Risk assessment is the process of identifying and quantifying a trader s exposure to risk based on their position in the market.

Transcription

1 Overview of Price Risk Assessment In order to effectively manage risk, the first step is to carry out a risk assessment that will allow traders and producer organizations to determine how and when risk is created. Risk assessment is the process of identifying and quantifying a trader s exposure to risk based on their position in the market. By frequently undertaking risk assessment as part of day to day operations, a trader will recognize his potential profit (or loss), at any point in time. This will enable the trader to make better and more informed trading decisions. Risk assessment is the vital first step in a price risk management program and one that a trader must have to be able to manage price risk. Without effective risk assessment a trader will not be able to manage price risk or mitigate the effects of volatile cotton prices. 22

2 Risk Assessment: A Three-Step Process The Three Steps for Risk Assessment: 1- Position Analysis Position analysis involves making an assessment of a cotton trader s purchases and sales. Any trader who has bought more cotton than he has sold, or sold more cotton than he has bought, will have a position that exposes him to risk. 2- Breakeven Analysis Breakeven analysis requires a trader to calculate the fixed and variable costs related to his cotton operations. By determining the total fixed and variable costs the trader faces, he can determine his bottom-line or breakeven. This is the point below which he will be losing money on his business. Breakeven analysis is a dynamic process, and will require frequent updating throughout the season as costs are likely to change. If a business fails to frequently update its breakeven calculations, they risk making decisions based on potentially inaccurate information. 23

3 3- Marking to Market Marking to market is the process of calculating the profit or loss position of the trader s operations, based on current cotton market prices and the calculations made during the position and breakeven analysis steps. 24

4 Risk Assessment as a Dynamic Process Risk assessment is not a "one-off" exercise, rather it is a dynamic process. The process will require updating on a regular basis, so that changes in market conditions are reflected in the trader s positions as he buys and sells cotton. Risk assessment is only useful if it is up-to-date, and the trader can determine his trading and hedging strategies. A trader, who is effectively assessing risk, will have up-to-date information on which to base his business decisions. The most efficient businesses update this information weekly, daily, or even multiple times a day. 25

5 Step 1: Position Analysis Any time a trader buys cotton without a sales contract, or sells cotton without having bought cotton, he is holding a position and faces exposure. Long position A "long" position occurs when a trader has purchased cotton without selling cotton. A purchase is determined when a trader fixes a price for the purchase of cotton with producers or other clients. The risk for the trader begins the moment the price for the purchase of the cotton is fixed. It does not matter if the cotton is delivered to him on the spot or if he will need to wait for a few weeks or even months for the cotton to be delivered. As soon as price is fixed the trader has agreed to buy cotton. At this point in the time, a trader will know the purchase price of the cotton that he has bought but he does not know the sale price. If cotton prices fall before he fixes a sales price he will face reduced profits or even losses. Short position A "short" position occurs when a trader has agreed to sell cotton at a fixed price, but has not yet purchased that cotton. 26

6 At this point, a trader will know the sale price of the cotton. However, the trader will not know the purchase price and faces the risk, that if cotton prices rise before he agrees a purchase price for the cotton, he will face reduced profits or even losses. A Normal Activity of Cotton Trading Taking short and long positions is just part of doing business in the cotton sector. So, in reality, there is nothing intrinsically wrong about a trader taking a short or long position - entering into contracts is just a core part of the cotton trading business. However, taking a position creates risk for a cotton trading business and the risk should be monitored, so that trading decisions can be made in an informed manner. Positions will change whenever a trader buys or sells cotton. It is vital that a trader updates his position calculations, and understands the impact of each transaction on his overall position. The need for understanding the overall position highlights the need for the position analysis process to be a central process of the trading business. Net Position A trader will make a number of individual transactions during a standard cotton season. Some of these transactions will create a short position (i.e. forward selling), and some will create a long position (i.e. purchasing cotton and building up stocks). While a trader may take a long position or a short position for each of these individual transactions, it is his "net position" that influences the business overall exposure to price volatility. It may be that a trader has one short position and one long position that "net off" the overall impact. When a trader looks at his entire business on any given day during the season, he should be able to look at, based on the sum of individual transactions, whether the trading business as a whole is in a net long or net short position. This process is called position analysis and involves looking at the individual purchases and sales to create an overall picture, and calculate whether his business holds a long or short position. The following pages detail a methodology for a trader to calculate and view his position on an ongoing basis. 27

