3 - Marking to Market
Marking to market is the process of calculating a trader’s current, or real-time
assessment of the profit or loss position of the business operations, based on current
coffee market prices and the calculations generated during the position and breakeven
analysis steps.
Risk Assessment as a Dynamic Process
Risk assessment is not a "one-off" exercise, rather it is a dynamic process. The process
will require updating on a regular basis, so that changes in market conditions are
reflected in the trader’s positions as he buys and sells coffee. Risk assessment is only
useful if it is up-to-date, and the trader can determine his trading and hedging
strategies. A trader, who is effectively assessing risk, will have up-to-date information on
which to base his business decisions. The most efficient businesses update this
information weekly, daily, or multiple times a day.
Step 1: Position Analysis
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Step 1: Position Analysis
Any time a trader buys coffee without a matching sales contract, or sells coffee without
having matching purchases, he is holding a position and faces exposure.
Long Position
A "long" position occurs when a trader has purchased coffee without selling
coffee.
A purchase is determined when a trader agrees a price for the purchase of coffee with
producers or other clients. The risk for the trader begins the moment the price for the
purchase of the coffee is agreed. It does not matter if the coffee is delivered to him on
the spot or if he will need to wait for a few weeks or even months for the coffee to be
delivered. As soon as the price is agreed the trader has bought coffee. At this point in
the time, a trader will know the purchase price of the coffee that he has bought but he
does not know the sale price. If coffee prices fall before he agrees a sales price he
will face reduced profits or even losses.
Short Position
A "short" position occurs when a trader has agreed to sell coffee at a fixed price
but has not yet purchased that coffee.
At this point, a trader will know the sale price of the coffee. However, the trader will not
know the purchase price and faces the risk, that if coffee prices rise, he will face
reduced profits or even losses.
A Normal Part of Coffee Trading
Taking short and long positions is just part of doing business in the coffee sector. So, in
reality, there is nothing intrinsically wrong about a trader taking a short or long position
and entering into contracts is just a normal part of the coffee trading industry. However,
taking a position creates risk for a coffee trader and that risk should be monitored, so
that trading decisions can be made in an informed manner.
Positions will change whenever a trader buys or sells coffee. It is vital that a trader
updates his position calculations, and understands the impact of each transaction on his
overall position. The need for understanding the overall position highlights the need for
position analysis to be a central process of the trader.
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Net Position
A trader will make a number of individual transactions during a standard coffee season.
Some of these transactions will create a short position (i.e. forward selling), and some
will create a long position (i.e. purchasing coffee and building up stocks). While a trader
may take a long position or a short position for each of these individual transactions, it is
his "net position" that influences the traders overall exposure to price volatility. It may be
that a trader has one short position and one long position that "net off" or ‘square’ the
overall position. When a trader looks at his complete picture on any given day during
the season, he should be able to see clearly, based on the sum of individual
transactions, whether he is in a net long or net short position. This process is called
position analysis and involves looking at the individual purchases and sales to create an
overall picture, and calculate whether he holds a long or short position.
The following pages detail a methodology for a trader to calculate and view his position
on an ongoing basis.
Long: Purchases that do not match sales in terms of quality or grade
Short: Sales that do not match purchases in terms of quality or grade.
Example:
Stock 500 bags Grad A
500 bags Grade B
Sales 1000 bags Grade B
Simple analysis: Position is ‘square’
Detailed analysis: Short 500 bags Grade B
Long 500 bags Grade A
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Step 1: Position Analysis
Identifying your exposure - a long position
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Position Analysis - Long Position
Example of a Long Position
The above slide provides an example of a coffee trader that has a net long position i.e.
who has purchased more coffee than he has sold. The slide shows a simple calculation
to see how that position can change month by month (or week by week), as new
purchases of coffee are made and sales of coffee agreed.
Long Position Throughout the Season
The slide shows that the trader has bought more coffee than he has sold. The trader
purchases coffee at the start of the season in June, builds up his physical stock of
coffee each subsequent month, before starting to sell the coffee in September. In this
example, the peak position is in September before the start of the sales, when the
trader is long 45,000 kgs of coffee. As sales continue in October and November, the
position begins to change and in November the trader holds a long position of just 5,000
kgs of coffee.
Risk that Coffee Prices will Fall
This example demonstrates a trader at risk that coffee prices will fall during the season
since he has not sold the coffee that he has purchased i.e. he has a long position. Such
a trader will be exposed to price risk until he has sold all the coffee that he has
purchased. This trader’s exposure is greatest during September and lowest during
November, which is the month when most of the coffee has been sold.
While this is only a simple example, it shows a situation that is common to many trading
businesses when they purchase coffee from producers, process the coffee, and then
subsequently sell the coffee to buyers. This is common practice in a number of
countries and coffee regions. However, this does pose financial risks to a trading
business if coffee prices fall significantly after they have built up coffee stocks in their
warehouses.
