COMMODITY MARKETS

Risk management : a Need for Corporates / a Business for Banks

Your Speaker : C.LECLERCQ (06 77 02 68 96)
2/3/4 Novembre 2020

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Table of content
• Commodity Markets:
• Market definitions / concepts,
• Market organisations,
• Market practices,
• Commodity market presentation,
• Market price structures,
• Commodity Risk Identification:
• Risk types & management,
• Absolute price risk,
• Relative price risk,
• Proxy hedge notion,

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Table of content
• Hedging Definition
• Hedging Strategies for the consumer
• Case Study : the Airline Company
• Hedging Strategies for the transformer
• Case Study : The cable Maker

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Commodity Markets
• Markets : Definition & Concepts:
• Market definition,
• Market driven by orders,
• Market driven by prices,
• Mixed markets,
• Market Organizations:
• Listed Markets / Organized Markets,
• Over the counter (OTC) markets,
• Contract comparison,

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Commodity Markets

OTC Contract Listed Contract

Terms of the contract Tailor made Standardize contract defined by
an exchange
Negotiation Usually by phone Via an exchange
Associated costs Commercial Margins Initial and variation margin
financing + Broker commissions,
exchange fees
Prices Not public Public and shared
Transaction details Not Public Public and shared
Provided services Full (research, pricing, etc) Limited to the execution
Market Liquidity Via Market Makers Via the exchange

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Commodity Markets
• Common Market Practices:
• Market Spread Definition,
• Order types:
• Market order,
• Limit order,
• Stop order,
• Validity : GTD, GFD, GTC, OCO ….
• Other variations
• Order executions,
• Full execution,
• Partial fills

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 Questions ?

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Commodity Markets
• Primary Roles of a Commodity Market :

Pricing

Delivery Hedging

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Commodity Markets
Foodstuff
• Commodity Classes:
Agricultural Industrial
Products (soft) Product

Commodities
Metals

Mineral
Products Energy
(hard) Products

Other
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Commodity Markets Base Metals Al, Cu, Pb, ZN

Non Ferrous
• Commodity Classes: Alloy
Production
Ni, Co

Metals
Ferrous Iron, Steel

Precious Au,Ag,PGM
Mineral
Products
(hard) Energy Coal, Oil,
Products Natural Gas

Fertilizer Phosphates
Other
Cement

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 Emission
Commodity Markets
• Commodity Classes:
Oil Aluminium

Electricity

PGM Steel

Plastics Zinc

Copper Lead Nickel

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 Questions ?

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Commodity Markets Price

• Market price structures:

Maturity
• Spot Price vs Forward Prices,
• Forward prices sources are :
Price
• Futures Exchanges,
• OTC markets,
• Structural Models,
• Cost of carry Models.
• Forward Prices shape Maturity

• Contango Curve,
• Backwardation Curve, Price
• Seasonality Curve,
• Forward Prices volatility

Maturity
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 Commodity Markets
• Commodity Prices are volatiles ….

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 Commodity Markets
• Commodity Prices are volatiles ….

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 Commodity Markets
• Commodity Prices are volatiles ….

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 Questions ?

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Commodity Markets
• Commodity Prices:
• Forward Prices & Volatility main drivers:
• A global view :
• Macroeconomic environment,
• Geopolitical environment,
• Investment made in commodity assets,
• With some micro drivers :
• Supply / Demand balance,
• Existing Market structure,

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Commodity Markets
• Example of fundamental analysis:

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Commodity Markets
• From a short term market consensus

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Commodity Markets
• To a long term market consensus

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 Questions ?

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Commodity Risk Identification
Hedged
Volume = Exchanged
5 Mt Volume
1Mt

Relative Offset
Price hedging
Risk
Absolute Fixed Price
Price Hedging
Risk

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Commodity Risk Identification
• Absolute Price Risk (1/2):
• Example of a commodity consumer: A car maker willing to manage its costs:
• Aluminium is a key component of the cost structure of a car maker. Thus if the aluminium
price increases, whereas the car maker has already fixed the selling prices of its cars, its
margin will be damaged and may even disappear in case of important price variations.
• Hedging is a rather common practice among commodity consumers. Shareholders are
usually open to hedging strategies that will ensure stable costs and future revenues.

• Another example of such absolute price risk, which is specific a as far it concerns
a commodity transformer, is the case of the Can maker who will Back to Back, on
a systematic basis, its physical contracts signed.

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Commodity Risk Identification
• Absolute Price Risk (2/2) :
• Example of a commodity producer: An oil producer willing to develop its oil fields
• In order to develop its oil fields, an oil producer makes a project finance deal with a
financial institution that provides financing to be repaid by the fields’ future cash flows.
• The study shows that the project is profitable until prices are above $50 per barrel.
• Thus to secure future cash flows, a hedge is embedded in the financing contract, so that
the client is able to repay the bank even if the oil price drops below $50/barrel.
• The hedge mitigates the risk of the financing contracts by providing an insurance on the
ability for the client to generate the expected cash flows.
• Hedging is NOT a common practice among commodity producers :
• Shareholders, especially in Europe, are often opposed to hedging strategies since
they’ve generally invested in commodity producers in order to be exposed to the
concerned commodity (oil, gold, …).
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Commodity Risk Identification
• Relative Price Risk :
• Example of a commodity transformer: A wheat miller willing to secure its margin
• A wheat miller buys wheat, that will be processed into flour. The selling price of the flour
will depend on the market wheat price. Thus, if during the time the wheat is transformed
into flour, the wheat price drops, then the miller may not be able to sell its flour at a profit.
• The longer the transformation process, the higher the risk for the transformer especially in
industries with small margins such as oil refiners or grains millers
• Commodity transformers and traders are usually interested in hedging to secure their
margins, but may not be able to afford the hedging costs. Besides, their risk profiles also
need to be considered good enough to allow CTY to trade.
• Another example of such type of risk being the Cables Maker Case (cf Averaging Case)

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 Questions ?

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Commodity Risk Identification
• Determinants of a firm’s hedging policy:
• In order to assess their own commodity risk, industrial compagnies have to identify
their risk exposure:

An effective hedging program

does not attempt to eliminate
all risks

The goal of any hedging program

The key challenge for a risk
should be to help the company to
manager is to determine the risks
achieve the optimal risk profile that Hedging the company is willing to bear and
balances the benefits of a
protection against the costs Rules and the ones it wishes to transform
by entering into hedging
associated to hedging

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Commodity Risk Identification
• Determinants of a firm’s hedging policy
IDENTIFY RISK
EVALUATE RISK
Measure the company exposure to commodity
This is another critical factor to analyse and
prices variations by examining amongst others :
consider when determining which risk we wish to
- Production / consumption volumes,
hedge, is the materiality of potential loss that
- End product price fixing methodology,
might occur if the exposure is not hedge ?
- Supply strategy, ….

DEFINE THE HEDGING POLICY

A hedging policy will impact the firm value CONTROL RISK
through: - Evaluate the hedge performance,
- Balance sheet - Understand the proposed hedging tools,
- taxes - Set up an accurate monitoring system,
- shareholders risk exposure view - Define a governance…
- impact the firm’s investment program
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Hedging Definition
• Hedging : action to cover an identified price risk with a financial derivatives
using a forward curve,
• Hedging : action to establish a position on a derivatives market
(futures/forwards/options) which is equal and opposite to a transaction
made on a physical market,
• Hedging provides certainty of prices over time,
• Hedging is a result of deep study of the commodity risks the company is
facing,
• When assessed, the company can select a panel of derivative strategies in
order to achieve a pre-defined objective.

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Hedging Definition
• Hedging strategies can be:
• Basic or plain vanilla, base on forwards / swap or simple options,
• Exotics, mixing both forwards and options in order to achieve specific profiles,
• Structured / Tailor-made solution to match client’s specifics /process.
• Hedging Vs Speculation:
• A hedger will start with a price exposure, then will buy or sell derivatives in
order to offset its price exposure,
• A speculator will start without exposure, will buy or sell derivatives and takes
on a price exposure.

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 Questions ?

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Hedging Strategy for the consumer
• Purchase of a Forward
• Definition : a forward is a contract to exchange a floating price for a fixed, for
a given quantity and at a predetermined specific maturity date.
• Purpose of the strategy : enables the consumer to be protected, up to a
specified quantity in the contract, against an increase in the market price, by
fixing a purchasing for the commodity, regardless of the market price
variations.
• Benefits of the strategy :
• No premium is paid by the consumer when entering in the transaction,
• The consumer is protected against an increase in the market price above the fixed
price of the forward contract.
• Drawbacks of the strategy :
• The consumer does not benefit, up to the quantity specified int the contract, from a
decrease in the market price below the fixed price of the forward contract, which
could result in a loss of opportunity if the market decreases.

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Hedging Strategy for the consumer
Consumer receives
• Purchase of a Forward the differential
Realised
Profit Price Open Position

Market Price Fixed price of

the forward Contract
Fixed Price of the
forward contract

Market Reference
Fixed price of Price
Consumer pays the the forward Contract
Loss
differential

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Hedging Strategy for the consumer
• Purchase of a SWAP on average
• Definition : a swap is a contract allowing an exchange of a floating price
calculated as an average, across one or several predetermined pricing period
(s), for a fixed price, and for a predetermined underlying quantity.
• Purpose of the strategy : with a swap, consumers are hedging, up to a
quantity fixed in the contract, against a market price increase, by fixing a
purchase price for their commodity, regardless of a market move.
• Benefits of the strategy :
• No premium is required when entering in the transaction,
• The consumers are protected against a market price increase above the fixed price of
the swap contract.
• Drawbacks of the strategy :
• Like the forward the consumers do not benefit, up to the quantity specified int the
contract, from a decrease in the market price below the fixed price of the Swap, which
could result in a loss of opportunity if the market decreases.

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Hedging Strategy for the consumer
Consumer receives
• Purchase of a Swap the differential
Realised
Profit Price Open Position

Market Price Fixed price of

the Swap Contract
Fixed Price of the
Swap contract

Market Reference
Fixed price of Price
Consumer pays the the Swap Contract
Loss
differential

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Hedging Strategy for the consumer
• Some additional Swap parameters to be discussed prior any
transaction :
• Definition of the pricing period :
• Monthly / Quarterly / Semi Annual / Yearly averages,
• Reference Price : Cash / Spot Price vs 3 months Price on metals,
• Definition of the volume to be hedge :
• Linear Schedule,
• Tailor made Schedule,
• Definition of the maturity of the hedge :
• Being an OTC structure, maturities, depending the asset class and underlying,
can go up to 5 – 7 yrs.

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Hedging Strategy for the consumer
• Some outright positions management:
• Forward or Swap are market tools, subject to real time pricing,
• The real time change in value generates a change in the associated Marked to
Market.
• Positions can be close be taking an opposite position :
• A long position by entering into a short position
• A short position by entering into a long position
• Closing a position freeze the marked to market which becomes a P/L
• Sometimes, for various reasons, a client may need to move its hedge
from one initial period to another one:
• This can be done at market price via a Time Spread :
• Borrowing or Lending transaction for metals for instance,
• This can be done under specific approvals vis Historical Price Carries (HPCs)
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 Questions ?

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Hedging Strategy for the consumer
• Purchase of a consumer Asian CALL
• Definition : an Asian Call is a contract giving the buyer the right to buy an
underlying asset for the average price during a specific period between the
beginning of the contract and the maturity date of the option. When entering
in such contract, the consumer will pay to pay an upfront premium.
• Purpose of the strategy : with the purchase of a Asian Call, consumers are
hedging, up to the quantity set in the contract, against a market price increase
by fixing a maximum purchasing price for their commodity, while having the
opportunity to benefit from a favourable market move on the downside.
• Benefits of the strategy :
• Consumers are fully protected against a market price increase above the call strike,
• Consumers benefit from a market price decrease.
• Drawbacks of the strategy :
• Consumers pay an upfront premium when entering in such transaction.
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Hedging Strategy for the consumer
• Purchase of a Asian Call Consumer receives
Realised the differential
Profit Price Open Position

