The International Monetary Fund (IMF) published their “World Economic Outlook” report in July 2022. The report forecasted a negative and uncertain outlook for the year and indicated that the organization believed that the risks they had highlighted earlier had begun to materialize. The world’s three biggest economies – The United States of America, China, and Europe, are predicted to face significant deceleration in the months to come.

In the earlier report published in April, the IMF lowered their estimate for growth in the world economy in 2022 to 3.6%. In this latest report, they further cut the forecasted growth to 3.2%. This marked a significant decline from 2021 when the global economy grew by 6.1%. The IMF director of research had stated that the world might be edging towards a global recession, only two years after the last one.

The IMF listed three major challenges facing the world’s economies as the cause for their concern. The first was the high inflation plaguing most of the western economies. Another was the Russia-Ukraine conflict that began in February and has caused substantial distress to the commodity markets. The prices for most agricultural and energy commodities rose remarkably due to the conflict as concerns increased over the supply of these products. The last reason was the COVID pandemic, which wreaked havoc on most economies. Not all countries have recovered completely from the downturn caused during the pandemic. The IMF report indicated that the weakening in the Chinese economy was worse than expected, as outbreaks and lockdowns continued.

These challenges, along with the measures employed to combat them, are forecast to drive growth in the U.S., China and Europe to 2.3%, 3.3% and 2.6%, respectively in 2022. The U.S. economy has already met the standard definition of a recession, with its GDP contracting for two quarters in a row. Additionally, as per the IMF report, the global economic growth for 2023 was estimated to be even lower – 2.9% on the back of these challenges. This value is marginally higher than the 2.5% growth level threshold, which usually indicates a global recession as per the IMF.

It is also important to note that while the IMF cut the forecasted growth globally and expressed concerns about a looming recession, it did state that some countries like Bahrain and India are still expected to perform strongly in the near future. The IMF projected a 7.6% growth in the Kingdom’s economy this year on the back of a strong demand for crude oil in a world recovering from the pandemic. The organization also expects the Kingdom’s non-oil sector to grow at 4.2% and inflation to be contained at 2.8% this year.

However, economic conditions globally have an impact locally in one way or another. Some of the effects have already been reflected in the volatile commodity markets and rising interest rates. In order to counter the surging inflation, the Federal Reserve has already raised its rate from 0.25% at the start of 2022 to 2.50% by the end of July. This has led to most Central Banks in the Gulf Cooperation Council region raising their benchmark rates to maintain price stability. The higher rates can potentially dissuade businesses from securing new borrowings, and from entering into hedges against the current debt. The current conditions have created a strong rationale for firms to establish measures and enhance those already in place to maintain stability in their operations and governance during these periods of stress and uncertainty.

The Federal Reserve, in an attempt to tame the 40-year high inflation, began a series of rate hikes in March 2022. The Fed’s last and biggest hike, 75 basis points, came following their July meeting. The Chairman of the Federal Reserve, Jerome Powell, in his address in August, stated that he is prepared to raise rates higher and keep them high until inflation falls back to the Fed’s 2% target. He noted that the tightening in monetary policy is likely to lead to slower economic growth and an increase in unemployment. Markets predict another 75 basis-point hike following the Fed’s September meeting, with some economists mentioning that rates would need to be kept at 4% or more for the Fed’s aim of reducing inflation to be achieved.

Source: Bloomberg

The chart above plots the Fed funds rate, and correspondingly the USD LIBOR 3M rate, and the 2Y and 10Y U.S. treasury yields since the year 2000. At the bottom, we observe the evolution of the 2/10 treasury spread. While the 2Y treasury yields usually move in a close proximity to the Fed funds rate, the spread contracts as the Fed Funds rate increases (a tightening in monetary policy employed by the Fed), and vice versa.

In addition to rising much higher than at the start of the year, interest rates currently demonstrate an interesting behavior. Since March, most yield curves have been inverted, with rates for shorter tenor rising higher than those for longer tenor. An inverted yield curve is usually associated with an economic slowdown. While this dynamic has existed for a major part of the year, the inversion has deepened recently. In the early part of August, the 2Y yield on the U.S. treasury increased over the 10Y yield by close to 50 basis points. Levels such as this have not been observed since the year 2000, when the growth in the U.S. economy slowed significantly. This period is usually referred to as the “Dot-Com bubble”.

The current Federal Reserve’s strategy to increase interest rates and employ quantitative tightening to reduce the number of holdings of government bonds from its balance sheet is in sync with the roadmap laid by the IMF in their “World Economic Outlook” report. As per the IMF, while this may bring some economic costs in the near term, it is necessary for macroeconomic stability in the longer term.

Factors such as a positive employment rate and steady inflation point to stability in the macroeconomic environment and monetary policies. In contrast, high inflation rates indicate an imbalance in the fiscal strategy, which can lead to broader issues for all participants. As noted earlier, the IMF projections and the inverted yield curve point to an economic slowdown in the near term. These events occasionally occur in a dynamic and interconnected global economy, and while they can be hard to predict at times, they pose a risk and, thus, are deemed necessary that all firms employ measures to guard themselves against their occurrence. The risk of the development of such events is referred to as economic risk.

Economic risk is the possibility of the occurrence of events or conditions in the whole economy that can affect the financial prospects of a company. It is also referred to as systematic risk since its impact is not limited to an individual company or industry. Economic risk impacts the profitability of trade between all participants in the economy. In an economic slowdown, the cost of funding increases, and most financial institutions will either minimize offerings or further increase the credit charges for counterparties. It can cause significant exchange risk volatility and may bring about changes in fiscal policies or regulations. These events usually have more than one source, which can include periods of recession, geopolitical circumstances, commodities supply-chain disruptions and rising prices, and many more.

It is important to note that while this risk cannot be negated entirely, it can be mitigated. Employing measures to manage economic risk may allow companies to survive or even thrive during periods of slowdown. The approach taken would generally be similar to one adopted to manage market risk and would include the following steps:

• Identify the sources of risk

• Quantify the risk

• Manage the risk

• Monitor the Risk

A recommended course of action beings with establishing a regulatory framework within the firm as early as possible and identifying the Key Performance indicators (KPI) that it believes must be protected. The presence of economic risk necessitates that the firm assesses and measures the impact on these KPIs not only from interest rates or foreign exchange fluctuations, but also from revenues that may be impacted by an economic downturn. Protocols and policies that are put in place, for example, to guide the hedging process or to ensure that the inventory is maintained efficiently, can prove beneficial, especially in periods which are stressed. Additional areas for focus can be optimizing cash flow forecasting and investing in new hardware and technologies to ensure that business can continue under unfavorable conditions.

The current economic environment displays the presence of high-impact economic risks. Within a relatively short period of time, the world has faced successive unpredictable events which have caused significant financial shocks in the global markets. These events show that the challenges companies face come from a variety of risk factors. Firms have been fueled to reassess and enhance their risk framework to ensure that they thrive in an environment of heightened uncertainty. While economists and market behavior indicate the possibility of an economic slowdown, firms must employ measures to ensure that they are not at the mercy of such events and can navigate periods of volatility with a clear heading.

Last month the Bahrain Exchange (Tadawul) launched single stock futures (SSF) contracts – its second in a series of derivatives products to be introduced in the Bahrain stock market. This new addition was released just two years after the launch of the MT30 Index futures contract, which was the first exchange-traded derivatives product in Bahrain. Diversifying the asset classes available for investors in the capital markets is one of the country’s main financial sector objectives. And as such, the introduction of derivatives can play an integral part in attaining such an endeavor. They provide for an effective tool to manage risk, expand products available for trading, enhance pricing transparency, and promote a well-functioning capital market.

