Risk Management Instruments for Countries Vulnerable to Exogenous Shocks: The Case for Food & Agriculture Cyril Muller Director Banking and Debt Management.

Risk Management Instruments for Countries Vulnerable to

Exogenous Shocks:The Case for Food & Agriculture

Cyril MullerDirector

Banking and Debt Management

Risk ManagementChallenges Facing Governments

Understand & Quantify risks in order to evaluate vulnerabilities under different scenarios

Take a broad view of fiscal risks beyond traditional financial risks (exchange rate/currency) to food, energy, fertilizer prices, but also exposure to natural disasters

Create a culture of risk management that strengthens capacity, is linked to sector policies & strengthens inter-ministerial cooperation

Bridge the gap to market solutions when & where they are appropriate through training & capacity building

Develop country-driven, customized approaches Identify active role for private sector partners

Examples of Risk Management Activities:

Hedging the price risk of imported oil & its impact on consumers of electricity: Dominican Republic, Panama, Honduras

Hedging oil price volatility and evaluating budgetary impact of natural disasters: Morocco

Hedging price risk of edible oil & fertilizer imports: Bangladesh, Philippines

Financing safety nets with weather hedges, commodity hedges, or contingent financing instruments: Ethiopia, Mauritius, Jordan

Technical support to facilitate use of physical commodity hedges for key food staples: Malawi, Haiti, Indonesia

Risk-sharing of underlying credit exposure to help expand private sector access to hedging instruments – IFC Global Agricultural Price Risk Management Facility

Market intermediation to mitigate drought risk with weather hedges: Malawi, Niger

Analysis of potential for pooling drought risks: Africa

4

Capacity-Building To model & assess the impact of drought To quantify exposure to maize import price increases To improve understanding of the cost/benefit of using

market-based approaches

Institutional Framework Recognized that different instruments would be appropriate

at different times

Risk Management Strategy IDA Credit provided funding to develop markets &

strengthen meteorological services Weather derivative – used to hedge risk of severe drought Physical call option on maize – used to hedge risk of import

price increases

An Integrated Risk Management Approachin Malawi



Institutional Framework Recognized that different instruments would be

appropriate at different times


strengthen meteorological services and risk management Weather derivative – used to hedge risk of severe drought Physical call option on maize – used to hedge risk of import

price increases


The Government of Malawi, with the support of DFID, pays a

premium in return for financial coverage (a payout) in the event

of a severe drought; World Bank plays an intermediation role by

standing between the Government and the market

counterparty (Swiss Re)



Institutional Framework Recognized that different instruments would be

appropriate at different times


strengthen meteorological services and risk management Weather derivative – used to hedge risk of severe drought Physical call option on maize – used to hedge risk of import

price increases


The Government of Malawi, with the support of DFID, paid a

premium to guarantee that white maize delivered to Malawi would

not increase above a fixed, SAFEX-based price; World Bank

played a facilitating role by helping to structure the contract

between the Government and the market counterparty

(Standard Bank)

Capacity-Building To assess the impact of intra-seasonal price risk on an

agricultural bank’s lending portfolio, and on financial sustainability of borrowers

To improve understanding of market instruments

Institutional Framework Local bank intermediates hedging transactions on behalf of

borrowers, thus lowering risk of default on loans Borrowers strengthen ability to manage intra-seasonal price

risk to secure revenue

Risk Management Strategy Swap transactions, option contracts, and forward

purchases/sales can be used by agribusinesses to protect a forward price

Hedging price risks protects revenue stream and strengthens credit-worthiness

An Integrated Risk Management Approachthrough a local bank

Capacity-Building To assess the impact of intra-seasonal price risk on an

agricultural bank’s lending portfolio, and on financial sustainability of borrowers

