COTTON PRICE RISK MANAGEMENT

1. COTTON PRICE RISK MANAGEMENT Africa – EU Cotton Partnership September, 2007 Roy Parizat Commodity Risk Management Group The World Bank

2. OUTLINE • Overview of CRMG • Lessons Learned to Date • Current Activities

3. COMMODITY RISK MANAGEMENT GROUP OBJECTIVES: • Testmarket-based solutions for managing price risk • Provide education to organizations interested in improving their internal risk management practices • Diminish the gap between developing country markets & the financial markets • Empower clients to analyze risk, make changes in the way they trade, and/or use international market products when conditions look right

4. LESSONS LEARNED • Start with proper risk assessment • Risk management solutions are diverse • can incorporate changes in the way sales contracts are negotiated • can incorporate price protection on NYBOT market • Organizational capacity is important • takes time & attention • Significant need for more education • Local banks have a role and can add value to the process • Requires willingness to “learn by doing” • patience in trying different approaches

5. RISK ASSESMENT Risk Position Report • Overall aim is to improve internal risk mgmt practices • Risk Position Report • Requires detailed information on purchases / sales • can help to quantify overall organizational risk • is a good business tool if updated & monitored regularly • can be used to evaluate different marketing or risk mgmt strategies

6. RISK ASSESMENT Risk Position Report • Overall aim is to improve internal risk mgmt practices • Risk Position Report – graphic representation • Position throughout the season can be shown diagramatically to improve comprehension and understanding of a clients risk position

7. RISK ASSESMENT Breakeven Price Analysis • Breakeven Price Analysis • Breakeven price = sales price level at which all costs are covered • Expressed in local price terms and equivalent NYBOT price • Conservative risk management strategy is to protect the breakeven price: • Either through forward sales • Or with price protection on the NYBOT market

8. RISK MANAGEMENT SOLUTIONS CAN BE DIVERSE Risk Management Export Sales with minimum price guarantee Back to Back Sales NYBOT Options Contracts Structured Finance with Inventory as Collateral • Solutions will have different costs / benefits at different times depending on the market • Need to explore, look at alternatives, monitor pricing regularly • Once you have determined your risk position, evaluate the costs, benefits, and impacts of different risk management solutions in order to identify the best solution/s for your business .

9. CURRENT ACTIVITIES IN EAST AFRICA • Continuing supporting risk management through local bank – CRDB Tanzania • CRDB Bank is major lender to agriculture – large portfolio in cotton (and coffee) • Faces default risk, non-repayment of bank loan when clients make losses due to unfavorable price movements • CRDB directly shares the risks of the clients they are lending to: • For Cotton – current marketing systems have high levels of risk, for example: a) purchases prices are paid when seed cotton purchased from farmers but sales prices may not be known for many months (long position) -- risk is that prices will fall b) contract sales can be fixed early on in season before cotton is purchased (short position) -- risk is that prices will rise

10. PROBLEMS OF GOING “LONG” • If prices rise between purchase and sale, ginners are profitable and make additional profits • If prices fall between purchase and sale, ginners:

11. WHY INVOLVE THE BANKS? • Price risk influences both the outreach, quantity, and cost of lending available • Banks have very strong commercial incentive for clients to improve profitability • Risk management is a financial activity • Can be added to financial services offered by banks • CRDB provides regular market/price updates to cotton clients • Working with banks provides advantages for ginners • Local banks already have working relationships with ginners • Clients can do business with a local phone call, through an existing relationship

12. CONSTRAINTS FOR TAKE-UP • Credit Risk • International providers not currently willing to take credit risk • Will require cash in advance payment of premium • This limits products available to options contracts which can be paid for upfront • Options contracts can be expensive i.e. for Put Options • Cost is high when market prices are low • Cost is high when covering longer period of time (6-8 months) But the reverse is also true: • Cost is low when market prices are high • Cost is low when covering shorter period of time (3-5 months)

13. RISK MANAGEMENT EDUCATION • How to design the risk position of the organization, intepret it and quantify it in to capture the actual magnitude of the risk. • How the cotton futures market works and the mechanics of the contracts for futures and options • Understanding the difference between the physical & financial market • How to manage a market account PREREQUISITES • Commercial and administrative strength within an organization • Management with sufficient autonomy to make decisions • Availability of timely information on internal business • Sufficient Volume • Good understanding of the local cotton market in order to analyze basis risk

14. For more information please contactwww.itf-commrisk.orgor royparizat@hotmail.comor jdana@worldbank.org