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BIPRU 7.4 Commodity PRR

General rule

BIPRU 7.4.1R

A firm must calculate its commodity PRR by:

  1. (1)

    identifying which commodity position must be included within the scope of the PRR calculation (see BIPRU 7.4.2R);

  2. (2)

    expressing each such position in terms of the standard unit of measurement of the commodity concerned;

  3. (3)

    expressing the spot price in each commodity in the firm's base currency at current spot foreign exchange rates;

  4. (4)

    calculating an individual PRR for each commodity (see BIPRU 7.4.20R); and

  5. (5)

    summing the resulting individual PRRs.

Scope of the commodity PRR calculation

BIPRU 7.4.2R

A firm's commodity PRR calculation must, regardless of whether the positions concerned are trading book or non-trading book positions:

  1. (1)

    include physical commodity positions;

  2. (2)

    (if the firm is the transferor of commodities or guaranteed rights relating to title to commodities in a repurchase agreement or the lender of commodities in a commodities lending agreement) include such commodities;

  3. (3)

    include notional positions arising from positions in the instruments listed in the table in BIPRU 7.4.4R; and

  4. (4)

    exclude positions constituting a stock financing transaction.

BIPRU 7.4.3R

Gold positions are excluded from the scope of the commodity PRR. Instead, they are included within the scope of the foreign exchange PRR (BIPRU 7.5).

BIPRU 7.4.4R

Table: Instruments which result in notional positions

This table belongs to BIPRU 7.4.2R(3)

Instrument

See

Forwards, futures, CFDs, synthetic futures and options on a single commodity (unless the firm calculates a PRR on the option under BIPRU 7.6 (Option PRR))

BIPRU 7.4.8R

A commitment to buy or sell a single commodity at an average of spot prices prevailing over some future period

BIPRU 7.4.10R

Forwards, futures, CFDs, synthetic futures and options on a commodity index (unless the firm calculates an PRR on the option under BIPRU 7.6)

BIPRU 7.4.13R - BIPRU 7.4.14R

Commodity swaps

BIPRU 7.4.16R - BIPRU 7.4.17R

A warrant relating to a commodity must be treated as an option on a commodity.

BIPRU 7.4.5G

BIPRU 7.4.2R includes a trading book position in a commodity that is subsequently repo'd under a repurchase agreement or lent under a stock lending agreement. Clearly, if the commodity had initially been obtained via a reverse repurchase agreement or stock borrowing agreement, the commodity would not have been included in the trading book in the first place.

BIPRU 7.4.6G

Firms are reminded that the table in BIPRU 7.6.5R (Table: Appropriate PRR calculation for an option or warrant) divides commodity options into:

  1. (1)

    those which must be treated under BIPRU 7.6; and

  2. (2)

    those which must be treated under either BIPRU 7.4 or BIPRU 7.6 (Option PRR), the firm being able to choose whether BIPRU 7.4 or BIPRU 7.6 is used.

Derivation of notional positions: General

BIPRU 7.4.7G

BIPRU 7.4.8R - BIPRU 7.4.19G convert the instruments listed in the table in BIPRU 7.4.4R into notional positions in the relevant commodities. These notional positions are expressed in terms of quantity (tonnes, barrels, etc), not value. The maturity of the position is only relevant where the firm is using the commodity maturity ladder approach or the commodity extended maturity ladder approach.

Derivation of notional positions: Futures, forwards, CFDs and options on a single commodity

BIPRU 7.4.8R

Where a forward, future, CFD, synthetic future or option (unless already included in the firm's option PRR calculation) settles according to:

  1. (1)

    the difference between the price set on trade date and that prevailing at contract expiry, the notional position:

    1. (a)

      equals the total quantity underlying the contract; and

    2. (b)

      has a maturity equal to the expiry date of the contract; and

  2. (2)

    the difference between the price set on trade date and the average of prices prevailing over a certain period up to contract expiry, there is a notional position for each of the reference dates used in the averaging period to calculate the average price, which:

    1. (a)

      equals a fractional share of the total quantity underlying the contract; and

    2. (b)

      has a maturity equal to the relevant reference date.

BIPRU 7.4.9G

  1. (1)

    The following example illustrates BIPRU 7.4.8R (2).

  2. (2)

    A firm buys a Traded Average Price Option (TAPO - a type of Asian option) allowing it to deliver 100 tonnes of Grade A copper and receive $1,750 in June. If there were 20 business days in June the short notional positions will each:

    1. (a)

      equal 5 tonnes per day (1/20 of 100 tonnes); and

    2. (b)

      have a maturity equal to one of the business days in June (one for each day).

  3. (3)

    In this example as each business day in June goes by the quantity per day for the remaining days does not change (5 tonnes per day) only the days remaining changes. Therefore, halfway through June there are ten, 5 tonne short notional positions remaining each for the ten remaining business days in June.

Derivation of notional positions: Buying or selling a single commodity at an average of spot prices prevailing in the future

BIPRU 7.4.10R

Commitments to buy or sell at the average spot price of the commodity prevailing over some period between trade date and maturity must be treated as a combination of:

  1. (1)

    a position equal to the full amount underlying the contract with a maturity equal to the maturity date of the contract which is:

    1. (a)

      long, where the firm will buy at the average price; or

    2. (b)

      short, where the firm will sell at the average price; and

  2. (2)

    a series of notional positions, one for each of the reference dates where the contract price remains unfixed, each of which:

    1. (a)

      is long if the position under (1) is short, or short if the position under (1) is long;

    2. (b)

      equals a fractional share of the total quantity underlying the contract; and

    3. (c)

      has a maturity date of the relevant reference date.

BIPRU 7.4.11G

The following guidance provides an example of BIPRU 7.4.10R. In January, a firm agrees to buy 100 tonnes of copper for the average spot price prevailing during the 20 business days in February, and will settle on 30 June. After entering into this agreement, the firm faces the risk that the average price for February increases relative to that for 30 June. Therefore, as highlighted in the table below:

  1. (1)

    the short positions reflect the fact that this could occur because any one of the remaining forward prices for February increase; and

  2. (2)

    the long position reflects the fact that this loss could occur because the forward price for 30 June falls.

BIPRU 7.4.12G

Table: Example of buying at the average spot price prevailing in the future

This table belongs to BIPRU 7.4.11G

Application of BIPRU 7.4.10R(1)

Application of BIPRU 7.4.10R(2)

From trade date to start of averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

A series of 20 notional short positions each equal to 5 tonnes of copper. Each position is allocated a maturity equal to one of the business days in February (one for each day).

During averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

As each business day goes by in February the price for 5 tonnes of copper is fixed and so there will be one less notional short position.

After averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

No short positions.

Derivation of notional positions: CFDs and options on a commodity index

BIPRU 7.4.13R

Commodity index futures and commodity index options (unless the option is included in the firm's option PRR calculation), must be treated as follows:

  1. (1)

    Step 1: the total quantity underlying the contract must be either:

    1. (a)

      treated as a single notional commodity position (separate from all other commodities); or

    2. (b)

      divided into notional positions, one for each of the constituent commodities in the index, of an amount which is a proportionate part of the total underlying the contract according to the weighting of the relevant commodity in the index;

  2. (2)

    Step 2: each notional position determined in Step 1 must then be included:

    1. (a)

      when using the commodity simplified approach (BIPRU 7.4.24R), without adjustment; or

    2. (b)

      when using the commodity maturity ladder approach (BIPRU 7.4.25R) or the commodity extended maturity ladder approach (BIPRU 7.4.32R), with the adjustments in BIPRU 7.4.14R.

