Page 1

sals.a Educational Research December 2008 sals.a Educational Research is a regular publication offering practical information about risk management using derivatives. The numerical examples in this

document can be viewed on the website (under DEMO) and field-tested using your own actual figures: It pays to know! This issue focuses on Risk Management – dead or alive? Primer: The fundamentals of diesel hedging, Part 1 Primer: Cross currency swaps, Part 1

KFPD GmbH An der Welle 4 60322 Frankfurt Deutschland Managing Director: Mr. Lauri Karp Telephone: +49-(0)69-7593 7732 E-mail: service@kfpsalsa.de Frankfurt Local Court HRB 81098 USt-ID: DE 256618623

Risk Management – dead or alive? www.kfpsalsa.com/news

The age of "decision deflation" is here: shock in the wake of the abrupt economic collapse has left consumers wary, believing market conditions for an important purchase could be more favourable tomorrow. And, decision makers in the financial industry are not immune to this. The back and forth arguments about the risks of derivative transactions results in the same sort of decision gridlock. The thin capital base of many non-listed companies continues to be chipped away by unexpected movements in the financial markets. Dealing with the effects of this volatility and affording companies more flexibility in operational decision-making is the main benefit of risk management. So, it would seem that risk management is alive and well – right?

by the governments in many places, long-term thinkers are planning for “inflation”, while the market responds to “deflation”. Lower commodities prices and a reduction in economic investments are fuelling fears of a resurgence in upward price pressures. Rejoicing about dollar strength is dulled by premonitions of the next dollar collapse. These contradictions present the clearest argument in favour of using derivatives for hedging purposes. “It takes two to tango!” But there has never been a shorter list of banks willing to take part in such transactions. The insistence with which companies are inviting bankers to the dance floor, is equalled or surpassed by the banks’ unwillingness to oblige. Thus, it would indeed appear that the answer is: dead – If nobody wants to dance! L.K.

Subjectively speaking, many factors support this view. Given the emergency injections of liquidity

Primer: The fundamentals of diesel hedging, Part 1 www.kfpsalsa.com/demo -> Market data -> “Commodities”.

“Commodities markets are taking a breather” – this is the best way to describe the current development of the oil price. Finance departments, however, cannot afford to take a break, because now is the time to actively consider commodities price management. Commodity price management is often mentioned in the same breath as "intelligent" procurement. And, indeed, securing a supply of materials or fuels is crucial for ensuring problem-free production and logistics processes. Operational measures, however, have their limits:

“Intelligent” procurement can only achieve limited cost savings, as it is impossible to underbid the market Such measures have only a short-term effect, and offer no protection against long-term price trends Fixed-price contracts are inflexible and have a short time horizon of 9-12 months

To supplement activities aimed at ensuring favourable procurement conditions, financial instruments linked to the crude oil or diesel markets can be used. This involves cooperation between the purchasing and finance departments,

Disclaimer The information contained in this document by KFPD GmbH does not constitute an offer for the purchase of securities, and is intended solely for informational purposes. In particular, the information contained herein contains no guarantees or other representations. KFPD GmbH makes no assurance and assumes no liability for the accuracy or completeness of the content. Information and data on interest rate swaps, interest rates, derivatives, currencies and markets, general or future market developments or any other statements about future possibilities reflect only the subjective views and/or assumptions of the author, based on the information available at the time. Any actions carried out on the basis of the methods depicted in this discussion paper are the sole responsibility of the customer. Neither this document nor any of its content should be construed as advice relating to financial or any other matters. It should also not be used a substitute for professional advice. None of the contents may be construed as a recommendation to conclude or avoid certain transactions without obtaining prior advice that takes into account the individual situation of the customer.


sals.a Educational Research - Dezember 2008

since commodities derivatives function in the same way as traditional forward currency transactions or interest rate swaps. Commodity price risk management is based on

2

3

over the past 12 months. The red circles represent the current prices. Figure 2: Change in the price of BRENT crude (1-month vs. 4year forward price)

an understanding of how commodities markets function,

160

Last 52 weeks statistics

140

determination of the right hedging period and

120

setting the minimum benchmark price.

