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  • 10.2.4-RISK AND THE RELATION TO TRADE CREDIT-FINANCIAL LIMIT

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  • Financial limit

     
     
    A volume limit is meant to avoid excessive risk. However, at a price of US$ 2,000/ton a 500-ton limit long or short represents US$ 1 million, but at US$ 4,000/ton the same 500 tons represents US$ 2 million. So, at US$ 2,000/ton, US$ 1 million is needed to cover a short position of 500 tons; double that amount if the price goes to US$ 4,000/ton. Conversely, at US$ 2,000/ton a long position of 500 tons costs US$ 1 million to finance but US$ 2 million at US$ 4,000/ton. Clearly, because exporters deal in physical coffee that must be financed, the volume limit by itself is not enough.

    A financial limitis needed as well to ensure the operation, the book, can be financed. However, the volume limit is equally important. A price change of US$ 200/ton against the exporter means a loss of US$ 100,000 for 500 tons; double that if lower prices had caused their financial limit to permit a position of 1,000 tons. To take a real-life example, in December 1999 the ICO 'other milds' indicator stood at 124 cts/lb ex dock: by the end of December 2001 the same indicator had fallen below 60 cts/lb and by the end of February 2011 it stood at no less than 296 cts/lb.

    Both types of limit are needed therefore to protect against drastic price changes. The financial limit kicks in when prices rise, and the tonnage limit kicks in when prices fall. The objective is to avoid exceeding one's financing capacity or incurring unsustainable trading losses.

    By adding the third position category (pending shipments and outstanding invoices) the daily position report will show both the funds applied by category, and the firm's total trading exposure. Unfulfilled contracts, shipments in progress and outstanding invoices should be subdivided to show the total exposure per individual client.

    The combination of financial and volume limits is also important for those trading on the futures markets where financial leverage or gearing may enable traders to turn, for example, a margin investment of US$ 100,000 into a US$ 500,000 coffee position (if they are permitted to trade at the ratio of 5 to 1). In this situation a 1% position profit means a 5% profit on the actual investment; conversely, a 1% position loss means dropping 5% on the investment. (In futures the volume limit would be expressed as a number of contracts.)