BF 3213 Enterprise Risk Management Lecture Notes

Lecture 1 Introduction and Course Overview BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1  Lecture 1 Introduction and Course Overview BF 3213 Enterprise Risk Mana...

Lecture 1 Introduction and Course Overview BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1  Lecture 1 Introduction and Course Overview BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1  Lecture 1 Introduction and Course Overview BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1 Course Overview o Managing risk has never been so complex and regulated for commodity trading organizations o All employees in a commodity trading company (trading, non trading- sales &marketing, middle and back office, legal, credit& compliance) are expected to understand and manage risk o Anyone aspiring to have a career in trading, risk management or a job in a trading organization will find value in this course. o This course will provide: ✓ Overview of the key risks that continue to challenge these firms ✓ How to assess and identify existing and emerging risks facing these firms ✓ How to maintain an effective risk management framework to monitor and manage such risks ✓ Overview and analysis of basic risk management techniques This course will outline the key risks facing commodity trading companies About Course Coordinator Sean Mulhearn o Involved with the financial markets for over thirty five years with experience in Asia, Europe, and the US o Commenced career at Citibank as credit analyst and worked there for 20 years in Australia, London and New York holding numerous positions- co-Head of Commodity Finance, Head of Commodity Sales, Head of Asian Commodities and Head of Australian Fixed Income and Derivatives. o Worked at Merrill Lynch (New York) in the Structured Finance department before moving back to Asia in 2006 where he worked for Standard Chartered Bank (Singapore), JPMorgan Asia (Singapore) and ANZ (Singapore) where he led the development of the commodity and structured commodity finance activities. o Designs and teaches risk management courses for banks, corporations and government agencies, guest speaker at various international conferences and contributor to media outlets such as CNBC and Bloomberg. o Founded Jacaranda Capital Partners in 2015, a boutique advisory and corporate training firm with offices in Sydney and Singapore. o Partner at Rock Elm Capital Partners, a US based private credit firm o Lecturer at Nanyang Technological University, Singapore Student Introductions ▪ What year are you in ▪ Which faculty are you from ▪ Who is also enrolled in 3214 Intended Learning Outcomes Intended Learning Outcomes(ILO) Objectives By the end of this course, you should be able to: 1. Define and describe typical risks for a commodity trading firm 2. Articulate key commodity market terminology and conventions 3. Design risk management framework that identifies, quantifies and mitigates key financial risks 4. Develop communication plan across multiple functions 5. Describe the pros/cons of various risk management techniques Assessments-How will you be measured Component Participation Quiz Case Study Total Weight 20% 30% 50% 100% Activity Attendance In-class 2 Group Case studies 1. Due before mid semester break Responding to First lecture 2. Due end of semester questions after mid semester Teams and topics to be announced Asking reflective break questions Each case study worth 25% Group (15%), Ind (10%) Sharing insights Rubric Class Participation Problem Solving & Decision Making # 1 RULE There is no such thing as a bad question ! Student Expectation H) Course Policies and Student Responsibilities 1. General Students are expected to complete all assigned pre-class readings and activities, attend all seminar classes and take all scheduled assignments and tests by due dates. Students are expected to take responsibility to follow up with course notes, assignments and course related announcements for seminar sessions they have missed. Students are expected to participate in all seminar discussions and activities. 2. Absenteeism Requires you to be in class to contribute to team work. In-class activities make up a significant portion of your course grade. Absence from class without a valid reason will affect your overall course grade. There will be no make-up opportunities for in-class activities. If you miss a session, you must inform your team members and me via email ([email protected]) prior to the start of the class 3. Quiz and Assignments You are required to submit any quizzes and assignments by the due dates. Schedule-Our journey over the semester BF 3213-1 Semester 1 AY 2024/25 Week Date Lecture Outline Topics Covered Hours Introduction to Course and Objectives Commodity market overview 22-Aug-24 1 12:30pm 3 Supply Chain Risk Sources and identification of risk 2 ABS LT6 Financial Market Risk FX, Funding & Interest rate, 23-Aug-24 12:30pm 3 Case Study 1 Task commodity, credit 2 05-Sep-24 3 Trading & Risk Techniques Physical, futures, OTC 12:30pm 3 4 Regulatory, political, legal & ABS LT6 06-Sep-24 4 Operational Risk 12:30pm 3 reputational 6 19-Sep-24 5 Developing Risk Culture-Case Study 2 ZOOM 12:30pm 2 Zoom MID SEMESTER BREAK 17-Oct-24 6 Group Presentations & Quiz 1 12:30pm 3 8 ABS LT6 18-Oct-24 7 Group Presentations cont Case Study 2 12:30pm 3 13 14-Nov-25 8 Team Presentations 12:30pm 3 Summary and review-Quiz 2 Team Pres ABS LT6 13 15-Nov-25 12:30pm 3 9 (cont) 12:30 15:30 26 Introduction Overview o Enterprise Risk is a methodology used by companies to manage risks across the entire organisation o Enterprise risk management (ERM) is the process of Identifying, Planning, Organizing and Managing Risk o International organisations such as (ISO) provide guidance and standards to help organisations identify and mitigate risks. Examples include o ISO 22301 – Business continuity management ✓ Business impact analysis to help identifying potential risks within the company. o ISO 31000 – Risk management ✓ Helps organizations develop a risk management strategy to effectively identify and mitigate risks, thereby enhancing the likelihood of achieving their objectives and increasing the protection of their assets o CSA’s Cyber Trust Mark and/or ISO 27001 – Information security management o Assess and identify IT related risks and how to mitigate them o Other ESG- Sustainability, Ethical Sourcing, etc.. environmental, social, governance (communications) o Over the semester we will look at how trading companies view and manage risk and how they protect themselves from unwanted risks.  