Commodity Risk Management

•13 March 200013 March 2000

Eastern Europe

39%

Importance of Commodities

World Merchandise Trade World Merchandise Trade

in 1998: $5.270 billionin 1998: $5.270 billion

World Commodity Trade World Commodity Trade

- soft and hard - soft and hard

commodities - commodities -

$1,055 billion$1,055 billion

around 20% of the total around 20% of the total

tradetrade

Latin America64%

Africa74%

Asia23%

Share in exportsShare in exports

Historical rationale for Historical rationale for interventionsinterventions

At the Central Bank level:At the Central Bank level:

– Keynes (1943): buffer stocks, central fundKeynes (1943): buffer stocks, central fund

– Compensatory finance and the IMF (1963)Compensatory finance and the IMF (1963)

– STABEX and SYSMIN (1975-2000)STABEX and SYSMIN (1975-2000)

Supply and trade management:Supply and trade management:

– Commodity Agreements: sugar and tin (1954); coffee (1962); Commodity Agreements: sugar and tin (1954); coffee (1962);

cocoa (1972), rubber (1980)cocoa (1972), rubber (1980)

– Lomé (1975) - commodity protocolsLomé (1975) - commodity protocols

– country buffer schemes: Australia (wool), PNGcountry buffer schemes: Australia (wool), PNG

Why all these Why all these

interventions?interventions?

Because volatile Because volatile

commodity prices create commodity prices create

volatile export earnings, volatile export earnings,

volatile central bank volatile central bank

reserves and volatile reserves and volatile

fiscal receipts, etc.fiscal receipts, etc.

End of National Price Stabilization

Schemes (Board, Caisse)

International CommodityAgreements

without economic provisions

Globalisation

Liberalization

End of Compensatory

Mechanism (Stabex, Sysmin)

New LoméConvention andimpacts of CAP

and US farmpolicy

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-Policy shift toward market-

based instruments, based instruments,

including risk including risk

management toolsmanagement tools

What’s the difference What’s the difference

between “old” and “new” between “old” and “new”

paradigms????paradigms????

Risk is not absorbed Risk is not absorbed

anymore, the idea is anymore, the idea is

now to transfer it.now to transfer it.

The concept is The concept is

completely different:completely different:

Manage price changes Manage price changes

rather than change rather than change

pricesprices

Price Risk AnalysisPrice Risk Analysis

UnderstandQuantify

Manage

Risk managementRisk managementRisk 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

Risk management refers to a variety Risk management refers to a variety

of instruments aimed at reducing of instruments aimed at reducing

price, index, exchange or interest price, index, exchange or interest

rate risks by transferring these risks rate risks by transferring these risks

to the market.to the market.

Tools:Tools:

– ForwardForward

– FuturesFutures

– OptionsOptions

– SwapsSwaps

– Commodity loans and Commodity loans and

bondsbonds

– Various combinations of Various combinations of

basic instrumentsbasic instruments

Futures Market Futures Market

OTC marketOTC market

Risk management

Finance

Bought by institutional investors eager to take on risks

Traded among banksand large institutionalinvestors

Instruments are traded on exchanges, ina transparentmanner

Not traded - bankslay off risks throughvarious operations, including on futuresexchanges

In general,instruments are not traded

Marketing

Forwardcontracts

Futurescontracts

Optionscontracts

Swaps Commodityloans & bonds

Organizedexchanges

Over-thecounter

Futures contractsFutures contractsPurposePurpose Futures are agreements which are standardized in

terms of quality, volume and delivery at a preset level

AdvantagesAdvantages No need to negotiate No need to negotiate

contract specificationscontract specifications minimal counterparty minimal counterparty

riskrisk initial position can initial position can

easily be reversedeasily be reversed delivery is not delivery is not

necessarily impliednecessarily implied

AdvantagesAdvantages No need to negotiate No need to negotiate

contract specificationscontract specifications minimal counterparty minimal counterparty

riskrisk initial position can initial position can

easily be reversedeasily be reversed delivery is not delivery is not

necessarily impliednecessarily implied

DisadvantagesDisadvantages working capital is frozen working capital is frozen

up in marginsup in margins possibility of profiting possibility of profiting

from favourable spot from favourable spot market developments is market developments is lostlost

spot terms of the hedged spot terms of the hedged product and the futures product and the futures contract may divergecontract may diverge

DisadvantagesDisadvantages working capital is frozen working capital is frozen

up in marginsup in margins possibility of profiting possibility of profiting

from favourable spot from favourable spot market developments is market developments is lostlost

spot terms of the hedged spot terms of the hedged product and the futures product and the futures contract may divergecontract may diverge

Underlying Underlying assetasset

ProfitProfit

lossloss

Option contractsOption contractsPurposePurpose Options are contracts conferring the holder the right,

but not the obligation, to purchase (call) or sell (put) a specific asset at a predetermined price on or before a specified date

