derivatives and commodity hedging the world bank treasury 1818 h street, n.w. washington, dc, 20433,...
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Derivatives and Commodity HedgingDerivatives and Commodity Hedging
The World BankTreasury1818 H Street, N.W.Washington, DC, 20433, USAtreasury.worldbank.org
OECD-MENA Senior Budget Officials Network
Randy Ewell, World Bank, Banking and Debt Management Department
2
Commodity prices have fallen sharply, beginning in July 2008 with the sharpest falls over the past month
Falls have been most severe in oil and metals
Agricultural commodity prices have also fallen, but by less
Price falls have been both large and fast
Many intermediaries in the commodity chain, who are naturally long, will have lost considerable money unless they were hedged and will may experience financing difficulties in the coming months
Un-hedged northern hemisphere farmers may experience large losses since the price falls have come just as crops are brought to market
Decreasing prices create an opportunity for importers (of food/oil) to lock in lower prices
The world has changed …The world has changed …
3
Commodity prices rose steadily from 2003 until the summer of 2008
This is the longest and most general commodity boom since the 1920s
Not all prices shared in the boom, and some started to fall in 2007
IMF commodity price indices, normalized at 2000 = 100 deflated by US PPI. The 2008 figure is the January-July average
75
100
125
150
175
200
225
250
275
2000 2001 2002 2003 2004 2005 2006 2007 2008
FoodsBeveragesAgricultural raw materialsMetalsEnergy
The aggregate pictureThe aggregate picture
4
Most least developed countries are oil importers but a significant minority are major exporters
Crude oil prices rose more or less steadily from 2001 to early July 2008 reaching over $140/bl
They have now halved to $70/bl
0
10
20
30
40
50
60
70
80
90
($/b
l, 2
00
0 p
rice
s)
Average, Brent and WTI first positions, deflated by US PPI. Source: IMF
Crude OilCrude Oil
5
Along with oil, metals prices have fallen furthest and fastest – particularly over the past month
Al, Ni & Zn are lower now than at the start of 2006
Cu, Pb & Sn are around the same level as Jan 2006
0
100
200
300
400
500
600
700
800
900
(Ja
n
20
03
= 1
00
)
Al Cu
Ni Pb
Sn Zn
20-Oct-08
Source: LME
Non-Ferrous MetalsNon-Ferrous Metals
6
Chicago (CBOT) corn prices jumped sharply in 2006 to peak in June 2008 at $7/bl. They have now fallen to $4/bl.
South African (SAFEX) white maize prices also rose but this reflected local factors. Although they have now fallen sharply in dollar terms, this is almost all due to the downward fall of the Rand
CBOT first position and SAFEX spot prices (converted into dollars), deflated by US PPI. Sources: CBOT, SAFEX and IMF
0
50
100
150
200
250
300
350
400
$/t
on
(2
00
6 v
alu
es)
JohannesburgChicago
MaizeMaize
7
Rice is the principal food of many poor people. An increase in the rice price has a negative impact on poverty levels worldwide
Bangkok rice export price.
Source: World Bank
320
330
340
350
360
370
380
$/t
on
India prohibits rice exports
RiceRice
8
Cotton prices have been very stable since 2005, albeit at a low level
They have dropped sharply over the past month to 60c/lb, lower in real terms than in 2004
This price fall will have caused serious problems for any unhedged ginner
0
10
20
30
40
50
60
70
80
(c/lb
, 2
00
0 p
rice
s)
0
200
400
600
800
1000
1200
1400
1600
(F.C
FA
/kg
, 2
00
0 p
rice
s)
c/lbF.CFA/kg
Cotlook A Index deflated by US PPI, and converted into F.CFA/kg and deflated by Burkina Faso CPI. Source: ICAC and IMF.
CottonCotton
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The food price crisis led many countries to revert to the food policies of the 1970s
Export bansCostly strategic grain reserves Reversal of diversification policiesPrice stabilization/subsidy programs
These policies carry risks
Can be destructive to market / tradeTotal financing needed for these interventions are unknown / unpredictable
Policy ResponsesPolicy Responses
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Dealing with RiskDealing with Risk
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Governments need to..
