43.Market risk can be influenced by changes in commodity prices, that is, commodity risk. Commodity risk is the risk that on- or off-balance sheet positions will be adversely affected by movements in commodity prices.

44.A commodity is defined as a physical product that can be traded on a secondary market, for example, agricultural products, minerals and precious metals. Gold; however, is covered under the framework for foreign exchange.

45.Price risk in commodities is often more complex and volatile than price risk associated with currencies and interest rates. One reason for this is that commodity prices are influenced by natural events such as floods and droughts. Changes in supply and demand also have more dramatic effects on price and volatility, and commodity markets often lack liquidity.

46.Commodity risk only has a general market risk component because commodity prices are not influenced by specific risk.

47.Banks using portfolio strategies involving forward and derivative contracts on commodities are exposed to a variety of additional risks, such as:

1. ▪ Basis risk. the risk of changes in the cost of carry for forward positions and options. Cost of carry is a margin and refers to the net effect of borrowing funds for a certain period of time and investing them in a financial instrument or commodity for the same period of time. If the interest earned on the instrument or commodity is greater than the cost of borrowing, then the cost of carry is positive. The cost of carry can also be negative if the cost of borrowing is greater than the interest earned.
2. ▪ Forward gap risk. This is the risk wherein forward prices may change for reasons other than a change in interest rates.

48.It is important to note that these risks could well exceed the risk associated with changes in spot prices of commodities.

   1.Treatment of Commodities

Offsetting

49.When measuring risk in commodities, offsetting between positions is restricted.

1. ▪ Offsetting is allowed between long and short positions in exactly the same commodity to calculate open positions.
2. ▪ In general, offsetting is not allowed between positions in different commodities. However, the Central Bank may permit offset between different sub-categories of the same commodity, for example, different categories of crude oil, if:
   1. ▪ they are deliverable against each other
   2. ▪ they are close substitutes for each other, with a minimum correlation of 0.9 between price movements over a period of at least one year

Correlations

50.Banks using correlations between commodities to offset commodity positions must have obtained prior approval from the Central bank of UAE.

   2.Calculating the Capital Charge

51.Two alternative approaches for calculating the capital charge for commodities are set out by the standardised measurement method:

a)Simplified Approach

52.Under the simplified approach, banks must express each commodity position, spot plus forward, in terms of the standard unit of measurement (barrels, kilos, grams, and so on).

The capital charge is the sum of two charges:

1. ▪ 15% of the net position in each commodity. All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included.
2. ▪ 3% of the bank's gross commodity positions, that is, the sum of the net long plus net short positions in each commodity, calculated using the current spot price. This charge addresses basis risk, interest rate risk and forward gap risk.

b)Maturity Ladder Approach

53.There are seven steps involved in calculating the capital charge for commodities using the maturity ladder approach. A separate maturity ladder must be used for each commodity.

   3.Treatment of Commodity Derivatives

54.All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included in the commodities risk measurement framework. This includes commodity futures, commodity swaps, and options where the “delta plus” method is used.