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Section II Understanding and using risk management tools

Section II Understanding and using risk management tools

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Section II Understanding and using risk management tools

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  1. Section IIUnderstanding and using risk management tools Measuring risk is essentially a passive activity. Managing risk is a proactive process, where, in dynamic markets, people are actively seeking to change their positions so that their institution has the risk profile they want it to have. Patrick BrazelSun Guard Capital Markets, Risk, January 1996

  2. Overview • Internal risk management tools • The evolution of gas marketing and pricing • Derivatives • Alternative risk transfer

  3. 1. Internal risk management tools Risk management is a comprehensive process that combines philosophy, principles and methodology to produce a culture of risk management permeating the firm. Bankers TrustRAROC and Risk Management, 1995

  4. Traditional risk management • Reduce discretionary spending when revenues are low • Lock in prices through physical contracts when they are at an attractive level • Keep high cash reserves • Keep stocks of the physical commodity • Use insurance for standard risk (separate policies for separate risks).

  5. Traditional risk management can be boosted by incorporating it in a corporate risk management policy. • This can include: • better gathering and use of information (reduces uncertainty, and allows more time to respond to changing conditions) • a more objective determination of how much money to keep in cash; and what credit lines to get from banks. • longer-term contracts that allow back-to-back matching of input and output pricing • diversification, and vertical integration. • All these have a place in a risk management programme, but they have a cost.

  6. « Optimal » risk management combines elements of such « internal » risk management, of insurance, and of use of market-based instruments.

  7. 2. The evolution of gas marketing and pricing “The future is full of growth opportunities for nimble firms, intensely competitive at the burner tip, and unforgiving of ponderous bureaucracies or strategic errors. The business prizes will go to those who can shed their past intellectual baggage and embrace the new world of natural gas entrepreneurship.” Vinod K. Dat, “Resolve Conflicting Interests,” Oil & Gas Journal, July 1985

  8. Much of the investments necessary for gas production and distribution are large, and to protect investors, long-term contracts, at times with long-term fixed prices, have been quite common. At the same time, by the very nature of natural gas use, consumption is volatile, so natural gas buyers would prefer more flexible marketing arrangements. In recent years, the balance of power is shifting from producers to consumers, and thus, long-term contract are giving way to spot trading.

  9. For example in the USA… Source: International Energy Agency

  10. Developments in the US domestic gas market • In 1982, hardly any spot market for natural gas. • In late 1980s, spot market accounted for 80% of total gas market. • By 1992, spot transactions had fallen back to about 35 to 40% of total gas trade; and this has since remained stable. • What happened around 1990 was that market players started using new types of long-term contracts, in which prices were not fixed, but indexed to the futures market prices.

  11. This shift is not necessarily to producers’ disadvantage. They already have had to adapt to consumers’ variable demand by storing gas, at a cost. And use administrative mechanisms to deal with peak demand. Market instruments are more efficient. In more developed markets, gas storage is now used not just as a way to ensure availability in peak demand periods, but also to give producers extra possibilities to profit from opportunities in the spot market. Having a vibrant spot market for natural gas is thus a win-win situation. And it will change the way companies trade. For example, in the crude oil market, it is common that cargoes are diverted en route to take advantages of price differentials.

  12. With spot markets for natural gas, companies that invest in the proper management systems will see: • the costs of idle assets • the impact of production decisions on profitability • the impact of storage decisions on profitability. • They will also be better able to assess the likely profitability of acquisitions, investments, and longer-term marketing contracts. • This should normally change companies’ behaviour.

  13. Spot markets for natural gas are inherently volatile. This gives new profit opportunities to those who have flexibility, whether in their supply or (if they have longer-term contracts) in their demand. The volatility of the spot market gives rise to the development of new, financial contracts, to enable gas buyers and sellers to mitigate these risks: futures, options and swaps. These financial contracts, combined with the flexibility of the spot market, are often superior to the old longer-term arrangements, and these longer-term arrangements are likely to disappear, or at least, to change (to volume contracts with a price indexed to the spot price).

  14. 3. Derivatives They're here, they're weird, and they're not going away. Yes, these beasties bite, but companies that tame them have a competitive edge. Terente P. Paré, Fortune, July 25, 1994

  15. Overview: • Price volatility • Overview of hedging instruments • Hedging with futures • Hedging with options • The over-the-counter market • Choosing the proper instruments

  16. Price volatility

  17. In the USA, natural gas prices are very volatile, more so than crude oil or coal prices. But US natural gas trade is spot-market oriented. In other parts of the world, longer-term contracts still dominate, and the prices in these contracts are less volatile than those seen at the level of Henry Hub.