Plan for & budget responsesRaise financing for responses & ensure rapid implementation Ensure that they are protected against future shocks
Donors & International community should..
Maximize value & impact of assistanceEnsure resources are not diverted from longer term programs
Both have led to renewed interest in ex ante solutions
Since ex post reactions are costly, inefficient, and difficult to finance & implement when countries are already in crisis
Increased Interest inIncreased Interest inRisk ManagementRisk Management
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No Shareholders – only VotersNot necessarily driven by returns on Capital or EquityRisk appetite virtually zeroUnfortunately, short term Horizons
Affected by PoliticsNot necessarily Commercial decisions, therefore the solution is not necessarily a commercially driven oneCannot ignore the ‘Power of One’ – the VETOAll solutions have to pass the ‘Monday Morning Quarterback’ test
Significant Factors for a NationSignificant Factors for a Nation
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Why Would a Nation Hedge ?Why Would a Nation Hedge ?
Reduce Volatility of the Budget in favor of stabilityStrengthen the probability of meeting the Budget
‘Targeted’ Hedging of Key Elements in BudgetEducationHealthInfrastructureInflation
Imports where there is inelastic demand and no substitution To address security of supply & security of energy and food
Investment of Government FundsCommodity Indices, Bonds, Notes where inversely Correlated to Budget
Event’ Hedging
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Hedging ProductsHedging Products
A commercial contract which limits the impact of adverse price movements which might take place between buying (or incurring production costs) and selling
Why? Traditional (unhedged) price stabilization programs can’t survive without high levels of subsidy / bailoutMarket intermediaries (co-ops, exporters) can’t survive repeated years of trading lossesBanks
A) Can’t survive repeated years of default when borrowers mismanage price exposures and have financial losses as a result
B) Will have to charge high interest rates to maintain lending in high risk agricultural sectors -the high cost of finance erodes margins for all
Oil Price Volatility HedgingOil Price Volatility HedgingIntroductionIntroduction
Why Hedge?
Oil prices are volatile and hard to predict
Exposure to oil price may harm fiscal policy
Uncertain fiscal revenues linked to oil exports may lead to shelving of planned projects or wasteful use of ‘windfall’ revenues
Hedging stabilizes cash flows
Allows to lock in prices in advance or specify their rangeSubstantially reduces volatility of revenuesReduces the risk of sudden financial loss due to adverse market movements
-15
-10
-5
0
5
10
15
Market Oil Price (USD/BBL)
Pro
fit/
Lo
ss
No HedgeNo Hedge
Current Price Current Price USD/BBLUSD/BBL
Selling on a spot basis exposes producer to rising and falling commodity prices
Oil Price Volatility HedgingOil Price Volatility HedgingIntroductionIntroduction
There are two ways to pursue stabilization
Self Insurance: Oil revenues in excess of a predefined average level are saved. Savings are used to complement oil revenues when they fall below average.
Oil revenues can be fixed or floored for future dates using market instruments.
The second method is usually more efficient
Hedging with markets
Oil Price Volatility HedgingOil Price Volatility HedgingHedging with MarketsHedging with Markets
There are generic instruments
No cost. Lock in future price. Do not permit upside gains
Futures/ForwardsSwaps
Put options Upfront cost (to buy puts). Place a floor on future price. Permit upside gains.
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Derivatives are used for either
Hedging, orSpeculation
Growth in Derivatives Use
Hedging
Speculation
Hedgers use derivatives to manage risk and protect themselves against the possibility that the market might go “against them”
Speculators use derivatives to produce a returnThey “take a view”, i.e. bet on where the market is going and try to make a profit
Scope of the Presentation
• For our purposes, the use of derivatives is a risk management tool
Derivatives IntroductionDerivatives Introduction
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End users: “SHORT” energy – concerned about rising prices
Eg. Airline, Industrial, Shipper, Road Transport, Railway: all active hedgers
Producers: “LONG” energy – concerned about falling prices
Eg. Energy Majors and Independents, State Oil Companies
Refiners and Power-Generators: MARGIN exposed – concerned about relative prices
Oil Refiner: Crude oil versus oil products (called “cracks”)Power-generator: Coal / Oil / Gas versus Electricity (“Dark / Spark spreads”)
Traders and Distributors: TIMING and / or BASIS RISK
Mismatch between purchase price and sale price windowMismatch between purchase price INDEX sale price INDEX Eg. buy LNG on Brent Index, Selling on UK Gas NBP
Who Hedges and Why?Who Hedges and Why?