Sources of Risk Foreign Exchange Financial Funding, liquidity and interest rate Commodity Market Credit and Equity Physical process Types of Risk Operational Technology/Internal Systems Compliance & Legal Reputation Regulatory Capital/Resource Allocation Strategic Competition, M&A Enterprise Risk Management establishes a framework to identify and manage risk leading to enhanced company value Overview of Market Commodity Markets are Volatile ▪ Commodities are the most volatile 90 Comparative Volatility of all major asset classes 80 ▪ Companies WTI USD Index Equities Bonds ✓Reduce revenue/increase costs 70 High 84.58 12.27 27.20 12.03 Low 18.02 3.33 6.12 2.91 ✓Gain/loss of market share 60 Average 37.04 5.93 14.07 7.09 ✓Impact on asset values ✓Access to capital & credit 50 ▪ Banks- 40 ✓ capital intensive with high risk factors 30 ▪ Investors 20 ✓ diversify risk 10 ✓ additional source of alpha 0 ▪ Traders- opportunity to capitalize Dec-21 Apr-22 May-22 Jan-23 Sep-23 Sep-21 Oct-21 Nov-21 Feb-23 Jul-23 Oct-23 Jan-22 Feb-22 Jul-22 Oct-22 Sep-22 Nov-22 Jan-24 Feb-24 Jul-24 Dec-22 Apr-23 May-23 Aug-21 Mar-22 Aug-23 Nov-23 Aug-22 Dec-23 Mar-24 Apr-24 May-24 Mar-23 Jun-23 Jun-22 Jun-24 on market disruptions; market liquidity, funding WTI Crude USD Index DJIA US 10 Yr Bond  Student Expectation- Awareness of Markets Markets are volatile and change every day Traders need real-time information to get the “trading edge” Markets are impacted by various factors ✓Economic- Inflation, GDP, Employment ✓Central bank activity- tightening vs easing ✓Geopolitical risks ✓Event Risk Markets respond differently to the same information- there are winners and losers Financial Market performance YTD: ✓US equities strong ✓Bonds flat ✓Commodities strong- cocoa, copper & gold- at historic highs ✓Bitcoin- BIG Winner 15 Aluminium rallies as Russian sanctions loom Supply side issues were back in focus amid a dearth of economic data. Geopolitical tensions remained supportive in the energy sector, while price-induced closures continued in metals. Aluminium led the base metals sector higher as supply side issues came back into focus. The rest of the complex was dragged along by the move, with recent closures of copper, nickel and zinc operations also providing some support. Iron ore futures rallied as the spectre of stronger demand after the Lunar New Year holiday boosted sentiment. Chinese Premier Li Qiang called for more rigours and effective measures to stabilise the slumping stock market. The market took this as a sign that new measures to support the economy may be forthcoming. This may be offset by rising supply, with exports from Australia and Brazil showing signs of recovery in recent weeks. Gold edged higher as traders waited for key economic data that may provide a guide to the outlook for interest rates. US GDP, jobless claims and durable goods data may help provide some clarity around the timing and pace of future rate cuts. Crude Oil Weak demand amid ongoing supply risks kept crude oil hemmed in a tight range. Tensions remain high in the Middle East as the US and UK launched more airstrikes on Houthi missile sites to prevent the Iran-backed group from attacking commercial vessels in the Red Sea. The risks have seen the prompt spread, where Brent’s front month future is trading at a USD0.48/bbl premium over the following month contract. North Asia LNG spot prices dipped. Demand for gas remains tepid amid a sluggish economic recovery. In addition, weather forecasts show unseasonably mild temperatures lasting until February, meaning demand for heating is likely to remain weak.  Global Traded Markets Financial Markets allow buyers and sellers to transact across multiple asset classes Foreign Exchange Financial Markets Traded Markets ✓ Physical/cash Interest Rate ✓ Derivative markets (futures/OTC) Equities Methods of Trading ✓ Open outcry ✓ Screen/Electronic Commodities Each market has its own characteristics, conventions, liquidity and jargon Market Jargon Long/Short Bullish/Bearish Risk on/Risk off Dovish/Hawkish Contango Backwardation WTI/Brent Henry Hub/LNG/JKM Platts Window MOPS Ring Trading On/off Warrant Cracks Spreads Forwards Swaps Options Put/Call/Collar/Skew Importance of Risk Management Key Theme- Understanding Participants across the Supply Chain Producer Convertor Distributer End User PRODUCE CONVERT TRADE CONSUME Majors Refiners/Pet Chem Importers Transportation Independents Utilities Exporters Industrial SOE Smelters Banks Investors Farmers &Co-Ops Crushers Exchanges o Not all organizations are exposed to the same risks o Risk profile varies on their role across the supply chain o Students will learn how to identify risks and appropriate risk management techniques Impact of Volatility o Business ✓ Gain/loss of business & market share ✓ Low share price- vulnerable to liquidation or takeover ✓ Acquisitions/divestures/impairments o Financial ✓ Reduced revenue/Increased costs ✓ Lower profits ✓ Impact on stock