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Over the past two to three years, managing a short commodity position has been fairly straightforward - BUY, BUY, BUY. Most commodity markets, while highly volatile, have gone straight up - aluminium has risen by over 50%, copper by 75% and crude, even off its highs, has gone up by over 75% since January 2003.

Of course, there were pullbacks, which provided excellent buying opportunities - for instance, from a high of $ 55 in October 2004, Brent crude fell sharply to around $ 40 in mid-December before embarking on its next spike upwards. Again, currently, Brent has fallen from a high of nearly $ 70 to below $ 55 (today). Is it ready to spike higher again? Or, is it just possible that it might dip a bit further before it shoots up again? Or, is the trauma over, and may the most profitable approach be to remain unhedged to take advantage of a falling market?

There are, of course, no consistently correct answers to such questions and it is critical that companies with such exposures build risk management processes that ensure bottom line protection without reference to how the markets ultimately move.

We have developed a process that endeavors to do this. It is an extension of our approach to forex risk management and follows a first principles approach.

Let us say, you have a regular exposure of 100 barrels a month to crude oil prices and you need to have some degree of certainty of what your costs are going to be so that you can plan your business effectively. Now, one possibility would be to simply hedge the entire exposure forward using the futures markets to fix your costs at the start of the financial year. This would give you 100% certainty of your costs; however, you would have no opportunity and if crude prices did fall over the year, you may find your margins crashing since competitors would be able to undercut you in the downstream (or service) market. A sounder approach may be to hedge 50% on Day 1 and leave the balance open to the market - this would give you, at least, a 50/50 opportunity. The downside, of course, is that you would have no certainty at the start of the year as to what your costs would be.

Another possibility would be to hedge the entire exposure with options. This would give you a worst-case cost for your inputs AND would enable you to take advantage of market opportunities. The ideal solution. However, nothing comes for free and this solution carries a price - a high one in the case of volatile commodities like crude. For a 12-month crude portfolio in July 2004, the cost of the option to hedge out the risk was as much as 15%. The table overleaf shows the risk for 12-month portfolios starting in each of the months from Jul 04 to Apr 05.

Clearly, the cost of buying options to hedge out the entire portfolio is very high and few companies would be comfortable forking out as much as 15% of their input costs up front.

Another approach, which is the one we recommend, would be to simulate an option payout on your at-risk flows, which is the ideal situation for any corporate. Here, we recognize that the cost of the options is a measure of the actual risk on the portfolio, but, rather than paying this cost up front, build it into the business plan as the risk-adjusted cost of buying crude. Note that if this risk-adjusted cost pushes the business plan below the profit comfort level, it means that there is more risk than you can comfortably carry and you need to hedge some part of the risk immediately; this provides a first pass risk management signal.

Let us assume, in this case, that the company (i) is looking to take advantage of possible opportunity and (ii) can build the risk into the business plan as a "worst case" or "target" value for its costs.

Note that the first benefit of this approach is that it provides the company with a defined USD value of its crude purchases - i.e., it separates market fluctuations out from the business. [We can apply the same approach to the USD/INR risk the company carries, to translate the worst case dollar cost to a worst case rupee cost. For this example, however, we will stick to managing the USD cost.]

Now, once this target value is set, the company has to ensure that this target value is never breached, and, of course, capture opportunity, if it becomes available. To do this, we use value at risk (VaR) as a hedge trigger indicator, and also capture some gain by moving the target value whenever the market moves favorably. The table overleaf shows the way this process would have worked.

The table shows that the approach

1) always protected the target value, sometimes improving it dramatically (by as much as 12%) - this means that you have complete certainty of your worst-case costs; and

2) performed reasonably well in comparison to the market (simulated by hedging 50% and keeping 50% open) - its performance ranged from 3.6% behind the market to nearly 10% ahead of the market; on an aggregate basis (over this test period), it was ahead of the market by about 2.5%.

We believe that this is an excellent way to start managing commodity price risk, assuming, of course, regulatory permissions and hedging processes are in order.

The approach can be made even more sophisticated by using delta hedging instead of VaR as the signaling indicator; however, in our view, this should be looked at only when the commodity hedging desk has considerable skill, since delta hedging requires almost daily trading in the market.

currency markets view: rupee and majors

INR

Fortnightly movement: O-45.63 H-46.05, L-45.60, C-45.77
Sentiment - mildly negative
Expected range for 1 Month: 45.60-46.10
Expected range for 3 Months: 45.25-46.50

Responding to the dollar's movements overseas, the Rupee slipped sharply at the start of the fortnight breaking the 46 level (to a low of 46.05); however, suspected RBI intervention and dollar selling by exporters helped it recover to above 46; nonetheless, it closed the period some 0.5% weaker at 45.77.