7 Step 1: Position Analysis The Long & Short of It Example of a Long Position A ginner, or a trader who has purchased more cotton than he has sold, has a net long position. He is exposed to the risk that cotton prices will fall. A ginner, or a trader, holding a long position is exposed to price risk until he has sold all the cotton that he has purchased. This situation is common to many ginning companies when they purchase cotton from producers, process the cotton, and then subsequently sell the cotton to buyers. This practice does pose financial risks to ginners if cotton prices fall significantly after they have built up cotton stocks in their warehouses. 28

8 Example of a Net Short Position A ginner, or a trader, who has sold more cotton than he has purchased has a net short position. He his exposed to the risk that cotton prices will rise. A ginner, or a trader, holding a net short position is exposed to price risk until he has purchased all the cotton that he has sold. Holding a short position, the trader is at risk that cotton prices will go up. If the sale prices are fixed in the agreed sales contracts for delivery at a later date, and if the price of cotton rises before delivery, the trader will have to pay more for the cotton purchases to meet the sales orders. If the trader does not raise prices for purchases in line with the increases of prices in the international markets, he will not be able to compete with other buyers and obtain the volumes of cotton he needs to fulfill the contracts. As such, the trader may see his profits fall or may even generate losses on those orders that he has committed to fulfill. There are often very good reasons for pre-selling cotton. For example, the trader might have a strong, long-term, relationship with the buyer, and pre-selling cotton provides an element of certainty in knowing that a guaranteed order is in place. However, this procedure generates price risk that the trader must take into account. We shall see the potential mitigating actions that can be taken as this course progresses. 29

9 Calculating Net Positions To determine his net position, a trader simply needs to keep track of purchases and sales of cotton (spot or forward contracts) on an ongoing basis, adding purchases, reported as positive (+), and sales, reported as negative (-). The net position changes with each transaction during the season. Pricing and Duration in Position Analysis The previous examples of a long position and a short position were simple examples of a trader who had purchased cotton in advance of selling it, and a trader who had agreed to future sales in advance of purchasing the cotton. While these were helpful to understand the concepts of "long" and "short", in reality, cotton businesses will often be in both positions at different points during the season. Their net position will change as the demand for cotton from international buyers and the supply of cotton in the local market changes. Regardless of whether a business finds itself in a long position or a short position, it is important to understand how the duration of this position and the price level of the position will influence the amount of risk the business is taking. Factors to Consider When Undertaking a Position Analysis A number of factors relating to pricing and the time period or duration that the position is held impact the overall position of the trader. These factors include: 30

10 1. How is the Purchased Commodity Priced? The magnitude of risk that a trader takes on is heavily influenced by how close the price at which a trader buys and sells is to the current market price. For example, if a trader is able to buy cotton from producers at price that is far below the current market price, he will be in a less risky position then a trader that is buying cotton from producers at a price (local equivalent) that is very close to current market price. For the first trader, who is purchasing cotton below the current market price, if the market falls before he sells there is still a chance that his purchase price could be at or equal to his sales price. However for the trader that is purchasing cotton from farmers at or close to the current market price, if the market falls even a few cents and he will immediately lose money. As another example, if a trader is able to agree to a sales contract with an international buyer at a price well above the currently market price they are in a less risky position then a trader who agrees to a sales contract at a price very close to the current market. For the trader who agrees to a sales contract above the current market price, if price moves up, he still may be able to purchase cotton from farmers at a competitive price. On the other hand, for traders who have a sales contract right at the current market price, they may not be able to raise the price they purchase from producers in order to compete with other buyers in the market and possibly not be able to get the volumes necessary to fill the contract. Another example can be seen in the two-phased pricing system that is utilized by cooperatives in a some countries. When purchasing cotton from cooperative members, the cooperative pays a stated price up-front and pledges to give producers a second payment at the end of the season. The second payment is essentially a "top-up" on the first payment and is usually based on the amount of profits the cooperative makes in a season. By setting the initial payment at a price well below the market, if prices fall, the cooperative will not lose money. They may only be able to make a small second payment (and in some cases no payment at all), but they will not lose money. The upside of this approach is that the cooperative is able to protect itself against small drops in market prices. The downside is that the cooperative may have difficulty getting farmers to sell them cotton since many farmers will take the higher price being offered by traders in the spot market even if there is the prospect of a second payment. Furthermore there is always the risk that the market could fall below the initial purchase price being offered. 2. When is the Pricing Decision Made? Price risk occurs at the moment the price of sale or purchase of the cotton is set. Often traders will buy or sell cotton based with the agreement for future delivery. For example, a cooperative might agree to buy all the cotton of its members at a fixed price in advance of harvest. When that cooperative agrees to a fixed price with its members it has exposed itself to the risk that the price for cotton will move down. On the flip side some traders agree to sales contracts well in advance of the harvest. At the time when they do this it would be impossible to deliver the cotton because the cotton is not available. In most cases they agree on a fixed price for future delivery. While the cotton will not be delivered for a few months, the moment the trader fixes the sales price he creates an open position. 31

