MANAGING COMMODITY RISK

FACTORS THAT AFFECT COMMODITY PRICES Expected levels of inflation, particularly for precious metal Interest rates Exchange rates, depending on how prices are determined General economic conditions Cost of production and ability to deliver to buyers Availability of substitutes and shifts in taste and consumption patterns Weather, particularly for agricultural commodities and energy Political stability, particularly for energy and precious metals

TYPES OF COMMODITY RISK Commodity Price Risk –Potential change in commodity price Commodity Quantity Risk –Potential change in demand & supply Commodity Basis Risk –Basis is difference between spot & future price –Potential change in basis Special Risks –Industry specific risk

TYPES OF PARTICIPANTS Commodity dealers who act on behalf of their companies Consumers of commodities, eg manufacturer, wholesaler, refineries etc Supplier of commodities, eg farmers, growers, mining companies etc

COMMODITIES MARKET Metals Agricultural commodities Grains Livestock Oilseeds Energy Peanuts Silk Rubber etc

COMMODITY FORWARD AND FUTURE Forward contract –Over the counter –Customized Futures contract –Standard packages –Delivery guaranteed by a clearing house

COMMODITY FORWARD AND FUTURES Basis (premium in forex contract) is based on calculation of carrying charges, insurance, difference of gold lease rate with dollar lending rate etc) Contango market (normal market)  forward/future price higher than cash price If short term demand high, market will push short term forward price/future price higher than long term forward/future price  backwardation/inverted market

SPECULATOR If basis is higher than actual carrying, insurance and borrowing cost, speculator/arbitrageur will buy commodity cash and sell a forward/future contract to deliver at maturity

SPOT DEFERRED CONTRACT Forward contract with multiple delivery dates At the end of every period the forward contract holder has the decision to exercise or roll over the quantity using a new forward rate  similar to option, but with a final obligation of delivery at the end of the contract (can be for 5-10 years)

HEDGING WITH COMMODITY FUTURES Seldom involves commodity delivery. Settled by buying an offsetting contract or rolling forward Basis Hedging  hedging using underlying commodities. But be aware of differences in location, delivery date and other factors.

HEDGING WITH COMMODITY FUTURES Needs to buy Grains in 3 months time Buys Grain in Futures Commodities at US$ Future Price for 3 months After 2 months sells 1 month Future Grain for US$ After 3 months –profit from Futures US$ 2.00 –Buys Grain in the spot market at US$ –Net purchase price US$ 15.10

Basis hedging Need to deliver Toraja Coffee in 3 months with cost US$100 per unit Sells 3 month coffee at Future price US$ 110 After 3 month buy an offsetting future contract for US$ 102 After 3 months the Toraja Coffee is sold cash for US$ 94  gain from future US$ 8, loss from transaction US$ 6, net gain US$ 2 Can also result in net loss, but minimized

MARGIN DEPOSIT Futures contract requires margin deposit which is to be adjusted at “ mark to market” Initial Margin Margin size is about 5% from the market price of a futures contract. Each day when you have a position opened, the gained profit is added to this amount or the loss is written off. Maintenance Margin If your losses result in making your margin account go down below a certain level called maintenance margin requirement (it is a minimum amount required for maintaining a margin account), a margin call occurs, i.e. your broker requires that you add money to your margin account to achieve the initial margin level.

SPREADS Intra market spread –Purchase and sale of 2 different delivery dates Inter market spread –Purchase and sale between 2 different exchanges for same delivery dates Inter commodity spread –Purchase and sale of two different commodity with the same delivery date  Traded as a product

COMMODITY OPTION Similar concept to Forex Option

COLLAR FOR COMMODITY Buy put option and sell call option for selling Sell put option and buy call option for buying Zero premium collar can be arranged

COMMODITY COLLARS FOR SELLING COMMODITIES BUY PUT OPTION STRIKE = $ 100 SELL CALL OPTION STRIKE = $ 120 MARKET PRICE = $150 MARKET PRICE = $ 80 SELL AT $120 Option not exercised SELL AT $ 100

COMMODITY COLLARS FOR BUYING COMMODITIES SELL PUT OPTION STRIKE = $ 100 BUY CALL OPTION STRIKE = $ 120 MARKET PRICE = $150 MARKET PRICE = $ 80 BUY AT $120 Option not exercised BUY AT $ 100

CLOSING OUT COMMODITY FUTURES/OPTIONS Similar to forex instruments

COMMODITY FINANCING Trust ( special vehicle set up ) Commodity indexed bonds Commodity indexed underwritten offerings

COMMODITY TRUST Funds raised through this trust will be used for metal mining / commodity growing Minimum interest is guaranteed If price of the commodity increases, the interest earned also increases proportionally

COMMODITY INDEXED BONDS Commodity raised through this bonds will be sold in the market to raise cash Repayment of installments and interest is in form of commodity Collateral is mine/extraction site/plantation Sinking fund might be required, taken from company’s net cash flow

GOLD INDEXED UNDERWRITTEN OFFERINGS A fixed interest is guaranteed The note is indexed to gold Index is 100 at time of issuance, e.g. 1 ounce of gold = $ equal index 100 Note holder can redeem the note after a certain period (usually 1 year) and can choose to receive cash or commodity Amount of commodity determined in advance and increases over time with the trend of the index

BENEFITS/RISK OF COMMODITY FINANCING For companies in this industry, repayment using commodity is beneficial since they are producing the commodity. If company is having production problem it will need to purchase the commodity elsewhere