Saturday, October 22, 2011

Commodity bonds to hedge price volatility

Commodity exporters have always been vulnerable to the vagaries of global commodity price volatility. Jeffrey Frankel suggests the use of commodity bonds by both commodity exporters and their buyers to hedge against price risks.

Exporters of a particular commodity would issue debt denominated in terms of the price of that commodity (say Aluminium bonds by Jamaica), rather than dollar or any other currency. The interest rate paid on this debt will increase or decrease depending on whether the commodity prices are rising or falling respectively. This will ensure that the cost of debt service adjusts automatically (and debt-to-export ratio does not rise) in case of a decline in the price of the underlying commodity. The purchasers of this debt could include the major buyers of these commodities, whose (price increase) risk can be mitigated by the increased returns from higher commodity prices. He writes,

Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. This pooling function would be particularly important in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.

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