Mitigation of Investment Risk

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1 1of 37 F A O P o l i c y L e a r n i n g P r o g r a m m e Module 3: Investment and Resource Mobilization Mitigation of Investment Risk

2 2of 38 Mitigation of Investment Risk By Calvin Miller, Senior Officer, Agricultural Management, Marketing and Finance Service, Rural Infrastructure and Agro-Industries Division, FAO, Rome, Italy of the FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS About EASYPol The EASYPol home page is available at: This presentation belongs to a set of modules which are part of the EASYPol Training Path Policy Learning Programme Module 3: Investment and Resource Mobilization, Session 5: Risk mitigation in agricultural investment EASYPol has been developed and is maintained by the Agricultural Policy Support Service, Policy Assistance and Resource Mobilization Division, FAO.

3 3of 38 Objectives After reading this module, you should know about : Requirements for rural investment Understanding levels of risk Risk mitigation products and approaches

4 4of 38 Definitions 1 Investor an individual, institution or company who commits money to investment products with the expectation of financial returns, Goal: Minimize risk while maximizing return Risk The quantifiable likelihood of loss or lessthan-expected returns. Examples: Currency risk, inflation risk, country risk, mortgage risk, liquidity risk, market risk, interest rate risk, credit risk, systematic risk, business risk 1

5 5of 38 Requirements for rural investment Supportive operating environment Attractive and resilient returns to investment Ability to assess and mitigate risk Suitable financial products and services Conditions to be successful Profit and resiliency make a profit and build assets in good times and draw against and insure against losses in bad times. Financial service options ability to obtain financial resources as needed

6 6of 38 Key challenges for rural investment Vulnerability Constraints Systemic Risk Market Risk Credit Risk Operational Constraints Investment Returns Low levels of Assets and Investment See notes for details

7 7of 38 Key challenges for rural investment Economic Environment Constraints Infrastructural Capacity Risk Political and Social Interference Regulatory Risk Capacity Constraints Technical Capacity and Training Risk Social Exclusion Risk Institutional Capacity Risk

8 8of 38 Risk at three levels 1. Enterprise/Business Risks 2. Financial Institution/Investor Risks 3. Macro/enabling Environment Risks Finance and investment are tools for rural development with many associated risks

9 9of Farm enterprise/ agribusiness risk Market stability and alternatives Competitiveness in the marketplace Production uncertainty Price predictability and profitability Resources and environment Asset risk

10 10 of Financial institution/investor risk: Client lending/investing risks Client enterprise/business risks Enterprise ROI Capital rotation Profitability and reinvestment Capacity, skill and technology Repayment capacity Client loan risks Client and household

11 11 of 38 Five C s for client loan analysis Character Integrity and Temperament Capacity Management Technical Human and Labor Capital Collateral Conditions Loan terms Production cycle Markets See notes for details

12 12 of Financial institution/investor risk: Portfolio risks (2) Market sector stability, competitiveness and trends Systemic and unpredictability risks Institutional/investor profitability risk Transaction and operational cost risks

13 13 of 38 Risks 3. Macro/enabling environment Macro economic environment Currency risk Country/regional risk Land tenure risk Country A Currency rating = B3 Bank deposits = Caa3 Country LT Rating = B1 Risk Premium = 4.5% Market risks Competitiveness risk Market vulnerability risk Social and political risks Country B Currency rating = A1 Bank deposits = A1 Country LT Rating = Baa2 Risk Premium = 1.3% * Moody s country ratings See notes for details

14 14 of 38 Responses for agricultural investment risk mitigation Risk mitigation tools and approaches for: A. Production Risk B. Price Risk C. Market Risk D. Finance

15 15 of 38 A. Mitigating Production Risk Diversification production and location Infrastructure and technology irrigation, storage, R & D Indexed Insurance weather or yield Farm/agribusiness techniques and technologies Access to timely inputs

16 16 of 38 A. Mitigating production risk (2) Right POP package of practices and varieties Financial Services Input Supply Farmers Training & Extension Output Market People s Organization Research and Technology Financial services bundled with technical assistance, technology and marketing

17 17 of 38 B. Tools for managing price risk Contract farming - interlinked credit-input-output marketing systems Trade finance input and output Commodity exchanges Forward contracting Hedging: futures and options Some tools are best used at the agribusiness level, but small farmers also benefit from these indirectly by having more stable prices and consequently more access to finance. Service intermediaries, ex. DrumNet, can also facilitate their use.

18 18 of 38 Price risk mitigation through value chain approaches Competitiveness Value chain linkages Medium/Large Exporters & Processors Commercial Banks Secured pricing Product diversification Market and technical guidance MFIs, Cooperatives, NGOs Local Traders & Processors Producer Producer groups groups Farmers Input Input Suppliers See notes for details

19 19 of 38 Hedging for price risk mitigation FARMERS BUYERS NGO/GO Tech Ass. FUTURE DEALS BROKER BROKER Selling Bids COMMODITY EXCHANGE Buying Bids See notes for details

20 20 of 38 Commodity price risk mitigation Producer s sales price Put price Floating price incl premium paid Market price Put strike

21 21 of 38 C. Approaches for mitigating market risk Information Long-term market trends Current and future prices Commodity and product information Trade and market development Increasing elasticity with open trade Commodity exchanges Market access

22 22 of 38 Increasing trade elasticity P 1 P 2 S 1 S 2 D Slope of demand curve influenced by: Transport infrastructure Consumption pattern diversification Storage capacity Available finance to traders Market institutions (e.g., warehouse receipt systems) Barriers to internal and regional trade (e.g., export/import tariffs, permits) See notes for details