Calculating Net Positions
The above slide shows how simple it is for a trader to calculate his position. The trader
simply keeps track of his purchases and sales of coffee (either physical or future
contracts/commitments) on an ongoing basis and by adding these positions together
can see what his exposure is throughout the season. When doing this it is helpful to
indicate purchases as positive (+) and sales as negative (-) to easily and accurately
determine a net position.
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Step 1: Position Analysis
Identifying your exposure - a short position
Position Analysis - Short Position
Example of a Net Short Position
The above slide shows a trader who has started the season by agreeing to contracts
with buyers for future delivery of coffee at a fixed price, i.e. he holds a short position.
The trader then purchases coffee from producers or farmers and fulfils these contracts.
In this example throughout the season the trader has a short physical position (with
more coffee sold than purchased).
Risk that Coffee Prices will Rise
Holding a short position, the trader is at risk that coffee prices will go up. The sale prices
are fixed in the agreed sales contracts, for future delivery in June, July, and August.
However, if the price of coffee rises during September, October and November the
trader will have to pay more for the coffee purchases to meet the sales orders. If the
trader does not raise prices for purchases in line with the increases of prices in the
international markets he will not be able to compete with other buyers and obtain the
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volumes of coffee he needs to fulfil the contracts. As such, the trader may see his profits
fall or even generate losses on these orders that he is committed to fulfill.
There are often very good reasons for pre-selling coffee. For example, the trader might
have a strong, long-term relationship with the buyer, and pre-selling coffee provides an
element of certainty in knowing that a guaranteed order is in place. However, this
procedure generates price risk that the trader must take into account. We shall see the
potential mitigating actions that can be taken as this course progresses.
Step 1: Position Analysis
Position Analysis - Pricing and Duration
Pricing and Duration in Position Analysis
The previous examples of a long position and a short position were simple examples of
a trader who had purchased coffee in advance of selling it, and a trader who had agreed
to future sales in advance of purchasing the coffee. While these were helpful to
understand the concepts of "long" and "short", in reality, coffee businesses will often be
in both positions at different points during the season. Their net position will change as
the demand for coffee from international buyers and the supply of coffee in the local
market changes.
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Regardless of whether a business finds itself in a long position or a short position it is
important to understand how the duration of this position and the price level of the
position will influence the amount of risk it is taking.
Factors to Consider When Undertaking a Position Analysis
A number of factors relating to pricing and the time period or duration that the position is
held impact the overall position of the trader. These factors include:
How is the purchased commodity priced?
The magnitude of risk that a trader takes on is heavily influenced by the how close the
price at which a trader buys and sells is to the current market price. For example, if a
trader is able to buy coffee from producers at price that is far below the current market
price he will be in a less risky position then a trader that is buying coffee from producers
at a price (local equivalent) that is very close to current market price. For the first trader,
who is purchasing coffee well below the current market price, if the market falls before
he sells there is still a chance that his purchase price could be at or equal to his sales
price. However for the trader that is purchasing coffee from farmers at or close to the
current market price, if the market falls even a few cents he will be immediately losing
money.
As another example, if a trader is able to agree to a sales contract with an international
buyer at a price well above the currently market price they are in a less risky position
then a trader who agrees to a sales contract at a price very close to the current market.
For the trader who agrees to a sales contract above the current market price, if prices
move up, he still may be able to purchase coffee from farmers at a competitive price.
On the other hand, traders who have a sales contract right at the current market price
may not be able to raise their purchase price in order to compete with other buyers in
the market and may possibly not be able to get the volumes necessary to fill the
contract.
Another final example can be seen in the system that is currently utilized by
cooperatives in a number of countries. Many cooperatives use a two-phased pricing
approach. When purchasing coffee from the cooperative members, the cooperative
pays a stated price up-front and pledges to give producers a second payment at the end
of the season. The second payment is essentially a "top-up" on the first payment and is
usually based on the amount of profits the cooperative makes in a season. By setting
the initial payment at a price well below the market, if prices fall, the cooperative will not
lose money. They may only be able to make a small second payment (and in some
cases no payment at all), but they will not lose money. The upside of this approach is
that the cooperative is able to protect itself against small drops in market prices. The
downside is that the cooperative may have difficulty getting farmers to sell them coffee
since many farmers will take the higher price being offered by traders in the spot
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market, ignoring the prospect of a second payment. Furthermore there is always the risk
that the market could even fall below the initial purchase price being offered.
When is the pricing decision made?
Price risk occurs at the moment when the price for sale or purchase of the coffee is set.
Often traders will buy or sell coffee for future delivery. For example, a cooperative might
agree to buy all the coffee of its members at a fixed price in advance of harvest. When
that cooperative agrees to a fixed price with its members it has exposed itself to the risk
that the price for coffee will move down. On the flip side some traders agree to sales
contracts well in advance of the harvest so before the coffee is available. In many cases
they agree to sell on a fixed price for future delivery. The moment the trader fixes the
sales price he creates an open position because the coffee will not become available for
purchase for some time.
Is the delivery amount and date known?
A trader who has agreed to a forward contract with a buyer will need to take account of
the amount of coffee that the contract is for and the delivery date. This is key as the
volume of coffee and date of delivery are key elements in establishing an obligation
today which will need to be met in the future. In addition the volume of coffee will
determine the size of the commitment (and the size of the potential exposure created).
Time between purchasing and selling (or contracting)?
The longer the period between the two sides of a transaction (the coffee purchase and
sale, or sale and purchase) the greater the potential for that trader to be impacted by
adverse price movements. Similarly, the shorter the period between a trader buying and
selling or selling and buying, the shorter the period during which the market can move
against the trader.
How is the Selling Price Determined?
When a trader contracts to sell coffee (signs a contract for future delivery with a buyer),
the manner in which prices are set will depend upon the agreed contract and its terms
and conditions. The contract between the trader and the buyer may be agreed at a fixed
price for delivery on a future date. Alternatively, the contract may be based on the
international coffee price, for example at the date that the coffee is dispatched. While
this is a slightly different contractual arrangement, the way in which risk is created is the
same: the date at which the price is agreed determines the point at which the trader
creates price risk for himself.
Step 2: Breakeven Analysis
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Step 2: Breakeven Analysis
The second step in conducting a risk assessment is calculating a trader’s breakeven
price. This is the price at which the trader needs to sell the coffee, in order to breakeven
and avoid making losses.
Breakeven Analysis calculates the minimum level of earnings required to cover the
costs of the operation or transaction.
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Breaking Even = Covering Costs
Breakeven accurately determines the total cost for the trader of exporting a pound of
coffee to a buyer. This is the minimum price at which the trader must sell the coffee, in
order to avoid making losses.
Breakeven for risk assessment is vital for management of the day-to-day operations of
the trading business. Traders need to know their breakeven figure if they wish to
effectively manage their business while making appropriate and profitable business
decisions. As you will see in this course, it is critical not only for the general commercial
activities of a trading business but also as part of the risk management activities of the
trader.
Total Costs Change with Changes in Fixed and Variable Costs
Breakeven is an activity that a trader should revisit frequently during a season as
market conditions and costs change. The costs of various variable and fixed costs are
prone to rise and fall, and a trader should regularly revisit his breakeven calculations to
see if the original inputs still hold. In a trading business where operating margins are
very thin, even a small change in costs can make the difference between profit or loss.
Fixed and Variable Costs
Breakeven involves looking at total costs, including both variable and fixed costs.
Variable costs are the costs that depend on the total volume (or amount) of coffee that
a trader buys and sells during a season. These costs are the costs associated with each
"unit" and the total outlay will rise proportionately with total volume of coffee traded.
Variable costs include costs such as the cost to purchase coffee from producers,
transportation costs, bags, and processing costs (milling).
Fixed costs are the costs that a coffee trading business will face irrespective of how
much (or how little) coffee that is traded during a season. These costs include office
costs, full time permanent staff costs, and any other costs that a trader must meet
regardless of volume. These costs need to be accounted for irrespective of how much
coffee is traded during a season.
Breakeven Calculated in Unit Costs (lbs) *
When calculating breakeven costs, a trader should calculate his breakeven cost per
pound. The reason for working in pounds is that the coffee market operates
internationally (and nationally) in pounds. Therefore, for coffee traders, at least part of
their business is done in dollars and breakeven analysis needs to be in these units for
comparison purposes. Pounds are also expressed by the symbol “lb”, which is also
used throughout this course.
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There are various formats and approaches that different companies use to record costs
and determine their breakeven. In carrying out this type of analysis or evaluation there
is no correct or incorrect way to do a breakeven analysis as long as the analysis
accounts for all costs associated with the business and results in a determination of a
breakeven price that will cover all of these costs and can be used to determine sales
contract prices and terms. The approach used in this section has been utilized by coffee
traders in the past but is only one example of how to determine costs and breakeven
calculations.
* 1 kg = 2.205 lbs
1 lb = 0.4536 kg
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Step 2: Breakeven Analysis
Breakeven Analysis - the Basic Analysis
Breakeven Analysis - A Simple Example
The above table shows the basic components and inputs used to calculate the
breakeven position per pound of coffee.
Starting with Variable Costs
The analysis should start with the variable costs per pound of coffee. Variable costs are
costs that rise and fall proportionately with the volume of coffee traded. Elements of
these costs include:


Purchase of coffee by the trader from farmers or producers
Transportation of coffee by the trader :
o from the point of purchase to storage facilities
o to the mill
o from the mill to storage facilities
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from storage facilities to the port
Coffee bags
Processing and warehousing costs
Coffee financing costs (variable costs for borrowing to purchase and process
coffee)
Manual temporary staff costs (additional staff that are recruited as volume of
coffee traded rise)
Insurance
o





Once all variable costs are added together, a figure should be available which shows
"total variable costs per pound of coffee".
