Commodity financial & risk management


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This article gave some explanation of managing a financial risk in commodity market.

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Commodity financial & risk management

  1. 1. CommodityFinancial and Risk Management Iwan Budhiarta Commodity Trading Adviser Malaysia, Dec 2011
  2. 2. I. Commodity finance• Introduction• Traditional finance vs Structured finance• Examples
  3. 3. Introduction: access to finance incommodity trade and development• Importance of the commodity sector for developing economies and financial constraints: - Over 2 billion people are estimated to derive their livelihood from production and trade of commodities; - More than 50 developing countries and LDCs depend on three or less leading commodities for at least half of their export earnings.• Commodity trade and production is credit-intensive.• Risks in commodity finance.
  4. 4. • Traditional finance (balance sheet based) vs Structured finance (transaction based)Economics, and political events that have global implications, especially inemerging markets, have compelled financiers to develop and adopt innovative,structured financing techniques to mitigate their risks and adapt to globalizationand privatization of commodity trading activities.- Until the onset of the Latin American financial crisis in the mid-80s, banks involvedinternational commodity finance relied on balance sheet lending and governmentguarantee.Structured finance, on the other hand, is based on the transaction for which thefinance is provided.- Such techniques aim to transfer risks in financing transaction from parties lessable to support those risks to those more equipped to support them in a mannerthat ensures automatic reimbursement of advances from the underlying assetssuch as inventory and export receivables... This forms the pillar of structured tradefinance.
  5. 5. Through use of structuring techniques, financiers can control their level of riskWithout structured With secured With structured finance: finance: finance: financier financier financier Will the How to Will the borrower $ control borrower $ reimburse? collateral? produce? Potential Potential Potential Goods Offtake borrower borrower borrower r
  6. 6. Practical use of structured trade finance: There are no distinct standardized types of structure trade finance transactions since one essential principle of these transaction is the ability to tailor a structure that will satisfy the needs and circumstances of all parties involved, provided that perceived or real risks are mitigated. We are going to present some basic forms of structured finance, their concept, and transactions flow. 1. Export receivables-backed financing 2. Supply Chain finance 3. Warehouse receipts finance
  7. 7. Success Factors Along The Value Chain Transport Transport Manufacture/ Storage Storage Agri Agricultural Agricultural Commodity Further Wholesale/Value Chain Inputs Production Sales Processing/ Distribution Packaging Financing Production / Trade / Export Wholesale Stages Processing • Local producers & processors; • Local producers & processors •Small commodity traders • Local distributors Agri • Commercial farmers; • •Commercial farmers •Large commodity traders • F & B ultinationals m Players • International input suppliers. suppliers • International input • Wholesalers. Producers Commodity Buyers Processors Traders • Input financing; • Working capital; • Working capital/liquidity; • Trade finance; • Working capital/basic cash • • Price risk management; Structured trade finance Financing • Crop risk management and collateral management, • Structured finance: Needs weather insurance • etc.; Price risk management; receivables-back finance, pre- • Structured finance: payment etc. • Foreign exchange. • Foreign exchange. WRS/inventory based finance, etc.. Pre-shipment finance Post-shipment finance
  8. 8. Export receivables-backed financing This model entails the provision of pre-export loans or advance payment facilities to an exporter, with repayment being obtained from the exporter’s receivables resulting from the sale of the pre- financed exported commodities. Under this model, banks take the following combined measures: (a) Taking security over the physical commodities in the form of a local-law pledge or similar security interest; (b) Assigning the receivables generated under the commodity export contracts; (c) Establishing an escrow account in a suitable (usually offshore) location into which buyers of the commodity are directed to pay the assigned export receivables.
