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An exploration of commodity income stabilization options for coffee farmers - page 35 / 47

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One obstacle is that if they had the choice, most producers would prefer to make individual, opportunistic choices about their risk management practices rather than having a certain choice imposed on them. Having a fixed price imposed on them is likely to be unpopular (and which fixed price would this be? A different price for each seller, as a function of the day that the sale is made? Or a pooled price, with the buyer in some way spreading out total costs and revenue across all the sellers?). A minimum price would be more easily accepted, but what minimum price? Not only do futures contracts fluctuate from minute to minute, there is also a wide choice of minimum prices available, all at different costs.

A second problem is that when a buyer builds a risk management component into a physical component, he is taking a credit risk on the seller. If the contract contains an element related to a minimum price, he risks losing the premium. If the contract assumes that the seller will receive a fixed price, the buyer has to manage the resultant risk by selling futures contracts; if prices then increase and the seller decides to default on his delivery, the buyer is not only left without goods, but also with a loss on the futures market. In order to provide such risk management services, then, the buyer either needs to have a strong trust in the seller, or he needs a way to mitigate the credit risk. In practice, the only efficient mechanism that would allow for this is a constriction point in the marketing chain: for example, all produce in a certain area will normally be sold through one processor, or a group of processors who cooperate; or all produce is sold through one central marketing agency (e.g., an auction). The buyers’ and sellers’ obligations can then be registered with this constriction point, and the revenues generated through the constriction point can be allocated to ensure that the obligations are met. In coffee, this can be difficult, except in the few African countries where auctions still exist: farmers generally have a wide variety of potential buyers of their produce. But price risk management transmission to farmers through processors has been used successfully in the cotton, palm oil and sugar sectors.

Both these problems can actually be managed more easily if the farmer is a buyer rather than the seller. In other words, it may well be feasible to build risk management into the physical contracts for the supply of inputs. For example, a farmer could be offered a choice between paying $10 for fertilizers now, or paying $12 six months later, with the proviso that if at that time the reference coffee prices is below US$1/lb, his loan is forgiven. The input supplier can cover the price risk by buying, say at a cost of US$1, an OTC option (called binary or digital option) which gives him a US$12 pay-out when the coffee price is below US$1/lb. So, at the end, either the price is poor and the supplier gets paid by the seller of the OTC instrument; or the price is good, and the farmer has a good enough revenue to pay the input supplier (if he does not, he will lose access to the program next year). This type of schemes is win-win—the input supplier makes an easier sale, the farmer only needs to pay for the inputs if the price for his production is good, and the OTC provider is able to sell an option for a premium paid up-front. Default risk for such win-win products is relatively low.

Finally, there are some possible products or methods that, while attractive at first sight, are unlikely to do much to make price risk management more easily accessible to coffee smallholders. One such product is the “mini contract,” contracts which are for quantities of commodities much smaller than those of conventional futures contracts (e.g., five tons instead of 25; 100 barrels instead of a thousand). Mini contracts for metals and energy contracts have been successful, but they have largely been picked up by small-scale speculators rather than small-scale hedgers. If the established western exchanges were to promote mini-contracts for coffee (such as the mini-“C” Arabica coffee contract introduced by the NYBOT), this is unlikely to have a different impact. The systems on these western exchanges are simply not set up to facilitate access by developing country farmers—contract

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