100 Price (USD/BBL)

It must be emphasized that a long-term commodity price hedge via the financial markets is by no means solely the prerogative of large companies. The transactions have come down so much in size that even family businesses and public-sector enterprises can take advantage of these instruments.

80 60 40 20 0

brent spot

Figure 1: Diesel price curve ICE Gasoil 0.1% in USD per metric tonne (12 December 2008) 650,00 600,00 550,00 500,00 450,00 400,00

The Diesel price curve shows the prices that can be realized in the market for various maturities (Dec. 2008-2011). The graphic depicts prices for the 1 diesel grade ICE Gasoil 0.1%. These are called “forward commodity prices” – but should not be confused with a forecast. In general, an upward sloping curve (“contango”) indicates lower demand for diesel, while a falling curve (“backwardation”) is a signal of short supply. The short end of the curve is considerably more volatile than the segments four years out and beyond. Political factors and speculation-related skewing of the supply/demand relationship at the long end of the curve play a minor role. Figure 2 illustrates the spread between the spot price (1 month) and the four-year forward rate for crude 1

The diesel grade ULSD 10ppm is also traded in the market. There is a very high correlation between the prices for this type of diesel and ICE Gasoil. The price difference is roughly USD 15-20 per metric tonne. For our calculations, we use the ICE Gasoil price.

ICE Brent - LCO Future swap

The long end of the crude oil curve, and the diesel curve derived from it, approximate the “marginal 2 costs of production” for oil extraction and refining (not taking into account the differences in quality between Brent and WTI or DUBAI oil). Currently, the marginal costs of production are estimated to be between USD 60-80 per barrel. The high price reflects that, in addition to the traditional, lowcost extraction methods used by OPEC and the CIS countries, a majority of the higher global demand for crude oil must be satisfied using new sources and more sophisticated production methods. Higher material and labour costs also play a role. A marked decline in demand and persistent levels of production by OPEC and CIS countries, however, could cause a decline at the long end of the curve. For the hedging of diesel transactions, the maturity of the transaction should be set in such a way as to offer the longest possible period of reliability for planning. Terms of 15-24 months should be selected for hedging the basic procurement needs of the business. Such a transaction aims at ensuring maximum procurement flexibility with medium-term planning reliability. Many hedging plans fail due to improper timing. Hopes for a better price often hold businesses back from hedging transactions. As a result, many self-described “conservative customers” remain in the highly speculative shortterm arena (oil price volatility is currently around 80%). In most cases, the forward curve for crude oil and diesel slopes downward (future prices are lower than near-term prices). The historic gap between long-term swap prices (concluded for a longer period) and the short-term price is perceived as “moderately prohibitive”. Since 2

Costs for profitable production of one additional litre of crude oil or diesel.


sals.a Educational Research - Dezember 2008

commodities prices “breath”, however, systematic hedging is possible: starting small and increasing hedging volume in the event of a significant decline in the long-term price. The hedging period can also be gradually increased as necessary. Banks now also provide well-constructed “product kits”, which offer solutions customised to specific client needs.

participants are willing to commit for a future delivery date. How does a diesel price hedge work? Term GASOIL DEC08 GASOIL JAN09 GASOIL FEB09 GASOIL MAR09 GASOIL APR09 GASOIL MAY09 GASOIL JUN09 GASOIL JUL09 GASOIL AUG09 GASOIL SEP09 GASOIL OCT09 GASOIL NOV09 GASOIL DEC09 GASOIL JAN10 GASOIL FEB10 GASOIL MAR10 GASOIL APR10 GASOIL MAY10 GASOIL JUN10 GASOIL JUL10 GASOIL AUG10 GASOIL SEP10 GASOIL OCT10 GASOIL NOV10 GASOIL DEC10 GASOIL JAN11 GASOIL FEB11 GASOIL MAR11 GASOIL APR11 GASOIL MAY11 GASOIL JUN11 GASOIL JUL11 GASOIL AUG11 GASOIL SEP11 GASOIL OCT11 GASOIL NOV11

