Background• United Grain Growers (UGG) is one of the Canada oldest grain distributors in Canada.• The agriculture business was risky. Anything that affected the quantity of grain shipped had a material impact on the firm’s revenues, profits and cash flow.• UGG was still faced with the problem of how to deal with the biggest risk: the weather• UGG has to identify the principal risks of the corporation’s business and ensuring the implementation of appropriate systems to manage these risks.
Agriculture and inparticular industry was one of civilization’s oldest industriesThe industry is quite volatile, characterizes by boom and bust cycles, and its roots in the forces of supply anddemand in the global market Grain supplies were variable due to natural forces such as pests, disease and weather.
To reduce volatility, many countries create policies inCanada for wheat (barley andoats/board gain) regulated by Three largestCanadian Wheat Board (CWB) distributor in that mandated monopsony 1998 were Saskatchewan Wheat Pool,Grain distributor like UGG Agricore, and were important UGGintermediateries between the farmer and the end market.
The Canadian agriculture industry was under pressure from several directions, and many farmers disagreed with CWB policies and its In 1995, goverment monopsony power. repealed legislation that kept gain transportation cost fixed (and low) for many years, and reviewing other grain transpotation and distribution systems.
Since 1993, derive about United Grain Growers 70% of its income from grain operation Strategy: UGG spent about $65 To modernize its grain handlingmillion on acquiring and business Issued building its non-grain limited To provide handling business voting farmers with 1993 common services beyond restructured shares on grain handling itself as a TorontoBuild new HTP elevators, public Stock corporation Exchangeupgrade existing elevator, Established funding activities in 1906Initial Public Offering Core Division Grain Handling Merchandising
The Industry Climate 1955 - New Industry regulation - Poor harvest contribution - Railroads began consolidating routes - Distributors can set their own tariffs - Higher grain prices- Four out of the five major competitors lost money in the handling business- UGG had to take $12.5 million charge to close 93 country elevators
The Industry Climate Manitoba Pool Alberta Pool Takeover UGG Elevators Rather than suffer substantial dilution of their existing investment, the bidders withdrew their offer Two bidders merged from Agricore
The Industry Climate• UGG formed a strategic ADM would gain “a secure grain supply alliance with Archer for its processing operations” Daniels Midland Company UGG could “plan more efficiently for future transportation and grain handling demands, and increase market shares• UGG also formalized a partnership with Marubeni Corporation
The Willis Report 1992, shareholders successfully sued their directors because the firm did not hedge its grain risk when prices were falling Emerging interest in risk management prompted UGG to participate in abenchmarking review of best risk management practices in its Treasury department
On site Risk BrainstormingFebruary 11, 1997, twenty UGG senior managersand other employees met for an on site riskbrainstorming, with task : 1. to identify the risk the firm faced 2. to rank them, by polling the group, in relative importance to the firm
Willis AttentionWillis focused its attention on the first group ofsix which included : A. commodity price risk B. inventory management risk C. customer and supplier counterparts risk D. account receivable and credit risk E. environmental risk F. weather risk
Earnings at Risk (EaR) Which had been developed by the financial community, to describe aggregate risk. EaR expressed a "worst- case" loss, set against a benchmark of expected profit, within a specified confidence or probability level.
CHARMCHARM (Comprehensive Holistic All Risk Model)generated graphical output in several formats tohighlight the various aspect of each risk.The most general format was a probabilitydistribution showing the probability of incurringa loss as a function of the size of the dollar loss .Cox had the information to do something toimprove the firms risk management performanceand potentially reduce UGGs long term cost ofrisk
What to do about the weather ?• Five of the six risk could be managed through traditional methods.• But about the weather risk ? – No financial products that would effectively mitigate the weather risk – Innovation to mitigate : weather derivatives pay a specified amount of money as a function of a particular weather characteristic
Six Major Risk Risk Instance(s) Earning at Risk Possible Alternatives Weather Impact on harvested 11.5 Weather Derivatives yields and InsuranceEnvironment Toxic waste 2.5 Insurance and controlCounterparty Failure of Supplier 4.3 Diversification/Due diligence/Contract Credit Payment Failure 1.6 Diversification/Due diligence/Contract Inventory Spoilage of Inventory, 2.2 Operational Control, UnderStock/OverStock and InsuranceCommodity Price Fluctuation 11.9 Futures and Options
List of RiskBusiness interruption Employee liability Pension plan performanceCargo/marine exposure Employee performance ProcessCivil disturbance /fidelity compliance/executionCommodity basis/ price environmental Product liabilityCompetition Foreign exchange Product performanceConsumer preferences Head office catastrophe Quebec separates from Industrial espionage CanadaContractual no-performance Intellectual property R&D venturesCredit/receivables Interest rates Regulatory (CWB, transportation)Counterparty Inventory Stock market crashDirectors & officers Labor strikeexposure Leverage (too much or too Strategic planningData accuracy little) Technology (choice, use of)Disease/spoilage Loss of key personnel transportationComputer system failure Mergers and acquisition unionizationEmployee injury Major property exposure weather
Willis Group Assessment 1 Weather 2 Environment Liability The Major Risks are 3 Counterparty 41Risks 4 Credit 5 Inventory 6 Commodity
All-Wheat yield in Saskatchewan and the July precipitation for 1960 through 1992The modeled yields, in turn, explained approximately 94% of the variability of UGG’sgrain handling earning. The yield depends on the rain according to the regressionequation Yield=15.5+0.0577*Rain, R-squared = 43%.