prices and financial ratios ✓ Access to capital & credit on optimal terms ✓ Companies management Managing volatility is integral to efficient risk management Importance of Risk Management Ratings Agencies “Commodity hedging is..a "continued weakness in “Big swings in commodity prices will component of a comprehensive commodity prices… may make it harder for investors to assess risk management program aimed weaken key financial metrics how businesses are performing and risks at mitigating EBITDA-margin to below our expectations for linked to counterparties” volatility.” the A+ rating ” Academic Studies: ▪ Hedging lowers the likelihood that a firm will face financial distress ▪ Cash flow volatility is negatively valued by investors ▪ Hedging allows top management to… …focus on the operations of their business Managing volatility is integral to efficient risk management Market Characteristics and Conventions Global Commodity Markets Energy Base Metals Precious Metals Agriculture Bulks/Other Crude Oil Copper Gold Soybeans Coal Refined Products Aluminum Silver Wheat Iron Ore Gasoline, Diesel, Heating Nickel Platinum Corn Oil, Jet Fuel, Fuel Oil Electricity Lead Palladium Coffee Pulp/Paper Natural Gas Zinc Sugar Pet Chem Emissions Tin Cocoa Steel CPO/Rubber Other  Commodity Prices do not move as One Commodity Returns 2023 Commodity Returns 2024 YTD -37.28 Soybean Oil Natural Gas -31.3 Palladium Nickel -27.78 Soybeans Lean Hogs -24.83 Sugar Wheat -23.52 Cotton Corn -22.94 Canola NY Harbor ULSD -22.91 Soybean Oil -21.46ICE Gasoil Zinc Natural Gas -20.97 Lead LME Nickel -19.24 Silver -19.23 Corn Soybeans RBOB Gasoline -17.61 Heating Oil -14.36Wheat Soybean Meal Lean -11.83Hogs Rough -9.1Rice Aluminum Brent Crude -5.2 Gas Oil LME-4.32 Lead Cotton WTI Crude -3.76 Crude Oil Live Cattle 1.64 Brent Crude Platinum 3.5 Live Cattle LME NASAAC 4.06 Copper LME Primary Aluminium 6.29 LME Copper 8.04 RBOB Gasoline Copper 9.4 Gold LME Zinc 11.98 Coffee LME Tin 20.48 Sugar Silver 23.15 Sugar Gold 28.73 Orange Juice Orange Juice 41.2 Coffee 52.63 Cocoa Cocoa 164.82 60 40 20 0 20 40 60 80 100 120 -50 0 50 100 150 200  Factors Impacting Prices o GDP/Employment o Inflation Economic Demand o Production Industrial & o Consumption Unrest Supply o Inventory Price Volatility o Drought (agri markets) o Military Geo Weather o Floods- (mining, agri) Political o Political o Hurricanes/Cyclones- (energy) o OPEC o Acts of God-Earthquakes Traders Commodities more vulnerable & hence more volatile Impact of Weather Japanese Earthquake Impact Sapporo o Fukishima disaster in 2011 LNG 6.0GW impacted key alternative supply markets Fukishima Earthquake & other Sendai Epicentre 12.7GW ✓ Coal Thermal Tokyo 3.5GW ✓ LNG Oil ✓ Fuel Oil Nuclear Reactor Dry cargo ports closed 3.2GW Other sea port LNG terminal closed LNG terminal Major city Nuclear Outage Replacement $60 USGC 211 Refinery Margins $50 o US-Impact of Hurricanes $40 $30 ✓ BP Horizon Oil spill $20 ✓ US Hurricane Season (May- $10 Nov) $- ✓ Rita, Katrina in 2001 Nov-05 Nov-05 Jun-05 Jun-05 Jul-05 Jul-05 Apr-05 Apr-05 Apr-05 Aug-05 Aug-05 Sep-05 Sep-05 Sep-05 Dec-05 Dec-05 May-05 May-05 Oct-05 Oct-05 Commodity Prices are Seasonal US Natural Gas Forward Curve US Natural Gas Inventories Winter Summer o Commodity forward curves reflect seasonal supply and demand: ✓ Summer (driving season) vs winter (heating) ✓ Growing and harvest seasons o Risk exposures across industries reflect this seasonality- Tourism, F&B, Transportation, Agricultural Some basic features–Forward curves Normal interest rate yield curve Inverse interest rate yield curve 10.0% 10.0% 9.0% 9.0% 8.0% 8.0% 7.0% 7.0% 6.0% 6.0% 5.0% 5.0% 4.0% 4.0% 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Commodity curve-Contango ($) Commodity curve-Backwardation ($) 80 80 75 75 70 70 65 65 60 60 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Forward Curve Structure – Contango & Backwardation o CONTANGO- when the future value of a commodity is o BACKWARDATION- when the future value of the greater than or a premium to the spot price. commodity is less than or a discount to the spot anticipation of buyers, immediate dd for physical market price. o Also know as ‘positive carry’ o Occurs when supply is tight and demand for o Theoretical value of forward curve is the cost to buy, immediate delivery is high- buyers willing to pay store and insure the specific commodity. premium o Arbitrage exist if the value of the forward curve is o Curve volatility can be significant particularly in greater than its theoretical value.- e.g. WTI times of “short squeezes”- e.g. nickel o This keeps the steepness of the curve in check. Contango Backwardation 700 700 600 600 Favours 500 500 400 400 Buyers 300 Favours 300 200 200 Sellers 100 100 0 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Fair Value and Arbitrage Fair Value and Arbitrage ▪ Fair Value is the cost to buy, store and insure $20.00 $20.00 ▪ Often the market forward value Arbitrage Market can vary from fair value $5 $15.00 ✓ Spot = $10 Insurance $2 ✓ Fair Value = $15 F Storage $2 a ✓ Market Value = $20 Funding $1 $10.00 $10.00 $- i r ▪ Traders look to profit from these opportunities V a $5.00 Spot $10.00 l Spot $10 Arbitrage u Buy Physical $ 15.00 e Sell Futures $ 20.00 $- Profit $ 5.00 Today 30 Days Forward Curves are Volatile Crude Oil Forward Curves Brent Crude Prompt versus 12 month Backwardation Contango o Forward curves are volatile o Forward curves can shift from contango to backwardation very quickly Market Conventions-Price Discovery o Commodities are generally quoted in USD o Quotations vary by commodity Futures Exchanges Trade Journals ✓ Energy $/bbl, $/MT, c/ gallon, c/liter, $/MMBTU, $cubic feet, ▪ $cubic meter ✓ Metals ▪ $/MT,c/lb, $/oz ✓ Ags ▪ c/ bushel, c/lb, $/MT