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  • 10.11.4-RISK AND THE RELATION TO TRADE CREDIT-PRICE RISK MANAGEMENT AS PURE INSURANCE

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  • Price risk management as pure insurance

     
     
    Price risk management as pure insurance means there is no direct link between the insurance of the price risk and the marketing of the coffee.

    Straight hedging by selling futures exposes the seller to margin calls, bringing with it the risk of potential hedge liquidity traps. Whether any lending institution or risk solution provider will finance such an operation without firm guarantees and collateral is doubtful. Indeed the notion will be a non-starter for most, small growers and solution providers alike.

    Buying put options, the right to sell futures at a stated price at some point in the future, is much simpler than hedging. The cost that needs to be financed is known up front, and no margin calls need to be faced. The premium will depend on circumstances, but can at times be very substantial. Even so, it may be easier to raise finance for this than for straight hedging. As always, the provider will still need to be reassured about how the cost of the option will eventually be recouped.*

    Tailored solutions. Risk solution providers tailor risk instruments to clients' requirements. For example, options can be graduated to extend over the usual marketing season by spreading equal portions over two or three futures trading positions, if so wished, at different strike prices. Each individual portion can then be exercised individually.

    Alternatively the solution provider may simply guarantee a minimum price. Against payment of a premium, they undertake to make good any shortfall between the insured price (the minimum price the growers wish to secure) and the price ruling for the stated trading positions in New York or London, either at a given date or based on the average price over a number of trading days. The producer has bought a 'floor': the guaranteed price less the cost of the premium. (Consumers would buy a 'cap' to protect themselves against future price rises.)

    Swap agreements. Producers can also 'swap' price risk by giving up the benefits from future price rises in exchange for a guaranteed minimum price. Swap agreements could also cover more than one crop year, with tonnages and settlement dates set for each quarter.

    The concept is nothing new, and has been extensively used to limit exposure to currency and interest rate fluctuations. Innumerable variables are possible, making it impossible to provide a standard model. See also topic 09.04.02.

    Note: Solution providers and commodity trade banks can put together different risk mitigation instruments but only for parties with the required critical mass, who are organized and who can find and afford the finance necessary to buy the price insurance they require.

    "For more on this see also topics 10.12.03 and 04.