Commodity Forward, Commodity Swap - key risks and features
Commodity Forwards & Swaps are risk management tools that can be utilised in order to hedge commodity risks and exposures generated through commercial activity. These products allow users to guarantee future cash-flows and remove the risks presented by market fluctuations for known future revenues or expenditures.
Key risks and features
- Market risk can materialise due to macroeconomic factors and may have an impact on a particular instrument or more broadly on markets as a whole.
- There is no direct risk to returns from market risk, however there is the potential for opportunity cost because whilst entering into one of the contracts above guarantees a known price on delivery, it is possible that on expiry Spot market conditions could be preferable to those agreed in the contract and thus a client may have been in a better position having not initially entered into the hedge.
- By entering into a bilateral contract a client is taking on a credit risk to Investec Bank plc. In the event that Investec should default on its obligations or become insolvent a client may not receive back the full value of their transactions.
- In adverse market conditions volatility can increase and this will lead to greater market risk. Volatility in commodity markets will vary between commodity type.
- In more volatile market conditions clients may be subject to a wider spread with regards to pricing available.
- Changes in volatility will have an impact on the mark to market of a derivative contract.
- Liquidity in commodity markets varies depending on the specific commodity type.
- In markets with less liquidity clients may be subject to a wider spread with regards to pricing available.
- Clients entering into commodity contracts with Investec may be exposed to indirect FX risk depending upon the details of the specific transaction. GBP clients purchasing a USD denominated commodity for example are exposed to both the underlying commodity risk and indirectly have an exposure to GBP/USD FX rates.
- This risk can be mitigated as a part of any commodity transaction undertaken as required.
- Concentration risk is not applicable to these products.
- Conflicts arising from Investec’s business model are managed through internal controls and process and is detailed in the Conflicts of Interest policy which can be found on the website.
- Commodity Spot markets are very transparent with up-to-date pricing available online. Pricing around other commodity instruments such as these products is not as transparent.
- Where markets are less transparent it can be challenging to form an independent assessment of a contract’s fair value.
- Investec may, from time to time, request that a client posts collateral against a trading position, subject to the specific arrangements agreed between Investec and client. These funds are required in order to protect Investec from losses should a client default on their obligations or become insolvent.
- Collateral held for MiFID Professional clients will be held in a margin account under a Title Transfer Collateral Arrangement (“TTCA”). A TTCA is a legal arrangement that gives Investec ownership of the clients margin funds whilst they are in possession of the Bank. Investec can therefore utilise these funds as required for liquidity or investment purposes as is deemed necessary.
- A client that has funds held by Investec as collateral is also exposed to the credit risk outlined above.
- Contingent Liabilities are not applicable to these products.
- These products do not have explicit exit fees that are payable above and beyond a client's mark to market and contractual obligations should they wish to close a position early, however there may be costs involved in this process depending upon market conditions at the time the client wishes to exit. A client may not be able to redeem the full original value of the contract.
- A client's ability to exit early will also be dependent upon the liquidity of the market at the time; should a market be illiquid at the point of early exit then the exit costs are likely to be more significant.
- There is no cost associated with exiting a product on expiry or at the end of its recommended holding period provided a client satisfies their contractual obligations.
- Leverage is not applicable to these products.
Interest Rate Risk
- Changes in interest rates will have an impact on the mark to market of derivatives because rates determine how future cash flows are discounted.