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Practicalities of use of price risk management Practicalities of use of price risk management marketsmarkets

Strategic aspects of price risk management Company control and management issues Some examples of typical abuses

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Risk

Why does price risk matter?

Reduces predictability

Can lead to unpleasant surprises

Leads to conservative behaviour: less investments, incl. by farmers

Exports

Imports

Investments

Government budget

Strategic aspects of price risk managementStrategic aspects of price risk management

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Unexpected price developments have an impact on economic development. For example:

Oil price increases

Oil import bill increase

Pressure on the currency

Pressure on the government budget

Oil import rationing

Crowding out of other imports

Worsening of debt service capacity

Increase in energy and transport

costs

Pressure on energy-intensive industriesThe terms of trade of farmers producing export crops deteriorates

Public transport requires even larger part of the expenditure of the poor

Social and political unrest


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The capacity to manage price risk creates improved predictability and makes it possible to avoid many potential bad surprises.

The markets for price risk management are very liquid for many, but not all commodities. The cost of “insuring” one`s price risk exposure on liquid markets is very low.

Main problem: lack of capacity of many entities to access these markets.

Many price risks can be managed


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ContentsContentsStrategic aspects of price risk managementStrategic aspects of price risk management

RISK MANAGEMENT IS NOT A ZERO-SUM GAMERISK MANAGEMENT IS NOT A ZERO-SUM GAME

With risk management:With risk management:

• Managers can focus on the real issues for their Managers can focus on the real issues for their company/ department instead of worrying about price company/ department instead of worrying about price levels.levels.

• Capital can be more efficiently allocated.Capital can be more efficiently allocated.

• Credit can be obtained with better conditions and Credit can be obtained with better conditions and better leverage for one own’s funds. better leverage for one own’s funds.

Don’t look at risk management in isolation, it Don’t look at risk management in isolation, it should be part of the overall company should be part of the overall company strategy.strategy.

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ContentsContentsStrategic aspects of price risk managementStrategic aspects of price risk management

100 100

Actual contribution

ALM improvement

Better use of resources

Increase of Margins/

Volumes with actual clients

Increase of profitability for new products /

clients

Non quantitative

factors

Performance enhancement

potential

2010

158

2

55

Example of expected improvements

Managing risk to maximize performance

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The use of the new financial tools has increased fast this The use of the new financial tools has increased fast this past decade. Some companies have used these tools past decade. Some companies have used these tools carelessly resulting in some spectacular losses.carelessly resulting in some spectacular losses.

Company Control and Management IssuesCompany Control and Management Issues

Examples:

One Asian Central Bank lost of all of its foreign currency reserves (80 million US$) in 3 months.

A Latin American mining company lost over 200 million US$.

An African bank lost 30 million US$.

Several European and Japanese companies (including Barings, Metallgesellschaft, Sumitomo and UBS) lost many hundreds of million US$, and in a few cases, over 1 billion.

Examples:

One Asian Central Bank lost of all of its foreign currency reserves (80 million US$) in 3 months.

A Latin American mining company lost over 200 million US$.

An African bank lost 30 million US$.

Several European and Japanese companies (including Barings, Metallgesellschaft, Sumitomo and UBS) lost many hundreds of million US$, and in a few cases, over 1 billion.

Examples Examples

UNCTAD secretariat; based on “Company control UNCTAD secretariat; based on “Company control and management structures”, 1996, report and management structures”, 1996, report

funded funded by the Government by the Government of Switzerland and the Singapore Commodity of Switzerland and the Singapore Commodity

ExchangeExchange

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Use of risk management Use of risk management instruments is not for the instruments is not for the uninitiated or those newly uninitiated or those newly introduced to the conceptintroduced to the concept

The company or The company or organization organization must decide must decide

what it wants to what it wants to do with the do with the instrumentsinstruments

Traders must Traders must have been told have been told what they are what they are allowed to doallowed to do

A proper A proper control and control and monitoring monitoring

system has to be system has to be set up.set up.

Then a large-scale use should start only after a Then a large-scale use should start only after a training and “experiment” phase which can easily training and “experiment” phase which can easily last for more than one yearlast for more than one year

If done inexpertly, use If done inexpertly, use of market-based of market-based instruments may instruments may enlarge a company’s enlarge a company’s risk exposure rather risk exposure rather than limit it.than limit it.