  18. Hedging with futures The market offers instruments to deal with volatility. The most commonly used are futures contracts. THESE ARE PRIMARILY FINANCIAL TOOLS TO MANAGE VOLATILITY, AND NOT TOOLS FOR PHYSICAL TRADING. The first futures contracts, for grain, were introduced in the mid-19th century. Oil futures markets only developed strongly during the 1980s. Natural gas markets followed in the USA in the 1990s, and in the late 1990s, electricity futures were introduced in the US and Europe.

  19. Spot sales Producers selling on a spot basis are fully exposed to rising and falling commodity prices.

  20. Forward sales protect producers from falling prices, but remove exposure to beneficial price developments. Spot sales and forwards Beneficial Price Developments Adverse Price Developments Spot sales leave producers fully exposed to price variations, good and bad.

  21. Fixed-price forward contracts make it possible to lock in prices. • However, they have a number of disadvantages: • dependence on the counterparty’s willingness • counterparty risk • lack of flexibility (what if you want to get out of the contract?) • pricing may not be optimal. • Instead of using forwards,one can use futures contracts, as traded on futures exchanges.

  22. Futures contracts are standardized 1. Quantity: stated in an agreed unit of measure 2. Quality: Stated in accordance with international standards 3. Expiration months: specifies the duration of the contract 4. Delivery terms: details how delivery is to be executed 5. Delivery dates: a firm fixed future date 6. Minimum price fluctuation: the minimum band within whichprice fluctuation may be allowed 7. Daily price limits 8. Trading days and hours They are traded anonymously.

  23. Profit/loss Underlying position (long) Price of the underlying Hedge (sale of futures) Hedging with futures

  24. Profit Result Price of the underlying Hedge (sale of futures) Loss Hedging with futures Underlying position (long)

  25. Profit Result after hedging Price Before hedging Loss You do not have to hedge your whole underlying position. You can also hedge part of it.

  26. Hedging - the principle: use the fact that your physical market and the futures market move in parallel, and take a position on the futures market that offsets the risk exposure that you have in the physical market. In this case, you plan to sell in March. Physical market price Futures price 1/1 100 110 sell futures <+ 110> (you don ’t get the money, but you have to pay a margin of say, 10) 1/3 90 100 sell physicals +90 close futures (buy) <-100> profit on futures: +10 Total earnings 100

  27. Basis risks: correlation between the two markets may be imperfect Physical market price Futures price 1/1 100 110 sell futures <+ 110> (margin 10) 1/3 90 105 sell physicals +90 close futures (buy) <-105> profit on futures: + 5 Total earnings 95

  28. Even if there is no relevant natural gas market, hedging may be possible. In particular, internationally-traded LNG is normally benchmarked to competing fuels, so there are different regional markets: • In the USA, LNG vs. pipeline gas. Benchmark: Henry Hub • In Europe, LNG vs. Low-sulfur residual fuel oil. Prices lower than in the US, and less volatile. • In Asia, LNG vs. crude oil: explicit indexation. Higher prices than in the rest of the world.

  29. The price index used in many Asian LNG contracts is the Japan crude oil index, JCC (the average price of 17 crude oils imported into Japan). This is not optimal for hedging, as there is a basis risk compared to the international crude oil futures contracts, WTI in New York and Brent in London. Still, this basis risk is manageable (and basis risk provides not just risk, but also opportunity). The basis risk is least with the Brent contract – WTI is at times influenced by purely domestic US factors. Over time, natural gas futures markets specific to Asia or even to India will develop. But even once these exist, it will probably be useful to look at arbitrage possibilities with the crude markets.

  30. When actually using futures markets, there are many practical issues that have to be taken into consideration. • In particular: • basis risk (how well do price developments on the futures market reflect prices on the relevant physical markets; normally, there are quality- and location-related risk, but in the case of natural gas, only the location-related basis is significant) • contract structure: is the market in backwardation or in contango, how typical is today’s situation, and what does this imply for the period at which one hedges? • margin call considerations.

