Commodity Risk - Mapping, Modeling, and Operational Risks

Businessman rolling dice by building with world map
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In an earlier article, I gave an overview of the topic of risk in commodity markets. In that piece, I described the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Three risks that are very important for those trading in the commodity markets are mapping, modeling. and operational risks.

Mapping risk can be a complicated affair. Many commodity deals have different components. Sometimes there are financing considerations as part of a deal. At times, logistics or transportation plays an important role in the ultimate satisfaction of the deal. Since commodity production often occurs in one location around the globe and consumption in another, governmental laws, rules, and regulations are an important component of many transactions. Of course, the transfer of the raw material from seller to buyer at a price also constitutes a risk. Each risk carries a cost. Mapping risk is, therefore, the risk that the map of the transaction from initiation to settlement flows in the fashion originally contemplated by both the buyer and the seller. As an example, a pre-export finance copper transaction between a buyer in China and a seller in Peru may entail providing funds up front, pricing on a market-based formula, shipping the metal from the South American nation for delivery at an arrival port on the Chinese coast.

This deal has many levels of risk. The ultimate price for the copper transaction reflects those risks. The mapping risk is the risk that the entire deal works as the parties anticipate. Think of the deal as a finished jigsaw puzzle and the components as the pieces that make up the whole.

Modeling risk is the risk that pricing, hedging or any quantitative model misrepresents anticipated results.

Pricing of derivatives is a mathematical endeavor. The formulas, programs or other quantitative aspects of pricing and monitoring risk are key aspects of the potential profitability of a commodity deal. One mistake can turn a profit into a loss. A wrong price can lead to financial disaster. The bigger the transaction, the more risk because a small mispricing can result in magnified results. As an example, consider an airline looking to hedge jet fuel consumption on a long-term basis. If the airline makes a mistake in the calculation of the forward price and it is above the market, that airline will overpay for the fuel putting it in a less competitive position than other airlines. The effects of a less competitive position may create a financial disaster. A mistake in the construction of a forward curve on an intra-commodity spread with a counterpart could cause one party to lose millions.

The final risk to consider is operational risk. This is the risk that a system or process fails to operate in order to support a transaction or a business. Operational risk includes the performance of actual computer systems but it can also mean the other processes necessary to meet business obligations.

If a ship is unable to dock at a port on an agreed upon date because paper work is not in order this would constitute an operational risk. The inability to remit funds on an agreed upon date due to a problem with instructions or a mistake by an employee would be an operational problem.

Mapping, modeling, and operational risk are three different levels of risk when it comes to the commodities business. Mapping is a risk that involves the initial construction of a transaction, a trade or a contract that maps out all responsibilities of the parties and eventualities that pertain to that transaction. Proper mapping ensures that pricing is commensurate with risk. Modeling is associated with the risk of pricing the actual deal and monitoring it during the life of the transaction. The initial price often depends on a proven quantitative model and the mark-to-market for margin and monitoring purposes is an important aspect of risk management.

Operational risk is the risk of executing the transaction. In every transaction, each party has a responsibility to meet their operational responsibilities.