As many of you are aware, a futures contract is a legally binding agreement between two parties, where both parties agree to buy or sell a particular asset of a specific quantity at a pre-specified date in the future for a fixed, predetermined price. Unlike the MT30 index futures, which derives its value from an underlying index, SSFs are based on individual stocks. The first tranche of SSF is based on ten listed companies. The choice of underlying stocks has taken into consideration typical factors, such as market capitalization and liquidity, to ensure sufficient trading activity in the SSF market. Each contract consists of 100 shares of a given stock, and trades are funded by depositing an initial margin. The initial margin (generally around 20% of the stock’s cash value) would be determined by the Securities Clearing Company (Muqassa) based on the potential volatility of the underlying and investor’s classification.

Following a number of capital market reforms in the last couple of years, the Bahrain stock market was successfully included in major global indices such as the FTSE Russel and S&P DJI Emerging Markets. And since then, it has been attracting more foreign investments. The launch of a new type of equity derivatives does seem like the next logical step towards enhancing local and foreign institutional investors scope in managing market risk and maintaining exposures to target investment benchmarks. Thus, such an introduction could undoubtedly add further depth and breadth to one of the largest stock markets in the region.

The impact of derivative trading on cash markets depends on many factors. It would include the regulatory structure, trading mechanism and infrastructure, contract design, and the time of introducing derivatives in the market. Having said that, the literature around the impact of SSF and derivatives, in general, on the underlying stocks (cash market) is somehow mixed.

In terms of volatility, the introduction of SSF trading doesn’t seem to influence the volatilities of their underlying counterpart. In fact, the underlying price volatilities had decreased by empirical examination in markets such as Thailand & Russia post the introduction of SSF. As for price discovery, the corroborative empirical evidence concerning the role of equity derivatives at large in the process in which the cash market incorporates new information into asset prices is well documented. This entails that the prices in the derivatives market lead the prices in the spot market as they reflect new information more efficiently.

Even so, a complete consensus among researchers around this particular role is still absent due to some conflicting or inconclusive results involving the direction, volatility, and pace of information flow between the two markets. What about liquidity? There is a considerable amount of debate regarding the impact of derivatives on the liquidity of the underlying assets. In markets such as the U.S., several studies have indicated a positive correlation between the introduction of derivatives and trading volumes of the underlying by statistically inspecting the volumes prior and post listing of the derivatives. On the other hand, in a market like Malaysia, the introduction of SSF did not seem to impact the cash market liquidity levels. While in India, some studies suggest that it had an adverse effect by diverting speculative activities from the cash market to the derivatives market.

Regardless of their impact on the cash market, there is enough evidence in the literature to suggest that derivatives markets tend to attract informed traders – be it for hedging, arbitraging, or speculating. Why not if they provide less transaction cost, less upfront money requirement, and fewer trading restrictions. When it comes to SSFs, their ability to structure a strategy focused on one individual company’s stock and offer leverage compared to stock trading makes them an attractive proposition for some traders.

They can also offer traders a decent alternative to short selling. Short selling occurs when a trader borrows a security and sells it on the open market, planning to buy it back later for less than the sale price. The Kingdom has regulated this trading mechanism since 2017 and subsequently amended it in 2021. Nevertheless, for reasons beyond the scope of this article, short selling is heard rather than seen locally. With SSF now in the market, traders can mimic the economic objective of short selling with relative ease and less cost, given the lack of the Uptick Rule required in short selling.

Apart from SSF’s capacity to assist fund managers and institutional investors in managing their investment portfolios according to different risk appetites, they can also play a key role in the nation’s initiatives toward developing the Exchange Traded Funds (ETFs) industry. Globally, SSF and index futures alike are usually utilized as effective tools to either raise leverage or deleverage ETF’s and meet investors’ required returns. Furthermore, an ETF fund manager may employ derivatives to hedge against the unfavorable movement in the underlying or entice investors who would bet against the direction of the underlying by investing in what is called inverse ETFs. It is worth noting that derivatives in general, and SSF in particular, are risky by nature. Traders and investors should understand that the risk of losing significantly more than the initial investment is consistently present. Dealing with derivatives would require vigilance. Positions are marked to market daily, and the possibility of margin calls must always be taken into consideration. With SSF, it is important to consider the level of volatility of the underlying stock as it has a direct relationship with the variability of trader’s open futures position. Moreover, the liquidity levels of the chosen futures instrument are of utmost importance. Illiquid instruments can exhibit excessive price disparities and, thus, could be a major determinant in the success or failure of a trading/hedging strategy.

Since its launch in August 2020, the MT30 index futures have attracted modest liquidity, to say the least. Based on press statements from Tadawul’s CEO, the instrument has traded more than 500 contracts with a total notional value of SAR 150 million. Moreover, he highlighted the strategic intentions behind its launch and that it targets a specific group of international investors that follow the MSCI. By looking at similar markets, the total notional value of derivatives usually matches or surpasses the equity trading value. The total trading value in the Bahrain stock market has amounted to SAR 2.24 trillion in 2021. Thus, it is fair to say that the Kingdom’s path towards reaching a peer-like level of volumes is yet far and unclear. Nevertheless, a limited level of liquidity is, to an extent, expected in the first year or two as market participants get familiar with the new product and the market reaches a form of maturity. To provide some global context, the below table, sourced from the World Federation of Exchanges 2021 report of derivatives activity, shows the top ten exchanges by the number of stock index futures contracts traded in 2021. When it comes to index futures, the B3 (a Brazilian stock exchange) constitutes around 60% share of global volume. As for the top stock index futures traded, the E-MINI S&P500 has been the most active, with more than 403 million contracts traded in 2021.

Several exchanges worldwide have attempted to introduce single stock futures, but not all have succeeded. The progression of trading activity and thus liquidity in the local exchange-traded derivatives market will rely on many aspects. The below brief is a non-exhaustive list of some of the key determinants:

Underlying & Contract Characteristics: Stocks with large market size, higher volatility, and deeper liquidity have shown to have a positive impact on contract success. In addition, regular mispricing between the spot and futures markets also invites informed investors to the single-stock futures market. Besides, factors such as the contract size, tick size, and contract months on a particular stock significantly contribute to the increase of open interest and traded volume. Few researchers have suggested that a smaller contract size can positively affect the futures trading volume, which in turn contributes to the success of the futures contract. On the other hand, tightening the daily price limit can have the opposite effect.

Investors Type & Knowledge: In a market where individual/retail investors heavily contribute to daily trading volumes, it would not be a surprise for such a market to experience limited liquidity in futures. As mentioned earlier, derivatives markets attract informed traders/investors, and hence, a futures contract would theoretically succeed if it addressed a commercial hedging need. This would require that informed speculators would be able to manage the risk of taking on the hedger’s positions. Realistically, the possession of knowledge among retail investors around futures market and the way in which they operate is instrumental to its success.

Additionally, the fact that futures are to some degree ambiguous from a Shariah-Compliant perspective seems to discourage a particular group of investors from trading them. A focused informational approach to address this gap may very well attract more investors.

Market Makers & Liquidity: Various researchers have highlighted the vital task of market makers in boosting liquidity. The most common types of market makers are brokerage houses. They would always provide transparent two-sided markets when a market is open. Even if liquidity is ample at certain times, their role when markets are volatile and spreads are wide may well allow for less price deterioration in a particular security. Market makers provide necessary liquidity and depth to markets and, at the same time, profit from the difference in the bid-ask spread.