AdvantagesAdvantages both traded on standardized both traded on standardized

exchange and on over-the-exchange and on over-the-counter (tailor-made)counter (tailor-made)

no “funding risk”: the costs no “funding risk”: the costs of protection are known up-of protection are known up-frontfront

possibility of benefiting from possibility of benefiting from favorable price movementsfavorable price movements

AdvantagesAdvantages both traded on standardized both traded on standardized

exchange and on over-the-exchange and on over-the-counter (tailor-made)counter (tailor-made)

no “funding risk”: the costs no “funding risk”: the costs of protection are known up-of protection are known up-frontfront

possibility of benefiting from possibility of benefiting from favorable price movementsfavorable price movements

DisadvantagesDisadvantages up-front premiums can up-front premiums can

be expensive, especially be expensive, especially if volatility is highif volatility is high

selling options can be selling options can be highly riskyhighly risky

option sellers need to option sellers need to pay margin callspay margin calls

DisadvantagesDisadvantages up-front premiums can up-front premiums can

be expensive, especially be expensive, especially if volatility is highif volatility is high

selling options can be selling options can be highly riskyhighly risky

option sellers need to option sellers need to pay margin callspay margin calls

Example: Put OptionExample: Put Option

Underlying Underlying valuevalue

ProfitProfit

lossloss

Swap contractsSwap contractsPurposePurpose

A swap is a purely financial instrument negociated directly between market participants (OTC) under which specified cash-flows are exchanged at specified intervals

AdvantagesAdvantages combination of hedging combination of hedging

and securing investmentsand securing investments long-term long-term no or less-strict margin no or less-strict margin

callscalls low administrative burdenlow administrative burden known counterpartyknown counterparty tailor-madetailor-made

AdvantagesAdvantages combination of hedging combination of hedging

and securing investmentsand securing investments long-term long-term no or less-strict margin no or less-strict margin

callscalls low administrative burdenlow administrative burden known counterpartyknown counterparty tailor-madetailor-made

DisadvantagesDisadvantages counterparty riskscounterparty risks positions are difficult to reversepositions are difficult to reverse high design/set-up costshigh design/set-up costs difficult to assess the “fair” difficult to assess the “fair”

price for the dealprice for the deal possibility of benefiting from possibility of benefiting from

favorable price movements favorable price movements may be lostmay be lost

DisadvantagesDisadvantages counterparty riskscounterparty risks positions are difficult to reversepositions are difficult to reverse high design/set-up costshigh design/set-up costs difficult to assess the “fair” difficult to assess the “fair”

price for the dealprice for the deal possibility of benefiting from possibility of benefiting from

favorable price movements favorable price movements may be lostmay 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 Example of swap agreement involving a producer, a involving a producer, a consumer and a bankconsumer and a bank

Price Risk Instability in the CommoditiesPrice Risk Instability in the Commodities

– coffee : 30%coffee : 30%

– cocoa: 10%cocoa: 10%

– aluminium: 20%aluminium: 20%

– zinc: 20%zinc: 20%

Who bears it?Who bears it?

Commodity Risk Commodity Risk

Management, goals:Management, goals:

– ensure a minimum priceensure a minimum price

– increase flexibilityincrease flexibility

– securise a financial flowsecurise a financial flow

– improve planimprove plan

– credit access credit access

– hedge a stockhedge a stock

– etc...etc...

Which actors are affected?Which actors are affected?

– ProducersProducers

– Exporters/tradersExporters/traders

– ProcessorsProcessors

– Importers Importers

– GovernmentsGovernments

Not a zero sum gameNot a zero sum game

Research by KPMG among its clients Research by KPMG among its clients

showed an average profit increase of 55 % showed an average profit increase of 55 %

+20 % due to better margin and higher +20 % due to better margin and higher

volume of business with existing clientsvolume of business with existing clients

+15 % to better asset-liabiity management+15 % to better asset-liabiity management

+10 % new products or clients+10 % new products or clients

Manager can concentrate on strategic issues Manager can concentrate on strategic issues

rather than to worry about day-to-day price rather than to worry about day-to-day price

movementmovement

Marketing and pricing policies can be improvedMarketing and pricing policies can be improved

Cash flow management is more efficientCash flow management is more efficient

Funds for profitable new ventures are more Funds for profitable new ventures are more

easily available, partly because of a better easily available, partly because of a better

credit ratingcredit rating

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

Example of coffee in Africa Using Risk Management as a

strategic tool:

– start the hedge : end 1994start the hedge : end 1994

– Price: average Sept-Dec 1994Price: average Sept-Dec 1994

– Period: 1995-1996Period: 1995-1996

– Price trend: slight contangoPrice trend: slight contango

– Additional earnings from hedging: 1,4 billion Additional earnings from hedging: 1,4 billion