Purchased Call
Strike Price
Market Price

Strategy Breakeven
Strike price + Premium
Market Reference
Purchased Call Price
Loss Strike Price
Consumer pays an
option premium
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Hedging Strategy for the consumer
• Purchase of a consumer Participative Swap
• Definition : the participating Swap, while working like a plain vanilla swap
allows the consumer to benefit from a part (ie percentage) of the market price
decerease, if any in the future.
• Purpose of the strategy : this strategy enables the consumer to be protected
against a market price increase by pricing the price of its commodity
purchases, regardless the future market variations. The purchaser of the
strategy benefits also from a pre determined percentage of favourable market
variation (decrease in market prices).
• Benefits of the strategy :
• Consumers are fully protected against a market price increase above the participating
swap strike,
• Consumers partially benefit from a market price decrease below the strike price of the
participating swap,
• No upfront premium is paid to enter into the strategy.
• Drawbacks of the strategy :
• Consumer doesn’t benefit from a part of the market decrease,
• The fixe price (strike) of the participating swap is high than a plain vanilla swap.
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Hedging Strategy for the consumer
Customer receives
• Purchase of a Participating Swap the differential
Realised
Profit Price Open Position

Swap Price
Market Price
PS
Price

Market Reference
Swap Price
Consumer pays the Price
PS
Loss Price
differential

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 Break
• Please draw the Four Main option strategies:
Profit + Call S=100, M=1 yr, P=10 Profit - Call S=95, M=1 yr, P=8

Market Price Market Price

Profit Profit
Loss + Put S=95, M=6 mths, P=4 Loss - Put S=100, M= 6 mths, P=6

Market Price Market Price

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Hedging Strategy for the consumer
• Purchase of a consumer Asian COLLAR
• Definition : a collar for a consumer combines the simultaneous purchase of a call
option and the sale of a put option with the same maturity and same quantity. Both
options have out of the money strikes. Usually, the strategy is zero cost.
• Purpose of the strategy : with a collar, a consumer is hedging, up to a quantity fixed
in the contract, against a market price increase, while they still have the opportunity
to partially benefit from a market price decrease. The Collar is an alternative hedging
solution to a standard call option allowing to reduce financing costs.
• Benefits of the strategy :
• Consumers are protected against a market price increase above the call strike,
• The consumers benefit from a market price decrease down to the put strike.
• Drawbacks of the strategy :
• Consumers do not benefit from a market price decrease below the put strike, which can
represent a loss of opportunity in case the market decreases,
• In some cases a premium is paid when entering in the transaction.

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Hedging Strategy for the consumer
• Purchase of a Collar Consumer receives
Realised the differential
Profit Price Open Position

Sold Put
Strike Price
Market Price
Purchased Call
Strike Price

Market Reference
Sold Put Purchased Call Price
Loss Strike Price Strike Price
Consumer pays the
differential
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Hedging Strategy for the consumer
• Purchase of a consumer CALL SPREAD
• Definition : a call spread is a combination of two call options, the purchase call option
having a strike price closer to the market price (near ATM) than the sold option (which
is OTM having a higher strike than the purchased option), both having the same
maturity and traded quantity. A premium still paid to enter in the structure.
• Purpose of the strategy : consumers, using this strategy, are able to set a maximum
purchasing price for their commodity up to a certain, while they still have the
opportunity to benefit from a favourable market move on the downside.
• Benefits of the strategy :
• Consumers are fully protected against a market price between the two call strikes,
• Consumers benefit from a market price decrease,
• Consumers pay a lower premium than the premium paid for buying a vanilla Call.
• Drawbacks of the strategy :
• Consumers still pay an upfront premium when entering into the structure,
• Consumers are not fully protected against a market price increase above the strike price of the
sold call.

