Table of Content I

Table of  Content  

Table of  Content  I

Table of  Depicitons  IV

Table of  Figures  V

Table of  Abbreviations  VI

1.  Introduction  1

1.1  Purpose of the study  1

1.2  Stakeholders and objectives  3

1.3  Structure of the study  4

2.  Theoretical basics and terminologies  6

2.1  Definition of Risk Management  6

2.2  Definition of Commodity Trading  8

2.3  Risk categories of a Company  10

2.4  Specific Commodity Risks and Issues  12

2.4.1  Market Price Risks.  12

2.4.2  Quantitative Risks.  13

2.4.3  Counterparty Risks  14

2.4.4  Basic Risks  15

2.5  The Risk Management Process  17

2.5.1  Risk Identification  17

2.5.2  Risk Valuation  18

2.5.3  Risk Management.  20

2.5.4  Risk Controlling  22

3.  Derivative financial instruments  23

3.1  Definition of Derivatives  23

3.2  Forward-based derivatives  24

3.2.1  Forwards  24

3.2.2  Futures  25

Table of  Abbreviation  II

3.2.2.1  The Stock market  26

3.2.2.2  Mark to Market  27

3.2.3  Swaps  28

3.3  Options  30

3.3.1  Terminology  30

3.3.2  The Call  33

3.3.2.1  The Long Call  33

3.3.2.2  The Short Call.  34

3.3.3  The Put  36

3.3.3.1  The Long Put  36

3.3.3.1  The Short Put  37

3.3.4  The Cap  38

3.3.5  The Floor  38

3.3.6  The Collar  39

3.3.7  Exotic Options  40

3.3.7.1  Multible Commodity Options  40

3.3.7.2  Path-dependent Options  42

3.3.7.3  Compound Options  45

3.3.7.4  Binary Options  45

4.  Practical Hedging Strategies  49

4.1  Forward-based Derivatives  49

4.1.1  Hedging with Forwards  49

4.1.2  Hedging with Futures  50

4.1.3  Hedging with Swaps  51

4.1.3.1  Plain Vanilla Swaps  52

4.1.3.2  Cross Commodity Swaps  52

4.1.3.3  Clean Dark Spread  54

4.1.3.4  Spot Basic Swap  56

Table of  Abbreviation  III

4.2  Hedging with Options  57

4.2.1  Put Options  58

4.2.2  Call Options  58

4.2.3  The Cap and Floor.  59

4.2.4  The Collar  60

4.2.5  Exotic Options  61

4.2.5.1  Path-dependent Options  61

4.2.5.2  Multiple Commodity Options  61

4.2.5.3  Binary Options  62

4.3  Analysis of advantageousness  64

5.  Conclusion  68

Work  Cited  VIII

Attachments   XXV

Table of  Depicitions  IV

Table of  Depicitons  

Depiction  1: Hubbert Curve  1

Depiction  2: Development of selected commodity prices 2001 - 2011  2

Depiction  3: Guideline of this paper  5

Depiction  4: Distinction of commodity markets  9

Depiction  5: Risk types and categories  11

Depiction  6: Basis and Basis convergence  16

Depiction  7: The Risk Management Process  17

Depiction  8: Profit and Loss resulting from Forward Contracts -  

Buying  vs. Selling Position  25

Depiction  9: Margin und Clearing Systems of a Futures Exchange  28

Depiction  10: Functionality of a Short Swap respectively Long Swap  29

Depiction  11: Option positions  33

Depiction  12: Purchase of a Call Option (Long Call)  34

Depiction  13: Sale of a Call Option (Short Call)  35

Depiction  14: Purchase of a Put Option (Long Put)  36

Depiction  15: Sale of a Put Option (Short Put)  37

Depiction  16: Payments of a Collar.  40

Depiction  17: Payment flows in Plain Vanilla Swap for jet fuel  52

Depiction  18: Payment flows within an Alumium/ Gas Swap  53

Depiction  19: Payment flows within a Natural Gas - Basic Swap  57

Table of  Figures  V

Table of  Figures  

Table 1:  History of Risk Management  7

Table 2:  Influencing factors on an Option Price.  32

Table 3:  Exemplarily calculation of Mark to Market  50

Table 4:  Calculation of a Clean Dark Spread  55

Table 5:  Example for a Long Put Option  58

Table 6:  Example for a Long Call Option  59

Table 7:  Sample calculation for a Collar  60

Table 8:  Example for a Cash on Delivery Option  63

Table 9:  Comparison of Hedging Instruments  66

Table of Abbreviations VI

Table of Abbreviations

AL Aluminum API American Petroleum Institute bbl. Barrel Bn. Billion ca. circa CBOT Chicago Board of Trade CDS Credit Default Swap cf. compare CME Chicago Mercantile Exchange e.g. for example EEX European Energy Exchange et al. et alia etc. et cetera EUR Euro ff. following pages GBP Great Britain Pound incl. including IPE International Petroleum Exchange JPY Japanese yen Kcal Kilocalorie kWh Kilowatt hour LPX Leipzig Power Exchange M. Million MiFID Markets in Financial Instruments Directive mmBTU Million British thermal units MT metric ton MWh megawatt hour