It remains to be seen whether SSF will perform as intended in the coming months and years. I believe the Bahrain Exchange as well as the entire ecosystem supporting this initiative deserves credit for their efforts in advancing the Bahrain stock market. It is worth noting that the launch of exchange-traded derivatives would not be possible without the development of the associated regulatory framework and market infrastructure. I have no doubt that, with time, this latest introduction will further promote the growth of the derivatives market in the country to include additional derivatives products. The next phase in line is exchange-traded options. Although more complicated to implement and trade than futures yet are, on a global scale, considered the most actively traded among equity derivatives products.

We currently live in a world of financial chaos with myriad factors beyond our control. Covid-19 still plagues some regions, constraining global supply chains. Commodities prices are going haywire as the energy crisis worsens. And central banks are raising rates at the fastest pace in decades, threatening to plunge economies into recession.

Digging deeper, you realize some factors are “known unknowns,” such as inflation skyrocketing; and we can prepare for them easily. But further complications arise when “unknown unknowns” strike! Who would have predicted the Russia-Ukraine war would break out just as the world emerged from lockdowns?

Looking at these events, it is nearly impossible to draw conclusions or determine likely outcomes. Even the most complex of financial models fail to predict black swans. This is exactly why it is disastrous to depend on market predictability in your decision-making process and your financial risk management.

Given the environment of rising central bank rates, I focus on interest rate risk management in this article. More importantly, I reveal how it is unsafe to play with the order of best practices when hedging.

The floating interest rate index in the local market, represented by the Bahrainn Interbank Offered Rate (SAIBOR), recently crushed a new record and reached a 13-year high. While the index tracks the corresponding London Interbank Offered Rate (the LIBOR), local economic factors play a role in moving the average spread beyond the comfort zone. Hence, the 3-Month SAIBOR reached 3.32% on 20^th June 2022, while the LIBOR counterpart traded at 2.12% during the same day. This represents a spread of 120 basis points (1.20%) versus the 10-year average of only 63 basis points (0.63%). The current spread is getting closer to historical averages.

Until very recently, to hedge a 5-Year loan via an Interest Rate Swap, the fixed cost was north of 4.40%, which remarkably increased from below 1.5% in 2020! These record numbers are attributed to a more aggressive Fed and expected rate hikes in the future.

Creating and endorsing an internal approach or framework to manage the interest rate risk is not a difficult task. But making it implementable and objective requires collective efforts among various stakeholders within the institution. Below are high-level guidelines.

The first step is documenting the items exposed to interest rate risk. It does not matter if the underlying is borrowing or investment. This process is also forward-looking, meaning you must factor in projected or highly probable transactions.

Certain core elements are involved in the identification stage. The company must examine its risk policy and appetite, understand the net position of the exposure, and remember the financial covenants or KPIs in place.

You have the exposure at hand now and are ready to quantify its impact. One of the common traps here is to apply quantitative assessments strictly and ignore the qualitative aspects.

Quantitative methodologies include using risk metrics to understand the magnitude of the risk, such as Historical Simulation of Value-at-Risk (VaR), sensitivity assessment, scenario analysis, and Monte Carlo Simulation. These methodologies not only indicate how much loss you should expect in bad times but also reveal the flipside of the coin: the opportunities these fluctuations hold.

Yet such quantitative analysis lacks meaning without proper contextualization. Qualitative assessment and expert judgment play a role in understanding the company’s direction when managing the risk. Together, the two methodologies eventually teach us how significant or insignificant the exposure is relative to the KPIs and the company’s objectives.

Companies must measure the impact of interest rate risks against the KPIs and/or the covenants. Doing so would provide an overall picture of how to manage the risk according to the risk profile.

Now is the time for action – dealing with the identified risks at hand. A vast array of approaches exists to control interest rate risks. They are not just restricted to off-balance sheet hedges. You can use on-balance sheet hedges to manage the risk via different techniques such as asset and liability management (ALM) or offsetting one exposure with another. An off-balance sheet hedge approach could utilize financial derivatives, which many corporates apply. However, this requires a holistic understanding of the associated accounting and economic implications.

Notably, “controlling” the risk does not necessarily mean taking action to control it. It includes avoiding it altogether, mitigating it, or accepting it.

This is the only stage where we know whether the risk management activities have been practical and effective.

All related stakeholders should be involved in the process across the management levels. There must be clear accountability and risk owners to enhance the feedback loop and supervise the effectiveness of the current risk management tools. It involves communication, which should also be present in all the stages above.

It is nearly impossible to create a standardized risk management approach and neither dynamically alter nor optimize it. Therefore, the process will evolve to become more efficient and tackle emerging risks. This adjustment process aims to bridge the gap between the actual result and the required output.

The board of directors and senior management rely on the report to assess the levels of risk, map it against the risk profile and evaluate the effectiveness of the current practices. Hence, assessing against quantifiable, relevant, critical, and timely KPIs is key to successful risk reporting, which would ultimately lead to a better and informed decision.

Risk management decisions must occur in the correct framework and context. Otherwise, the outcome from basing the decision on non-controllable factors will prove, sooner or later to be suboptimal.

Once the institution insulates itself from subjective decision-making and complies with clear guidelines and best practices, it can produce clear, unbiased, and objective outcomes with lasting impact.

The art of financial risk management does not lie solely in establishing the correct policy and procedures. It also lies in ensuring they are implementable with a clear accountability matrix. Attaching emotions or market forecasting will, inevitability, destroy the essence of proper financial risk management and hedging practices in any organization.

It’s fair to say that the global economic scene is not a pleasant one to watch nowadays. Corporates are penalized with severe supply shortages, soaring geopolitical concerns, cloudy economic outlook, and volatile prices across almost all asset classes. In return, we are all forced to feel this in our daily routine as economies battle one of the most aggressive inflation episodes ever witnessed. For example, looking at Turkey, April’s reading for Consumer Price Index (CPI) increased to 70% year-on-year; a compelling case for corporates to reconsider doing business in the country. In this bulletin, we will try to understand what inflation is? What can cause inflation? Explore the policy changes that can control inflation and how investors can manage it?

The winner of the 1976 Nobel Memorial Prize in Economic Sciences, Melton Freidman, once described inflation as “a dangerous and sometimes fatal disease that if kept unchecked can destroy a society”. Freidman was known for being one of the greatest monetarism advocates of all time. The textbook definition of inflation is the rate of increase in prices over a given period of time.

Inflation can be measured in various ways and methods; the most used methods are the following:

• Producer Price Indexes (PPIs): output PPI measures the average change over time in the selling prices received by domestic producers for their output. Input PPI measures the changes in the cost of the basket of purchases required as inputs into the production process.
• Consumer Price Index (CPI): a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services. CPI is the most common across inflation measures as it calculates the broader inflation that all consumers feel.
• Personal Consumption Expenditure (PCE): instead of looking at a pre-defined basket, PCE tracks the change in prices of goods and services purchased by consumers throughout the economy over a given period. Noteworthy, the Federal Reserve’s inflation target is based on Core PCE, which takes out categories that can have severe price swings like food and energy to make underlying inflation easier to see.

As prices rise, the money you saved in the past buys you fewer goods and services today; or in other words, you lost some purchasing power. Likewise, high inflation levels could drastically erode investment returns. To account for inflation effects, investment managers often look at ‘real’ returns instead of ‘nominal’ returns. Whereby real returns are the amounts earned post adjusting for inflation. Therefore, when real returns on deposits are negative, individuals are compelled to spend rather than save and to take on riskier investments than usual. In conclusion, the effect of high inflation on real investment returns could prove destructive.

