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Corporate Risk Mngmnt-commodity Hedging

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an intro to hedging in commodities ( cotton and copper)

Published in: Economy & Finance, Technology

Corporate Risk Mngmnt-commodity Hedging

  1. 1. How to Manage Your Commodity Risk ?? An Eyeopener.
  2. 2. TYPES OF CORPORATE RISKS FACED <ul><li>Business risks: </li></ul><ul><ul><li>Commodity Risk : </li></ul></ul><ul><ul><ul><li>Price risk: price fluctuations. </li></ul></ul></ul><ul><ul><ul><li>Quantitative: natural calamity, weather, etc. </li></ul></ul></ul><ul><ul><li>Concentration Risk: </li></ul></ul><ul><ul><li>International operations Risk: </li></ul></ul><ul><li>Financial Risks: </li></ul><ul><ul><li>Credit Risk: </li></ul></ul><ul><ul><li>For-ex Risk: </li></ul></ul><ul><li>Operational Risks: </li></ul>
  3. 3. COMMODITY RISK <ul><li>Reasons: </li></ul><ul><ul><li>Change in inventory value. </li></ul></ul><ul><ul><li>Inflation leading to : </li></ul></ul><ul><ul><ul><li>Increase in production-infrastructure cost. </li></ul></ul></ul><ul><ul><ul><li>Increase in production-Raw material cost. </li></ul></ul></ul><ul><ul><li>Change in Selling price-Price Fluctuations. </li></ul></ul>
  4. 4. COMMODITY RISK Reasons: fluctuations
  5. 5. COMMODITY RISK <ul><li>Countering the risk:-Hedging </li></ul><ul><ul><li>Commodity futures (selling price) </li></ul></ul><ul><ul><ul><li>OTC </li></ul></ul></ul><ul><ul><ul><li>Local exchanges </li></ul></ul></ul><ul><ul><ul><li>International exchanges </li></ul></ul></ul><ul><ul><li>Inventory hedging (Cost price) </li></ul></ul><ul><ul><li>Options </li></ul></ul><ul><ul><li>Swaps </li></ul></ul><ul><ul><li>Borrowing linked to commodity prices. </li></ul></ul>
  6. 6. COMMODITY RISK <ul><li>Hedging: By Futures contracts in India </li></ul><ul><li>Definition: </li></ul><ul><ul><li>Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. </li></ul></ul><ul><ul><li>Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). </li></ul></ul>
  7. 7. <ul><li>EXAMPLE OF A HEDGE: </li></ul><ul><li>Prediction: A Farmer predicts Price will go down from Rs 62/kg (spot price-Oct) to Rs 55/kg (spot price-Dec). </li></ul><ul><li>Hence, the Farmer Sells a December 20th Futures contract at Rs 62/kg. </li></ul><ul><li> </li></ul>COMMODITY RISK Spot 1 st Dec
  8. 8. HEDGE RATIO <ul><li>Definition: </li></ul><ul><ul><li>A ratio comparing the value of a position protected via a hedge with the size of the entire position itself. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged. </li></ul></ul><ul><li>Example: </li></ul><ul><ul><li>Say a textile manufacturer is to receive delivery of 425 quintals of Raw cotton after three months. If he buys three, 3 months futures contract covering 255 quintals of cotton, then his hedge ratio is 3:5. he is protected 60 % of his exposure. </li></ul></ul><ul><ul><li>The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk. </li></ul></ul>
  9. 9. TYPES OF HEDGES <ul><li>Long Hedge </li></ul><ul><ul><ul><li>This requires taking a long position in the futures contract </li></ul></ul></ul><ul><ul><ul><li>Appropriate when a certain asset or commodity would be purchased in the future and one is interested in locking in the price now </li></ul></ul></ul><ul><ul><ul><li>Textile Company would use a long hedge </li></ul></ul></ul><ul><li>Short Hedge </li></ul><ul><ul><ul><li>This involves a short position in the futures contract </li></ul></ul></ul><ul><ul><ul><li>Applicable when a hedger already owns an asset and expects to sell it in the future </li></ul></ul></ul><ul><ul><ul><li>The Aluminum producer would use a short hedge </li></ul></ul></ul>
  10. 10. TYPES OF HEDGES (cont..) <ul><li>Cross Hedge </li></ul><ul><ul><li>Cross Hedge is used to hedge price risk of different but economically related commodities </li></ul></ul><ul><ul><ul><li>􀁺Correlation analysis is used </li></ul></ul></ul><ul><ul><li>Hedging and cross hedging should only be attempted if the price movements are similar and basis risk is acceptable to the hedger </li></ul></ul><ul><ul><ul><li>Example: Aviation turbine fuel- crude oil. </li></ul></ul></ul>
