Diversification is simply the process of disseminating investment through a range of assets to reduce risk. A typical example of a personal diversification plan is the 60-40 concept, which devotes 40 percent of the portfolio to bonds and 60 percent to stocks. 

FREMONT, CA: In capital markets, the word ‘risk’ means different things for different people. The danger is a feature of systemic liquidity at the exchange level. It is a degree of market exposure for institutional investors. For retailers, the risk is the amount of capital in harm’s way at any given time. However, no matter a company’s position on the market, one thing is certain: one must actively manage risk.

For educational purposes, there would be no better way to explore the definition of risk than in the energy markets. Read below all about energy trading and risk management at the exchange, institutional and retail levels.

Promoting Market Liquidity

As the world’s biggest derivatives market, the Chicago Mercantile Exchange (CME) provides billions of dollars’ worth of trades every business day. Energy futures and options are one of the most common sectors of the CME. For derivative exchanges, liquidity freezes and counterparty risk are two main areas of concern. The exchange’s central business is to clear, settle and guarantee all trades carried out through its services. If the parties concerned default on their commitments, the exchange is responsible for ensuring that stocks stay solvent and that trading proceeds uninterrupted. Energy markets and risk management are also taken very seriously in exchanges such as the CME.

Daily, the CME takes several measures to deter disasters. Next, the CME oversees participants for signs of financial and organizational pressure. Second, market actors are expected to post performance bonds (margins) to prove that they can fulfill their financial obligations. During times of increased uncertainty, the CME is expected to increase the margin criteria to ensure that markets remain as orderly and productive as possible.

Diversification

If one has ever consulted a financial advisor or saved in a 401(k), then they are familiar with the idea of portfolio diversification. Diversification is simply the process of disseminating investment through a range of assets to reduce risk. A typical example of a personal diversification plan is the 60-40 concept, which devotes 40 percent of the portfolio to bonds and 60 percent to stocks.  In terms of institutional energy trading and risk management, the idea of diversification is applied somewhat differently. To fine-tune risk exposure, hedge funds, producers, and banks use energy derivatives in various ways.