Presentation on theme: "Derivatives and Commodity Hedging"— Presentation transcript:
1 Derivatives and Commodity Hedging OECD-MENA Senior Budget Officials NetworkRandy Ewell, World Bank, Banking and Debt Management DepartmentThe World Bank Treasury 1818 H Street, N.W. Washington, DC, 20433, USA treasury.worldbank.org
2 The world has changed …Commodity prices have fallen sharply, beginning in July 2008 with the sharpest falls over the past monthFalls have been most severe in oil and metalsAgricultural commodity prices have also fallen, but by lessPrice falls have been both large and fastMany intermediaries in the commodity chain, who are naturally long, will have lost considerable money unless they were hedged and will may experience financing difficulties in the coming monthsUn-hedged northern hemisphere farmers may experience large losses since the price falls have come just as crops are brought to marketDecreasing prices create an opportunity for importers (of food/oil) to lock in lower prices
3 The aggregate pictureCommodity prices rose steadily from 2003 until the summer of 2008This is the longest and most general commodity boom since the 1920sNot all prices shared in the boom, and some started to fall in 2007IMF commodity price indices, normalized at 2000 = 100 deflated by US PPI. The 2008 figure is the January-July average
4 Crude OilMost least developed countries are oil importers but a significant minority are major exportersCrude oil prices rose more or less steadily from 2001 to early July 2008 reaching over $140/blThey have now halved to $70/blAverage, Brent and WTI first positions, deflated by US PPI. Source: IMF
5 Non-Ferrous MetalsAlong with oil, metals prices have fallen furthest and fastest – particularly over the past monthAl, Ni & Zn are lower now than at the start of 2006Cu, Pb & Sn are around the same level as Jan 2006Source: LME
6 MaizeChicago (CBOT) corn prices jumped sharply in 2006 to peak in June 2008 at $7/bl. They have now fallen to $4/bl.South African (SAFEX) white maize prices also rose but this reflected local factors. Although they have now fallen sharply in dollar terms, this is almost all due to the downward fall of the RandCBOT first position and SAFEX spot prices (converted into dollars), deflated by US PPI. Sources: CBOT, SAFEX and IMF
7 RiceRice is the principal food of many poor people. An increase in the rice price has a negative impact on poverty levels worldwideBangkok rice export price.Source: World Bank
8 CottonCotton prices have been very stable since 2005, albeit at a low levelThey have dropped sharply over the past month to 60c/lb, lower in real terms than in 2004This price fall will have caused serious problems for any unhedged ginnerCotlook A Index deflated by US PPI, and converted into F.CFA/kg and deflated by Burkina Faso CPI. Source: ICAC and IMF.
9 Policy ResponsesThe food price crisis led many countries to revert to the food policies of the 1970sExport bansCostly strategic grain reservesReversal of diversification policiesPrice stabilization/subsidy programsThese policies carry risksCan be destructive to market / tradeTotal financing needed for these interventions are unknown / unpredictable
11 Increased Interest in Risk Management Governments need to..Plan for & budget responsesRaise financing for responses & ensure rapid implementationEnsure that they are protected against future shocksDonors & International community should..Maximize value & impact of assistanceEnsure resources are not diverted from longer term programsBoth have led to renewed interest in ex ante solutionsSince ex post reactions are costly, inefficient, and difficult to finance & implement when countries are already in crisis
12 Significant Factors for a Nation No Shareholders – only VotersNot necessarily driven by returns on Capital or EquityRisk appetite virtually zeroUnfortunately, short term HorizonsAffected by PoliticsNot necessarily Commercial decisions, therefore the solution is not necessarily a commercially driven oneCannot ignore the ‘Power of One’ – the VETOAll solutions have to pass the ‘Monday Morning Quarterback’ test
13 Why Would a Nation Hedge ? Reduce Volatility of the Budget in favor of stabilityStrengthen the probability of meeting the Budget‘Targeted’ Hedging of Key Elements in BudgetEducationHealthInfrastructureInflationImports where there is inelastic demand and no substitutionTo address security of supply & security of energy and foodInvestment of Government FundsCommodity Indices, Bonds, Notes where inversely Correlated to BudgetEvent’ Hedging
