Thursday, April 15, 2010

How could price risk hedging be bad for producers?

When one faces fluctuations in income, it seems quite natural to find some way to insure yourself. For farmers, price fluctuations can be a serious problem, especially with non-diversified crops. In developing economics, this insurance was provided by commodity marketing boards. But as their margins kept increasing, fueling incredible corruption, they have been abandoned virtually everywhere. Instead, the World Bank has been advocating commodity futures, where farmers can hedge their risk. In principle this looks like the perfect thing to do.

But there are some pitfalls, as Sasha C. Breger Bush argues. First, farmers may face margin calls, and given the wide fluctuations in the underlying prices, this can be devastating if you have little assets to meet those calls. The weakest thus go bankrupt, facing essentially something like a gambler's ruin. Second, hedging provides the wrong incentives if farmers do not understand that current low prices mean that their supply should be reduced and they should diversify. Clearly, it is not obvious to find a mechanism that allows farmers to whether price fluctuations while still letting the price influence demand and supply the way it should.

No comments: