UTI BANK Risk Department Central Office CMD: President (CB):

SVP (SME & Agri):

SVP (Risk):

VP (Risk): Nov 2005 AGRI BUSINESS MEASURING COLLATERAL VALUE RISK COMMODITY LINKED EXPOSURES
IN

9th

1. Agribusiness Portfolio: Our Banks agribusiness portfolio has increased from Rs 1336.65 crs in FY2004 to Rs 1590.90 crs FY2005. During the year we have sanctioned/disbursed credit to farmers for specific crops/commodities under contract farming arrangement and in other cases against warehouse receipts. These exposures have direct or indirect linkage with commodities as they form a substantial part of the agribusiness value chain. At present exposure is spread over commodities such as castor seeds, Paddy, Maize, cotton, sugarcane etc. Also under SME segment where units are engaged in processing of agricultural produce such as crude palm oil, soya meal etc, and commodity linkages are substantial, volatile commodity prices inflict significant price risk on both direct and indirect commodity exposures. We discuss below briefly the different category of risks that can impact such exposures.

Commodity risk management

2. Definition of commodity finance (direct exposures): The Basel II document on capital adequacy under paragraph 224 refers to commodity finance as short term lending to finance inventories/receivables of exchange traded commodities such as crude oil, metals or crops where the exposure will be repaid from the proceeds of the sale of commodity and the borrower has no independent capacity to repay the exposure. The structured nature of the financing is designed to compensate for the weak credit quality of the borrower. 3. Credit Risk in Commodity exposures: Dimensions of credit risk differ as between direct/indirect exposures on commodity. 3.1 Risks-Direct exposures (of self liquidating nature): Price risk: Uncertainty around the value of the commodity bundle collateralizing the exposure due to volatility in commodity prices/deterioration in quality of stock deposited at the warehouse. Liquidity Risk: Liquidity risk arises when the commodity bundle collateralizing the exposure is not saleable within the specified tenor of the exposure. Credit Risk: In self-liquidating short term structured commodity finance credit risk (defined as probability of default) is driven by the above two factors. 3.2 Risks- Indirect exposures: (which are not self liquidating) Indirect lending to commodities encompasses lending for crop production, agriculture processing and other related agriculture activities where commodity linkages form substantial part of the value chain. Production risk: Risks relate to loss in value of produce due to agrarian factors such as soil types, drought, flood, crop disease, lower land holdings etc. Price Risk: It is defined as uncertainty in output prices farmers expect to realize and contrary input prices processing units pay for agriculture produce. The nature of price risk will differ from commodity to commodity. Price risk is present in case of indirect lending during the preharvesting period as the prices of output as well as various inputs are subject to volatility. Financial risk: This refers to the degree of financial leverage of the farmers/processing units in relation to their cash flows. Credit Risk: The above factors are the key drivers to a credit risk resulting in loss due to default. . 4. Importance of Managing Price risks: Commodity risk management

As mentioned above, price risks are significant drivers of credit loss in direct commodity lending as compared to indirect commodity lending. Being self-liquidating in nature, the repayment capacity of structured commodity lending exposures depends upon factoring/managing price risks while taking a credit decision. Therefore, it is important that banks measure price risks separately and stipulate adequate margins to factor the same while setting exposure limits. Price risks/ value at risk associated with specific commodities can be measured using several statistical techniques. It is natural that such risk measurement must be centralized to serve as input to the process of monitoring credit risk of the Banks commodity exposures/ portfolio. 5. BASEL Perspective on margin requirements: The Basel document on capital adequacy under paragraph 156 to 160 clearly spells out the following basic requirements to be met if banks were to internally estimate margin requirements for collateral (such as commodities) backing their credit exposures. Volatility estimates should be under 99th percentile confidence interval. Minimum holding period of the stock to be considered for volatility estimates will be dependent upon the type of transaction and the frequency of re margining to the market. Banks may use margin requirements for shorter holding periods scaled up to estimate the margin requirement for longer periods by using the square root of time formula. Banks must take into account the liquidity of lower quality assets in which case holding period should be adjusted upwards given the relatively lower liquidity of collateral. Choice of observation period sample data points for statistical estimation of margin requirements shall be minimum one year. Also weighted average time lag of observations cannot be less than 6 mths. Banks are required to update their databases no less frequently than once in every three months and should re assess them whenever the market prices are subject to material changes. Effectively margin requirements for commodity exposures must be reviewed every three months. Banks are free to use any model. Examples are historical simulation and Monte Carlo Simulation.