14 Hedging ProductsA commercial contract which limits the impact of adverse price movements which might take place between buying (or incurring production costs) and sellingWhy?Traditional (unhedged) price stabilization programs can’t survive without high levels of subsidy / bailoutMarket intermediaries (co-ops, exporters) can’t survive repeated years of trading lossesBanksA) Can’t survive repeated years of default when borrowers mismanage price exposures and have financial losses as a resultB) Will have to charge high interest rates to maintain lending in high risk agricultural sectors -the high cost of finance erodes margins for all
15 Oil Price Volatility Hedging Introduction Why Hedge?Oil prices are volatile and hard to predictExposure to oil price may harm fiscal policyUncertain fiscal revenues linked to oil exports may lead to shelving of planned projects or wasteful use of ‘windfall’ revenuesHedging stabilizes cash flowsAllows to lock in prices in advance or specify their rangeSubstantially reduces volatility of revenuesReduces the risk of sudden financial loss due to adverse market movements
16 No Hedge Current Price USD/BBL Selling on a spot basis exposes producer to rising and falling commodity pricesCurrent Price USD/BBL
17 Oil Price Volatility Hedging Introduction There are two ways to pursue stabilizationSelf Insurance:Oil revenues in excess of a predefined average level are saved. Savings are used to complement oil revenues when they fall below average.Hedging withmarketsOil revenues can be fixed or floored for future dates using market instruments.The second method is usually more efficient
18 Oil Price Volatility Hedging Hedging with Markets There are generic instrumentsFutures/ForwardsSwapsNo cost. Lock in future price. Do not permit upside gainsPut optionsUpfront cost (to buy puts). Place a floor on future price. Permit upside gains.
19 Derivatives Introduction Growth in Derivatives UseDerivatives are used for eitherHedging, orSpeculationHedgingHedgers use derivatives to manage risk and protect themselves against the possibility that the market might go “against them”SpeculationSpeculators use derivatives to produce a returnThey “take a view”, i.e. bet on where the market is going and try to make a profitCocoa ExampleYou may think there are thousands of different reasons for using derivatives and there are, but if you really look closely it turns out derivatives are mostly used for just one of two basis functions: hedging and speculation. Hedgers use derivatives to manage uncertainly, and speculators use derivatives to wager on it. Hedgers use derivatives to reduce financial risk or the prospect that the price of things might “move against them”. They may use derivatives to match assets to liabilities to reduce exposure or brings things that are less certain to certainly when you don’t have an appetite for uncertainty. Consider a chocolate manufacturer who knew 6 months ago they would need to buy cocoa beans today. They face the prospect of a hurricane damaging the cocoa crop and drastically reducing the available supply of cocoa beans on the market leading cocoa bean rising significantly. If this uncertainty is not desirable, you may use a forward contract to mitigate that risk.By contrast speculators use derivatives not to reduce financial risk but to potentially profit from it. Doing so is often called “taking a view” on future prices because that term sounds more legitimate than “gambling.” But speculating really is little more than gambling on an uncertain outcome. If one has the view that IBM’s stock price will be higher in 6 months than it is today, he or she can buy options to buy IBM stock in 6 months at today’s price. If their prediction comes true they can profit handsomely. If not, they lose whatever they paid for that option – or 100% of their investment. That’s speculating. Our purpose in discussing derivatives here is not to tout “technical trading” or other purported surefire miracles for making money. Rather, you will find our presentations geared toward the use of derivatives as a means of hedging and managing risk such as exposure to currency, interest rates or commodity price fluctuation and not on speculation.Scope of the PresentationFor our purposes, the use of derivatives is a risk management tool19
20 Who Hedges and Why?End users: “SHORT” energy – concerned about rising pricesEg. Airline, Industrial, Shipper, Road Transport, Railway: all active hedgersProducers: “LONG” energy – concerned about falling pricesEg. Energy Majors and Independents, State Oil CompaniesRefiners and Power-Generators: MARGIN exposed – concerned about relative pricesOil Refiner: Crude oil versus oil products (called “cracks”)Power-generator: Coal / Oil / Gas versus Electricity (“Dark / Spark spreads”)Traders and Distributors: TIMING and / or BASIS RISKMismatch between purchase price and sale price windowMismatch between purchase price INDEX sale price INDEXEg. buy LNG on Brent Index, Selling on UK Gas NBP