11 3. Are the Delivery Volume and Date Known? A ginner, or trader, who has agreed to a forward contract with a buyer will need to take account of the volume and delivery date of cotton that must be delivered at the specified date. If the trader does not know what the volume will be, or when the delivery will be due, he will not include this as a short transaction. There is no obligation if there is only a vague agreement to an order at a future date, and a firm contract is not in place. 4. Time Between Purchasing and Selling? The longer the period between the two sides of a transaction (the cotton purchase and sale, or sale and purchase), the greater the potential for a trader to be impacted by adverse price movements. Similarly, the shorter the period between a trader buying and selling or selling and buying, the shorter the period during which the market can move against the trader. 5. How is the Selling Price Determined? When a trader contracts to sell cotton (signs a contract for future delivery with a buyer), the manner in which prices are set will depend upon the agreed contract and its terms and conditions. The contract between the trader and the buyer may be agreed at a fixed price for delivery on a future date. Alternatively, the contract may be based on the price of the international cotton price, at the date that the cotton is dispatched. While this is a slightly different contractual arrangement the way in which risk is created is the same. As discussed above the date at which the price is fixed determines the point at which the trader creates risk for himself. 32

12 Step 2: Breakeven Analysis The second step in conducting a risk assessment is calculating a trader s breakeven price. This is the price at which the trader needs to sell the cotton, in order to breakeven and avoid making losses. Breakeven analysis calculates the minimum level of earnings required to cover the costs of the operation or transaction. Breaking Even = Covering Costs Breakeven accurately determines the total cost for a trader of selling a pound of cotton to a buyer. This is the minimum price at which the trader must sell the cotton, in order to avoid making losses. Breakeven for risk assessment is vital for management of the day-to-day operations of the trading business. Traders need to know their breakeven figure if they wish to effectively manage their business while making appropriate and profitable business decisions. As you will see in this course, it is critical not only for the general commercial activities of a trading business, but also as part of the risk management activities of the trader. Total Costs Vary With Changes in Fixed and Variable Costs Breaking even is an activity that a trader should revisit frequently during a season, as market conditions and costs change. The costs of various variable and fixed costs are prone to rise or fall, 33

13 and a trader should regularly revisit his breakeven calculations to see if the original inputs still hold. In a trading business where operating margins are very thin, even a small change in costs can make the difference between profit and loss. Fixed and Variable Costs Breaking even involves looking at total costs, including both variable and fixed costs. Variable costs are the costs that depend on the total volume (or amount) of cotton that a trader buys and sells during a season. These costs are the costs associated with each "unit" and will rise proportionately with total volume of cotton traded. Variable costs include costs such as the collection costs to purchase cotton from producers, transportation costs and processing costs (ginning). Fixed costs are the costs that a cotton trading business will face irrespective of how much (or how little) cotton is traded during a season. These costs include office costs, full time permanent staff costs, and any other costs that a trader must meet regardless of volume. These costs need to be accounted for, irrespective of how much cotton is traded during a season. Breakeven Calculated in Cost Per Unit When calculating breakeven costs, a trader should calculate his breakeven cost per pound. The reason for working in pounds is that the cotton market operates internationally in pounds. Therefore, for cotton traders, at least part of their business is done in dollars and breakeven analysis needs to be in these units for comparison purposes. Pounds are expressed by the symbol lb, which is used throughout this course. There are various formats and approaches different companies use to record costs and determine their breakeven. In carrying out this type of analysis or evaluation there is no correct or incorrect way to do a breakeven analysis, as long as the analysis accounts for all costs associated with the business and results in the determination of a breakeven price that will cover both fixed and variable costs and can be used to determine sales contract prices and terms. The approach used in the following chapters of this module have been utilized by cotton traders in the past, but is only one example of how to determine costs and breakeven calculations. 34

