Risk Library
   Documents by Author
     Committees at the Bank for International...
       Amendment of the Capital Accord to Incor...
         Part A - The standardised measurement me...
           A.1 Interest Rate Risk
           A.2 Equity Position Risk
           A.3 Foreign Exchange Risk
           A.4 Commodities Risk
           A.5 Treatment of Options










 

Part A - The standardised measurement method

A.4 Commodities Risk

1. This section establishes a minimum capital standard to cover the risk of holding or taking positions in commodities, including precious metals, but excluding gold (which is treated as a foreign currency according to the methodology set out in A.3). A commodity is defined as a physical product which is or can be traded on a secondary market, e.g., agricultural products, minerals (including oil) and precious metals.

2. The price risk in commodities is often more complex and volatile than that associated with currencies and interest rates. Commodity markets may also be less liquid than those for interest rates and currencies and, as a result, changes in supply and demand can have a more dramatic effect on price and volatility. These market characteristics can make price transparency and the effective hedging of commodities risk more difficult.

3. For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. However, banks using portfolio strategies involving forward and derivative contracts are exposed to a variety of additional risks, which may well be larger than the risk of a change in spot prices. These include:

  • basis risk (the risk that the relationship between the prices of similar commodities alters through time);
  • interest rate risk (the risk of a change in the cost of carry for forward positions and options);
  • forward gap risk (the risk that the forward price may change for reasons other than a change in interest rates);

In addition banks may face credit counterparty risk on over-the-counter derivatives, but this is captured by the 1988 Capital Accord. The funding of commodities positions may well open a bank to interest rate or foreign exchange exposure and if that is so the relevant positions should be included in the measures of interest rate and foreign exchange risk described in A.1 and A.3.

4. There are three alternatives for measuring commodities position risk which are described in Sections I to III below. As with other categories of market risk, banks may use models subject to the conditions set out in Part B. Commodities risk can also be measured in a standardised manner, using either a very simple framework (Section III) or a measurement system which captures forward gap and interest rate risk separately by basing the methodology on seven time-bands (Section II). Both the simplified approach and the maturity ladder approach are appropriate only for banks which, in relative terms, conduct only a limited amount of commodities business. Major traders would be expected over time to adopt a models approach subject to the safeguards set out in Part B.

5. For the maturity ladder approach and the simplified approach, long and short positions in each commodity may be reported on a net basis for the purposes of calculating open positions. However, positions in different commodities will as a general rule not be offsettable in this fashion. Nevertheless, national authorities will have discretion to permit netting between different sub-categories of the same commodity in cases where the sub-categories are deliverable against each other. They can also be considered as offsettable if they are close substitutes against each other and a minimum correlation of 0.9 between the price movements can be clearly established over a minimum period of one year. However, a bank wishing to base its calculation of capital charges for commodities on correlations would have to satisfy the relevant supervisory authority of the accuracy of the method which has been chosen and obtain its prior approval. Where banks use the models approach they can offset long and short positions in different commodities to a degree which is determined by empirical correlations, in the same way as a limited degree of offsetting is allowed, for instance, between interest rates in different currencies.

I. Models for measuring commodities risk

6. Banks may choose to adopt the models approach as set out in Part B. It is essential that the methodology used encompasses:

  • directional risk, to capture the exposure from changes in spot prices arising from net open positions;
  • forward gap and interest rate risk, to capture the exposure to changes in forward prices arising from maturity mismatches; and
  • basis risk, to capture the exposure to changes in the price relationships between two similar, but not identical, commodities.

It is also particularly important that models take proper account of market characteristics - notably delivery dates and the scope provided to traders to close out positions.

II. Maturity ladder approach

7. In calculating the capital charges under this approach banks will first have to express each commodity position (spot plus forward) in terms of the standard unit of measurement (barrels, kilos, grams etc.). The net position in each commodity will then be converted at current spot rates into the national currency.

8. Secondly, in order to capture forward gap and interest rate risk within a time-band (which, together, are sometimes referred to as curvature/spread risk), matched long and short positions in each time-band will carry a capital charge. The methodology will be rather similar to that used for interest rate related instruments as set out in A.1. Positions in the separate commodities (expressed in terms of the standard unit of measurement) will first be entered into a maturity ladder while physical stocks should be allocated to the first time-band. A separate maturity ladder will be used for each commodity as defined in paragraph 5 above. For each time-band, the sum of short and long positions which are matched will be multiplied first by the spot price for the commodity, and then by the appropriate spread rate for that band (as set out in Table 7 below).

9. The residual net positions from nearer time-bands may then be carried forward to offset exposures in time-bands that are further out. However, recognising that such hedging of positions among different time-bands is imprecise, a surcharge equal to 0.6% of the net position carried forward will be added in respect of each time-band that the net position is carried forward. The capital charge for each matched amount created by carrying net positions forward will be calculated as in paragraph 8 above. At the end of this process a bank will have either only long or only short positions, to which a capital charge of 15% will apply. An example of how the maturity ladder approach works is set out in C.3.

10. Even though the Committee is aware that there are differences in volatility between different commodities, it has decided in the interest of simplicity, and given the fact that banks normally run rather small open positions in commodities, that one uniform capital charge for open positions in all commodities should apply. Those banks which desire to be more precise in this area may choose to adopt the models approach.

11. All commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices should be included in this measurement framework. This includes commodity futures, commodity swaps, and options where the "delta plus" method

Table 7

Time-bands and spread rates

Time-band
Spread rate
0 - 1 month
1.5%
1 - 3 months
1.5%
3 - 6 months
1.5%
6 - 12 months
1.5%
1 - 2 years
1.5%
2 - 3 years
1.5%
over 3 years
1.5%

is used (see A.5). In order to calculate the risk, commodity derivatives should be converted into notional commodities positions and assigned to maturities as follows:

  • futures and forward contracts relating to individual commodities should be incorporated in the measurement system as notional amounts of barrels, kilos etc. and should be assigned a maturity with reference to expiry date;
  • commodity swaps where one leg is a fixed price and the other the current market price should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding with each payment on the swap and slotted into the maturity ladder accordingly. The positions would be long positions if the bank is paying fixed and receiving floating, and short positions if the bank is receiving fixed and paying floating;
  • commodity swaps where the legs are in different commodities are to be incorporated in the relevant maturity ladder. No offsetting will be allowed in this regard except where the commodities belong to the same sub-category as defined in paragraph 5 above.
III. Simplified approach

12. In calculating the capital charge for directional risk, the same procedure will be adopted as in the maturity ladder approach above (see paragraphs 7 and 11). Once again, all commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices should be included. The capital charge will equal 15% of the net position, long or short, in each commodity.

13. In order to protect the bank against basis risk, interest rate risk and forward gap risk, the capital charge for each commodity as described in paragraphs 7 and 11 above will be subject to an additional capital charge equivalent to 3% of the bank's gross positions, long plus short, in that particular commodity. In valuing the gross positions in commodity derivatives for this purpose, banks should use the current spot price.

Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * Amendment of the Capital Accord to Incorporate Market Risk * Part A - The standardised measurement method