# Physical commodity trading quantitative risk return model

I am very new to commodities, I was previously in portfolio management/optimization (Black Litterman Markowitz etc). I am now a Buy-Sell analyst for Petrochemicals, and need to understand the basic concepts of physical commodity trading in order to create a model supporting trading decisions. I have been through Investopedia, IHS, Forbes, and a few other sources with a comb but am yet to find any actual simple examples of incorporating variables like risk appetite or political risk into a risk-return model for a single transaction. Any help/ advice on where to start is highly appreciated, I am completely lost.

Your question piqued my interest. While not specific to commodities, this looks like a good starting point for quantifying political risk:

Practically, this means taking the following steps (according to Rigobon 2003):

Step 1: Define the treatment group, or a set of “event” days on which the variance of the unobservable factor is high, such as the Italian referendum on December 4.

Step 2: Choose a set of “non-event” days to serve as a control or comparison group. Common practice suggests choosing non-event days one or a few days before the event days, so as to minimize the influence of risk factors other than the political one. Political risk may also change on these days, but (by assumption) they change less than on event days. This assumption is a leap of faith, but hopefully a reasonable one.

Step 3: Apply a standard econometric technique known as instrumental variable (IV) regression. Consider regressing changes in one variable of interest (e.g., the CDS spread of Spanish sovereign debt) on changes in a second variable (e.g., Italian CDS spreads), that is then instrumented by a proxy.3 This proxy is the same variable but with opposite sign on non-event days.

Unlike a traditional event study, this approach does not apply the unrealistic assumption that political risk only changes on event-days. In situations like the Italian referendum, in which periodic polls revealed changes in voter preferences, the traditional event-study method may underestimate the magnitude of the political risk.

• thankyou verymuch, am now reading this! Assuming I am able to quantify the risk of an event, how do you think I should go about factoring it into a trade deal? thankyou for the sexsigma reference I didn't think of checking their insights! – El_1988 May 23 '18 at 8:07
• I read the Case study in the link, very informative. The complexity I have yet to find any concrete resources for, is how do Physical commodity traders like Trafigura or Glencore actually plug this quantified political risk into a VaR and Risk-Return model to make a decision. For portfolios the vanilla is the Markowitz or Black-Litterman, right? so what is the base quantified models for Physical Deals and Risks? do I minus it? multiply ? that's where I am maybe ignorantly stuck. – El_1988 May 27 '18 at 12:20

Commodity prices depend on global supply and demand but not on the perception of the market regarding an adequate risk premium for a specific asset class.

Have a look on this Claude Erb and Campbell R. Harvey, "The Tactical and Strategic Value of Commodity Futures"