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To what To what risks is the company risks is the company exposed ?exposed ? Define the strategy of Define the strategy of

risk management risk management (which risk (which risk management instruments can management instruments can help to attain corporate goals help to attain corporate goals and avoid the risk)and avoid the risk)

Strict rules for Strict rules for the tactical use of risk the tactical use of risk management have to be management have to be defineddefined A proper A proper

corporate structure has corporate structure has to be created in order to be created in order to control the use of to control the use of risk management toolsrisk management tools

11

22

33

44

These are the These are the different stages different stages a company a company should pass should pass through in order through in order to have an to have an efficient risk efficient risk management management programme, with programme, with sound company sound company controls.controls.


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Market-based price risk management Market-based price risk management can bring three kinds of problemscan bring three kinds of problems

IncompetenceIncompetence SpeculationSpeculation AbuseAbuse

Human error and Human error and omissionsomissions

Bad choice of toolsBad choice of tools

Bad choice of option Bad choice of option strike pricesstrike prices

Timing problemsTiming problems

By being too much By being too much confident in the confident in the market’s trendmarket’s trend

To cover some To cover some previous mistakes or previous mistakes or losseslosses

Fraud and white collar Fraud and white collar crime (crime (i.e.i.e. capital capital flight,flight, embezzlementembezzlement))

To prevent misappropriation, fraud, error or risk-enlarging To prevent misappropriation, fraud, error or risk-enlarging use of risk management instruments, it is essential to set up use of risk management instruments, it is essential to set up a good company-level control structure before use startsa good company-level control structure before use starts

These risks should not be These risks should not be underestimated, and one underestimated, and one should not lightly start to should not lightly start to become active in risk become active in risk management markets.management markets.


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SpeculationSpeculation

The temptation to speculate The temptation to speculate with the company’s money is with the company’s money is very large, becausevery large, because

Successful speculation Successful speculation brings large profits with brings large profits with direct reward for those direct reward for those responsible responsible (public (public recognition, promotion, recognition, promotion, large salary increases…)large salary increases…)

A faulty speculation A faulty speculation doesn’t cost the individual doesn’t cost the individual much moneymuch money

Speculators’ optimism Speculators’ optimism usually makes the usually makes the problem largerproblem larger

A speculator may hope A speculator may hope that he will be able to that he will be able to hide losses long enough hide losses long enough to allow him to make a to allow him to make a profit sufficiently high to profit sufficiently high to offset these lossesoffset these losses

To avoid risk, it To avoid risk, it would be naive to would be naive to simply rely on an simply rely on an individual’s sense individual’s sense of responsibilityof responsibility


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Managers dealing Managers dealing with losses only with losses only when they are when they are

discovereddiscovered

Opportunity Opportunity presenting itselfpresenting itself ++

Large Large losses due losses due to fraudto fraud


Fraud can Fraud can however easily however easily be avoided by:be avoided by:

Listening to Listening to rumoursrumours

Limiting as much Limiting as much as possible the as possible the

opportunities for opportunities for fraudfraud

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The risk management disasters of the 1990s have a number of The risk management disasters of the 1990s have a number of factors in common. These factors are nothing new, as similar factors in common. These factors are nothing new, as similar management problems have led to large losses in real estate management problems have led to large losses in real estate lending and in letters of credit financing in the past.lending and in letters of credit financing in the past.


E.g., option premiums are E.g., option premiums are reported as real profits; or losses reported as real profits; or losses are carried over from one year to are carried over from one year to

the next.the next.

While systems were put in place, While systems were put in place, the control philosophy never the control philosophy never

became part of the company’s became part of the company’s way of operating. way of operating.

FLAWED MONITORING FLAWED MONITORING SYSTEMSSYSTEMS

FLAWED MONITORING FLAWED MONITORING SYSTEMSSYSTEMS

INATTENTIVE INATTENTIVE MANAGEMENTMANAGEMENT

INATTENTIVE INATTENTIVE MANAGEMENTMANAGEMENT

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Too often, blind trust in one Too often, blind trust in one person has replaced prudential person has replaced prudential

controls and limit-setting. controls and limit-setting. Managers are often afraid to reign Managers are often afraid to reign

in successful traders. in successful traders.

BLIND TRUSTBLIND TRUSTBLIND TRUSTBLIND TRUST

It can be highly tempting to It can be highly tempting to speculate with the company’s speculate with the company’s

money. If things go wrong, one money. If things go wrong, one can blame the markets or the can blame the markets or the

sellers. sellers.

EVASION OF EVASION OF RESPONSIBILITIESRESPONSIBILITIES

EVASION OF EVASION OF RESPONSIBILITIESRESPONSIBILITIES

If overly complicated instruments If overly complicated instruments are selected, managers often do are selected, managers often do

not know how to react when not know how to react when things start going wrong. things start going wrong.