  11. 11. TYPES OF HEDGES (cont..) <ul><li>Unbalanced hedge </li></ul><ul><ul><li>Description : The future contract standardized size units do not match the cash position quantity </li></ul></ul><ul><ul><li>Solution : A combination of regular size futures and mini contracts can be used to reach a futures position as close as possible to the cash position. </li></ul></ul><ul><ul><li>Variations </li></ul></ul><ul><ul><ul><li>Over hedge: occurs when futures quantity exceeds the cash quantity. </li></ul></ul></ul><ul><ul><ul><li>Under hedge: occurs when the cash position exceeds the future quantity. </li></ul></ul></ul>
  12. 12. TYPES OF HEDGES (cont..) <ul><li>Inter-commodity spread </li></ul><ul><ul><li>Price movements between related underlying instruments tend to correlate fairly well and such gains in one derivatives position may offset losses in a related instrument </li></ul></ul><ul><ul><li>􀁺 Companies can hedge their input and output price risk </li></ul></ul><ul><ul><ul><li>􀁺 Soya oil manufacturers--Soybean and Soya oil </li></ul></ul></ul><ul><ul><ul><li>􀁺 Refiners—Crude and gasoline </li></ul></ul></ul><ul><ul><ul><ul><li>􀁺 Crack Spread </li></ul></ul></ul></ul><ul><ul><li>􀁺 Exchanges offer an inter-commodity spread discount on initial margin </li></ul></ul>
  13. 13. TYPES OF HEDGES (cont..) <ul><li>Intra commodity spread: </li></ul><ul><ul><li>Bull: long near end contract; short far end contract. </li></ul></ul><ul><ul><li>Bear: short near end contract; long far end contract. </li></ul></ul>
  14. 14. Fundamentals <ul><li>Difference between spot and future price depends (fundamentally) upon: </li></ul><ul><ul><li>Storage characteristics of the commodity </li></ul></ul><ul><ul><li>Supplies of the commodity </li></ul></ul><ul><ul><li>Production and consumption cycle for the commodity </li></ul></ul><ul><ul><li>Ease of short selling the commodity </li></ul></ul><ul><ul><li>Transaction costs </li></ul></ul><ul><li>(Good storability) +(Prod>consumption)= price moves according to cash and carry model. </li></ul>
  15. 15. Commodities that can be Hedged <ul><li>Two examples: </li></ul><ul><ul><li>Cotton. </li></ul></ul><ul><ul><li>Copper. </li></ul></ul>
  16. 16. COTTON <ul><li>Why Hedge? STATS speak for themselves. </li></ul><ul><ul><li>2008-09: Global predictions: </li></ul></ul><ul><ul><ul><li>Production: 158.172 Mn Bales (up 3%) </li></ul></ul></ul><ul><ul><ul><li>Use: 161.7 Mn Bales (up 1%) </li></ul></ul></ul><ul><ul><li>India: </li></ul></ul><ul><ul><ul><li>07-08: 31 Mn Bales (up 11%) </li></ul></ul></ul><ul><ul><li>China: </li></ul></ul><ul><ul><ul><li>Production expected to increase + decreased import duties= increased demand, hence market share of China down. </li></ul></ul></ul><ul><ul><li>US: </li></ul></ul><ul><ul><ul><li>Area under cultivation expected to decrease= market share of the US down. Imports up </li></ul></ul></ul><ul><li>Cotton prices have been defying fundamental measures of supply and use. </li></ul>
  17. 17. COTTON <ul><li>Stages for Hedging: </li></ul><ul><ul><li>Raw Cotton: Hedge against increase in Price </li></ul></ul><ul><ul><ul><li>Farmer </li></ul></ul></ul><ul><ul><ul><li>Yarn producer </li></ul></ul></ul><ul><ul><ul><li>Textile producer </li></ul></ul></ul><ul><ul><li>Cotton Yarn: </li></ul></ul><ul><ul><ul><li>Buyer: Hedge against Price rise. </li></ul></ul></ul><ul><ul><ul><li>Seller: Hedge against Price fall. </li></ul></ul></ul><ul><ul><li>Textile: </li></ul></ul><ul><ul><ul><li>Buyer (Garment manufacturer): Price Rise. </li></ul></ul></ul><ul><ul><ul><li>Seller : </li></ul></ul></ul><ul><ul><ul><ul><li>Domestic seller: Price Fall. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Exporter: Price Fall and For-Ex Risk. </li></ul></ul></ul></ul>
