Financial Instruments to Hedge Commodity Price Risk for Developing Countries

Abstract

This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.Many developing economies are heavily exposed to commodity markets, leaving them vulnerable to the vagaries of international commodity prices. This paper examines the use of commodity options-including plain vanilla, risk reversal, and barrier options-to hedge such risk. It then proposes the use of a new structured product-a sovereign Eurobond with an embedded option on a specific commodity price. By extracting commodity price risk out of the bond, such an instrument insulates the bond default risk from commodity price movements, allowing it to be marketed at a lower credit spread. The product is also designed to help developing countries establish a credit derivatives market, which would in turn enhance the marketability and liquidity of sovereign bonds. JEL Classification Numbers: G10, G13, G15

Managing and Harnessing Volatile Oil Windfalls

“…Lu and Neftci (2008) therefore argue for structured-reverse options that lower the cost of plain-vanilla options by selling other options simultaneously (zero-premium collar). Yet, such products can lead to substantial losses if commodity prices rises above their cap.…”

Primary commodity prices: Co-movements, common factors and fundamentals

“…Movements in commodity prices are important for the welfare of both developing and developed countries (see, among the others, Lu and Neftci, 2008, Frankel, 2008, and Daude et al, 2010. 3 This importance has spawned a considerable academic literature with a primary focus on their time series properties.…”

Alternative Financing Instruments for African Economies

“…Efficient debt management policies as noted by [5] Dooley (2010) should minimize the debt servicing costs and avoid debt instruments that are likely to cause defaults. The issuing of cost-effective debt instruments such as indexed bonds as suggested by [6] Lu and Neftci (2008), reduce government borrowing costs and the likelihood to default. Similarly, [7] Price (1997) note that indexed bonds are cost saving.…”