This post is written by Gloria Kessler, Agricultural Marketing Advisor/Agricultural Economist, USAID/BFS.

Cash crops such as coffee and cocoa – are often high-risk, high-return crops which can provide great incomes for smallholders when prices are high, but can leave them unable to earn a living when prices are low.

In addition to the short-term income losses, low prices can push farmers into a poverty trap from which it may be difficult to recover. Farmers can default on loans, and eventually even lose productive assets, making it difficult to get back to working profitably if the price shock is severe enough. The current situation of low international coffee prices points to the importance of developing price risk management skills, tools, and broader strategies before market prices lead to a crisis situation among smallholder producers.

But price volatility can damage profitability – and eventually damage market linkages – through unusually low prices and high prices. High prices can increase the temptation for farmers to break agreements with farm gate buyers (side sell). This, in turn, makes some farm gate buyers unable to fulfill their contracts with larger-scale buyers – and can even drive some farm gate buyers out of business. Reducing the number of farm gate buyers eventually shifts bargaining power increasingly away from farmers, often forcing them to sell their crop for whatever price they are offered.

Many cooperatives provide much-needed security to farmers by guaranteeing their producers a minimum price for their crops (often offering a second payment as well based on market prices). However, if cooperatives agree to buy crops from farmers for a certain price, and then market prices increase, farmers may side sell, making it difficult for coops to fulfill any set contracts with buyers. Alternatively, if market prices drop very low – and this happens before cooperatives finalize contracts with buyers – cooperatives are likely to take a loss when they sell, undermining their long-term financial stability.

Financial hedging instruments, such as put and call options, are used by some cooperatives (and other kinds of buyers) as a kind of “price insurance” – protecting buyers and sellers from prices that are very high or very low. This “price insurance” can help maintain long-term buyer and seller relationships during high and low prices, strengthening the broader market system. And the more consistent income that can be achieved through price risk management facilitates long-term planning and investment. However, these tools entail a cost and a certain level of capacity to be used effectively. Some cooperatives (and other kinds of buyers) may not yet be ready to incorporate financial hedging instruments into a price risk management strategy. In these cases, helping cooperatives (and other buyers) understand how their buying and selling practices may expose them to price risk can be a powerful first step towards ensuring cooperatives provide sustainable benefits to their farmers, and that buyers remain in business – contributing to thriving, competitive markets.

Learn more at the resource sidebar about coffee and cocoa price risk management tools and strategies – and the conditions necessary for them to function effectively – with a special focus on coffee in Guatemala and Honduras.