Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy

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Case Studies and Risk Management in Commodity Derivatives Trading

Hilary Till

15.1 INTRODUCTION

Risk management in commodity futures trading takes two different forms, depending on whether trading is done as a commercial or a purely speculative enterprise.

In a commercial enterprise, the rationale for trading activity is usually to “optimize the value of physical assets”; and the returns and risks from this activity would be expected to be a small fraction of the enterprise's overall profits and losses. One would include BP's trading activity in this category, for example.

Commercial and investment banks also engage in commodity derivatives trading, historically to facilitate their overall business in financing natural-resource producers. This is arguably the case historically with Canadian commercial banks.

For commercial enterprises, the important aspects of risk management are in adhering to regulatory rules and laws, and in establishing strict operational policies and procedures over every facet of risk-taking activity.

For a purely speculative participant, the emphasis is almost entirely on market risk-management. The barriers to entry in futures trading are remarkably low: strictly speaking, a participant solely needs a quote device to track the markets and a Futures Commission Merchant (FCM) to execute and clear one's trades. Arguably, the tail risk on a futures trading position is ultimately the responsibility of an FCM.

It is ingrained in the minds of financial-market ...