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© FAO January 2008
Mitigation of Investment Risk
Module 3: Investment and Resource Mobilization
Session 5: Risk Mitigation in Agricultural Investment
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
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© FAO January 2008
By
of the
FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS
Mitigation of Investment Risk
Calvin Miller, Senior Officer, Agricultural Management, Marketing and Finance Service, Rural Infrastructure and Agro-Industries Division, FAO, Rome, Italy
About EASYPol
The EASYPol home page is available at: www.fao.org/easypol
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.
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Objectives
After reading this module, you should know about :
Requirements for rural investment
Understanding levels of risk
Risk mitigation products and approaches
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Definitions1
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 less- than-expected returns.
1 www.investorwords.com
Examples:Currency risk, inflation risk, country risk, mortgage risk, liquidity risk, market risk, interest rate risk, credit risk, systematic risk, business risk
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Key challenges for rural investment
Vulnerability ConstraintsSystemic RiskMarket RiskCredit Risk
Operational ConstraintsInvestment ReturnsLow levels of Assets and Investment
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Key challenges for rural investment
Capacity Constraints
Technical Capacity and Training Risk
Social Exclusion Risk
Institutional Capacity Risk
Economic Environment Constraints
Infrastructural Capacity Risk
Political and Social Interference
Regulatory Risk
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
1. Farm enterprise/ agribusiness risk
Market stability and alternatives
Competitiveness in the marketplace
Production uncertainty
Price predictability and profitability
Resources and environment
Asset risk
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
2. 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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Five “C’s” for client loan analysis
Character
Capacity
CapitalCollateralConditions
Integrity and Temperament
• Management• Technical • Human and Labor
• Loan terms• Production cycle• Markets
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
2. 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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Risks 3. Macro/enabling environment
Macro economic environment
Currency risk
Country/regional risk
Land tenure risk
Market risks
Competitiveness risk
Market vulnerability risk
Social and political risks
Country A
Currency rating = B3
Bank deposits = Caa3
Country LT Rating = B1
Risk Premium = 4.5%
Country BCurrency rating = A1
Bank deposits = A1
Country LT Rating = Baa2
Risk Premium = 1.3%
* Moody’s country ratings
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Responses for agricultural investment risk mitigation
Risk mitigation tools and approaches for:
A. Production Risk
B. Price Risk
C. Market Risk
D. Finance
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
A. Mitigating production risk(2)
Right POP – “package of practices” and varieties
Financial Services
Farmers
Input Supply
Output Market
Training & Extension
People’s Organization
Research and Technology
Financial services bundled with technical assistance, technology and marketing
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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.
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Price risk mitigation through value chain approaches
Competitiveness
Value chain linkages
Secured pricing
Product diversification
Market and technical guidance
Input Supplier
Commercial Banks
MFIs, Cooperatives,
NGOs
Farmers
Input Suppliers
Producer groups
Producer groups
Medium/Large Exporters &Processors
Commercial Banks
MFIs, Cooperatives,
NGOs
Local Traders & Processors
Farmers
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Hedging for price risk mitigation
BROKER
COMMODITY EXCHANGE Buying Bids
FUTURE DEALS
FARMERS BUYERS
NGO/GOTech Ass.
BROKER
SellingBids
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Market price
Producer’s sales price
Put priceFloating priceincl premium
paid
Put strike
Commodity price risk mitigation
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
S1
S2
D
P2
P1
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)
Increasing trade elasticity
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Price unpredictability
Maize grain prices are generally less predictable in countries that restrict grain trade than in countries having open borders1
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)
1Yearly data from 1994 to 2006 in Malawi and Mozambique
Example:
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Rural products for differentiated groups
Products for farmers 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
Products for non-agr. or transition rural households
Multi purpose loans:– flexible microenterprise and trade loans– lines of credit and multipurpose use loans– emergency and consumption loans
Multiple, easy access, savings products
RemittancesHealth and property insurance
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Trade credit
Trade / seasonal credit
ProductReceipt
Key
Warehouse receipts: Map of product, receipt and credit
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
Traders and FarmerOrganizations
Exporter/ Wholesaleror Processor
Inspection &
Licensing Co.
Bank
Insurance Co.
Warehouse
Farmers
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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.
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Other investment enhancement mechanisms
Investment funds
Special Purpose Vehicles
Guarantee Funds
Capital enhancement guarantees
Legal reserve requirements
Major catastrophe insurance
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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.
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Promoting Investor Capital Risk Mitigation
Capital enhancement
Liberal financial sector with progressive collateralization policies
Credit guarantees
Guarantees and enhancements if required as incentive for risk of unknown
But,
Not appropriate tool to deal with systemic nor market risks
Have high unit cost/lack of economies of scale
Responding to the Future
SeeSee notes notes forfor detailsdetails
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
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 long- term investment
Subsidies
Cost-benefit, equity of benefits, sustainability
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Summary: New mitigants are required
Price Risk • Use of market basedprice instruments
• Couple with Loan Agreement• Hedge portfolio or each loan• Use microfinance institutions • International banks and brok-erage houses are partners
• Capacity building programs
Measures Methodology
Crop/Weather Risk • Index based Weather Insurance
• Rely objectively on specific weather events
• Compare measurable, objective,correlated risk to yields/incomes
• Conducive policy and regulatoryenvironment a must
• Use innovative structures
• Capture cash flows• Use “organized” intermediateagencies
Collateral Risk
Governments and TA providers have to play in key role in ‘importing’ innovative successful practices
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
www. fao.org/ag/agswww.ruralfinance.org
FAO resources
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Risk mitigation strategies: Ex ante risk mitigation strategies
Informal risk management Formal risk management
Agricultural production strategiesAdvanced cropping techniques
Diversification of income sourcesCrop income / Livestock mixOff farm activities / seasonal labor
Consumption /income smoothing Precautionary savings & buffer stocksCredit access
Risk sharing with othersMutual help supportCrop sharing arrangements
Price and market riskContract farming, forward contractsFuture contract and price optionsStorage (Warehouse receipt finance)
Production riskWeather/production insuranceCatastrophe insurance
Public strategiesEducation /trainingPest management systems / conservationInfrastructure supportGood regulatory environment
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Risk mitigation strategies: Ex ante risk mitigation strategies
Informal risk management Formal risk management
Income smoothing mechanismsSale of assetsSale of labor
Risk sharing systemsRemittancesSeasonal migrationMutual aid
Coping with shocks: private mechanismsLending – leasingRestructuring finance obligations
Public / private mechanismsCash 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
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Further readings
Miller, Calvin, 2007. Risk Mitigation and Management for Agricultural Investment, workshop background paper, Module: Investment and Resource Mobilization.
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© FAO January 2008
FAO Policy Learning ProgrammeModule 3: Investment and Resource Management
Session 5: Risk Mitigation in Agricultural Investment
Links to Module 3 : Sessions 1-8
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
Module 3: Investment and Resource Management
FAO Policy learning programmeCapacity Building Programme on Policies and Strategies for Agricultural and Rural Development