To improve understanding of market instruments

Institutional Framework Local bank intermediates hedging transactions on behalf of

borrowers, thus lowering risk of default on loans Borrowers strengthen ability to manage intra-seasonal price

risk to secure revenue

Risk Management Strategy Swap transactions, option contracts, and forward

purchases/sales can be used by agribusinesses to protect a forward price

Hedging price risks protects revenue stream and strengthens credit-worthiness

An Integrated Risk Management Approachthrough a local bank

Through the new Agriculture Price Risk Management Product, IFC would share credit risk with a participating international bank

which might otherwise face constraints on assuming credit exposure to emerging market counterparties; objective is to

extend the reach of hedging products to strengthen resiliency

of agribusiness

Bridging the market Gap

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Governments &

Private Sector Entities

in Developing Countries

Challenges:

•No precision in assessing & quantifying the risk

•No legal framework

•No institutional framework

•No technical expertise

•Fears about reputational risk

•Lack of sustained attention

Risk Markets

Capacity Building is Critical

Country-based work:

Risk assessment to analyze impact of commodity price shocks on the budget

Assessing legal and regulatory infrastructure

Review of potential commodity hedging solutions Technical support to design a framework and governance process Review of other institutional issues that would impact implementation, including

decision-making and technical capacity Education for ministry staff, stakeholders and policy-makers Technical advice related to structuring and executing transactions with the market

International cooperation:

Sharing best practices & establishing guidelines

Organizing a network of experts & practitioners 11

Objective: To strengthen a government’s ability to implement commodity risk management strategies supported by sound analysis and a robust institutional framework

Managing the Fiscal Impact of Commodity Price Shocks

Two main questions:

1. Can the risk of a price shock be mitigated using market instruments?

(commodity hedge component)

2. Are there other ways to finance responses to the price shock?

(contingent financing component )

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NOTE: A commodity risk management strategy can use either of these components, or a combination of the two.

Categories & Types of Hedging Products

Financial Hedging Tools

Commodity Hedging Tools

Option Contracts

(Contingent Imports/Exports)

Investment Banks Multinational Trading Companies, Importers, Exporters

Physical Hedging Tools

ForwardContracts Futures Options




Option Contracts


Can be very challenging to use since:- Creates an unknown and unpredictable future liability since the market counterparty must be paid if the market moves in an adverse direction- Requires financing of a credit line or a credit guarantee which can be sizeable- Does not generally result in physical delivery of the commodity- Involves locking in prices at an absolute level with no flexibility to take advantage of favorable prices later







Option Contracts


- Caps prices but allows flexibility to take advantage of lower price movements that may occur in the future- Requires payment of an “insurance” premium- Does not generally result in physical delivery of the commodity- Can work well for energy commodities, cash crops, food crops well-integrated with international markets (wheat)







Option Contracts


- Locks in a fixed price or price which fixes over the average of a specific time frame in the future (for example one month or a set of months)- Available through physical supply chains for most commodities - Results in delivery of the physical commodity







Option Contracts


- Caps prices but allows flexibility to take advantage of lower price movements that may occur in the future- Requires payment of an “insurance” premium- Results in delivery of the physical commodity- Can work for food crops not well-integrated with international markets such as rice, edible oils, and other commodities with high basis risk vis a vis futures exchanges




Bridging the Market Gap

Analytical & Advisory Services

Commodity Hedging Products

Contingent Finance Products

Investment Operations /

Public Goods

A Programmatic Approach to Risk Management


Risk assessment to analyze impact of commodity price shocks

Assessing legal and regulatory infrastructure

Technical support for ministry staff, stakeholders and policy-makers

Technical advice related to structuring and executing transactions with the market





Public Goods



Commodity swap/cap linked to loans – requires liquid futures market (i.e. available for energy products, wheat/corn, not available for rice)Financial hedging products – also requires underlying liquid futures market Physical hedging products – involves pre-arranging contingent import/export agreements for protection on commodity price and supply (more flexible as to products covered – i.e. rice, edible oils)