LACK OF COMPREHENSIONLACK OF COMPREHENSIONLACK OF COMPREHENSIONLACK OF COMPREHENSION

In some cases, one single person In some cases, one single person or group sets policy, executes or group sets policy, executes

transactions, monitors transactions, monitors performance and controls the performance and controls the

funds. funds.

NO SEPARATION OF NO SEPARATION OF TRADING, ACCOUNTING TRADING, ACCOUNTING

AND CONTROLAND CONTROL

NO SEPARATION OF NO SEPARATION OF TRADING, ACCOUNTING TRADING, ACCOUNTING

AND CONTROLAND CONTROL

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Are all instruments Are all instruments dangerous to use?dangerous to use?

No. There are:No. There are:

* instruments for one-off * instruments for one-off strategic risk strategic risk managementmanagement

* instruments for active, * instruments for active, day-to-day useday-to-day use

Relatively Relatively safesafe

Can be Can be dangerousdangerous


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Conclusion:Conclusion:

Companies/countries should use the Companies/countries should use the instruments that go with their needs, instruments that go with their needs, and avoid instruments they cannot and avoid instruments they cannot control. There are relatively safe control. There are relatively safe instruments (one-off swaps, options), instruments (one-off swaps, options), and more complex ones which require and more complex ones which require active monitoring. active monitoring.


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ContentsContentsSome examples of typical abusesSome examples of typical abuses

Most of the well-reported trading losses were the result of deliberate speculation by individuals who were able to go ahead due to a complete failure of supervision.

E.g., Barings – the same person who traded also reported on the results of the trade, and was able to manage the day-to-day financial implications of these trades (even when he requested much more funds for his trading, senior management did not become suspicious).

In other cases, senior management itself was speculating. E.g., MG Corp. (the US subsidiary of Metallgesellschaft). Massive speculation on the forward curve of oil prices and no consideration of the costs of maintaining positions.

In other cases, individuals lost relatively small amounts of money. But determined that if they had declared it, they would be fired. Therefore they kept doubling their debt over and over as long as senior management ignored it. Small losses could thus grow to huge ones. E.g., Codelco, Chile. In some cases, senior management in the company was itself responsible – e.g., the rolling forward of Yen-US$ forwards by Japanese oil companies.

But traders have always shown great initiative in finding new ways to abuse the system. After all, the risk-reward ratio can be quite attractive.

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Mis-allocating trades

A trader is able, at the end of the day, to allocate trades either to his company account or to his private account.

Simultaneous purchase and sale of identical contracts.

And then, when it is clear which position is profitable, which loss-making, allocate these to particular accounts. For example:

- to avoid taxes, allocate profit-making position to offshore account.

- to bribe persons, allocate profit-making position to their account.

This has been a rather common practice, but tax authorities in developed countries have become wise.

Deliberately mis-pricing inter-firm trade

E.g., one individual owns 100% of company A and 51% of company B. He can initiate complex transactions between A and B which are deliberately mis-priced in A’s benefit.

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Front-loading

Swaps can be structured in such a way that they have the same expected payment flow as a loan. That is, funds are coming in now and it is expected that funds will flow out in the future.

Swap price

Forward price curve

With a floating-for-fixed swap, one can expect to receive funds now….

But to have to pay them back later.

This has been used to avoid corporate controls in lending (e.g., in the case of Sumitomo, by its copper trader to avoid senior management detection of his losses in copper trade), or to avoid government control on foreign lending.

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Selling options to boost earnings or reducing losses, without reporting the risks

This is possible if the company has a poor accountancy system. It has been used quite frequently by traders to avoid end-of-year losses. Proper marked-to-market accountancy would prevent this from happening.

Mis-stating option values

Particularly for exotic options, it is difficult to have a fair valuation – different systems give different values, and each of these values may differ from the actual value in the market. The best way to reduce the risk of a deliberate mis-pricing of option values is to separate the responsibilities of trading these options, and those of valuing them.

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Rolling positions forward at historic prices

This has for a long time been a popular measure in Japan to hide losses (and when these finally came out because banks were no longer willing to take the credit risk, a few losses of over 1 billion US$ were reported). Proper marked-to-market accountancy would prevent this from happening. Most countries now have rules banning the rolling of positions at historic prices, or prescribing their use (e.g., such rolling is only possible if senior management has given its explicit approval).

Not counting the cost of money

If a company does not recognize the cost of money in its treatment of derivative gains and losses, an unscrupulous trader could, by turning over a massive volume of funds, appear to make large profits.

E.g., buy a 3-months treasury bill today, sell it tomorrow – if rates have not changed, he will make a small profit (less time to maturity).

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