The universal principle of the Conservation of Risk
Whilst the management of commodity price risk is generally the most pressing and visible responsibility of a hedging manager it is but one of many sources of risk that must be considered. In addition to this volatility there exist dimensions of uncertainty, complexity, and ambiguity that need to be factored into a strategy. Indeed, the act of hedging itself introduces these other forms of risk into the equation, so hedging should be viewed as an ongoing and dynamic process rather than a static solution. In this paper, we review the wider aspects of risk that a coherent and effective hedging programme will actively consider.
This is a topic we explored in some detail in our first article (Commodities: Risk isn’t always where you expect it to be), and is closely linked to market-price risk. To recap, Basis Risk is the risk that the value of a hedging contract will not move in line with its underlying exposure. When considering which instrument, maturity and reference index to apply in a hedging program for commodity price risk the ramifications of these choices upon the basis risk that arises are paramount. However, although a well-crafted hedge can minimise basis risk, it is seldom eradicated entirely. Why would a hedging counterparty choose to introduce this new risk in the process of eliminating the original risk? Firstly, the basis risk is taken as a trade-off to reduce Liquidity Risk. In nearly every case, each group of commodities markets have developed a single benchmark which concentrates participation into that index generating the necessary liquidity. The remaining price grades, differentiated by location and quality, are then traded in the physical markets by means of applying a positive or negative price-differential to that benchmark. Secondly, basis risk itself is orders of magnitude smaller than outright market price risk since a basis differential is typically a small percentage of the Flat Price. The volatility of that differential is similarly orders of magnitude smaller than the volatility of the flat price. Hence, even in situations where acceptable liquidity exists to transact a hedge in a minor grade, a primary risk-reducing strategy is to convert market price risk into basis risk and then eliminate the basis risk over a longer period of time.
In conclusion, a decision to hedge is driven by a need to protect commodity price risk, and the choice of instrument based on liquidity considerations will introduce an element of basis risk which can be eliminated over time.
For a hedge to be effective the counterparty to that hedge must honour its obligations under it. The risk that the counterparty is either unwilling or unable to meet their obligations is called counterparty risk. This risk is greatly reduced with exchanged-traded or -cleared derivatives as every trade is cleared through a Central Counterparty (CCP), meaning the CCP becomes the seller to every buyer and the buyer to every seller in a transaction. The CCP holds Initial Margin (IM) from both buyer and seller, and then pays or demands Variation Margin (VM) daily according to ongoing variations in market price. In the event that a counterparty fails to meet a VM call the CCP will liquidate the position. The holding of IM is designed to cover any losses that this liquidation might incur due to market moves during the time taken to cure the situation. Should it be insufficient there is a waterfall of backstop provisions that get tapped, including a default fund contributed to by clearing member firms. However, when a hedge is transacted and cleared bilaterally (Over-The-Counter) the buyer and seller face each other directly. Such a trade is typically executed under terms defined by an ISDA Master Agreement, a standardised legal agreement governing derivative contracts. It is further customised by an accompanying schedule, and sometimes a Credit Support Annex (CSA). The CSA can allow for mitigation of counterparty risk by stipulating the terms and conditions under which collateral and VM are exchanged. Counterparties can bilaterally agree an amount of uncollateralised exposure, called a Credit Line, at their discretion. Any losses in the event of default will then be recoverable through normal litigation and creditor processes. An ISDA will also deal with Termination Events, Events of default, Netting, Cross-company liabilities, and Taxation. Why would a counterparty want to assume counterparty risks when they can trade with a CCP on an exchange? Firstly, this is a trade-off between costs and exposure to an entity’s inability to meet obligations. Exchanges will make daily VM calls which can drain funding liquidity whereas OTC transactions can have clean credit lines where no IM or VM is required. Where a a natural internal offset to a counterparty’s ability to pay can be found an OTC transaction may be more advantageous. Secondly, exchanges typically only offer the benchmarks as Underlying Indexes whereas it may be possible to obtain acceptable liquidity in a closer, or even exact Index under an OTC transaction.
