Management of price risks. Value at risk for evaluating trading positions in the coal market

List of contents

B LIST OF ABBREVIATIONS

C LIST OF FIGURES

D LIST OF TABLES

E LIST OF SYMBOLS

1 INTRODUCTION TO THE TOPIC

2 BASICS AND DEFINITIONS
2.1 DEFINITION OF RISK
2.2 DESCRIPTION OF RISK MANAGEMENT
2.2.1 The definition of Risk Management
2.2.2 The Risk Management Process
2.2.3 Risk Management strategies
2.3 FINANCIAL VERSUS COMMODITY POSITIONS AND RELATED RISK REDUCTION
2.3.1 Differences between financial and commodity positions
2.3.2 Risk reduction for positions

3 EVALUATING PRICE RISKS OF POSITIONS BY THE VALUE-AT-RISK
3.1 THE PRINCIPLE OF THE VALUE-AT-RISK APPROACH
3.1.1 Value-at-risk related measures of (price) risks
3.1.2 Depicting the value-at-risk
3.1.2.1 The expression of the approach
3.1.2.2 Premises for the calculation
3.1.2.3 The value drivers
3.1.3 The various value-at-risk approaches
3.1.3.1 The variance-covariance method
3.1.3.2 The Historical Simulation
3.1.3.3 The Monte Carlo Simulation
3.2 EVALUATING APPLIED VALUE-AT-RISK APPROACH BY BACK-TESTING
3.3 A CRITICAL RECOGNITION OF THE VALUE-AT-RISK’S SERVICES
3.4 ALTERNATIVE CONCEPTS FOR MEASURING PRICE RISKS
3.5 EVALUATING POSITIONS BY THE VALUE-AT-RISK
3.5.1 Conditions and barriers for managing price risks by the value-at-risk
3.5.2 Value-at-risk based Risk Management in the financial sector

4 MANAGING PRICE RISKS IN THE INTERNATIONAL COAL TRADING BUSINESS
4.1 OUTLINING THE INTERNATIONAL STEAM COAL MARKET
4.2 RAG TRADING GMBH - PLAYER IN THE INTERNATIONAL COAL TRADING BUSINESS
4.3 EVALUATING POSITIONS BY THE VALUE-AT-RISK AT RAG TRADING GMBH
4.3.1 Depicting relevant risks at RAG Trading GmbH
4.3.2 Taken steps for evaluating trading positions at RAG Trading GmbH
4.3.3 Establishing a value-at-risk based evaluating process
4.4 RECOMMENDATION

5 CONCLUSION AND FURTHER OUTLOOK

F ATTACHMENTS

G BIBLIOGRAPHY

H LIST OF SOURCES

B List of abbreviations

C List of figures

Figure 1: Risk Management culture

Figure 2: Risk steering process

Figure 3: Sale positions and related price risks

Figure 4: Purchase positions and related price risks

Figure 5: Selection of the appropriate holding period

Figure 6: Global coal production and trading volumes in 2003

Figure 7: Development in Australian steam coal prices 1982 - 1999

Figure 8: Historical API#2 and API#4 price quotations (monthly averages)

D List of tables

Table 1: Consumption of electricity in the OECD countries 1960 - 2002

Table 2: Comparison of attributes of methods for calculating the value-at-risk

Table 3: Common z-values

Table 4: Factors of coal price fluctuations and outcomes

Table 5: Hundred days backward scheduling of the API#2 - 1st quarter 2006

E List of symbols

illustration not visible in this excerpt

1 Introduction to the topic

Presentation of the problem

Two words deeply determine the world economic since the 90’s of the 20th century - “risk” and “Risk Management”. However, coming to the result that these concerns have been ignored before that time would be seriously misinterpreted. Early trials to identify and analyse risks could be recognized by archaeological discoveries in the EuphratesTigris area and have been dated around the year 3.200 B.C.¹

The economy already realized the importance of risks and Risk Management at the be- ginning of modern economics. Today this concern is handled more exactly than in the Ancient World, with full awareness and more systematically. Taking risks more sys- tematically into consideration is caused by more rapidly changing basic conditions in the world markets. But, what are the reasons for these developments? Some decades before the world economy proceeded in relative predictable channels and followed more or less fixed inherent laws. This could especially be noticed in many commodity markets, like the steam coal market. This market as a commodity market will be analysed in more detail in the scope of this diploma thesis.

