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Trading and Capital-Markets Activities Manual

Instrument Profiles: Commodity-Linked Transactions
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

The term commodity-linked transaction is used to denote all transactions that have a return linked to the price of a particular commodity or to an index of commodity prices. 

The term commodity-derivative transaction refers exclusively to transactions that have a return linked to commodity prices or indexes and for which there is no exchange of principal. The term commodity encompasses both traditional agricultural products, base metals, and energy products, so that all those transactions that cannot be characterized as interest or exchange-rate contracts under the Basle Accord are designated commodity transactions. Precious metals, which have been placed into the foreign-exchange-rate category in deference to market convention, are not included. 

CHARACTERISTICS AND FEATURES 

A commodity-linked contract specifies exactly the type or grade of the commodity, the amount, and the future delivery or settlement dates. In these transactions, the interest, principal, or both, or the payment streams in the case of swaps, is linked to a price of a commodity or related index. However, given that banks are not allowed to trade in the underlying physical commodity (with the exception of gold) without special permission, these contracts are settled for cash. 

Factors that affect commodity prices and risk are numerous and of many different origins. Macroeconomic conditions, local disturbances, weather, supply and demand imbalances, and labor strikes are examples of factors that have a direct impact on commodity prices. In many other traded markets, such factors would have a more indirect effect. 

USES 

Commodity-linked markets offer participants a way to hedge or take positions in future commodity prices. Market participants include commodity producers or users, such as mining, energy, and transportation companies, that want to lock in future costs or revenues by entering into a contract at a given price. 

In general, financial institutions view commodity-linked transactions as a financial risk-management service for customers with commodity-price exposure, similar to the foreign exchange and interest-rate risk management products that banks have historically offered. Over-the-counter (OTC) transactions can be tailored to the customer's needs and, therefore, offer more flexibility than exchange-traded contracts, particularly for longer-term insurance. 

Examples of commodity-linked products offered by banks include commodity-linked deposits, commodity-linked loans, commodity linked swaps, and commodity-linked options. Examples of these products and the ways in which hedgers and speculators use these products are described below. 

Commodity-Linked Deposits 

The following is an example of a deposit with the return linked to a commodity index: 

A $100,000 one-year deposit has a return linked to the price of oil. The deposit pays at maturity either (1) a guaranteed minimum return of 3 percent or (2) 90 percent of any gain in the market index (relative to an index rate set at the outset of the transaction) of oil over the life of the deposit, whichever is greater. The depositor is able to benefit from a rise in the price of oil (however, by only 90 percent of the rise that would have been received if he or she had purchased the physical oil). The asset is less risky compared to the purchase of the actual physical oil because the principal is protected against a fall in the price of oil. 

Commodity-Linked Loans 

The following is an example of a loan with interest payments linked to a commodity index: 

A financial institution lends an oil company $1 million for five years with interest payments linked to the price of oil as opposed to a conventional loan at 8 percent. The initial oil index is set at $20 per barrel. Interest payments are the greater of 4 percent or the excess of any gain in the market price of oil relative to the $20 per barrel base, up to a maximum of 25 percent. The borrower pays a lower interest rate compared to a non-commodity-linked loan when oil prices fall, but shares the upside potential of its oil revenues with the lender when the price of oil rises. 

Commodity-Linked Swaps 

Commodity-linked swaps are defined as an agreement between two counterparties to make periodic exchanges of cash based on the following terms:

  notional quantity (for example, number of barrels or tons) of the specified commodity 

  index, based on a defined grade and type of commodity, whose prevailing price is publicly quoted 

  fixed price agreed to by the counterparties (The fixed price is usually above the spot price per unit for the defined commodity at the date the swap is consummated.) 

  at specified intervals during the term of the swap, there are settlement dates at which the counterparties agree to a net exchange of cash (The amount of cash to be exchanged is determined as follows: 
- One counterparty is the fixed price payer. At each settlement date, the fixed price payer owes the counterparty the notional amount of the contract multiplied by the fixed price. 
- The other counterparty is the floating-rate price payer. At each settlement date, the floating price payer owes the counterparty the notional amount multiplied by the index price prevailing on the settlement date.) 

