Dealing with Commodity Price Uncertainty

Abstract

Market liberalization has increased the appeal of commodity derivative instruments (such as futures, options, swaps, and commodity-linked notes) as a means of managing price uncertainty. In many emerging countries both government and the private sector are increasingly using these instruments. Liberalization in commodity markets has brought profound changes in the way price risks are allocated and managed in commodity subsectors. Price risks are increasingly allocated to private traders and farmers rather than absorbed by the government.

The success of market reform depends on the ability of the emerging private sector to make full use of the available range of modern commodity marketing, price risk management (such as futures, options, swaps, commodity bonds, and so on), and financing instruments. Because farmers do not generally have direct access to these instruments, intermediaries must be developed. Larger private traders and banks are in the best position to become these intermediaries.

Preconditions needed for accessing modern commodity marketing, price risk management, and financing instruments are:

Creating an appropriate legal, regulatory, and institutional framework.

Reducing government intervention that crowds out private sector involvement.

Providing training and raising awareness.

Improving creditworthiness and reducing performance risk.

The use of commodity derivative instruments to hedge commodity price risk is not new among developing countries. The private sector in many Asian and Latin American countries, for example, have been using commodity futures and options for some time. More recently, commodity derivative instruments are being used increasingly in several African countries and many economies in transition. And several developing and transition economies have sought to establish commodity derivative exchanges.

This paper - a product of the Commodity Policy and Analysis Unit, International Economics Department - is part of a larger effort in the department to investigate alternative price risk management and finance systems under market liberalization.