Including Fixed Costs
The next step in the breakeven analysis is to calculate the total amount of fixed costs for
the entire season. Fixed costs are costs that are required to run the trading business,
irrespective of the volume of coffee traded. Elements of these costs include:





Full time staff costs (permanent members of staff employed by the coffee trading
business)
Office costs (costs of running the trader’s office(s))
Telecommunications costs
Office and business insurance costs (not the variable costs of stocks insurance)
Travel costs for sales events, marketing shows and meetings
Once all fixed costs have been identified and added together, the total figure for the
fixed costs of the trading business for a full season will be known. These costs need to
be divided into a "per pound" figure, based upon the total amount of coffee that is
anticipated to be traded during the season. It is important to keep that this is only an
estimate since the actual fixed costs "per pound" will not be known until the end of the
season when the volume is known. Therefore it is important to keep in mind that if
volume changes this "per pound" fixed cost will also change. For example, if coffee
volumes are substantially above anticipated levels, per pound fixed costs will decrease.
On the on other hand, if volume at the end of the season is substantially less the fixed
cost per lb will rise.
Once the variable costs per pound and the fixed costs per pound are known, the figures
are added together to arrive at the breakeven amount per pound of coffee for the
projected turnover volume.
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Step 2: Breakeven Analysis
Breakeven Analysis - Dynamic Monitoring Through a
Season
Impact of a Change in Variable Costs on Breakeven Analysis
Frequent monitoring of costs throughout a season is vital to identify changes in fixed or
variable costs. Failure to recognize and account for a change in costs, will result in a
trader having an incorrect understanding of his breakeven position. This may potentially
lead to inappropriate decisions being made during a season that result in financial
losses. While almost any costs (transportation, bags, labour) can change during the
season, the most common change in the breakeven price is due to changes in the
purchase price of coffee.
In the table above, a rise in the purchase price of coffee (price paid by a trader to
producers for their coffee), significantly alters the breakeven price. We can see that a
fifteen cent rise in the cost of coffee purchased from coffee producers, leads to a fifteen
cent rise in the breakeven price. If the trader fails to acknowledge and account for the
impact that this change would have on his breakeven analysis, it would have an
adverse impact on his business decisions. Without accounting for the rise in coffee
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price, the trader will underestimate the price required to sell the coffee in order to
breakeven and cover costs.
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Step 2: Breakeven Analysis
Breakeven Analysis - Accounting for Other Costs
Breakeven Equivalent Price on the International Coffee Market
Once a trader understands his breakeven position, he can use this figure to calculate if
the international market prices (i.e. on the futures market) are sufficient to cover his
breakeven position. One additional figure needs to be incorporated in this calculation, to
accurately reflect the domestic coffee price against the international market price. This
figure is the differential between local and international coffee prices and is comprised
of the quality differential and, usually, the cost of bringing the coffee to FOB port of
shipment. The total differential is also shown in cents per pound (c/lb).
Differentials are determined by comparing the price of individual types of
physical coffee with the price traded on the futures market. Differentials can be a
premium or a discount and are commonly used in the trading of both arabica and
robusta.
Futures markets are based on standardized quantity, quality and delivery conditions:
individual futures contracts therefore only differ in terms of delivery period and, of
course, price. Consequently each individual physical type of coffee needs to be
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compared with what the futures market represents which is how the basic differentials
are established. Better quality (or less costly to ship and land abroad) = a premium or
positive differential. Lower quality (or more costly to ship and land abroad) = a discount
or negative differential.
General price movements for most physical or green coffee are closely correlated to
movements on the main futures markets (New York for arabica – London for robusta)
that in turn reflect changes in the general availability and international demand for
coffee. Differentials on the other hand reflect the availability and demand for individual
types or grades of coffee and fluctuate independently, alongside the international price.
Much of the world’s physical coffee is priced by combining the futures price with a
differential to arrive at the sales or purchase price, usually basis FOB port of shipment.
Differentials are publicly quoted in the market and are well known, especially for the
more widely traded coffees.
Final Breakeven Price on the International Coffee Market
The final figure calculated as breakeven will be the price of coffee, that a trader needs
to see on the international market, in order to breakeven. This figure enables a trader to
look at the international market price, and evaluate the likelihood of making a profit (if
their breakeven price is below the international market price), or a loss (if their
breakeven price is above the international market price).
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Step 3: Marking to Market
Step 3: Marking to Market
The final step in risk assessment is known as marking to market. Marking to market is
the process of determining current profitability by looking at the costs and position of a
trading company in relationship to current market conditions. This is carried out by using
both position analysis and the breakeven price calculation to determine if, at current
international prices for coffee, the company would be making or losing money.
