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A Model for Lowering Inter-Annual Revenue Variability for the Cotton Chain in WCA Countries
by Jean CordierProfessor, Agrocampus Rennes
ITF CRM annual meeting, Pretoria, May 16, 2006
A model developed with the support of the French Foreign Ministry and the Agence Française de Développement (AFD)
– Introduction : the « producer » problem– The model and its assumptions– Results– Advantages and limits
ITF CRM annual meeting, TUT, Pretoria, May 16, 2006
A Model for Lowering Inter-Annual Revenue Variability for the Cotton Chain in WCA Countries
INTRODUCTION : THE « PRODUCER* » PROBLEM
Reference market price Ft
FOB price (basis = 50)
… Revenue = P.Q
decrease increase
Cost of production
Ft
Ft - 50 •
* « Producer » = ginner + farmer
- Risk concern of the producer : price and quantity
- Risk concern of the ginner : quantity and price
f(relationship P - G)
Risk on revenue
INTRODUCTION : THE « PRODUCER » PROBLEM
Risk perception :
- Revenue variability … σ
- Value at Risk : Prob 5 %
Revenue(t) < 174 F.CFA
Impact on :
- Short Term invest. choices
- Long Term invest. choices
Impact on chain competitivity
σ
Shocks and crisis
300
500
700
900
1 100
1 300
1 500
2006
2009
2012
2015
2018
2021
2024
2027
2030
Réel
Plancher
Shock Crisis
INTRODUCTION : THE « PRODUCER » PROBLEM
Productivity gains
In a competitive market, price is fluctuating through time above and below cost of production
THE « PRODUCER » PROBLEM AND ITS « ANSWER »
700 Reference market price Ft
650
FOB price (basis = 50)
And with the benefit of a price lift
With a floor price
decrease increase
Cost of production
Ft
Ft - 50
Being profitable
•
OBJECTIVE OF THE MODEL
1. Reduce the revenue variability of the global Cotton Chain in WCA countries
o Directly from price risk management
o Indirectly from cultivated surface management
o … nothing, to the present time, on crop yield/weather risk management
2. Improve the VaR(5%) of the cotton producer
3. Share the residual risk between ginners and producers
CONTEXT OF THE MODEL = WCA COUNTRIES
• Unicity of farmer cotton price through space
• Unicity of price through time (within a crop year)
• March(t) Posted Price for Oct-November delivery t
• Posted price payment at delivery (Oct-Nov) and price bonus at the end of the crop year
• Organisation of (most) WCA cotton chains
CONTEXT OF THE MODEL = WCA COUNTRIES
Nominal cotton price (cts/lb)
30,0040,0050,0060,00
70,0080,0090,00
100,00
1975
-76
1977
-78
1979
-80
1981
-82
1983
-84
1985
-86
1987
-88
1989
-90
1991
-92
1993
-94
1995
-96
1997
-98
1999
-00
2001
-02
2003
-04
2005
-06
EUR/USD exchange rate
0,50
0,70
0,90
1,10
1,30
1,50
1,70
1975
-76
1977
-78
1979
-80
1981
-82
1983
-84
1985
-86
1987
-88
1989
-90
1991
-92
1993
-94
1995
-96
1997
-98
1999
-00
2001
-02
2003
-04
2005
-06
- A fixed exchange rate EUR/F.CFA
- A devaluation between EUR/F.CFA in 1994
Crop yield in BF
0
500
1 000
1 500
THE PROPOSED MODEL AS A SECOND BEST
Reference market price Ft
FOB price (basis = 50)
decrease increase
Cost of production
THE MODEL
1. Use of reference markets (NYBOT/Cotlook A and exchange rate USD/EUR to define a « fair » CIF-FCFA reference price
2. Define the basis Bt for eliciting the WCA FOB-FCFA price Bt = transportation cost minus quality premium
3. Design « price layers » with respect to probability of occurrence
→ Layer A : Risk retention layer Prob(Layer A) ≈ 90 %– Layer B : Market instrum. layer Prob(Layer A) ≈ 10 %– Layer C : Market failure layer Prob(Layer A) ≈ 1-5
%
4. Design tools matching each layer with portfolio consistency and governance potential
5. Define a formula pricing for sharing cotton value between ginners and producers
THE PROPOSED MODEL
Reference market price Ft
FOB price (basis = 50)
decrease increase
Cost of production
ABC
TOOLS ORGANIZATION IN THE MODEL
• « Risk retention layer » = Layer A
Intra-annual smoothing : selling diversification using futures and forward contracts (private basis)
Inter-annual smoothing : price and revenue smoothing using a Buffer Fund and a Withdrawal Right (private professional basis)
• « Market insurance layer » = Layer B
Risk transfer to market : price derivative contract (« bear put spread »)
• « Market failure layer » = Layer C
External support : local covered eventually by internationalGovernance of crisis (early signals, crisis procedure implementation)
ASSUMPTIONS OF MODEL SIMULATION FOR BURKINA FASO
• Lognormal price distribution for the world cotton price in cts/lb (NYBOT or Cotlook A) LN(St) has a normal distribution : N(0 ; 0,20)