Funding Liquidity Risk
In the previous paragraph we showed how counterparty risk can be mitigated with the use of a CCP or CSA. This mitigation generates obligations to make VM payments which give rise to funding liquidity risk (risk of running short of cash to meet obligations). If the hedge scheme has been devised appropriately then VM demands should only arise in situations where the company’s profitability is improving, a situation known as right-way risk. Even in these situations, the operational burden and price of funding this demand still needs to be factored into the cost-benefit analysis during the design stage of the hedge program. Companies for whom cash flow or credit availability are likely to be constrained should opt for hedging strategies that do not require the posting of VM, such as for long call or long put option strategies, or to acquire clean-credit lines under an ISDA type of agreement, if possible.
Market Liquidity Risk
On the subject of liquidity risk, the market liquidity risk of a hedge relates to how quickly the company could initiate or unwind a transaction without materially impacting the market price. As a general rule, the longer the tenor and the more esoteric the derivative, the greater the market liquidity risk of the hedge. In the event of the need to unwind a hedge, its market liquidity risk would manifest either in the need to cross a wide bid-offer spread to transact with a market maker, or in the greater market risk of a longer period of time to execute the transaction piecemeal
This is the risk of losses that arise from the potential unenforceability of, or the unfavourable interpretation of, the agreements governing a bilateral derivatives contract. This is particularly the case when a transaction is of non-standard terms and is traded OTC by entities in different legal jurisdictions. Legal risk is addressed by limiting derivative transactions to standardised products cleared on exchanges that are based in jurisdictions with proven and stable financial law. Legal Risk can also be mitigated by mirroring terms in offsetting transactions and through the inclusion of robust cross-default clauses.
This is the risk of loss arising from the changes in laws or regulations governing the company’s business and financial activity. This is a wide-ranging risk factor, and one that is difficult to mitigate. History is replete with examples of companies caught off-guard by sudden commodity export restrictions or import tariffs. With respect to commodity derivatives specifically, the USA’s Dodd-Frank Act of 2010 had wide-ranging implications for banks in the commodities business. Whilst the final ruling by the CFTC exempted many physically settled commodities derivatives used for commercial business purposes, for a long time this was a source of major uncertainty. As new laws or regulations are enacted compliance to them is often extremely costly, both financially and in terms of senior management’s focus. Other examples of this type of risk with respect to hedging would be if an exchange decided to change margining requirements or position size limits, potentially creating a cash call on the company or requiring the unwind of part of the hedge.
Without special treatment, the gains or losses on the company’s derivative hedges would often not be recognised in the same period or section of the firm’s financial statements as those of the hedged exposure. The aim of hedge accounting is to remove this income statement volatility by pairing the commodity exposure with its designated hedge and treating them as one. However, the accounting treatment of derivative hedges is in continual evolution and so this is another potential source of risk. The last decade has witnessed a move away from International Accounting Standard 39 (IAS39) to the International Financial Reporting Standard 9 (IFRS9). This standard provides a guide to the qualifying criteria for a derivative transaction to be designated as a hedge, as well as associated disclosure requirements. It also enforces subsequent assessment of the hedge’s effectiveness that may lead to required rebalancing or even discontinuation.
This is the risk of losses arising from decisions driven by what turn out to be inaccurate models and assumptions. For instance, a basis-risk may be deemed acceptable using historical correlations between two assets that turns out to bear no relation to the future price relationship. Or a model, projecting future mine production volumes, may contain approximations and assumptions that lead to an incorrect hedge volume being transacted.
A common theme has emerged over the course of this article: the measures taken to reduce one form of risk tend to produce new risks elsewhere. For example, market risk is transformed into basis risk, counterparty risk, and liquidity risk. Counterparty risk transmutes into funding liquidity risk and legal risk. One might say there exists a universal principle of the Conservation of Risk which stipulates that risk can only be transferred or transformed but not destroyed.