Coffee prices are highly volatile and unpredictable. As the minimum prices offered by fair trade buyers only apply to a small percentage of world coffee trade,1 most growers are faced with considerable price uncertainty. This poses severe problems for them. Most of the 20–25 million households engaged in the coffee sector are smallholders, without the financial wherewithal to withstand serious financial shocks. Naturally, they try to mitigate their risk exposure through such practices as diversification and reduced use of inputs.
Traditional risk management measures are costly. They lead to a considerable reduction of farmers’ incomes, particularly poorer farmers. In the past, governments have tried to provide safety nets through such mechanisms as marketing boards, which buy at guaranteed prices, or price stabilization funds—but these also have proved to be very costly for farmers. Market-based risk management instruments can provide a more effective alternative, allowing farmers to optimize their risk/reward equation at a lower cost. While overall, use of these market-based instruments does not reduce the volatility of coffee earnings, it makes them more predictable, at least over a 6–12 month time horizon. This, in turn, makes it possible for farmers to better plan their activities, and improves their ability to raise bank finance.
The four major categories of risk to which farmers are exposed are: price, weather, pest and health. Market-based instruments are readily available for price risk, and are starting to emerge for weather risk. Organized exchanges offering the most basic of these instruments, futures and options, have operated for a long time, providing transparency to the market, and low-cost risk transfer tools for those able to access them. While use of price risk management instruments is an incomplete solution, it has sufficient merits on its own and will make the overall burden of risk more bearable.
There is a wide range of market-based price risk management instruments available: traded on organized futures and options exchanges or the over-the-counter market; incorporated into the pricing formulas of physical trade transactions; or encapsulated in financing deals. None of these instruments fundamentally alters the risky character of the marketplace, but they empower those active in the market to manoeuvre a way through these risks, considerably improving the certainty of receiving or paying certain prices six months, one year or even three years in the future (for soft commodity markets such as coffee, risk management markets rarely offer instruments beyond this time horizon). Futures and options are the building blocks: the use of futures locks in a fixed price for some time in the future; the use of options guarantees a minimum or maximum price while still allowing the possibility to benefit from price improvements. These building blocks can be combined and modified in many ways in order to create a risk management product that fits best with a user’s requirements.
The use of market-based price risk management instruments by coffee growers has so far been very low. Direct use of futures and options markets—there are two of particular relevance, for Arabica coffee in New York and Robusta coffee in London—is difficult for developing country coffee farmers and even their cooperatives for a number of reasons: meeting the conditions of the intermediaries on these markets is hard; reaching the necessary levels of market sophistication requires considerable investment; and meeting the financial
1 Fewer than a million coffee farmers sell to the fair trade system, and then generally only a portion of their production. This is out of a total of some 20–25 million coffee farming households.