21 Forward Contract vs Futures An over-the-counter (OTC) contract determining the price of the underlying to be paid or received on an obligation beginning at a future start dateEssentially forwards contracts lock-in the price of the underlyingForward Contract vs FuturesInstrument is similar to that of a futureThe payment under the contract is equivalent to a margin payment but……Payment at maturity only: Higher credit riskOTC ContractForward contracts are not standardizedMaturity dates agreed by the partiesNominal amount can be adjustedNominal amounts in any currencyDay count convention applicable in the reference rate and currency chosen
22 The role of clearing houses Credit Risk Mitigation FuturesFuturesFutures: obligation to buy or sell an underlying instrument at a certain price and dateA futures is a method to lock in a pricePhysical delivery of the underlying assetCash settlement: difference between the spot and the futures priceExchange traded and standardized contract: specified quantity and quality of the instrument, price per unit, date and method of delivery (if any)The role of clearing housesFutures counterparties interact with the exchange’s clearinghouse (CH). Clients do not know whom they have traded withA futures trade is really two tradesThe agreement will be honored by the CHTo protect itself the CH demands thatAn initial collateral amount is deposited to cover future lossesA futures account is marked to market daily. Daily margin increase to cover unrealized losses from daily market movementsNo party will incur a big loss at maturityParty AClearing houseParty BCredit Risk Mitigation22
23 Characteristics of Swaps What is a Swap?A contract between two counterparties to exchange streams of cash flowsCharacteristics of SwapsDefined period of time and can be customizedContracts are traded over-the-counter (OTC)Cash flows are calculated over a notional principal amountInterest Rate SwapsExchange of fixed payments against floating interest paymentsMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter interest rate exposure and align asset and liabilitiesCurrency SwapsExchange payments in one currency for anotherMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter the currency exposure of an asset or liabilityCommodity SwapsExchange payments linked to the price of a commodityUsed to reduce volatility in income/expenditures due to fluctuations23
24 Forward and Futures: A Summary SimilaritiesBoth futures and forwards represent agreements to buy or sell some underlying asset in the futureBoth allow for physical or cash settlement depending on the underlying instruments (interest rates, commodities, etc)Both entail market risk and can be used for hedging purposesDifferencesFuturesForwardsExchangeExchange tradedOver the counterCounterpartyClearinghouseCounterparty in the forward agreementTransaction TimingMarked-to-market every dayTransact when purchased and on the settlement dateCustomizationStandardized: Amount, currency, dates are fixedNon-standardized: Amount, currency, maturity dates can be adjustedCredit RiskMinimal: essentially eliminated through margining processCounterparty credit riskRegulationHighly regulatedPrivate, unregulated transactionsLiquidityHighly liquidIlliquidBid-Ask SpreadLowHigh
25 Endogenous Term-Structure of Futures Prices For low oil prices the market is in contango, i.e. the term structure is upward-sloping.For medium oil prices the term structure of futures prices can be slightly humpedFor high oil prices the market is in backwardation.Backwardation occurs when the oil price expected for the expiration date declines with the maturity of the futures contracts.Oil futures prices exhibit “mean-reversion,” i.e., prices in contracts for delivery many months in the future converge to the long-term expected price.
26 Hedging with Futures or Forward Contracts Firm commitment that provide for the futures sale/delivery of crude oil at a specified priceGains or losses realized daily (Futures)P/L from the agreed upon price vs. the actual market price on the delivery date is usually settled on the delivery dateProfit to seller= initial futures price - ultimate market priceProfit to buyer= ultimate market price - initial futures price
27 Using Futures for Hedging Oil FuturesA country with a long position in commodities (i.e. an oil producer) loses out if the price of the commodity drops and gains if the commodity price rises.To hedge that position, it can sell exchange-traded futures to lock in the price.Therefore, no matter if the price moves up or down, the producer is not exposed to the volatility because the gain/loss on the futures contract will offset the gain/loss on the commodity.