As an example, suppose an oil company wishes to protect itself against a decline in oil prices and enters into a commodity-swap agreement with a bank. The company will receive a fixed price and pay a floating price linked to an index of the price of oil. Thus, the company trades the upside potential of rising oil prices for the assurance that it will not receive a price below the fixed price agreed on at the inception of the trade. 

As a further example, suppose a utility company wishes to protect itself from rising oil prices and enters into a commodity-swap agreement with a bank. The utility company will pay a fixed price and receive a floating price linked to an index of the price of oil. Thus, the utility trades its upside potential if oil prices fall for the assurance that it will not pay a price above that agreed on at the inception of the trade. 

Commodity-Linked Options 

Commodity-linked options convey the right to buy (call) or sell (put) the cash-equivalent amount of an underlying commodity at a fixed exercise price (there is no physical delivery of the underlying commodity). The purchase of a commodity-linked call by an oil user, for example, sets a cap on the price of oil that the user will pay. If oil prices rise, the oil user will exercise the call option, which is the right to buy oil at the lower exercise price. The seller of a call option may have a long position in a given underlying commodity, thus selling off the upside potential of the commodity in exchange for the premium paid by the purchaser of the call. 

The purchase by an oil producer of a put option indexed to the price of oil sets a floor on the price of oil that the producer will receive. The bought put therefore allows the holder to establish a minimum price level on the underlying commodity. If the price of oil in the open market falls below the strike price of the option, the oil producer will exercise the put to lock in the strike price. 

DESCRIPTION OF MARKETPLACE 

Commodity-linked derivatives are traded in both the exchange and OTC markets. There are several fundamental differences between the futures exchanges and the OTC markets for commodities. First, futures contracts may entail delivery of the physical commodity upon expiration of the contract, whereas OTC contracts generally are settled for cash. Second, futures contracts are standardized, while OTC contracts are tailored, often specifying commodities and maturities that are not offered on the exchanges. Third, the OTC market typically handles only large transactions, whereas exchanges may accommodate transactions as small as the value of a single contract in a given commodity. As a result, the OTC commodity markets tend to be less liquid than the exchanges, but at the same time they offer products that can be more customized to meet the users' specific needs. 

Market Participants 

Primary players in the commodity markets are commodity producers and end- users, hedge funds and mutual funds, and investment and commercial banks. Commercial banks are relatively small players in the commodity markets; it is estimated that they account for roughly 5 to 10 percent of trading activity in the domestic energy sector and even less in agricultural commodities. However, these banks fill an important niche by acting as intermediaries between producers and users of oil and gas products, which is also important for market participants. Banks apply tested risk-management techniques and market-making skills, which has helped to increase liquidity in the markets. Additionally, the ability of banks, acting as financial intermediaries, to transform risks has enabled entities to hedge attendant exposures (for example, credit risk) which are a component of energy transactions, though not directly related to the price of energy. 

Market Transparency 

For all exchange-traded commodity products, transparency is high. In the OTC markets, wide variations of transparency exist based on the product, volume traded, grade, delivery point, maturity, and other factors. 

PRICING 

Similar to the term structure of interest rates, commodity price curves exist which convey information about future expectations. In addition, they reflect the prevailing yield curve (cost-of-carry) and storage costs. 

Energy prices are said to be in ''contango'' when the forward prices are greater than expected spot prices at some future date; prices are said to be in ''backwardation'' when future spot prices exceed forward prices. The term structure has little forecasting power, however. Forward prices have not been proven to be accurate forecasts of future spot prices. 

The theory of contango holds that the natural hedgers are the purchasers of a commodity, rather than the suppliers. In the case of wheat, grain processors would be viewed as willing to pay a premium to lock in the price that they must pay for wheat. Because long hedgers will agree to pay high futures prices to shed risk, and because speculators require a premium to enter into the short position, the contango theory holds that forward prices must exceed the expected future spot price. 

