ISSUE 33 May 2006

Humanitarian Exchange Magazine

Tackling vulnerability to hunger in Malawi through market-based options contracts

by Rachel Slater, ODI, and Julie Dana, World Bank

Malawi has faced repeated food crises since 2003, and vulnerability to food insecurity is increasing. Many households are unable to meet their food needs, and are highly susceptible to volatility in the price of staple foods, especially maize. In the 2005–2006 agricultural season, final food estimates indicated that Malawi would face a food gap of around 400,000 tonnes. In response, the government secured additional supplies of maize at a capped price from South Africa via an options contract based on the South Africa Futures Exchange (SAFEX) white maize prices. As a way of ensuring the availability of food at acceptable prices, this approach has significant implications for donors and humanitarian agencies, particularly those involved in food aid distribution.

How do options contracts work?

Commodity options contracts are typically used to hedge against price volatility. They operate in a similar way to insurance. Payment of a premium is exchanged for the right, but not the obligation, to either buy or sell a commodity at a predetermined price for a particular period of time into the future. The premium cost is determined by the difference between the current market price and the price protected, the length of time that the price protection is needed and the volatility of the market. There are two types of options contracts. Put options are options to sell at a specified price in the future, and are typically used by producers or exporters to protect against falling prices. Call options are options to buy at a specified price in the future, and are typically used by importers to protect against rising prices. When combined with a physical delivery contract, options contracts can help importers manage costs, and mitigate the risk that prices will increase dramatically when there is a shortage in the market.

The goal of an options contract for maize, used in the context of food security, is to ensure that affordable maize is available on the local market. During food shortages, local maize prices tend to increase. This exacerbates the risk of hunger because higher prices mean that food becomes unaffordable to vulnerable households. Governments often respond to this risk by intervening in markets – for example by subsidising food staples like maize. However, this can discourage private sector commercial imports, thus exacerbating the shortage and leading to an increase in prices. Humanitarian responses that seek to meet the needs of vulnerable people at an individual or household level, including through the distribution of food aid, can also have a negative impact on local and regional trade, and can increase the volatility of food prices.

Options contracts provide a contingent, or back-up, import strategy that can be used to prevent local prices rising to unaffordable levels on commercial markets, whilst at the same time avoiding disruption and disincentives to local markets by sending clear signals to the private sector about when the government will import, how much it will import, and at what price. In short, options contracts can address the key problems associated with importing food in a shortage year.

 

Call options in Malawi

In September 2005, the Malawian government signed an options contract with Standard Bank of South Africa giving it the right, but not the obligation, to buy additional maize at a price fixed at the time the contract was signed. The contract allowed for the purchase of a maximum of 60,000 tonnes of maize at a cost of approximately $18m – enough to meet the food gap if donor and private sector commercial imports did not reach anticipated levels. The UK Department for International Development (DFID) provided the financing to pay the options premium up-front, and the World Bank provided technical support. The options contract provided the government with a mechanism to trigger additional imports at short notice, put a price cap on the cost of maize from South Africa and provided protection against the risk that prices would move higher. Finally, agreeing an ‘over the counter’ contract meant that the cost included delivery to Malawi, reducing uncertainty over transport prices. Previously, examination of the scope for using risk management tools such as futures and options to help manage price volatility in food-insecure countries was limited by a concern about basis risk: the risk that prices on the exchange would not move in a correlated way with prices at the local level, for example in a different country often geographically far away from the exchange. This risk was removed in the ‘over the counter’ call option contract used by the Malawi government since it was structured to include price protection on both the SAFEX white maize futures price, and for transport to Malawi.

In response to continued evidence of shortages in the market and concern about rising local prices, the government exercised the first tranche of the options contract on 7 October, buying 30,000 tonnes of maize. It exercised the second tranche on 15 November, when it bought the remaining 30,000 tonnes. Again, this was in response to continued shortages and concern about rising prices.

Malawi’s early experience with options contracts was largely positive. The majority of maize purchased was used to meet humanitarian needs and did not reach the commercial market. It was thus not possible to test the effect of the options contract on retail prices. At the same time, the maize bought under the contract had the best delivery performance of all the maize imported into Malawi, and helped to avoid severe shortfalls in the humanitarian pipeline. Additionally, by the time of delivery in December/January, prices had risen by between $50 and $90 a tonne above the ceiling price of the contract. Without the options contract, Malawi would have paid significantly more to secure South African maize in late 2005 since both the SAFEX white maize price and transport costs had increased. It became clear that taking an ‘over the counter’ option was more cost-effective than a contract that did not include delivery.