28 Hedging through OTC Options - Price Floor (Insurance) Price FloorsAlternatively, if the producer wants to participate in the upside gains, it may choose to enter into a series of put options to create a price floor, which means that the producer is guaranteed a minimum price for its commodities.However, an upfront premium must be paid to purchase this series of put options
29 Consumer: Buying a Call Option – Cap Key considerationsIllustrative exampleObjectiveTo cap forward price.DescriptionIt is the right, but not the obligation, to buy specific volumes of diesel at a specified price (the strike price) during a specified period of time.In purchasing a call option, the party is effectively buying insurance against higher products prices.The buyer pays an upfront premium for protection from prices above the specified cap strike price.The average monthly settlement price is compared to the strikeIf settlement price is lower than the strike price, the client does not receive anythingIf settlement price is higher than the strike, the client receives the difference between the strike and the settlement priceAdvantagesLocks in a cap over a time period and is protected from any price appreciation above the strikePrice rises in the physical market are compensated by hedging gainsBenefit from potential upside, should diesel prices drop.DisadvantagesThe buyer has to pay an upfront premium to buy a call option.PriceUSD/mtThe client receives the difference between the floating and fixed price1500SwapNo exchangeTimeStrikePotential gainsMarket PricePotential costsIndicative Levels - Jet Cargos CIF NWEAug Jul 2009Strike PremiumUSD 1500 / mt USD 85 /mt
30 Hedging Instruments - Summary Fixed for Floating Swap The below table illustrates the tools available to hedge against a fall in commodity pricesHedging InstrumentsDescriptionBenefitsPotential CostsFixed for Floating SwapEnables the party to eliminate their price exposure, protecting themselves from a fall in oil prices.To do this the party sells a swap to bank and receive a fixed rate in return for paying the floating market rate.No upfront premiumBy receiving a fixed market price there is greater control over their revenue base.Forgone benefit from rising oil pricesFloorIn purchasing a put option, The buyer is effectively buying insurance against lower prices.The party pays an upfront premium for protection from prices below the specified floor strike priceAble to retain 100% of the upside if market prices rise (minus the premium paid for floor).Must pay an upfront premium for upside protection.Zero Cost CollarCollars involve buying a put and offsetting the premium by selling a call option struck above the market.The party receives the same protection as a put option provides, however, the group has sold away some of its upside in order to finance the purchase of the put.No upfront premium is paid.Floored on the downside, but is allowed to ride the market up to the call strike that it sells.Party loses the benefit of rising prices above the cap option strike price.
31 Case Study – Outright Exposure - Airline An airline is exposed increase in jet fuel prices and can choose a variety of tool to hedge depending on their risk philosophy.The most vanilla product that an airline could utilise is a swap. Here the airline would enter a swap and pay a fixed price in return for the floating price.Hedging ToolsDescriptionBenefitsPotential CostsFixed for Floating SwapEnables the airline to eliminate their price exposure, protecting themselves from a rise in fuel prices.To do this the airline would enter a swap and receive the floating market rate in return for paying a fixed price.No upfront premiumBy receiving the floating market price the client now has greater control over their cost baseForgone benefit from falling pricesAirline pays supplier floating price for jet fuelAirlineSupplierAirline receives jet fuel from supplierAirline receives the floating price from BankAirline pays a fixed price to BankBank
32 Case Study – Outright Exposure - Airline An airline can also hedge their exposure using options.The below table outlines the different hedging options available:Hedging ToolsDescriptionBenefitsPotential CostsCapIn purchasing a call option, The airline is effectively buying insurance against higher prices.The airline pays an upfront premium for protection from prices above the specified cap strike price.The client is able to retain 100% of the downside if market prices decline (minus premium paid for cap)The client must pay an upfront premium for upside protection.Zero Cost CollarCollars involve buying a call and offsetting the premium by selling a put option struck below the market.The airline receives the same protection as a cap option provides, however, the group has sold away some of its downside in order to finance the purchase of the call.No upfront premium is paid.The client is capped on The upside, but is allowed to ride the market down to the put strike that it sells.The client loses the benefit of falling prices below the floor option strike price.Three waySimilar ides to a Zero Cost Coupon, yet the Airline would sell an additional call with a strike above the existing collar to fund a lower collarNo upfront premium is paidMarket levels are capped at a lower level than a Zero Cost CouponThe client is exposed to prices above the upper call level and loses the benefit of price below the floor
33 Hedging through OTC Swaps (Fixed Price Swap) Fixed Price SwapsSwaps are basically a series of futures or forward contracts. Swaps can be used when a commodity producer wants to hedge at a several points in time.In this case, the producer enters into a fixed price swap, which guarantees a set selling price no matter how much the commodity price moves in the future.