o Benchmark/Reference Prices come from a variety of sources ✓ Futures Exchanges ✓ Trade Journals Industry Associations ✓ Associations- LMBA-gold/silver o Benchmarks are important as used in most physical contracts Supply Chain Risks Key Theme- Understanding Participants across the Supply Chain Every company has a commodity exposure- the challenge is to find it ! Producer Convertor Distributer End User PRODUCE CONVERT TRADE CONSUME Majors Refiners/Pet Chem Importers Transportation Independents Utilities Exporters Industrial SOE Smelters Banks Investors Farmers &Co-Ops Crushers Exchanges o Risk profile varies on their role across the supply chain o Risk solutions should therefore reflect business role and risk profile  Risk Profile Varies Across the Supply Chain Every company has a commodity exposure- the challenge is to find it ! Producer Convertor Distributer End User o Risk Profile o Risk Profile o Risk Profile o Risk Profile o Long life assets/reserves o Long life fixed assets o Short term trade cycle o End of the supply chain o Depleting or amortizing asset o Depreciating asset o Low barriers to entry o Price taker o High barriers to entry- large o High barriers to entry- o Liquidity intensive o Short term risk profile capital, regulatory large capital, regulatory o Multiple trading o Product cycle/Budgets o Outright price risk o Margin risk strategies o Geography & Geopolitical o Challenges o Challenges o Procuring consistent o Challenges o Challenges o Replacing depleting reserves quality feedstock o Liquidity- e.g. Noble o How to pass on price o Access to capital o Margin management o Logistics changes o Access to long term hedging o Geographic competition o Counterparty credit o Competitive pressures o Counterparty credit Risk Management Framework Ongoing Process IDENTIFY MANAGE-Execution o Market -FX-, funding and interest o Process rate, commodity, credit o Segregation of duties o Operational o Ongoing Review Manage o Strategic Identify o Compliance and regulatory QUANTIFY EVALUATE o Volumes- How much o Prioritize Evaluate Quantify o Frequency-How often o What to manage and how o Credit-Who from/to o Risk alternatives o Sensitivity-impact of price o Stakeholder expectations changes o Competitive impact Identifying Risk Body Frame- Steel, Al o Standard car highlights multiple commodity risks Interior- Plastics faced by auto manufacturers Electronics- Copper o Toyota Corolla o Worlds top selling Tyres- Rubber car since 1966 o 40 Mill sold Engine- fuel o WHAT ARE THEY ? Convertor- plat/pall Battery- Lead Identifying and Quantifying Peuget 307 MT o 92 Million cars manufactured pa* Hot rolled steel 176,600 Cold rolled steel 51,300 Plastic 35,900 o Raw materials represent 47% of total Iron Castings 35,500 Aluminum 34,000 o Key Raw materials are: Rubber 18,700 Glass 11,250 Type % car Qty/vehicle Qty PA (MT) Stainless Steel 7,500 Steel 22% 900kg Copper/Brass 6,300 82,800,000 Lead 4,000 Aluminium 225kg 20,700,000 Other STEEL 3,500 Magnesium 1 Plastics 15% 150kg 13,800,000 Zinc Castings 1 tyres, belts, hoses, Oz Rubber seals Platimun 32,000 Reading Palladium 64,000 https://www.eurofinance.com/news/american-automakers-ramp- Rodium 8,100 up-commodity-hedging-as-they-play-catch-up-to-vw-bmw/ End of Day 1 End of Day 1  Lecture 2 Financial Market Risk BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1  Lecture 2 Financial Market Risk BF 3213 Enterprise Risk Management Nanyang Business School AY 2024-25 Semester 1 Schedule-Our journey over the semester BF 3213-1 Semester 1 AY 2024/25 Week Date Lecture Outline Topics Covered Hours Introduction to Course and Objectives Commodity market overview 22-Aug-24 1 12:30pm 3 Supply Chain Risk Sources and identification of risk 2 ABS LT6 Financial Market Risk FX, Funding & Interest rate, 23-Aug-24 12:30pm 3 Case Study 1 Task commodity, credit 2 05-Sep-24 3 Trading & Risk Techniques Physical, futures, OTC 12:30pm 3 4 Regulatory, political, legal & ABS LT6 06-Sep-24 4 Operational Risk 12:30pm 3 reputational 6 19-Sep-24 5 Developing Risk Culture-Case Study 2 ZOOM 12:30pm 2 Zoom MID SEMESTER BREAK 17-Oct-24 6 Group Presentations & Quiz 1 12:30pm 3 8 ABS LT6 18-Oct-24 7 Group Presentations cont Case Study 2 12:30pm 3 13 14-Nov-25 8 Team Presentations 12:30pm 3 Summary and review-Quiz 2 Team Pres ABS LT6 13 15-Nov-25 12:30pm 3 9 (cont) 12:30 15:30 26 Financial Markets Markets are volatile and change every day Traders constantly looking for real-time information to get “trading edge” Participants need be aware of the hot topics and key factors influencing global markets Markets are influenced by sentiment and expectations Unexpected events can create significant market volatility Bob Mankoff appeared in 1981 in the The New Yorker. 3 Copper led the base metals sector after Beijing unveiled a plan to boost liquidity in its banking sector. China’s central bank governor, Pan Gongsheng, announced the bank would cut China’s reserve ratio requirement by 0.5ppt. This is expected to provide CNY1tn of long-term liquidity to the market. Better than expected economic activity in the US also left the market more confident about the demand outlook. This comes amid heightened concerns of supply disruptions across the metals sector. Copper, aluminium, nickel and zinc all have supply issues hanging over their markets. The iron ore market was also swept up in the optimism following the cut to China’s RRR. Futures rallied more than 2% on hopes it would boost activity in the country’s construction sector. This comes as inventory data suggests demand remains weak. Stockpiles of steel at major Chinese steel mills rose 6.7% to 15.4mt in mid-January from early January, according to data from China Iron and Steel Association. Gold edged lower after the stronger than expected business