Our focus in many of our derivatiViews to date has been on the effects, often unintended, of global regulatory efforts on derivatives markets. Every now and then, however, it’s refreshing to read about the continuing innovation and targeted solutions that have been, and we are confident will continue to be, a hallmark of the derivatives business.
A case in point is the solution that the World Bank is delivering through a program in Malawi. The World Bank, of course, was party to what is widely considered to be the first swap three decades ago. They have continued to be an active user of derivatives to manage their significant interest rate and currency exposures. What is perhaps less widely known is that, in connection with their extensive programs in developing countries, they are providing innovative solutions to chronic problems faced by those countries’ economies.
Weather derivatives have been around for over a decade. The World Bank’s structuring of a weather risk management transaction in Malawi delivers a custom-tailored solution to address fluctuations in rainfall and, therefore, production of maize, a critical part of the Malawi economy where agriculture contributes 38 percent of GDP.
In order to provide the protection desired, an index was constructed, the Malawi Maize Index, that reflects the typical yield in maize production per hectare. The index consists of several fixed parameters and one variable factor, precipitation. When rainfall falls below a certain level, the index provides a projection of the loss in maize production, with compensation to Malawi for the shortfall.
As with many derivatives, the structure responds to a specific need with a carefully developed solution. Its effectiveness also relies on access to reliable historical data so that models of maize production can be projected with a reasonable degree of accuracy. In this case the Malawi government has been using a production model since 1992, so almost two decades of information was factored in.
The World Bank manages its exposure by entering into an offsetting arrangement with a market counterparty, in this case Swiss Re, which in turn can choose to hold onto that risk or similarly hedge its exposure.
Cost was an important consideration for Malawi, which paid a premium for this option. This may be a small transaction in a tiny corner of the global derivatives world, but it is important to keep these cost considerations in mind. Users of derivatives will ultimately bear the cost of regulatory reform through higher prices for the products they use. For some that may mean choosing not to manage a risk, leaving themselves exposed to the underlying risks they face in their business or, as in this case, for an entire country’s economy.
Rain and maize are, at some level, no different from rates and credit. For the derivatives business, they are variations on the theme of understanding your risks and being innovative in managing them. Let’s not lose sight of that essential truth.