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An over-the-counter (OTC) contract determining the price of the underlying to be paid or received on an obligation beginning at a future start dateEssentially forwards contracts lock-in the price of the underlying
Forward Contract
OTC Contract
Forward contracts are not standardizedMaturity dates agreed by the partiesNominal amount can be adjustedNominal amounts in any currencyDay count convention applicable in the reference rate and currency chosen
Forward Contract vs
Futures
Instrument is similar to that of a future
The payment under the contract is equivalent to a margin payment but…
…Payment at maturity only: Higher credit risk
Forward ContractForward Contract
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Futures: obligation to buy or sell an underlying instrument at a certain price and date
A futures is a method to lock in a pricePhysical delivery of the underlying assetCash settlement: difference between the spot and the futures price
Exchange traded and standardized contract: specified quantity and quality of the instrument, price per unit, date and method of delivery (if any)
Futures
The role of clearing houses
Futures counterparties interact with the exchange’s clearinghouse (CH). Clients do not know whom they have traded with
A futures trade is really two trades
The agreement will be honored by the CHTo protect itself the CH demands that
An initial collateral amount is deposited to cover future losses
A futures account is marked to market daily. Daily margin increase to cover unrealized losses from daily market movements
No party will incur a big loss at maturity
Clearing houseParty A Party B
Credit Risk Mitigation
FuturesFutures
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A contract between two counterparties to exchange streams of cash flows
What is a Swap?
Characteristics of Swaps
Defined period of time and can be customizedContracts are traded over-the-counter (OTC)Cash flows are calculated over a notional principal amount
Interest Rate Swaps
Exchange payments linked to the price of a commodityUsed to reduce volatility in income/expenditures due to fluctuations
Currency Swaps
Commodity
Swaps
Exchange of fixed payments against floating interest paymentsMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter interest rate exposure and align asset and liabilities
Exchange payments in one currency for anotherMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter the currency exposure of an asset or liability
SwapsSwaps
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Futures Forwards
Exchange Exchange traded Over the counter
Counterparty Clearinghouse Counterparty in the forward agreement
Transaction Timing
Marked-to-market every day Transact when purchased and on the settlement date
Customization Standardized: Amount, currency, dates are fixed
Non-standardized: Amount, currency, maturity dates can be adjusted
Credit Risk Minimal: essentially eliminated through margining process
Counterparty credit risk
Regulation Highly regulated Private, unregulated transactions
Liquidity Highly liquid Illiquid
Bid-Ask Spread Low High
Both futures and forwards represent agreements to buy or sell some underlying asset in the future
Both allow for physical or cash settlement depending on the underlying instruments (interest rates, commodities, etc)
Both entail market risk and can be used for hedging purposes
Similarities
Differences
Forward and Futures: A SummaryForward and Futures: A Summary
Endogenous Term-Structure of Futures Endogenous Term-Structure of Futures PricesPrices
For low oil prices the market is in contango, i.e. the term structure is upward-sloping.
For medium oil prices the term structure of futures prices can be slightly humped
For high oil prices the market is in backwardation.
Backwardation occurs when the oil price expected for the expiration date declines with the maturity of the futures contracts.
Oil futures prices exhibit “mean-reversion,” i.e., prices in contracts for delivery many months in the future converge to the long-term expected price.