activity data in the US raised further doubts on how soon the Fed will switch to monetary easing. Swap markets are now pricing in a less-than-50% chance for a March rate cut. Crude oil gained following a bigger than expected drawdown in US inventories. The mood was aided by the Chinese government’s planned measures to unleash more money to boost growth. Nevertheless, the gains were limited amid ongoing concerns of strong growth in supply outside of OPEC. Risks of disruptions emanating from the Israel-Hamas war are also easing. There is growing talk of a ceasefire between the two parties, with Arab nations working on an initiative that could offer Israel further normalisation of relations with Arab states. European gas prices rebounded following signs shipments are being delayed amid tensions in the Red Sea. The move was exacerbated by some opportunistic buying following the 10% fall this year. North Asian LNG prices were also dragged higher. Hot Topic- Oil prices trade negative o In April as Covid-19 caused a global sell off in all asset classes the WTI crude oil futures fell dramatically below zero for the 1st time in history ! o WHY ? o We will investigate what caused this to occur o NB Difference between spot physical and futures ! Key Market Event- Nickel Volatility o Mar 8 LME Nickel touched $100,000/MT ✓ Double it's all-time high ! ✓ Over the last 5 yrs it has risen by $11,000/MT ✓ That week alone, it’s rose by 72,000/MT o LME halted trading and cancelled traded o Trading resumed Mar 17 ✓ Ceased for 2 consecutive days ceased after it fell more the max lower price limit (12%) o Case Highlights- Classic Short Squeeze ✓ Caused MTM losses of $8B ✓ Trader unable to meet margin calls ✓ Differences between futures and OTC markets ✓ How exchanges deal with extreme volatility o LME was sued for its action which it won in court in Dec 2023 Sources of Risk Foreign Exchange Financial Funding, liquidity and interest rate Commodity Market Credit and Equity Physical process Types of Risk Operational Technology/Internal Systems Compliance & Legal Reputation Regulatory Capital/Resource Allocation Strategic Competition, M&A Financial Market Risk Transactional- sales and expenses FX Translation-fcy assets/liabilities Strategic- acquisitions &capex FM Risk Funding & Interest Fix/floating Duration management Rate Physical purchases and sales Commodity Direct and Indirect Buyers Credit/Equity Sellers Shareholder management Organizations are exposed to multiple market risks The Challenge is how to manage them Foreign Exchange Foreign Exchange Market o Daily turnover of $7.5Trillion/day (Apr 22 vs $6.6 trillion 19) o USD is dominant currency being on 88% of all trades o Singapore largest FX centre in Asia with daily turnover of USD930b (10% of total) o Range of FX products- spot, forwards, swaps, currency swaps, options o Key Participants-Banks, institutional investors, funds, Central banks, individuals and speculators Sources of Foreign Exchange Risk Companies are exposed to various direct and indirect foreign exchange risks FX Risk Transactional Translation Strategic Income Statement Balance Sheet Contingent Sales FCY assets Investment Expenses FCY liabilities Divestment Payments FCY Investments CAPEX M&A Examples What type of foreign exchange exposure are the following: Translational SG Trader has China sub which owns warehouses to store the inventory SG trader buys/sells nickel inventory in USD Transactional Company has foreign currency loans to take advantage of lower interest rates Strategic/ translational Example-Australian Coal Producer Summary o Australian coal producer exports 1 Million MT of coal every month o Coal is benchmarked against Newcastle coal index o Coal is priced in USD (currently USD100/MT) o AUD is the company’s home currency with all costs incurred locally in AUD o What type of FX risk is the company exposed to ? o TRANSACTIONAL transactional= selling coal every month o TRANSLATION o STRATEGIC o Variability of revenue due to FX changes FX Rate $ 0.6500 $ 0.6600 $ 0.6700 $ 0.6800 $ 0.6900 $ 0.7000 $ 0.7100 $ 0.7200 $ 0.7300 $ 0.7400 $ 0.7500 Revenue (AUD) $ 15,384,615 $ 15,151,515 $ 14,925,373 $ 14,705,882 $ 14,492,754 $ 14,285,714 $ 14,084,507 $ 13,888,889 $ 13,698,630 $ 13,513,514 $ 13,333,333 Monthly Gain/Loss $ 1,098,901 $ 865,801 $ 639,659 $ 420,168 $ 207,039 $ - -$ 201,207 -$ 396,825 -$ 587,084 -$ 772,201 -$ 952,381 o 1 c rise in AUD =A$20ok reduced revenue Impact of AUD Volatility Impact of changes in the AUD: o Exporters ✓ Mainly denominated in USD ✓ Rising AUD reduces revenue o Importers ✓ Imported goods typically denominated in fcy ✓ Lower AUD increases the costs for imported items Funding & Interest Rate Funding and Interest Rate Debt facilities generally takes the form of: o Short Term ✓ Overdraft ✓ Working Capital- revolving lines of credit, commercial paper o Long term borrowings o Typically secured by land, plant & equipment o Fixed Income securities (bonds) Investments generally takes the form of: o Deposits o Fixed income securities- bonds/debentures o Credit terms on contractual purchases and sales also have funding component Global Bond Market o Global Bond Market in 2022 was $133Trilllion (ICMA). o US and China dominate issuance of corporate bonds (55%) o Main issuers include: ✓ Sovereigns/Governments (73%) ✓ Banks & Corporations ✓ Asset backed vehicles o GFC , QE and now post COVID has seen dramatic increase in issuance globally o Commercial banks own large amounts of bonds for regulatory capital requirements Interest Rate Risk -Yield Curves Yield Curves 2.50% 3 basic shapes: Normal ▪ Normal Yield Curve 2.00% Flat 1.50% ▪ Inverse Yield Curve Inverse ▪ Flat Yield Curve 1.00% 0.50% 0.00% 1 2 3 4 5 66  Term Structure of Interest Rates and Credit Spreads Yield Curves 4.00% 