In contrast, when prices decrease over time (deflation), consumers would spend less and slow economic growth. This dilemma led economists and central banks to believe that a moderate inflation of around 2% is healthy for economic growth. Consumers are more likely to buy now than wait when prices are expected to increase. Such consumers’ behavior could fulfill economic growth aspirations.

Theoretically, inflation can be classified as demand-pull or cost-push inflation. Demand-pull inflation arises when aggregate demand increases more rapidly than aggregate supply in an economy. This type of inflation is found easier to control. It can mainly be caused by expanding economy, increased government spending, or overseas growth.

On the other hand, cost-push inflation is mainly caused by surging production costs such as raw material, labor, capital, or land. To reduce rising production costs, producers pass the increase in costs to consumers. Thus, it is reasonable to view PPI as a contributor and a leading indicator to CPI changes, especially when there is enough liquidity in the economy.

What is causing current inflation levels?

In the chart below, we break down the United States’ CPI readings into their contributions. We notice that “Commodities Excluding Food and Energy Commodities” and “Services Excluding Energy Services” accounted for more than 60% of inflation readings over the past 12 months.

But that still does not tell us if this was passed by producers or fueled by rising demand. However, when we compare the changes in United States’ CPI to PPI over the same period (chart below), we find that PPI changes were almost mirrored by CPI movements – indicating that price increases were passed by suppliers to end consumers.

Governments and central banks have various tools that could tame inflation, but none is always efficient. To combat inflation, governments could implement contractionary fiscal policy by raising taxes and/or decreasing government spending to reduce the total level of spending. Nonetheless, empirical studies suggest that fiscal policy could suffer a time-lag till the policy effects are achieved. Moreover, governments could control inflation through price and wage controls. Still, this method failed to reduce long-term inflation back in 1970s. Most economists do not consider fiscal policy the best approach to combat inflation.

Moving on to monetary policies, increasing interest rates and/or reducing the money supply could both have rewarding results on inflation reduction. However, when facing cost-push inflation, higher interest rates increase the cost of borrowing and discourage consumer spending and investment. Higher rates will also tend to cause appreciation in the exchange rate, reducing the price of imported goods. This will reduce inflation but also reduce economic activity and lead to lower economic growth and potentially a recession.

This is why when there is cost-push inflation, central banks tend to allow inflation to temporarily remain high, expecting inflation will be ‘transitory’ as we have seen over the past year. When inflation-denial elapses, monetary policymakers often take desperately expedited measures to reduce inflation – realizing it might be too late to control inflation, which can shock economic growth and lead to a recession.

Hedging inflation risk could arguably be achieved by acquiring assets that can preserve their value or generate yields higher than expected inflation. This was traditionally done through investing in real-estate and commodities. In 2022, commodity funds linked to raw materials saw rising inflows from investors looking to hedge against inflation, pushing the S&P GSCI raw materials index up by 41% YTD. Apart from traditional inflation hedging techniques, below are two of the most used instruments to hedge inflation:

• Inflation-Linked Bonds (ILBs) like the U.S. Treasury Inflation-Protected Securities (TIPS): TIPS are government-backed bonds that adjust the value of the principle according to the changes in the underlying inflation index (i.e., CPI). The TIPS spread is an actively watched spread, which shows the difference in yield between TIPS and regular U.S. Treasury securities with the same maturity. By the end of May-2022, the 5-year TIPS spread was 2.954%, meaning that inflation will need to average 2.954% over the next 5-years for TIPS to break even with a regular 5-year U.S. Treasury note.
• Inflation Swaps: Like any swap structure, inflation swap is a 2-legs swap where one party agrees to pay a fixed rate cashflow in exchange for a floating rate linked to an inflation index (i.e., CPI). In U.S. CPI swaps, for example, the floating payments will be determined by actual CPI readings while the fixed payments will be based on market implied inflation levels derived from CPI swaps curve.

Considering that TIPS carry high duration risk and significant correlation to U.S. treasury yields, inflation swaps (albeit their wide varieties in structures) are often more efficient in inflation risk management. Afterall, inflation risk can cause material damage to long term projects and is worth careful considerations and modelling.

Just as the global economic systems began to recover from the impact of the COVID 19 pandemic, another crisis hit. In late February, Russia initiated its invasion of Ukraine, boosting the uncertainty in the markets and adding more tension to already strained economic systems. To top it up, the inflation pressures in the west have left officials scrambling to tighten monetary policies. The US Federal Reserve have raised rates for the first time since 2018 and indicated to the world that further rate hikes would be coming.

On the day of the conflict, prices spiked markedly as unpredictability around the availability of these commodities arose. While prices corrected following the panic buying, they remain higher than their pre conflict levels, and the consensus in the markets is that the uncertainty is here to stay.

Volatility in the markets has increased significantly in response to the uncertainty. The chart below shows how commodity prices have been reacting to the current conflict. Both counties involved in the conflict are major exporters of agricultural commodities (like corn and wheat), energy commodities (like oil and natural gas) and minerals (like platinum and nickel).

The latest conflict has fueled further the supply chain disruptions caused by the pandemic. This has led to an increase in inflation pressures, particularly in the west. U.S inflation numbers recorded for March at 8.5% was the highest they have been in four decades. These events have highlighted the importance of having a rigorous risk management framework. Additionally, firms must also reassess this framework to ensure that it serves the purpose of protecting the firms from such unforeseen events.

While employing risk management and mitigation strategies should be approached neither with the intention of speculation nor with the fear of market movements in the future, it is vital to recognize that these extraordinary events do happen and can impact firms harshly. This holds true, particularly for firms that have exposure to commodities, as the current times demonstrate that logistical issues can negatively affect a firm’s operations.

Risk management is built around the quantification of risk using various measures and then taking adequate actions to mitigate that risk. The most popular measure used for quantification in financial risk management is the Value-At-Risk (VaR), which measures the maximum loss in the value of a portfolio over a predetermined time period for a given confidence interval. The wide use of VaR is a result of its flexibility and ease of use. Various regulatory bodies also use the VaR measure to set banks’ market risk capital requirements.

Most banks and firms use the VaR measure, and some even report it in their financial statements. As can be expected, heightened volatility in the markets impacts this quantification of risk. Additionally, the VaR measure can serve as the platform for stress tests by regulatory bodies to establish capital requirements, particularly for banks. Following are a few examples of how governments and financial institutions have been impacted by the events in the past few years:

VaR breaches – Top US banks recorded multiple VaR exceptions during their back testing exercises for the last quarter of 2021. This was even before the Russia-Ukraine conflict began. The steeply rising commodity prices point to expectations of further breaches in VaR for these banks in the coming months.

Fed’s severe stress test – The Federal Reserve announced markedly stringent conditions for banks’ stress-test scenarios for 2022. This decision was a result of the degree of uncertainty banks face in the current environment and to ensure their balance sheets can bear the impact of the possible global market shocks.

BoE postpones stress tests – The Bank of England announced its decision to postpone its annual stress test exercise for UK banks. It said that this decision was taken to allow these banks to manage the global financial market disruption occurring due to the Ukraine-Russia conflict.

Most banks already see the effect that surging commodity prices have on their Value-at-Risk amounts. Goldman Sachs reported a significantly higher Total Value-at-Risk for Q1 2022 as commodity prices and interest rates climbed to multi-year highs. Its Commodity VaR increased by 53% over the previous quarter to USD 49 million, the highest value in over a decade. The graph above shows that their current Commodity VaR is higher than what it was even during the 2020 pandemic scenario. Similar results are reported by other banks, which have increased exposure in commodities over the last few years.

