1239286220863 craig baker commodity price risk management (1)

8/14/2019 1239286220863 Craig Baker Commodity Price Risk Management (1)

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Market-Based Solutions for

Commodity

Price Risk Management

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-Craig Baker

Commodity Risk Management Group,

World Bank

EUROPEANCOMMISSION

ALL ACP AGRICULTURAL COMMODITIES PROGRAMME

ACP GROUPOFSTATES


2/17

What Creates Price Risk?

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

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Agenda


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4/17

Impacts of Price Risk

Example:producer prices fixed at the beginning of the season;

If prices risebetween purchase and sale, farmers groups / ginnersare profitable and:

Profits are returned to farmer in the form of 2ndpayment;

Balance sheets remain in tact, loans are repaid and finance isavailable for the following season

If prices fallbetween 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


5/17

Some Examples

African Food Aid $800m in 2006

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

El Salvador2001/2 - $250m Coffee Debt

Senegal2006 - $20m Cotton Debt

What or who is Next?

African Food Aid $900m in 2007


6/17

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 creditto 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


7/17

Can Risk Management Tools Help?

toreplace costly, inefficient, disruptive ex postresponseswith cheaper, more efficient, targeted ex anteresponses

that stimulate private sector agricultural lending


8/17

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 andbring about long terms obligations.

We need to demystify risk management and separate it

from speculation!


9/17

Overview of Price Risk Management (Hedging)

Tools

Two main products: Futures Contract;

Option Contract:

A financial agreementbetween two parties that gives the buyer

the right but not the obligationto buy or sell a futures contract

within a specific period of time at a specific price level;

Has an upfront costAkin to insurance;

Standardised contracts that specify:

Price;

Quantity;

Delivery date;

Settlement Date


10/17

Option Contracts..

PUT Option

Contingent Export

CALL Option

Contingent Import

Definition

PUTS = purchase the

right but not the obligation

to SELLa specific futurescontract at a specified price

within a specified time

CALLS = purchase the

right but not the obligation

to BUYspecific futurescontract at a specified price

within a specified time

Offers Protection against prices moving down against prices moving up

What You Get

If market moves down, you

receive the difference

between price protected

and the prevailing market

price

If market moves up, you

receive the difference

between price protected

and the prevailing market

price


11/17

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

Riskmanaging 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;

BUTgenerally very difficult to access risk management marketsdirectly so best approach is to access price risk mgmt solutions

through market intermediaries


12/17

Application of Risk Management Tools

Market Intermediaries (Cooperatives / Buyers / Traders / Processors) Riskmanaging price volatility in between time of purchase & sale; avoiding trading

losses caused by intra-seasonal price volatility; maintaining own credit-worthiness andability 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


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Risk Assessment is the First Step!

Risk comes from not knowing what you're doingWarren Buffet

Every participant in a commodity chain has risk that is determinedby 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 patternsinfluence risk;

Banks / Financiers should be using these tools and assist

Market Intermediaries with the adoption of these practices!


14/17

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


15/17

Three Risk Assessment Tools

Breakeven Analysis:

Breaking even = covering costs;

Costs change over time depending on changes in:

Fixed costsTransport, Ginning, Milling, Roasting;

Variable costsPurchase 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?


16/17

The Alternative Approach....

We should be managing risks instead of managing crises

Dr. Abera Deressa


17/17

Lesson Learned

Price risk tools if carefully applied may yield:

Reduced cost of borrowing from banks;

Increase access to creditas confidence of repaymentincreases;

Stability of earnings & secure minimum operatingmargin;

Assurance of price to be offered farmers;

Capacity building for improved risk management alsostrengthens marketing / financial knowledge;

Ensure that it is not just another cost in the value

chain...

Capacity building on these issues takes time

1239286220863 craig baker commodity price risk management (1)

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