Market Prices Change Every Day & Changes in Market Prices Affect Profit & Loss
As we saw in the introductory module of this course, coffee prices are highly volatile,
often moving significantly over short periods of time. We saw that even on a day-to-day
basis, coffee prices can change. These changes have a significant impact on coffee
traders, as their profit margins are usually thin and even small adverse movements in
international coffee prices, can lead to losses.
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"What is Our Estimated Profit and Loss Today?"
Marking to market involves comparing the trader’s current position (position at a certain
point in time) with the international coffee price. This provides a current assessment of
the trader’s profit or loss. The trader will consider his current position (how long or short
he is), the breakeven, and then perform a mark to market analysis to calculate the profit
or loss.
Marking to market = Analyzing Profit and Loss Against the Current Market Price
The goal of marking to market is for a trader to know if he needs to update his trading
strategy, in order to avoid a potential loss or to realize a potential gain.
Step 3: Marking to Market
The International Coffee Market
Thinking in Two Markets
When a trader is "marking to market" they are using the results of their position analysis
and breakeven analysis and the international market prices for coffee to determine how
they are doing and whether they are operating profitably or at a loss at a point in time.
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The trader will be an expert on their local coffee market as they will be working with
local farmers and producers as well as exporters and buyers. They will have a good
understanding of local prices and local issues that affect their business. However when
marking to market a trader will need to be looking at the international prices quoted for
coffee and relating this price to their current business operations to determine how they
stand and how they are doing. This requires a trader to gain a good understanding of
how international markets operate and how their activities relate to the traders local
markets.
The local and international markets are very different marketplaces but are also closely
related. A trader who is effectively managing risk will need to be "thinking in two
markets" namely their local physical market and also the international financial coffee
markets. As this course has already illustrated prices in all local coffee markets are
ultimately determined by movements on the international financial coffee markets - as
such a trader that is trading coffee needs to have a good understanding of the pricing of
coffee on the international markets.
course provides a great deal more information about the international coffee markets how they operate; who participates in them; how pricing is determined; and how they
offer risk management services to coffee businesses. For more information on the
international markets please see Module 4A, and this "Introduction to the Futures
Markets" document.
Step 3: Marking to Market
Marking to Market - An Example
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An Example of Marking to Market
The above example provides an overview of the three step risk assessment.
As we can see:




the trader has an open long position (calculated in step 1) of 37,500 lbs of coffee (they
have bought this coffee prior to selling it).
the trader has calculated that his breakeven price (calculated in step 2) for a lb of coffee
is $1.68 (this is the international market price that would at least cover the trader’s costs
and avoid a loss)
currently the international price for coffee is below the trader's breakeven costs by 7.67
cts for each pound of coffee.
at this point in time (calculated in step 3), the trader has a total loss of $2,875.
What does this mean?
Marking to market involves taking a trader’s current position (whether long or short) and
the breakeven price, to calculate if the trader will make money or lose money, at current
market prices. The result of this exercise will guide the trader on steps that need to be
taken going forward.
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In this example, the trader has not yet actually lost money, but if he were to sell his
coffee today at today’s current market price, he would generate a loss of $2,875.
Any loss (or gain) shown when marking to market, only occurs once the trader has
actually undertaken the final purchase or sale of the transaction. However, marking to
market gives the trader a strong appreciation of where he currently stands.
As we have already noted, coffee prices are volatile and any change in the price of
coffee, will affect the trader’s current loss or gain. In the example above, if the trader
undertook this exercise a week later, the price of coffee would have risen by 10 c/lb.
The trader would find the loss of 7.7 c/lb turned into a gain of 2.3 c/lb, resulting in an
estimated total profit of $862 (i.e. 2.3 c/lb multiplied by 37,500 lbs).
By understanding the current position, performing a breakeven analysis and marking to
market the results, the trader can update his positions on a frequent basis. In this way, a
trader will have a much clearer idea about potential gains or losses. Most importantly,
the business decisions of the trader will be based on relevant and timely analysis.
Also if the trader is facing a loss the potential total loss exposure becomes known.
Knowing this potential loss exposure enables the trader to assess if available finance
would allow for a short position to be urgently turned into a square or long position by
buying in stocks.
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Step 3: Marking to Market
Marking to Market - Example of Loss
When International Prices are Lower than the Breakeven Price
Another example is a trader who is long 30,000 lbs of coffee (i.e. he has bought the
coffee without having either sold, or agreed to sell, the coffee).
The trader has calculated the breakeven price on the international market (including CIF
and market differentials) at $1.65/lb. However the current market price in the
international commodity markets is $1.55/lb. This means that if the trader were to sell
his coffee today, he would generate a loss of 10 c/lb.