First hints for upcoming changes have been given by the oil crises in 1973. Up to this time, exorbitant increasing commodity prices could be observed only a few times and were not as serious. However, such increasing commodity prices and especially oil prices did not shake markets for twenty-five years and it turned out that the explosion of commodity prices could not be recognized till the end of the 20th century.² Nevertheless, referring to prices’ development at that time combined with the word “prank” would be a misnomer due to the lasting nature. This incident was accompanied by increasing volatility of commodity prices. Especially companies in the commodity markets had to react flexibly to the changing market situation.³ It became important to deal with changing conditions in the micro as well as in the macro environment. React- ing fast in accordance to changes in the market (situation) is still as important. The increasing globalization, caused by falling borders and partial or complete tariff removal, the end of the Cold War and the end of most socialistic regimes of former Eastern Bloc resulted in enterprises expanding from “old” industrialized countries into those newly open countries. By finding new markets these enterprises were in the position to diversify and try to distance themselves from competitors. Furthermore, companies were able to extricate themselves from saturated markets.⁴

By opening new markets some countries were able to climb within a relative short time from developing to emerging countries. Due to its very high growth rates within a few years, China for example was able to catapult itself from the category of developing countries to emerging countries. China is just one example of an emerging market. Countries like the “Tiger States” (Singapore, Thailand etc.), India and Turkey obtained similar results. On the other hand, these incidents resulted in the world markets starting to fluctuate more often and lasting due to changes in supply and demand. This caused increased volatility in most markets and therefore higher price risks.⁵

One further reason for increasing volatility is the fact that the emerging markets transfer their own internal problems and imbalances into the international markets. It should not be forgotten, that such countries still have a lack in infrastructure which can be seen in the financial as well as the physical infrastructure. Additionally, unsafe political circumstances also put a strain on the world economy.

Moreover, increasing volatility especially in the commodity markets are caused by increasing or decreasing demand for such goods and over-supply or shortages in raw materials. Growing population also increased demand.⁶

If a company’s reaction is based on vague presumptions and premises only, misjudge- ments might result in disadvantageous consequences. The world economy necessitates analysing the markets respectively the conditions in a special market more systemati- cally.

In response to the described situations, Risk Management was perfected and further developed. It started to be more important to provide flexible potentialities for reacting to changes in the markets (external factors). Increasing complexity of the world economy and increasing interweaving between countries due to the globalization, can take seriously influence a company’s decision making process.⁷

The focus of this diploma thesis will be on how companies can manage their risks re- lated to the steam coal market, with present-day increasing prices and market risks. In addition to the high price risks level in purchasing commodities, trading positions bear many additional risks. Therefore, taking directional positions might endanger enter- prises, depending on the levels of potential losses and economic impact on the com- pany.

The thesis shall analyse how a position can be evaluated systematically and as safely as possible. There are a couple of approaches for evaluating positions, but the value-at-risk approach became the most common approach within the last years. The approach can- not be substituted in the financial branch any more and due to its practicability, the value-at-risk approach is becoming a common Risk Management tool in the guild of many coal trading companies as well. It is scrutinized if the method applied in the bank- ing sector can be transferred to the non-financial sector and particularly the coal trading business.

Course of the research

The diploma thesis is oriented less mathematical and describes even more conditions, ways and drawbacks, for determining and managing price risks by the value-at-risk. The second chapter is about giving detailed definitions of the most important terms like risks, Risk Management and trading positions. In addition, the differences between financial and commodity positions are clarified.

The third chapter then deals with a detailed description and definition of the value-at- risk approach, its characteristics as well as the possibilities to make use of the approach in companies. This chapter also gives a few alternative approaches for evaluating the price risk of trading positions and is as well completion of the theoretical part. Chapter four focuses on how the value-at-risk approach can be used in the coal trading business. For finding a practical reference point in the coal market, the coal trading company RAG Trading GmbH is analysed. After the recent situation in the coal market and the company has been described, potential ways of evaluating price risks of posi- tions are examined. The findings of chapter two and three are then transferred to the organizational structure of the coal trader. A brief recommendation at the end completes the transferring process.

The last chapter is about listing of the results and findings. Moreover, the future of the coal trading business and proper management of price risks is given closely.

2 Basics and definitions

2.1 Definition of risk

Most experts assume that the origin of the word “risk” can be found in the Arabic lan- guage by the word risq or in the ancient Latin language by the word risicum. The Ara- bic word means circumstances and things given by God, whereas people can draw prof- its with them and have a favourable outcome. By contrast, the ancient Latin word origi- nally means the difficulty and the challenge of sailors which arise from barrier reefs. The word contains the meaning of unfavourable events, so that this comes more closely to the definition of risk today.⁸ This definition is linguistical and does not clearly repre- sent the economic meaning of the word.

The analytical definition stipulates risk as a part of uncertainty in wider meaning. The individual usually assumes to know potential alternative consequences of own action and is able to assign occurrence probabilities to all consequences. By contrast, uncer- tainty in the narrower meaning, stipulates that the individual is not able to assume prob- abilities and therefore does not know the potential alternative consequences.⁹ Further- more, risk is often defined as a threat to make a wrong decision, whereas it remains un- solved how the threat of making a wrong decision shall be measured and evaluated.¹⁰ Additionally, the economic definition provided by the literature describes risks as the threat that events and actions prevent enterprises from reaching their goals and aims and putting strategies into action.¹¹

The so-called two-sided risk definition describes risk as the positive (upside risk) or negative (downside risk) divergence from an assumed event or outcome (expected value). This definition includes the fact that risks are closely linked with chances.¹² In general, most literature sources do not provide readers with the definition for “chances” although they are important in business as well. Especially enterprises, but also individuals accept risks due to get opportunities for yielding profits. The term “chance” is often circumscribed by positive dispersion.¹³

Risks can be divided by taking their occurrence, character or their consequences into account. The literature provides with countless different risk categorizations, so that it is not simple to define risks clearly. However, most useful definition for this diploma thesis is provided in the following. Risks can be categorized into four groups:¹⁴

− external risks
− performance risks
− financial risks
− risks arising from the organization.