This increase in VaR numbers in the last quarter demonstrates the ramifications that the supply-chain disruptions and uncertainty in the commodities markets are having on financial institutions that trade in them. Comparable observations are visible in firms and corporate entities that are exposed to these markets too, including those within the Kingdom. This holds particularly true for those enterprises that rely on agricultural products, as these have been the most hit. The current scenario has propelled many to become cognizant of the significance of implementing operational and risk management protocols and be better equipped to tackle these situations in the future.

his series of unprecedented events demonstrated that firms must employ resilient risk management strategies to protect their interests. While measures such as VaR are essential, firms must employ other strategies to increase the efficacy of risk management.

The following are areas to explore to achieve this end:

Forward-Looking Strategies – The most favored strategy for computing VaR is historical simulation. This approach involved the use of historical strategies; thus, it is backward-looking. Calculating VaR from simulated values using Monte Carlo Simulation can offer an alternative to this approach.

Stressed VaR – The Stressed VaR (SVaR) was introduced after the 2008 recession to be used to review bank’s capital requirements. The goal was to ensure and maintain enough capital to survive stressed conditions. This approach relies on historical data under stressed conditions to assess the firm’s profitability and sustainability under similar stressed conditions.

Measuring Tail Risk – Tail risk is the risk of loss under scenarios with very low probability and beyond the scope of VaR. One of the approaches to address this issue is the Expected Shortfall approach which quantifies the amounts during the worst scenarios losses.

Variance modeling – Using statistics such as Exponentially Weighted Moving Average (EWMA), which gives more weight to the recent events, acts better to calibrate the VaR model to the current market conditions.

 Additionally, firms that deal with commodities can also benefit from applying risk management at the procurement end of operations. This would include updating the inventory policy, understanding the impact of commodity inflation in the supplier contracts, and ensuring that proper tools are in place to combat supply chain disruptions.

These crises the world has seen in recent times and the degree of uncertainty in the markets that followed have left many seeking clarity and striving to bring back normalcy into their operations. Unpredictable events such as these remain outside anyone’s control. They impact firms globally and have the potential for undesirable and dire consequences. Thus, they deem necessary that firms take deliberate action to ensure smooth and uninterrupted operations.

Last month the Federal Reserve officially began pushing toward a tighter monetary policy. The Fed increased its benchmark interest rate by 25 basis points, the first since 2018. Relative to recent history, the pace of policy normalization is expected to be aggressive, with six additional hikes planned for this year. To maintain monetary stability, the Saudi Central Bank (SAMA) followed suit by raising its repo rate and reverse repo rate by 25 basis points.

Addressing reporters’ questions, the Fed Chair has stated that inflation is too high; the labor market is over-heated, and price stability is a “pre-condition” for the central bank as it confronts the toughest price pressures since the 1980s. As global recovery from the pandemic is still taking place, inflation has been accelerating at a different pace across several economies. In Saudi, the CPI index for inflation jumped to 1.6% in February 2022 year-over-year, up marginally from January’s 1.2% figure. In the U.S., CPI was up 7.9% (Y-o-Y) in February 2022, while prices paid to U.S. producers (measured by the Producer Price Index (PPI)) rose (Y-o-Y) by a significant 10%. It is reasonable to say that those figures are yet to reflect the economic disruptions resulting from the war in Ukraine, which are likely to increase inflationary pressures going forward.

As the Russia-Ukraine war intensifies in destruction, so does the impact it causes on the global economy. Elevated volatility levels across different asset classes have been the general theme since the conflict had erupted. This is especially the case with commodities, given that Russia and Ukraine produce and export a huge number of materials the world utilizes daily. From metals to agriculture, the ongoing conflict is limiting crucial supplies and driving up prices in the process. These current economic conditions are changing the shape of the yield curve.

The term yield curve refers to the relationship between the short- and long-term interest rates. Typically, it is a line that plots yields (i.e., interest rates) of fixed-income securities having equal credit quality but varying maturity dates. Historically, the yield curve has taken on three fundamental shapes; normal, inverted, and flat.

A normal yield curve is one in which long-term rates are greater than short-term rates, and thus, has an upward slope. A flat yield curve reflects a state where yields are the same across all maturities. An inverted yield curve is where long-term rates are less than short-term rates, giving the curve a downward slope. Under normal circumstances, the yield curve is upward sloping to reflect the natural extension of the higher risks associated with long maturities and to compensate for the opportunity cost. Depending on the economic conditions, the yield curve can experience parallel and nonparallel shifts. It is relatively rare for the curve to be inverted, and such phenomena have been traditionally linked with recessions. In fact, most U.S. recessions since the 1950s have been preceded by an inverted yield curve, making it one of the best indicators of a shifting economic cycle.

Naturally, the yield curve would flatten before it begins to invert, and this would occur due to a rise of short-term rates by more than long-term rates or a fall in long-term rates at a faster pace than short-term rates.

As of March’s end, the state of the U.S. yield curve is flat if we are to be guided by the spread of ten over two-year U.S. Treasuries (2/10 Treasury spread). This spread has recently been narrowing significantly as the Fed tightens its policy to counter an extraordinary inflation. This 2/10 Treasury spread had typically been used to reflect the curve shape, given that the two-year Treasury yield captures short-term interest rates movements. Such a spread has had a mean of 110 basis points looking at data for the last ten years. The ten-year over five-year Treasuries spread have already inverted – seeing that the last ten years’ historical average for this spread is 57 basis points. Nevertheless, there is still the chance that the curve could revert to its normal position should the Fed begins selling its arsenal of long-dated Treasures and reduce its balance sheet once inflation targets are achieved.

Similarly, the Saudi Riyal Swap Curve (where Saudi banks usually borrow and lend) is no different. At the time of writing, the spread between a seven-year swap and a three-year swap is around negative 20 basis points. The ten year historical average between those two swaps is 85 basis points. Likewise, the five-year swap had historically been priced at a premium of around 44 basis points (last ten years average) over the three-year swap. Currently, the five-year swap is less than the three-year swap by around 12 basis points, making the inversion in this part of the curve official as well. Looking at the short term, three months Bahrainn Interbank Offered Rate (SAIBOR) has recently breached the level of 2.40% (five-year historical average is 1.75%). The below graph illustrates the Saudi Riyal forward curve as of March 31^st, 2022, and as compared with one year ago.

As central banks continue to increase interest rates to curb inflation, short-term borrowing rates tend to rise. This could impact a broad range of consumer and commercial loans. Thus, making borrowing more expensive for consumers, including small business loans, mortgage rates, and credit cards. This, in turn, has the potential to slow economic growth. Unlike a steep and normal yield curve, where banks can borrow at short term (lower interest rates) and lend at longer term (higher interest rates), a flat or inverted curve can pressure banks’ margins and discourage lending. Hence, an inverted yield curve can indicate economic sentiment and may suggest a poor long-term outlook. Yet, many would argue against this interpretation, as there are other explanations for the inversion that do not suggest the possibility of a recession.

Since the start of the year, hedge deal activity in Saudi has considerably increased across corporates in various industries. This has been an expected outcome given the big movements in the curve and the rapid increase in short term rates, particularly three months SAIBOR. The majority of entities who have hedged and fixed their SAIBOR in the last two years are experiencing a material boost in their mark to market (MtM) derivatives valuations.