  9. 9. EXAMPLE: Receivable-Based Financing1. Underlying transaction: To trade naphtha and crude oil.2. Lender: XYZ Bank. Shipment Buyers (Oil3. Facility Amount: US$ 50 million for credit Exporter Refineries) facility. Letter of4. Exporter: Oil company Acknowledgment Letter of Undertaking5.. Importers: oil refineries worldwide. (remedial procedures in Payment at case of non-performance) Payment after7. Tenor: 30-90 days from B/L date. shipment 30-90 days from B/L date through8. Collateral: Outstanding account an escrow receivables. account XYZ Bank Assignment of9. Facility Period: 1 year. contract/A/R etc..10. Each transaction amount: Over US$5 million.This financing is given to the exporter once goods are shipped and repayment is doneautomatically by importer through an escrow account.This creates an automatic reimbursement procedure.This enables exporters to use future trade flows to raise self-liquidating export-based financingat better cost and tenor. It also enables financiers to externalize country and credit risks by theassignment of export contracts and receivables, and by receiving payment in an offshore escrow
  10. 10. Example - revolving pre-export finance for fishermen and a fishprocessing plant Foreign Local Monitoring bank bank Loan used for buying oil Diesel oil Reimbursement Diesel Processor/ Fisher Fish freezing Fish Foreign men plant buyers Fish Local market
  11. 11. A simple warehouse receipt finance scheme - open to various depositors. This can act as a model to reach farmers - who are often willing to pay high interest rates. 4. Provide credit 3.Lodges receipts with bank Farmer Banks 1. Deposits products5.Signs sales Guarantee, insurance, contract 2.Issues Warehouse etc. receipts Guarantee 9. Delivers agencies receipt; Approves warehouse Warehouse Government makes delivery Trader regulator 6. Reimburses credit; in return, bank transfers receipts
  12. 12. An example of using a collateral manager to financeSouth-South trade Acceptable payment will allow rice to be released Bank from import warehouse Payment when goods enter into warehouse controlled by the collateral manager Rice Rice Warehouse Warehouse exporter Importer Collateral manager takes full control from moment on that goods enter export warehouse, until release (as authorized by the bank) from the import warehouse. The bank will have recourse to him for most losses during this period.Collateral management Collateralagreement manager
  13. 13. Commodities will increasinglybecome a financial asset – anycommodity will be like a Commo- Moneycurrency. ditiesFinancial markets will developaround these new “currencies”.Independent entities will bedoing the leg work to convertcommodities, as they movethrough the value change, intofinancial assets. “Paper”Technology will link it alltogether – through a GlobalCommodity Receipt system.
  14. 14. WRS in Tanzania- The CFC funded Coffee and Cotton marketing development project whichwas launched in 1999.- Tanzania has passed a Warehouse Receipts Act (2005) and WarehouseRegulations (2006),- and has designated a Licensing Board in the Ministry of Industry, Trade andMarketing-This has registered some 20 warehouses (12 for cashew, 5 for coffee, 2 forcotton and 2 for paddy rice), and plans to establish a fully-fledged licensingregime.
  15. 15. WRS in TanzaniaCommodities Finance includes:- Traditional crops (coffee, cotton) has expanded their loans portfolio atground level.The WRS has taken off with coffee since the latter 90s and 25% - 30% of the country’s exportsare reported to pass through the system, much of it supplied by POs (farmer business groups,primary cooperative societies etc.) that bulk on behalf of their members.- Non traditional crops such as Paddy (MF-linked approach, with upward of10,000 tonnes being stored by farmers per year), Maize and sunflowers arerecognized and getting finance from the bank.- Cashew nut WRS initiative emerged in 2007. More than 168 primarycooperative societies in cashew nuts sub sectors are financed in in thebusiness of raw cashew nuts. Total loan portfolio in cashew nuts WRS financeexceed U$50 million.
  16. 16. II. Price risk management• Describing briefly organised and over-the-counter markets• Hedging tools
  17. 17. Hedging Market used for risk management is divided in two part Market used for risk management is divided in two part Commodity Over-the-counter exchange marketAlthough the basic ways to use these tools can easily be learned, hedging strategies canbecome quite complex. { The need to pay margin deposits/guarantees Even with a good mastery of Margin calls, which could be required, and which these instruments, some can be high difficulties exist, due to: The fact that in some countries, intermediaries do not really exist, or even use of these markets is banned
  18. 18. Tools for Commodity Risk Management• Specification of price or minimum price in contracts for sale of commodities by farmers or processors at future date• Forward and futures contracts – Forward contracts negotiated on individual basis – Futures contracts specified on commodity exchanges – Options is right and not obligation to purchase or sell a commodity at a a ”strike” price on or before a specified date – pay a premium at time contract signed
  19. 19. Concept of price risk managementFinancial markets provide possibilities to hedge against price risks. Thesehedging instruments are:FuturesOptions (put, call)Swaps
  20. 20. Futures Futures are kind of standardised contracts for future delivery of an asset (that could be commodity). There are: Helpful to Useful for some An ideal hedge price risk marketing benchmark exposure strategies price Lock-in a future price Initial position can easily be reversed Give a good benchmark price to barterProtect the value of inventories Delivery is not necessarily implied or finance storage No need to negotiate contract specificationsThese kinds of contracts are regulated by exchange’s authorities, and there execution are guarantee byclearing houses.
