ALL ACP AGRICULTURAL COMMODITIES PROGRAMME

EUROPEAN COMMISSION
ACP GROUP OF STATES

Market-Based Solutions for Commodity Price Risk Management

Craig Baker Commodity Risk Management Group, World Bank

Agenda
What Creates Price Risk?
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Impacts of Price Risk; Can Risk Management Tools Help? Overview of Risk Management Tools; Application of Risk Management Tools; Risk Assessment;

Lessons Learned;
Not Covered (due to time) Actual examples of successful implementations

What Creates Price Risk?

Fixing prices for either purchases or sales;

Volume:
The more volume purchased and sold without managing risk, the larger the exposure

Time:
When buying or fixing a price before selling OR selling or fixing a sales price before buying; .. more time between purchases & sales = more risk

Impacts of Price Risk

Example: producer prices fixed at the beginning of the season; If prices rise between purchase and sale, farmers groups / ginners are profitable and:
Profits are returned to farmer in the form of 2nd payment; Balance sheets remain in tact, loans are repaid and finance is available for the following season

If prices fall between purchase and sale, farmer groups/ ginners: May avoid making sales in order to avoid losses; May be forced to lower the purchase price to farmers; May default on sales because can not procure enough product; May make sales and book losses; May not have cash to continue paying farmers; May go out of business

Some Examples

African Food Aid $900m in 2007

Burkina Faso -2005/6 - $110m in Cotton Debt

African Food Aid $800m in 2006 Senegal 2006 - $20m Cotton Debt

What or who is Next?

El Salvador 2001/2 - $250m Coffee Debt

Impact on Financial Institutions

Existing challenges in agri-lending include: low collateral, infrastructure, knowledge, price volatility, market access (phones), weather (climate) risk, agri technology; Banks have experienced adverse consequences of volatility and this affects willingness to supply competitively priced credit to the agricultural sector;

Credit supplied is therefore often based on conservative collateralised schemes and very little innovation exists in terms of lending products; High cost of finance erodes margins for all;
Objective: improve risk management to assure continued engagement of banking sector in agricultural financing

Can Risk Management Tools Help?

to replace costly, inefficient, disruptive ex post responses with cheaper, more efficient, targeted ex ante responses that stimulate private sector agricultural lending

Overview of Price Risk Management (Hedging) Tools

Derivatives are financial weapons of mass destruction Warren Buffet It is not the plain vanilla contracts that Buffet was referring to when making these statements but rather the overall lack of understanding of exposures arising from exotic contracts that are impossible to price and bring about long terms obligations. We need to demystify risk management and separate it from speculation!

Overview of Price Risk Management (Hedging) Tools

Two main products:
Futures Contract; Option Contract:
A financial agreement between two parties that gives the buyer the right but not the obligation to buy or sell a futures contract within a specific period of time at a specific price level; Has an upfront cost Akin to insurance;

Standardised contracts that specify:

Price; Quantity;

Delivery date;
Settlement Date

Option Contracts..
PUT Option CALL Option

Contingent Export Contingent Import PUTS = purchase the CALLS = purchase the right but not the obligation right but not the obligation to SELL a specific futures to BUY specific futures Definition contract at a specified price contract at a specified price within a specified time within a specified time Offers Protection against prices moving down against prices moving up If market moves down, you If market moves up, you receive the difference receive the difference What You Get between price protected between price protected and the prevailing market and the prevailing market price price

Application of Risk Management Tools.

Governments
Risk - managing food supplies / reserves; reducing the need for and cost of policy interventions Assist Governments with the:
Need to build confidence in commercial solutions;

Need improved planning

Producers
Risk managing sale prices to cover cost of inputs Assists Producers with the::
Need to understand how the global market moves & affects local prices; Need for confidence that producer price is competitive in the market;

BUT generally very difficult to access risk management markets directly so best approach is to access price risk mgmt solutions through market intermediaries

Application of Risk Management Tools

Market Intermediaries (Cooperatives / Buyers / Traders / Processors)
Risk managing price volatility in between time of purchase & sale; avoiding trading losses caused by intra-seasonal price volatility; maintaining own credit-worthiness and ability to pay back loans; managing farmer credit risk when extending loans for inputs & production
Assists Market Intermediaries with the:

Need to understand & be able to quantify risk throughout the season;

Need to offer competitive prices to farmers and be confident of ability to pay that price; Need to improve management of intra-seasonal price and credit exposures; Need to understand global markets & improve negotiating power

Banks / Financiers
Risk - managing credit risk for financing farmers & market intermediaries Assists Banks / Financiers with the:
Need to improve risk assessment capabilities & monitoring throughout the season; Need to offer risk management solutions to borrowers; Need to balance extending / increasing credit without increasing risks;

Can play a critical role in helping a country gain access to financial markets

Risk Assessment is the First Step!

Risk comes from not knowing what you're doing
Warren Buffet
Every participant in a commodity chain has risk that is determined by its business practices:
Price Fixing; Purchases and Sales Patterns; Volumes of Purchases and Sales;

Types of Contracts;
Levels of Credit

Risk Assessment = understanding how purchase & sales patterns influence risk; Banks / Financiers should be using these tools and assist Market Intermediaries with the adoption of these practices!

Three Risk Assessment Tools

Position Analysis:
What is your (clients) position relative to the market? In which direction is your (clients) exposure?

If you:
BUY before you SELL (long position); or SELL before you BUY (short position)

...you (your clients) are at risk and have taken a position LONG positions = risk of prices moving down; SHORT positions = risk of prices moving up

Three Risk Assessment Tools

Breakeven Analysis:
Breaking even = covering costs;

Costs change over time depending on changes in:

Fixed costs Transport, Ginning, Milling, Roasting; Variable costs Purchase price

Asses costs in terms of unit costsUsh/Kg; What is the price level at which you (your clients) are breaking even?

Mark to Market Analysis:

Compares breakeven level vs. current market level; What is the current exposure quantified in $ terms?

The Alternative Approach....

We should be managing risks instead of managing crises

Dr. Abera Deressa

Lesson Learned
Price risk tools if carefully applied may yield:
Reduced cost of borrowing from banks;
Increase access to credit as confidence of repayment increases;

Stability of earnings & secure minimum operating margin;

Assurance of price to be offered farmers; Capacity building for improved risk management also strengthens marketing / financial knowledge; Ensure that it is not just another cost in the value chain...

Capacity building on these issues takes time