The groups of performance risks, financial risks and risks arising from the organization can be united to the group of “internal risks”. This categorization reflects both the mi- cro- and macro environment of enterprises and is a general view of risks. Firstly, the group of external risks contain the risks that arise from markets/customers, competitors, technology, politics etc. These are risks that the companies are faced with by the surrounding, i.e. the macro environment. Secondly, performance risks arise from the fact that disadvantageous developments in logistics, production or quality have to be managed by companies.¹⁵

The third group of risks result from the threat that business partners do not fulfil financial obligations or that the payment of interest or redemption cannot be carried out what might lead to illiquidity.¹⁶ Companies are faced with the fourth group (risks arising from the organization) due to inadequate systems, controlling mechanism, human errors or making wrong decisions by the management board.¹⁷

Market risks

Market risks as a part of the external risks are the focus of attention in this diploma the- sis due to their important role. They result from fluctuations of several market determi- nants, like interest rates, currencies or market prices. Furthermore, performance risks that arise by the consumption of assets and means of production cannot be compensated by appropriate profits at worst and play therefore an important role for trading compa- nies.

Furthermore, the market risks result from possible financial losses in assets that can be attributed to changing global economic factors and are determined by price risks, basic risks (risk of correlation) and market liquidity risks whereas the price risks are the most important fact in this regard.¹⁸

Price risks

The price risks result from price changes that are the most influencing factors especially in trading companies.¹⁹ This means the risk buying an asset and selling at a loss and vice-versa.²⁰ It is the most natural thing in the world that buying at high prices before a market decline and selling at low prices, inevitably can lead to a run of losses and going bankrupt. On the other hand, price risks can effectuate severely on enterprises in times of high volatility. Heavy competition and temporal slight losses sometimes cannot be prevented.

These risks are quite important to pay attention to. However, occasionally expensive management of price risks does not obviously belong to the key issue of many enterprises, although prices often determine if gains or losses are shown in the books. Additionally, the volatility in some markets result that rigid price calculation in business life become useless at worst.²¹

In general, the significance and value of the price risks are determined by the parameters current price of an asset, necessary quantity and price volatility. The price risks are a product made up of all these parameters.²² In detail, they are determined by factors like assumptions of market participants, weather, shortages and general circumstances like market trends, as well.²³

Volume risks

These risks can arise from the fact that the supply or demand of an asset rises or falls, so that supposing the supply escalates for instance, producers can sale less of their assets. On the other hand, rising demand can result in shortages of the availability of assets.²⁴ Due to the increasing threat of risks, managing them professionally and systematically is of paramount importance.

2.2 Description of Risk Management

2.2.1 The definition of Risk Management

Risk Management describes the steering and regulation of existing and future risks, so that the enterprises’ value can be increased by decreasing existing and potential risks at more constant rates of return. Furthermore, it is the counterpart of yield management. These are fundamental parts of the so-called value-oriented management in enter- prises.²⁵ The yield management analyses the market in regard to find new sources for making returns. The Risk Management evaluates the risk arising from (new potential) markets/market niches and evaluates if the potential returns are proportional to potential risks.

In result, both components are inseparably interlocked and might not be ignored in today’s business. In addition, Risk Management is characterized by all organizational regulations, measures of risk analysis and the regulation for facing the entrepreneurial risk.²⁶ Rational Risk Management shall follow three cardinal rules at best:²⁷

− expected values are thought to be maximized
− severe business catastrophes shall be avoided
− remote possibilities shall be ignored.

As stipulated in the first chapter, Risk Management cannot be ignored by modern com- panies. Trading in foreign markets in general but especially in emerging markets (newly industrialized countries) is risky, depending on the political and economic stability in the country where business is carried out.²⁸

Additionally, Risk Management is required by newly changed legal and moral regulations like the KonTraG in Germany or the Sarbanes-Oxley-Act in the USA. By enacting them, the transparency of companies is thought be increased so that the interests of associates, share holders and creditors are the focus of attention. Thus, the management and supervision system of corporations can be improved.²⁹

As the management is obliged to report about their company and especially risks, the Risk Management has to be organised professionally. In addition, the Codes of Conduct are designed to decrease the influence of negative impacts by the Risk Management. The Sarbanes-Oxley Act of 2002 for instance leads to significant new requirements on enterprises that are listed or intend to get listed on stock exchanges in the USA.³⁰ These requirements have been held up as an example for other regulations and other require- ments in regard to transparency and the Risk Management Processes. The Risk Management is the most important “junction” between the strategic manage- ment (which is given by the management board of an enterprise) and the daily busi- ness/operative departments.³¹ As directives for this are issued by the management the top-down procedure is applied. Additionally, the risk policy of an enterprise is put into action by the Risk Management that is assisted by the so-called Risk Controlling.³² However, there shall be drawn a clear dividing line between both. Risk Controlling is mostly executed by the controlling department and is responsible for developing a kind of methodical competence in regard to risks, providing the Risk Management with me- thodical assistance, establishing a risk-oriented reporting and developing risk-oriented instruments. Therefore, Risk Controlling ensures that the company is provided with method and instruments to manage risks.