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Hedging Strategy for the consumer
• Purchase of a Call Spread Consumer receives
Realised the differential
Profit Strategy Breakeven Price Open Position
Strike price + Premium

Purchased Call
Strike Price
Market Price
Sold Call Strike
Price

Market Reference
Purchased Call Sold Call Strike
Price
Loss Strike Price Price
Consumer pays an
option premium
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 Break
• Please draw the following strategies on one P/L Chart:
• Long a 100 USD/Mt call 6 months bought at 8 USD/Mt
• Short a 100 USD/Mt put 6 months sold at 9 USD/Mt
• Short a forward at 100 USD/Mt

Profit

Market Price

Loss

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Case Study : Airline hedging Objective &
Strategy (1/5)
• Hedging objective :
• Jet fuel costs represent a major portion of Airlines direct operating expenses
• be protected against unexpected and significant adverse price movements
• Not be disadvantaged in a significant way vis-à-vis its competitors in the event of
favourable price movements.
• Hedging strategy :
• The strategy must answers the following questions :
• What is the Airline’s objective in terms of hedging?
• Be protected against price increase only?
• Keep the possibility to benefit from favourable price movements?
• Be ready to pay for a more sophisticated/flexible solution?
• Be ready to reduce its protection level and/or its possibility to benefit from
favourable price movements, in order to reduce the cost of the hedging
solution?
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Case Study : Airline hedging Objective &
Strategy (2/5)
• Hedging strategy :
• Which portion of consumption should be hedged?
• The Airline can hedge all or part of its jet fuel consumption: Hedging all of its consumption offers
a full protection, but partial hedging may be used to reduce the impact of adverse movements in
prices whilst continuing to take advantage of favourable movements
• Usual practice for a Corporate is to hedge only part of their commodity exposure.
• Which underlying should be hedged?
• Straightforward hedging: the Airline may hedge using the same market underlying (i.e. jet fuel
reference) as for its physical purchases. This is the simplest and safest way to hedge
• Proxy-hedging: In case of poor or limited liquidity of the considered underlying, here jet fuel (or in
case of non-quoted underlying), the company may decide to hedge using a another more liquid
underlying as a “proxy”. A proxy is another underlying, like gas oil or brent crude, of which price
behaviour is close to that of jet fuel (i.e. the jet fuel price and the proxy price are correlated).
Although the hedge is not perfect, proxy-hedging may be a cost-effective solution for the Airline.
• What does the market allow at the time (e.g. price levels, liquidity)?

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Case Study : Airline hedging Objective
& Strategy (3/5)
• Hedging strategy :
• Which hedging tool should be chosen?
• The cost for the Airline and the sophistication/flexibility of the hedging solution will depend on the
hedging product e.g.:
• A swap guarantees a fixed price for no additional cost for the Airline but doesn’t allow it to
benefit from price favourable movements
• A call option protects the Airline against a price increase and allows it to benefit from a price
decrease, but comes at a cost : the option premium
• A ”three-way” collar is a cheaper solution than the call option, that still both protects against
adverse price movements and allows benefits from favourable movements, but within
certain price ranges only. Outside those price ranges, the Airline is no longer protected or
cannot benefit from favourable price movements. By adjusting these price ranges, the cost
of the three-way collar may even drop to zero for the Airline.
• What does the Airline believe the market evolution will be?
• For example, if the Airline believes that no significant price decrease is to be expected, there is
no point in buying a call premium or reduce the protection level with a three-way collar
• If the Airline considers very likely that jet fuel prices stay between $680 and $695 per ton for the
year to come, it may use these price bounds to define the strike prices of a collar for instance.
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Case Study : Airline hedging Objective &
Strategy (4/5)
• Purchase of a consumer “3-Way Collar”
• Definition : this structure corresponds to the purchase an Asian Call spread while
simultaneously selling an Asian Put option with a strike lower than the two strike of the call
spread. All three options have the same contractual quantity as well as the same maturity.
The aim of the strategy is to achieve a zero cost premium structure.
• Purpose of the strategy : consumers, using this strategy, are partially hedge, up the
quantity fixed in the contract, against a market increase, while they still have the
opportunity to benefit from a favourable market move on the downside. This is an
alternative strategy to a standard call option or a collar allowing a better hedged level at a
reduce cost.
• Benefits of the strategy :
• Consumers are fully protected against a market price between the two call strikes,
• Consumers benefit from a market price decrease down to the put strike,
• In most of the cases the strategy is designed to be zero cost.
• Drawbacks of the strategy :
• Consumers are not fully protected against a market price increase above the strike price of the sold
call.
• Consumers do not benefit from a market decline below the put strike, which can result into a loss of
opportunity,
• Sometimes consumers might have to paid a premium.