Commodity risk management

6. Methodology: For the purpose of calibration, price risk is defined statistically as volatility in prices. As a first step we identified few commodities namely Coffee, Castor seeds, RBD Palmolien, Chilli, Sugar and Soya meal across which our Bank has currently exposure both through direct/indirect lending to these commodities. Historical data on prices spanning at least 100 trading days across the above commodities were obtained in order to calibrate the volatility. Based on the historical data, volatility of commodity prices were measured using two fundamental statistical techniques namely equally weighted variance method and Exponentially Weighted Moving Average Method. The volatilities were measured along different tenor such as Daily, Weekly, Monthly, Quarterly, Semi Annually and Annually indicating the risk over different holding periods. The above two methods are well known and have been used by reputed organizations such as J.P Morgan (Risk metrics) for analyzing volatility of their exposures. Brief idea on the above two methods is provided in the annexure. 7. Results on Sample data: On carrying out statistical analysis, we have arrived at the above volatility estimates for commodities across different time horizons. Price volatility (in percentage changes) estimated by the basic VAR method across different holding periods of commodity stock is as presented below:
Volatility in Commodit y Coffee Castor Seeds Chilli Soya Meal RBD Palmolien Sugar % as measured by equally weighted variance method Data Daily Weekly Monthly Quarterl Semipoints y Annual 120 1.41 3.73 7.71 13.36 18.89 270 0.89 2.34 4.85 8.40 11.88 120 300 250 300 1.60 0.82 1.18 0.51 4.24 2.17 3.11 1.35 8.78 4.49 6.44 2.79 15.21 7.78 11.15 4.83 21.51 11.00 15.77 6.84 Annual 26.72 16.80 30.42 15.55 22.31 9.67

Volatility estimates in % under EWMA method Commodit Data Daily Weekly Monthly y points Coffee 120 1.25 3.31 6.86 Castor 270 0.93 2.47 5.12 Seeds Chilli 120 2.14 5.66 11.72 Soya Meal 300 078 2.08 4.30 RBD 250 2.93 7.75 16.04 Palmoilen Sugar 300 0.34 0.90 1.87

Quarterl y 11.88 8.86 20.30 7.44 27.78 3.23

SemiAnnual 16.81 12.53 28.71 10.52 39.28 4.57

Annual 23.77 17.72 40.60 14.88 55.55 6.46

Commodity risk management

Commodity risk management

Apparently, the sample size is not adequate for some commodities, as we had to depend upon the price history provided by NCDEX. However with continuous updating of commodity data, it is possible to enrich the database on price history resulting in better volatility estimates. In case of commodity exposures (direct/indirect) backed by forward/futures contracts on exchanges, margin requirements will be based upon the exchange regulations and no in-house calibration is required. However in case of un-hedged exposures, the Bank on the basis of the volatility of the underlying commodity can estimate margin requirements. Margin requirements will depend upon the mark to market period chosen by the Bank. For instance, assuming an exposure to Chilli and monthly marking-to-market period, initial margin should atleast be (2.32 * 11.72%) = 27.26% to cover losses in 99% of cases over a period of one month. The factor 2.32 relates to 2.32 standard deviations at 99% confidence intervals. At the end of one month, exposure should be marked-to-market again and margin call, if required, be given to the customer to replenish the margin account. 8. Suggested Risk management measures: Given the Banks exposure in commodity lending and BASEL requirements on managing credit/market risk associated with collaterals, the following action points are suggested to sensitize decision making in respect of commodity exposures. : a) Quarterly Management Information system on the following to be regularized on a quarterly basis: Identifying and reporting commodity exposures. Estimating and revising margin requirements across commodity exposures. Identifying short fall in margin money in existing margin calls. exposures and triggering

Recommended actions in case of default in margin money requirements.

b) As adequate time series and continuous data on commodity price history will be required for volatility estimates, it is preferable to purchase commercial data bases available if any, on price history, to complement the data downloadable from commodity exchanges. Also adequate software to be developed/purchased in order to mine the data base, compute volatility estimates, map the volatility to a specific term structure, flag extreme volatilities and also provide enough flexibility for additional analysis.