By contrast, the Risk Management is executed by the management itself or closely re- lated departments in most enterprises. It is responsible for integrating basic issues of the risk policy, establishing along with risk culture, starting off the Risk Management Proc- ess and the steering of risks by knowing the current risk situation of the company or in the market.³³ The Risk Management deals with one key question of enterprises, how the risks can be incurred and managed.

Moreover, the Risk Management represents or even helps shaping the risk culture of an enterprise. The risk culture is categorized in risk-averse, risk-meticulous, risk-ignorant as well as risk-conscious attitude that characteristics can be seen in provided figure. Companies’ attitude in regard to risk is determined by various reasons and circum- stances like branch, size of the company, shareholder value etc. The attitude can be ex- pressed and calculated mathematically as well as statistically. If a company’s risk atti- tude is risk-averse (risk- ignorant) is the expected return relatively higher (or smaller) than the benefit for the company.³⁴ For instance, risk-averse companies would not take many risky actions or generate risky deals. They pursue defensive management strate- gies especially in regard to risks in general.

illustration not visible in this excerpt

Figure 1: Risk Management culture³⁵

It is important that various regulations are introduced in enterprises to ensure that the Risk Management is able to manage risks sufficiently and prevent as much negative impacts as possible. The regulation should be binding on the employees (especially the management) and accepting risks should be according to return-oriented thinking. Furthermore, the Risk Management has to contain previously laid down threshold values of potential threats in all respect, whereas the higher authority in hierarchy then has to be informed if a threshold value has been exceeded.³⁶ This flow of information is applied according to the bottom-up procedure.

2.2.2 The Risk Management Process

The Risk Management in companies is ideally executed according to the Risk Manage ment Process that contains following steps:

1) risk identification
2) risk analysis/risk evaluation
3) risk steering
4) risk monitoring.

The strategies that can be applied for managing risks are contained in the previously mentioned Risk Management Process.

Risk identification

This implies that the companies classify all threatening risks, regardless if future or ex- isting risks are meant, according to the categorization in chapter 2.1 or similar classifi- cations, whereas this step can be assisted by check lists for instance. In addition, risk identification contains that all relevant risks, potential threats and losses are structured and recorded detailed. The appropriate relationships between single risks are also intro- duced into the viewing, whereas implicit risks in operative processes have to be identi- fied as well.³⁷

After that, the companies have to care about bringing identified risk and company’s risk profile into accordance, so that defining a clear view of risks and risk profile is abso- lutely necessary.³⁸ For preventing that the risk profile is interpreted differently within the company, company-wide standardized top-down guidelines have to assist in identifying all risks.³⁹ Companies are enabled to apply various kinds of methods, but the se- lection of the method depends on the agreed risk profile and companies’ aims. In practise, two different types of methods are distinguished - first, collecting and searching methods.

Collecting methods predominantly identify existing risks and contain methods like check lists, the SWOT analysis, the Risk Identification Matrix analysis etc. Searching methods can be distinguished into the group of analytical hods and creativity methods. It is important that these approaches do not provide with qualitative, but quantitative information about risks. In other words, by applying such methods enterprises are only enabled to list up and categorize all risks.⁴⁰

By contrast, analytical methods (morphological approaches etc.) as well as creativity methods (Delphi method etc.) are applied to identify future and hitherto unknown risks. Those are parts of so-called proactive Risk Management. Analytical methods assume enterprises as undisturbed systems and determine which threatening factors might disturb the system. Creativity methods evaluate the existing as well as potential risks by creative processes and divergent thinking.⁴¹

The process of risk identification assists in taking counteracting measures as risks are identified as sufficiently as possible. Therefore, Risk Management requires permanent identification of risks, listing risks up to the latest point of view and finding out potential sources of risks.⁴²

Risk analysis/risk evaluation

By applying the risk analysis potential internal and external risks found by the first step are analysed and examined in regard to the influences on the company. The determina- tion of required reaction time and then finding appropriate counteracting ways is applied afterwards.

The risk evaluation provides companies with the possibility to evaluate the threats in regard to their timing, the occurrence probabilities and also the value of potential dam- ages/losses.⁴³ Especially the value of potential losses leads to the decision if appropriate counteracting measures have to be taken. Appropriate strategies are provided by the risk

steering. Furthermore, companies are able to take a look at risks’ correlation, sensitivity and other relationships.⁴⁴

Risk analysis can be assisted by the Risk Map approach for instance. In this model the consequences of potential losses are related to the occurrence probability. The conse- quences are measured by a monetary scale, showing the value of potential losses and the occurrence probabilities in percent.⁴⁵ All risks are assigned to this by previously men- tioned facts so that the risks might exceed given risk limits. The higher the occurrence probability is and the higher the value of potential losses, the more it is probable to ex- ceed the limits.⁴⁶ If the limits have been exceeded the enterprise has to take counteract- ing measures.

illustration not visible in this excerpt

Figure 2: Risk steering process⁴⁷

Risk steering

This step deals with taking active influence on risks that have been identified and analysed according to companies’ individual risk profile.⁴⁸ Appropriate strategies for steering risks are provided in chapter 2.2.3.

