Derivatives as efficient Risk Management instruments - Application to Commodity Markets

Table of Content

Table of Depicitons

Table of Figures

Table of Abbreviations

1. Introduction
1.1 Purpose of the study
1.2 Stakeholders and objectives
1.3 Structure of the study

2. Theoretical basics and terminologies
2.1 Definition of Risk Management
2.2 Definition of Commodity Trading
2.3 Risk categories of a Company
2.4 Specific Commodity Risks and Issues
2.4.1 Market Price Risks
2.4.2 Quantitative Risks
2.4.3 Counterparty Risks
2.4.4 Basic Risks
2.5 The Risk Management Process
2.5.1 Risk Identification
2.5.2 Risk Valuation
2.5.3 Risk Management
2.5.4 Risk Controlling

3. Derivative financial instruments
3.1 Definition of Derivatives
3.2 Forward-based derivatives
3.2.1 Forwards
3.2.2 Futures
3.2.2.1 The Stock market
3.2.2.2 Mark to Market
3.2.3 Swaps
3.3 Options
3.3.1 Terminology
3.3.2 The Call
3.3.2.1 The Long Call
3.3.2.2 The Short Call
3.3.3 The Put
3.3.3.1 The Long Put
3.3.3.1 The Short Put
3.3.4 The Cap
3.3.5 The Floor
3.3.6 The Collar
3.3.7 Exotic Options
3.3.7.1 Multible Commodity Options
3.3.7.2 Path-dependent Options
3.3.7.3 Compound Options
3.3.7.4 Binary Options

4. Practical Hedging Strategies
4.1 Forward-based Derivatives
4.1.1 Hedging with Forwards
4.1.2 Hedging with Futures
4.1.3 Hedging with Swaps
4.1.3.1 Plain Vanilla Swaps
4.1.3.2 Cross Commodity Swaps
4.1.3.3 Clean Dark Spread
4.1.3.4 Spot Basic Swap
4.2 Hedging with Options
4.2.1 Put Options
4.2.2 Call Options
4.2.3 The Cap and Floor
4.2.4 The Collar
4.2.5 Exotic Options
4.2.5.1 Path-dependent Options
4.2.5.2 Multiple Commodity Options
4.2.5.3 Binary Options
4.3 Analysis of advantageousness

5. Conclusion

Work Cited

Attachments

Table of Depicitons

Depiction 1: Hubbert Curve

Depiction 2: Development of selected commodity prices 2001 - 2011

Depiction 3: Guideline of this paper

Depiction 4: Distinction of commodity markets

Depiction 5: Risk types and categories

Depiction 6: Basis and Basis convergence

Depiction 7: The Risk Management Process

Depiction 8: Profit and Loss resulting from Forward Contracts - Buying vs. Selling Position

Depiction 9: Margin und Clearing Systems of a Futures Exchange

Depiction 10: Functionality of a Short Swap respectively Long Swap

Depiction 11: Option positions

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

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

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

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

Depiction 16: Payments of a Collar

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

Depiction 18: Payment flows within an Alumium/ Gas Swap

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

Table of Figures

Table 1: History of Risk Management

Table 2: Influencing factors on an Option Price

Table 3: Exemplarily calculation of Mark to Market

Table 4: Calculation of a Clean Dark Spread

Table 5: Example for a Long Put Option

Table 6: Example for a Long Call Option

Table 7: Sample calculation for a Collar

Table 8: Example for a Cash on Delivery Option

Table 9: Comparison of Hedging Instruments

Table of Abbreviations

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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

Depiction 1: Hubbert Curve

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Obtained of: http://planetforlife.com/oilcrisis/oilpeak.html, Sourcing date: May 19, 2011

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 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 markets⁴ like shown in Depiction 2.

Depiction 2: Development of selected commodity prices 2001 - 2011

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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 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.

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:

Depiction 3: Guideline of this paper

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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 1¹¹ on the following page shows an outline of Risk Management’s history.

Table 1: History of Risk Management

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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 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 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 CO2 emission certificates etc. are not commodities.^B

The following Depicition 4²¹ shows an overview of the different forms of commodities referring to the MiFID.²²

Depiction 4: Distinction of commodity markets

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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 Depiction 5²⁷ illustrates the described classification.

Depiction 5: Risk types and categories

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

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 make extraordinary depreciations on their inventory as well as on unfinished and finished goods.³⁴

A Spread risk arises if companies not only use commodities within their production process, but rather sell these in a changed form on the market. In that case, the sale price of a product is heavily linked to the price development of the used commodity. Refineries, for example, are frequently confronted with this risk as they convert crude oil into oil products like heating oil, kerosene and diesel. Also producers of aluminum face the risk of rising prices for electricity and simultaneous falling aluminum prices.

