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Performance Benchmarking for PnL


This post shares with you, gentle reader, some thoughts and considerations regarding ‘performance’ in the context of benchmarking PnL.


This post is a follow up to yesterday’s post, which was also on the topic of ‘performance’, though for that post, it was in the context of system runtimes, i.e., how fast things run in a CTRM system.



1) What Are We Talking About? Point Of View as *Consumer* Of Commodities, e.g., Cocoa Butter

2) Natural Short

3) Need a ‘Hedge Model’

4) Point Of View as *Producer* Of Commodities, e.g., Natural Gas wellheads

5) Periodic Comparisons, Reporting PnL Differences

6) CTRM System Design Considerations



1) What Are We Talking About? Point Of View as *Consumer* Of Commodities, e.g., Cocoa Butter


Benchmarking in this context is comparing your actual performance, i.e., the trades you really made and the PnL (Profit and/or Loss) that you actually incurred to some other benchmark.


Using the stock market example, a hedge fund that picks stocks with certain characteristics may want to compare their performance to either the S&P 500 index or to similar type hedge funds.


The example we’ll give is for CTRM systems and for a *Consumer* of commodities.


We will consider the case of a firm that makes, for example, candy bars.  And they are in business now and expect to be in business for a long time. 


They buy various commodities as raw ingredients to their factory.  We’ll use Cocoa Butter in our example as one of them.


Figuring that they’ll need to buy a certain amount of Cocoa Butter, let’s say, monthly, ‘forever’, they may decide they want to hedge their market risk.


When it comes to market risk, we can describe two choices:

a) They can do no market risk hedging, at least nothing formal or organized.  They can simply buy the raw materials each month at whatever the current market price is. 


And perhaps buy physical, i.e., physical purchase trades, where they agree as of the time they did the trade to pay a fixed price for delivery at some point in the future.  E.g., monthly deliveries and corresponding monthly (fixed) payments for the next six months.


b) Alternately, they can decide to do hedging with derivatives, i.e., mostly futures with maybe some swaps and options. 


There are actually some special considerations for Cocoa Butter hedging, which we’ll mention here, though it is a bit off topic… not that that has ever stopped us before.


Consideration 1)

While Cocoa Butter is what is used in the factory, there are no Cocoa Butter futures.  Instead, they trade Cocoa Beans.  Cocoa Butter is to Cocoa Beans as Unleaded Gas is to Crude Oil.  One is refined from the other.  


So, naturally, you would expect one MT (metric ton) of Cocoa Butter to cost more than the same weight of Cocoa Beans.  The ratio of prices is called the ‘Butter to Bean’ ratio and has historically been around 2 to 1, plus or minus a bit.  E.g., with a ratio of 2.1, if Beans are $2000/MT, then Butter would be $4200/MT.


Point here is, you need to adjust the quantity of futures that you would buy for hedging purposes by the ratio to be properly hedged.


Consideration 2)

For Cocoa Beans and the ‘Softs’ in general, e.g., Sugar, Coffee, only a limited number of futures months are actively trades.  March, May, July, September and December.  However, your factory might run all year, i.e., all twelve months of the year.  If you want to hedge planned/forecasted January purchases of Cocoa Butter, you’ll want to hedge that with the March futures contract, i.e., the closest one that exists/is actively traded.


Consideration 3)

There is another consideration that is not special to Cocoa Beans, but we’ll mention it anyway in the interest of completeness.  Which is that you need to convert the physical quantity that you need to hedge, e.g., 110 MT of the physical, to the appropriate number of futures contracts.  The contract size for Cocoa Beans is 10 MT, so if you are trying to hedge 110 MT of Cocoa Bean equivalent need, that would mean you would buy 11 MT of the futures contracts to hedge. 


An important note on that:  At some point, you’ll need to buy the real physical Cocoa Butter so as to run your factory.  When you do, you’ll need to sell out any futures contracts you bought as hedges.  So, ultimately, for each and every hedge you added, so as to hedge the market risk, you’ll need to reverse at some point. 


2) Natural Short

For clarify, in this example, there is no speculation.  i.e., no trades are being done for ‘for profit’ purposes.  Everything is being done to hedge existing risk that naturally arises from having a need for the raw commodity.


Such a need is called a ‘Natural Short’.  In fact, for CTRM system purposes, you would typically enter this into the system as if it were a ‘trade’.  i.e., if you think you’ll need 100 MT a month for the next 2 years, you can enter that into the system as a ‘short’ (i.e., a ‘sell physical’) trade.  The 100 MT in this case is just a forecasted amount and could go up or down.  Firms might typically revise or at least double check their forecasts about once a month.