Risk monitoring

As the last step, risks have to be monitored regularly. The identification and steering of risks is important and the fundamentals of successful Risk Management. However, after

the risks have been minimized, all potential effects on the company have to be borne in mind as consequences of risks might befall the company unexpectedly.⁴⁹

2.2.3 Risk Management strategies

As mentioned previously, the Risk Management ensures that the companies’ risk policies are put into action. Apart from this, enterprises in general pursue four different strategies as a part of the risk steering to manage future or existing risks:

1) risk avoidance
2) risk reduction
3) risk limitation
4) risk retention.

Above shown list can be interpreted as a chain of successively applied Risk Manage- ment strategies. Nevertheless, every strategy can be applied irrespectively of each other.

Risk avoidance

By pursuing the first (defensive) strategy the companies try to find the source of every single risk and avoid it. As a result, chances to yield further profits are eliminated by this way. In other words, risk avoidance leads to cause-related evasive actions in regard to sources of risks and risk-causing factors.⁵⁰

Risk avoidance can be carried out actively and/or passively, whereas risks are controlled purposefully in the scope of active avoidance. Passive avoidance is restricted to take actions for moderating the consequences of potential risks and losses, so that economic damages can be moderated. This can result in setting aside reserves for instance. As previously mentioned, avoiding risks and sources of risks certainly eliminate various chances for yielding profits.

On the other hand, severe risks are avoided. If the companies are threatened by severe negative impacts, chances to yield profits are lower than suffering losses in the majority of cases. From this point of view, risk avoidance is sensible.⁵¹

Risk reduction

Enterprises counter underlying business and identifiable risks with appropriate strategies and approaches to manage the risks, whereas these are not completely shifted.⁵² It depends on the applied approach for managing risks how far they can be reduced. Risk reduction is more flexible as more attention is paid to potential chances and therefore, this strategy is more often applied as risk avoidance in practice.⁵³

In general, it can be utilized by making long-term business contracts, employing suffi- cient staff etc.⁵⁴ In addition, risk reduction is applied by establishing risk limits that can be regarded to trading volumes or assets’ potential losses.⁵⁵ Uncertain risks are not eliminated completely but reduced to an acceptable level, as eliminating all downside risks (risk) lead to eliminating all upside risks (chance) in most cases. Thus, companies are enabled to make risky business and take appropriate actions for managing the risks simultaneously.⁵⁶ The reduction can be carried out by cause-related actions like the oc- currence probability of risks (prevention of damages) and effect-related actions (reduc- ing the severity of damages). Last actions have to be carried out if damages influence the balance sheet of the enterprise.

Risk limitation

The strategy is divided into risk shifting and risk dispersion.⁵⁷ First of both defines the action where the risks are shifted factually/contractually and partly/completely to third parties. The shifting is defined as generating risky business deals combined with further counter-business, that transfers the risks completely or a majority part to third parties. Additionally, risk shifting does not eliminate the risks but causes the accepting party being changed. It is divided into insurance risk transfer and non-insurance risk transfer. First of both is a common way to shift risks, where the insurance takers are able to transfer the risks to the insurance company by paying a risk premium. The riskier the business is the higher is the risk premium. The risk premium’s value depends on the potential threat, percentage excess and how far actions have been taken for preventing the risks.⁵⁸

Nevertheless, taking insurances is the most expensive way to manage risks. Taking valid insurances neither influences the occurrence probability of the threat, nor do they provide with the guarantee that risks are completely covered. The sources of risks are not eliminated but do not certainly endanger the insurance taker.⁵⁹

Non-insurance risk transfer can be managed by general or specific contractual conditions so that risks (even non-insurable risks) can be transferred to the business partners. It is self-explanatory, that it depends on the companies’ negotiation power in which way and how much risk is shifted to their contract partners. The more risks are shifted the more important it is for the company.⁶⁰

Risk dispersion is linked closely to the Portfolio Theory and describes how price risks of portfolios can be managed in regard. The theory states that the more portfolios are diversified by different assets, the higher is the chance that losses of one asset can be compensated by profits of other assets.

