|CCP: TE 99/5
COMMITTEE ON COMMODITY PROBLEMS
INTERGOVERNMENTAL GROUP ON TEA
Ottawa, Canada, 27-29 September 1999
DEALING WITH PRICE RISKS
RISK MANAGEMENT TOOLS
TOOLS USED BY THE TEA TRADE
TOOLS USED IN OTHER MARKETS
ADVANTAGES AND DISADVANTAGES OF RISK MANAGEMENT TOOLS
RELEVANCE FOR THE TEA TRADE
EVIDENCE OF PRICE RISKS
1. The world market for tea has been in marginal over supply during the last decade, which has resulted in a decline in prices in real terms. The Group in its effort to arrest this trend, has investigated various measures primarily to improve returns to the industry by stimulating demand in potential growth markets; and, its biggest undertaking to date, the promotion of the health benefits of tea to increase per caput consumption in both existing and "new" markets. Another method of minimizing price uncertainty and improve returns to the industry (and subsequently to the growers) is through better risk management. This document discusses some of the risk management tools used by traders of other commodities. The Group may wish to evaluate some of these and decide on their relevance and possible adaptation to the tea trade.
2. Over the past two decades, the trade of agricultural commodities has evolved from spot markets where the commodity is transferred from seller to buyer immediately after the two parties agree on a price, to other various forms, the most popular being forward and futures markets. Trading in these markets occurs when participants can find commodity price information for a future date and lock in on these prices for future delivery. The contracts or transactions in these markets are commonly known as risk management tools.
3. The advantage of using risk management tools is that users can hedge their price risks. These tools transfer risks from the market participant who is averse to risks to those who seek risks, such as the speculator. These tools have been used by governments, traders, and in some cases producers, to deal with price uncertainties in other commodity markets, including those for coffee, cocoa and sugar. Experience shows that when used appropriately, risk management tools allow users to deal with price risks effectively.
4. Most of the world’s tea is traded in either auction or forward markets. Auctions account for the largest proportion in major producing countries, about 84 percent of the total tea traded in 1997 (Table 1). Auction markets are called spot or cash markets in terms of price discovery (information on prices and the quantity and form (bulk) of tea traded in auctions are standardized). Spot markets provide information regarding instantaneous prices only, as prices set are for goods that will be delivered immediately. They do not provide price information for a future date nor do they allow for hedging.
Table 1. Quantities of tea sold at auctions in producing countries
5. Tea sold through forward contracts is gaining in popularity1. A significant advantage of this market over the auction market is that the participants can lock on prices they wish to trade in the future. In the forward market, a buyer and a seller buy/sell an agreed amount of goods for delivery on an agreed future date at a pre-determined price. In other words, each forward contract is an agreement negotiated between a buyer and a seller, customized to meet the specific needs of both parties. Since forward contracts require negotiations between seller and buyer, only the participants who have a counterpart can participate in this market. Therefore, participants without a trading reputation may find it difficult to enter the market. Furthermore, prices in this market tend to be less transparent compared to auction prices.
6. Besides spot and forward contracts, there are various types of risk management tools used in agricultural commodity trading. Most are made up of a combination of forward, futures, and options.
7. Futures contracts are risk management tools similar to forward contracts in terms of price discovery but are standardized and traded in exchanges2. Negotiations between buyers and sellers regarding rules and conditions are not required in the futures market because regulations of the exchange apply to all transactions. Futures contracts involve margins (collateral) to deal with counterparty risk (failure to meet obligation by either trading partner) where buyers and sellers are required to pay an initial deposit and margin calls when prices move against them. In the futures market, the physical purchase is often separated from hedging while they are one in the forward market. In other words, in a futures market users can close their positions before maturity, while forward contracts usually involve physical delivery of goods at maturity.
8. Options contracts are similar to futures contracts but options give their owner a right, not an obligation, to buy or sell a commodity at a specified future date at a pre-determined price. If the agreed price is well below the current trading price, the owner of the call option (the right to buy or sell) will gain if the difference is greater than the cost of the option. Options give users protection against unfavourable price movements without losing a chance to gain profits from favourable movements. Several commodity exchanges offer commodity options. Contract terms are determined by the exchanges.
