Traditional Physical commodities and energy markets are moving to derivative trading and can only get help from other industries

1. Cradlecroft Risk Management Consultants
[HOW TO SURVIVE
YOUR MARKET
GOING
“DERIVATIVE”]
STEEL MILLS, AGRICULTURAL PRODUCERS, DRY
BULK, TANKERS, CONTAINERS, MINES, OIL and
FERTILISER PRODUCERS, SHIPYARDS ALL FIND
THEMSELVES IN NEED OF HELP TO NAVIGATE
THROUGH THEIR NEWLY ADOPTED “PAPER”
MARKET SEGMENT
Phoebus Kaloudis
www.cradlecroft.com
+44(0)7958397806
info@cradlecroft.com

2. How to survive your market completely. Traditional trading strategies
change, margins and hedging strategies
moving to paper trading.
change. The nature of the physically
Time and time again traditional businesses tradable product determines the level of
come across business model changes that change that a traditionally operating
require them to incorporate derivatives into industry player will have to make to
their day to day operations. The resistance survive let alone prosper. It is very
to change is very big but market important to understand that the changes
developments such as the recent that need to be made have to be made with
movement of Iron Ore to Spot price has flexibility in mind, the nature of derivatives
caught the players (Steel Mills, Mines, will change the business by making it more
Traders) by surprise and this resistance adaptable to change and destroys the
falters or is destined to be ignored. It has traditional rigidities and market
become clear that dismissing the market inflexibilities.
changes will have grave consequences since
Most of the Risks in introducing derivatives
the new volatility can make or break the
in traditional Physical Trading Company
biggest of players.
involve mainly the fact that people’s
The risks associated with introducing perceptions of what constitutes execution
derivatives in a traditional business model and market exposure has evolved into
that has been around for a long period are something different.
substantial. For a certain size of business
Most Physical Trading Operations are not
the operational risks combined with the
operationally concerned that someone
human resource and software requirements
within the organisation may erroneously or
make the introduction of derivatives a no go
maliciously commit the company into a
area. However the majority of companies
contract that was not intended to. The
benefit greatly from their introduction
reason for that is the fact that no Physical
simply because of the enhanced Risk
Contracts can be executed without the
Management capabilities they offer
awareness of other departments that will
combined with the cash flow/margin
raise the flag etc. in addition; the mitigation
stability and lowering of Market Risk. In
of this risk in the Physical Market is quite
addition, for traders and operators the
simple since there are always ways to get
introduction of derivatives allows for
out of Physical Contracts etc. in addition the
profiting from market inefficiencies as well
risk is small since the Physical Business does
as arbitrage.
not offer any leverage, nobody can
Whether it is the usage of a financed asset physically commit 10 Vessels in a company
such as a Vessel in Shipping or Iron Ore for a that has only got 5. However this situation
Mine or trading on a physical deliverable changes completely once Derivatives are
such as a Vessel Time Charter or a Cargo introduced into the business. People
load of Grain or Fertiliser the introduction (literally anybody, external or internal
of derivatives changes the game unless the right procedures are in place) can
www.cradlecroft.com
+44(0)7958397806
info@cradlecroft.com

3. commit the business to contractual business model having the understanding of
agreements that have financial implications the risks and benefits in trading derivatives
far larger than the company itself, leverage before trading the first hedging deal. What
becomes a concern. One can execute happens in less structured environments
virtually unlimited number of Freight more often than not is that the first deal is
Forward Agreements, Steel Billet, Iron Ore traded and the operation tried to work
or Fertiliser Swaps for virtually unlimited around it. One has to weigh the risks and
size. make their own mind on which path to
follow. At the end of the day this depends
In addition, most Physical Trading on risk profile more than anything.
Companies are not technologically or
human resource capable to handle the Which ever way one chooses there are
increased volatility of a Derivatives market products out there put together by
structuring parties for fees that may offer a
These issues bring to light that Traditional superior service to one’s needs. This is not a
Physical Trading firms are usually Risk Profile related decision but more a
operationally incapable to handle the new matter of scale and strategic drive towards
challenge. trading and not only hedging. In other
Their main internal resource is their words, if your newly appointed or planned
Treasury department, they are the only Derivatives Trading department is a cost
people within the firm that understand the centre similar to Treasury then you may be
basics of derivatives hedging, margins, better off without it.
credit risk, exposure management etc since Most of the businesses that have to
they have been used to dealing with this transform themselves to incorporate
through their Foreign Exchange and Interest derivatives need to look to other industries
rate exposure management. for help. They are moving into uncharted
However internal resources are at times not territory where their business will have to
sufficient or not capable of change be re-invented, re-designed and re-built.
management. Cross industry expertise is They can only count on help from other
key. The knowledge acquired in one industries or consultants.
industry is very helpful in the next and so Derivatives are perhaps the only solution to
on. The obstacles are the same and
lowering the new price risks that have
solutions are similar. Not many people for appeared in these physical markets.
example in the Mining business think that
someone that has just integrated In order to set up a derivatives operation
derivatives in a Fertiliser Producers business one needs assistance from other industries
model is the person to turn to for advice. and consultants otherwise the risks will
This is slowly changing, together with the most likely outweigh the benefits
adopting of derivatives.
In an ideal world one would review their
www.cradlecroft.com
+44(0)7958397806
info@cradlecroft.com