US dollarsUS dollars

Two-yea r hedge 1995-1996 sta rted in the end of 1994,Two-yea r hedge 1995-1996 sta rted in the end of 1994, ($ million) ($ million)

AfricanAfricanC ount riesC ount ries

19951995 19961996

CoffeeCoffeeExportExport

HedgeHedge11

CoffeeCoffeeexportsexports

HedgeHedge11

Export of Arabica Export of Arabica

EthiopiaEthiopia 271,9 271,9 + 66,4+ 66,4 278,1 278,1 + 112,3+ 112,3

KenyaKenya 320,8 320,8 + 61,1+ 61,1 297,0 297,0 + 103,4+ 103,4

TanzaniaTanzania 135,9 135,9 + 28,4+ 28,4 127,5 127,5 + 48,1+ 48,1

BurundiBurundi 91,6 91,6 + 22,9+ 22,9 41,7 41,7 + 38,7+ 38,7

TotalTotal(including(including

910,0 910,0 +185,0+185,0 820,0820,0 + 310,0+ 310,0

Export of Robusta Export of Robusta

UgandaUganda 426,2 426,2 +118,1+118,1 396,6 396,6 + 274,2+ 274,2

C ôte d ' Ivoi reC ôte d ' Ivoi re 388,9 388,9 + 85,7+ 85,7 291,2 291,2 + 198,9+ 198,9

C ongo, D.R. ofC ongo, D.R. of 148,7 148,7 + 26,7+ 26,7 76,7 76,7 + 61,9+ 61,9

C ameroonC ameroon 93,0 93,0 + 19,1+ 19,1 64,3 64,3 + 44,4+ 44,4

TotalTotal(including(including

1215,01215,0 +275,0+275,0 975,0 975,0 + 640,0+ 640,0

Source: based on UNC TAD estimationSource: based on UNC TAD estimation11 It is assumed that the hedge locked in t he ave rage prices of It is assumed that the hedge locked in t he ave rage prices ofSeptember-December 1994 for a 2-year pe riod (1995-1996), onSeptember-December 1994 for a 2-year pe riod (1995-1996), on

AfricanAfricanC ount riesC ount ries

CoffeeCoffeeExportExport

HedgeHedge11

CoffeeCoffeeexportsexports

HedgeHedge11

TotalTotal(including(including

TotalTotal(including(including

Source: based on UNC TAD estimationSource: based on UNC TAD estimation11 It is assumed that the hedge locked in t he ave rage prices of It is assumed that the hedge locked in t he ave rage prices ofSeptember-December 1994 for a 2-year pe riod (1995-1996), onSeptember-December 1994 for a 2-year pe riod (1995-1996), on

Example of new scheme after the abolition of Stabex and

Sysmin

A proposal to replicate compensatory mechanisms with

market-based tools

Let’s concentrate on two instruments (options and swaps) Let’s concentrate on two instruments (options and swaps)

and on their potential use in addressing the problems of and on their potential use in addressing the problems of

coffee and cocoa sectorscoffee and cocoa sectors

Price instability in the coffee sectorRobusta, 1991-1999

With this type of instability, stabilization funds

as well as compensatory mechanisms are costly

and hardly sustainable

e.g. 1994/95 versus 1995/96e.g. 1994/95 versus 1995/96

– 1994/95 more than 400 US$/tonne1994/95 more than 400 US$/tonne

– 1995/96 less than 150 US$/tonne1995/96 less than 150 US$/tonne

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

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:

purchase of put options

enter into a swap and buy calls

EXTRA SLIDE ON COFFEE (SEE EXCEL)

Futures and options market

SCHEMEBuy a put

Coffee & cocoa producing country

Minimum prices

Put optionPut option

Coffee or Coffee or cocoa pricecocoa price

ProfitProfit

Price level determined bythe coffee & cocoa producing country or automatically by the Scheme

lossloss

Bear Put spreadBear Put spread

Coffee or Coffee or cocoa pricecocoa price

ProfitProfit

lossloss

Buy high strike put /Sell low strike put

Futures market SCHEMEbuy a call

Coffee & cocoa producing country

Fixed prices

Swap

If price above fixed price If price below

fixed price

current price levelcurrent price level

level below which country is affectedlevel 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 Scheme2) on a continuous basis, governments are informed of possible

protection levels and related costs3) government can then lock in prices on voluntary basis

An example of a new structure:

the International Task Force on

Commodity Risk Management

(ITF)

Under discussion:

Supplying Risk Management ToolsSupplying Risk Management Tools

IntermediationIntermediation

Transaction guarantees by an International StructureTransaction guarantees by an International Structure

Provision of a Safety Net for PricesProvision of a Safety Net for Prices

Construction of Risk Management InstitutionsConstruction of Risk Management Institutions