3.50% Corp Bond 3.00% 2.50% Yield 2.00% Govt –US Treasury 1.50% 1.00% 0.50% 0 1 2 3 4 5 years o Yield Curves are derived off credit spreads o Credit spreads are volatile o Government best credit quality o Traders and fixed income portfolio manager actively manage credit spread between government, swap and corporate curves o Yields increase over time as credit quality erodes Funding/Liquidity-Duration Management Liquidity is the lifeblood of any trading organization o Liquidity risk is the risk that a business will have insufficient funds to meet its financial commitments o Liquidity for funding is different to market liquidity which is determined by factors such as volume, open interest, bid/offer spreads o The two key elements of liquidity risk are : ✓ Short-term cash flow risk ✓ Long-term funding risk o Companies need an appropriate balance of short & long term funding to reduce reliance on certain markets and/or rollover risk o Examples include Noble, ADM, Enron Sources of Liquidity Risk Liquidity risk can arise from: o Seasonal fluctuations o Unplanned reduction in revenue OR increase in costs o Business disruption OR counterparty default o Unplanned capital expenditure o Inadequate cashflow management of working capital and future debt obligations o Breach of loan covenants o The liquidity of a company’s funding is often measured by: ✓ Quick ratio ✓ Gearing/Leverage Analyzing Liquidity Risk Analysing funding and liquidity risk: o Does the business rely on certain financing facilities o Is the business dependent on one lender o What is the maturity profile of the facilities- ensuring that not all financings mature on the same date o What is the strength relationships with lenders, shareholders and investors o What if market conditions change- e.g. coal lending o What is the availability of funds in extreme crisis conditions (e.g. Global Financial Crisis) o What is the status of financing facilities (committed vs uncommitted) Commodity Global Commodity Markets Energy Base Metals Precious Metals Agriculture Bulks/Other Crude Oil Copper Gold Soybeans Coal Refined Products Aluminum Silver Wheat Iron Ore Gasoline, Diesel, Heating Nickel Platinum Corn Oil, Jet Fuel, Fuel Oil Electricity Lead Palladium Coffee Pulp/Paper Natural Gas Zinc Sugar Pet Chem Emissions Tin Cocoa Steel CPO/Rubber Other Global Commodity Markets o Global and regional markets o Energy ✓ Crude Oil & refined products ✓ Gas & LNG o Metals- Precious & Base ✓ Gold, Silver ✓ Platinum, Palladium ✓ Ali, Copper, Nickel, Lead, Zinc, Tin o Bulks ✓ Coal & iron ore o Agri ✓ Corn, wheat, coffee, sugar, cotton, palm oil, cattle Credit/Counterparty Risk Assessing the risk of your trading partners o Counterparty risk is risk that a party involved in a transaction might default on its contractual obligation. o Counterparty risk can exist: ✓ Commercial physical contracts ✓ Finance ✓ Trading transactions o Counterparty default has resulted in significant losses, particularly during the GFC o Banking regulations ensure banks hold capital based on: ✓ Credit quality of customer ✓ Type of transaction-loan, derivative ✓ Derivative charges based on underlying volatility Trading and Risk Management Risk Profile varies across the Supply Chain Producer Convertor Distributer End User Majors Refiners Traders Transportation Independents Bio Fuel Importers Utilities SOE Pet Chem Exporters Industrial Farmers & Co-Ops Smelters Banks Consumers Crushers Exchanges Investors o Risk exposures differ across the supply chain ✓ Producers – long life reserves, capital intensive, high barriers to entry, outright price risk ✓ Convertors – capital intensive, high barriers to entry, margin risk e.g. refinery margins ✓ Trading companies – short term, opportunistic, key risk- access to liquidity ✓ Consumers– competitive pressures, product cycles and budgetary years Risk Profile varies across the Supply Chain Producer Convertor Distributer End User Traders Importers Exporters Banks Exchanges o Commodity Traders are be exposed to multiple commodity price risks o Purchases- Who do you buy from o Sales- Who do you sell to o Inventory- where do you store o What are the commercial terms- price, tenor, amount o Logistics- how the commodity is transported Managing Risk-Not a Precise Science Risk Appetite Low Medium High o Not all companies trade or manage their risks in the same way. o Factors influencing actions: ✓ Risk Appetite ✓ Management policy ✓ Objectives – strategic (reduce volatility) versus opportunistic ✓ Sophistication & credit quality ✓ Location & market liquidity ✓ Competitive pressures ✓ Ratings agencies and shareholders expectations ✓ History- that’s the way we have always done it! Summary- Risk Management Process MANAGE IDENTIFY o Execution considerations o FX – revenues, expenses, Capex o Pricing o Interest rate – fixed versus o Hedge Counterparty floating o Regular review of market o Commodity –energy, metals, agri Manage Identify conditions o Market index or benchmark (if any) EVALUATE o Sensitivity analysis – how price changes impact QUANTIFY business Evaluate Quantify o Volumes and amounts o What to hedge – FX, rates, o Frequency commodity o Seasonality o Which hedge instrument- o Counterparty credit physical, futures, OTC Case Study 1 ESG- Impacting Commodity Traders o Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. o ESG has become increasing important criteria in determining investments and lending activities o ESG practices are now been measured and reported by ratings agencies o Companies vary in how they communicate their market risk management activity- CASE STUDY 1 Environment Social Governance Energy Use Human rights Communication Waste Child labour Accounting Pollution Product safety Management conservation Community Transparency Animal welfare