Risk retention

The companies usually only accept risks consciously if the Risk Management leads to disproportional efforts, the risks are less important and the remaining risks are monitored permanently. The risks that remain after applying the three previously mentioned risk strategies have to be monitored professionally and systematically by the risk moni toring that is explained in chapter 2.2.2.⁶¹ Furthermore, the companies have to take active precaution if the risks occur actually (setting aside reserves).⁶²

The Risk Management Committee

Another strategy to handle risks in companies is the Risk Management Committee that has to be viewed isolated from previously mentioned risk steering strategies. This committee unites the integrated systems of controlling, monitoring and steering all en- trepreneurial risks. The responsibility contains among others the ongoing development and adjusting of the Risk Management in regard to changing markets and risk situations as well as the modification and integration of new risk steering measures and regula- tions. The committee monitors the operative business consults the management board as a staff panel, gives recommendations and provides with assistance in regard to take counteracting measures for protecting company’s survival.⁶³

The Risk Management Committee has to be certainly independent and needs the authority to issue recommendation which have to be taken into consideration and must not be ignored. However, the meaning of experts is divided as some claim that the RMC needs the authority to issue directive, whereas other experts intend to award just an advisory character to the RMC. Additionally, it is recommended by literature that the group consists of the independent chairman, legal adviser, financial manager, risk manager(s) and the head of the accounting department.⁶⁴

2.3 Financial versus commodity positions and related risk reduction

2.3.1 Differences between financial and commodity positions

Positions can be divided and categorized by underlying assets, liquidity or point of view among others. In general, positions can be divided into sale positions (short positions) and purchase positions (long positions). Sale positions are contracts where the seller or holder does not yet possess the underlying asset that the buyer has purchased.

illustration not visible in this excerpt

Figure 3: Sale positions and related price risks⁶⁵

In this regard, sale positions mostly can be understood as sales contracts with an explic- itly determined and mostly fixed delivery date (commodities) respectively time to expi- ration (for financial instruments) in the future. Therefore, the seller is provided with some time to buy or stock up on the sold asset, whereas the remaining time obviously depends on the delivery date/time to expiration. The price risks that arise from sale positions can be seen in above provided figure.

By contrast, purchase positions are contracts where an asset is bought and held. This is the simplified, strict definition for the financial sector. However it is less valid for the non-financial sector in the majority of cases.⁶⁶ In the financial sector, purchase positions can be regarded as buying a specific quantity of shares or other financial assets. A cou- ple of such positions with underlying financial assets form a portfolio. In the non-financial sector purchase positions can be regarded as contracts where assets are bought and then held by the company. However, for bought assets it is not clarified who will eventually buy and use the asset and a potential buyer has to be found. At the best a buyer is found till the assets are delivered by the provider from a trading com- pany’s point of view.

The previously mentioned group of positions can also be interpreted as portfolios in the non-financial sector. By contrasts to the financial sector, positions are not held for diversifying price risks through correlation advantages according to the risk dispersion, but make use of advantageous prices or satisfy potential customers’ demand.

illustration not visible in this excerpt

Figure 4: Purchase positions and related price risks⁶⁷

However, purchase positions in the non-financial sector are often more than just pur- chasing the underlying asset, but even a purchase contract from traders’ point of view, whereas the potential end-buyer of the asset is undetermined. Therefore, as the non- financial sector is reflected a buyer for the commodity has to be found, so that the trader is not obliged to take the delivery without having a consumer.⁶⁸ The price risks that arise from purchase positions can be seen in above provided figure. Commodities as underlying assets are goods which are supplied by different producers and are usually offered with a standardized quality and in demand by large number of consumers. Goods like different kinds of food for example, grain or cattle as well as other various kinds of raw materials like sources of energy (coal, crude oil etc.) are ranked up among commodities.⁶⁹

In today’s business, commodities are subject of the process of commoditisation. The commoditisation is the process by which the traditional trading practices based on long- term contracts are being replaced by short-term markets. Spot prices of long-term con- tracts do not always correspond to current supply and demand situations directly, but prices of short-term contracts are driven directly by supply and demand.⁷⁰ The commoditisation means that markets for commodities are changed from direct trad- ing to spot markets respectively OTC⁷¹ markets as well as stock exchange trading.⁷² As a basic prerequisite for trading in OTC markets or stock exchange trading, the com- modities have to be standardized to make them more transparent and provide liquidly as well as supply commodities with homogeneous specifications.⁷³ Commodities can be characterized by various and different specifications that all influences the pricing of such commodities. The fewer goods are standardised the more time and expenses are required for taking all characteristics into account and the less liquid are these underly- ing commodities. In result, many OTC markets would therefore lose interest in such goods. The process of commoditisation of some commodities is partly still in its in- fancy, so that traded goods are still less standardized.

This is the most important difference between new emerging physical commodities and financial positions. Financial positions are relatively standardized (like swaps⁷⁴ ). But commodities in practice are less standardized and need to be pushed into this direction.⁷⁵ Besides standardization, the value drivers of both kinds are different. Due to the fact that the limited content of this diploma thesis might be exceeded by mentioning the value drivers of all financial underlying assets, the value drivers of options⁷⁶ shall be depicted briefly.