23 23 of 38 Price unpredictability Example: Maize grain prices are generally less predictable in countries that restrict grain trade than in countries having open borders 1 Controlled trade countries high/low ratio average = 168% (range = 63 to 625%/yr) Open border countries high/low ratio = 77% (range 43 to 129%/yr) 1 Yearly data from 1994 to 2006 in Malawi and Mozambique

24 24 of 38 D. Tools to mitigate financing risks Due diligent loan analysis Portfolio and product diversification Strategic linkage partnerships Collateralization warehouse receipts, futures contracts Credit guarantees Enabling environment adequate policies, fiscal responsibility See notes for details

25 25 of 38 Rural products for differentiated groups Products for farmers Products for non-agr. or transition rural households Investment loans Warehouse receipt loans Trader loans to the trader to the clients linked with trader Futures and options Insurance products indexed crop and livestock insurance health and property insurance Multi purpose loans: flexible microenterprise and trade loans lines of credit and multipurpose use loans emergency and consumption loans Multiple, easy access, savings products Remittances Health and property insurance

26 26 of 38 Warehouse receipts: Map of product, receipt and credit Bank Receipt Exporter/ Wholesaler or Processor Traders and Farmer Organizations Trade credit Farmers Key Trade / seasonal credit Inspection & Licensing Co. Product Insurance Co. Warehouse Highlights: Warehouse receipts are a financial product structured to reduce lending risk. The feasibility of its use depends upon the government policies and enforcement and on the effectiveness and capacity of the warehouse managers. Inspection and licensing authority may be public or private There should be multiple warehouses and banks serving the market

27 27 of 38 Warehouse receipts - preconditions Legal and regulatory requirements re: rights and responsibilities of participants, title and transferability of goods, use of receipts for collateral Commonly accepted grades and standards Trustworthy certification and inspection service Market information Legal and regulatory expertise re contracts, commercial code, financial regulations Financial institution acceptance of instrument Contract enforcement both through legal means and education A warehouse receipts system requires private and public interventions. The first step in the development of this kind of financing is the development of warehouse space that can be used by a range of producers and processors, not just to a few large operations, accepted standards and adequate policies.

28 28 of 38 Other investment enhancement mechanisms Investment funds Special Purpose Vehicles Guarantee Funds Capital enhancement guarantees Legal reserve requirements Major catastrophe insurance See notes for details

29 29 of 38 Responding to the future Promoting healthy rural enterprises and business Profitable businesses can absorb risk Market competitiveness promotion Conducive tax and business environment Use of risk management tools to reduce vulnerability Hedging, futures, etc. See notes for details

30 30 of 38 Responding to the Future Promoting Investor Capital Risk Mitigation Capital enhancement Liberal financial sector with progressive collateralization policies Credit guarantees But, Guarantees and enhancements if required as incentive for risk of unknown Not appropriate tool to deal with systemic nor market risks Have high unit cost/lack of economies of scale See notes for details

31 31 of 38 Caution with good intentions to enhance investment Directed Development (revolving) Funds Not an appropriate risk mitigation approach Lack specialized financial management expertise and structure Lack sustainability and can damage rather than support longterm investment Subsidies Cost-benefit, equity of benefits, sustainability

32 32 of 38 Summary: New mitigants are required Price Risk Crop/Weather Risk Collateral Risk Measures Use of market based price instruments Index based Weather Insurance Use innovative structures Methodology Couple with Loan Agreement Hedge portfolio or each loan Use microfinance institutions International banks and brokerage houses are partners Capacity building programs Rely objectively on specific weather events Compare measurable, objective, correlated risk to yields/incomes Conducive policy and regulatory environment a must Capture cash flows Use organized intermediate agencies Governments and TA providers have to play in key role in importing innovative successful practices

33 33 of 38 FAO resources www. fao.org/ag/ags

34 34 of 38 Risk mitigation strategies: Ex ante risk mitigation strategies Informal risk management Formal risk management Agricultural production strategies Advanced cropping techniques Diversification of income sources Crop income / Livestock mix Off farm activities / seasonal labor Consumption /income smoothing Precautionary savings & buffer stocks Credit access Risk sharing with others Mutual help support Crop sharing arrangements Price and market risk Contract farming, forward contracts Future contract and price options Storage (Warehouse receipt finance) Production risk Weather/production insurance Catastrophe insurance Public strategies Education /training Pest management systems / conservation Infrastructure support Good regulatory environment

35 35 of 38 Risk mitigation strategies: Ex ante risk mitigation strategies Informal risk management Formal risk management Income smoothing mechanisms Sale of assets Sale of labor Coping with shocks: private mechanisms Lending leasing Restructuring finance obligations Risk sharing systems Remittances Seasonal migration Mutual aid Public / private mechanisms Cash transfer Social assistance and social funds - Risk reduction strategies are developed prior to risk events to reduce the potential risk - Risk coping strategies reduce the impact of a loss after the risk event occurs

36 36 of 38 Further readings Miller, Calvin, Risk Mitigation and Management for Agricultural Investment, workshop background paper, Module: Investment and Resource Mobilization.

37 37 of 38 Links to Module 3 : Sessions 1-8 FAO Policy learning programme Module 3: Investment and Resource Management Session 1: Investment in agriculture & rural development Session 2: Environment for private investment in agriculture & rural development Session 3: Sources and uses of financial resources Session 4: Strategies for increasing farm financing resources Session 5: Risk mitigation in agricultural investment Session 6: Sector-wide approaches (SWAps) Session 7: Socio-economic & livelihood analysis FAO Policy learning programme Capacity Building Programme on Policies and Strategies for Agricultural and Rural Development

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