14 Step 2: Breakeven Analysis Breakeven Analysis - The Basics The list below shows the basic components and inputs used to calculate the breakeven position per pound of cotton. Starting With Variable Costs Breakeven analysis should start with the variable costs per pound of cotton. Variable costs are costs that increase or decrease proportionately with the volume of cotton processed and traded. Variable costs include: Purchase of seed cotton by the ginner or trader from farmers or producers (producer price at farm gate or collection point) Seed cotton marketing and collection costs Transportation costs from collection point to ginnery Ginning costs: o seasonal labor o energy o consumables (baling materials) o spare parts and maintenance 35

15 Transportation, cost from ginnery to the port Storage and transit costs at the port (FOB sales) Controlling costs (weight, quality) Shipping costs (CFR sales) Insurance costs (seed cotton, lint, cottonseeds) during transportation and storage Financing costs (short term seasonal credit for purchasing, processing and shipping cotton) Marketing costs (commissions, export taxes, etc) All variable costs are added together to calculate the "total variable costs per pound of cotton". Including Fixed Costs The next step in the breakeven analysis is to calculate the total amount of fixed costs for the entire season. Fixed costs are costs that are required to run the trading business, irrespective of the volume of cotton traded. Fixed costs include: Permanent labor Office and management costs Travel costs Telecommunications costs Insurance (fixed assets, buildings, etc) 36

16 Interests on mid- and long-term credits Depreciation Once all fixed costs have been identified and added together, the total figure for the fixed costs of the trading business for a full season will be known. These costs need to be divided into a "per pound" figure, based upon the total amount of cotton that is anticipated to be processed and traded during the season. It is important to keep in mind that this is only an estimate since the actual fixed costs "per pound" will not be known until the end of the season when the volume is known. Therefore it is important to keep in mind that if volume changes, this "per pound" fixed cost will also change. For example, if cotton volumes are substantially above anticipated levels, fixed costs per pound will decrease. On the other, if volume at the end of the season is substantially less than anticipated, fixed costs per pound will rise. Once the variable costs per pound and the fixed costs per pound are known, the figures are added together, to arrive at the breakeven amount per unit (kilogram, ton or pound of cotton lint) in the position (location and INCOTERMS [1]) and in the currency in which the cotton will be sold. The revenues from sales of cottonseeds per unit of lint are generally deducted from the breakeven (when all variable and fixed costs are allocated to lint production, rather than allocating a share of those costs to cottonseeds production). [1] INCOTERMS are the globally recognized set of terms and definitions which relate to international trade. They are developed and published by the International Chamber of Commerce (ICC). More information is available from the ICC website or from Wikipedia. 37

17 Step 2: Breakeven Analysis Breakeven Analysis - An Example As we saw in the previous section, breakeven analysis involves calculating both variable costs and fixed costs, to come to a breakeven figure per kg of cotton lint produced for sale. This is the figure that a cotton trader will need to sell their cotton at just to cover his costs. The slides below show a simple numerical example of a breakeven process, the steps are: 1. calculating variable cost per kg of lint 2. calculating fixed cost per kg of lint 3. accounting for cotton seed sales 4. equating the breakeven price arrived at with the international cotton price quoted on the international market Calculating Variable Cost / Kg In the table above we can see that the cotton trader has calculated their variable cost per kg of lint as 700 (this is of course in their local unit of currency, as they purchase seed cotton and pay processing costs in local currency). To reach this figure for variable cost / kg they had to: 38

18 include the purchase price of seed cotton, collection costs (collecting the seed cotton from farmers, etc.) and the transportation costs to the ginnery. account for the ginning out-turn - in this example the trader knows that it takes 2.5kgs of seed cotton to produce 1 kg of cotton lint (out-turns will vary slightly depending on location, etc. and a trader will use his specific out-turn figures to calculate his breakeven). include all the costs from ginning to delivering to port, these include ginning fees, transporting to port, storage, etc. When all of these costs are added together, the trader discovers that his total variable costs are 700 per kg of cotton lint. Now they need to add in their fixed costs... Calculating Fixed Costs / Kg In the table above, we can see that the trader has calculated his fixed cost / kg of lint at 100 (in local currency). The trader did this by: adding together all total costs - including permanent staff, depreciation and all other costs that apply to their operations, irrespective of how much (or how little) cotton they trade. This gives the trader a figure of 3,600,000,000 for total fixed costs. dividing the total fixed costs by the total production of lint (the total amount of lint they will be trading). This then gives them a figure of fixed costs per kg of lint. {Total production of lint in this example is given as 36,000 tons so it must be converted into kgs. To do this conversion multiple by 1000 (ie 36,000 tons x 1,000 = 36,000,000 kgs).} 39

