Commodity Risk Management as a function is undergoing a crucial phase today as a result of several structural changes worldwide. As banks quit commodity trading businesses and regulatory reporting tightens, Risk Managers are being forced to think of new ways to deal with the changes. When faced with such an environment, I believe it is far more important to have the right questions rather than the right answers. So in this blog post, we identify the Top 5 Questions Commodity Risk Managers should ask.
- How often are inputs from Risk Management incorporated in your organization’s trading and budgeting decisions?
This is one of the most critical questions facing every Risk Manager today. It’s just another way of asking “How relevant is Risk Function to your organization?”, since for many organizations, Risk Management is just an obligatory process that has been pushed down from the top and has very little practical value. The view that it is seen as a way to “control the trades (the primary money-makers)” does not help either. Ironically, until you incorporate Risk in trading & budgeting decisions, you will never be able to prove how it can be used to improve margins, sustainability and competitive edge.
- How do you identify and act on Hot-spots in the portfolio?
Many organizations are not equipped (either technologically / people skill wise) to see diversified component risk, since it involves far greater amount of calculations. This handicap makes them work with a naive approach of stand-alone risk that is never really a good idea. Component or Marginal Risk shows the sensitivity of the portfolio to a particular position. It gives a clear idea of the real hot-spots in the portfolio that can be tweaked to reduce the risk.
- How much of your Risk Function is Technology-enabled?
One of the main reasons for Risk Function remaining a non-starter in many organizations is the lack of an appropriate technology solution that can address specific risk requirements. For the purpose of this discussion, we can safely assume that a complex maze of excels with formulae referencing back and forth is not a “technology-enabled” solution ! A real solution should automate the risk process, making it easier to track the most critical areas of the portfolio. It must be easy-to-use and provide the most needed metrics instantly.
Take a look at RiskEdge Software, which is built specifically for Commodity businesses with latest technology. It is configurable, easy-to-use, and cost-effective allowing organizations of all sized to adapt it easily either on Cloud or on-premise.
- How do you estimate and prepare for losses beyond VaR?
Most organizations stop with calculating VaR numbers for their portfolios. This approach holds good only if you assume that losses will never cross VaR ! Many organizations struggle with even integrating VaR in their Risk Management approach due primarily to lack of well-defined Risk Limits and Policies. Such half-hearted measures eventually prove more dangerous than not having a Risk Function at all since the former approach gives a false sense of security. A few organizations really go beyond these boundaries and use Conditional VaR / Expected Shortfall combined with regular Stress Testing of their Portfolios to check how much they can lose in extreme scenarios.
Further Reading: You might want to read our Whitepaper on “How to Optimize Hedging Costs“. Although it is written with specific focus on Oil Refining Companies, you can use the central theme to estimate how it could benefit your organization.
- How do you measure the RoI of your Risk Management Function?
This is probably the most important question of all, since it can potentially close the loop with the first question. If the efficiency, utility, significance of Risk Function can be somehow (even with back-of-the-envelope calculations) proved to the senior and middle management, the adoption of Risk across various departments will be easier, and it will certainly make sense for everyone to include inputs from Risk into trading & budgeting decisions.
Further Reading: You might want to read our Whitepaper on “Measuring RoI on Risk Management” which lists a new approach on measuring the effectiveness of your Risk Function.
I believe these 5 questions are most relevant for any organization that is undertaking a sweeping change in their Risk Management Function. Let us know what you think about these questions and if you have any other questions that you would like us to include in this list ! You can write to us on email@example.com with your suggestions. We respond to every email that we receive (minus the spam, of course !)