The options contract approach is also a step towards ensuring that responses to food shortages and food insecurity do not jeopardise longer-term growth by distorting prices and incentives, and disrupting private sector activity. One of the key challenges that the private sector in Malawi faces is uncertainty about when the government will intervene in maize markets. To address this problem, the options agreement was made public via a government press release, to ensure the least possible disruption to commercial markets. This release of information eliminates uncertainty about government actions, since the private sector now knows when and at what price the government will bring in maize, and can make informed decisions about commercial imports. Private sector traders in Malawi and in the region are supportive of this approach, and look forward to an opportunity to be involved commercially.

In the future, the government (or donors) could resell maize purchased through the options contract to local traders, who would then manage distribution and commercial sales. In this way, the government or donor role is limited to risk management (a critical need in Malawi, where local traders’ capacity to manage imports is weak). Over time, and as the capacity of local traders and the commercial market strengthens, this risk management function would naturally fall back to the private sector, as is evident in developed countries where traders and importers continuously hedge risk with futures and options.

Implications for humanitarian agencies

Options contracts can be a way of improving food aid responses. There are two main types of benefit: enabling more efficient and cost-effective operations; and enabling better responses to potential crises.

Efficient and cost-effective operations

Options contracts have the potential to enable a proactive, risk-management approach to the procurement of food by humanitarian agencies. They offer potential cost savings by allowing agencies to buy protection at lower market prices when these are available, and can potentially speed up response mechanisms since triggering pre-arranged options contracts can be quicker than tendering for supply contracts.

Local and regional trade are also supported through options contracts. More strategic procurement can prevent the price spikes that occur following WFP buying announcements, and clear signals about the size, timing and price of agency purchases prevent uncertainty in the market. Because donor procurement plays such a dominant role in markets like Malawi’s, agencies should be encouraged to implement new approaches to avoid the risk of market collapse. Focusing on the risk-management function appears to be a natural, and valuable, role for agencies involved in food security, but positive impacts will be limited until organisational policies are re-evaluated with risk-management functions in mind. That is, WFP should think of itself as in the risk management business, not the food procurement business. Finally, agencies’ contingency planning is improved because using guaranteed prices adds to the stability of operations and makes cash flow more predictable. Options contracts have the potential to maximise the value of every food aid dollar

Changing the approach of humanitarian agencies

Chronic vulnerability to food insecurity in Southern and Eastern Africa is an increasing problem, but the toolbox of responses that humanitarian agencies (and governments) draw on remain largely focused on ex post responses – as if chronic vulnerability and hunger are unexpected and unpredictable problems. Finding the tools and institutional structures that enable more ex ante responses to vulnerability is critical, and options contracts are, potentially, one such response. Enabling agencies like WFP to work with option contracts will, however, require some significant transformations in the way that funds are accessed and budgets managed.

Options contracts require long-term procurement plans if they are to be cost-effective. For those agencies that have significant core funding, this may not be a problem. However, where the procurement of food depends on contributions by donors to emergency appeals, the opportunities to agree at an early stage what food requirements will be in the future, and to ensure an early response, have been limited. Options contracts are a solution to this problem since they allow for contingent import contracting. As an example, donor agencies can begin purchasing options contracts at the first sign of a problem, then exercise or ‘call’ for deliveries only if needs become apparent. This is similar to the just-in-time supply chain management used by major corporations as a way of maximising efficiencies and reducing costs.

Budgeting processes within agencies also have implications for the use of options contracts. In many agencies, significantly less money is budgeted for disaster preparedness and prevention than is allocated to disaster response. The advantages of options contracts provide a strong argument for using spending on disaster prevention to reduce overall levels of humanitarian need by heading off crises before they emerge. But agencies do not have unlimited resources and there is inevitable competition between budget lines for disaster preparedness and prevention and for disaster response. Spending money on options contracts means that there is less money to spend later on emergency aid if the option does not enable a crisis to be averted. Most importantly, humanitarian agencies receive much less credit for their roles in preventing emergencies than they do for responding effectively when an emergency arises.

Conclusion

Options contracts are just one potential tool for improving food security strategies. Ensuring that poor people’s access to food is strengthened remains critical, and the optimal role of governments, agricultural policy, social safety nets, international organizations, and donors will continue to be heavily-debated. Nonetheless, there is significant potential for options contracts to make humanitarian agencies more efficient (by improving the value of every food aid dollar), more effective (by mitigating price risks and thereby reducing overall levels of humanitarian need) and more supportive of local trade (by focusing on risk management roles instead of trading functions). In order to fully demonstrate the real (rather than potential) impacts of options contracts, continued testing of the approach is needed, alongside a in-depth analysis of the incentives and disincentives for humanitarian agencies to adopt such an approach...

Rachel Slater (r.slater@odi.org.uk) is a Research Fellow in the Rural Policy and Governance Group at ODI. Julie Dana (jdana@worldbank.org) is a Technical Specialist with the Commodity Risk Management Group at the World Bank. She is a former commodities trader.

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