19 It should be raised here that the trader will need to have a reasonably good understanding of what volume of lint he anticipates trading during the season - as this will play a big part in determining what his fixed cost / kg is. If the trader overestimates total production, he will end up with a lower per kg cost than is accurate, while if the trader underestimates production, he will end up with a higher per kg cost than is accurate. As such, a trader will start the season estimating (making a calculated guess) as to what volume of cotton lint they will be trading and as the season progresses, they shall have to keep updating the figures to reflect any changes in total volumes. Now that the trader has both a variable cost / kg and a fixed cost / kg they need to calculate their total cost of lint / kg... Calculating Total Cost Lint / Kg In the table above we see the trader has calculated their cost of lint / kg. They have also converted this from local currency to US dollars. They did this by: Adding together the fixed and variable costs / kg to reach a figure of 800 (local currency) for the total cost of one kg of lint i.e =800. Taking account of the income that they will earn from selling cotton seeds. They calculate the income from cotton seeds by: 40

20 o using a formula to determine how much cotton seed they will get from the seed cotton (in this example they assume 50%) o they have estimated (in the variable costs) that they need 2.5kgs of seed cotton to produce 1 kg of lint. As such with a 50% seed cotton to cotton seed formula they know they'll get 1.25 kgs of cotton seed for every kg of lint they have. o they estimate the market price for cotton seed sales will be 80 (local currency) per kg. o as such for each kg of lint they will generate 1.25kg of cotton seed which will sell at 80 (i.e x 80 = 100). As the cotton seed that they sell is an additional stream of income, they have to deduct this figure from the total costs per kg of lint to reach the net cost of lint / kg (this extra income in effect reduces the breakeven cost). This leaves the trader with a figure for net cost of lint per kg in local currency. The next step in the process is to use the exchange rate to calculate the US dollar / kg figure. The final step in the process is to then work out what the US cost per lb is (cotton in international markets is quoted in lbs and as such to compare and contrast for breakeven purposes the trader needs to work out their figures in lbs). This is a simple calculation which involves dividing the US dollar cost of 1 kg on lint by Now the trader has a breakeven figure per lb in US dollars. There is now just one more step to follow - namely equating the breakeven figure with the cotton quoted on international markets. This final step will be covered in a few pages time in the section "Accounting for Other Costs". 41

21 Step 2: Breakeven Analysis Breakeven Analysis - Dynamic Monitoring Throughout A Season Impact of a Change in Variable Costs on Breakeven Analysis Frequent monitoring of costs throughout a season is vital to identify changes in fixed or variable costs. Failure to recognize and account for a change in costs will result in a trader having an incorrect understanding of his breakeven position.this may potentially lead to inappropriate decisions made during a season that could result in financial losses. While almost all costs (transportation, labor, power, etc.) can change during the season, the most common change in price is due to the change in the purchase price of cotton. A rise in the purchase price of cotton (price paid by a trader to producers for their cotton), significantly alters the breakeven price. If the trader fails to acknowledge and account for the impact that this change would have on his breakeven analysis, it would have an adverse impact on his business decisions. Without accounting for the rise in cotton price, the trader will underestimate the price required to sell the cotton in order to breakeven and cover costs. In the above table we can see what happens when a change in one of the elements of a variable cost changes. In this case the price of seed cotton rises significantly and this directly raises the total variable cost per kg. Any change in any part of the variable cost elements will affect the variable cost total and therefore a trader must continually monitor costs and update their breakeven analysis. 42

22 Step 2: Breakeven Analysis Breakeven Analysis - A Change in Quantities A Change in Fixed Costs Per Pound Changes to assumptions on quantity of cotton traded during a season, will directly affect the breakeven price. Basically if a trader has conducted a breakeven at the start of a season he will have had to estimate what volume of cotton he is anticipating to purchase and trade that season. However if the volume of cotton traded during the season is different / changes from his earlier assumption he will find his breakeven changing as the fixed cost per lb will change due to the change in total volume of cotton traded. Even if variable costs per pound and total fixed costs do not change, a change in the total amount of cotton traded can have a significant effect on the trader s breakeven price. Therefore, it is vital that the trader monitor not just the variable and total fixed costs, but also the total volume of cotton traded during the season. While fixed costs remain the same throughout a season, any change in total quantity of cotton traded during a season will change the fixed cost per unit, and the overall breakeven price for an lb or kg of cotton. 43