The sensitivity factors of options’ value drivers are also called the Greeks, as all sensitivity factors are abbreviated by Greek letters. These factors show the value drivers of options that can be a component of financial positions:⁷⁷

− asset price (sensitivity factor: delta į)
− time to expiration (sensitivity factor: theta ș)
− volatility of underlying asset’s price (sensitivity factor: vegaorzetaȗ) − interest/risk-free rate (sensitivity factor: rhoȡ)
− exercise price

The value of options is lastingly influenced by the price of the underlying asset - the market price (current price) - which is called basic price as well. In other words, the conditions of options depend on the markets’ price quotation for the underlying asset, which cannot be foreseen easily in general. The basic price is determined by share prices or share indices for instance.⁷⁸ The delta of an option that is the sensitivity factor for the asset price reflects the dependence of the option price upon the price (quotation) of the underlying asset like shares and time values.⁷⁹

The time to expiration is the term of the option with a fixed maturity date. The time pe- riod influences option prices and the trends in option prices can be partially indicated as a function being dependent on the time.⁸⁰ The option theory additionally states that the premium is larger the longer is the time to expiration.⁸¹ The sensitivity theta describes daily losses in the value of an option, with decreasing time to expiration and decreasing influence of the losses in value on the option price, the more market and basic price are diverging.⁸²

Another option price influencing factor is the volatility of underlying asset’s market price. The price volatility influences the option price and more risk premium has to be paid with increasing risk.⁸³ The higher is the implied volatility of the option the higher will be the premium.⁸⁴ The sensitivity factor vega of option positions is a measure for fluctuations in volatility and is decreasing, the more market and basic price are diverging and the lower the time to expiration is.

The interest or risk-free rate of an option influences the price of an option as well. The rho is the sensitivity measure that reflects the dependence of an option based on changes in interest/risk-free rates.⁸⁵ Additionally, the market prices influence the option price.

Derivatives, the name of the category containing options, swaps, futures⁸⁶ etc. are influenced by psychological factors. In some cases good respectively bad news improve/pressurize future prices for instance.

Commodities imply partly the same influence factors like the price of the underlying assets where the price of the assets themselves is meant in this case. However, commodities are partly fraught with different influencing factors that are based on effects of the macroeconomic, psychological factors and in some cases even weather. Due to the fact that commodities are influenced by many and various value drivers, only the most important are listed up in the following:⁸⁷

− economic growth
− supply and demand situation
− psychological factors
− production capacity
− stockpile situation
− weather/seasonal fluctuation

First of all, economic growth is one of the most important value drivers as the growth in economy generally reflects a growth in population and increasing in the output of goods and services per capita. Due to the key role of commodities, especially food and other agricultural goods as well as sources of energy are needed in every household, eco- nomic growth can be determined in this way. Therefore, increasing electricity consump- tion is an indicator for economic growth, because increasing of electricity results in in- creasing demand for sources of energy. Growth rates in electricity that prevail in the markets of industrialized countries can be seen in the following table.

According to this, the demand for commodities generally grows so that the prices for appropriate assets change. Prices might also decrease correspondingly, in case of decreasing demand as a result of decreasing economic growth.⁸⁸

As previously discussed, the supply and demand situation influences commodity prices significantly. Steeply rising demand (especially on short-term basis) leads to steeply escalating commodity prices.

illustration not visible in this excerpt

Table 1: Consumption of electricity in the OECD countries 1960 - 2002⁸⁹

Considering long-term oriented demand, producers are spurred to extend production so that the supply situation leads to falling prices.⁹⁰

One further important value driver of many commodities are psychological factors.

[...]

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¹ Cp. Kolluru, R. (1996), p. 1.4.

² Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 4-1.

³ Cp. Reichmann, T. (2001), p. 599.

⁴ Cp. Zentes, J., Swoboda, B. (1998), p. 9 et seq.

⁵ Cp. ibid., p. 13 et seqq.

⁶ Cp. Eydeland, A., Wolyniec, K. (2003), p. 5.

⁷ Cp. Reichmann, T. (2001), p. 599.

⁸ Cp. Wharton, F. (1992), p. 4.

⁹ Cp. Palupski, R. (2003), p. 3.

¹⁰ Cp. Perridon, L., Steiner, M. (2002), p. 100.

¹¹ Cp. Reichmann, T. (2001), p. 607.

¹² Cp. Merbecks, A. et al. (2004), p. 24.

¹³ Cp. Palupski, R. (2003), p. 34.

¹⁴ Cp. Reichmann, T. (2001), p. 611.

¹⁵ Cp. ibid.

¹⁶ Cp. Ziegenbein, K. (2004), p. 59.

¹⁷ Cp. Kendall, R. (1998), p. 163.

¹⁸ Cp. Locarek-Junge, H. (1998), p. 202; Bergschneider, C. et al. (2001), p. 220.

¹⁹ Cp. Gleason, J. T. (2001), p. 70.

²⁰ Cp. http://www.steunenberg.de/deriv.html, dated 18 June 2005.

²¹ Cp. Bayrische Hypo- und Vereinsbank AG (2004), p. 6.

²² Cp. Gleason, J. T. (2001), p. 70.

²³ Cp. Benz, A. (2004), p. 3.

²⁴ Cp. Bergschneider, C. et al. (2001), p. 225.

²⁵ Cp. Horváth, P. (2002), p. 779.

²⁶ Cp. Kirchner, M. (2002), p. 18.

²⁷ Cp. Ansell, J., Wharton, F. (1992), p. 12.

²⁸ Cp. Mobius, M. (1995), p. 14 et seq.