contribution Shareholders rights Case Study 1 Company Reporting of Risk Management Practices Distributer Producer Convertor End User Trader o Your task: ✓ Form teams of 8-10 participants 1. which of the 2 company would you invest in ✓ Choose any regional commodity trader 2. which is better - analysis decision 3. who u think does better job ✓ Research the company and their key market segments 4. set up grp by sep 6 ✓ Identify their key market risks 5. ✓ Explain how they communicate their management of market risk: Currency Funding & interest rate Commodity ✓ Describe how they compare to their regional competitors o Results to be delivered via a 25 min group presentation on October 17-18 o Teams need to be formed and company chosen sent to me by Sept 19 o ALL team members are expected to contribute to the presentation Gradings and Tips o Key Grading Criteria ✓ Quality of analysis- risk identification and sensitivity analysis ✓ How the company currently communicated and manages risk ✓ Peer group comparison- how does your company compare to their industry peers ✓ Clarity of presentation ✓ Team work- involvement of all team members o Sources of Information ✓ Company balance sheets and press releases ✓ Reuters, ✓ Bloomberg ✓ S&P Commodity Insights End Day 2 Enterprise Risk Management Lecture 3 Trading & Risk Techniques Schedule-Our journey over the semester BF 3213-1 Semester 1 AY 2024/25 Date Topics Covered Hours Week Lecture Outline Introduction to Course and Objectives Commodity market overview 22-Aug-24 1 12:30pm 3 Sources and identification of risk Supply Chain Risk 2 ABS LT6 Financial Market Risk FX, Funding & Interest rate, commodity, 23-Aug-24 12:30pm 3 credit Case Study 1 Task 2 05-Sep-24 3 Trading & Risk Techniques Physical, futures, OTC 12:30pm 3 4 ABS LT6 06-Sep-24 4 Operational Risk Regulatory, political, legal & reputational 12:30pm 3 6 19-Sep-24 ZOOM 12:30pm 2 Zoom 5 Developing Risk Culture-Case Study 2 MID SEMESTER BREAK 10-Oct-24 12:30pm 3 6 Group Presentations & Quiz 1 8 ABS LT6 11-Oct-24 7 12:30pm 3 Group Presentations cont Case Study 2 13 14-Nov-25 12:30pm 3 8 Team Presentations ABS LT6 Summary and review-Quiz 2 Team Pres 13 15-Nov-25 12:30pm 3 9 (cont) 12:30 15:30 26 Admin o Todays Lecture- o Trading and Risk Management Techniques o Case Study Due after mid semester break- Oct 10/11  Check Teams list  Company should be chosen  Break out rooms on Friday lecture  Each team will be allocated 20 min presentation  Be time efficient- not too many slides Crude oil gained as supply disruptions in Libya worsen. The North African country declared force majeure at the El-Feel field, a key oil field that produces around 70kb/d. This offset concerns that OPEC is planning to proceed with its production hikes. Several delegates within the OPEC+ alliance said last week that they expect to proceed as planned in adding 180kb/d in supplies within weeks. Demand was also in focus following more weak economic data in China. Factory activity contracted for a fourth consecutive month in August. Gasoline consumption may be impacted by rising electric vehicle sales. European gas futures edged lower amid signs of ample supplies. The amount of LNG idling at sea has jumped, signalling Europe has more than enough supplies despite worries over potential disruptions. This comes amid nearly full storage facilities in the region. Iron ore futures fell back below USD100/t following further evidence of weak demand. This follows the latest rescue package, which included allowing provinces to loosen or scrap new home price guidance to let market demand play a bigger role. The economy is also grappling with burgeoning inventory, in that there are 382m square metres of unsold new homes as of July. A stronger USD and concerns over weak demand in China weighed on sentiment across the base metals complex. Zinc led the sector lower, despite Chinese smelters vowing to lower output due to a tight concentrate market. The recent supply crunch in the US copper market is quickly unwinding, with 25kt of metal pouring into Comex warehouses in August. Trading Strategies Identify- Risk Profile varies across the Supply Chain Producer Convertor Distributer End User Risk Appetite Low Risk Medium Risk High Risk o Not all corporations in the same industry manage their risks in the same way.  Physical vs Futures vs OTC  Management policy  Objectives - reduce volatility versus opportunistic  Sophistication & credit quality- access to credit  Location and market liquidity  Competitive pressures  Ratings agencies and shareholders expectations Trading Strategies Future direction of the market Changing Shape of Forward Curve Long vs short positions 3 yrs v 10yrs Prompt v 12 mth Calendar spreads Curve/Time Directional Spreads Location Relative value Location differentials Arbitrage- Physical v Futures US vs Europe vs Asia Spreads- bonds- corp vs govt, cracks-jet vs crude Ratios- Gold/ silver Traders undertake various trading strategies to maximize profit Trading Strategies Directional-Outright Geographic Calendar-Time Spread Relative Value Crack Spread  Trading Strategies-Curve/Time Spreads Forward curves are volatile S e Traders can trade the shape of the forward curve ll Commonly used strategy in bond markets  3yrs vs 10yrs, B u  Cash vs 3 yrs y Flattening Examples in commodities:  Seasonal- Summer vs winter  Prompt vs 12 mth  Calendar Types of trades:  Steepening or flattening  Opportunistic when for specific points of the curve appear oversold or overbought  Trading Strategies-Relative Value/Crack Spreads o Traders can trade the variations between different products Spread Analysis-Sing Jet vs Brent Crude o Crack Spreads: Refinery Margins  Gasoline Vs Crude Oil-(WTI or Brent)  Heating Oil Vs Crude Oil (WTI or Brent)  Sing Jet Kero vs