The contrasting theory of contango is backwardation. This theory states that natural hedgers for most commodities will want to shed risk, such as wheat farmers who want to lock in future wheat prices. These farmers will take short positions to deliver wheat in the future at a guaranteed price. To induce speculators to take the corresponding long positions, the farmers need to offer speculators an expectation of profit. The theory of backwardation suggests that future prices will be bid down to a level below the expected spot price. 

Any commodity will have both natural long hedgers and short hedgers. The compromise traditional view, called the ''net hedging hypothesis,'' is that the forward price will be less than the expected future spot price when short hedgers outnumber long hedgers and vice versa. The side with the most natural hedgers will have to pay a premium to induce speculators to enter into enough contracts to balance the natural supply of long and short hedgers. 

The future price of an energy product is determined by many factors. The no-arbitrage, cost-of-carry model predicts that futures prices will differ from spot prices by the storage and financing costs relevant to inventory. The future spot price is the only source of uncertainty in the basic model. Carry is the sum of the risk-less interest rate and the marginal cost of storage. Because carry is always positive, the cost-of-carry model predicts that energy prices will always be in contango. 

Empirical evidence suggests, however, that the term structure of energy is not fully explained by carry. The term structure of energy prices is not always in contango. Oil and natural gas markets often become backward dated due to external factors or supply concerns. Further, the market rarely shows full carrying charges. In other words, futures prices as predicted by a cost-of-carry model generally exceed those observed in the market, even when prices are in contango. 

HEDGING 

Participants in the OTC commodity markets may have more difficulty hedging their positions than participants in the foreign-exchange and interest-rate markets because of the shallowness and illiquidity of OTC commodity markets. It is also difficult to match the terms and maturities of exchange-traded futures hedges with OTC commodities instruments. 

To hedge the spot risk associated with commodity-linked transactions, traders will offset a long position with a short position. The choice of the hedge instrument used generally depends on (1) market conditions, that is, whether the financial institution has a natural offsetting position; (2) the risk appetite of the institution; and (3) cost. Because exchange-traded futures contracts are standardized, they are usually cheaper than the equivalent OTC contracts and are normally the preferred hedge instrument. However, the margin and collateral requirements of exchange-traded contracts may mean that OTC contracts have lower transactions costs than futures traded on exchanges. Moreover, the terms of a futures contract will rarely be identical to the terms of an OTC contract, leaving the financial institution with residual risk. 

Commodity swaps, in particular, may be entered into on a perfectly matched basis, with the financial institution guaranteeing the payments of two parties with equal and opposite interests. In a perfectly matched transaction, the financial institution writes a separate, offsetting long-term swap contract with each party, incorporating a margin to cover costs and the risk of counterparty default, and closes simultaneously both sides of the transaction. When engaging in matched commodity swaps, a financial institution is exposed to commodity-price risk only when the counterparty on one side of a matched transaction defaults, and the financial institution must enter the market to hedge or rebalance its book. 

However, the need to match transactions perfectly at all times would limit the ability of financial institutions to serve their customers and to compete in the existing market. For example, if a financial institution enters into swap agreements for its own account with one counterparty, it may not be able to establish a matching offsetting transaction immediately. Therefore, it may wish to hedge its commodity price risk in the futures or related markets until an offsetting swap can be written. When an exact offset is found, the two swaps are matched and the hedge position is unwound. 

Some financial institutions may seek a matched book by the end of the day, while others are willing to carry an open swap for weeks or to rely on other hedging techniques, such as hedging on a portfolio basis. For example, a financial institution may hedge the commodity-price exposure of the entire portfolio of independently contracted swaps without ever seeking exactly offsetting transactions. Hedging models help to determine the amount of exposure already offset by the transactions currently in the book. The residual exposure is then hedged using exchange-traded futures and options so that it is reduced to less than the position limits established by the financial institution's management. Some of the most serious financial-institution participants in the commodity swap market are hedging on a portfolio basis. 

