Markets are versatile, and not surprisingly, there is a very wide range of market-based price risk management instruments available. This annex describes the principal ones, categorized by the way in which they reach the customer: are they used on a stand-alone basis, or built into some other transaction?
Stand-alone price risk management instruments are available on the organized futures market as well as the over-the counter market.
Organized futures markets offer two products: futures and options. By using futures contracts, producers can lock in certain price levels independent of their physical trading operations. For example, by selling futures contracts when prices are attractive, they can lock in these prices even if they do not yet have any product to deliver, or they have them in storage but are not yet ready to sell. If by the time that the producer is ready to sell prices have fallen, the low price he will receive for his produce will be compensated by a profit on his futures position (realized by buying futures to offset the earlier sale). However, the use of futures markets for risk management purposes is only useful if the prices of the markets for one’s physical products and the futures prices are well-correlated. In the case of coffee, this is not always so: premium grades generally have poor correlation. Using futures contracts can also be cumbersome: timing decisions are difficult to made, and cash flow requirements (to pay upfront margin depositions as well as later margin calls) can be demanding.
Options give the buyer the right, but not the obligation, to buy or sell an underlying asset (usually a futures contract) at a certain fixed price. This right expires at a certain date (the maturity date) and in order to procure this right, the buyer has to pay a premium. An option which gives the right to buy is called a call, and an option which gives the right to sell a put. Buyers can have this conversion right at any time until the option’s maturity (in this case, the option is called “American”), or he could have the right to convert only at maturity (a “European” option). Options on futures contracts are easier to use than futures. From the perspective of a producer, they are similar to an insurance contract: he pays a premium to buy put options, and the “insurance” pays out when prices fall. Indeed, options can be used to replicate the price guarantee schemes abolished in recent years by many developing country governments. There are no margining requirements, and operational requirements are not overly cumbersome.
The over-the-counter market offers a wide array of tools (instruments are basically made on demand by a bank or trading company, and tailored to the needs and conditions of the client). Many of these instruments are inaccessible to producers—for example, swaps (which lock in the prices that one receives over the medium- to long-term) require high volumes, as they can be cumbersome to set up.31 But there are some simpler instruments available that can be of use.
What will market-based weather risk management have to offer?
Weather risk management instruments—futures, options and a range of over-the-counter products—provide coverage for a series of weather-related risks: rainfall, temperature, wind
31 Deals of this nature can of course be used at the government level. For example, a leading investment bank offered at least one East African coffee producer in the early 1990s the possibility to lock in for a period of several years a price slightly below the (then, historically high) prevailing coffee price in return for giving up part of its potential revenue from further price increases. This offer did not lead to any deal.