventions. 3000000 LME and British regulators will have to persuade them it won't ever 2000000 happen again if they are to return. 1000000 LME nickel trading volumes fell by 35% year-on-year in May, part of a 0 JAN FEB MAR APR MAY JUN broader 13% decline in trading activity last month. LME’s promised forensic report – awaited Emergence of Price Reporting Agencies Warren C. Platt (1883–1963) - National Petroleum News in Cleveland, Ohio in 1909. Platts Oilgram - an influential source for petroleum prices. Platt founded companies were acquired in 1953 to become part of what was then known as McGraw-Hill group and later became a part of S&P Global. Platts under McGraw-Hill – Coverage of more assets to turn the company into a energy information provider. * Argus Media was established in 1970 by former Daily Telegraph journalist Jan Nasmyth. In 1979, Argus became the first reporting agency to quote crude oil prices and published the first ever daily crude market wire. Major Price Reporting Major Sectors covered by PRA’s Agencies Fossil Fuel Markets Platts Argus Power Markets Opis Agriculture, Forestry and Metal RIM Markets ICIS McCloskey Environmental Markets and Weather Natural Gas Intelligence Services Reuters FX, Interest Rates, Credit and Equity Price Reporting Agency? Price-reporting agencies (PRAs) agencies that reports on fundamentals of asset classes and bring transparency to the physical commodity markets. -Provide transparency, enabling efficient functioning of PRAs publish price assessments = prevailing open-market markets. price level in specific physical markets – per specific published methodology for the respective asset class/commodity. Frequency – daily/weekly/monthly - for a subscription fee. Publish databases, analysis and real-time market news, and some are involved in related businesses, such as consultancy and knowledge sharing events. PRAs are independent of the markets they report on and have no vested interest in any of the price assessments that they publish. PRAs compete with one another to publish the most accurate and most relevant assessment of a given asset class’ price in a particular market. Source: Massey, D. (2016) Benchmark Pricing What the Market Expects Characteristics of a Good Convergence between market Benchmark Adherence to international values and published values norms of trading Benchmarks that fully reflect Chain formation, high degree market fundamentals of circulation Responsible behaviour Leads to the development of a Complete transparency forward market High degree of transparency - Benchmark assessment methodology is clearly defined Benchmark assessments are open to industry scrutiny Market acceptance Process of Commodity Price Determination American Metal Market The Metal Bulletin Group, which includes American Metal Market, is a leading price reporting agency (PRA) and intelligence provider for the metal & mining markets covering over 2000 non-ferrous, ferrous, raw material and non- metallic mineral prices. LIBOR – Awaiting Transition * The regulator of LIBOR, the Financial Conduct Authority (FCA), indicated in 2017 that it will no longer require banks to participate in the LIBOR rate setting process after 2021. LBMA Standards in Gold LBMA Standard Maintains three main Components The Good Delivery system – Quality Assurance and Traceability The Global Precious Metals Code - Ethical trading of precious metals and applies to all participants actively trading in the Loco London precious metals market. The Responsible Sourcing Program - Ethical sourcing of the metals and provides confidence in the market that all LBMA stamped bars are produced from raw materials sourced responsibly. Good Delivery List (GDL) Refiners accredited to produce gold of LBMA standard. This is the global industry standard, licensed and recognised by exchanges, central banks and traders worldwide. A refiner must comply and satisfy all of the following three requirements, not just at the point of application for the GDL, but on an ongoing basis. Challenges with Price Reporting Agencies: Market Evolution and Transparency Evolution: Commodity markets are evolving both from a market and a policy perspective. - The evolution implies that the way PRAs report prices may change. - For example, a trend that began a decade ago is commodity trading activity moving East. Transparency: A key issue with PRAs has been transparency. In simple terms, do the prices they report reflect supply and demand conditions or they have been influenced by commercial interests? IOSCO Principles for Price Reporting Agencies - 2012 The Principles are best practices on: Governance and oversight Quality and integrity of the methodologies Accountability and Audit The IOSCO Requirements: A strong Code of Conduct, policies and stringent training All methodologies are published to ensure transparency to stakeholders All changes to methodology and/or price specification are implemented only after have sought and considered market participants views and feedback A fully auditable process developed following the IOSCO requirements Platts’ Market on Close (MOC) Platts Market-on-Close (MOC) is a price-discovery system designed to yield a price assessment reflective of market values at the close of the typical trading day. The MOC process is a very structured