Financial Instruments to Hedge Commodity Price Risk for Developing Countries

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Many developing economies are heavily exposed to commodity markets, leaving them vulnerable to the vagaries of international commodity prices. This paper examines the use of commodity options—including plain vanilla, risk reversal, and barrier options—to hedge such risk. It then proposes the use of a new structured product—a sovereign Eurobond with an embedded option on a specific commodity price. By extracting commodity price risk out of the bond, such an instrument insulates the bond default risk from commodity price movements, allowing it to be marketed at a lower credit spread. The product is also designed to help developing countries establish a credit derivatives market, which would in turn enhance th