1

A Brief Session on

Commodity Price Risk Management(CPRM)

2

IntroductionI am Head of Treasury Risk Management relating to Fx, Interest Rates & Commodities (Cotton) in The Arvind Mills Ltd and my role is: managing the financial risks on our exposures in these markets on a continuous basis adopting appropriate strategies for hedging, taking into account factors that affect the prices.

This session is for sharing with you some aspects of Commodity Price Risk Management with respect to Cotton.

3

Topics of DiscussionAt the end of this session …

You would become aware of some of the basic risks inherent in commodity trading/hedging and the groundwork needed to have a proper risk management setup.

You would have an idea about certain popularly used hedging tools in futures market and also in OTC market and how to use them under different circumstances.

You would also understand the difficulties & limitations in this activity

4

Why Hedge?The procurement price of cotton, the projected sales of fabrics/ apparels & their price would be of prime importance in the Company’s business plan

If the Company has to pay a higher price for cotton than the budgeted price, it has to incur loss. Even if the Company is able to sell its products at higher than envisaged price the loss taken on procurement of cotton could still affect the budgeted cash flows.

The cotton price fluctuates due to supply & demand factors and also due to seasonal factors and government policies. There are markets in which the prices can be hedged so as to arrest any adverse price moves affecting the profit

5

The Approach• Company has a natural liability in Cotton,

which is a significant one.

• Company has assets in the form of Cotton inventory.

• Both Assets & Liabilities need to be managed well in order to protect against adverse price moves that could upset budgeted objectives

• Generate cash inflows and minimize outflows

6

HedgingPrice risk in cotton is hedgeable & that of fabric/apparel is not as there are no commodity markets for them

Risk management is not necessarily a profitable activity but is a risk mitigating activity. We neutralize an exposure by hedging at a level that would not affect the planned levels.

Risk management activity may result in losses, viewed from an MTM angle of the hedge portfolio and also can lead to cash outflows.

Dynamic/systematic risk management has a chance to minimize losses but would increase bank charges & workload.

7

Risk Profile & Goal setting forRisk Management Process

Taking into account the budgeted needs and also the nature & size of the market in relation to the size of Company’s requirement, a suitable hedging policy should be devised.

If debt servicing or other cash commitments assume importance then the Company would be less tolerant to cash outflows in CPRM. Instead Company would look at the CPRM activity as a cash generator.

Suitable strategies should be devised to achieve the desired goals which should simultaneously seek to arrest the price risk.

8

Hedging Basis Risk

Price risk on cotton can be hedged through NYBOT or Indian Commodity Exchanges but it involves a risk called Basis risk.A risk that the value of the financial instrument does not move in line with the underlying exposure. Generally, it refers to an imperfect hedge where the matched risk-offsetting positions are not in identical markets.Basis risk can also be seen as residual risk that remains when the hedge transaction does not fluctuate in the same way as the underlying.The imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.In a broad sense it should be ensured that the basis differential does not vary much from price moves of the underlying.

9

Hedging Tools -Over The Counter Market - OTC

• Governed by Industry Standards –ISDA – as opposed to CFTC for futures.

• Common types of hedges available• Forward contracts• Swaps• EFP (Exchange for Physicals)• Options & Option combinations

10

Forward Contracts

These contracts are traded between market participants.Both the price and identity of participants is not entirely transparentForward contracts have a very low cost.No contractual obligation of payment until settlement (Co’s may have to put up a LC on entering a deal)Close out : a deal can be closed out only by selling it, to a different counter party – a series of buys and sells creates a chain , who are obliged to pass a physical cargo from one to another

11

Forward ContractsThese are traded round the clock , play a complementary role (can be used outside normal exchange hours)Enable to trade larger volumes – without costParticipants can choose trading partnersThey may involve physical delivery – the close link with the underlying physical market – suited for companies in the business of supplying and looking for short-term instrumentsLimitations : involves physical delivery ultimately if not squared – difficult or costly to close out a positionParticipants : large Trading cos, Investment Bankers

12

Swaps -OTCThe attraction of swaps are – they are purely financial transactions and can be traded without incurring quality risks and delivery problems; they offer the prospect of the perfect hedge- can be tailor made; they can be traded far into the future – fills the gap left by other instruments

A swap allows a company to effectively lock in a fixed price for a commodity that they want to buy or sell over a certain period of time.It protects the company against adverse movements in prices in the market , but excludes the benefits of favorable market movements.A swap is a financial transaction, there is no physical delivery of the commodity, it’s settled in cash.The original physical contract with the supplier remains unaffected.

Buying a Swap: Going long a fixed price protects against price increases – but will not benefit if the price falls during the life of the swap.Selling a Swap: Going short a fixed price protects against falling prices – but will not benefit if the price rises during the life of the swap.

13

Swaps -OTCSwap Contract - parametersPrice Element :

Fixed Price (negotiated and agreed)Floating Price (determined in the future – based on a benchmark)

• Fixed volume per period• “Buyer “ buys fixed price volume , sells floating• “Seller” sells fixed price volume, buys floating• One period or term period• Contracts are offset with financial settlement• Net Payment made to the receiver after the period

Advantages: No upfront fee. Hedges price riskDisadvantages: Gains through favorable price moves would not accrue to

the hedger.

