Commodity Risk Management and Development

Abstract

In 1995, 57 countries depended on three commodities programs that used market-based approaches for dealing for more than half their exports, reports UNCTAD. And with market uncertainty. commodities, fuels, grains, and oilseeds are important This change in approach coincided with a significant imports for several countries. The notorious volatility of rise in the use of market-based commodity risk commodity prices is a major source of instability and management instruments -aided by the liberalization of uncertainty in commodity-dependent countries, affecting markets, the lowering of trade and capital control governments, producers (farmers), traders, processors, barriers, and the globalization of commodity markets. and financial institutions. Further, commodity price By the mid-1990s, several governments, state instability has a negative impact on economic growth, companies, and private sector participants began using income distribution, and poverty alleviation.commodity derivatives markets to hedge their Early attempts to deal with commodity price volatility commodity price risks. Participation in those markets is relied on buffer stocks, buffer funds, government growing, but important barriers to access remain, intervention in commodity markets, and international including counterparty risk, problems small groups (such commodity agreements to stabilize prices. These were as farmers) have aggregating risks, basis risk (no largely unsuccessfulsometimes spectacularly so.correlation of local and international prices), no local Buffer funds went bankrupt, commodity agreements reference prices, low liquidity, no derivatives markets for were suspended, buffer stocks proved ineffective, and certain products, and low levels of knowhow. government intervention was both costly and ineffective.International institutions, local governments, and the As the poor performance of such stabilization schemes private sector could facilitate developing countries' became more evident, academics and policvmakers began access to derivatives markets and the use of risk distinguishing between programs that tried to alter price management tools to solve public sector problems. distribution (domestically or internationally) and This paper -a product of Rural Development, Development Research Groupwas prepared for the roundtable discussion on New Approaches to Commodity

Managing and Harnessing Volatile Oil Windfalls

“…Barrier options (for example, an up-and-out put option or a knockout option) are cheaper. Various developing countries use commodity derivatives markets to hedge against commodity price risk (for example, Larson, Varangis, and Yabuki, 1998).…”

Financial Instruments to Hedge Commodity Price Risk for Developing Countries

“…Some countries have used commodity derivatives to smooth future revenues. As documented by Larson, Varangis, and Yabuki (1998), many developing countries have begun using commodity derivatives markets to hedge commodity price risks. For example, Chile's state-owned company, Codelco (the world's largest copper producer), is already active in copper risk management.…”

Price stabilization using buffer stocks

“…It is a well-known fact of economic reality that commodity prices are extremely volatile (Deaton and Laroque, 1992;Larson, Varangis and Yabuki, 1998;Osbourne, 2004). One of the instruments for price stabilization, which is found frequently in the economic literature, is the so-called buffer stock scheme.…”

“…Jha and Srinivasan (2001) underline the importance of the operation of buffer stock programs for India. A retrospect in economic reality shows that the introduction of such programs, both in national and international level, faced difficulties with the funds that supported them (Larson, Varangis and Yabuki, 1998).…”