Indeed, we have received several queries concerning restructuring some ineffective hedges and the possibility of monetizing some of the deep in-the-money effective ones. On the other hand, should an entity considers hedging this year – we believe it is not too late, and as long as it is being done for the right reasons. The current shape of the curve provides an opportunity for corporates to increase the maturity of their hedges to cover longer term risk and satisfy risk management objectives. For example, it costs about the same now to exchange floating cash flows for fixed on a seven-year hedge as it does by doing so for three years.

In these volatile times, we couldn’t emphasize enough the importance of putting the measures to establish the related KPIs and thresholds that would define an entity’s desired hedge ratio and future hedging requirements. Plenty of research has shown that timing the market is close to impossible and will usually result in the formation of a flawed hedging strategy. The alternative is to introduce an element of consistency and pursue a pre-defined hedge plan that would cater to an entity’s financial risk management objectives beyond the changing landscape of economic cycles.

Most Saudi banks offer various financial derivatives that help companies and beneficiaries manage their financial risks. Yet some companies suffer negative repercussions from misselling, suboptimal practices, exposure to significant losses, and late discovery of inaccurate decision-making, bringing transactions nearer a speculative trade than a hedging one.

As the famous proverb says, “An ounce of prevention is worth a pound of cure.” And in this article, I hand out a few ounces to help us prevent these repercussions.

Most of these derivatives locally are linked to two main asset classes: interest rates and foreign exchange. Such transactions fall under the regularity umbrella of the Saudi Central Bank “SAMA”, which supervises the banking sector and imposes policies and procedures banks must follow when dealing with derivatives.

These transactions occur locally and directly between companies or individuals on one hand and banks on the other. They happen via Over-The-Counter (OTC) transactions and are not Exchange-Traded through a clearinghouse with greater transparency and credit protection. SAMA handles all aspects over the financial derivatives in its scope of OTC transactions (such as interest rates and foreign exchange) and the settlement of banking disputes.

A financial derivatives sale between the bank and the company cannot occur until after fulfilling the governing agreements. Moreover, it includes providing the bank’s required credit limits (where applicable) to the company. This implies the bank’s prior knowledge of the client’s hedging needs and a complete understanding of its financial position.

For example, suppose the total debt is one billion Saudi riyals. This company aims to enter into an Interest Rate Swap (IRS) hedging product with over one billion. Unless clear justification exists, this means the hedge exceeds the need (over-hedging). Therefore, all bank stakeholders (from the corporate banking relationship manager to those in the treasury department) must document this product’s suitability.

Some argue that gaining a complete picture of the derivative exposures of one company with all the banks is impossible. Yet mitigating risks in this aspect is straightforward. A practical step is investigating the financial statements and their disclosures. Additionally, documenting the client’s declarations about other hedging activities entered into with other banks is a viable solution to counter such exposure blurriness.

The importance of hedging varies from one company to another according to risk tolerance. It accounts for economic angles, but also the accounting impact. Yet many companies are not fully aware of the accounting impact that financial derivatives introduce. They typically realize it when issuing financial statements and after implementing hedging.

Problematically, we find some companies try hard to insulate the financial statements from any fluctuations caused by recording the impact of hedging. This makes the accounting matter more important than the economic benefit obtained from hedging. Therefore, banks should prioritize asking companies about this before selling them financial derivatives.

It is not the bank’s duty to provide an accounting perspective of derivatives impact. Still, accounting standards require companies to reflect financial derivative transactions in their financial statements. As part of the sale due diligence process, I think banks should document such aspects in the bank’s suitability and appropriateness form.

Risk disclosure and demonstration is the top priority. Financial derivatives range in complexity from vanilla to highly complex structured products. We all know that the bank does not (and should not) act in advising capacity when selling these products, as its role involves selling the product and showing how it works. However, given the potentially enormous consequences of financial derivatives, there must be a clear framework for explaining risks to the client.

For example, demonstrations must go beyond merely presenting pay-off scenarios if market prices change. It should also indicate what the product’s fair value (Mark to Market) could be. By doing so, the product’s effectiveness and suitability will be understood and documented better ahead of the trade. For example, some products are structured so that their benefits are capped, but their losses expose the company to an open-ended risk.

Banks need not provide companies with comprehensive analysis and scenarios for all products. But I advise they exercise due diligence when selling a structured and complex financial derivative. As a result, the company knows the risks of fluctuations on the fair value and other critical and related elements. If the product is classified as a vanilla instrument, then enhanced due diligence may be unnecessary because understanding the product is easy. When the company’s debt suffers because of high interest rates, for example, the vanilla hedging product compensates for the losses and vice versa almost symmetrically.

There is no ceiling or regulatory framework banks should follow for the profitability of selling financial derivatives to corporate and retail clients. But to avoid disputes down the line, the bank must create an internal procedure that activates if the expected profit from the financial derivatives transaction exceeds a certain threshold.

Document the rationale for this profitability and have the concerned department or responsible managers approve the process. Doing so will limit individual staff from taking advantage of the clients’ unawareness of the derivative pricing details. Going this extra mile helps avoid incidents where the price significantly exceeds what the prevailing market prices reflect during the derivative trade execution.

Not every derivatives restructuring is effective. The objectives of restructuring differ drastically from one company to another. The aim may be to postpone the losses incurred by the company from closing a suboptimal product that failed to suit its initial needs. Or there might be an economic or commercial reason for desirable restructuring.

For example, a simple interest rate hedging product may be restructured because the underlying hedged debt has had its repayment schedule changed, meaning it no longer matches the hedging product schedule. Here, restructuring and adjusting would make the product compatible again with the debt, so it becomes an effective hedge as before.

With all this, I believe SAMA must impose clear rules and a framework on banks for restructuring financial derivatives (especially the structured trades). Specifically, these rules may include imposing a minimum level of approval from the client side for the restructuring.

According to the company’s established governance, such consent could come from the executive committee or the board of directors (adding one more level beyond the authorized person inside the company who closed the original derivative trade). Likewise, the bank follows the same approach to create another path of approvals on restructuring, with all relevant stakeholders documenting the justification. This protects both the bank and the company, ensuring restructuring is required and consistent with the company’s objectives and risk management.

Some of the prevention steps in this article are complex. But I believe if even some are implemented, they will contribute to the whole process of informed decision-making by clients and companies and enhance the levels of governance within banks. There might also be a decent reduction of disputes and issues related to dealing with financial derivatives in the medium and long term.

As corporates adapt to the new-norm and as cross-border business collaborations arise, we noticed more Saudi companies are now investing in vibrant emerging markets (EM), such as those represented by the ‘BRICS’ – Brazil, Russia, India, China, and South Africa. The comparative advantages in labor cost, natural resources, raw materials, growth prospects, and technology make these countries an investor magnet. But it also magnifies Foreign Exchange (FX) risk management complexities for companies accustomed to the relatively higher certainties of major currencies. In this bulletin, we will summarize the key characteristics of emerging markets currencies, recap the hedging hurdles and attempt to highlight the main risk management process differences when dealing with such currencies. For the sake of simplicity, we will assume throughout the article that the exposure is only to a single currency and that there are no offsetting / natural-hedging opportunities.

When managing a currency risk exposure, it is necessary to understand its hedging dynamics and back-test how it would’ve historically performed under different hedging strategies. In addition to trading challenges (like low liquidity, derivatives market inefficiencies, counterparty, and country risk), dealing with emerging and frontier market currencies often means facing additional challenges like high ‘cost of carry’ and low predictive power.

