COTTON PRICE RISK MANAGEMENT

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COTTON PRICE RISK MANAGEMENT

• Africa EU Cotton Partnership
• September, 2007
• Roy Parizat
• Commodity Risk Management Group
• The World Bank

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OUTLINE

• Overview of CRMG
• Lessons Learned to Date
• Current Activities

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COMMODITY RISK MANAGEMENT GROUP OBJECTIVES

• Test market-based solutions for managing price
  risk
• Provide education to organizations interested in
  improving their internal risk management
  practices
• Diminish the gap between developing country
  markets the financial markets
• Empower clients to analyze risk, make changes in
  the way they trade, and/or use international
  market products when conditions look right

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LESSONS LEARNED

• Start with proper risk assessment
• Risk management solutions are diverse
• can incorporate changes in the way sales
  contracts are negotiated
• can incorporate price protection on NYBOT market
• Organizational capacity is important
• takes time attention
• Significant need for more education
• Local banks have a role and can add value to the
  process
• Requires willingness to learn by doing
• patience in trying different approaches

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RISK ASSESMENT Risk Position Report

• Overall aim is to improve internal risk mgmt
  practices
• Risk Position Report
• Requires detailed information on purchases /
  sales
• can help to quantify overall organizational risk
• is a good business tool if updated monitored
  regularly
• can be used to evaluate different marketing or
  risk mgmt strategies

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RISK ASSESMENT Risk Position Report

• Overall aim is to improve internal risk mgmt
  practices
• Risk Position Report graphic representation
• Position throughout the season can be shown
  diagramatically to improve comprehension and
  understanding of a clients risk position

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RISK ASSESMENT Breakeven Price Analysis

• Breakeven Price Analysis
• Breakeven price sales price level at which all
  costs are covered
• Expressed in local price terms and equivalent
  NYBOT price
• Conservative risk management strategy is to
  protect the breakeven price
• Either through forward sales
• Or with price protection on the NYBOT market

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RISK MANAGEMENT SOLUTIONS CAN BE DIVERSE
Risk Management
Export Sales with minimum price guarantee
Back to Back Sales
NYBOT Options Contracts
Structured Finance with Inventory as Collateral

• Solutions will have different costs / benefits
  at different times depending on the market
• Need to explore, look at alternatives, monitor
  pricing regularly
• Once you have determined your risk position,
  evaluate the costs, benefits, and impacts of
  different risk management solutions in order to
  identify the best solution/s for your business .

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CURRENT ACTIVITIES IN EAST AFRICA

• Continuing supporting risk management through
  local bank CRDB Tanzania
• CRDB Bank is major lender to agriculture large
  portfolio in cotton (and coffee)
• Faces default risk, non-repayment of bank loan
  when clients make losses due to unfavorable price
  movements
• CRDB directly shares the risks of the clients
  they are lending to
• For Cotton current marketing systems have high
  levels of risk, for example
• a) purchases prices are paid when seed cotton
  purchased from farmers but sales prices may not
  be known for many months (long position)
• -- risk is that prices will fall
• b) contract sales can be fixed early on in
  season before cotton is purchased (short
  position)
• -- risk is that prices will rise

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PROBLEMS OF GOING LONG

• If prices rise between purchase and sale, ginners
  are profitable and make additional profits
• If prices fall between purchase and sale,
  ginners

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WHY INVOLVE THE BANKS?

• Price risk influences both the outreach,
  quantity, and cost of lending available
• Banks have very strong commercial incentive for
  clients to improve profitability
• Risk management is a financial activity
• Can be added to financial services offered by
  banks
• CRDB provides regular market/price updates to
  cotton clients
• Working with banks provides advantages for
  ginners
• Local banks already have working relationships
  with ginners
• Clients can do business with a local phone call,
  through an existing relationship

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CONSTRAINTS FOR TAKE-UP

• Credit Risk
• International providers not currently willing to
  take credit risk
• Will require cash in advance payment of premium
• This limits products available to options
  contracts which can be paid for upfront
• Options contracts can be expensive
• i.e. for Put Options
• Cost is high when market prices are low
• Cost is high when covering longer period of time
  (6-8 months)
• But the reverse is also true
• Cost is low when market prices are high
• Cost is low when covering shorter period of time
  (3-5 months)

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RISK MANAGEMENT EDUCATION

• How to design the risk position of the
  organization, intepret it and quantify it in to
  capture the actual magnitude of the risk.
• How the cotton futures market works and the
  mechanics of the contracts for futures and
  options
• Understanding the difference between the physical
  financial market
• How to manage a market account

PREREQUISITES

• Commercial and administrative strength within an
  organization
• Management with sufficient autonomy to make
  decisions
• Availability of timely information on internal
  business
• Sufficient Volume
• Good understanding of the local cotton market in
  order to analyze basis risk

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For more information please contactwww.itf-commr
isk.orgor royparizat_at_hotmail.com or
jdana_at_worldbank.org