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Case Study : Airline hedging Objective &
Strategy (5/5)
The Airline receives the
• Purchase of a “3 way Collar” differential with a
Realised maximum amount
Profit Price Open Position

Sold Put Strike

Price
Market Price
Purchased Call Sold Call Strike
Strike Price Price

The Airline pays the Market Reference

differential Sold Put Strike Purchased Call Sold Call Strike
Price
Loss Price Strike Price Price

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Hedging Strategy for the consumer
• Additional Consumer structures taking advantage of the market
volatility :
• Purchase of a Capped Swap
• Purchase of a Range Swap
• Purchase of Range Out Swap
• Purchase of an extendible Swap
• Purchase of a Target Accrued Redemption Swap

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Hedging Strategy for the consumer
Consumer receives
a differential with a
• Purchase of a Capped Swap maximum payoff
Realised
Profit Price Open Position

Market Price Swap Price

Swap Price Capped Swap
Price

Market Reference
Swap Price Capped Swap Price
Consumer pays the Price
Loss
differential

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Hedging Strategy for the consumer
Benefit of the
hedge disappears
• Purchase of a Range Swap Customer receives
the differential
Realised
Profit Price Open Position

RS
Swap
Price
Market Price
Swap Price RS
trigger

Market Reference
Consumer pays the RS Swap RS Price
Loss Swap Price trigger
differential
Price

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Hedging Strategy for the consumer
Consumer receives
• Purchase of a Range Out Swap the differential
Realised
Profit Price Open Position

ROS Swap
Trigger Price
Market Price Swap Price

ROS
Price

Market Reference
ROS Swap ROS Price
Consumer pays the Trigger
Price
Price
Loss
differential

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 Break

• You are currently working as a Sales for a financial institution based in London.
• One of your customer entered last year into a swap transaction in order to hedge its
physical purchases for 2020.
• He bought a Vanilla Swap for 250 Mt of copper per month over Cal 20 at 5 500
USD/mt.
• Today, your client ask you to consider the transfer a part of its April 20 hedge in
order to adjust the hedge with its current physical consumption in decline following
the Covid19 crisis.
• Customer asks you to move 150 Mt from April 20 to Oct/Nov/Dec20 in 50 Mt par
month.
• How do you proceed such adjustments ?

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Hedging Strategy for the transformer
• Purchase of an Averaging
• Definition :
• an averaging transaction is a 2 steps operation where the transformer locks on a spread between two different
pricing periods of a specific commodity : the moment when the transform proceeds to the purchase of its commodity
(which represents a part of the total costs of purchase of raw materials to be used in the production process) and the
moment when it sells its end product (in which the final price contains an element of the price if the purchased
commodity)

• Purpose of the strategy :