  31. price Backwardation. Common nowadays for many commodities, including crude oil, metals other than gold, and sugar March 99 May Sept Dec Mar 2000 May etc. Time of contract expiration price Contango. Common nowadays only for precious metals, and often visible in markets for coffee, cocoa, and grains Time of contract expiration March 99 May Sept Dec Mar 2000 May etc.

  32. Futures contracts can be used: • - to avoid the effects of fluctuations in prices for producers who, • because of their limited production volume or seasonal • factors, are not able to spread out their sales over the year; or • for consumers, who because of their limited size cannot • spread out their purchases; • - to protect the value of inventories, or partly finance the cost of • storage; • - to secure a processing margin; • - to "lock in" future prices at an attractive level; and • - to improve marketing policies. • The main disadvantages of using futures contracts are that: • - they freeze up working capital • - although they may provide protection against unfavourable price changes, they do not permit profiting from favourable ones. • - they cannot be used for uncertain volumes.

  33. Hedging with options Using futures to cover price risks can provide price protection, but has one important disadvantage: while strongly reducing the likelihood of losses, the possibility to benefit from price improvements is also lost. Options do not have this disadvantage: By buying an option, protection can be obtained against unfavourable price movements, while the possibility to profit from favourable ones remains.

  34. This is the basic reason for the use of options for hedging purposes. To determine what option might be useful to protect against price risks, firstly the risks have to be identified: are price rises, or on the contrary, price declines the risk? Then, to protect against the effects of a price change, an option can be bought giving profits when prices move in the direction that the buyer wants to protect against. Losses on the physical goods will then be compensated by profits on the options, just like is the case for futures contracts.

  35. In the case of futures contracts this kind of price protection is paid for by giving up the possibility of profiting from improved prices. In the case of options, a fixed price has to be paid: the premium. For example, if money would be lost when prices decline (such as is the case for a producer who is to sell his production, or for a trader who has unsold commodities in stock), an option that gives a profit when prices decline should be bought. This is called a put option. Graphically, this looks as follows: Put option As can be seen in the chart of the put option, declining prices cause losses on the physical transactions, but buying a put option gives a profit. Profit/loss Strike price Unlimited profit Spot price of the physical at the term period Max. loss equal to the premium paid

  36. If a price increase would involve a loss of money (such as is the case for a consumer who still has to buy the commodities he needs, or for a trader who has sold commodities for a fixed price, while he does not have these commodities in stock), an option can be bought which gives a profit when prices increase. Such an option is called a call option. Graphically, this looks as follows: When prices increase, losses are made on the physical position, but buying a call option will then give profits. The result is: protection against price increases, but with still the possibility to profit from price declines. Call option Profit/loss Strike price Unlimited profit Max. loss equal to the premium paid

  37. The option is like an insurance: it provides protection against price declines (put option) or price increases (call option), and simultaneously the possibility to profit from reverse price movements. more

  38. Sell Buy gives the right (not the obligation) to buy the underlying at the set price implies an obligation to sell the underlying at the set price, if the call is exercised Call gives the right (not the obligation) to sell the underlying at the set price implies an obligationtobuy the underlying at the set price, if the put is exercised Put Generally speaking, an option is a contract granting its buyer a right, but not the obligation to buy or sell a defined quantity of the underlying product (for example a futures contract) at a pre-fixed price, and to do so during a period agreed beforehand or upon the contract's expiry. The option buyer, also called its holder, can choose to let the option expire or to exercise it. On the contrary, the writer or seller of an option has the obligation to fulfil the contract when the buyer decides to exercise. So with these two options, four option positions can be taken:

  39. You can also hedge only part of your downside risks. Profit After hedging Before hedging Loss

  40. When buying option contracts, the right, but not the obligation, to buy or sell a futures contract at a given price is obtained. When prices move favourably, this right will not be exercised, and therefore, the purchase of options provides protection against unfavourable price movements, while permitting to profit from favourable ones. Only the sellers of options have to pay margins. To buy an option, one has to pay a premium - when prices increase, this is the maximum loss from the option purchase. But, simplifying a bit, when prices decline, an options buyer will make a profit which is more or less commensurate with the extent of the price decline. Options may be a better hedging vehicle than futures in the case of an uncertain supply - e.g. in the case of a gas company that can not be sure of the quantity it will be able to supply. They are often used to protect prices in deals with not fully reliable partners. If a fixed price deal with a seller has been concluded, and this position is covered with a futures contract, one may get stuck with a loss-making uncovered futures contract if the physical leg of the transaction disappears. The sale of options also allows the generation some profits, but at a high risk, at least if those selling ("writing") are not properly protected by, for example, physical inventory.