system for information gathering that allows transparent and fully verifiable market information to form the basis of the daily price assessment. General Guidelines for MOC: All bids/offers must be available to the market Sufficient time to react to the bids and offers Transactions between affiliates not used in assessment Open to any credible participants Participants should be familiar with the guidelines Published bids and offers are firm PRA Methodologies – A Review Sl. No. Methodology KeyAdvantage KeyDisadvantage A true market expert will Depends on individual reporter to 1 Expert Judgment make the right assessment get it right Locks in commitment from Potential suppliers of key 2 FixedPanel key market players information may be missing Flexible to capture key Editorial selection problematic, 3 FloatingPanel market information less prestigious Eliminates editorial Bad judgment can skew the final 4 Non-adjustedPanel involvement assessment Removes outliers that could Arbitrary judgment call, could 5 AdjustedPanel negatively impact pricing eliminate the key information Both ‘trade’ and ‘panelist’ Small trades could skew the 6 HybridPanel views are reflected assessment Allows greater context to Only as good as the price reporter 7 Survey emerge and his contacts Based on actual trade, no Lacks context; timing could skew 8 Volume-weightedAverage judgmental calls the assessment Transparent and allows easy Limited underlying liquidity and 9 Market - on- Close price comparison participation Perfect convergence Limited participation, unregulated 10 PRA Physical Delivery between assessment and process commodity Can reflect the market 11 Derivative Based practice; potentially highly Risk of circularity in assessment regulated Enables assessment in Dependent on stable relationships 12 Relative Value illiquid markets in relative value Clearly shows where sellers Does not clearly identify buying 13 Best Offer are operating levels PRA Benchmarks and their usage Particulars Usage inPractice Derivative settlement price Major physical benchmark Benchmark Usage Reference Price for termdeals Reference price for spot trade Data for mark – to - market Informational Usage (Data) General price reference data Fundamental data Market Analysis Informational Usage (Text) Specialist news reporting General news reporting Energy PRAs Warren Cumming Platt - Father of the PRA Industry - 1923 - Oilgram - - Oil Pricing for Oil Companies Breakthrough - 1928 - US Gulf Crude Oil Price Assessment - Independent Reference point for Oil Sales Contracts in US Europ-Oil Prices - John Nasmyth - 1970 European Crude and products prices assessments Relatively stable oil - till 1970s - Became volatile in 1973 - Arab Oil Embargo - Several Competitors emerged - DeWitt & co (1973) 1979 - Independent Chemical Information Services - ICIS 1981 - Natural Gas Intelligence - Ellen Beswick - Referred in most NG Hubs in the US RIM Intelligence - Japanese Energy Markets During 1990 - Argus, Platts and Reuters - Went over to other geographies to set up relevant PRAs Liberalisation of Electricity Markets in Europe - Furthermore, Power PRAs and Coal PRAs emerged 1993 - Here Energy - Gas-based PRA 2000 - Point Carbon - Norway, Oslo - European Emission Markets Benchmark The Metal PRAs Prominent PRAs – Metal Bulletin, Fast Markets (AMM), Iron Age/Scrap Price Bulletin, etc. Iron Age – 1859 – Irish settlers in New York – Williams Sr and David – Publications Shipped across 50 countries American Metal Markets – Weekly - 1882 – 1300 metal prices Metal Bulletin – Quin’s Metal Markets Letters – 1913 Focused on LME – wider coverage of 103 markets (precious/base/ferrous/rare metals) – followed by CRU (1969) – 11 locations CME – Hedging Alumina/Al and Premiums – Metal Bulletin and Platts Assessments Steel in Asia – public sector driven – negotiated term/annual contracts 2010 – rapid spot trading in iron ore in addition to rapid swings in steel prices = BHP Billiton – Platts Assessmt 62 FE (cif China) – Spot Benchmark TSI – Steel Business Bulletin Group (2001) – Underpins much of derivatives trading CBEX – CBMX – Alternative spot exchanges to Platts Survey – Dalian Iron Ore Futures Similar efforts on Coking Coal by PRAs – Platts Australia fob – Chinese PRAs – Umetal, MySteel, SteelHome, CuSteel Precious Metals – London Gold Fix – NM Rothschild – 12th Sept 1919 – 3 PM fix @1968 – NMR -> Barclays (2004) – DB left Silver fix – 2014 – Breakdown of London Fix – FCA fined Barclays for Gold price manipulation by one of its traders GBP 26 mil – systems and control failures and conflict of interests London Fix - LBMA 2014 - Gold fixing to ICE , CME group and TR – Silver, Platinum/Palladium – LME Minerals – Industrial Minerals an offshoot of MB – coverage of a wide range of minerals Agricultural PRAs Public Ledger (1760) - Currently a Informa Group Company - Launched “Open to All Parties, Influenced by None” - News, Analysis and Data for 700 Agri. Comm – IOSCO Compliant even 250 years ago. Cotton Outlook - Cotlook A Index - US and UK Presence CME Group - European Biomass Derivatives - Argus European Wood Pellets CIF NWE assessment ICO - Polled Coffee Prices from US, Germany and France - Daily Index F. O. Licht (Informa Agribusiness Intelligence) - International Coffee Report Platts (2012) - Australian Premium