Commodity Risk Management 13 March March 2000

Eastern Europe 39% Importance of Commodities n World Merchandise Trade in 1998: $5.270 billion n World Commodity Trade - soft and hard commodities - $1,055 billion n around 20% of the total trade Latin America 64% Africa 74% Asia 23% n Share in exports

Historical rationale for interventions n At the Central Bank level: –Keynes (1943): buffer stocks, central fund –Compensatory finance and the IMF (1963) –STABEX and SYSMIN ( ) n Supply and trade management: –Commodity Agreements: sugar and tin (1954); coffee (1962); cocoa (1972), rubber (1980) –Lomé (1975) - commodity protocols –country buffer schemes: Australia (wool), PNG

Why all these interventions?

Because volatile commodity prices create volatile export earnings, volatile central bank reserves and volatile fiscal receipts, etc.

End of National Price Stabilization Schemes (Board, Caisse) International Commodity Agreements without economic provisions Globalisation Libe ralization End of Compensatory Mechanism (Stabex, Sysmin) New Lomé Convention and impacts of CAP and US farm policy New environment for agriculture and trade new actors confronted with price instability Potential revamping of WB & IMF Overhaul Global Financial Architecture

Policy shift toward market- based instruments, including risk management tools What’s the difference between “old” and “new” paradigms????

Risk is not absorbed anymore, the idea is now to transfer it. The concept is completely different: Manage price changes rather than change prices

Price Risk Analysis Understand Quantify Manage

Risk management Risk management is a way to control and modify risk profiles; Among other things, it reduces earnings volatility creates a stable planning environment decreases likelihood of financial problems increases the countries and firms debt capacity increases investment opportunities increases customer/supplier comfort systemizes decision making process Risk management requires Management agreement Reliable control systems Good understanding of risks Strong comprehension of risk management tools

n Risk management refers to a variety of instruments aimed at reducing price, index, exchange or interest rate risks by transferring these risks to the market.

n Tools: – Forward – Futures – Options – Swaps – Commodity loans and bonds –Various combinations of basic instruments n Futures Market n OTC market

Risk management Finance Bought by institutional investors eager to take on risks Traded among banks and large institutional investors Instruments are traded on exchanges, in a transparent manner Not traded - banks lay off risks through various operations, including on futures exchanges In general, instruments are not traded Marketing Forward contracts Futures contracts Options contracts SwapsCommodity loans & bonds Organized exchanges Over-the counter

Futures contracts Purpose  Futures are agreements which are standardized in terms of quality, volume and delivery at a preset level Advantages n No need to negotiate contract specifications n minimal counterparty risk n initial position can easily be reversed n delivery is not necessarily implied Advantages n No need to negotiate contract specifications n minimal counterparty risk n initial position can easily be reversed n delivery is not necessarily implied Disadvantages n working capital is frozen up in margins n possibility of profiting from favourable spot market developments is lost n spot terms of the hedged product and the futures contract may diverge Disadvantages n working capital is frozen up in margins n possibility of profiting from favourable spot market developments is lost n spot terms of the hedged product and the futures contract may diverge

Underlying asset Profit loss

Option contracts Purpose  Options are contracts conferring the holder the right, butnot the obligation, to purchase (call) or sell (put) a specific asset at a predetermined price on or before a specified date Advantages n both traded on standardized exchange and on over-the- counter (tailor-made) n no “funding risk”: the costs of protection are known up-front n possibility of benefiting from favorable price movements Advantages n both traded on standardized exchange and on over-the- counter (tailor-made) n no “funding risk”: the costs of protection are known up-front n possibility of benefiting from favorable price movements Disadvantages n up-front premiums can be expensive, especially if volatility is high n selling options can be highly risky n option sellers need to pay margin calls Disadvantages n up-front premiums can be expensive, especially if volatility is high n selling options can be highly risky n option sellers need to pay margin calls