Hedging with Futures or Forward ContractsHedging with Futures or Forward Contracts
Firm commitment that provide for the futures sale/delivery of crude oil at a specified price
Gains or losses realized daily (Futures)
P/L from the agreed upon price vs. the actual market price on the delivery date is usually settled on the delivery date
Profit to seller
= initial futures price - ultimate market price
Profit to buyer
= ultimate market price - initial futures price
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-$30.00
-$20.00
-$10.00
$0.00
$10.00
$20.00
$30.00
$90 $95 $100 $105 $110 $115 $120 $125 $130 $135 $140
Price / Barrel
Pro
fit
/ L
oss
Long Inventory
Short Futures
Final Payout
A country with a long position in commodities (i.e. an oil producer) loses out if the price of the commodity drops and gains if the commodity price rises.
To hedge that position, it can sell exchange-traded futures to lock in the price.Therefore, no matter if the price moves up or down, the producer is not exposed to the
volatility because the gain/loss on the futures contract will offset the gain/loss on the commodity.
Oil Futures
Using Futures for HedgingUsing Futures for Hedging
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$90
$95
$100
$105
$110
$115
$120
$125
$130
$135
$140
1 2 3 4 5 6 7 8 9 10 11 12
Month
$/B
arr
el
Market Price
Floor - Realized Price
Alternatively, if the producer wants to participate in the upside gains, it may choose to enter into a series of put options to create a price floor, which means that the producer is guaranteed a minimum price for its commodities.
However, an upfront premium must be paid to purchase this series of put options
Price Floors
Hedging through OTC Options - Price Floor Hedging through OTC Options - Price Floor (Insurance)(Insurance)
29
Illustrative example Illustrative example
Indicative Levels - Jet Cargos CIF NWEIndicative Levels - Jet Cargos CIF NWE
Aug 2008- Jul 2009
Strike Premium
USD 1500 / mt USD 85 /mt
Time
Price
USD/mt The client receives the difference between the floating and fixed price
No exchange
StrikeMarket Price
Potential gainsPotential costs
1500
Swap
Objective
To cap forward price.
Description
It is the right, but not the obligation, to buy specific volumes of diesel at a specified price (the strike price) during a specified period of time.
In purchasing a call option, the party is effectively buying insurance against higher products prices.
The buyer pays an upfront premium for protection from prices above the specified cap strike price.
The average monthly settlement price is compared to the strike
• If settlement price is lower than the strike price, the client does not receive anything
• If settlement price is higher than the strike, the client receives the difference between the strike and the settlement price
Advantages
Locks in a cap over a time period and is protected from any price appreciation above the strike
Price rises in the physical market are compensated by hedging gains
Benefit from potential upside, should diesel prices drop.
Disadvantages
The buyer has to pay an upfront premium to buy a call option.
Key considerations Key considerations
Consumer: Buying a Call Option – CapConsumer: Buying a Call Option – Cap
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Hedging Instruments Description Benefits Potential Costs
Fixed for Floating
Swap
Enables the party to eliminate their price exposure, protecting themselves from a fall in oil prices.
To do this the party sells a swap to bank and receive a fixed rate in return for paying the floating market rate.
No upfront premium
By receiving a fixed market price there is greater control over their revenue base.
Forgone benefit from rising oil prices
Floor
In purchasing a put option, The buyer is effectively buying insurance against lower prices.
The party pays an upfront premium for protection from prices below the specified floor strike price
Able to retain 100% of the upside if market prices rise (minus the premium paid for floor).
Must pay an upfront premium for upside protection.
Zero Cost Collar
Collars involve buying a put and offsetting the premium by selling a call option struck above the market.
The party receives the same protection as a put option provides, however, the group has sold away some of its upside in order to finance the purchase of the put.
No upfront premium is paid.
Floored on the downside, but is allowed to ride the market up to the call strike that it sells.
Party loses the benefit of rising prices above the cap option strike price.
The below table illustrates the tools available to hedge against a fall in commodity prices
Hedging Instruments - SummaryHedging Instruments - Summary
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Airline
Bank
Supplier
Airline pays supplier floating price for jet fuel
Airline receives jet fuel from supplier
Airline pays a fixed price to Bank
Airline receives the floating price from
Bank
Hedging Tools Description Benefits Potential Costs
Fixed for Floating
Swap
Enables the airline to eliminate their price exposure, protecting themselves from a rise in fuel prices.
