Market-Based Solutions for

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ALL ACP AGRICULTURAL COMMODITIES PROGRAMME
European Commission
ACP Group of States

• Market-Based Solutions for
• Commodity
• Price Risk Management

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Craig Baker Commodity Risk Management
Group, World Bank
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Agenda

• 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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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

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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

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Some Examples
Burkina Faso -2005/6 - 110m in Cotton Debt
African Food Aid 900m in 2007

• African Food Aid 800m in 2006

Senegal 2006 - 20m Cotton Debt
What or who is Next?
El Salvador 2001/2 - 250m Coffee Debt
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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

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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

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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!

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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

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Option Contracts..
PUT Option Contingent Export CALL Option Contingent Import
Definition PUTS purchase the right but not the obligation to SELL a specific futures contract at a specified price within a specified time CALLS purchase the right but not the obligation to BUY specific futures contract 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
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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

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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

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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!

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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

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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?

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The Alternative Approach....

• We should be managing risks instead
  of managing crises

Dr. Abera Deressa

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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