BIPRU 7.4.14R

Table: Treatment of commodity index futures and commodity index options

This table belongs to BIPRU 7.4.13R(2)(b)

Construction of index

Notional position (or positions) and maturity

Spot level of index is based on the spot price of each constituent commodity

Each quantity determined in Step 1 as referred to in BIPRU 7.4.13R is assigned a maturity equal to the expiry date of the contract.

Spot level of index is based on an average of the forward prices of each constituent commodity

Each quantity determined in Step 1 as referred to in BIPRU 7.4.13R is divided (on a pro-rata basis) into a series of forward positions to reflect the impact of each forward price on the level of the index. The maturity of each forward position equals the maturity of the relevant forward price determining the level of the index when the contract expires.

BIPRU 7.4.15G

  1. (1)

    An example of using BIPRU 7.4.13R and the table in BIPRU 7.4.14R is as follows.

  2. (2)

    A firm is long a three-month commodity index future where the spot level of the index is based on the one, two and three month forward prices of aluminium, copper, tin, lead, zinc and nickel (18 prices in total).

  3. (3)

    Step 1: the firm should decide whether to treat the full quantity underlying the contract as a single notional commodity position or disaggregate it into notional positions in aluminium, copper, tin, lead, zinc and nickel. In this case the firm decides to disaggregate the contract into notional positions in aluminium, copper, tin, lead, zinc and nickel.

  4. (4)

    Step 2: if the firm uses the commodity simplified approach,1 nothing more need be done to arrive at the notional position. In this case the firm uses the commodity maturity ladder approach and so subdivides each position in each metal into three because the level of the index is based on the prevailing one, two and three month forward prices. Since the future will be settled in three months' time at the prevailing level of the index, the three positions for each metal will have maturities of four, five and six months respectively.

Derivation of notional positions: Commodity swaps

BIPRU 7.4.16R

A firm must treat a commodity swap as a series of notional positions, one position for each payment under the swap, each of which:

  1. (1)

    equals the total quantity underlying the contract;

  2. (2)

    has a maturity corresponding to the payment date; and

  3. (3)

    is long or short according to BIPRU 7.4.17R.

BIPRU 7.4.17R

Table: Treatment of commodity swaps

This table belongs to BIPRU 7.4.16R

Receiving amounts which are unrelated to any commodity's price

Receiving the price of commodity 'b'

Paying amounts which are unrelated to any commodity's price

N/A

Long positions in commodity 'b'

Paying the price of commodity 'a'

Short positions in commodity 'a'

Short positions in commodity 'a' and long positions in commodity 'b'

BIPRU 7.4.18G

The table in BIPRU 7.4.17R shows that where the legs of the swap are in different commodities, a series of forward positions are created for each commodity (that is, a series of short positions in commodity 'a' and a series of long positions in commodity 'b').

BIPRU 7.4.19G

The table in BIPRU 7.4.17R also covers the case where one leg is unrelated to any commodity's price. This leg may be subject to a PRR under another part of BIPRU 7; for example, an interest rate based leg would have to be included in a firm's interest rate PRR calculation.

Calculating the PRR for each commodity: General

BIPRU 7.4.21R

A firm must use the same approach for a particular commodity but need not use the same approach for all commodities.

BIPRU 7.4.22R

  1. (1)

    A firm must treat positions in different grades or brands of the same commodity-class as different commodities unless they:

    1. (a)

      can be delivered against each other; or

    2. (b)

      are close substitutes and have price movements which have exhibited a stable correlation coefficient of at least 0.9 over the last 12 months.

  2. (2)

    If a firm relies on (1)(b) it must then monitor compliance with the conditions in that paragraph on a continuing basis.

BIPRU 7.4.23R

If a firm intends to rely on the approach in BIPRU 7.4.22R(1)(b):

  1. (1)

    it must notify the appropriate regulator in writing at least 20 business days prior to the date the firm starts relying on it; and

  2. (2)

    the firm must, as part of the notification under (1), provide to the appropriate regulator the analysis of price movements on which it relies.