14

Swaps -OTC• The price of a swap depends on 3 main factors :

• The cost of hedging the swap position• The credit rating of the swap user, and• The margin required by the swap provider

• most important is the “cost of hedging”• And this depends partly on the term structure of the forwards

or futures market – being used to hedge the price risk• The other two factors play a role, but their significance have

diminished as market has become competitive and liquid• In theory – a swap agreement is equivalent to holding a portfolio of

forward or future contracts and arbitrage will ensure that the price reflects this• swap price = combination of futures relevant for the swap period

• A calendar strip of Swap price takes the average value of the strip.

15

OTC-SpreadsApart from long and short positions, traders also commonly tradeSpreadsA Spread position is initiated by a simultaneous purchase and sale of futures contracts or swaps

on the same commodity but with different delivery months orOn different commodities for delivery in same or different months

Spreads involve holding both long and short positions. Price changes in the underlying , results in simultaneous gain or losses on both sides/legs of the spreadSpreads are traded when there is a predictable economic price relationship between commodities

16

OTC- Spreads

Time Spreads – difference between prices at two different periods, also called a intra-commodity spread (ex. May-July CT futures spread)

Inter-commodity spreads – difference between two different but related commodities (ex. NY Cotton - MCX Cotton)

17

CFD –Contract for Differentials

Allows hedging the risk of price difference between a commodity and another bench mark price of a commodity. (Bench mark commoditiesare used for pricing. Eg. Hedging through price differentials between NY Cotton & Surendar Nagar/MCX Cotton-or NCDEX Cotton)

CFDs are not available readily here but can be formed synthetically by legging two different contracts.

CFDs are generally settled using averages of a particular week’s worth of daily price assessments

18

EFP -Exchange for Physicals EFP – Exchange of a futures position for physical commodity

Buyer – can give long position to the seller and get physical commodity

Both buyer and seller can take independent position on the futures When the physical transaction is agreed – EFP is registered on the exchange giving the opposite position - closes the futures positionUsed extensively – all deliveries made against future contracts are EFP’sEFP’s enable long term deals – as both the buyer and seller have the flexibility to price, when they think it is rightTechnically, EFPs are considered as a method of delivery

Instead of exchanging the futures position for Physical position, it can be exchanged for swap position also.

19

Exchange Traded Cotton Futures & Options

NYBOT - Active Trading months – March, May, July, October & DecemberOption contracts will be available for the nearest ten delivery months for March, May, July, October & DecemberThere are several unique characteristics for this market, which can be seen in the specification pages for the contracts.In MCX the nearest comparable contract is Kapas.

20

FuturesCan be used as hedging vehicle. Easy to enter & exit Cash outflow – Margin & BrokerageTrading hours – 10.30 am to 2.14 pm NY timeGains & losses are proportional to the advances & declines in the prices.Trading lines are offered by Banks.

21

OptionsFirstly to arrive at a meaningful option strategy one should be able to assess the most probable & least probable directions/ levels the price would achieve using various inputs. Without this the strategy would not yield consistently good results..Could be used as an insurance as well as an instrument to generate cash.Exchange traded options are better than OTC options.Options do not extinguish an exposure like futures or swaps.Ideal strategies focus on betting on high probability events from the long side & low probability events from the short side.To the extent possible it is advisable to go for simple structures rather than getting entangled in complex structures as most of the Indian companies are not ideally placed to handle the risks.Too big a topic to fit into this slide show.

22

OptionsCompany would gain if..

1) the inventory value appreciates2) able to buy cotton at a cheaper rate 3) if cotton is bought at lower rate & sold off at higher rates4) if cotton is sold off at higher rates & picked up at lower

rates.

Keeping the above four goals in mind suitable option strategies can be devised. It could be so devised that the strategies themselves could partially fund the operation.

23

OptionsIn rising market..

Buying futures with a stop could be a simple strategyOr buying a future & also buying a put as an insuranceNext could be buying a callOr Buying a future and selling a call at a higher strike above the envisagedtarget (to earn premium)Another one could be just Selling a putStill another one could be a buying a call near the money and selling a callat a higher level in the same month to earn some premium (Bull Spread/Call spread/Vertical Spread)

24

OptionsIn a falling market..

Selling futures with a stop could be a simple strategyOr selling a future & also protecting it with a long call Next could be just buying a putOr Selling a Future and selling a put at lower strike below the envisaged target (to earn premium)Another one could be just selling a callStill another one would be to buy a put near the money and selling a put at lower level in the same month to earn some premium (Bear Spread/ Put Spread/ Vertical Spread)

25

Options

In a sideways market with mild bullish or bearish bias..

Strategies like Strangles or Straddles can be used.A Straddle involves purchase of a put & call or the sale of a put & call . These options would have a common strike price & expiration date.A Strangle entails purchase of put & call or sale of put & call with a low put strike & high call strike but with a common expirationdateThese strategies are suitable more for traders in options than risk managers

26

OptionsThe strategies are numerous in a dynamic

hedging environment using options.

The three important rules to be kept in mind is to 1. Make Time value decay work for you2. Understand the risks3. Know when to hold & when to exit

1.

27

Risk ManagerThe risk manager should ideally have a thorough understandingof the market, possess knowledge of the fundamental & seasonal factors along with good idea on technicals. Knowledge of Statistics and proficiency in using spreadsheet would be an added advantage. He/She should convey details of risks throughsome well designed MIS and should have the patience to explainto the management about the risks involved and the potential losses.