Public Goods



Weather Derivative or Catastrophe Bond – relevant for weather shocks affecting commodity production (local or elsewhere)Contingent Loan for Catastrophes –could be used to provide immediate liquidity in the event of a natural disaster affecting commodity productionContingent Loan for Budget Support –could be supported by an overall commodity risk management strategy that incorporates policy/market responses and hedging tools





Public Goods



•Modernizing meteorological services (investments in reporting & communications infrastructure)

•Financing regional approaches to risk pooling (Africa Drought Risk)•Investment in agricultural productivity growth, agricultural institutions, extension services, roads, ports, power, storage, irrigation systems and information and communication technology





Public Goods


World Bank Proposed Approaches

1. Expand capacity building for commodity risk management as an integral part of broader fiscal risk management – using successful debt management advisory service program as the anchor point

2. Integrate risk management approaches into loans and credits

3. Facilitation of commodity hedging by: providing assistance to help governments and private sector entities

structure & execute physical hedging transactions providing market intermediation services for financial commodity

hedges de-linked from loans

4. Risk-sharing of underlying credit exposure to help expand access to risk management tools to agribusiness entities (through the IFC’s proposed Global Agricultural Price Risk Management Facility)

World Bank Proposed Approaches

Deliverables for June Agriculture Ministers Meeting New IFC Global Agricultural Price Risk Management Facility Expanded capacity building for commodity risk management Scaling up of efforts to integrate risk management approaches into loans

and credits Launch of facilitation of commodity hedging by helping governments and

firms structure & execute physical hedging transactions , and launch of new service to provide market intermediation services for financial commodity hedges de-linked from loans

At November Summit Implementation: what, where and who Sharing of lessons learnt How we can expand the toolkit, including with other MDBs, donors and

the private sector

Concluding Thoughts

Budget vulnerability as a result of price volatility & exogenous shocks is detrimental to longer term investment and development programs (public and private)

Both low and middle-income countries have problems accessing risk markets due to lack of knowledge about products and how to use them

There are no risk management instruments that can mitigate the impact of longer term trends, but short-term volatility has a big impact and can be managed

There may be natural hedges and/or benefits to risk pooling & regional collaboration

Broad participation is needed to make this work: MDBs, CAADP/NEPAD, International Organizations, bilateral donors, countries with similar experiences, and private sector partners

Banking and Debt Management Contacts

Cyril Muller Director

[email protected]

Julie Dana Senior Financial Officer

[email protected]

Annex

Stand-Alone Financial Hedging Instruments(Examples for Importers)

Instrument Description Advantages Disadvantages

Futures Contract

An agreement to buy a specific quantity of the exchange traded commodity contract, at a specific price, on a specific date in the future.

•No upfront costs.•Provides ability to “lock in” forward prices through a financial contract.

•Since prices are “locked in” the hedger can not take advantage of lower prices if they occur in the future.•Creates an unknown and unpredictable future liability since hedger will owe the market counterparty if the market moves in an adverse direction.•Requires financing of a credit line or a credit guarantee.•Requires managing cash flow /liquidity requirements to support (potential) daily margin calls.•Requires significant operational capacity to manage the hedging program.

Call Option Contract

An agreement that provides the hedger with the opportunity, but not the obligation to buy or sell a specific quantity of a commodity, at a specific price, on a specific date in the future. Can be used to cap prices by creating a price ceiling.

•Provides ability to cap prices while still providing hedger with the ability to take advantage of lower price movements that may occur in the future.•In this way acts as an insurance contract.•Ease of administration.

•Has an upfront cost, which is market-driven and volatile but can range from 5-12% of the value of the underlying price for a 6-18 month coverage, depending on market conditions.

Physical Hedging Instruments(Examples for Importers)


Fixed Price Forward or Average Sales/Purchase Contracts

Agreements to purchase a commodity on a specified forward date for a specified, predetermined price, or price formula.

Pricing of forward contracts can be customized - hedger can lock in at a fixed price or over the average of a specific time frame in the future (for example one month or a set of months).