As the trader has 30,000 lbs of coffee, this means that total market to market loss (the
total loss if the coffee were sold today), would be 30,000 lbs multiplied by 10 c/lb i.e.
30,000 x 0.10 = $3,000.
Summary
This example does not state that the trader is currently making a loss. However, it
shows that when the international price of coffee is at $1.55/lb, the trader has the
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potential to make a $0.10 loss for each pound of coffee were he to sell. The trader will
realize this loss only if he actually sells the coffee. However, this exercise provides the
trader with a good overview of his business and the potential gain or loss (at a certain
point in time) based on his position, the breakeven price, and the current international
price of coffee
Step 3: Marking to Market
Marking to Market - Example of Gain
When International Prices are Higher than the Breakeven Costs
In this example, the trader is long by 30,000 lbs (i.e. he has bought the coffee without
having either sold, or agreed to sell, the coffee).
The trader has calculated the breakeven price on the international market (including CIF
and market differentials) at $1.65/lb. However the current market price in the
international commodity markets is $1.85/lb. This means that if the trader were to sell
his coffee today, he would generate a gain of 20 c/lb.
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As the trader has 30,000 lbs of coffee, this means that total market to market gain (the
total gain if the coffee were sold today), would be 30,000 lbs multiplied by 20 c/lb i.e.
30,000 x 0.20 = $6,000.
Summary
This example does not state that the trader is currently making a gain. However, it
shows that on a specific day when the international price of coffee is at $1.85/lb the
trader would make a $0.20 gain for each pound of coffee if he were to sell. The trader
will realize this gain only if he actually sells the coffee. However, this exercise provides
the trader with a good overview of his business and the potential gain or loss (at a
certain point in time) based on his position, the breakeven price, and the current
international price of coffee.
Any movement in the international market price that occurs between this exercise and
the sale of the coffee, will impact the final earnings of the trader and should be recorded
in his marked to market analysis. The trader can now make better and informed
decisions about his business. For example, the trader may wish to continue building
coffee stocks, knowing that the breakeven price is significantly below the market price
and showing a profit. Or, because he knows that the market might fall, the trader may
be happy with the marked to market profit estimate, and quickly sell the coffee in order
to realize the profit.
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Step 3: Marking to Market
Profit and Loss Profiles
Profit & Loss Profiles - Net Positions
The above diagrams show how a trader can show profit or loss, depending on his net
position, as the market price for coffee rises or falls. This highlights the fact that a
trader’s potential profits and losses are dependent upon the net position (long or short),
and the direction of market price movements. All traders should try and understand the
message of these diagrams, as they illustrate why a trader should always be aware of
his net position and monitor prices. In this way, the trader can see when he is benefiting
from price movements, and when the price movements are affecting his business
adversely.
Long Position(left side diagram)
A trader who holds a long position (i.e. he has bought more coffee than he has sold),
benefits from a rise in coffee prices and generates increased profits as the price of
coffee moves up further from the breakeven price. On the other hand, the trader is
adversely impacted from a fall in coffee prices, as the price moves further downwards
and away from the breakeven price.
Short Position (right side diagram)
The reverse is true for a trader with a net short position. A trader who is short (has sold
more coffee than he has bought) generates profits as the price of coffee falls further
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below the breakeven price. On the other hand, the trader is adversely impacted from a
rise in coffee prices as the price rises further upwards and away from the breakeven
price.
Summary
Both "long" or "short" positions create risk for the trader as the price of coffee moves. A
trader needs to understand his net position and take actions that will protect him from
changing coffee prices.
The net position is important to understand, as it determines the potential exposure to
price movements. A trader will need to know his net position and his breakeven at all
times. He can then compare these figures to the international market prices, and
calculate the potential profit or loss for his business at any given moment.
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Monitoring Price Risk
Monitoring Price Risk
Need for Frequent Updating and Constant Monitoring
As we have seen, there are three steps that a trader must work through in order to
undertake a risk assessment. However these steps are not "one-off" exercises, but
steps that require constant updating, monitoring and reviewing.
Risk Analysis is a Dynamic Process
A trader’s position will vary throughout a season as he buys and sells coffee. Similarly,
the breakeven point will vary as costs of the operations change. In addition, the
international coffee market prices vary on a daily basis, and therefore, the trader’s
marking to market will alter on a daily basis.
It is vital that a trader continually and consistently revisits the price risk assessment, to
be aware of changes and the current standing of his business. This will enable the
trader to make decisions in a sensible, informed and knowledgeable manner.
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Monitoring a position can be done through continual updating of marked to market
analysis. By consistently updating this analysis, trading companies can keep track of
how changes in the price of coffee will affect their overall profitability and inform their
business decisions.
Failure to Monitor Risk will Result in Trading Losses
A trader who fails to update the risk assessment analysis may find that he is working on
outdated and incorrect assumptions, resulting in losses rather than gains.