As the cash flow risk immediately affects the profit and loss account (P&L account) as well as the profit margin of a company, this risk type is usually noticed and considered to be more threatening. The management of the fair value risk is usually done within the context of the working capital management where inventories are only as high as the currently necessary demand.³⁵ Only a Supply Risk can arise in case of a supply shortage of the used commodity.

Therefore commodity management needs to have the market price risk always in mind and analyze which opportunities and risks arise from the acquisition of certain commodities. The regulation respectively hedging of these risks is the main part of this study and will be discussed in the following chapters 3 and 4.

2.4.2 Quantitative Risks

As commodities are of limited availability and can sometimes not be delivered or acquired in a planned amount, quantitative risks are a consequently impact. Power supply companies, for example, often conclude long-term purchasing contracts to hedge their gas and electricity supply. Possible exceeding quantities of agreed delivery amounts have to be purchased short-dated for current market prices. Power supply companies usually calculate future energy consumptions by historical data as they have experience values of energy consumption for various days, weeks, months or even specific daytimes. Usually the demand for energy respectively electricity is strongly affected by the weather.³⁶ A warm winter, for example, leads to less energy consumption than predicted. However, the public utility companies conclude fixed contracts with fixed amounts, calculated by historical data. In case of a lower energy consumption, a quantitative risk results for the public utility company as they purchased more energy respectively electricity than needed.³⁷

This risk can also be described as the Sales Risk. It arises in case of unpredictable demand behavior and describes the sum of all loss-risks that occur in combination with the sales of a product respectively commodity.³⁸

Vice versa Procurement Risks occur within the sales activity of a company. These risks can be further subdivided into transportation risks, storage risks, and delivery risks. These risks arise due to the fact that commodities which are needed for a company’s production have to be available at the right time and in the right quantity and quality. Comparable to the owner of forward products, the physical possession of a commodity gives a company the advantage of the maintenance of their supplies and the punctual respectively proper availability of their needed commodities.³⁹

2.4.3 Counterparty Risks

The Counterparty Risk describes the risk which arises in case of a total or partial failure of a counterparty and the following depreciation of a financial transaction. That risk arises if a counterparty or business partner does not act as arranged and does not meet their obligations. Therefore the counterparty risk is also categorized as a credit risk.⁴⁰

In this matter, a counterparty is described as a business partner who obligated himself to perform a particular service.⁴¹ Dealing only with business partners with a good credit history offers companies a certain protection against this type of risk. The usage of internal and external ratings as well as the observation of respective spreads of Credit Default Swaps (CDS) gives a company the possibility to estimate the credit history of a contractual partner. The introduction of counterparty limits restricts the volume per counterparty and leads to a diversification and reduction of this risk.⁴²

The effective height of a counterparty risk is besides the failure probability also dependent on the type and position of the financial transaction. The failure amount of derivatives is usually much lower than the agreed nominal volume.⁴³ After receiving of the option premium a short call option writer does not have a further counterparty risk (even so a market price risk) as he does not expect any further payments from his counterparty or business partner.

2.4.4 Basic Risks

The Basic Risk or also called Correlation Risk describes the risk of a different price development of the hedging instrument and the underlying commodity. This risk can arise if the hedging instrument does not refer to the same place, the same product, or the same maturity date like the underlying commodity. In the process of commodity price hedging, the usage of a varying hedging instrument compared to the underlying, is usually unavoidable due to the large number of different commodities compared to a few liquid hedging instruments.⁴⁴ The difference between the future price and the spot price of a similar or related commodity is described as the basis.⁴⁵

If commodity markets mark “Contango”, the forward prices mark above the spot prices. Therefore the basis is negative. Vice versa the market is in “Backwardation” if the spot prices mark above the forward prices.⁴⁶ The following Depiction 6⁴⁷ shows the coherence of Contango and Backwardation.

Depiction 6: Basis and Basis convergence

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The risk that the value of a hedging instrument develops a different price than the value of the underlying commodity constitutes one of the largest uncertainty factor of a risk management hedge. To achieve an effective and successful hedging strategy it is crucial to choose the right financial derivative for a certain underlying. Often the market for financial derivatives does not offer a hedging product which equals the underlying commodity in every feature. In this case an investor should choose a hedging instrument which comes closest to the features of the underlying commodity.⁴⁸

2.5 The Risk Management Process

The Risk Management Process constitutes the central point within the risk management of a company. Constantly changing environmental conditions and influences require permanent acting of a company to flexibly react to these environmental parameters.⁴⁹ Therefore the Risk Management Process should be seen as an ongoing process and includes all activities of a systematic management of risks. The following Depiction 7⁵⁰ illustrates this process which will be profoundly explained in the following subchapters.