•If forward prices are fixed, hedger loses the ability to take advantage of lower prices if they occur in the future.•If forward prices are based on the average of a future time period, hedger still has uncertainty associated with what that final price level will be.

Buying a Physical Call Option (Price Cap) for Imports

•Forward contracts which provide a maximum price, i.e. a cap.

•Provides ability to cap prices while still providing hedger with the ability to take advantage of lower price movements that may occur in the future.•In this way acts as an insurance contract.

Has an upfront cost, which is market-driven and volatile but can range from approximately 5-12% of the value of the underlying price for a 6-18 month coverage, depending on market conditions.

Commodity Hedge Linked to a Loan(Examples for Importers)


Commodity Swap linked to a Loan

Existing or new loan is structured so that repayments decrease when the market price moves up; and repayments increase when the market price moves down.

•No upfront cost.•Provides ability to index loan repayment to a fixed commodity price.

•Creates an unknown and unpredictable future liability since borrower will have higher repayment obligations to IBRD if the market moves down.•Is based on an underlying futures price (i.e. on an exchange) so coverage may imply some basis risk.•Is a financially-settled instrument (i.e. does not result in delivery of the commodity).

Commodity Cap linked to a Loan

Existing or new loan is structured so that repayments decrease when the market price moves up.

•Provides ability to index loan repayment to a capped commodity price and in this way acts as an insurance contract.•Does not create an unknown and unpredictable future liability since borrower will not owe IBRD if the market moves down.

•Has an upfront cost, which is market-driven and volatile but can range from 5-12% of the value of the underlying price for a 6-18 month coverage, depending on market conditions.•Is based on an underlying futures price (i.e. on an exchange) so coverage may imply some basis risk.•Is a financially-settled instrument (i.e. does not result in delivery of the commodity).

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Physical Hedging Instruments(Example for Exporters)


Repurchase Agreement for Exports

•Agreement to sell now at a pre-agreed price, with the option to repurchase at a later time (i.e. 6,12,18 months) if needed.

•Provides ability to lock in value of high export prices now without being concerned about deficit in the future.•In this way acts as commodity “loan” – product is sold now and will be re-supplied at a later date if needed.

Repurchase option has an upfront cost, which is market-driven and volatile but can range from approximately 5-12% of the value of the underlying price for a 6-18 month coverage, depending on market conditions.

Contingent Financing Instruments:(Examples for Food Importers )

Instrument Description Potential Application for food Importers

Weather Derivative

IBRD Intermediates these contracts on behalf of borrowers; Payments are triggered by adverse weather events according to pre-specified conditions (e.g. levels of rainfall, seasonal temperatures, etc.).

•Could be used to address impact of a weather shock affecting national food production or food imports from another country.

Catastrophe Bond

Fixed income security that insures the sponsor of the bond against a pre-defined set of natural disasters such as earthquakes or hurricanes. If a covered event occurs during the bond’s life, the sponsoring country retains the bond principal to fund emergency relief and reconstruction work.

•Could be used to address impact of a weather shock affecting national food production or food imports from another country.

Contingent Financing Instruments:Potential Application for Food Importers

Instrument Description Potential Application for food Importers

Contingent Loan for Budget Support

Provides borrower with access to immediate liquidity following a shortfall in resources due to adverse economic events or unfavorable changes in commodity prices or terms of trade.

•Could be used to address impact of commodity price shock or unfavorable changes in terms of trade•Triggers could be established which relate to overall commodity risk management strategy.

Contingent Loan for Catastrophes

Provides borrower with access to immediate liquidity following a natural disaster.

•Could be used to cover adverse weather events affecting food production.•More likely applicable for coverage of national events than events happening in other countries.

Disclaimers

©2011 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433/ Telephone: 202-473-1000/ Internet: www.worldbank.org

E-mail: [email protected]

All rights reserved.

This work is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The 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. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.

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Risk Management Instruments for Countries Vulnerable to Exogenous Shocks: The Case for Food & Agriculture Cyril Muller Director Banking and Debt Management.

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