Calculating the PRR for each commodity: Simplified approach

BIPRU 7.4.24R

A firm which calculates a commodity PRR using the commodity simplified approach must do so by summing:

  1. (1)

    15% of the net position multiplied by the spot price for the commodity; and

  2. (2)

    3% of the gross position (long plus short, ignoring the sign) multiplied by the spot price for the commodity;

(and for these purposes the excess of a firm's long (short) positions over its short (long) positions in the same commodity (including notional positions under BIPRU 7.4.4R) is its net position in each commodity).

Calculating the PRR for each commodity: Maturity ladder approach

BIPRU 7.4.25R

A firm using the commodity maturity ladder approach must calculate the commodity PRR following the steps in BIPRU 7.4.26R and then sum all spread charges, carry charges and outright charges that result. A firm must use a separate maturity ladder for each commodity.

BIPRU 7.4.26R

  1. (1)

    A firm must calculate the charges referred to in BIPRU 7.4.25R as follows.

  2. (2)

    Step 1: offset long and short positions maturing:

    1. (a)

      on the same day; or

    2. (b)

      (in the case of positions arising under contracts traded in markets with daily delivery dates) within 10 business days of each other.

  3. (3)

    Step 2: allocate the positions remaining after step 1 to the appropriate maturity band in the table in BIPRU 7.4.28R (physical commodity positions are allocated to band 1).

  4. (4)

    Step 3: match long and short positions within each band. In each instance, calculate a spread charge equal to the matched amount multiplied first by the spot price for the commodity and then by the spread rate of 3%.

  5. (5)

    Step 4: carry unmatched positions remaining after step 3 to another band where they can be matched, then match them. Do this until all matching possibilities are exhausted. In each instance, calculate:

    1. (a)

      a carry charge equal to the carried position multiplied by the spot price for the commodity, the carry rate of 0.6% and the number of bands by which the position is carried; and

    2. (b)

      a spread charge equal to the matched amount multiplied by the spot price for the commodity and the spread rate of 3%.

  6. (6)

    Step 5: calculate the outright charge on the remaining positions (which will either be all long positions or all short positions). The outright charge equals the remaining position (ignoring the sign) multiplied by the spot price for the commodity and the outright rate of 15%.

BIPRU 7.4.27G

The matched amount in BIPRU 7.4.26R is the lesser (ignoring the sign) of either the total long position or the total short position. For example, a band with 1000 long and 700 short results in a matched amount of 700. The unmatched amount would be 300.

BIPRU 7.4.28R

Table: Maturity bands for the maturity ladder approach

This table belongs to BIPRU 7.4.26R

Band

Maturity of position

Band 1

0 ≤ 1 month

Band 2

> 1 month ≤ 3 months

Band 3

> 3 months ≤ 6 months

Band 4

> 6 months ≤ 1 year

Band 5

> 1 year ≤ 2 years

Band 6

> 2 years ≤ 3 years

Band 7

> 3 years

BIPRU 7.4.29G

BIPRU 7.4.30G is an example illustrating the calculation of the commodity PRR on an individual commodity using the commodity maturity ladder approach (BIPRU 7.4.26R). After the firm has carried out the pre-processing required by BIPRU 7.4.26R(2) (that is, step 1), it follows steps 2 to 5 as shown below. Because the firm is using the commodity maturity ladder approach the spread rate is 3%, the carry rate is 0.6% and the outright rate is 15%. The example assumes that the spot price for the commodity is £25.

BIPRU 7.4.30G

Table: Example illustrating the commodity maturity ladder approach

This table belongs to BIPRU 7.4.29G

BIPRU_Chapter_7_008rev2

Calculating the PRR for each commodity: Extended maturity ladder approach

BIPRU 7.4.31R

A firm may use the commodity extended maturity ladder approach to calculate the commodity PRR for a particular commodity provided the firm:

  1. (1)

    has a diversified commodities portfolio;

  2. (2)

    undertakes significant commodities business;

  3. (3)

    is not yet in a position to use the VaR model approach to calculate commodity PRR; and

  4. (4)

    at least twenty business days before the date the firm uses that approach notifies the appropriate regulator in writing of:

    1. (a)

      its intention to use the commodity extended maturity ladder approach;1 and

    2. (b)

      the facts and matters relied on to demonstrate that the firm meets the criteria in (1) - (3).