  41. No need to fear « speculators » Unlike physical markets, the markets (commodity exchanges) on which futures and options are traded need a good dose of speculators. These can be small, individual speculators, or large investment funds. This is good for the hedgers (the physical trading community). Speculators provide liquidity, which means that hedgers can buy or sell when they want at or near the price that they can see quoted on the market; even if the hedging community feels that prices will move in one way, speculators will act as counterparties. Speculators rarely push futures prices away from supply/ demand equilibrium, and if they do, this does not last long. And it provides new profit opportunities for hedgers.

  42. The over-the-counter market Exchange-traded futures and options may not fully meet the companies’ requirements. In response, banks and trading companies have developed an at times baffling range of « over-the-counter » products. The simplest of these are swaps – similar to futures – and average-price options. But there are many more, often combinations of simpler products, at times new products based on mathematical models.

  43. Risk management Marketing Finance Organized exchanges Over-the counter Forward contracts Futures contracts Options contracts Swaps Commodity loans & bonds In general, instruments are not traded Bought by institutional investors eager to take on risks Instruments are traded on exchanges, in a transparent manner Not traded - banks lay off risks through various operations, including on futures exchanges Traded among banks and large institutional investors

  44. Over-the-counter markets offer a wider range of products, most of which do not require daily margin payments. • Thus, they may be easier to use for many market participants. However, there are some disadvantages, compared to the futures and option contract traded in organized exchanges: • pricing is not transparent • the contracts may be difficult to revert • there is a real counterparty risk (imagine that you had a long-term contract with Enron…). Futures exchange clearing houses have started offering clearing (guarantee) services for the over-the-counter market, but this is still in its inception.

  45. Swaps A swap is a purely financial instrument under which specified cash-flows are exchanged at specified intervals. A swap can be described as a series of forward contracts each with the same price but does not involve deliveries of physical commodities. In summary, swaps transactions are purely financial instruments that are used to reduce price risks and to manage cash flows. Obtain easier and cheaper access to capital Guarantee income streams Lock in long-term prices Long term instrument No or less-strict margin calls From financial operations or new investments Combination of price hedging and investment securitization Low administrative costs once structured Tailor-made to cover the needs of the company

  46. Although they are normally provided by banks, swaps can be arranged by producers too.

  47. Example of a straightforward swap Assume a fertilizer company who wants to protect himself against rising natural gas pices and therefore wants to lock in the price of his purchases of 1 MBTU of natural gas annually, over a period of 5 years. A bank accepts to carry the price risks for these sales. Commodity:Natural gas Amount:5 MBTU Payer of fixed price:Fertilizer company Payer of floating price: Commercial bank Tenor: Five years, with annual payments Fixed priced: (0.05 premium above the market price) Floating price: The average of the daily closing spot prices of the natural gas prices quoted in over the year preceding each payment date. Settlement: Netting-out

  48. The swap deal The swap deal can be described as follows: 1. The fertilizer company undertakes to pay the bank an agreed fixed price (i.e. ) times a specified tonnage of the product (), and in return the bank is obliged to pay the fertilizer company an average of the daily closing spot price of the white sugar over the year preceding each payment date. 2. At regular intervals (i.e. annually) and during the life of the swap (i.e. five years), the fixed and the moving prices are compared and the difference, netted out, is paid to the deserving party. If the average fluctuating (world) price is > than the agreed fixed price, the bank has to pay the difference to the trader; or If the average fluctuating (world) price is < than the agreed fixed price, the trader has to pay the bank. 3. A fixed deposit in addition to the potential compensating payments have to be paid by the trader to the bank, as performance guarantee.

  49. The plant has fixed apurchasing price at The gas seller has fixed its selling price at Fertilizer plant Bank Gas seller Spot price Spot price Spot price Spot price Spot market Spot price Spot price Over the next five years, the fertilizer company will be buying natural gas at the spot price but will be effectively receiving this variable price from the bank. In order to lay off price risks, the bank may conclude a similar deal with a market participant (a gas seller) that wishes to sell at fixed price in exchange for the market prices. Alternatively the bank can layoff its risks on the futures market.