²⁹ Cp. Reichmann, T. (2001), p. 600 et seq.

³⁰ Cp. Leech, T. J. (2003), p. 1 et seqq.

³¹ Cp. Gleason, J. T. (2001), p. 273.

³² Cp. Ziegenbein, K. (2004), p. 58.

³³ Cp. Reichmann, T. (2001), p. 609.

³⁴ Cp. Schmidt, R. H., Terberger, E. (1997), p. 292.

³⁵ Following to: KPMG (1998), p. 9.

³⁶ Cp. Ziegenbein, K. (2004), p. 58.

³⁷ Cp. ibid.

³⁸ Cp. Reichmann, T. (2001), p. 610 et seq.

³⁹ Cp. Pfennig, M. (2000), p. 1310.

⁴⁰ Cp. Romeike, F. (2003a), p. 174 et seqq.

⁴¹ Cp. ibid.

⁴² Cp. Reichmann, T. (2001), p. 612.

⁴³ Cp. Ziegenbein, K. (2004), p. 59 et seq.

⁴⁴ Cp. Horváth, P. (2002), p. 782.

⁴⁵ Cp. Reichmann, T. (2001), p. 613.

⁴⁶ Cp. Horváth, P. (2002), p. 782.

⁴⁷ Following to: Reichmann, T. (2001), p. 614.

⁴⁸ Cp. Reichmann, T. (2001), p. 614.

⁴⁹ Cp. Reichmann, T. (2001), p. 617.

⁵⁰ Cp. Wolf, K., Runzheimer, B. (2003), p. 90.

⁵¹ Cp. Diederichs, M. (2004), p. 189.

⁵² Cp. Reichmann, T. (2001), p. 615.

⁵³ Cp. Wolf, K., Runzheimer, B. (2003), p. 90.

⁵⁴ Cp. Ziegenbein, K. (2004), p. 64.

⁵⁵ Cp. Schierenbeck, H. (1999), p. 13.

⁵⁶ Cp. Diederichs, M. (2004), p. 190.

⁵⁷ Cp. Wolf, K., Runzheimer, B. (2003), p. 90.

⁵⁸ Cp. Diederichs, M. (2004), p. 190.

⁵⁹ Cp. Diederichs, M. (2004), p. 192 et seq.

⁶⁰ Cp. ibid.

⁶¹ Cp. Reichmann, T. (2001), p. 617.

⁶² Cp. Horváth, P. (2003), p. 782.

⁶³ Cp. Reichmann, T. (2001), p. 619.

⁶⁴ Cp. Kendall, R. (1998), p. 60 et seqq.

⁶⁵ Following to: internal sources of RAG Trading GmbH.

⁶⁶ Cp. Hull, J. C. (2001a), p. 660.

⁶⁷ Following to: internal sources of RAG Trading GmbH.

⁶⁸ Cp. TFS Energy (2001), p. 5.

⁶⁹ Cp. Bouchaud, J. P., Potters, M. (2003), p. 77 et seq.

⁷⁰ Cp. Bergschneider, C. et al. (2001), p. 89 et seqq.

⁷¹ By contrast to products which are traded at stock exchanges, OTC products are individual (custom- made) products which are offered for example by brokers or banks; cp. Bergschneider, C. et al. (2001), p. 288.

⁷² Cp. Rudolph, B. (1995), p. 6.

⁷³ Cp. Bergschneider, C. et al. (2001), p. 89.

⁷⁴ Two contract parties commit themselves to exchange (swap) a series of interest payments at specified intervals on specified amount, whereas the features of swaps are quite individual; cp. Hogger, M., Kesy, C. (2000), p. 114.

⁷⁵ Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 11-4.

⁷⁶ An option is a contract that entitles to but does not obligates buyers to purchase or sell the underlying asset at a specific price (basic price) and at or till specific date in the future, whereas the option’s buyer has to pay a risk premium for transferring market risks to the seller of the option; cp. Kendall, R. (1998), p. 230.

⁷⁷ Cp. Kendall, R. (1998), p. 230 et seqq.

⁷⁸ Cp. Pechtl, A. et al. (2002), p. 589.

⁷⁹ Cp. Kendall. R. (1998), p. 231.

⁸⁰ Cp. Pechtl, A. et al. (2002), p. 589.

⁸¹ Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 13-3.

⁸² Cp. Kendall, R. (1998), p. 232.

⁸³ Cp. Bergschneider, C. et al. (2001), p. 226 et seq.

⁸⁴ Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 13-3.

⁸⁵ Cp. Kendall, R. (1998), p. 232.

⁸⁶ Future contracts are agreements between two parties with that an underlying asset will be sold or purchased in the future. The holder of the in general highly standardized future contract is obliged to sell/purchase underlying asset; cp. Hull, J. C. (2001b), p. 6.

⁸⁷ Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 3-1 et seqq.

⁸⁸ Cp. Hill & Associates, Inc., Doyle Trading Consultants, LLC (2004), p. 3-1 et seqq.

⁸⁹ Following to: OECD (2004), p. II.253.

⁹⁰ Cp. Kropp, M., Schubert, D. (2000), p. 1244.