  21. 21. Differences between Forward and Futures ContractsForward Contracts Futures ContractsMost are traded OTC Are traded on organized exchanges through clearing housesCan be tailor-made to match specific Have standardized contract termshedging needsRequire cash transfer only at maturity of Require initial transfer for margincontract payments and may require daily settlements to adjust margins to adverse price movementsInvolve a high degree of counterparty risk Imply very little counterparty risk becausebecause no clearing house facility exists the clearing house guarantees the fulfillment of contractual obligationsContain the expectation of physical Only a small fraction of futures contractsdelivery result in actual delivery of the underlying commodity
  22. 22. Options Options contracts give the right (but not the obligation), to purchase or sell a specific asset at a predetermined price on or before a specified date. There are two kinds of options contracts:Call option Put option US call: the right to buy at any time US put: the right to sell at any time during the period. during the period. European call: the right to buy, but only European put: the right to sell, but only at the end of the period. at the end of the period. Main use are for: Obtaining short- Part of Protection against term finance marketing unfavourable price strategy movements An over-the-counter In regard of longer-term Limits the size of the maximum loss but financing trade relationships do not eliminate the opportunity to take advantage of favourable price movements
  23. 23. Swaps A swap is a purely financial instrument under which specified cash-flows are exchanged at specified intervals. Obtain easier Lock in long- Guarantee and cheaper term prices income streams access to capital From financial operations or No or less-strict margin calls Long term instrument new investments Low administrative costs once Combination of price structured hedging and investment securization Tailor-madeIt should be noticed that swaps are purely financial tools, which means that no delivery of physicalare requested.
  24. 24. Coffee Cooperative in Tanzania• Multiple payments to farmers throughout the year – Minimum price when deliver coffee – Supplementary payments based on price at which coffee sold on world market• Risk to cooperative of setting initial price – Too low, farmers sell elsewhere – Too high, lose money• Mitigated through hedging in futures market
  25. 25. The practicalities ofrisk management: themarkets
  26. 26. Commodity exchangesCommodity exchanges are financial organised market Main Commodity Exchange around the world:where commodities are traded on standard contract. Main Commodity Exchange around the world:There exist a several commodity exchanges around Chicago Board of Trade (CBOT) Chicago Board of Trade (CBOT)the world, each place trading a certain part of New York Mercantile Exchange (NYMEX) New York Mercantile Exchange (NYMEX)commodities. Coffee Sugar and Cocoa Exchange (CSCE) Coffee Sugar and Cocoa Exchange (CSCE) New York Commodity Exchange (NYCE) New York Commodity Exchange (NYCE)Commodity exchanges provide London Metal Exchange (LME) London Metal Exchange (LME) International Petroleum Exchange (IPE) International Petroleum Exchange (IPE) Standardised contracts London Commodity Exchange (LCE) MATIF London Commodity Exchange (LCE) MATIF (Paris) (Paris) Strict controlled financial streams Efficient market (due to the As shown, main commodity exchanges are located in USA normally great volume of trade, and UK. There are the most efficient and can therefore clear information, control...) provide good international benchmark prices for the commodity they trade. Good international benchmark prices for the traded commodities Secured trade
  27. 27. Over the counter marketThe need for more sophisticated and specific hedging instrument has lead the over-the-counter market to be more and more used. This is mainly due to the fact that this kind ofmarket provide: direct interaction between client and intermediary (bank, trade house, brokerage firm…) contract uncontrolled by a clearing house tailor made contract long term hedging instrumentsNevertheless, it should be paid attention to the following fact: this market is not transparent once entered into a transaction, it is very difficult to reverse margin are not about to decrease, since contracts are not standardised (i.e. intermediaries try to keep contract highly tailor made then not competitive).
  28. 28. Thank you Iwan B.,CTA, CPM, Dipl.FP, BBA, MSc(Strat), MEng