3) Need a ‘Hedge Model’

What we mean by ‘hedge model’, is the official, company approved plan for market risk hedging.


Examples might be:

a) Hedge 100% of your market risk, as calculated by the CTRM system, going out for 4 months.  And then nothing after that.

b) Hedge 100% of your market risk for the next three months, then 80% of your risk for the 3 months after that, then 60% for the next three months, then 40% for months 9 to 12, then nothing after that.


Note that no firm would, or could hedge 100% of their market risk ‘out to infinity’.  For firms that decide to hedge market risk, i.e., using derivatives, they’ll need some target end date. 


Side note: Search the internet for a case study/example of an airline that hedge too far out into the future their fuel needs.  For a time, they did OK, relative to other airlines, when fuel prices rose.  Then they did horribly bad when fuel prices sank and other airlines, who didn’t hedge, where able to buy/take advantage of the cheaper fuel, and so were able to undercut their prices.


4) Point Of View as *Producer* Of Commodities, e.g., Natural Gas wellheads

You could flip the signs from the example above to go from a consumer of commodities to a producer of commodities.


For a producer example, suppose you have/own or have leased natural gas wellheads or some source of natural gas.  Your normal business is to sell it, which can be at the current/spot market or at some point in the future.  If you sell it at a fixed price, e.g., monthly for the next 12 months, you have locked in your price and effectively have no market risk on that gas.


Alternately, you can ‘sell it’ in the derivatives market, i.e., sell futures for some months out, so as to hedge your market risk.  Then when you actually sell the physical product, you would reverse the futures, i.e., buy them back.


As with the consumer example, you need some plan for how this is done, which we called a ‘hedge model’, with the main parts of the plan being how much to hedge and for what time periods.


5) Periodic Comparisons, Reporting PnL Differences


Now that we have established the example and that there is some ‘company approved’ hedge model, we’ll note that in practice, traders, meaning the people doing the market risk hedging, will typically be given some discretion. 


They can choose to hedge more or less than the approved hedge model dictates.  Or they may choose to hedge in a different month versus what the hedge model requires.  For example, if they feel the March month is too illiquid, they may hedge the same volume in the May month (futures contracts) instead.


Now we get to the good part of this blog post, where we tie these things together.  You have these two parts:

5.1) You have the hedge model recommendations for hedging, i.e., we are assuming that a CTRM system is capable of providing a report that combines all existing physical, derivatives (e.g., futures) and forecasted usage (sometimes called ‘demand’), as well as your hedge model, e.g., 100%/80%/60%/40% for each of the upcoming 3 month periods, and shows how many futures you need to buy/sell to comply with the hedge model rules.


5.2) And you have the actual trades that were done.


What you want, therefore, is to see how the real trades and traders did versus the rules-based model.  Hopefully, the traders are doing better.  Otherwise, you might feel you are better off just getting a bunch of college interns to come in and ‘blindly’ do trades (buy/sell futures) based on whatever the model produces (in the form of a report).


You’ll compare, e.g., weekly or monthly, the PnL of the ‘benchmark portfolio’ of trades, i.e., a fictitious set of trades that were imaginarily booked into the CTRM system to match the hedge model report recommendations, to the real trades that were entered.


Ideally, a CTRM system would allow for multiple benchmarks, i.e., multiple hedge models.  E.g., show PnL of actual trades versus a hedge model of 100% for 4 months, and, separately, show PnL versus the above example of 100%/80%/60%/40%. 


6) CTRM System Design Considerations


6.1) A ‘cheat’ approach to benchmarking would be for a system to actually create ‘real’ benchmark trades into the system.  i.e., book futures trades, buys and sells, into a separate trade book/portfolio called, for example, ‘Benchmark #1’.  Or have a separate ‘trade status’ to indicate that these are benchmark trades. 


For this approach, creating PnL difference reports, i.e., between the real/actual trades and the benchmark trades would be the easy part.  Since you are effectively comparing just two sets of trades.


6.2) A better approach would be to not have to actually book and ‘fake’ trades.  Instead, the system would calculate the PnL difference between the benchmark and the real trades by examining the daily hedge model reports to see what they recommended and compare that to the closing prices for each day.


The advantage of this approach is that firms can create new ‘hedge model’ parameters and apply them, even retroactively, since you’ll always have the real trades to work with and the other information needed, i.e., closing prices and the hedge reports. 


Also, this approach can be better for performance of the system, since you would not need to include hedge model trades as part of the end-of-day process.



Introduction to CTRM

Click on this link for a great introduction to CTRM software: Introduction to CTRM Software




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