23 The table above provides a simple illustration of how a change in the volume of cotton lint produced can affect the cost per lb or kg of cotton lint. In the above table, the estimated production volume of lint was 2,520,000 kgs this resulted in a fixed cost per kg of 200. However when the production volume is revised down to 1,680,000. The fixed cost per kilo rises to 298/kg and this directly raises the total cost per kg of lint produced. As the example shows it is vital for a trader to keep updating their breakeven to ensure that changes in volumes and costs are identified, so that they can operate with correct information on their breakeven price. 44

24 Step 2: Breakeven Analysis Breakeven Analysis - Accounting for Other Costs As we saw in the breakeven example, the final step in conducting a breakeven analysis is to compare it to the international market price. The table below details how this is done. Breakeven Equivalent Price on the International Cotton Market Once a trader understands his breakeven position, he can use this figure to calculate if the international market prices are sufficient to cover his breakeven position. One additional figure needs to be incorporated in this calculation, to accurately reflect the domestic cotton price against the international market price. This figure is the differential between the local price and the international cotton price, represented by the benchmark Cotlook A Index. Differential The differential figure is made up of a quality differential and location differential. Quality Differential 45

25 The international reference price for cotton is based on a standard cotton quality (grade Middling, staple length 1-1/32 inch or 27.8 mm). However, cotton quality varies with the origin (or growth), the variety, climatic conditions, production practices, harvesting and ginning methods. Those quality differences translate into price differentials, i.e. a premium or a discount against the base quality of the reference cotton. The trader will need to add (or subtract) this differential to the existing breakeven. Quality differentials for a given growth are well known, and they are available from various sources (Cotton Outlook, cotton associations, international merchants). A quality premium will be added to the trader s breakeven price, while a quality differential discount will be subtracted. Daily quotations for the main types of cotton traded internationally are published by Cotton Outlook and are available on a subscription basis. Location Differential International reference prices are based on Cost and Freight (CFR) costs main Far East ports. The cost of maritime insurance is usually paid by the buyer. The quotations also include the commission paid to the agent in the importing country (usually 1% of the sale price). International prices include shipping costs from the exporting country to the port of importation, which are not included in the traders breakeven costs (which will usually only include FOB costs). In order to get a breakeven figure that is comparable to the international price, the differential from FOB to CFR must to be added to the trader s breakeven price. Final Breakeven Price on the International Cotton Market The final figure calculated in breakeven analysis is the price of cotton that a trader needs to see on the international market, in order to breakeven. This figure enables a trader to look at the international market price, and evaluate the likelihood of making a profit (if their breakeven price is below the international market price) or a loss (if their breakeven price is above the international market price). 46

26 Step 3: Marking to Market The final step in risk assessment is known as marking to market. Marking to market is the process of determining current profitability by looking at the costs and position of a trading company in relationship to current market conditions. This is carried out by using both position analysis and the breakeven price calculation to determine if, at current international prices for cotton, the company would be making or losing money. Market Prices Change Continuously, and Changes in Market Prices Affect Profit and Loss As we saw in the introductory module of this course, cotton prices are highly volatile, often moving significantly over short periods of time. We saw that even on a day-to-day basis, cotton prices can change. These changes have a significant impact on cotton traders, as their profit margins are usually thin and even small adverse movements in international cotton prices, can lead to losses. "What is Our Estimated Profit and Loss Now?" Marking to market involves comparing a trader s current position (position at a certain point in time) with the international cotton price. This provides a current assessment of the trader s profit or loss. The trader will consider his current position (how long or short he is), the breakeven, and then perform a mark to market analysis to calculate the profit or loss. Marking to Market = Analyzing Profit and Loss at the Current Market Price 47

27 The goal of marking to market is for a trader to know if he needs to update his trading strategy, in order to avoid a potential loss or to realize a potential gain. 48

28 Step 3: Marking to Market The International Cotton Market Thinking in Two Markets When ginners/traders are "marking to market" they are using the results of their position analysis and breakeven analysis and the international market prices for cotton to determine how they are doing and whether they are operating profitably or at a loss at a given point in time. A ginner is knowledgeable about the local cotton market as he is working with local farmers and producers as well as exporters and buyers. He will have a good understanding of local prices and local issues that affects his business. However when marking to market, a trader will need to look at the international prices quoted for cotton and relate this price to his current business operations to determine how he is doing. This requires traders to gain a good understanding of how international markets operate and how their activities relate to the local markets. The local and international markets are very different marketplaces, but are also closely related. A trader who is effectively managing risk will need to be "thinking in two markets" namely their local physical market and also the international financial cotton markets. As this course has already illustrated, prices in all local cotton markets are ultimately determined by movements on the international financial cotton markets - as such, a trader that is trading cotton needs to have a good understanding of the pricing of cotton on the international markets. 49