Table of Abbreviation VII

NYMEX New York Mercantile Exchange OTC over the counter P&L profit and loss p. page p.a. per annum pub. published Q3 Third Quarter resp. respectively USc United States Cent USD United States Dollar WTI West Texas Intermediate www world wide web

1. Introduction 1

1. Introduction

The following categorized introduction attempts to give an intelligible overview of the present Master Thesis. At first the purpose of this study will be explained, including the illustration of the importance of a commodity risk management for companies as well as the rising importance of commodity markets. Additionally the stakeholders and objectives will be presented, followed by a comprehensive structure of this Thesis.

1.1 Purpose of the study

Companies operate nowadays on a global and more and more tougher market. ¹ Not only the stabilization and extension of the own sales numbers got more difficult to manage in a global competition, but also the purchase of commodities for an own production got harder. By taking the example of the “Hubbert curve” (Depiction 1) it is apparent that the competition for commodities, in fact oil and gas, is currently at the top of the historical and assumed future demand. Commodity experts and analysts furthermore assume that the worldwide oil extraction has currently reached its maximum. 2

David O’Reilly - chief executive of Chevron - said 1995, that it took 125 years to spend the first trillion barrel of oil whereat the next trillion barrel will be consumed

¹ Cf. Biethahn, Joerg; Mucksch, Harry; et al.; Ganzheitliches Informationsmanagement, (2004), p. 48.

² Cf. Petermann, Jürgen; Sichere Energie im 21. Jahrhundert, (2006), p. 69.

1. Introduction 2

within the next 30 years. ³ This indicates the progression of the human energy thirst of the last decades. Based on a rising demand in nearly all commodity areas, intensified by a rising demand of densely populated countries like India and China, prices for commodities rose until 2008 in the equivalent markets ⁴ like shown in Depiction 2.

This remarkable accretion of the bygone years, especially within the raw oil prices allured speculators who even speeded up this price increase. However, in 2008 a trend reversal appeared and the prices fell in a never been speed. This adverse development, triggered by the financial crisis and the subsequent economic crisis was even reinforced by speculators who bet on further falling rates. Speculators are therefore often unsolicited by many market participants. However, speculators possess a crucial function within the commodity trading with derivative financial instruments: They provide the needed liquidity on that particular market. ⁵ A further but negative effect which occurred by speculators is the risen volatility of the commodity markets and the associated higher risks. For that reason the management of commodity risks became an essential competitive factor for companies and plays a central role within the risk management. Without an efficient risk management a company is exposed to the extreme market vacillations and has to hope for a positive development of commodity prices. Furthermore there are additional risks which can be reduced and

³ Cf. http://constructioninformer.com/2010/03/04/taking-the-wide-view-on-constructions-oil-challenges/,

Sourcing date: September 7 ^th , 2011.

⁴ Cf. Young, James; Crude Oil prices - Review and Outlook, (2006), p. 31.

⁵ Cf. Albrecht, Peter; Maurer, Raimond; Investment- und Risikomanagement, (2008), p. 14.

1. Introduction 3

controlled by an effective risk management. Noteworthy is the currency risk, as various commodities are for example traded in USD and trigger a further risk - the currency risk - for a company. However this risk is not taken into account in this study as this thesis concentrates on various commodity price risks and the respective hedging by derivative financial instruments.

