Commodity Risk - Country Default and Cross-Asset Market Risk

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The old saying goes, no-risk, no-reward. In another 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 article gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Two risks that are crucial for those trading in the commodity markets are country default risk and cross-asset market risk.

Country Default Risk

Country default risk is the risk that a country will not be able to meet its financial commitments. When a country defaults on a transaction, it can harm the performance of all other financial obligations or instruments within that country as well as other nations with which it has relations. Country default is rare, but it does occur.

I remember back in the early 1990s the company I was working for, a physical commodity trading company, entered into a deal to buy the production of an agricultural commodity from a West African nation. The company advanced funds in a pre-export finance deal and expected to receive the raw material at a pre-agreed price in the future. The price of the commodity appreciated, and the government decided to default on the transaction, selling its output to another market participant at a higher price. This deal that fell apart is an example of a country default, as the state-owned production company was the party that did not honor the contract.

Another issue for businesses or individuals doing business with countries that complicate the matter of country default risk is the issue of sovereign immunity. This concept is that a state or nation is immune from civil suits or criminal prosecution. In many commodity contracts where one party is financing commodity production upfront for future delivery, the financing party often attempts to have the government sign a waiver of sovereign immunity.

However, these nations will only waive this immunity under exceptional circumstances. Aside from a waiver of sovereign immunity, it can be tough to get a country or government to perform on a contract once a default has taken place because political issues tend to take precedence over issues of commerce.

Cross Asset Market Risk

Cross asset market risk is the risk that the impact of changes in the correlation between prices, volatilities, correlations, foreign exchange levels, interest rates or any other variables is beyond acceptable limits. An example of cross-asset mark risk would be a significant movement in an inter-commodity spread. Let us consider the silver-gold ratio. Over the past forty years, the average level of this market relationship is 55:1 or 55 ounces of silver value contained in each ounce of gold value. When the ratio moves above the 55:1 level silver becomes cheap compared to gold on a historical basis. When it moves below silver becomes expensive. There are times when a market participant hedges exposure in one commodity with an opposite position in another related product. A significant long position in gold hedged with a short position in silver would be an example of a cross-asset market risk.

Other examples could be Chicago soft red winter wheat versus Kansas City hard red winter wheat or lean hogs versus live cattle. Each of these examples is within the same commodity sector; therefore, there is some degree of historical correlation. Gold and silver are both precious metals. Chicago and Kansas City wheat are both grains and hogs and cattle are both animal proteins. Many futures exchanges, such as the Chicago Mercantile Exchange (CME) offer lower margin rates through cross margining of one related commodity against another. The futures exchanges validate that these types of transactions are less volatile over time than outright long or short positions. However, these types of spreads often still contain serious risks. Cross asset market risk is, therefore, an important risk to consider particularly for highly diversified portfolios.

On the series three exam, the licensing test for professionals in the futures industry, the same question always appears. The true-false question is a statement: Spreads are less risky than outright long or short positions. The answer is always false, which highlights the importance and relevance of cross-asset market risk.


In 2016, volatility increased across all asset classes. Over the first six weeks of the year, equity prices dropped by 11.5% only to recover and move into positive territory over the months that followed. Many commodity prices climbed higher as the U.S. central bank and others around the world continue to keep interest rates at historically low levels. The lack of an interest rate hike in the U.S. caused the upward momentum of the dollar to stop providing further support to raw material prices. Precious metals rose over the first seven months of the year and entered into a bull market as investors sought safety in an environment of fear and uncertainty.

During 2016, the risk of country default rose in many areas around the world. Negative interest rates in Europe and Japan were a sign of poor economic conditions. Many oil producing nations around the world continued to suffer under the weight of low petroleum prices. In Venezuela, the decline in oil revenues was a primary cause of hyperinflation and food shortages in the nation. In Nigeria, the value of the currency dropped precipitously. These events increase the potential for countries under economic pressure to default on obligations.

Additionally, increasing market volatility resulted in an increase in cross-asset market risks in all assets. The rise in the prices of precious metals occurred in all currencies, a sign that paper money has declined in value which creates another form of cross-asset risk.