29 Step 3: Marking to Market Examples of Marking to Market The following example provides an overview of the three-step risk assessment: Phase 1 The trader has an open long position (calculated in step 1) of 3,750 tons of cotton (he has bought this cotton prior to selling it). Phase 2 The trader has calculated that his breakeven price (calculated in step 2) for a lb of cotton is 63 cents (this is the international market price that would at least cover the trader s costs and avoid a loss). Phase 3 Currently the international market price for cotton is 58.5 cents per pound, i.e. 4.5 cents below the trader's breakeven costs. If the trader were to sell the cotton at this level of price, the trader would lose $372,000 $ ((4.5cts/lb x ) x 3,750,000) (calculated in step 3). What Does This Mean? Marking to market involves taking a trader s current position (whether long or short) and the breakeven price, to calculate if the trader will make money or lose money, at current market prices. The result of this exercise will guide the trader on steps that need to be taken going forward. In this example, the trader has not yet actually lost money, but if he were to sell his cotton today at today s current market price, he would generate a loss. Any loss (or gain) shown when marking to market, only occurs once the trader has actually undertaken the final purchase or sale of the transaction. However, marking to market gives the trader a strong appreciation of where he currently stands. As we have already noted, cotton prices are volatile and any change in the price of cotton, will affect the trader s current loss or gain. In the example above, if the price of cotton rises by 10 cts/lb one month later to reach 68.5 cts/lb, the trader would find the loss of 4.5 cts/lb turned into a potential gain of 5.5 cts/lb, resulting in an estimated total profit of $455,000 ((5.5 cts/lb x2.024) x 3,750,000 kg). By understanding the current position, performing a breakeven analysis and marking to market the results, the trader can update his positions on a frequent basis. In this way, a trader will have a much clearer idea about potential gains or losses. Most importantly, the business decisions of the trader will be based on relevant and timely analysis. 50

30 Step 3: Marking to Market Marking to Market - Example of Loss When International Prices are Lower Than the Breakeven Price A trader is long 3,000 metric tons of cotton (i.e. he has bought the cotton without having either sold, or agreed to sell, the cotton). The breakeven price on the international market (including quality and location differentials) is 58 cents per pound. The equivalent current market price is 55 cents/lb. This means that if the trader were to sell his cotton today, he would generate a loss of 3 cts/lb. The total market to market loss (if the cotton were sold today), would be $198,000 (3 cts/lb x x 3,000,000 kg). This example does not state that the trader is currently making a loss. However, it shows that when the international price of cotton is at 55 cts/lb, the trader has the potential to make a 3 cent-loss for each pound of cotton if he were to sell. The trader will realize this loss only if he actually sells the cotton. However, this exercise provides the trader with a good overview of his business and the potential gain or loss (at a certain point in time) based on his position, the breakeven price, and the current international price of cotton. 51

31 Step 3: Marking to Market Marking to Market - Example of Gain When International Prices are Higher Than the Breakeven Costs A trader is long 3,000 metric tons of cotton (i.e. he has bought the cotton without having either sold, or agreed to sell, the cotton). The breakeven price on the international market (including quality and location differentials) is 58 cents per lb. The equivalent current market price is 65 cents/lb. This means that if the trader were to sell his cotton today, he would generate a gain of 7 cts/lb. The total market to market gain (if the cotton were sold today), would be $463,000 (7 cts/lb x x 3,000,000 kg). This example does not state that the trader is currently making a gain. However, it shows that on a specific day when the international price of cotton is at 65 cts/lb, the trader would make a 7-cent gain for each pound of cotton if he were to sell. The trader will realize this gain only if he actually sells the cotton. However, this exercise provides the trader with a good overview of his business and the potential gain or loss (at a certain point in time) based on his position, the breakeven price, and the current international price of cotton. Any movement in the international market price that occurs between this exercise and the sale of the cotton, will impact the final earnings of the trader and should be recorded in his marked to market analysis. The trader can now make better and informed decisions about his business. For example, the trader may wish to continue building cotton stocks, knowing that the breakeven price is significantly below the market price and showing a profit. Or, because he knows that the market might fall, the trader may be happy with the marked to market profit estimate, and quickly sell the cotton in order to realize the profit. 52

