MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN AGRICULTURE

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MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN
AGRICULTURE

• Garth A. Baker
• Director of Research,
• Caribbean Institute for the Mathematical Sciences
  
• Nothing is more practical than a good theory
  -- Descartes

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DOMINICA QUANTCONSORTIUM ON AGRICULTURE

• PARTICIPATING INSTITUTIONS ( March 8. 2004 )
•  
• Dominica Banana Producers Limited ( DBPL )
• Nature Island Pineapple Producers Association (
  NIPPA )
• Caribbean Agricultural Research and Development
  Institute (CARDI)
• Caribbean Institute for the Mathematical
  Sciences ( CIMS ) 
• OECS Export Development Unit ( OECS-EDU )
•  Dominica Export Import Agency ( DEXIA )
•  Windward Islands Crop Insurance Limited (
  WINCROP )
• Centre de Cooperation Internationale en
  Recherche Agronomique pour le Development ( CIRAD
  ), Paris, France
• EMPLOY SCIENTIFIC RESEARCH TO PILOT BUSINESS
  INITIATIVES
• IN THE FORM OF JOINT VENTURES

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• SUBSISTENCE FARMING INTERNATIONALLY
  COMPETITIVE
• Revive the banana industry
• Diversification (pineapples)
• OPTIMIZATION OF PRODUCTION
•  q       What does the market want?
• q       Organize production to fit the market.
  Take the guesswork out of production
• q       Use accurate, scientific crop forecasting

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. 
PROTECT INVESTMENTS

• q       Affordable catastrophe insurance. Can
  fine structure
• modeling for the Caribbean improve
  catastrophe
• insurance pricing?
• q       Hedge market risk with financial
  instruments. Take the
• uncertainty out of export marketing.
• q       Affordable insurance for crops other than
  bananas.
• Affordable comprehensive insurance, including
  
• coverage for drought, flood and possibly
  disease.

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REGIONAL CONSOLIDATION

• q       Lower production costs.
•  
• q       Acquire greater market share.
•  
• q       Distinguish Caribbean product aim for
• niche market.
• q   Optimal transportation networks dynamic
• scheduling

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• The only thing that is certain is that nothing
  is certain.
• Pliny the elder
• Historia Naturalis
•  
• Common sense is not so common.
•   Voltaire
•  
•   A fool must now and then be right by chance.
• William Cowper
• Conversations

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RISK PREDICTION AND MANAGEMENT

• q       Quantitative determination or estimate
  of Risk
•  
• Determine probabilistically
  all possible cases between the extremes
•  
• Maximum Likelihood Scenario
• Worst Case Scenario
• q       Insurance
•  
• q       Reinsurance
•  
• q       Alternative Risk Transfer
• Securitization of Agricultural Insurance
  Risk
•       
• q   Portfolio Management
• Fixed income securities / Hedge Funds
•  

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PUT OPTIONS
  Most business and financial transactions are
a gamble wherein the buyer hopes to be buying
low, and the seller hopes to be selling high. One
side is always doomed to disappointment. Peter
Bernstein, economic consultant, 1996.   Every
act of production is a speculation in the
relative value of money and the good produced.
Frank Knight, economist, 1977. Farmers stand to
benefit from high sale prices and are vulnerable
to low sale prices in symmetric contrast,
supermarkets/ processors tend to benefit from low
sale prices and high sale prices are threatening
to them.
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CONTRACTS

• I. Each farmer pays the bank a premium, say 3
  Arawak, for the right to sell the produce
  ( through or to the bank) at the prearranged
  price of 100 Arawak, within a designated period
  of time, say up to December 31. The farmer has
  the option to exercise this right to sell at the
  specified price or not, during the period of
  validity of the contract. Should the farmer opt
  to sell, the bank is legally bound to make the
  purchase.

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CONTRACTS

• II. Each supermarket/processor pays the bank
  a premium, say 5 Arawak, for the right to buy the
  produce (through or from the bank) at the
  prearranged price of 100 Arawak, during the
  period up to January 1. The supermarket/processor
  has the option to exercise this right to buy at
  the specified price or not, during the period of
  validity of the contract, and should the
  supermarket/processor opt to buy at any such
  time, the bank is legally bound to effect the
  sale.

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LOW SALE PRICE

• If the actual market sale price at the time of
  sale, (December 31,) is below 100, say 70,
  then
•       The bank pays the difference, 30, to the
• farmer
• The farmer obtains 100 3 97
•   The supermarket/processor looses
• their premium, but in effect pays 70
  5
• 75, thus making a profit of 25.

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HIGH SALE PRICE

• If the actual market sale price happens to be
  above 100, say 122, at the time of purchase,
  (January 1), then
• The bank pays the difference, 22, to the
• supplier.
• The supermarket pays 100 5 105, in
• effect.
• The farmers loose their premium, but in
  
• effect sell at 122 3 119, yielding a
• profit of 19.

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OPTION PRICING
Fischer Black -----Arthur D. Little Myron
Scholes ----M.I.T.
1973 Robert Merton ----M.I.T. time, interest
rates, price spread, volatility 1997 Nobel
Prize in Economics Louis Bachelier , These,
Universite Paris, 1900 Chicago Board Options
Exchange, April 1973
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   A B C ? ?
? X Y Z  
Investment Bank Insurance/Reinsurance Securities
Exchange ( OECS/ CARICOM )
 
FARMERS
MARKETERS
SUPERMARKETS PROCESSORS

REGULATORY BODY   What types of contracts are
best suited for hedging market risk in
agriculture (volatility) to protect OECS producer
marketing processing chain ? How are these
contracts to be managed and overseen, with
transparency and international legal credibility?
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CIMS Perspective on Risk Management at the
Macro-Level

• Portfolio Management alla Markowitz (1954 )
• Diversification should be pursued based
  upon optimization critera, taking into account
  both market information and agro-ecological
  conditions and economic and social constraints.
  i.e. market driven optimization of production
  however, what is to be optimized is the
  performance of the portfolio as a whole over
  time. The relevant question is What (diverse)
  combination of crops yields optimality? Value at
  Risk type analysis.
• Insurance and other financial instruments for
  macro-level risks.
• Computer simulation for stress analysis test
  all the what if scenarios credit risks, credit
  futures, credit options?
• Special financial conglomerate for macro-level
  finance, insurance and reinsurance. Credit Bank /
  Insurer / Reinsurer / Securities Trader / Trade
  Finance . . . expand WINCROP?
• Regional Portfolio Optimisation?

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Alan Greenspan, Chairman of the Federal Reserve
Board   Lecture at the University of Utha,
November 1994  
There are some who would argue that the role of
the bank supervisor is to minimize or even
eliminate bank failure but this view is mistaken
in my judgment. The willingness to take risk is
essential to the growth of a free market economy
. . . If all savers and their financial
intermediaries invested only in risk-free assets,
the potential for business growth would never be
realized.
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SOOTHSAYER Beware the ides of March.
CAESAR He is a dreamer let us leave him

Julius Caesar,
Act I, Scene II
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DUKE SENIOR ( in exile )

• Sweet are the uses of adversity
• Which, like the toad, ugly and venomous,
• Wears yet a precious jewel in his head
• As You Like It
• Act II, Scene I.