Crude Oil (WTI or Brent) o Traders can also trade other relationships  Energy- Sing 180 vs Marine FO, heating oil vs gasoline  Metals- Gold/Silver ratio o Factors influcencing spreads:  Seasonality (gasoline-heating)  Regulatory (IMO)  Event/Geopolitical Trading Strategies-Relative Value/Ratio Trades  Gold Silver Ratio In precious metals gold/silver ratio is a commonly traded spread Traders beleive the price of gold will outperform or underperform other precious metals- silver  Trading Strategies- Locational Arbitrage Traders optimize profits by buying the same product in one location and Trade Summary sell/ship to alternative location locking in profit Buy London $2,500 Freight $25 Examples include: Total Cost $2,525 Gold-London vs NY, London vs Shanghai Sell NY Comex $2,550 Profit $25 Energy- Brent/WTI, Singapore Jet Fuel vs European Jet Example- Transatlantic - NY vs London Price of Gold in London is $2,500/oz Price of Gold in US is $2,550/oz Buy London Freight costs Sell NY @$2550 Cost of Freight= $25/oz @$2500 $25 Action/Trade 1. Trader buys Gold in London ($2,500) 2. Trader transports gold to US = Cost $25 (inc freight and insurance)  3. Trader sells Gold in US for $2,550 4. Trader locks in profit of $25 Trader needs access to logistics/ freight options 12  Trading Strategies- Locational Arbitrage-US v London o Spreads are traded by arbitragers (often banks). o They buy spot (London) and o Sell futures (New York) o This causes the gap to narrow o Due to flights cancellations and refineries shut down due to Covid supply was short, hence the “arb” was risky as the shorts had no access to supply causing the spread to widen. o In March, 2020, the spread increased to $60 dollars/oz o This generated significant revenue for  the bullion banks 13 Trading Strategies- Locational Arbitrage-US v London  14  Trading Strategies- Locational Arbitrage-China v London o Traders can also trade differentials between China London market o Typically demand from China sees China gold prices trade at a premium to LBMA o In July 2024 Chinese “premiums” traded at a discount of -$11.25 per ounce below London LBMA price  Lowest level in 2-years o Recovery in the China economy may  see spread rally back to positive territory World Gold Council | Curriculum | Basics of Bullion Trading and Risk Management 15 Trading and Risk Tools Common Trading and Risk Management Tools Trading and Risk Commonly used strategies include: Tools  Physical – embedded in contracts  Financial Derivatives ‘Paper trading” Physical Futures OTC Derivative= securities that derive their value from an underlying asset- e.g. commodity, fx, equity, bond. Main derivatives markets: Swaps Bi-lateral Regulated  Exchange Traded Futures Options agreements Exchanges Exotics  Over the Counter (OTC) Example Physical Oil 10k bbl/mth Physical Oil Buyer Producer $$$ Index- Brent Crude ICE Scenario o Oil Company produces 10,000 barrels of oil per month o Oil reserves have a life of 30 years o Physical oil is sold to buyers based on ICE Brent crude oil benchmark o Payments are made monthly o It has read reports suggesting that oil prices may fall due to a decision by OPEC to increase production o It wants to protect 50% revenues for the next 6 months from falling due to lower oil prices o What should they do ? Physical Futures OTC Physical –Bi Lateral Agreements Physical Oil Physical Oil Buyer Producer Index Fix $75 o Counterparties often incorporate Solution price terms into physical agreements o Producer negotiates with buyer to sell 50% of total  Fixed price volume at a fixed price for the next 6 months a a fixed price  Options to extend o Remaining 50% to be sold at Index  Option to increase volume o Current Price =$75/bbl o While simple they expose both FIXED PHYSICAL= Fixed price, Fixed term, Fixed Volume counterparties to significant risks SURVEY WHAT HAPPENS IF THE PRICE DOUBLES ? WHAT HAPPENS IF THE PRICE HALVES ? Physical –Bi Lateral Agreements Physical Oil Physical Oil Buyer Producer Fixed or Index Benefits o Simple- No change to existing delivery arrangements o No new documentation- price included in commercial contract o Confidential o No brokerage, margin, or utilization of bank credit lines Pitfalls/Risks o Credit- significant performance risk o Price transparency & competitiveness- limited to supplier’s price o Lack of flexibility- ONLY specific commodity in contract  Quantity/Volume hedged  Maturity & timing  Instruments- swaps and options Futures Exchanges o A futures exchange is an organised central marketplace to facilitate the trading of financial market products- foreign exchange, fixed income, commodity.  CME, ICE, LME, SGX, ASX Futures Exchanges o A futures contract is an agreement to buy or sell a specific asset at a specified future date and price. o Futures contracts are standardized  Specific asset-e.g. interest rates, foreign exchange, commodity  Contract size- 1 lot =1,000 barrels-oil, or 1 lot =25MT  Instruments- forwards, options (puts and calls)  Specific expiration schedule – Monthly(e.g. 3rd Wednesday) or seasonal  Physical delivery and quality specifications o All trades governed by the rules of the exchange more volume= more  Initial margin commission  Variation margin o Trades executed via futures broker Futures Prices o Futures prices can be found in various locations:  Exchange websites  Bloomberg, Reuters, S&P ICE BRENT Contract Codes Mth Code Mth Code o Ticker identifies specific commodity, month and year: Ticker + Mth + Last digit of Year Jan F Jul N Feb G Aug Q o Ticker for ICE Brent Dec 2024 contract Mar H Sep U CO Z 4(2024) Apr J Oct V May K Nov X o Futures expiry table is otherwise known as strip Jun M Dec Z o Futures are used as the building blocks for OTC swaps and options Liquidity-Futures Markets o Futures market