Risk Management

1
Risk Management

• Major thrust in agriculture
• Change in government programs
• Management is not avoidance
• No risk, no reward
• Too much risk and you may not be in business to
  receive the reward.

2
Risk definition

• A chance of an unfavorable outcome
• Not certain
• Something you want to avoid
• Production risk
• Yield, efficiency, deathloss, fire, spoilage
• Price risk
• For most commodities price risk is greater than
  production risk

3
Revenue risk

• Revenue P x Q
• Production risk impacts Q
• Price risk impacts P
• In the aggregate P and Q are inversely related
• Reduce production risk with management and
  insurance
• Hedging can reduce price risk

4
Hedging definition

• Holding equal and opposite positions in the cash
  and futures markets
• The substitution of a futures contract for a
  later cash-market transaction

5
Preharvest hedging example

• A farmer will have 50,000 bushels of corn to sell
  after harvest
• The farmer is long the cash market
• Damaged by a price decline

6
Preharvest hedging example

• To have an equal and opposite hedge the farmer
  would sell 10 corn futures contracts that expires
  near the expected marketing time.
• The farmer would short the futures
• The futures position would benefit from a price
  decline

7
Preharvest hedging example

• Step 1 Know cost of production
• Step 2 Convert futures price to local price
  using the basis
• For this farmer the historic basis for December
  corn is 0.25 under the board.
• Dec corn _at_ 2.84 gt 2.59
• Adjusting for commission 2.58

8
Preharvest hedging example

• Step 3 Call broker and place order to sell 10
  Dec Corn contracts at the market
• Step 4 Broker calls to confirm fill
• Step 5 Send margin money to broker
• 400 x 10 4,000

9
Preharvest hedging example

• Account is settled every day and the farmer must
  maintain 400/contract in margin account.
• Farmer will receive margin calls if the price
  moves higher than his futures position (2.84).

10
Preharvest hedging example

• November farmer harvests 50,000 bu
• Prices could have gone up or down
• Basis could be wider or narrower than expected

11
Hedging example Higher Prices

• Dec Corn futures 3.06
• Basis as expected -0.25
• Cash corn 2.81
• Futures position
• 2.84 - 3.06 -0.01 -0.23
• Net price 2.58

12
Hedging example Lower Prices

• Dec Corn futures 2.70
• Basis as expected -0.25
• Cash corn 2.45
• Futures position
• 2.84 - 2.70 -0.01 0.13
• Net price 2.58

13
Hedging example Basis Change

• Dec Corn futures 2.70
• Basis is wider -0.30
• Cash corn 2.40
• Futures position
• 2.84 - 2.70 -0.01 0.13
• Net price 2.53
• Difference is due to basis change

14
Hedging results

• In a hedge the net price will differ from
  expected price only by the amount that the actual
  basis differs from the expected basis.
• Basis estimation is critical to successful hedging

15
The Storage Hedge

• Store grain at harvest for sale a later date
• Protect against adverse price change
• Help earn a carrying charge
• Storage, interest

16
The Storage Hedge

• Time Cash July Fut Basis
• Nov 1 2.40 2.85 0.45
• Action store sell
• July 1 2.70 3.00 0.30
• Action sell buy
• Gain/loss 0.30 -0.15 0.15
• Net gain from storage hedge is 0.15 and is
  equal to the change in basis

17
The Storage Hedge

• Gain from a narrowing basis
• Futures increased less than cash
• Watch for historically wide basis to begin
  storage hedge in hope that the basis will narrow
• The futures position protects against falling
  prices during storage period

18
Forward Contracts

• Contract for delivery
• Defines time, place, form
• Tied to the futures market
• Buyer offering the contract must lay off the
  market risk elsewhere
• The buyer does the hedging for you

19
Forward contract advantages

• No margin account or margin call
• Working with local people
• Flexible sizes
• Known basis
• Tangible
• Simple

20
Forward contract disadvantage

• Inflexible
• Replace price risk with production risk
• Difficult to offset
• Must deliver commodity
• Buyer takes protection
• The known basis may be wider