Commodity Trading and Risk Management : Stress Testing Emmanuel Fragnière Haute École de Gestion de Genève Option Majeure en Commodity Trading 1 Haute École de Gestion de Genève

Commodity Markets Futures and forward contracts are among the most common types of derivatives traded for commodities. Buying (or selling) a future in commodity means you buy (or sell) the obligation to deliver this commodity at a specific date – expiry or delivery date-in a specific price - Forward Price. Every day in major future Exchanges all over the world, forward prices are defined for different expiry dates, according to the supply and demand rules.

The Notion of Forward Curve With the term Forward Curve we mean a curve that it is constructed when we connect forward prices for different delivery dates (months) of a specific commodity, for a specific market. An example of forward curve concerning Kansas Wheat futures market is shown following.

Exchanges and Price Risk As it is referred above, in futures definition, one difference of futures with forward contracts is that futures are traded in organized markets which are called Exchanges. Among the organized exchanges that trade in futures contracts are the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Futures Exchange and Kansas Board of Trade in U.S There are, as well, in United Kingdom such as London Metal Exchange and in the rest of Europe some other Exchanges.

Notions from Price Risk I Basis Risk Contango Backwardation Long and short net position Hedging with Futures contracts Profit & Loss account Margin requirements

The Forward Curve The curve that contains the forward prices for different expiry dates- forward curve-is among the most used tools for analysis in commodities market. This curve has the particularity to change every day, as forward prices change every day.

Speculation with Futures Buying futures contracts with the hope of later being able to sell them at a higher price is known as “going long.” Conversely, selling futures contracts with the hope of being able to buy back identical and offsetting futures contracts at a lower price is known as “going short.” An attraction of futures trading is that it is equally as easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).

Spot Price and Forward Price When someone buys or sells a future contract has to take into account two different prices concerning the underlying commodity of this contract: the spot price which is the price of the commodity at present (for immediate delivery) and the forward price which is the price of the commodity in the future, specifically at the expiry date of his contract. Spot price describes the current situation of the market and that’s why it is important but forward price is the price in which the owner of a future contract has the obligation to buy or sell the specific commodity and sometimes it is more important than the spot price.

Standardized Maturity Dates In every market futures contracts are traded with different expiry dates (usually referred as maturity or delivery dates). Usually, these delivery dates are not exact dates but a month of a year. We could see for example that in KCBT, a Wheat Futures Market, wheat futures contracts are traded with expiry (delivery) dates March, May, July, September and December. This means that if someone buys a wheat futures contract for December 2005 he buys, in the same time, the obligation to deliver sometime in December (the exact date specified by the Exchange, KCBT in this case) a specific amount of wheat and that’s why December is called a delivery month for Kansas wheat futures market.

Graphical Representation of FC A general definition for Forward Curve can be: “The set of forward or futures prices with different expiration dates on a given date for a given asset.” Therefore –adjusting the above definition to commodities market - we can say that a forward curve is the curve that created if we draw the set of prices for a commodity or a derivative of a commodity against the time until the delivery date. (Maturity or Expiration date for other markets)

Stress Test of the Forward Curve Develop a new forward curve that would correspond to an « adverse » evolution of prices according to your actual long and short position. For example, your net L&S calendar position is long, so you are expecting an upward shift of the forward curve. Your risk manager develop a stress test that corresponds to a downward move of the current forward curve of 15%. If you buy in his/her story better hedge your position in case of an unexpected price decrease.

12 Example of Data to build the FC

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14 Back Testing and Stress testing Back testing means checking a posteriori how many times losses have overtaken the VaR at 99% for a period of 10 days. Stress testing means simulating “extreme” scenarios through “shocks”.

15 Case Study in Excel Each group gathers around a laptop in the teaching room Together we learn how to stress the forward curve from a fictitious L&S position