34 Hedging through OTC Swaps (Fixed Price Swap) Producer receives floating price from off taker supplierProducerOff takerProducer delivers oil to off takerProducer pays the floating price throughout periodProducer receives a fixed price throughout the periodBank
35 Consumer: Buying a Fixed Price Swap Key considerationsIllustrative exampleObjectiveTo lock in forward price.DescriptionThe buyer locks in the price for a fixed volume of diesel over a predetermined period by buying a fixed price swapThe average monthly settlement price is compared to the swap priceIf settlement price is lower than the swap price, the buyer pays the difference between the settlement price and the swap priceIf settlement price is higher than the swap price, the buyer receives the difference between the swap price and the settlement priceAdvantagesLocks in a fixed price over a time period and is protected from any price appreciation above the swap pricePrice rises in the physical market are compensated by hedging gainsNo upfront premium requiredDisadvantagesLoose all the potential gain from downside price moves below the swap pricePrice decreases in the physical market are offset by hedging lossesPriceUSD/mtThe client receives the difference between the floating and fixed price1325The client pays the difference between the fixed and floating priceTimeHedgedPotential gainsMarket PricePotential costsIndicative Levels – Jet Cargos CIF NWEAug Jul 2009Fixed Level USD / mt12
36 Using Put Options for Hedging Oil Put OptionsAlternatively, the commodity producer may want to participate on the upside movement of the commodity price, which is not possible if futures contracts are used.Buying put options allows the producer to gain when the price of the commodity drops, which offsets the loss in the commodity position. On the other hand, when the price of the commodity rises, the producer will gain from the commodity position, and at the same time do not face a marked-to-market loss in the hedging instrument as in the case of the future.The cost is the price of the option, which can be very high in volatile markets
37 Hedging through OTC Options - Zero Cost Collars (Price Bands) Since buying options can be expensive, the producer may choose to forgo some upside by selling call options at a higher strike price and at the same time, lower its price protection by buying a put option at a lower striker price, which is basically a collar strategy.Collars can be structured so that it costs the producer nothing, but a trade-off must be made with a lower floor when compare with a normal floor strategy.
38 Consumer: Zero Cost Collar Key considerationsIllustrative exampleObjectiveTo hedge at zero cost whilst benefiting from the part of the downsideDescriptionThe party buys a call option and finances it by selling a put for the same time period and quantities at zero upfront cost.There are multiple possible combinations of call and put strikes so that the collar is zero-costA non-zero-cost collar can also obviously be envisaged (i.e. the client paying a reduced premium compared to the standalone call)The monthly average settlement price is compared to the strike levels of the monthly put and callIf the settlement price is lower than put strike, the client pays the difference between the average and the put strikeIf the settlement price is higher than call strike, the client receives the difference between the call strike and the averageIf the monthly average is between the two strikes, nothing happens.AdvantagesHedging method against upward price moves while maintaining some downside participationZero-cost structureDisadvantagesIf the market price drops below the put strike , the client will be buying at the put strike.The client has upward price exposure comparing the current swap level vs. the put strikePriceUSD/mtThe client receives the difference between the call strike and fixed price1500No exchangeSwap1200The client pays the difference between the put strike and floating priceTimeStrike - PutPotential gainsStrike - CallPotential costsMarket PriceIndicative Levels - Jet Cargos CIF NWEAug Jul 2009The client buy Call Strike USD 1500 / mtThe client sell Put Strike USD 1200 / mt
39 Rules for Sovereign Hedging Understand all aspects of ones current exposures and the contemplated HedgeStrong procedures with checks and balancesRemember……..……..This is NOT speculation!Create a regulatory environment for Industry to hedge in order to……Encourage InvestmentReduce Volatility of EarningsEncourage Consumers to take ownership of HedgingRegulatory & Tax EnvironmentReward ‘Right Way Exposure’Do NOT remove totally the fundamental price movementThis is needed in order that supply and demand can balance out
40 Questions to ConsiderIn light of the recent financial crisis, to what extent are governments still concerned about commodity price volatility?The recent fall in food/energy prices has created some relief for governments who are importing these commodity classes. Are they able to take advantage of the price decreases and lock in supplies/prices at these lower levels? If not, why not?Should governments be involved in commodity risk management?If so, how?If not, why not?Are there other examples of countries using macro level commodity risk management strategies?What should the World Bank Group be doing to support governments in this area?