The world is a complex unpredictable place. Private firms, with the help of creative financial markets, have developed a range of risk management tools to mitigate, price, and share risk.  Nancy Birdsall and I argued years ago that the innovation of Wall Street could be better applied to problems in developing countries. Colleagues Vij Ramachandran and Ben Leo show how the World Food Program could be greatly enhanced by simple hedging.  And Guillermo Perry makes a persuasive case that the multilateral development banks should move beyond lending to provide tools for countries to manage volatility and create stability, such as hedging and insurance.

Thus, I should be extremely pleased to read today, on page A13 of the Washington Post that:

The [World Bank] and J.P. Morgan are setting aside $200 million each to help finance what World Bank President Robert B. Zoellick described as “plain vanilla hedges,” allowing agriculture-related businesses in developing nations to lock in prices well in advance of a harvest or commodity purchase. The lack of such financial tools in poorer nations — and even in better-developed economies such as Brazil — means that farmers, agricultural cooperatives, food processors and similar businesses can’t plan well or get bank loans. That limits investment and, ultimately, production, Zoellick said.

I’m absolutely in favor of these kinds of initiatives and have been thinking through other possible ways to apply financial instruments like derivatives to development problems.  So I should be cheering this latest announcement.

But one nagging obstacle has been skepticism (some practical, some ideological) that poor people and poor countries will get screwed by people selling such instruments. If subprime lending in the United States was predatory, so the thinking goes, then what’s likely to happen when brokers start selling complex financial instruments to rural African farmers?  This is something I think has been over-stated and can be dealt with through project design.  But it continues to be a real worry.  So I was also glad to see that, according to the Washington Post, “safeguards have been put in place” in the new J.P. Morgan-World Bank initiative to prevent speculation or abuse. Without details it’s hard to know if these are for real (or, like some safeguards, so stringent that they effectively kill the idea). As Perry argues, the key is getting a credible organization, like a multilateral development bank, to intermediate.

Then I turned the page to A14:

J.P. Morgan to pay $153.6 million to settle fraud suit….J.P. Morgan Securities sold investors a complex instrument that was secretly designed to help a hedge fund profit at their expense, the government alleged Tuesday.

Clearly having credible private sector partners will be essential too.

1. Rick Walleigh :
   July 12th, 2011 at 1:24 pm

   Good luck, but even with the best intentions, this approach will meet with serious challenges. The financial institutions will not go into this with the objective to lose money. That means that in many situations, farmers will sell their crops for less than they could have (if they had taken the risk and held the crops til harvest). The farmers will like the certainty but won’t like receiving less than spot market prices for their crops. They’ll feel as if they’re being screwed, even if they aren’t. And that assumes that the banks aren’t trying to screw them.

2. Daniel Clarke :
   November 1st, 2011 at 6:32 pm

   Todd,

   Derivatives sold to individuals often don’t make any financial sense because of the combination of cost (positive expected net transfer from individual to financial institution) and basis risk.

   Derivatives sold to large companies are often traded close to the actuarially fair price. Derivatives sold to poor individuals aren’t. Gine et al. report that in India farmers have to pay between $1.75 and $5 for $1 of expected claim payment from weather derivatives. Moreover it’s not always clear that the correlation between the net transfer from the derivative and losses on the asset to be insured are particularly high.

   The combination of cost and basis risk in a given product can mean that *nobody* should purchase the product. I have a (mostly theoretical) paper which makes this point ( http://www.economics.ox.ac.uk/.....per572.pdf ). I also analyse 31 weather derivatives sold to poor farmers and find that no risk averse expected utility maximiser would optimally purchase positive amounts.

   Banerjee and Berg (http://ageconsearch.umn.edu/handle/114240) find correlation as low as 1% for indexed products in the Philippines.

   I’m nervous about the sale of derivatives (or index insurance products) to poor farmers unless both the cost and basis risk is low. This seems very difficult to do in practice.