A minimum diesel price (excl. fuel tax, taxes and EBV fees) serves as a good reference value for evaluation of hedge quality. Unlike world market prices (USD in metric tonnes), these are expressed in the more practical terms of EUR per litre. Example: a modern “40 tonne” tanker lorry consumes between 30-35 litres of diesel in 100 kilometres on a normal route. The average distance travelled by a lorry is roughly 10,000 kilometres per month. The table at right shows the current world market prices for diesel in USD per metric tonnes and "net 3 pump prices" in EUR per litre (excl. taxes). Based on this, a tanker lorry consuming roughly 3,500 litres per month would currently (Dec. 08) have a monthly diesel bill of approx. EUR 1,015/vehicle (excluding taxes!). The forward prices for the period Dec. 2009 – Dec. 2010 provide the best estimate of possible diesel price developments. That is: the price levels at which market 3

Formula: EUR/L = [USD-price per MT / EUR-USD exchange rate]/1176

Maturity 25 Dec. 2008 25 Jan. 2009 25 Feb. 2009 25 Mar. 2009 25 Apr. 2009 25 May 2009 25 June 2009 25 July 2009 25 Aug. 2009 25 Sep. 2009 25 Oct. 2009 25 Nov. 2009 25 Dec. 2009 25 Jan. 2010 25 Feb. 2010 25 Mar. 2010 25 Apr. 2010 25 May 2010 25 June 2010 25 July 2010 25 Aug. 2010 25 Sep. 2010 25 Oct. 2010 25 Nov. 2010 25 Dec. 2010 25 Jan. 2011 25 Feb. 2011 25 Mar. 2011 25 Apr. 2011 25 May 2011 25 June 2011 25 July 2011 25 Aug. 2011 25 Sep. 2011 25 Oct. 2011 25 Nov. 2011

Price (USD/MT) 429.25 440.25 452.50 464.25 474.00 484.00 493.75 505.00 515.00 523.75 531.00 536.75 542.25 552.25 560.50 567.75 573.75 578.00 580.75 587.50 593.50 598.25 600.75 603.50 603.75 607.25 610.75 614.00 615.75 617.75 619.75 622.50 625.25 628.25 631.25 633.00

EUR/L 0.2746 0.2819 0.2900 0.2977 0.3041 0.3106 0.3171 0.3244 0.3310 0.3367 0.3414 0.3451 0.3487 0.3553 0.3607 0.3655 0.3695 0.3724 0.3743 0.3788 0.3828 0.3860 0.3878 0.3897 0.3900 0.3925 0.3949 0.3972 0.3985 0.4000 0.4015 0.4034 0.4054 0.4075 0.4097 0.4110

Look for Part 2 in our January 2009 issue. receive To receive more details on the practical application of diesel hedging directly via e-mail, subscribe to our free newsletter.

Primer: Cross currency swaps, Part 1 www.kfpsalsa.com/demo -> “Educational Research” -> Sample portfolios “Cross currency swap”.

A cross currency swap (“CCS”, also known as a “currency swap” or “interest and currency swap”) is an instrument for active interest rate management, used since the 1980s by large companies and family-owned businesses in Germany. A CCS can be employed, e.g. to make use of interest rate advantages vis-à-vis the home currency. Cross currency swaps are commonly used in connection with the EUR/JPY and the EUR/CHF exchange rates, as these currencies offer nominally lower interest rates as compared to the euro. To take advantage of this, a CCS is concluded for existing fixed-rate debt (e.g. in EUR), so that a lower foreign interest rate (e.g. in CHF) can be realised “after the fact”. A CCS subjects the client to unlimited currency risk in terms of both interest payments and periodic principal repayment (amortisation swap) or final exchange at maturity. Fundamentally, a CCS is an exchange of interest payments in the two currencies. Moreover, the

nominal amount is generally exchanged at the end of the transaction period, based on a fixed exchanged rate agreed in advance (usually the current spot price). A conventional transactions:

CCS

The initial exchange

comprises

three

sub-

4

Interest payment(s) Final exchange In practice, there is usually no actual initial exchange of currencies.