1- Cost of Carry:

Due to the high interest rates in emerging markets, forward contracts normally trade at relatively higher cost than major currency pairs. The below chart compares the cost of carry, measured by the spread between the 1-year forward rate and spot rates, for BRICS and the major pairs:

As shown above, the BRICS, to varying extents, have a higher cost of carry when compared to major pairs. Investment returns in BRL, for example, could be eroded due to the high ‘expected’ year-on-year currency movements.

2- Low Predictability:

The second challenge in managing emerging markets’ currency risk is the low predictability of future movements. Taking the sterling pound (measured by GBPUSD) and Russian rubble (measured by USDRUB) as an example, we backtested the ‘mis-realization’ spread between the 12-month forward strike and the realized spot rate (on contract expiry date) over the last 20-years measured by ((realized spot – forward strike)/forward strike):

As demonstrated above, the USDRUB mis-realization spread moved within a significantly wider range as opposed to GBPUSD. Such variations could weaken the forward rate as a forecast and budgeting tool for investors and ultimately inflate cash/value preservation hurdles.

Global practitioners attempt to overcome the low predictability challenge through deploying Early Warning Signs (EWS) techniques, utilizing economic signals (like GDP growth, inflation, exports, account balance, money supply metrics, capital inflows … etc.) or market-based signs like credit default swaps (CDS). Still, an investor would eventually need to accept relatively higher model risk and lower predictability of future returns than major pairs.

Keeping in mind how emerging markets currencies are different, managing currency risk would follow the usual FX risk management process shown below:

The main differences we noticed in managing emerging markets currency risk are as follow:

1- Risk Identification: considering the material impact of emerging markets currency, it is often analyzed at the early investment due diligence stages.

2- Risk quantification: given the low predictability we discussed, relying on a single quantification model is unadvisable. A hedger would want to stress the currency using various techniques and backtest it in stressed economic conditions (like previous devaluation episodes) to see how it would perform and if any ‘break points’ pop-up.

3- Risk Management Plan: it makes sense to consider reducing the cost of hedging by pushing strike rates beyond at the money levels, but make sure you are not jeopardizing your hedging objectives nor adopting an ‘open-ended’ risk profile. Moreover, try to understand how the selected derivative contracts are delivered and what execution margins will be charged to your entity.

Investing in emerging markets could unlock a bundle of comparative advantages but would increase currency risk management hurdles such as lack of certainty and high cost of hedging, thus, requires greater due diligence efforts as opposed to major currency pairs. Make sure you understand the inherent dynamics of the currencies in your portfolio, seek to deploy adequate risk quantification methods, and optimize a hedging strategy that meets your objectives without exposing your entity to an ‘impactful’ risk profile.

The COVID-19 pandemic induced supply chain disruptions have impacted commodity prices dramatically. This has prompted traders and treasuries worldwide to assess their policies for managing commodity price risk.

Most governments had to shut down their economies due to the pandemic post March 2020. This caused production to come to a standstill and commodity prices to surge. While the prices for most commodities fell in the short term, to absorb the shock from the pandemic, the trend of an upsurge in prices can be easily observed.

Commodities differ from the other asset classes because they are tangible resources and require storage. Storage is usually bought for a limited period and can be expensive, and the price of storage can also play a major factor in the price of the commodity itself. To gain an idea around the importance of storage, in early 2020 the pandemic caused the global demand of oil to plunge, and the price of WTI crude oil futures became negative, since at the time oil price fell to such a level that it was more expensive to hold oil than to sell it. Similar effects were observed in other commodities such as corn and cotton as well. This is known as ‘storage risk’ and is an acknowledgement to the fact that more care needs to be given when dealing with commodities.

Commodities are subject to other risks as well. Prices of most commodities have an element of seasonality within them, which means that there is a pattern of price rise and fall at particular times during the year. As mentioned before, the storage risk needs attention as well. The seasonality component is due to the supply and demand of the commodity having set patterns for increase and decline.

Similar to other classes of securities, commodities are traded frequently on financial markets and can be spot traded or have their derivative traded on the market. Derivatives on commodities include futures, forwards, swaps, and option contracts on these commodities.

These derivatives are traded on the exchange (for example the Chicago Mercantile Exchange (CME) or over-the-counter (OTC)). As with the other asset classes, these derivatives primarily exist to protect holders or producers of the commodity from price fluctuations and to stabilize their projected earnings and cash flows.

Even within Bahrain, we see multiple local banks offering OTC tailored solutions, but the underlying asset class determines the depth and characteristics of the instrument.

Agricultural commodities – this group includes goods that are grown or farmed, such as corn, wheat, soybeans, coffee, cotton, etc. The prices of these goods usually increase or decrease in a seasonal pattern and mean-reversion is usually inherent in their price.

Metals – this group consists of gold, silver, platinum, copper, aluminum, etc. Prices for these goods are not seasonal and usually do not follow mean-reversion. A subset of this group is the precious metals, which include gold, silver, and platinum, and these commodities are usually held for investment purposes as well.

Energy Products – energy commodities are crude oil, heating oil, natural gas, and electricity. Among all commodities, the crude oil market is the largest globally, with demand being close to 100 million barrels per day. Their prices are usually assumed to follow a mean-reverting process.

An unusual commodity that comes under the umbrella of energy commodities is electricity. It is considered uncommon since it cannot be stored. However, derivatives contracts exist on electricity, such as power futures that are traded on NYMEX.

Market risk management has become commonplace in most firms around the globe; however, the focus is usually around the management of risks from interest rate and foreign exchange fluctuations. More emphasis is required on the consequences of commodity price risk and EBITDA fluctuations arising due to inventory price movements. A comprehensive risk management strategy at the firm level that utilizes all options available is recommended to manage EBITDA margin volatility and betting on the markets is not advised. It is also prudent to match inventory volume to supply and demand and collaborate with the sales/operations department to identify and quantify such risks.

Additionally, while the operations department usually handles the procurement of the underlying commodities, risk management and financial hedging is typically performed within the treasury. This means that the firm must employ policies and procedures, along with an appropriate accounting treatment to align the consideration of commodities between these two departments.

Cost of carry – This refers to the expenses a firm incurs on account of holding commodities in their inventory, such as storage costs, insurance, and antiquation.

Convenience yield – Opposite to the cost of carry, the convenience yield is the premium associated with holding an inventory. In case of an inverted market or scarcity, holding the commodity becomes more beneficial than buying it in the futures market.

Basis risk – Basis is the difference in the price of the physical commodity and its future price. Basis risk is the possibility of the price of the commodity and its futures not moving in a correlated manner. Proxy hedges are adopted to manage basis risk and work by hedging a contract of one quality or in one market with a contract of a different quality or in another market. For example, using gas oil or heating oil to hedge against jet fuel.

Contango and backwardation – Contango is the normal market condition, i.e., the futures price is higher than the spot price. This is observed in mining commodities such as gold, and in this case, the basis is negative. Backwardation is the opposite. Here the price of the futures contract trades below the spot price, and the basis is positive. This happens for agricultural commodities in the event of shortages.

Commodity risk management should be given equal importance within a firm’s risk management policy as the interest rate, and foreign exchange risk management as the price fluctuation of commodities within the inventory can have a considerable impact on earnings if not properly managed.

The risks associated with commodities are detailed below:

Price Risk – This refers to an unfavorable movement in the price of the commodity caused by macroeconomic factors.

Quantity Risk – This is the risk related to the changes in the availability of the commodity.

Cost Risk – Cost risk is the risk of an increase in the costs of services due to demand and supply and can impact business costs.

Regulatory risk – Regulatory risk is also called political risk and refers to the risk of new laws or regulations that affect the price of the commodity.