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Liquidation
Liquidation
Liquidation is the process through which a trader can close out his current position. For
example, if a trader has a sales contract he will need to purchase coffee to cover that
position in order to "liquidate his position". Until a trader has liquidated his position the
exact gain or loss that will be "banked" or secured remains unknown.
Liquidation - Defined
Liquidation is the process of realizing a loss or a gain by liquidating longs or buying in
shorts.
Trader Positions and the Impact of Liquidation
A trader is liquidating his position whenever he closes a position (either buying coffee
when short, or selling coffee when long).
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However, if the trader has not been conducting frequent risk assessments he is doing
this blind without knowing what the loss or gain might be. On the other hand, a trader
who has been conducting frequent risk assessments will close a position (buying coffee
when short or selling coffee when long), with a clear knowledge of the profit (or a loss)
that he is realizing. The difference is obvious and significant. All traders prefer to make
decisions knowing the potential outcome.
For example, a trader who realizes that his present net position will result in a loss may
change the strategy he uses to liquidate his position in order to avoid a lose.
Alternatively, the trader may decide that he can afford to cover the loss. This is clearly a
much better position under which to operate, rather than making decisions "blind" and
not being able to make an informed choice.
Liquidation Timing Varies Based on a Number of Factors
Liquidation requires either the ability to buy coffee from coffee producers or sell coffee
to a buyer. The time that this takes will vary based on circumstances and from trader to
trader. A trader who wants to liquidate a position will have to account for the time this
takes, and appreciate that any changes in coffee prices during liquidation will impact his
ultimate gain or loss.
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Summary of Risk Assessment
This module has shown how a coffee trader can undertake a risk assessment of his
business through position (long or short), breakeven, and marked to market analysis
(understanding the current profit or loss at a specific moment in time).
Utilizing the Resources of this Module
The first resource in this module is a case study which presents a coffee trader that
carries out an effective (and dynamic) price risk assessment. In addition the resources
in this module walk course participants through a practical step by step guide to conduct
an effective risk assessment. Templates for this analysis are also provided.
The final activity for this module is an assignment that asks attendees to conduct a risk
assessment of their trading business. They should go through the three steps and
understand where their trading business stands. Course attendees will be able to
submit these risk assessments for review by the course instructors.
Once these steps have been completed, course participants will have the tools and the
knowledge to undertake frequent, dynamic, and practical risk assessments on an
ongoing basis for their businesses.
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Introduction
The goal of risk management for a coffee trader is to reduce his exposure to volatile
prices. He will attempt to lock-in a minimum profit level for the business and avoid
losses should prices move against him. A coffee trader who has identified his exposure
to price risk and decided to take action to control this risk will need to consider the range
of risk management solutions available, and build a strategy that protects his business.
Managing risk does not have to be overly complex, as in most cases there is a strategy
that can be undertaken by any trader who chooses to do so. Some risk management
approaches can be more complex than others. In some cases a trader might need to
use financial instruments that were previously unfamiliar to him, but in others he might
simply need to negotiate with exporters or make some changes to his purchase/ sales
patterns. In all cases a trader, irrespective of the size of his business, should be able to
identify tools that he is comfortable with, and implement a strategy that enables him to
manage price risk.
This section will provide an overview of the two types of risk management approaches
that a coffee trader can utilize. These can be physical or financial, and subsequent
modules of this course will go more deeply into using these effectively
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Managing Risk
Considering How Much Risk a Trader is Comfortable With
A risk management strategy does not implicitly mean that all risk has to be managed.
Rather, a trader needs to determine just how much risk he wishes to mitigate and how
much open or uncovered risk he can deal with. Any risk management action will come
at a cost to the trader, whether it is a financial cost (for purchasing financial hedging
instruments) or an opportunity cost (of selecting to sell or buy coffee at a different point
in time rather than waiting until an ideal point). At times the trader may decide that he
would rather leave some of the risk open rather than incur these costs.
Selecting Ways of Managing Price Risk
Different ways exist to manage price risk. Depending on a trader’s own business
situation it is likely that he will utilize a variety of different tools to manage his risk. It is
very rare for a trader to manage his entire risk through just one tool or method. A risk
management strategy will often involve a combination of methods selected based on
the specific needs and requirements of a trader’s business. These tools will also be
chosen based on both the effectiveness and the cost efficiency of these tools.
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No "One Best Strategy" for Managing Risk
Every trader will face a different set of circumstances and have a different set of risk
management preferences. By examining these specific circumstances and preferences traders
can develop an optimal risk management strategy for their business. This is true even when two
traders are operating in a similar location and with similar business practices. Each trader
should always examine his own business situation, and tailor a strategy for managing the risk
that is unique to his business.
Managing Risk
Managing Risk Through Physical Strategies
There are two primary methodologies for managing price risk: the use of physical
trading tools, and the use of financial instruments.