Example: Put Option Underlying value Profit loss

Swap contracts Purpose  A swap is a purely financial instrument negociated directly between market participants (OTC) under which specified cash-flows are exchanged at specified intervals Advantages n combination of hedging and securing investments n long-term n no or less-strict margin calls n low administrative burden n known counterparty n tailor-made Advantages n combination of hedging and securing investments n long-term n no or less-strict margin calls n low administrative burden n known counterparty n tailor-made Disadvantages n counterparty risks n positions are difficult to reverse n high design/set-up costs n difficult to assess the “fair” price for the deal n possibility of benefiting from favorable price movements may be lost Disadvantages n counterparty risks n positions are difficult to reverse n high design/set-up costs n difficult to assess the “fair” price for the deal n possibility of benefiting from favorable price movements may be lost

Producer Bank Pays an amount based on Liffe (Matif, CBOT)+/- premium/discount consumer Received an amount calculated using the fixed price Pays an amount calculated using the fixed price receives an amount based on Liffe (Matif, CBOT) +/- premium/discount Example of swap agreement involving a producer, a consumer and a bank

n Price Risk Instability in the Commodities – coffee : 30% – cocoa: 10% – aluminium: 20% – zinc: 20% n Who bears it?

n Commodity Risk Management, goals: –ensure a minimum price –increase flexibility –securise a financial flow – improve plan –credit access –hedge a stock – etc... n Which actors are affected? – Producers – Exporters/traders – Processors – Importers – Governments

n Not a zero sum game n Research by KPMG among its clients showed an average profit increase of 55 % n +20 % due to better margin and higher volume of business with existing clients n +15 % to better asset-liabiity management n +10 % new products or clients

n Manager can concentrate on strategic issues rather than to worry about day-to-day price movement n Marketing and pricing policies can be improved n Cash flow management is more efficient n Funds for profitable new ventures are more easily available, partly because of a better credit rating

n Three concrete illustrations of the importance of commodity risk management on the international scene: – an example of coffee in Africa –an example of new scheme after the abolition of Stabex and Sysmin –an example of a new structure discussed under the International Task Force on Commodity Risk Management

n Example of coffee in Africa Using Risk Management as a strategic tool: – start the hedge : end 1994 – Price: average Sept-Dec 1994 – Period: – Price trend: slight contango – Additional earnings from hedging: 1,4 billion US dollars

n Example of new scheme after the abolition of Stabex and Sysmin n A proposal to replicate compensatory mechanisms with market-based tools n Let’s concentrate on two instruments (options and swaps) and on their potential use in addressing the problems of coffee and cocoa sectors

Price instability in the coffee sector Robusta,

n With this type of instability, stabilization funds as well as compensatory mechanisms are costly and hardly sustainable n e.g. 1994/95 versus 1995/96 –1994/95 more than 400 US$/tonne –1995/96 less than 150 US$/tonne

n International facility: –price insurance to developing countries on some automatic basis –a certain “volume” of commodities is protected (e.g. based on the export volumes of the past 3 years) –If prices fall below a certain trigger level, the exporting country is compensated for the difference

n How such a scheme might be designed? –Let’s take only two examples - however, it should be stressed that risk management instruments can be combined in any way one wishes to generate new instruments: n purchase of put options n enter into a swap and buy calls

EXTRA SLIDE ON COFFEE (SEE EXCEL)

Futures and options market SCHEME Buy a put Coffee & cocoa producing country Minimum prices

Put option Coffee or cocoa price Profit Price level determined by the coffee & cocoa producing country or automatically by the Scheme loss

Bear Put spread Coffee or cocoa price Profit loss Buy high strike put / Sell low strike put

Futures market SCHEME buy a call Coffee & cocoa producing country Fixed prices Swap If price above fixed price If price below fixed price n current price level n level below which country is affected

To sum up, how this can be used?  A) Automatic basis: price insurance to developing countries on some automatic basis, - a certain “volume” of commodities is protected (e.g.based on the export volumes of the past 3 years) by the Scheme  B) Dialogue with each Government involved: 1) each government is, ex ante, given a budget within the Scheme 2) on a continuous basis, governments are informed of possible protection levels and related costs 3) government can then lock in prices on voluntary basis

n An example of a new structure: the International Task Force on Commodity Risk Management (ITF)

n Under discussion: n Supplying Risk Management Tools n Intermediation n Transaction guarantees by an International Structure n Provision of a Safety Net for Prices n Construction of Risk Management Institutions