The Most Significant Risk is The Correlation Risk
06 June 20145 min reading
CWB Director of Commodity Risk Management
“Correlation risk is the most significant immediate risk that affects each hedging attempt. Correlation risk is the risk that the commodity exchange prices will fail to closely track the price of the actual commodity. Grain traders need to recognize the importance of high correlation between the prices on the grain exchanges and the prices for the physical commodities that they are trading.”
Justin Daniels is the Director of Commodity Risk Management at Canadian Wheat Board (CWB). According to Daniels; Commodity exchange markets isolate a single component of the price risk. Stating that additional risks including quality, logistics, and delivery timing are managed through specific contract terms between the actual buyer and seller, as opposed to being handled by a commodity exchange position, DANIELS emphasizes that the most significant immediate risk that affects each hedging attempt is correlation risk. In other words, he puts an emphasis on the risk that emerges when the prices in the commodity exchanges fail to closely track the price of the actual commodity. Justin DANIELS answered our magazine’s questions on the subject.
Mr. Daniels, firstly could you give information about the role of commodity exchanges on today’s trade?
Commodity exchanges are an important aspect of commodity risk management for some of the main commodities, for example corn, soybeans, wheat, and rice. Commodity exchanges allow exposure to price risks for these commodities to be isolated and actively managed by industry participants and the financial industry. This has resulted in a very broad group of participants with very diverse reasons for trading and very diverse price ideas that allow efficient matches between buyers and sellers.
What are the risks that buyers and sellers are encountering especially in the wheat and grain markets and what is the role of the stock markets on minimizing these risks?
Commodity exchange markets isolate a single component of the price risk. Additional risks including quality, logistics, and delivery timing are managed through specific contract terms between the actual buyer and seller, as opposed to being handled by a commodity exchange position.
Stock markets have risks within themselves for buyers and sellers. Could you tell about these risks and the risk and risk management in terms of stock market in general?
There are several corporate level risks including the risk of margin calls and the risk that brokers will declare bankruptcy, however correlation risk is the most significant immediate risk that affects each hedging attempt. Correlation risk is the risk that the commodity exchange prices will fail to closely track the price of the actual commodity.
Are there any specific conditions and rules for trading in the stock markets? If there are, what are these?
Commodity exchanges are used to isolate the price risk associated with a specific set of criteria including quality, timing, and location. Under conditions where a company is trading commodities that have prices highly correlated to the prices traded on the commodity exchanges, an effective hedge against price movements can be traded; however this only impacts one component of the contract for the physical commodity. In order to accomplish this hedge, companies that are involved in trading physical product need to arrange an account with a broker that has access to the commodity exchange. The trade in physical product continues to occur between two parties that are able to negotiate the remaining terms.
What should buyers and sellers take into consideration in trading the grain-based products in the stock markets?
Grain traders need to recognise the importance of high correlation between the prices on the grain exchanges and the prices for the physical commodities that they are trading. It is likely that regional commodity exchanges will have better price correlation and may result in better (more effective) hedges.
What do you think about what kind of a development would be experienced on both supply and demand and prices with the new season expectations in the grain markets?
Production and usage of the major agriculture commodities continue to trend higher, putting significant pressure on regional and international logistics. There is no international shortage being projected this year, which should result in general downward price pressure, however there may be regional and short term instances where the physical commodity is relatively scarce. As a result, physical commodity traders need to continue to focus efforts on ensuring product remains available to meet specific end use requirements.
How the grain exchanges were affected from the political issues in Ukraine that has an important place in wheat production and trade? What do you think about the future effect of Ukraine on the grain exchanges in the coming days?
The grain exchanges reflected the additional risk associated with some unknowns regarding the continued availability of Ukrainian and to a lesser extent Russian wheat. This highlights one of the big benefits of grain exchanges which is the ability to quickly assimilate information from many sources into tradable and publicly disseminated prices.
Could you tell us the working method of CWB, your task field and works in there?
I am the director of Commodity Risk Management at CWB, responsible for all commodity-related hedging strategy and execution, including exchange traded derivatives.
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