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  • QA 126
    Question:
    Can growers use Put Options to manage price risk?
    Background:
    Recently we read that growers in Tanzania are using put options to reduce their price risk. This sounded very interesting but we are not clear as to how this works. Can you explain?
    Asked by:
    Processor - Papua New Guinea
     
    Answer:

    Yes, growers can use put options to manage some of their price risk, always provided that local financial regulations do not inhibit access to international risk management instruments. 

    As explained in section 09.03 of the Guide, growers and/or processors can establish a minimum price or price floor by buying put options. Against payment of a fee or premium, put options confer the right (but not the obligation) to sell coffee futures at an agreed price. If during the life of the option the market falls below that price (the strike price) then the option can be exercised. The profit then helps to offset the lower price that the physical coffee will now realise. If the market does not fall then the option is allowed to expire. The grower loses the premium paid to buy the option but this cost is recovered from the sales proceeds of the physical coffee. In other words, the option taker pays a premium (an insurance) to protect against price falls. *

    In the example you refer to the procedure is that once coffee deliveries commence, the grower cooperative purchases a put option for half its estimated seasonal throughput. Once this quantity is reached a decision is made whether or not to purchase a further option to cover the remainder. Of course this procedure varies in accordance with seasonal factors. The option cost depends on the scope of the price cover that is bought. The cost is recovered as part of the pre-finance the bank provided against warehouse receipts (WRS) issued by the cooperative. Because the goods are now hedged (through the price floor provided by the put option), the interest rate is typically lower, in this case by about two percent. As and when an option shows value a decision is made to sell or exercise it.

    Having a put option in place not only facilitates access to credit but also means cheaper credit! Having an official warehouse receipt helps but, is still not quite good enough. This is so because banks do not like to finance goods that are unsold, i.e. goods that are exposed to price risk. The put option strategy also helps ensure the smooth running of the post-harvest operations (advance payments, processing and marketing) carried out by cooperatives and processors. In the case in question the net cost of the exercise was around five percent but this is variable and can be higher. **

    However, there is an important limitation… 

    The put options only protected against price falls once the harvest had been delivered for processing. But, in a twelve month cycle the grower may carry the crop on the trees for as long as eight or nine months, whilst the processing/sale cycle may be three months only. Therefore, the grower continues to carry the price risk throughout the growing season: protection only kicks in when processing starts. The reason is relatively straightforward: put options that cover also the long growing period simply cost far too much.

    This means that, for the present at least, the put option mechanism is only affordable for the very much shorter processing and marketing season. The alternative of using futures instead of options is also out of reach: the monetary importance of potential margin calls cannot be quantified and, as a result, realistically no credit is available to finance them. See topics 08.09.05 and 09, as well as 10.02.05 in the Guide for more on this.

    Plenty of challenges remain therefore…

    * Options can be purchased through local commercial banks who in turn use brokers with access to futures markets: New York - arabica - www.theice.com and London - robusta - www.euronext.com . Of course Brazilian growers will use their own exchange in Sao Paulo - www.bmf.com.br . However, specialised finance houses and banks also write their own options, in response to the specific requirements of a client. These are known as OTC or 'over the counter' options.

    ** The cost of options depends on the price cover one buys and for what length of time. Market volatility also plays a role and, therefore, the cost of options fluctuates constantly. Costs also depend on the arrangements made by the facilitating commercial bank. Buying put options is a combination of risk management and credit strategy. Unless the principle is already well accepted in a country, we would suggest that one should probably look for a minimum seasonal throughput of between 50 to 100 tonnes to render the probably considerable effort to get the mechanism in place, worthwhile. For more visit also www.worldbank.org/agrm, the website of the World Bank's Agricultural Risk Management Team - ARMT, the initiators of this particular approach.

    Posted 01 December 2006
     

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