There have been some conflicting medium term projections from global banks, with the majority calling for a weaker rupee - 46.50 by March and 47.50 by March 2007 - although there are also views (again, held by "respected" global banks) that the rupee could strengthen to 42.50 by December 2006. Clearly, we (finally) have a market.

We subscribe to the near-term weakness of the rupee, since it is clear that domestic growth will continue to suck in imports, keeping the current account deficit in high focus. However, we don't see any runaway weakness, since it is equally clear that rupee interest rates are going to remain firm - the surprise rise in MIBOR two weeks ago (to above 7,25%) suggests that there is something in the market that most analysts have not yet taken into consideration. In our view, that "surprise" is going to be continued strong(er) economic growth, which will lead to higher imports on the one hand and higher credit offtake, meaning firm interest rates, on the other. Another factor that we believe will prevent any runaway weakness in the rupee is RBI's commitment to maintain inflation contained.

And then there's the wild card of the redemption of the India Millenium Deposits due next month. Our view is that these should broadly be market neutral, with RBI and SBI having prepared for the redemption for some time; last week's upward tweak to NRE rates do suggest that there is some nervousness that the proceeds will flee, leading to further tightness in the domestic market.

All this should keep the rupee narrowly volatile in a tight range just below 46 in the near term. In the event global markets get wild [see below], we would expect the rupee to reflect some of this volatility, particularly given RBI's new found enjoyment of volatility.

EUR

Fortnightly movement: O-1.1802 H- 1.1830 L-1.1639 C-1.1772
Sentiment - negative to neutral, could improve
Expected range for 1 Month: 1.1600 -1.1900
Expected range for 3 Months: 1.1200-1.2300

The social unrest in France, political stalemate in Germany, the anti rate hike rhetoric from the Eurozone finance ministers, a very upbeat TICS report showing net capital flows of about $102 bn into the US and the next Fed chairman nominee Ben Bernanke's anti-inflation stance, pushed the euro down to about 1.1640 even in the face of a record US trade deficit of around $66 bn. The euro was, however, able to find its feet and stage a modest recovery after weaker than expected US housing market data, a sharp drop in Philly Fed index and an apparent volte face by the ECB President signaling an impending rate hike.

The unrest in France has waned and the political deadlock in Germany has ended. Yet, the euro may find it tough to stage a sustained recovery over the 1.1875-1.1900 resistance zone unless the markets begin to perceive an erosion of the dollar's interest rate advantage which would in turn probably require a series of strong Eurozone data and weak US data.

If, however, the Euro is not able to break through the 1.1875-1.1900 area, which is a good possibility, it is conceivable that the Euro bearishness could flip into dollar strength, which could drive the Euro to new lows. This, in turn, could be part of the final unwinding of the dollar strength, which has been expected by analysts for over a year [see our report last week, entitled, ANOTHER VALETINE'S DAY MASSACRE?]
Time to buy volatility.

GBP

Fortnightly movement: O-1.7479 H- 1.7517 L-1.7095 C-1.7166
Sentiment: negative and could worsen further
Expected range for 1 Month: 1.7000-1.7300
Expected range for 3 Months: 1.7000-1.8000

Sterling too declined steadily but manged to stay over 1.7350 despite the very upbeat US TICS report and the UK annual inflation easing to 2.3%. It was only last Wednesday that sterling fell below the 1.73 support, slumping by nearly 2 cents on revival of rate cut expectations after Bank of England's forecasts of lower growth and easing/benign inflation.

Sterling may find support over 1.70 and consolidate in the 1.70-1.73 area but only a sustained recovery over 1.73 may prevent further declines.

JPY

Fortnightly movement: O-118.27 H- 119.55 L-116.84 C-119.09
Sentiment: very negative (for yen)
Expected range for 1 Month: 116.50-122.50
Expected range for 3 Months: 113.75-125.00

Early on, the dollar slipped just under 117 yen on mild profit-taking as also higher than expected Japanese Q3 GDP growth at an annualised rate of 1.7%. However, the greenback resumed its surge with the Japanese Vice Finance Minister appearing unconcerned about the recent yen weakness, BoJ Governor seeing no early end to the ultra-easy monetary policy and PM Koizumi echoing these remarks. As if all this anti-yen rhetoric were not enough, the ruling LDP leader said that if the BoJ didn't continue with quantitative easing and zero interest rates, it risked amendment of the BoJ laws! In the event, the dollar rose as high as 119.55 and might have even tested the 120-yen level but for rumours (since denied) of an emergency meeting held by the Chinese central bank on the yuan.

If President Bush's visit to China doesn't fuel speculation of an imminent yuan revaluation, the dollar could well surpass the psychological 120-yen level to around 122.50 yen before any significant correction.