Commodity Trading & Risk Management
Commodity trading involves many risks of loss, which financial market participants such as banks, hedge funds and insurance companies seek to prevent. Commodity transactions also may involve nonfinancial companies, such as airlines or farms, that engage in trading activities to hedge (protect) against losses due to unfavorable price changes.
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Commodity Defined
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A commodity is an economic good, like corn, fuel, milk or gold, that is bought and sold on a securities exchange. A commodity also can be nonphysical, such as electricity. A financial institution, such as a bank, a private equity firm or a hedge fund, may buy or sell a commodity with a profit motive. This practice is called speculative trading. A nonfinancial company may engage in commodity trading to avoid losses if prices move unfavorably.
Commodity Trading Regulations
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An institution that engages in commodity trading activities must comply with regulatory requirements, depending on products traded, industry, corporate legal status and transaction characteristics. For U.S.-based business partners, transaction documents may have to conform to rules promulgated by the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) or the Commodities Futures Trading Commission (CFTC). International transactions may need to adhere to International Swaps and Derivatives Association (ISDA) agreements.
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Risk Management
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Risk management is a business practice that helps a corporation's top management avoid losses in operating activities. Risk management techniques ensure that internal controls, procedures and guidelines in commodity trading systems are adequate and functional. They also ensure that controls conform to senior management's recommendations, commodities regulations and industry guidelines. A control is a set of instructions that managers put into place to limit losses due to error, neglect or technological malfunction. Risk management tools include internal audit reviews, segment controls and market or credit risk computer models.
Market Risk
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Market risk originates from unfavorable changes in commodities on securities exchanges. Price variations also may relate to currency rate changes. A commodity market risk manager applies complex statistical methods, such as VaR (value at risk), stress testing and Monte Carlo simulation, to identify, assess and monitor risks inherent in a company's commodity trading activities. For example, a junior risk manager at a gold trading desk may note that the desk's average VaR for the week is $52 million.
Credit Risk
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Credit risk arises if a business partner (also called counterparty) engaged in a commodity transaction is unable to reimburse a loan or meet other financial commitments when they become due. A counterparty may default because of bankruptcy or temporary financial problems. A credit risk manager typically applies math-based tools and computer models, such as worksheets and financial statements, to rate counterparties as high, medium or low based on expected losses if they default.
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