White Physical Prices - Daily - Replaced CBOT Reference PRIMA Markets, F.O. Licht - Bioenergy market assessments CME Group - Butter and Cheese Prices - settle on USDA monthly reference prices Are you a user of PRA benchmark ? If so, please note: - Market of reference should be relevant (quality/place/duration) - The assessment methodology is transparent and finalized after public consultation - Independence of the employees - Checks and balances/Internal Reviews key to the strength of PRA assessments - Actual trade-based assessment would always be better - Third-party certified for adherence to IOSCO principles – Implementation and Adherence - A traded benchmark would be more relevant and accurate – Spot trades - With liquid underlying OTC markets - There are also premiums or discounts of the benchmarks traded - Also collects and publishes a lot of market intelligence and analysis reports Commodity Price Risk Management Identification, Measurement, Management, Governance and Accouting KNOW PLAN your risk to hedge them Measure Distingui Categoris e Drawi Understa nd sh Creati ng Ask ng a Hedgi frame ng work strate gy 1Risk Management Policy Board approved, Authority structure, MIS 2Regulatory Approvals In case of hedging at overseas exchange 3 Appointing Brokers Reputation, financial standing, cost, credit lines, service 4 Internal setup Staffing Front and Back office, Training, Recordings, Communication flow 1 How much to hedge? Hedging Ratio 2 Where to hedge? Natural, Domestic or International exchange 3 When to hedge? Benchmark, scale-up / down plan, review 4 Collateral Margin, MTM 5 Go Live Practical, NOT a trophy Customised, NOT copied, pasted Examples, NOT Theory alone Permitted tools, exchanges 1Risk Management Policy Authority Structure Trading limits Rights and responsibilities Periodicity of meetings Dos and Don’ts When hedging on international exchanges: RBI policy Direct, indirect exposures 2Regulatory approvals Appointing (experienced) AD bank Board Resolution Special Bank Account Post approval: Monthly regulatory filings Annual Audit report Regulator by national agency Reputation, Legal suits Financial standing 3 Appointing brokers Credit lines Service; Coverage across regions Brokerage Front Office Back-office Recording 4 Internal Setup Training Communication flow MIS Hedge Accounting Timing mismatch: 100% Absolute Risk 1 How much to hedge Compulsory Discretionary Odd-lot book Natural hedging 2 Where to hedge Domestic exchange International exchange Benchmark Budget Project cost 3 When to hedge Average of the month Transaction price Scale up, scale down Initial margin 4 Collateral MTM (Variation) margin 5 Go Live! Key points Commodity hedging is a niche subject; first timers might explore engaging a subject matter specialist Importance of MIS Periodic review of effectiveness Corporates hedging on International exchanges /OTC: RBI Regulations The first time RBI notified about commodities was in in 2000 via the FOREIGN EXCHANGE MANAGEMENT (FOREIGN EXCHANGE DERIVATIVE CONTRACTS) REGULATIONS, 2000 Notification No. FEMA 25 /RB-2000, dated 3rd May 2000. Key Clarification: As per RBI/2017-18/138 A.P. (DIR Series) Circular No. 19 March 12, 2018 , Hedging of Commodity Price Risk and Freight Risk Further, RBI withdrew relevant instructions on the subject contained in the following in Overseas Markets was permitted for corporates circulars stand withdrawn as on April 1, 2018. in India as per the new guidelines released and came into force on April 1, 2018. i.A. P. (DIR Series) Circular No. 68 dated January 17, 2012 on “ Risk Management “Authorized Dealer category ! Banks may permit and Inter-Bank Dealings - Commodity Hedging”. eligible entities to hedge commodity price risk ii.Section E and F of A. P. (DIR Series) circular no. 32 dated December 28, 2010 on and freight risk overseas using permitted “Comprehensive Guidelines on Foreign Exchange Derivatives and Overseas Hedging of products and may remit outside India foreign exchange “ All payments/receipts related to Commodity Price and Freight Risks” and the relevant appendices. hedging of exposure to commodity price risk and iii.A. P. (DIR Series) Circular No.35 dated November 10, 2008 on “Remittance freight risk shall be routed through a special related to Commodity Derivative Contract Issuance of Standby Letter of Credit / Bank account with the bank for this purpose. Guarantee”. Banks shall keep on their records full details of all hedge transactions and related remittances made by the entity. Banks are permitted to issue SBLC/. Guarantee. Realization and repatriation FX accruing resulting from these hedging transaction to be kept in current account and guided as per the Foreign exchange management act of 2015 Regulations have a say on hedging Governance and Organisation Structure Information and reporting lines Shareholders Dehne risk appetite Board of Directors Approves policy Financial Risk Controls and manages risk Committee Realisation of Connmodity Risk exposure identification and Oversight over risk management strategy control function ► Middle office Front office Back office TREASURY Transaction processing and accounting Audit 1 Risk Committee Internal Audit periodically reviews the process for compliance with the procedures Economist/ Risk review Team Thank You 65