BIPRU 7.4.32R

A firm using the commodity extended maturity ladder approach must calculate its commodity PRR by:

  1. (1)

    following the same steps as in BIPRU 7.4.26R but using the rates from the table in BIPRU 7.4.33R rather than those in BIPRU 7.4.26R; and

  2. (2)

    summing all spread charges, carry charges and outright charge that result.

BIPRU 7.4.33R

Table: Alternative spread, carry and outright rates

This table belongs to BIPRU 7.4.32R

Precious metals (excluding gold)

Base metals

Softs (agricultural)

Other (including energy)

Spread rate (%)

2

2.4

3

3

Carry rate (%)

0.3

0.5

0.6

0.6

Outright rate (%)

8

10

12

15

BIPRU 7.4.34G

For the purposes of BIPRU 7.4.31R(1) a firm has a diversified commodity portfolio where it holds positions in more than one commodity in each of the categories set out in the table in BIPRU 7.4.33R and holds positions across different maturities in those individual commodities. A firm would not have a diversified commodity portfolio if it held positions in only one commodity in each of the categories set out in the table in BIPRU 7.4.33R. This is because the rates in the table in BIPRU 7.4.33R assume firms have positions in more than one of that category's commodities. Different commodities within a given category are likely to exhibit different volatilities, so where a firm does not have a diversified commodity portfolio in that category, the rates applying to that category might underestimate the regulatory capital required for a certain commodity at certain times.

BIPRU 7.4.35G

What constitutes significant business in BIPRU 7.4.31R(2) will vary from firm to firm. The more regularly the firm undertakes trades in commodities and the more consistently it has positions in the relevant commodity, the more likely it is to be undertaking significant business for the purposes of BIPRU 7.4.31R(2).

BIPRU 7.4.36R

Where a firm is:

  1. (1)

    treating a commodity index derivative as if it was based on a single separate commodity (see BIPRU 7.4.13R(1)(a)); and

  2. (2)

    using the commodity extended maturity ladder approach to calculate the commodity PRR for that commodity;

it must determine which index constituent incurs the highest rate in the table in BIPRU 7.4.33R and apply that rate to the notional position for the purposes of BIPRU 7.4.32R.

BIPRU 7.4.37G

Where an index is only based on precious metals, BIPRU 7.4.13R and BIPRU 7.4.36R allow the firm to treat the single notional position as precious metal for the purposes of BIPRU 7.4.32R. However, if the index contained a mix of precious metals and base metals the firm would have to treat the notional position under BIPRU 7.4.36R as a base metal because base metals attract a higher rate than precious metals in the table in BIPRU 7.4.33R.

Liquidity and other risks

BIPRU 7.4.38R

If a short position to which BIPRU 7.4 applies falls due before a long position to which BIPRU 7.4 applies, a firm must also guard against the risk of a shortage of liquidity which may exist in some markets.

BIPRU 7.4.39G

In particular, where BIPRU 7.4.38R applies and the short position constitutes a material position compared to a firm's total commodity positions, it should consider a further commodity PRR charge in respect of that position depending on the likelihood of a shortage of liquidity in that market.

BIPRU 7.4.40R

A firm must safeguard against other risks, apart from the delta risk, associated with commodity options.

BIPRU 7.4.41R

The interest-rate and foreign-exchange risks not covered by other provisions of BIPRU 7.4 or by the provisions of BIPRU 7.2 (Interest rate PRR) or BIPRU 7.5 (Foreign currency PRR) must be included in the calculation of general market risk for traded debt securities and in the calculation of foreign currency PRR.