1.2 Stakeholders and objectives

Primarily interested parties of this paper are besides all in risk management interested parties, companies with the ambition of a compensation respectively decimation of risks, related to the commodity trading.

The objective of risk compensation which is closely related to the protection of attractive acquisition and sales prices determines the critical analysis of companies with this topic. Therefore companies only receive the possibility to find hedging transactions which are individually customized to their needs, if they conduct a comprehensive analysis of all possible hedging possibilities. The priority objective of this paper is therefore the outline and explanation of a chosen spectrum of derivative financial instruments which are useful for an efficient management of commodity risks. The reader will receive an appropriate knowledge basis to make a critical decision whether derivative financial instruments are favorable for an own application and usage. Additionally the often occurring aversion towards this area and all related terminologies shall be taken into account. In the CBS television program “Sixty Minutes” derivatives were characterized as being too complicated to describe but also too important to ignore. ⁶ The relevance as well as the consequence of financial instruments for the current economic situation was already mentioned in the chapter “Purpose of the study”. Therefore the statement of CBS, derivatives are too important to ignore, can be agreed. However the assertion, derivatives are too complicated to describe, has to be refuted. The present thesis attempts to give an intelligible explanation of functionality, advantages and disadvantages of various derivative financial instruments.

⁶ Cf. Boyle, Phelim P.; Boyle, Feidhilm; Derivatives, (2001), p. XI.

1. Introduction 4

1.3 Structure of the study

As described in the previous chapter, the main objective of this thesis is, to give the reader an extensive comprehension of derivative financial instruments. To ensure a uniform understanding of this subject, chapter 2 will first give a historical and terminological view of elementary knowledge, used in this paper. Therefore chapter 2 defines different company risks, profoundly describes the subordinated risk “Commodity Price Risk” respectively shows certain commodity issues as well as extensively classes these risks within the process of risk management. Subsequently the reader receives a theoretical insight into the wide range of derivative financial instruments, to accomplish the objective of setting an understandable knowledge base.

At first, forward-based derivatives which belong to the category of unconditional financial transactions will be explained, followed by a theoretical explanation of the more complex, conditional forward transactions. These conditional forward transactions are usually options and their possible modifications. Valuation models of options like the Black-Scholes model are not considered as an appropriate elaboration would exceed the scope and objective of this paper. ^A After the reader receives a theoretical knowledge basis, chapter 3 transparently demonstrates by various fictional practical examples how derivative financial instruments can be used for a successful commodity risk hedging. Both, the buyer’s as well as the seller’s perspective will be specified. Subsequently to the individual practical hedging strategies an analysis of advantageousness will summarize the several key facts of the described and illustrated hedging instruments and show the best possible applicability. At first the advantages as well as disadvantages of Forwards compared to Futures will be observed, followed by a comparison of the several option types. Finally a reflection of advantageousness will assort all described conditional as well as unconditional forward transactions. The conclusion completes the described approach and gives a summarized prospective of this paper.

The described procedure of this paper is visualized in the guideline in Depiction 3 on the following page:

^A Note: The book „Optionen, Futures und andere Derivate“ (2006) of Hull, J.C. offers an extensive knowledge

about the Black-Scholes model.

1. Introduction 5

2. Theoretical basics and terminologies 6

2. Theoretical basics and terminologies

The following chapter gives an explanation and definition of relevant terminologies, respectively sets up a better understanding for the following main part of this thesis. By covering the definition of the word “Risk” and the different “Risk Categories”, explaining the process “Risk Management”, and giving a fundamental knowledge of “Commodity Trading” and “Derivatives”, the following chapter 2 will provide a basis as well as an understanding of the importance of commodity-risk hedging.

