The effects of option hedging on the costs of domestic price stabilization schemes

Casual observation leads to the conclusion that stabilization funds tend to be short-lived. While it may be that some funds have failed due to poor management or unwarranted political interventions, the stochastic components of commodity prices can generate insurmountable difficulties for even the most expert managers. Price-band schemes contain an element of information feed-back and offer transparent rules -- attributes which make such schemes preferable to many alternative mechanisms -- but the benefits to producers tend to be, on average, quite small. Similar average benefits can be generated with very small import taxes or producer subsidies. Nevertheless, such schemes can have large single-year effects. The simulation results demonstrate that, if adopted, such funds should be hedged unless the government is not at all adverse to the fund's financial failure. Still, hedged or unhedged, such funds will, with eventual certainty, generate large levels of debt as a statistically"rare"sequence of events must eventually occur. By hedging, the funds are more likely to survive in the short-run.