As mentioned earlier, storage risk is another risk that can affect the firm’s earnings. It is worth noting that in the case of certain commodities, especially essential foods, many producers are not permitted to increase the price on account of government regulations. This means that the control of this risk and cost becomes much more significant. The risk to a firm from commodity price fluctuations needs to be assessed from the firms’ operations and can vary depending on whether the firm is a commodity trader, buyer, seller or holds certain commodities in its inventory for use towards the production of other goods.

A commodity risk management strategy involves a comprehensive framework that includes the frequent monitoring of price changes, identification of the risks involved, quantification of the risks and applying an appropriate hedge strategy. From our observation of the local markets, the relationship between the supplier and procurer, and the contractual obligation of the party responsible for absorbing the cash flow timing risk is the first thing to consider when advising for managing commodity risk. The nature and operations of a firm define the extent to which it will be exposed to commodity price risk, and so a unique hedge strategy needs to be implemented to protect the firm’s earning from being affected by price swings.

Due to the unique nature of the commodity asset class, there are additional considerations that need to be assessed in the modelling of commodity prices. Additional modeling elements are employed to make it a better fit for estimating future commodity prices. Components such as time-dependent drift factors, seasonal factors, and Poisson processes can be incorporated into the model to manage mean-reversion, seasonality, and jumps in the commodity prices, respectively, based on the nature of the commodity. Over time, more sophisticated models have been developed for the use of forecasting oil prices. Some of the features of recent models include the use of convenience yields and stochastic volatility.

It can be clearly observed in recent times that markets remain volatile and inhospitable. Treasurers are exposed to market risks, whether it be from interest rates, FX, or commodities. It can be easily perceived that a robust risk management framework is essential to a firm’s success. A pro-active approach towards hedging can protect against a decline in earnings, and at the same time, contribute to staying ahead of the competition. The path towards risk management involves deep analysis and sound measurement, and the onus is on the firm to employ comprehensive risk mitigation policies.

It seems that there has been a change of sentiment when it comes to economic conditions lately. The era of ultra-low global interest rates environment is being debated. Both lagging and leading indicators in some of the major economies have been providing mixed messages. Global inflationary pressure has been recently in the forefront of central banks agendas and the driving force behind much of the argument around monetary policy normalization.

The latest Consumer Price Index (CPI) reading, for the month of October, showed a 6.2% year-over-year increase in prices in the U.S. which is significantly higher than the projected 5.8%, as well as September’s 5.4%. This annual reading was the highest since December 1990. In the Eurozone, annual inflation for the same month came in at 4.1%, which is the highest since July 2008. In the UK, October inflation reading was standing at 4.2%, up from 3.1% in September and represents a 10-year high. These are attention-grabbing readings. Yet many argue that rising inflation reflects temporary pandemic-related supply-demand mismatches and higher commodity prices compared to their low base from a year ago. Nevertheless, by using alternative measures of inflation (Core CPI, 24 months period inflation, etc.), many analysts have suggested that there is more to this surge in prices than indicated and inflation this year will likely persist into 2022.

As for the U.S. jobs market, the unemployment rate fell to 4.6%, the lowest level since May 2020. More than 18 million jobs have been added back since the economic recovery started. Still, such a number remain 4.2 million jobs below pre-pandemic level. In early November, the Federal Open Market Committee (FOMC) announced its highly anticipated asset purchase reduction program, and treasury yields across the curve dropped from the recent highs seen in late October as market’s expectation of Fed rate hikes in the first half of next year has lessened. But high interest rates volatilities had continued mainly derived by prospects of higher inflation. Currently, expectations for the first increase in the Fed target range have moved forward to July 2022 with the market currently expecting two 25 basis point rate hikes in 2022. There remains, however, a strong element of uncertainty. This article has been written as a new variant of Covid (Omicron) emerges, with early cases being reported in South Africa. This may add further doubt about future economic growth, and interest rates outlook.

To preserve monitory stability, the central bank would need to effectively maintain the Dollar/Riyal exchange rate within the framework of the pegged exchange rate regime. Hence, local interest rates tend to be influenced by its U.S. counterparts. Local liquidity factors play a role too. In light of that, local rates had remined relatively low, where the 3 months Saudi Riyal Interbank Offered Rate (SAIBOR) had averaged at around 87 basis points since Q1 last year.

Recently, there have been plenty of developments that could change the economic narrative of the pandemic era. According to official reports, the Kingdom’s real GDP, buoyed by the non-oil sector, is expected to grow by 2.6% in 2021 and 7.5% in 2022.  Inflation (measured via CPI) is expected to stand at around 3.3% in 2021 and 1.3% in 2022. Yet, annual inflation has largely dropped since July this year averaging at circa 0.5% up until October as the base year effect of raising the value-added tax fades-out. Covid has been under control so far with relatively few new cases and high immunization rate.

Daily production of oil continues to grow since June 2021 and prices per barrel has been averaging closer to $70 in the last 12 months. The Ministry of Finance (MoF) has upwardly revised Bahrain’s fiscal outlook for 2021 and 2022. The government debt is expected to grow by SAR 83 billion in 2021 and SAR 52 billion in 2022 which represents 30.2% Debt-to-GDP ratio in 2021 and 31.3% in 2022.

Generally, interest rates are relatively low at the beginning of an economic expansions, but they usually tend to rise as the economy grows. To start, let us first look at the developments in the Saudi Riyal interest rate forward curve as it projects the expected future floating-rate cash flows used to calculate the fixed rate in an interest rate swap. The position, steepness, and volatility of the forward curve are the key factors that determine the price of interest rate derivatives.

By looking at the chart above, it takes paying roughly 2.31% to hedge a given SAR bullet notional for five years by late November as opposed to 1.98% at the end of September via an interest rate swap. An increase of 33 basis points is not necessarily something out of the ordinary in the local swap market, but rather the relevant speed of which expectations have changed is what worth noting. Similarly, for an at-the-money interest rate cap, implied volatilities over the period covering the next five years have increased on average by around 17 basis points. This is a staggering average increase of 63% across the five-year curve in less than two months. Compared to late November, the same can be said for Q2 and Q1 of this year, as volatilities increased by around 28% and 31%, respectively.

Implied volatilities represent the expected volatility of the underlying index (SAIBOR) over the life of the cap. They are an integral component in making up the premiums of these options. As expectations change, option premiums react appropriately. All levels are as of the time of writing and are subject to change as per market developments.

Interest rate risk management is not purely about controlling the interest line in the profit and loss statement. It also engulfs the management of the entire debt profile of the business, including its maturity, currency, the fixed-floating mixture of the debt and expectations of future interest rates. Accordingly, corporate borrowers should have a clear understanding of some of the key elements impacting their desired risk profile.

A possible shift in the interest rate cycle can have significant implications on a business profitability and growth. It requires some basic knowledge around an entity risk appetite, debt portfolio structure, duration, cash flow timing, and interest rate sensitivity. Also, being aware of assets that can create an offsetting effect, such as stable and core cash that can be invested, would potentially optimize hedging activities. In other words, by looking at the net debt position as opposed to absolute debt, off-balance sheet hedging (i.e., via derivatives) may possibly be confined. This in turn would reduce its associated cost.

In this article, we have seen how the cost of hedging can shift as the economic sentiment and rates outlook changes. It is therefore helpful to understand the different ways a hedging program can be effectively implemented. Strategies that take into consideration the increasing cost of hedging, yet at the same time, maintain an entity’s financial risk management objectives are the ones worth pursuing. As a rule of thumb, all hedging activities should be objectively justified and thus have a direct impact on an entity KPI(s).