To do this the airline would enter a swap and receive the floating market rate in return for paying a fixed price.
No upfront premium
By receiving the floating market price the client now has greater control over their cost base
Forgone benefit from falling prices
An airline is exposed increase in jet fuel prices and can choose a variety of tool to hedge depending on their risk philosophy. The most vanilla product that an airline could utilise is a swap. Here the airline would enter a swap and pay a fixed price in return for the floating price.
Case Study – Outright Exposure - AirlineCase Study – Outright Exposure - Airline
32
An airline can also hedge their exposure using options.The below table outlines the different hedging options available:
Hedging Tools Description Benefits Potential Costs
Cap
In purchasing a call option, The airline is effectively buying insurance against higher prices.
The airline pays an upfront premium for protection from prices above the specified cap strike price.
The client is able to retain 100% of the downside if market prices decline (minus premium paid for cap)
The client must pay an upfront premium for upside protection.
Zero Cost Collar
Collars involve buying a call and offsetting the premium by selling a put option struck below the market.
The airline receives the same protection as a cap option provides, however, the group has sold away some of its downside in order to finance the purchase of the call.
No upfront premium is paid.
The client is capped on The upside, but is allowed to ride the market down to the put strike that it sells.
The client loses the benefit of falling prices below the floor option strike price.
Three way
Similar ides to a Zero Cost Coupon, yet the Airline would sell an additional call with a strike above the existing collar to fund a lower collar
No upfront premium is paid
Market levels are capped at a lower level than a Zero Cost Coupon
The client is exposed to prices above the upper call level and loses the benefit of price below the floor
Case Study – Outright Exposure - AirlineCase Study – Outright Exposure - Airline
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$90
$95
$100
$105
$110
$115
$120
$125
$130
$135
$140
1 2 3 4 5 6 7 8 9 10 11 12
Month
$/B
arr
el
Market Price
Sw ap - Realized Price
Swaps are basically a series of futures or forward contracts. Swaps can be used when a commodity producer wants to hedge at a several points in time.
In this case, the producer enters into a fixed price swap, which guarantees a set selling price no matter how much the commodity price moves in the future.
Fixed Price Swaps
Hedging through OTC Swaps Hedging through OTC Swaps (Fixed Price Swap)(Fixed Price Swap)
34
Producer
Bank
Off taker
Producer receives floating price from off taker supplier
Producer delivers oil to off taker
Producer receives a fixed price
throughout the period
Producer pays the floating
price throughout period
Hedging through OTC Swaps Hedging through OTC Swaps (Fixed Price Swap)(Fixed Price Swap)
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Illustrative example Illustrative example
Indicative Levels – Jet Cargos CIF NWEIndicative Levels – Jet Cargos CIF NWE
Aug 2008- Jul 2009
Fixed Level USD 1325.00 / mt12
Time
Price
USD/mtThe client receives the difference
between the floating and fixed price
The client pays the difference between the fixed and floating price
HedgedMarket Price
Potential gainsPotential costs
1325
Objective
To lock in forward price.
Description
The buyer locks in the price for a fixed volume of diesel over a predetermined period by buying a fixed price swap
The average monthly settlement price is compared to the swap price
• If settlement price is lower than the swap price, the buyer pays the difference between the settlement price and the swap price
• If settlement price is higher than the swap price, the buyer receives the difference between the swap price and the settlement price
Advantages
Locks in a fixed price over a time period and is protected from any price appreciation above the swap price
Price rises in the physical market are compensated by hedging gains
No upfront premium required
Disadvantages
Loose all the potential gain from downside price moves below the swap price
Price decreases in the physical market are offset by hedging losses
Key considerations Key considerations
Consumer: Buying a Fixed Price SwapConsumer: Buying a Fixed Price Swap
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-$30
-$20
-$10
$0
$10
$20
$30
$90 $95 $100 $105 $110 $115 $120 $125 $130 $135 $140
Price / Barrel
Pro
fit
/ L
oss
Long Inventory
Long Put
Final Payout
Alternatively, the commodity producer may want to participate on the upside movement of the commodity price, which is not possible if futures contracts are used.