  18. 18. COTTON <ul><li>Steps: </li></ul><ul><ul><li>Identity Risk. </li></ul></ul><ul><ul><li>Quantify Risk. </li></ul></ul><ul><ul><li>Calculate Possible and optimum Hedge Ratio. </li></ul></ul><ul><ul><li>Hedge: options available </li></ul></ul><ul><ul><ul><li>Simple hedge: </li></ul></ul></ul><ul><ul><ul><ul><li>Long- short. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Short- long </li></ul></ul></ul></ul><ul><ul><ul><ul><li>intra commodity calendar Hedge: spread (safer) </li></ul></ul></ul></ul><ul><ul><ul><li>Cross Hedge: If contract not available for the type. </li></ul></ul></ul><ul><ul><ul><li>Inter commodity spread. </li></ul></ul></ul><ul><ul><ul><li>Inter Exchange spread. </li></ul></ul></ul>
  19. 19. COTTON <ul><li>Tax Benefit and provisions: </li></ul><ul><ul><li>Refer to: http://www.taxmann.com/DitTaxmann/IncomeTaxActs/2006ITAct/casesec43(5).htm </li></ul></ul><ul><ul><li>Hedging profits/income if any treated as business income, different from speculative income. </li></ul></ul><ul><ul><li>Hedging loss is treated as business loss and not speculative loss. </li></ul></ul><ul><ul><li>Hedging contracts can be both for purchase and sale ; </li></ul></ul><ul><ul><li>In order to be a genuine and valid hedging contract of sale, the total of such transactions should not exceed the total stock of the raw material or merchandise in hand. </li></ul></ul>
  20. 20. COTTON <ul><li>Tax Benefit and provisions (continued): </li></ul><ul><ul><li>In order to be genuine and valid hedging contract of purchase, there should be an existing forward contract of sale by actual delivery. </li></ul></ul><ul><ul><li>The hedging contracts need not necessarily be in the same variety of the commodity; they can be in connected commodities, e.g., one type of cotton against another type of cotton. </li></ul></ul><ul><ul><li>Forwards allowed when: </li></ul></ul><ul><ul><ul><li>commodity not traded on exchange. </li></ul></ul></ul><ul><ul><ul><li>No traded commodity correlated to intended commodity </li></ul></ul></ul>
  21. 21. COTTON <ul><li>Margin: causes leverage. </li></ul><ul><li>Caution: </li></ul><ul><ul><li>Leverage: Because of Margin deposit. </li></ul></ul><ul><ul><li>Tick Size: </li></ul></ul><ul><ul><li>Price limits during last month: </li></ul></ul>
  22. 22. SMC global: Your helper; your Guide!! <ul><li>Member of NCDEX and MCX. </li></ul><ul><li>ISO 9001:2000 certified DP for commodities. </li></ul><ul><li>Proactive and timely world class research based advice and guidance. </li></ul><ul><li>Investor meet/seminars across India. </li></ul><ul><li>Brokerage: Negotiable based on turnover. </li></ul><ul><li>Service: offline/online/software based (real time screen) </li></ul>
  23. 23. MCX- your options <ul><li>You can hedge in: </li></ul><ul><ul><li>Cotton L staple. </li></ul></ul><ul><ul><li>Cotton M staple. </li></ul></ul><ul><ul><li>Cotton S staple. </li></ul></ul><ul><ul><li>Cotton yarn. </li></ul></ul><ul><ul><li>Kapas. </li></ul></ul>
  24. 24. NCDEX: your options. <ul><li>You can hedge in: </li></ul><ul><ul><li>Indian 28.5 mm cotton. </li></ul></ul><ul><ul><li>Indian 30 mm cotton. </li></ul></ul><ul><ul><li>Shankar kapas. </li></ul></ul>
  25. 25. COPPER INDUSRY <ul><li>Global Production:18.29 mn tonnes </li></ul><ul><li>Consumption: 18 mn tonnes </li></ul><ul><li>Major players in India </li></ul><ul><li>- Hindalco Industries Ltd </li></ul><ul><li>- Sterlite Industries Ltd </li></ul><ul><li>- Hindustan Copper Ltd </li></ul><ul><li>Other than these co.’s around 1000 secondary producers exist in the market. </li></ul>
  26. 26. INDIAN CONTEXT <ul><li>Contribution to world Production is low around 3.5 – 4%.Annual Production around 650000 MT </li></ul><ul><li>Major Consumers: Telecommunication, Power Cables,Wires,Construction,Transportation,Consumer Durable,Defense. </li></ul>
  27. 27. HEDGING - Reasons <ul><li>Price fluctuations in International metal exchanges </li></ul><ul><li>Disturbances in Production copper mines or Refineries </li></ul><ul><li>Changes in consumption/demand pattern (China,America). </li></ul>
  28. 28. HEDGING-Reasons(Cont.) <ul><li>Changes in market demand </li></ul><ul><li>- Optical Fibers </li></ul><ul><li>- Change from fixed line to wireless </li></ul><ul><li>Disadvantages of secondary producers. </li></ul><ul><li>- Treatment and refining charges </li></ul>
  29. 29. Porter’s Model-Copper Industry
  30. 30. THANK YOU

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