The use of futures and options to hedge an individual commodity-linked transaction, or a portfolio of such transactions, does not eliminate the residual basis risk resulting from differences between the movements in the prices of two commodities used to offset one another. When risk managers or traders cannot profitably execute a hedge in the same commodity, they may use a second commodity whose price tends to move in line with the first. Such a hedge is necessarily imperfect and cannot eliminate all risk. For example, prospective oil hedgers may incur basis risk because of discrepancies between the nature of the underlying instrument (for example, a crude oil futures contract versus a jet fuel swap) or the location of the deliverable-grade commodity (for example, North Sea oil versus West Texas Intermediate oil). 

RISKS 

Many of the risks associated with commodity-linked activities are similar to those connected with interest-rate and foreign-exchange products. Price, counterparty credit, and delivery risks all exist. In the case of commodity-linked transactions, these risks may be further exaggerated due to illiquidity, volatility, and forward pricing problems. 

Basis Risk 

One of the primary risks facing investors in commodity-linked transactions is basis risk- the risk of a movement in the price of a specific commodity relative to a movement in the price of the commodity-linked transaction. The definition of commodity that is often used to signify like, interchangeable products cannot be applied freely. Variances of grade, delivery location, and delivery time frame-among other things-give rise to numerous basis issues which must be carefully managed. Price risk can be reduced by hedging with either exchange-traded or OTC contracts. However, if contract terms are not equivalent, substantial basis risk can result. Types of basis risk include, but are not limited to, grade risk; location risk; calendar (nearby versus deferred-month) risk; stack-and-roll risk (hedging deferred obligations in nearby months on a rolling basis); and, in the energy markets, risks associated with crack spreads (the price differential between refined and unrefined products). 

Liquidity Risk 

The OTC-commodity derivative markets are generally much less liquid than the foreign exchange and interest-rate derivative markets, since commodity-linked derivative products are currently offered by relatively few financial institutions. As a result of the shallow nature of the market, liquidity usually drops off for contracts on forward prices beyond one year. 

In addition to their relative scarcity, OTC commodity-linked transactions are customized to meet the needs of the user. This characteristic of the market exacerbates the ability of a financial institution to hedge commodity-linked derivative transactions; perfectly offsetting instruments are rarely available in the OTC market and there may be a significant degree of basis risk when hedging with exchange-traded instruments. For purposes of hedging long-dated (more than one year) crude oil, the OTC market is superior to exchange-traded markets in terms of liquidity. 

Volatility Risk 

Commodity prices can be much more volatile than interest rates or foreign-currency rates, although this is sensitive to the time period and market conditions. The smaller size of the commodity markets is partially responsible for the heightened volatility of commodity prices. Changes in supply or demand can have a more dramatic effect on prices in smaller markets, as reflected in the measured volatility. Thus, a disruption in any one source of supply may greatly affect the price since many commodities are dominated by only a few suppliers. In addition, the fact that only a few suppliers exist can result in prices that are subject to manipulation. Demand for commodities can also depend heavily on economic cycles. 

ACCOUNTING TREATMENT 

The accounting treatment for commodity-linked transactions is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

The credit-equivalent amount of a commodity-linked contract is calculated by summing- 

1. the mark-to-market value (positive values only) of the contract and 
2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are as follows. 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Commodity derivatives are not considered investments under 12 USC 24 (seventh). A bank must receive proper regulatory approvals before engaging in commodity-linked activities. 

REFERENCES 

Bodie, Kane, and Marcus. Investments. Richard C. Irwin, Inc., 1993. 
Das, Satyajit. Swap and Derivative Financing. Chicago: Probus Publishing, 1993. Falloon, William. ''A Market Is Born.'' Managing Energy Price Risk. London: Risk Publications, Financial Engineering, Ltd., 1995. 
McCann, Karen, and Mary Nordstrom. Energy Derivatives: Crude Oil and Natural Gas. Federal Reserve Bank of Chicago, December 1995.

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