• he strategy aims is to reduce the risk of volatility of the cash flows linked to the purchase/sale price of a commodity
arising form the delay between when the company proceed to the purchase of a commodity and the moment it
proceeds to the sale of this commodity in a semi or final product
• This type of risk is generally supported by industrial company such as cables manufacturers or automotive suppliers
as commodities constitute an important part of the the product which will be transformed.
• With an averaging transaction, the transformer has the guaranty of the selling price for its end-product equal to the
price he paid to buy it plus or minus an initial fixed guaranteed differential, covering the entire period of processing
the commodity until the delivery of the finish product.
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Hedging Strategy for the transformer
• Purchase of an Averaging
• Benefits of the strategy :
• An averaging transaction allows the transformer to gain more visibility on its cash flow
directly linked to its commodity purchases and sales within the cost of purchased
commodity, over the entire period between its purchases of the commodity and the
sale of its end product,
• Under a specific market conditions, the locked differential between the commodity
purchased and the sale price may generate a positive margin for the transformer
which may improve its global margin,
• No premium is paid by the consumer when entering in the transaction.
• Drawbacks of the strategy :
• With such hedging transaction, the transformer foregoes benefiting from potential
favourable price moves on the market,
• Under specific market conditions, the hedging via an averaging transaction may
generate a cost for the transformer which may impact its global margin.
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Hedging Strategy for the transformer
• Purchase of an Averaging
• What are the steps for an averaging transaction :
• Step 1: At T, the transformer wants to hedge its risk on a commodity price variations
between period T +1 and T+2. In order to hedge such risk, the transformer will enter
into an averaging transaction. Doing that, the financial institution will guarantee to the
transformer a selling price at T+2 equal to the price of its purchases in T+1 plus or
minus a fix amount X. The averaging transaction consists, after setting the 2 periods,
one quantity equal for both legs, one currency being the same for both legs, in locking
the X which will be fixed for the entire life of the transaction.
• Step 2: when, in T+1, the commodities reference price for the first period is known,
then the averaging transaction can be considered as transformed into a swap
transaction to cover the second period where the transformer will be selling of the
swap. The price for this swap being the the average or the price of the first leg /
period plus or minus the initial locked differential X.
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Hedging Strategy for the transformer
• Purchase of an Averaging
• What are the steps for an averaging transaction :
• Step 3: at the maturity of the averaging transaction, in T+2, the
settlement which the financial institution will organize with the
transformer will be similar to the one we can have with the sale of a
swap:
• If the commodity reference price is below the selling price (ie the average or price
of period T+1 +/- X), then the transformer will receive from the financial institution
the differential between the selling price and the commodity reference price
based on the pre defined quantity.
• If the commodity reference price is above the selling price (ie the average or price
of period T+1 +/- X), then the transformer will pay to the financial institution the
differential between the selling price and the commodity reference price based on
the pre defined quantity.
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Hedging Strategy for the transformer
• Purchase of an Averaging
• Conclusion: an averaging transaction is a tailor made structure that can be design for
every combination of periods, reference prices for a single commodity depending the
risk structure the transformer is facing.
• We can identify 4 basic structures :
• Average vs Average
• Average vs one day pricing
• One day pricing vs an average
• One day pricing vs one day pricing
• The price of the structure is not a function of the absolute price level of the
commodity, but depends from the shape of the forward curve of the commodity.
Contango Backwardation
Purchases indexation prior Profit Cost
the sales indexation
Purchases indexation later Cost Profit
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Hedging Strategy for the transformer
• Purchase of an Averaging
• Cash flow profile linked to the purchases / sales of raw materials : Hedged vas
Unhedged

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Hedging Strategy for the transformer

• Example cable maker case :

• The sale of 250 Mt of cables planned on march 2017 are indexed on the average of
reference LME prices of the same month.
• The supply of the Cathodes needed to produce this contract is performed 3 months
before (in December 2016) and indexed on the average of reference LME prices of
the same month.
• Both average are converted in EUR/Mt.
• Checking the current market condition on the LME, we see that the customer can
today fix a differential of -4 EUR/Mt (backwardation).
• The differential comes from the actual forward curve on copper converted in EUR/Mt.

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 Hedging Strategy for the transformer
• Example cable maker case :

Dec16
Price

Mar 17
Price

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Hedging Strategy for the transformer
• Example cable maker case :
• This differential is then added to the average on December 2016 when known.
• If we suppose that this average corresponds to 5 000 EUR/Mt, then the customer will get
an hedge on its sales of march 2017 at 4 996 EUR/Mt.
• At the end of the march 2017, the settlement will be calculated following this method :
• If at the end of march 2017, the monthly average is at 4 900 EUR/Mt:
• The company sells its Cables on a base of 4 800 EUR/Mt, buys its physical copper at 5 000 EUR/Mt
and receives from the Bank 196 EUR/Mt.
• The cable maker has finally bought at 5 000 EUR/Mt, sold at 4 996 EUR/Mt and has realized a margin
of -4 EUR/Mt.
• If at the end of march 2017, the monthly average is at 5 100 EUR/Mt:
• The company sells its final products on a base of 5 200 EUR/Mt, buys its Cathodes at 5 000 EUR/Mt
and pays to the Bank 204 EUR/Mt.
• The customer has finally bought at 5 000 EUR/Mt, sold at 4 996 EUR/Mt and has realized a margin of
-4 EUR/Mt.

