Commodity Derivatives: Markets and Applications

2

Risk Management

SYNOPSIS The purpose of this chapter is to define the concept of risk, within a corporate and investment banking context.

 

The word “risk” used without any context is meaningless. It is like saying that some is physically “fit” – fit for what? Just because someone can run a marathon doesn’t guarantee that he or she will be able to swim 26.2 miles. I doubt if many accomplished marathoners would be able to swim even one mile continuously, let alone 26.2!

For much of this book we will define the concept of risk as uncertainty, but even this is a contentious definition. Among many of my classroom participants there is a belief that fixing the price of a contract somehow results in a risk-free situation. Although it may give certainty of cashflow, it does not allow a participant to benefit from a favourable move in market prices. Hence there is an opportunity cost.

The first part of the chapter attempts to categorise risk into terms that will allow for a clearer analysis of exposures faced by market participants. As one key theme within commodity risk management is the concept of time, the structure of market prices will be analysed according to the activities of market participants.

The chapter focuses on some of the risk management issues faced by corporates and investment banks ^1a. From the corporate perspective the question of whether to hedge or not is discussed and a framework for analysing risk is presented. The presented framework is a “top down” approach ...