HEDGING THE COMMODITY PRICE RISKS
USING FINANCIAL INSTRUMENTS
SYED ALAMDAR ALI
Hailey College of Banking & Finance Lahore
Apr 21 - 27, 2008
Developing countries produce and export a large amount of raw material commodities, such as crude oil (Venezuela, Nigeria, and the Republic of Congo), copper (Chile and Zambia) and agricultural commodities, such as tobacco, cotton, sugarcane etc. In particular, some developing countries' exports are highly concentrated in one or two leading commodities such as Pakistan in cotton. This heavy reliance on commodities exposes these economies to price volatility in a form of terms of trade shocks, raising two related concerns. The first one is the large fluctuations in revenue collections, and the other is that it complicates public debt management. Either concern, if realized, will have an adverse impact on the economy. The first concern is obvious. Price volatility is likely to affect the fiscal balances of economies revenues of which rely heavily on commodity-related taxes, royalties, and dividend income (in heavily state-owned commodity sectors). When commodity prices drop, revenue will fall, forcing countries to cut spending or incur debt. By contrast, a rise in commodity prices may create a revenue windfall, raising questions about an economy's absorptive capacity and ways to spend the excess revenue. The second concern arises because governments cannot accurately predict future revenues and financing needs; therefore, they face difficulty in projecting external borrowing need. In the worst-case scenario, countries dependent of commodity revenues may not be able to make debt payments or may have to pay high interest rates for new external debt when price shocks cause fiscal balances to deteriorate, the exact time that they need resources for financing. Some debt instruments could address this concern by linking debt payment to commodity prices or the GDP growth rate-commodity-linked or GDP-linked bonds. Professor Salih Neftci of the City University of New York with Mr. Yinqiu Lu in a paper submitted to the International Monetary Fund examines the use of commodity options-including plain vanilla, risk reversal, and barrier options-to hedge such risks. A brief review of the options made available for the purpose is hereunder:
Plain Vanilla Options: In vanilla options, a put option provides insurance against drops in commodity prices, while a call option insures against unfavorable price hikes. Hedging can be achieved by choosing a proper strike price and adjusting its level and at the same time as the cost of this insurance.
Risk Reversals: A traditional way to cut option costs is to sell other options, so that the earnings from the short position will lower the insurance cost of the long option position. Risk reversal (RR) is one example of a zero-cost structure. As an example, we consider one country whose economy is heavily dependent on copper. Given that a plunge in world copper prices would severely affect the country's fiscal balance and current account, the country enters into option transactions to hedge the copper price risk. Let the current copper price index be 100, and the country decides to buy a long-dated 20 percent put with strike 80 on copper for US$500 million. The cost of such a three-year option position would be US$47 million. To cut those costs, the government could sell an call with a strike price of 120. The sale of the 20 percent out-of-the-money call will raise US$47 million if we ignore the volatility smile, yielding a net portfolio cost of zero. The structure is called a zero premium collar .In this case, the country is fully hedged for any price below 120.
Barrier Option Structures: By introducing various barriers in plain vanilla contracts, creating instruments known as barrier options, we can fix the drawbacks of risk reversal approaches discussed above. This option is an up-and-out put, which gets knocked out or ceases to exist if the underlying asset price exceeds a certain barrier during the life of the contract. Except for the knockout property, the option is the same as a plain vanilla put option. An up-and-out put option is similar to a dynamically managed risk reversal. The country could enter a risk reversal by buying a plain vanilla put and selling a plain vanilla call with the property that if asset price reaches knockout barrier; the two options will have the same value. Hence, if asset price hits knockout barrier, the country could sell the put and close the call position. In other words, at certain point in time the country could liquidate the portfolio at zero cost. The loss from the dynamically managed risk reversal is zero when asset price exceeds knockout barrier. This replication of risk reversal is exactly an up-and-out put option. In the worst case, the country will bear some liquidation losses (gap risk), though such risk would be minimal. Hence, knock-out or knock-in features make options affordable and eliminate the drawbacks of risk reversals, albeit at a higher cost. Public entities in developing economies could therefore use such instruments to hedge commodity risk, without the political backlash of risk reversals.
Barrier options can take various forms. For example, up-and-out and down-and-out barriers can be combined into one product, known as the double-no-touch knock-out, an option that expires if price touches any of the barriers. In partial barrier and forward-starting barrier options, barriers exist for only a portion of the option's life. The main advantage of such products is that they lower hedging costs.
The barrier options described above can also be combined to produce more complex products, such a multi-underlying barrier options or amortizing barrier options. Multi underlying barrier options may be "in" or "out," conditional on more than one underlying price. Such structures are especially useful for developing economies that are heavily dependent on two commodities. The amortizing barrier option may be useful to countries with exposure to sustained movements in commodity prices, as it is designed to earn or lose a fraction of its value, proportional to the time the underlying price is above the barrier. We can further modify barrier options by adding more complicated barriers. In a resettable barrier, for example, once one barrier is touched, another already known barrier gets activated. Such instruments give developing economies greater flexibility in hedging commodity risk.
After examining the use of options the paper then proposes the use of new structured product-a sovereign Eurobond with an embedded option on a specific commodity price. By extracting commodity price risk out of the bond, such an instrument insulates the bond default risk from commodity price movements, allowing it to be marketed at a lower credit spread. The product is also designed to help developing countries establish a credit derivatives market, which would in turn enhance the marketability and liquidity of sovereign bonds.