Risk Management Strategies using Physical Trading
Physical trading involves the use of sales contracts with exporters and buyers
overseas to offset and manage price risk. Physical strategies for managing risk include:

Back to back trading: This is the simplest and most common approach to managing
risk. It involved the simultaneous, or nearly simultaneous, selling and buying of coffee.
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We discussed in Module 2 that if a trader buys coffee without also selling or sells coffee
without also buying he has created an exposure to price risk for his business. By moving
these two actions (buying and selling coffee) as close together as possible the trader
minimizes this risk. To do this he must make his transactions as "back to back" as
possible. In back to back trading, for example, a trader will purchase coffee and at the
same time negotiate a contract with a buyer to sell that coffee at a set price. This
ensures that both the purchase and the sale price of coffee are known and there is no
risk of price movements occurring that may result in losses for the trader. In addition
because the two transactions are carried out in the same time period both transactions
will more than likely have the same reference price.

Other structured sales contracts. At times traders will be able to negotiate with their
buyers a full range of contracts, which have elements embedded into the contract terms
that will be useful in offsetting and managing price risk. These include:

Minimum price forward contracts: A trader will agree to a contract with a buyer where a
minimum price (or "price floor") for the coffee is agreed. This ensures that should prices
fall in the period that the trader is buying and delivering the coffee to fulfil the contract, he
will be guaranteed the minimum price. However if prices rise the trader will gain from the
rise.

Price-to-be-fixed contracts: A trader agrees to a contract with a buyer where the
amount of the coffee to be sold is known but the price will be fixed at a future point in time
(often at the date of delivery). The future (forward) price will be based on an agreed
formula (usually based on the international price of coffee at that date). This enables a
trader to guarantee that he has a buyer for a certain amount of coffee. However he is not
bound to a price until a point in the future.

Long term forward contracts: A trader has a long-term relationship with a buyer where
the buyer guarantees purchases of coffee on a long term and ongoing basis. This protects
the trader from the risk of failing to secure a buyer for their coffee in the future. These
contracts often work on the same basis as price-to-be-fixed contracts. The price is fixed at
a point in the future (often at the date of delivery).
More detail and explanation of physical trading methods will be covered in the next module of
this course.
Combination of Strategies to Manage Price Risk
It is likely that most traders depending on their business model and circumstances will
use a combination of physical contracts to manage risk. Traders may also use financial
instruments where suitable physical contracts are not available. Such a combination will
form the trader’s price risk strategy, which will be tailored to their own business
circumstances.
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Managing Risk
Hedging Strategies using Financial Instruments
As mentioned in the introduction to this module, there are two primary groups of tools
that can be used to manage price risk: the use of physical trading tools and the use of
financial instruments.
Hedging with Financial Instruments
Financial Instruments involve the use of financial markets or exchanges to "hedge"
the physical exposure of a trader. There are two kinds of instruments that a trader might
take advantage of:

Futures: A futures contract is a contract to buy or sell coffee in the international coffee
market at a pre-agreed grade, price, and quality in the future. How these contracts
function will be discussed in more detail in the following modules. These contracts can
be used to manage risk by offsetting a contract in the physical market through the use of
a financial futures contract. For example at the same time that a trader purchases coffee
from a producer in the local market, he can sell a futures contract in the international
market. In this way the trader locks in a sales price at a future point in time to protect
himself against drastic price falls in the market generally. Alternatively, a trader who has
agreed to a fixed price contract with a buyer for a certain amount of coffee at a set price,
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but has been unable to purchase the necessary coffee, can purchase a futures contract
that will protect the trader from the risk of coffee prices rising drastically, until the point at
which he is able to purchase the physical coffee in the physical market. This process
and the functioning of futures markets will be described in much more detail in the
following modules of this course.

Options: A trader uses "options on futures" to gain the same protection as futures
contracts offer but without the obligation to complete the transaction. Different types of
options contracts can be used to protect a buyer who is either long or short against rising
and falling coffee prices. Options are attractive as they don't carry an obligation to
complete the transaction, however unlike futures contract they do require an upfront
premium payment to purchase the options contract. These contracts will also be covered
in more detail in the following modules of this course.
In summary, there are a variety of methods or tools which traders can use to protect his
business against price risk. In most circumstances, a trader would prefer to protect his
business by using physical trades (contracts) as these are the core tools of his
business, are often less costly to utilize and are transacted with counterparts that trader
is familiar with (i.e. buyers / exporters). However in situations where managing risk
within the context of their physical business is unavailable financial instruments can
provide a useful additional set of tools for managing price risk.
Combination of Strategies to Manage Price Risk
It is likely that most traders, depending on their business model, will use a combination of
physical contracts to manage risk. They will use financial instruments where physical
instruments are not available. Such a combination will form the trader’s price risk strategy,
which will be tailored to their own business circumstances.
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