4

A CCS with an initial exchange of currencies is used for foreign-currency debt, and involves immediate conversion of the foreign currency amount into the home currency, e.g. in connection with financing transactions on the US private placement market.

3

3


sals.a Educational Research - Dezember 2008 Figure 1: Payment flows of a CCS EUR/CHF as seen in sals.a (without initial exchange; with return of the nominal amount)

In the example, two fixed interest rates (EUR = 4.5% p.a. and CHF = 3.5% p.a.) are swapped. A swap can also involve variable interest rates for one or both of the currencies (known as a “basis swap”). Figure 2: Interest payments for the EUR/CHF-CCS (exchange of nominal amount not included)

Final exchange:

@ EUR/CHF=1.5713

The payment flows depicted in figure 2 result from a long-term financing transaction in EUR. Sample plc pays interest on the nominal CHF amount at a

fixed rate in CHF. If the EUR/CHF exchange rate remains stable, the CCS results in a lower interest burden from the EUR-denominated loan. Appreciation of CHF, on the other hand, reduces the interest rate advantage, as more CHF must be purchased at a higher price on the market. Final exchange takes place at current EUR/CHF spot rate. The risk of loss is not quantifiable – nor is the potential gain. Thus, the risk profile must be analysed precisely, in order to avoid unwelcome surprises. Although CCS transactions can be concluded for maturities of 1 to 30 years, the company has the flexibility to terminate a CCS during the term. The market value of a CCS changes daily, based on the market situation, so that the bank has to pay the company the difference upon termination of the transaction if the market value is positive, or vice versa in the case of a negative market value. By the way: cross currency swaps bear a resemblance to forward currency transactions, but the two should not be confused. Unlike a CCS, a forward transaction involves the exchange of the principal amount only at maturity, with no interest payments made during the term. Discount or premium in the forward rate is the equivalent of an interest rate differential under a currency swap. In our next issue, read Part 2 of our CCS primer, with details about possibilities for practical application to your specific needs.

Information on our comprehensive range of services is available from our

Service line

+49 69 7593 7200 More information? www.kfps alsa . com

Portfolio management • Management of financial portfolios • Interest rates • Currencies • Commodities • Additional services • Value at Risk/Cash Flow at Risk • IFRS7/IAS39-Analyzes

E-Services • Newsletter/Research • Competence mailings • Sample analyses & sample portfolios • Product comparisons

Support • Technical support • Ask our experts • service@kfpsalsa.com • http://help.kfpsalsa.com

Disclaimer The information contained in this document by KFPD GmbH does not constitute an offer for the purchase of securities, and is intended solely for informational purposes. In particular, the information contained herein contains no guarantees or other representations. KFPD GmbH makes no assurance and assumes no liability for the accuracy or completeness of the content. Information and data on interest rate swaps, interest rates, derivatives, currencies and markets, general or future market developments or any other statements about future possibilities reflect only the subjective views and/or assumptions of the author, based on the information available at the time. Any actions carried out on the basis of the methods depicted in this discussion paper are the sole responsibility of the customer. Neither this document nor any of its content should be construed as advice relating to financial or any other matters. It should also not be used a substitute for professional advice. None of the contents may be construed as a recommendation to conclude or avoid certain transactions without obtaining prior advice that takes into account the individual situation of the customer.

4

3

sals.a Educational Research - December 2008  

sals.a Educational Research is a regular publication offering practical information about risk management using derivatives. This issue foc...

Read more
Read more
Similar to
Popular now
Just for you