Managing food industry business and financial risks with commodity‐linked credit instruments

Abstract

This paper reviews the use and structure of commodity-linked credit instruments. It is argued that in the absence of contingent markets food firms face increasing financial risk reduced investment, and limited access to debt markets. One strategy is to issue commodity-linked credit whose payment structure is linked to the price of an underlying commodity. In some cases, a commodity-linked bond (CLB) can be structured to provide an incentive to investors by sharing in profit gains. If the goal is to hedge financial risks, CLB's can also be constructed that reduce the loan principle or coupons depending on price movements. I.Introduction One of the most important managerial roles facing the agriculture and food industry is the management of business risks arises from commodity price fluctuations. The prevalence of these risks affects not only capital structure decisions on the optimal balance between debt and equity but also the timing of commitments for capital investment. Unmanaged, business risks give rise to higher costs of capital and volatile share prices. To mitigate risks a number of financial instruments such as forward contracts, futures, swaps, and options have been developed and most companies have established risk management strategies. For example farmers, grain marketers and other sellers of commodities can hedge there risk by taking short positions in futures markets or purchasing put options, while buyers of commodities can hedge risk by taking long positions in futures contracts or buying call options.The purpose of this paper is to examine a different class of structured financial products, collectively referred to as Commodity-Linked Credit Instruments, that links the payoff from a derivative such as a forward contract, futures contract, or option to the repayment covenants of a loan or bond. In section II we discuss the relationship between financing, hedging, and investment, Section III introduces the structure of a commoditylinked bond and discusses how they can be used to balance business and financial risk for the food industry. Section IV develops a general framework to support the main contentions, from a finance point of view, of sections II and III. Section V provides an overview of CLB pricing issues including convenience yield, interest rate risk, convenience yields and bankruptcy risk. Section V concludes with a general model framework based upon the work of Harrison and Kreps (1979). Section VI delves into structure issues in more depth. While the models of section V provide a framework for understanding CLBs in general, in practice firms that have issued commodity-linked bonds have used a variety of different structures. Therefore, section VI builds on the review in Attah Mensa (1992) by reconstructing the payoff or boundary conditions to a number of actual CLB products. The paper concludes in section VI.I

Designing catastrophic bonds for catastrophic risks in agriculture

“…Linked credit instruments can be important for farmers, agribusiness, or financial institutions at the micro (Jin and Turvey, 2002;Turvey, 2006Turvey, , 2008Shee and Turvey, 2012), meso- (Collier et al, 2011;Weber et al, 2015;Miranda and Gonzalez-Vega, 2011;Miranda and Farrin, 2012), or macro- (Mahul and Ghesquiere, 2007;Michel-Kerjan et al, 2011;Clarke and Doherty, 2004;Thieken et al, 2006) levels of economic development. When a government or institution issues CAT bonds triggered by an index, it could actively distribute the indemnity payment to the victims based on the observed losses.…”

Collateral‐free lending with risk‐contingent credit for agricultural development: indemnifying loans against pulse crop price risk in India

“…Agricultural applications of risk‐contingent credit are limited and can be found in Jin and Turvey (2002) who advanced a basic model for farm credit, Turvey (2006) with commodity‐linked bond formulations for agribusiness, and Turvey (2008) for the pricing of weather‐linked credit, mortgages, and bonds. Carter (2011) examined the impacts of risk‐contingent credit on financial market deepening and its impacts on farm households.…”

Small businesses and risk contingent credit

“…There also are some limited applications of agricultural commodity‐linked instruments. Applications have been applied to agricultural risks in developing economies with a general focus on sovereign debt (Jin and Turvey, 2002; Turvey, 2006; Priovolis, 1987; Anderson et al , 1989; Myers and Thompson, 1989; Myers, 1992; Claessens and Duncan, 1993; Lu and Neftci, 2008). Related applications to weather and catastrophe bonds include Chantarat et al (2008), Turvey (2008), and Xu et al (2008).…”