2.1 Definition of Risk Management

The history of Risk Management began in 1202 when Leonardo Fibonacci published his “Books of Abakus”. Fibonacci explained that people would have a better calculation possibility if they would use the Hindu-Arabic numbering system instead of the calculation with letters. However, it took almost three hundred years until effective risk studies began. In his book “Summa de arithmetic, geometria et proportionalita”, Luca Pacioli occupied himself with the double entry accounting and the question of profit distribution of gambling stakes. For a long time, the problem of profit distribution was discussed under the term “question of points”. ⁷ In 1654, Pascal and Fermat solved this problem with their discovery of the probability theory. ⁸ Since then, risk disclosures and risk valuations further developed. In 1926, Knight and Neumann constructed the theory games and redefined the terms uncertainty and risk. ⁹ Further mile stones within the last years were the development of the Black and Scholes model, which allows the fair pricing of options as well as the Value at Risk Approach of Morgan Stanley, which showed new possibilities of risk valuation. ¹⁰ Table 1 ¹¹ on the following page shows an outline of Risk Management’s history.

⁷ Cf. Wolke, Thomas; Risikomanagement, (2008), p. 6 ff.

⁸ Cf. Koch, Peter; Geschichte der Versicherungswissenschaft in Deutschland, (1998), p. 27.

⁹ Cf. Bewersdorff, Joerg; Diskrete Mathematik für Einsteiger, (2007), p. 248 ff.

¹⁰ Cf. Wolke, Thomas; Risikomanagement, (2008), p. 6 ff.

¹¹ Cf. Wolke Thomas; Risikomanagement, (2008), p. 10.

2. Theoretical basics and terminologies 7

In order to adequately define the term “Risk Management”, it is required to differentiate between and separately treat the terms “Risk” and “Management”, in addition to the foregoing historical reflection.

It should first be mentioned that there is no global definition of the word risk within the economical literature. ¹² Among other definitions, risk can be classed with the term uncertainty, which in turn can be distinguished into two different forms. The first form matches the total uncertainty of future states and is unquantifiable. The second form of uncertainty is the measurable risk, based on objective and subjective probabilities for expected incidences. ¹³ However this definition of risk is controversial

¹² Cf. Wolke, Thomas; Risikomanagement, (2008), p. 2.

¹³ Cf. Schneck, Ottmar; Risikomanagement, (2010), p. 22 ff.; and cf. Schmitz, Thorsten; Wehrheim, Michael;

Risikomanagement, (2006), p. 15 ff.

2. Theoretical basics and terminologies 8

in practice. An additional definition of the term risk is the consideration of a risk as a negative deviation of planned objectives and goals. 14

A further and commonly used attempt of a definition derives from the etymology, in fact the incurrence and verbal development of the respective term. The early-Italian word “risicare” means “to dare something” and the Latin word “risco” can be loosely translated as “to circuit a cliff”. ¹⁵ Considering these two translations and word usages, a useful definition can be derived. Therefore, the term risk is defined as an environmental impact which can be counteracted and minimized by a sly procedure and strategy (to circuit a cliff). 16

The term “management” derives from the Latin word “manus agree” which means “to lead”. ¹⁷ In the literature this term possesses two diverging meanings. On the one hand, this term describes the institution of a company which possesses executive purposes and represents the economic interests of the company. ¹⁸ On the other hand, the term management can be defined as a corporate function which is exercised by leading personnel. This function is often subdivided into the sections planning, realization, and controlling. ¹⁹ These sections offer an adequate relevance for the term “management” in the context of this thesis. Therefore, “management” can be defined as the planning, controlling and supervision of corporate decisions, resulting from external arising occurrences.

In conclusion, the process of risk management is the specific influence of a company on eventually occurring risks, with the purpose of an optimal control of these risks.

2.2 Definition of Commodity Trading

Analogous to the term definition of chapter 2.1 it is also appropriate to separately define the terms “Commodity” and “Trading”.

The linguistical roots of the term “Commodity” derive from the French word “commodité”, which means “benefit” or the Latin word “commoditas” which stands for “proper consistency”. Generally, commodities are exactly defined and standardized goods. By definition of the MiFID (Markets in Financial Instruments

¹⁴ Cf. Markowitz, Harry M.; Portfolio Selection: Efficient Diversification of Investments, (1959), p. 187 f.; and

cf. Copeland, Thomas E.; Weston, John Fr., et al.; Financial Theory and Corporate Policy, (2003), p 145 ff.

¹⁵ Cf. Strohmeier, Georg; Ganzheitliches Risikomanagement in Industriebetrieben, (2007), p. 28 f.; and cf.