Commodity risk management

c) Although delivery of credit on commodity based lending is through branch network, it is felt preferable to centralize the management of commodity risk at the central office. Initially, weekly/monthly marking-to-market can be done to measure the value at risk and branches/zonal offices /credit department at central office be updated for onward action. d) With increase in the depth of commodity database, the horizon over which the price risk is observed can be extended beyond one year. The above initiatives will not only help in pricing risks based on volatility estimates but also enable to discover opportunities for improved lending to commodity segment. Submitted for information

Krishnan Chari Asst Vice President( Risk )

Dinesh Chaudhary Dy Manager( Risk )

Commodity risk management

Annexure 1
A brief technical note on statistical method used for estimating price volatility To estimate the volatility of each commodity empirically, commodity prices are observed at fixed intervals of time like daily, weekly, monthly etc. In this case, we have taken daily commodity prices available from NCDEX. Daily volatility is the standard deviation of daily returns of commodity prices. Therefore, the steps involved are: 1. Daily percentage changes in commodity prices are calculated using the formula: ui = Ln (Si / Si-1) where Si: Commodity prices at end of ith (i = 1, 2, 3..n) day Ln: Natural logarithm ui: Daily return of a commodity However, all the data points were not spaced over 1 day because of market closure on weekends and holidays. One must take into account weekends and other nontrading days as the price changes over these periods signify return for more than a single day. As we are assuming that the spot price of the commodity follows a geometric Brownian motion, this could be done simply by dividing log price changes by the square root of the number of intervening days (e.g., three days in the case of a week-end), and then calculating the sample variance. 2. Calculation of daily volatility Daily volatility, s, of a commodity is calculated by taking the standard deviation of all ui where i = 1,2,3n. Daily volatility can then be scaled to n-day volatility by using the formula:

n-day Volatility = Daily volatility * n

The scaling factor of n appears because we assume commodity prices to follow Markow process. In case of Markow processes, the past history of a variables and the way the present has emerged from the past are irrelevant. When Markow processes are considered, variance in successive time periods are additive. This is because

Commodity risk management

change in two periods is the sum of two independent normal distributions. When two independent normal distributions are added, the result is a normal distribution with variance equal to sum of the variances of two distributions. Therefore, 7-day variance is 7 times 1-day variance added together. As a result, 7day standard deviation is equal to:

1-day variance * 7 = 1-day standard deviation * 7

Choosing n, number of observations, is generally set equal to the number of days to which volatility is to be applied. Therefore, for our purpose, we should be using observations of last 180-360 days. The above method gives equal weight to all ui. If our objective is to estimate the current level of volatility, we can give more weight to recent data. For this we can use EWMA method. Exponentially Weighted Moving Average In EWMA method, less weight is given to older ui. According to the model,

2n = 2n-1 + (1- ) u2n-1

The estimate of the volatility for day n is calculated from n-1 (the volatility estimate for day n-1) and un-1 (the most recent daily return in commodity prices). The value of governs the responsiveness of the current estimate to the most recent daily return in commodity prices. A low value of assigns greater weight being given to recent returns in commodity prices. In this case, estimates produced for volatility on successive days are highly volatile. A higher value of (a value close to 1) produces estimates of the daily volatility that respond slowly to new information provided by the daily returns. In this case, we have used = 0.94. This is the value used by the J.P. Morgans Risk Metrics database. The company found that across a range of different market variables, this value of gives forecasts of the volatility that come closest to realized volatility.

Commodity risk management