Comprehensive Holistic All Risk Model CHARM CHARM plot showing the probability distribution of earning with and without the impact of the weather. When the weather risk is removed, the variation in EBIT is smaller, as shown by the lighter curve, though expected value is the same. The probability showing incurring a loss as a function of the size of the dollar loss.
Definition: What is Value at Risk?• Summary statistic that quantifies the exposure across many assets/liabilities classes to market risk.• Identifies ‘How Much’ one can loses if adverse market conditions prevail.• Captures diversification or Portfolio Effect.• Measurisk Approach – Full Monte-Carlo Valuation-based without approximations – Risk calculation based on evaluation of log changes in market instruments – Method allows modeling of entire distribution of expected profits and losses and shape of risk surface over time and tail risk Nasdaq Drop Asian Flu Drop Nasdaq 95% VaR Euro Rally
Earnings at Risk and Corporate Treasury• Longer time horizon than traditional asset management • Multi-Step Monte Carlo • More data needed to define covariance matrix• View of multiple time horizons (I.e. Each quarter of the fiscal year)• Quantify risk across business lines• Ability to optimize trading activities - view impact of different hedging strategies
Earnings at Risk• Measure of earnings volatility• Income Statement Perspective• Used to define risk appetite• Can help answer “What should be hedged?”• Focus on market moves to: – FX Rates – Interest Rates – Commodity Prices• Perspective: Basket of Exposures (“Portfolio Effect”)
The Estimation of the 6 Major Risks Risk Instance(s) Earning at Risk Possible Alternatives Weather Impact on harvested 11.5 None yieldsEnvirontment Toxic waste 2.5 InsuranceLiability Counterparty Faliure of Supplier 4.3 Diversivicaiton/DD/Cont ract Credit Payment Failure 1.6 Diversivicaiton/DD/Cont ract Inventory Spoilage of Inventory, 2.2 Operational Control UnderStock/OverStock Commodity Price Fluctuation 11.9 Insurance/ Futures
The top 6 Risk based on its severe risk 2. Environmental 1. Weather Liabilities 3. Credit • Its effect on grain volume • The Toxic waste released to • The Failure of UGG Partner would disturb the Business external environment could to pay their Debt to UGG raise social risk and could would Disturb UGG Cash raise penalty from Flow government 4. Commodity 5. Couterparty Exposure 6. Inventory • The Fluctiation of • The Probability of UGG • The Understock condition Commodity Price could Suppliers (Upstream and might result the loss of result a severe Downstream) not to market opportunity disturbance to UGG meet their contract • The Overstock inventory business obligation would result higher risk since the grain price are very fluctuative
Weather Risk Exposure 1 ALTERNATIVE RISK MANAGEMENT APPROACHES Retention Weather DerivativesThe Insurance Contract Idea
• First, UGG had been and planned to continue making large investments in storage facilities (grain elevators).• Second, the variability in its cash flows caused UGG to hold extra equity capital as a cushion against unexpected low cash flows in any given year.• Third, although much of UGG’s current business could be characterized as a commodity business, UGG tried to distinguish itself from competitors by creating products 7 with brand names and by providing on- going services to customers
• Weather derivatives were a relatively new risk management tool.• A contract could be tailored on a number of dimensions to meet the specific needs of the buyer.• For simplicity, the illustration assumes that the relationship between gross profit and the weather index is linear. Since low values of the weather index correspond to low expected profits for UGG, a derivative contract that would pay UGG money when the index is low would provide a hedge.• Hedging their weather risk with derivatives was feasible, but it suffered from several difficulties. Although Willis had performed a sophisticated analysis of the effect of weather on UGG’s gross profit, the results of this analysis had to be converted into a desired contract structure.
The Insurance Contract Idea• UGG knew that the primary reason weather was important was because weather affected UGG’s grain shipments.• The obvious problem with such a contract is the moral hazard problem – UGG’s pricing and service also influences its grain shipments.• One solution to this problem was to use industry-wide grain shipments as the variable that would trigger payments to UGG.• UGG also considered the possibility of integrating grain volume coverage with UGG’s other insurance co• Willis then contacted several major commercial insurers, including a division of the large reinsurer Swiss Re, called Swiss Re New Markets. Located in New York, this group structured innovative risk financing deals for commercial entities.
Risk Assessment to the weather problem Estimate probability distribution of and correlation among losses Measure the expected loss individually and in combination on ROE, EVA, EBIT Changes in weather was ranked the highest source of risk Grain volume and lagged crop yields highly positively correlated Relationship between weather and gross profit Weather >>> Crop Yields >>>> Grain Volume >>>> Gross Profit
Environment Liabilities, Credit, Commodity, Conterparty and Inventory Risk Exposure Environment Liabilities2 -Insurance - Increase Control Credit 3 - Diversivication of parnership to avoid depedency with limited number of partners - Be more selective to choose partner Commodity4 -Futures - Options Counterpart 5 - Diversivication of parnership to avoid depedency with limited number of partners - Be more selective to choose partner Inventory6 -Increase Control - Insurance
Suggestion and ConclusionWe propose the use of insurance for the weather uncertainty (option 3) due :1. Broader Loss Coverage, not only weather risk2. The premium of insurance cost can be reduced3. Company would much more safe