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An exploration of commodity income stabilization options for coffee farmers - page 40 / 47





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Annex: An overview of market-based commodity price risk management instruments and their uses

The simplest way to describe the difference between market-based price risk management instruments and non-market instruments is that the former externalize risk—they transfer risk from one party to another. In contrast; the latter depend on asset reallocation within a group (e.g., from the general government budget to farmers’ subsidies, or from the IMF’s account to one of its member countries) or over time (stabilization funds, savings funds, self- insurance and the like).

Coffee futures markets provide large benefits to the coffee community. They provide price transparency (futures market prices are widely available, including to producers, and act as a benchmark for negotiating physical prices); ensure price discovery (allowing information to flow efficiently to the market as a whole, ensuring that most of the time, prices are as close as possible to a true reflection of the supply/demand balance and eliminating most of the information asymmetries that prevail in commodity markets where no futures exchange exists); and make it possible to transfer risk. Contrary to insurance markets, risk transfer on futures exchanges, at least in the case of liquid futures contracts, is very efficient: many studies have shown that there is no “risk premium” transferred from hedgers, as a group, to speculators (in other words, if one abstracts from the impact of risk management on a hedger’s wider business operations, other than a slight brokerage costs, average income is not affected by risk management—whether with futures or with options—so improved price certainty is achieved at little or no cost).

Do speculators distort futures market prices?

Users of commodity futures markets include not only those involved in physical trade, but also non-trade users—commonly (though misleadingly) known as speculators. A natural question, then, is whether the participation by such speculators distorts the prices generated on an exchange. After all, speculators’ behaviour is at least partly determined by developments outside of the coffee sector.

A first point to be made here is that even if speculators were to distort commodity futures prices, those involved in physical trade and active on the exchange would be able to arbitrage between the physical and futures markets and make risk-free profits. But this admittedly would not help the many producers and others who are not using the markets but are affected by their prices.

So how much price distortion is caused by speculators? On balance, relatively little. First, they often have a market stabilizing function. Large investors generally have extensive research operations. This allows them, for example, to take positions against market manipulation efforts by large trading houses. Second, their decision-making models vary widely—when some see reason to enter into the market, others will exit. Third, the large investment funds restrict their involvement in each individual market so that they will have no difficulty exiting their position. But it is true that with active speculators on a market, prices react very fast to new information, and often overreact—short-term price volatility (within a day) increases, making it more difficult for hedgers to manage their futures positions properly.


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