• Normal distribution for the exchange rate USD/EURO : N(1,15 ; 0,22)
• Normal distribution for farm cotton yield : N(1063 ; 113)
• Normal distribution for cultivated area : N(700000 ; 70000)
• No current distribution on FOB-to-CIF cost or quality premium
0
200
400
600
800
1 000
1 200
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Moving Average smoothing
PARAMETRIZATION TESTED
• Pivot price calculated using first order exponential smoothing (4 years and α = 0,7)
• Price layers : A > 700, 600 > B > 700 and C < 600
• Upper bound = 110 % of pivot priceLower bound = 90 % of pivot price
• Percentage of surplus given to the Buffer Fund (BF) = 100 %
• Maximum size of the Buffer Fund = 15 % of pivot priceMaximum size of the Withdrawal Right (WR) = 15 % of pivot price
• Formula for sharing cotton FOB value between the ginner and the producer :
• Ginner margin : M = 200 + 0,1*P• Producer price : PProd. = (PFOB – M)* 0,42
Revenu filière Burkina Faso
140
240
340
440
540
640
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Fonds de lissage et Droit tiragedu Burkina Faso
-80,0
-60,0
-40,0
-20,0
0,0
20,0
40,0
60,0
80,0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
THE BUFFER FUND « AUGMENTED » WITH WITHDRAWAL RIGHT
Example of simulation :
Distribution for Prix producteur initial (B61)
Mean = 213,1876
X <= 139.55%
X <= 311.2395%
0
1
2
3
4
5
6
7
8
50 150 250 350 450
Valu
es i
n 1
0^
-3
Distribution for Prix producteur final / A+B+C (B57)
Mean = 220,4832
X <= 176.515%
X <= 284.0395%
0
0,002
0,004
0,006
0,008
0,01
0,012
0,014
0,016
0,018
0,02
100 200 300 400
Current situation
Impact of the model
Example of simulation :
Smoothing simulationExtreme Situations = Schocks and Crisis
300 500 700 900
1 100 1 300 1 500
Réel
Lissé
Plancher
Simulation du lissage + "méplat" + aideSituations extrêmes = Choc et Crise
300 500
700 900
1 100
1 300 1 500
2006
2009
2012
2015
2018
2021
2024
2027
2030
Réel
Lissé
Lissé + tunnel
Plancher
CriseShock
RESULTS OF MONTE CARLO SIMULATION
• Robust model under current hypothesis (Monte Carlo simulation)
• Risk decrease for WCA cotton chains– 35-40 % decrease of the coeff. of variation of the producer price– 30-35 % decrease in standard deviation of the producer price
• Value at Risk (5%) improvement : 20-25 %
• Use of Layer C : 3 to 5 % for an average of 37 MM F.CFA (Burkina Faso – 700.000 ha), 1 or 2 times every 30 years (37 or 74 MM F.CFA)
MODEL ADVANTAGES
• Effective risk reduction for WCA cotton chains
• VaR(5%) improvement
• Non-distorting mechanism
• « clear principles » and parametrization to reach local objectives
• Non manipulable therefore « sustainable »
• Linked to « market » through the use of market signals (exponential smoothing) and instruments (futures-forward, options)
• Cultural acceptability in merging « buffer funds » and « market instruments » therefore « locally acceptable » … in addition to parametrization
MODEL LIMITS
• Jumps are not considered (FCFA devaluation, strong production cost changes – i.e. GMO – strong cotton area increase) … therefore additional « governance » mechanisms are required to handle jumps consequences
• Requirement of a national agreement for sharing the world cotton value and risk in between ginners and producers (formula margin and productivity targets)
• Unknown derivative market liquidity, inducing transaction costs on the knockout option through market intermediaries (banks, international trading firms, specialized intermediaries)
• Requirement of an agreement between the local Cotton Chain (Interprofession) and the Government for « Layer C management »
… IMPLEMENTATION ISSUES
• Need to move from current national situations (objective and also constraint of pilot tests)
• Set theoretical and practical layers limits (A, B and C)
• Premium issue (perceived cost/benefit, how much, flexible/fixed)
• A need for normative costs (ginners)
• Adaptation to national ginners structure (one or several ginners)
• Institutional, legal, initial endowments issues
THANKS FOR YOUR ATTENTION
ITF CRM annual meeting, Pretoria, May 16, 2006
Besoin d’un « plan marketing » et d’un suivi
Plan MKG :
Fondement du suivi
Compatibilité des aides par rapport à l’O.M.C.
• Notion de choc et de crise
• Amélioration possible de la règle de « catastrophe naturelle » telle que rédigée en annexe 2 – paragraphe 7 de l’accord de Marrakech
Revenu coton - Période 2006-32
0
100
200
300
400
500
2006
2009
2012
2015
2018
2021
2024
2027
2030
Revenu brut
Revenu "structuré"
- Autor. OMC
- Aide prévue
10 % confidence
0,00
200,00
400,00
600,00
800,00
1000,00
1200,00
1400,00
2001 2002 2003 2004 2005