Buying put options allows the producer to gain when the price of the commodity drops, which offsets the loss in the commodity position. On the other hand, when the price of the commodity rises, the producer will gain from the commodity position, and at the same time do not face a marked-to-market loss in the hedging instrument as in the case of the future.
The cost is the price of the option, which can be very high in volatile markets
Oil Put Options
Using Put Options for HedgingUsing Put Options for Hedging
37
$90
$95
$100
$105
$110
$115
$120
$125
$130
$135
$140
1 2 3 4 5 6 7 8 9 10 11 12
Month
$/B
arr
el
Market Price
Collar - Realized Price
Since buying options can be expensive, the producer may choose to forgo some upside by selling call options at a higher strike price and at the same time, lower its price protection by buying a put option at a lower striker price, which is basically a collar strategy.
Collars can be structured so that it costs the producer nothing, but a trade-off must be made with a lower floor when compare with a normal floor strategy.
Price Bands
Hedging through OTC Options - Zero Cost Hedging through OTC Options - Zero Cost Collars (Price Bands) Collars (Price Bands)
38
Objective
To hedge at zero cost whilst benefiting from the part of the downside
Description
The party buys a call option and finances it by selling a put for the same time period and quantities at zero upfront cost.
There are multiple possible combinations of call and put strikes so that the collar is zero-cost
A non-zero-cost collar can also obviously be envisaged (i.e. the client paying a reduced premium compared to the standalone call)
The monthly average settlement price is compared to the strike levels of the monthly put and call
• If the settlement price is lower than put strike, the client pays the difference between the average and the put strike
• If the settlement price is higher than call strike, the client receives the difference between the call strike and the average
• If the monthly average is between the two strikes, nothing happens.
Advantages
Hedging method against upward price moves while maintaining some downside participation
Zero-cost structure
Disadvantages
If the market price drops below the put strike , the client will be buying at the put strike.
The client has upward price exposure comparing the current swap level vs. the put strike
Key considerations Key considerations Illustrative example Illustrative example
Indicative Levels - Jet Cargos CIF NWEIndicative Levels - Jet Cargos CIF NWE
Aug 2008- Jul 2009
The client buy Call StrikeUSD 1500 / mt
The client sell Put Strike USD 1200 / mt
Time
Price
USD/mtThe client receives the difference
between the call strike and fixed price
The client pays the difference between the put strike and floating price
1200
1500
SwapNo exchange
Strike - CallMarket Price
Potential gainsPotential costs
Strike - Put
Consumer: Zero Cost CollarConsumer: Zero Cost Collar
39
Understand all aspects of ones current exposures and the contemplated Hedge
Strong procedures with checks and balances
Remember……..……..This is NOT speculation!
Create a regulatory environment for Industry to hedge in order to……Encourage InvestmentReduce Volatility of Earnings
Encourage Consumers to take ownership of HedgingRegulatory & Tax EnvironmentReward ‘Right Way Exposure’
Do NOT remove totally the fundamental price movementThis is needed in order that supply and demand can balance out
Rules for Sovereign HedgingRules for Sovereign Hedging
40
In light of the recent financial crisis, to what extent are governments still concerned about commodity price volatility?
The recent fall in food/energy prices has created some relief for governments who are importing these commodity classes. Are they able to take advantage of the price decreases and lock in supplies/prices at these lower levels? If not, why not?
Should governments be involved in commodity risk management?
If so, how?If not, why not?
Are there other examples of countries using macro level commodity risk management strategies?
What should the World Bank Group be doing to support governments in this area?
Questions to ConsiderQuestions to Consider
41
©2008 The International Bank for Reconstruction and Development / The World Bank1818 H Street NW Washington DC 20433Telephone: 202-473-1000Internet: www.worldbank.org E-mail: [email protected] rights reservedThe findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. Rights and PermissionsThe material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 978-750-4470; Internet: www.copyright.com. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: [email protected].
Disclaimer
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