Romeike, Frank; Modernes Risikomanagement, (2005), p. 17 ff.

¹⁶ Cf. Wolke, Thomas; Risikomanagement, (2007), p. 8 f. and cf. Bieta, Volker; Kirchhoff, Johannes; et al.,

Risikomanagement und Spieltheorie, (2002), p. 102 f.

¹⁷ Jung, Ruediger H., Kleine, Meinolf; Management, (1993), p. 22.

¹⁸ Cf. Boddy, David; Management (2008), p. 35.

¹⁹ Cf. Gerke, Wolfgang; Gerke Börsen Lexikon, (2002), p. 519.

2. Theoretical basics and terminologies 9

Directive), commodities are physical objects which are deliverable and fungible. ²⁰ With the term fungible the MiFID defines the compatibility and the defensibleness. This means that a commodity should be able to be determined by number, measure or weight. Individually produced and custom built items are therefore not a good respectively a commodity. Properly speaking, electricity should not be counted as a commodity, as it does not fulfill the requirement to be a physical good. However, it is also handled as a commodity for the reason of identical treatment with other energy sources and carriers.

Therefore, every kind of intangible product such as stocks, bonds, inflation rates or interest rates are not counted as a commodity. Certain rights, even if they are closely linked to a commodity, are not treated as such. Therefore, certificates such as CO 2 emission certificates etc. are not commodities. ^B The following Depicition 4 ²¹ shows an overview of the different forms of commodities referring to the MiFID. 22

^B Note: The Appendix on page XXV shows a list of chosen commodities and their specifications.

²⁰ Cf. http://dictionary.reference.com/browse/commodity, Sourcing date: August 31 ^st , 2011.

²¹ Cf. Rudolph, Bernd; Schaefer, Klaus; Derivate Finanzinstrumente, (2005), p. 190.

²² Cf. Horstmann, Karl-Peter; Cieslarczyk, Michael; Energiehandel: Ein Praxishandbuch, (2006), p. 197 f.

2. Theoretical basics and terminologies 10

The word “trading” does not derive from a certain language but can rather be terminologically substantiated. On the one hand, there is the institutional trade which purchases goods with the objective of a profitable sale. On the other hand, the term “trading” can be defined as the acquisition and the sale of goods. This definition equals the underlying purpose of this study and will further be considered as the main definition of the term “trading”. 23

In ancient times, merchants had a brisk trading of precious metals, wines, oils, spices and lumbers which was in that time, primary done by bartering. Therefore, the implementation of coinage was in that time a compelling step to ease and further the trade. To transport goods over long distances, the shipping was a commonly used conveyance. ²⁴ Even today the spatial bridging between the producer and the consumer is an essential function of the trade. Further functions of the trade are the spatiotemporal, the quantitative as well as the qualitative bridging. ²⁵ The main purpose of the trade is therefore, is to provide the required goods in respective quality and quantity at the right place. In fact, the commodity trading pursues the same objective regardless whether a producer or a consumer of commodities conducts the trade. Both parties have the same interest - to ensure an optimal exchange of the traded goods.

To finalize the definition it can be said that the commodity trading includes the process of acquisition, as well as the sale of various commodities with the objective to provide these qualitatively, quantitatively, on schedule, as well as at the right place.

2.3 Risk categories of a Company

Generally risks can be classified into different categories. Applying these classifications to risks of a company, a categorization and differentiation into strategic risks, operational risks and financial risks, optimally reflects the affiliation of every single risk resp. the categorization of the here relevant commodity risks. ²⁶ Furthermore the strategic, as well as the operational risks, are further subdivided distinguished into external and internal risk categories. The following

²⁷ illustrates the described classification. Depiction 5

²³ Cf. Kloth, Ralph, Waren- und Informationslogistik im Handel, (1999), p. 5 f.; and cf. Mattmueller, Roland;

Tunder Ralph, Strategisches Handelsmarketing, (2004), p. 9 ff.

²⁴ Cf. Herrmann, Christoph; Weiss, Wolfgang; et al., Welthandelsrecht, (2007), p. 42 f.

²⁵ Cf. Mattmueller, Ralph; Tunder, Roland; Strategisches Handelsmarketing, (2004), p. 11.

