Commodity prices have exhibited a downward trend relative to the prices of manufactures, and more recently also in nominal terms, for at least a century and probably longer (Grilli and Yang, 1988). However, the pace of this fall varies from commodity to commodity, and, even more markedly, from one decade to another (Gilbert, 2003).
This negative trend is generally regarded as resulting from the effects of productivity-enhancing technical change in production and intermediation processes, which, in the case of manufactures, is partly reflected in higher product quality and specifications (Lipsey, 1994). It seems likely that most primary prices will continue to fall relative to manufactures prices, but there is no reliable means of knowing by how much and which commodities, if any, will be exceptions to this pattern. This variable trend poses problems for any attempt to link debt service payment to commodity prices.
The swap and swaption schemes considered above would give borrowing countries the benefit of repayments based on floating commodity prices for the entire lifetime, perhaps up to 40 years, of a concessional loan. It is clearly not possible to forecast likely levels of any commodity price over this type of horizon.
This implies that extreme caution should be exercised in making commitments in relation to the absolute level of any price over a horizon of this length. If commodity prices continue to decline, floating for fixed swaps would give a very considerable benefit, but one achieved at the expense of the lending countries. But they would also impose upon them the risk that scarcity might eventually reverse the downward trend of the past century. These risks will probably not be countenanced, certainly by lenders, but possibly also not by borrowers.
For these reasons, we modify the instrument structures so that, in technical terms, they have time-varying strike prices. The cost is that the arrangements we discuss can contribute relatively little to issues of debt sustainability over the longer term.
The initial price P0 in schemes considered above acts as the contract strike price. These are fixed strike instruments. Generalization to a floating strike is straightforward, simply by replacing P0 and Q0 in equations (3-7) by time-subscripted prices
This notation reflects the commodity agreement and compensatory finance practice in which P avt and Q avt are moving averages of past prices. We now have a 2x2 matrix of possibilities:
The upper row defines the schemes considered in equations (3-7) and Figure 1. In what follows, we confine attention to schemes defined by the lower row of the table.
By Prof. Christopher L. Gilbert, Prof. Alexandra Tabova
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Summary: Index