9. Risk management tools have been widely used in organized exchanges and through over-the-counter (OTC) arrangements. Exchange-traded contracts are typically standardized according to maturity, contract size and delivery terms. OTC contracts, such as forward contracts, are customized to users’ needs and often specify commodities, tools and/or maturities that are not offered on any exchange. Table 2 lists advantages and disadvantages of OTC and standardized contracts. The needs of all the players in the tea trade cannot be found in any one, single market. Therefore, it is important that each participant understand the use of tools appropriate for their market and choose the most suitable. For example, users may have to give up part of their potential gains from favourable price movements, while standardized contracts require users to pay an initial deposit or when they buy/sell contracts, and margin calls when prices move against them3. In addition, the cost of operation (and set-up) is often transferred to the users as "fees".
Table 2. Advantages and Disadvantages of OTC and Standardized Contracts
|Main characteristics||Contracts are directly negotiated between two parties and are customized for the specific needs of the parties||Contracts are standardized in terms of commodity, size, prices and contract-terms and traded in organized exchanges. Markets close daily (futures).|
10. The forward contract is the only risk management tool currently used in the tea trade. Forward contracts help deal with price risks but they are less flexible than other risk management tools. Since the risk is shared only between the seller and buyer, a gain from price movement to one party is a loss to the other.
11. In general, the development of a standardized risk management market requires transparent prices, low basis risks and enough liquidity. Prices of tea are fairly transparent since they are set at well-organized auctions. However, uncertainties remain in terms of basis risks and liquidity. Basis risk arises when the design of standardized contracts traded in the international markets is too generalized and does not reflect local needs. Liquidity depends on the numbers of traders and investors willing to participate in the market. An increasing volume of the trade in value added teas indicates that the market has became increasingly diversified. Diversification could contribute to lower liquidity and higher basis risks, but OTC markets can reduce basis risks and liquidity problems by customizing contracts.
12. Developing new risk management products suitable for tea requires dealing with not only technical aspects but also commodity specific aspects or those related to local conditions. Among the commodity-specific aspects for tea trade is the short time period covered by risk management tools (likely to be less than six months), while effective hedging strategies are usually longer-term.
13. In addition to the traditional supply and demand side variations, the global tea market has been confronted by increasing uncertainties, as economic and market conditions of participants have become more changeable and unpredictable. These uncertainties have led to increasing price volatility (Annex). Price fluctuations result in incomes from tea being unpredictable and may discourage long-term investment.
14. The use of risk management tools has become increasingly important in other major commodity markets, including those for coffee and cocoa. The continued growth of risk management markets suggests that benefits could be substantial. Though there are certain issues and requirements for using these tools and developing the markets, the introduction of risk management tools other than forward contracts may be useful in the tea market.
15. The tea industry could achieve more remunerative and stable returns if it can protect against the risks of price volatility in the world market. Though reduction of price risks through the use of risk management tools may allow the tea industry to obtain these goals, achieving better price risk management in the tea market is not easy without identifying a system and instrument suitable for tea. Efforts could be made to develop a holistic approach, to better manage the income from tea against unpredictable and unfavourable price movements. The Group may therefore wish to review the price situation and consider risk management tools available in other commodity markets with a view to developing a long-term strategy to improve the market outlook for tea.
Tea prices are volatile. As can be seen from Chart 1, tea prices in the three major auctions fluctuate from month to month and also from year to year with occasional spikes. There is no specific pattern to the movements, suggesting that incomes have been affected by unpredictable price "booms and bust" cycles. Also, the prices in the three centres do not always move together, they differ in terms of level, volatility and direction, particularly for the prices between Calcutta and Mombassa, and between Calcutta and Colombo. The correlation coefficients for each pair from 1985 to 1998 are 0.13 and 0.29, respectively, suggesting that region-specific factors such as economic events and weather conditions affected the movement of tea prices, and these markets were not fully integrated.
Chart 1. Tea price movement of 3 major auction prices: 1985-1998 (Nominal prices, US cents/kg)
Source: International Tea Committee
Chart 2 shows the prices of tea in the three major auctions, deflated by the manufactured unit value (MUV). This price-series measures the impact of the respective price movement in the world tea market on the purchasing power of the tea exporting countries. The chart shows that the level and direction of the purchasing power of the countries exporting tea have randomly fluctuated every year.
Chart 2. Terms of Trade of Tea (1985-1998): 1990=100 constant prices, US cents/kg
Source: International Tea Committee and World Bank
1 Markets with similar functions existed much earlier but it is only recently that the popularity of these markets has started to grow
2 Forward contracts could be standardized and traded in an exchange, but these tradable forward contracts are available only in a few countries, and in a few commodities.
3 For the options, only sellers are required to pay margins.
4 Basis risk exists when the standard (quality, price movements etc) of goods traded are different and therefore the need to hedge risk.