²⁶ Cf. Romeike, Frank; Finke, Robert B.; Erfolgsfaktor Risiko-Management, (2003), p. 168.

²⁷ Cf. Martin, Thomas; Bär, Thomas; Grundzüge des Risikomanagements, (2002), p. 75ff.

2. Theoretical basics and terminologies 11

External strategic risks refer to the area of operation within a company and include

(Own illustration)

all markets, customer groups and products which are relevant to the corporation. These risks enclose all possible developments on this area of operation, regardless of whether the origin of the risk is political, social, legal, or economical. Not only should current areas of operations be taken into consideration, but also possible or potential areas of the company. Therefore external strategic risks possess in a broader sense a risk but, also an opportunity.

Internal strategic risks exist in the concept of the company’s value and supply chain. In this context, a company is compelled to decide which processes should be performed by its own process chain and which processes should be performed by subcontractors. Basic decisions for a company are processes like outsourcing or off-shoring of production processes. Furthermore, a company has to decide which resources it generally wants to invest, from the personnel policy to guidelines of merchandise purchased up to investment policies. Risks therefore arise at the interface point to external partners (possible quality problems, supply shortage etc.) and bring into question whether the company’s own production and contribution is profitable. ²⁸ Like the external strategic risks, internal strategic risks also include certain risks, but also possible opportunities.

External operational risks include all unique and unmethodical incidences, which can externally affect a company, such as natural disasters, court proceedings, or fraud. Like strategic risks, operational risks also include risks as well as opportunities. However, these mainly consist of risks instead of opportunities.

²⁸ Cf. Kaiser, Thomas; Wettbewerbsvorteil Risikomanagement, (2007), p. 65.

2. Theoretical basics and terminologies 12

Internal operational risks refer to all unique respective unmethodical incidences which are triggered by internal sources. Examples for these risks are embezzlement, human mistakes, IT problems, and workplace accidents. In fact, internal operational risks are negative divergences from planned and scheduled processes. 29

Financial risks arise from possible changes and developments of market prices, which is the credit history of contractual partners etc. ³⁰ These risks can individually affect various areas respectively sections and transactions within a company. Exemplarily for financial risks are the interest rate risk, currency risks, credit risks, and as a matter of fact, commodity risks. 31

Due to the focus of this thesis on commodity risks and possible hedging instruments, commodity risks and certain issues will be further explained and profoundly defined within the following subchapters.

2.4 Specific Commodity Risks and Issues

The following chapter concentrates on the commodity risks which are classified within the financial risks. The chapter mainly focuses on specific commodity risks, subdivides them and appoints certain special commodity issues.

2.4.1 Market Price Risks

Companies directly and indirectly apply a significant amount of commodities in their production process. As the prices for commodities change daily, companies face an uncountable extent of risk resulting from value changes of certain commodities and mining rights. In case the acquisition of the used commodities is settled in future, intermediate rising market prices can worsen a company’s profit margin. This risk is also referred to as the Delivery Price Risk or the Cash Flow Risk. ³² The risk lies in the fact that intermediate rising prices increase purchasing costs. If commodities are purchased and stored as inventory prior to the production process, companies can be confronted with a Fair Value Risk as prices for that stored commodity could fall in the meantime. ³³ The rapid economic slump in 2008, for example led to rising stock levels of automotive and engineering companies. Linked to dropping commodity prices, the value of their inventories reduced enormously. In the inventory list at the end of the year these companies had to

²⁹ Cf. Wolf, Klaus; Risikomanagement im Kontext der wertorientierten Unternehmensführung, (2003), p. 41 f.

³⁰ Cf. Goetze, Uwe; Henselmann, Klaus; et al.; Risikomanagement, (2001), p. 132ff.

³¹ Cf. Romeike, Frank; Finke, Robert B.; Erfolgsfaktor Risiko-Management, (2003), p. 199.

³² Cf. Eller, Roland; Heinrich, Markus; et al., Kompaktwissen Risikomanagement, (2010), p. 61.

³³ Cf. Nguyen, Tristan; Bilanzielle Abbildung von Finanzderivaten und Sicherungsgeschäften, (2007), p. 15 ff.