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Hedging Strategy for the transformer

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The Proxy Hedge Notion

• Often used in the search for liquidity

• Aluminium High Grade Vs Aluminium Alloy
• ICE Brent vs Jet Fuel
• Systematically generate a risk :
• A correlation risk

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 COMMODITY MARKETS
Risk management : a Need for Corporates / a Business for Banks
Your Speaker : C.LECLERCQ (06 77 02 68 96)
2/3/4 Novembre 2020

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Table of content
• Market organisation
• Trading Floor organisation
• Bank risk management
• Outright risk vs Volatility risk
• Business Profitability
• Conclusion

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Market Organisation
• Financial Markets
Producers Transformers Consumers

Investment
Banks

Organized Future
Clearing House OTC Brokers
Exchanges

Financial
Traders Hedge Funds
Institutions
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Market Organisation
• Trading Floor Organisation
Research

Legal Compliance Risks IT

Counterparties
SALES TRADERS MARKET
Clients / Banks

Middle
Office
Back Office

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Bank Risk Management
• Outright price Risk Management
• Forward curve risk management
• Looks like a transformation risk
• Option Book Management
• The need for a sensitivity analysis
• The Greeks :
• Delta
• Gamma
• Vega
• Theta
• A additional underlying to manage, the volatility :
• Implied volatility
• Real Volatility

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Bank Risk Management

Implied Volatility

Intrinsic Value

Time Decay
Out of the money At the money In the money

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Bank Risk Management
• Greeks
• Delta:
• Rate of Change of the option’s premium against a change in the underlying asset,
• Hedge Ratio,
• Probability of exercise,
• Some Premium for exotic options,
• Usually expressed as a percentage or underlying equivalent underlying,
• Gamma:
• Rate of change of the option’s Delta against a change of the underlying asset,
• Measure the convexity of the position,
• Generally expressed as a percentage or underlying equivalent,
• Theta:
• Rate of change of the option’s premium against a change in the option’s maturity,
• A measure of the time Decay,
• Usually expressed in USD per day,
• Vega:
• Rate of change of the option’s premium and the underlying’s implied volatility,
• Measure the sensitivity of the option with the implied volatility quoted by the market,
• Usually expressed in USD per % of increase,

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Bank Risk Management
• Greeks

+ Call - Call + Put - Put

Delta

Gamma

Theta

Vega

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 Exercise
• Please draw the following strategies on one P/L Chart:
• Long a 100 USD/Mt call 6 months bought at 8 USD/Mt
• Long a 100 USD/Mt put 6 months bought at 8 USD/Mt

Profit

Market Price

Loss

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 Exercise
• Please draw the following strategies on one P/L Chart:
• Long a 100 USD/Mt call 6 months bought at 8 USD/Mt
• Short Two 110 USD/Mt Calls 6 months sold at 3 USD/Mt

Profit

Market Price

Loss

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Option Risk Management
• The most common option strategies used to manage an option book
Expectation Price price Price

Volatility Buy a Put Buy a Straddle Buy a Call

Buy a Put Ratio Buy a Strangle Buy a Call Ratio
Spread Spread

Volatility Buy a Put Spread Buy a Call Spread

Sell a Collar Buy a Collar

Volatility Sell a Call Sell a Straddle Sell a Put

Sell A Put Ratio Sell a Strangle Sell a Call Ratio
Spread Spread

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Bank Risk Management
• Few words about Profitability
• Commercial Side
• Transactions done with customers consume Credit Lines
• Credit Line consumption = Bank’s capital use
• Need for profitability
• Commercial Margins :
• Maturity of the transaction,
• Volatility of the underlying,
• Rating of the customer.
• Quantification
• NBI
• Rarorc
• RWA
• Trading side
• P/L vs limits

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Conclusion

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