32 Profit and Loss Profiles Net Position A trader can show profit or loss, depending on his net position, as the market price for cotton rises or falls. This highlights the fact that a trader s potential profits and losses are dependent upon the net position (long or short), and the direction of market price movements. All traders should always be aware of their net position and monitor prices. In this way, the trader can see when he is benefiting from price movements, and when the price movements are affecting his business adversely. Long Position A trader who holds a long position (i.e. he has bought more cotton than he has sold), benefits from a rise in cotton prices and generates increased profits as the price of cotton moves up further from the breakeven price. On the other hand, the trader is adversely impacted from a fall in cotton prices, as the price moves further downwards and away from the breakeven price. Short Position The reverse is true for a trader with a net short position. A trader who is short (has sold more cotton than he has bought) generates profits as the price of cotton falls further below the breakeven price. On the other hand, the trader is adversely impacted from a rise in cotton prices as the price rises further upwards and away from the breakeven price. 53

33 Conclusion Both "long" and "short" positions create risk for the trader as the price of cotton moves. A trader needs to understand his net position and take actions that will protect him from changing cotton prices. The net position is important to understand, as it determines the potential exposure to price movements. A trader will need to know his net position and his breakeven at all times. He can then compare these figures to the international market prices, and calculate the potential profit or loss for his business at any given moment. 54

34 Monitoring Price Risk Need for Frequent Updating and Constant Monitoring As we have seen, there are three steps that a trader must work through in order to undertake a risk assessment. However these steps are not "one-off" exercises, but steps that require constant updating, monitoring and reviewing. Risk Analysis is a Dynamic Process A trader s position will vary throughout a season as he buys and sells cotton. Similarly, the breakeven point will vary as costs of the operations change. In addition, the international cotton market prices vary on a daily basis, and therefore, the trader s marking to market will alter on a daily basis. It is vital that a trader continually and consistently revisits the price risk assessment, to be aware of changes and the current standing of his business. This will enable the trader to make decisions in a sensible, informed and knowledgeable manner. Monitoring a position can be done through continual updating of marked to market analysis. By consistently updating this analysis, trading companies can keep track of how changes in the price of cotton will affect their overall profitability and inform their business decisions. Failure to Monitor Risk will Result in Trading Losses 55

35 A trader who fails to update the risk assessment analysis may find that he is working on outdated and incorrect assumptions, resulting in losses rather than gains. 56

36 Liquidation Liquidation is the process through which a trader can close out his current position. For example, if a trader has a sales contract he will need to purchase cotton to cover that position in order to "liquidate his position". The actual gain or loss that will be "banked" is not known until a trader has liquidated his position. Liquidation - Definition The process of realizing a loss or a gain, achieved through the purchasing and selling of cotton, i.e. converting existing stocks at hand into cash, is the process of liquidation. Trader Positions and the Impact of Liquidation A trader is liquidating his position whenever he closes a position (either buying cotton when short, or selling cotton when long). However, if the the trader has not been conducting frequent risk assessments, he is doing this blind without knowing what the loss or gain might be. On the other hand, a trader who has been conducting frequent risk assessments will close a position (buying cotton when short or selling cotton when long), with a clear knowledge of the profit (or a loss) that he is realizing. The difference is obvious and significant. All traders prefer to make decisions knowing the potential outcome. 57

37 For example, a trader who realizes that his present net position will result in a loss may change the strategy he uses to liquidate his position in order to avoid a loss. Alternatively, the trader may decide that he can afford to cover the loss. This is clearly a much better position under which to operate, rather than making decisions "blind" and not being able to make an informed choice. Liquidation Timing Depends on a Number of Factors Liquidation requires either the ability to buy cotton from cotton producers, or to sell cotton to a buyer. The time that this takes will vary from trader to trader depending on circumstances. A trader who wants to liquidate a position will have to account for the time this takes, and appreciate that any changes in cotton prices during liquidation will impact his ultimate gain or loss. 58

38 Summary of - Risk Assessment This module has shown how a cotton trader can undertake a risk assessment of his business through position (long or short), breakeven, and marked to market analysis (understanding the current profit or loss at a specific moment in time). : As a next step, why not conduct a risk assessment of your business. If you are not currently within a season, use last seasons data to see how your position changed throughout the season. If you're currently in a season, see where you are and what your marked to market position looks like! 59