Depiction 7: The Risk Management Process

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2.5.1 Risk Identification

Within the first step of the Risk Management Process different instruments offer companies a possibility to find respectively identify their risks. With these instruments a company possesses the possibility to identify the risks, introduced and described in chapter 2.3. Due to the main focus of this thesis, only two of these identification instruments^C will be explained shortly.^D

Usually the collection respectively identification of potential risks can be made by the analysis of the company and its environment. The basic purpose of these analyses is the gathering of information for projections as well as a detection of strengths and weaknesses of a company and its environment. These analyses usually refer to historical data. As mentioned, only two of the identification instruments will be mentioned in the following. The first one is the Document Analysis which is usually done within a company analysis. This analysis searches for potential risks, based on existing contracts, notifications or schemes as well as documents from the operational accounting.

The second mentioned identification instrument is the Portfolio Technique. This technique is usually applied if a company wants to ensure an optimal mix of a security portfolio.⁵¹

With these and the other appointed risk identification instruments a company can identify potential the financial risks, mentioned and described in chapter 2.3.

2.5.2 Risk Valuation

Within the second step of the Risk Management Process, the encountered risks from chapter 2.3 are valued respectively assessed. Financial Risks (according to chapter 2.3 - Financial Risks) are counted among the quantifiable risks. This constitutes the difference between quantifiable and unquantifiable risks, as quantifiable risks can be measured, valued and their extent of losses determined. The following subchapters introduce and discuss various valuating instruments which can be used for the measurement of financial risks. Due to the main focus of this study on hedging possibilities and scenarios, these valuating instruments will be only shortly described.

Value at Risk

The Value-at-Risk Model grew in popularity during the nineties, particularly in consequence of the standardized Value-at-Risk Methodology which was developed by the Risk Metrics Group in 1994. Triggered by different regulations of the Basle Committee on Banking Supervision in 1996, various banks started to evolve internal Value-at-Risk models to determine market risks.⁵² Today the Value-at-Risk approach is not only used in financial institutions but also by industrial and commercial corporations.

The Value-at-Risk approach can be used once a company has perceptions about the probability of occurrence. In this case these risks should be traded on a financial market and generally insurable. Furthermore the Value-at-Risk approach is based on a quantitative forecast model and is defined as the loss which certain financial instruments or particular portfolios face in the worst case.

The application possibilities of the Value-at-Risk approach are basically customizable. Therefore the Value-at-Risk approach can be applied to particular risk positions as well as to the whole investment portfolio of a company. Furthermore it is possible to measure with the Value-at-Risk approach particular risks (such as commodity price risks) but also the risk potential of summarized positions (for example the whole market risk).⁵³

Cash-Flow at Risk

The Cash-Flow-at-Risk approach can be analogously used to the Value-at-Risk approach if a company has cognizance of the height and probability of occurrence of their risks. Whereas the Value-at-Risk is applicable to the market value, the Cash- Flow-at-Risk can be referred to a certain cash flow. In connection with the valuation of financial risks, a cash flow can be seen as a financial flow which arises as a payment in a specific period. These cash flows can be part of the usual business operation (e.g. sales revenues), the financial sector (e.g. interest payments) or the hedging operations (payments of swap).⁵⁴ In the context of the Cash-flow-at-Risk approach, all individual cash flows are analyzed, which are based on their values, exposed to the financial risk. Therefore all payments which are made in an other than the concern currency are analyzed as these are all exposed to the currency risks. As a result the company can measure the values of single currency positions and the respective risk exposure of that particular cash flow position.⁵⁵ The same process can be applied to the commodity risks. In the case of the commodity risks, all cash flows are considered which arise in context with commodity trades.

Earnings at Risk

While the Cash-flow-at-Risk is calculated by the expected revenues and expenses, the Earnings-at-Risk is calculated on the basis of the expected income and expenditures. For the Earnings-at-Risk approach the probability of occurrence of the risk is also necessary.⁵⁶ Like the Value-at-Risk approach, the Earnings-at-Risk approach can also be used within the risk measurement and indicates the maximal lower deviation respectively negative difference of a planned objective. This approach simulates the effects of financial risks on the relating annual profit of a company. As a result external analysts and investors can deduce company values like the Price Earnings Ratio ^E or the Return on Equity. The limitation of the revenue’s volatility can in terms of a value-centered Risk Management lead to an increase of the share price and the Shareholder Value of the company.⁵⁷

Scenario- and Sensitivity Analysis

The Scenario and Sensitivity Analysis can be applied in case that a company does not have an analysis of the probability of occurrence of their risks. Within the Scenario analysis a company valuates its risks (especially market price risks) by simulating various market and price developments and examines impacts on the company’s exposures. In this process the company uses the three-value-technique which includes an optimistic, a pessimistic and a subjective value of the risk. In this matter the optimistic value constitutes the “Best Case Scenario” and the pessimistic value the “Worst Case Scenario”. The most realistic value constitutes a subjective valuation of the underlying risks. As a basis for the calculation of these scenarios a company usually uses historical values.⁵⁸

With the following sensitivity analysis a company estimates the effects of changing market prices on their profit or market value.⁵⁹

2.5.3 Risk Management

An important part within the whole Risk Management Process is the third step - the Risk Management respectively the actual managing of risks which were identified and measured within the first two steps. Therefore this part is geared towards the objective to positively change a company’s risk situation as well as achieve a balanced proportion of anticipated revenue and risk.⁶⁰ This triggers the fact that a company has to decide how to deal with their risks. Possible methods of the Risk Management step are explained in the following.

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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.

³ Cf. http://constructioninformer.com/2010/03/04/taking-the-wide-view-on-constructions-oil-challenges/, Sourcing date: September 7th, 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.

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

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

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.

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.

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.

^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 31st, 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.

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.

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

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.

³⁴ Cf. http://www.wiwo.de/finanzen/die-finanzkrise-ist-laengst-nicht-ausgestanden-262329/; Sourcing date: September 1st, 2011.

³⁵ Cf. Bhattacharya, Hrishikesh; Working Capital Management, (2006), p. 144 ff.

³⁶ Cf. Eller, Roland; Heinrich, Markus; et al., Kompaktwissen Risikomanagement, (2010), p. 92 f.

³⁷ Cf. Deubel, Andreas; Risikomanagement mit Wetterderivaten, (2009), p. 22 ff.

³⁸ Cf. Hanisch, Markus; Brennpunkt Agrarpreise, (2010), p. 10 f.

³⁹ Cf. Eller, Roland; Heinrich, Markus; et al.; Kompaktwissen Risikomanagement, (2010), p. 93 ff.

⁴⁰ Cf. Gabath, Christoph; Innovatives Beschaffungsmanagement, (2011), p. 205 f.

⁴¹ Cf. Gregory, Jon; Counterparty Credit Risk, (2010), p. 14.

⁴² Cf. Gabath, Christoph; Innovatives Beschaffungsmanagement, (2011), p. 15.

⁴³ Cf. Gregory, Jon; Counterparty Credit Risk, (2010), p. 11 ff.

⁴⁴ Cf. Eller, Roland; Heinrich, Markus; et al.; Kompaktwissen Risikomanagement; (2010), p. 35 ff.

⁴⁵ http://www.dasinvestment.com/themenkanaele/rohstoffe/detailansicht/datum/2009/03/02/die-contango- falle/; Sourcing date: August 30th, 2011.

⁴⁶ Cf. http://www.investopedia.com/articles/trading/05/021605.asp#axzz1WWBPFoTa, Sourcing date: August 20th, 2011.

⁴⁷ Cf. http://www.backwardation.de; Sourcing date: August 20th, 2011.

⁴⁸ Cf. Dennin, Torsten; Besicherte Rohstoffterminkontrakte im Asset Management, (2009), p. 14 ff.

^C Note: Common used Risk Identification instruments are: Technical and Organisational Tools, Company Analyses, Environmental Analyses, Projection Techniques and Early Detection Techniques.

^D Note: The book „Wertorientiertes Risk-Management für Industrie und Handel“ of Gleißner and Meier offers a broad knowledge basis wihtin the subject of „Risk Identification“ respectively the whole Risk Management Process.

⁴⁹ Cf. Wiederkehr, Bruno; Zueger, Rita-Maria; Risikomanagementsystem im Unternehmen, (2010), p. 17

⁵⁰ Cf. Gunkel, Marcus; Effiziente Gestaltung des Risikomanagements, (2010), p. 56.

⁵¹ Cf. Golub, Bennett W.; Tilman, Leo M.; Risk Management, (2000), p. 8 ff.

⁵² Cf. Chew, Donald C., Corporate Risk Management, (2008), p. 163 f.

⁵³ Cf. Schneck, Ottmar; Risikomanagement, (2010), p. 143 f.

⁵⁴ Cf. Chew, Donald C., Corporate Risk Management, (2008), p. 187 ff.

⁵⁵ Cf. Wolke, Thomas; Risikomanagement, (2007), p. 225.

⁵⁶ Cf. Jorion, Philippe; Value at Risk, (2007), p. 411.

^E Note: The Price Earnings Ratio is a comparison of the relation between the current share value of the company and the rate of return per share.

⁵⁷ Cf. Jorion, Philippe, Value at Risk, (2007), p. 413 f.

⁵⁸ Cf. Brigham, Ehrhardt; Financial Management, (2010), p. 439.

⁵⁹ Cf. Schneck, Ottmar; Risikomanagement, (2010), p. 161.

⁶⁰ Cf. Kalwait, Rainer; Meyer, Ralf; et al.; Wertgenerierung durch Chancen- und kompetenzorientiertes Management, (2008), p. 311.