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Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
Putting It Together Plus Brownstone
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Putting It Together Plus Brownstone

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Risk Management for Agricultural Grain Crops

Risk Management for Agricultural Grain Crops

Published in: Education, Business
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  • 1. Putting it All Together: Risk Management Decisions Nick Piggott Dept. Agricultural and Resource Economics North Carolina State University Email: [email_address] Webpage : www.ag-econ.ncsu.edu/faculty/piggott/gmark.html Perquimans, Chowan, Gates Counties North Carolina 3/19/2009 Copyright  Nick Piggott
  • 2. Agriculture is Risky <ul><li>Many types of risk </li></ul><ul><ul><li>today’s program focuses on revenue risk </li></ul></ul><ul><li>Risk management education programs typically pigeonhole/isolate the following topics: </li></ul><ul><ul><li>outlook (gauging market conditions and possible risks ahead) </li></ul></ul><ul><ul><li>marketing tools (forward contracts, hedging futures/options) </li></ul></ul><ul><ul><li>crop insurance (establishing min. production or revenues levels) </li></ul></ul><ul><ul><li>safety net (govt. programs) </li></ul></ul>Copyright  Nick Piggott
  • 3. Reality and Challenge <ul><li>An effective risk management strategy most likely includes all or some combination of the four components </li></ul><ul><li>The challenge is to first understand each individually, and then second how they interact </li></ul><ul><ul><li>interactions might be complementary or offsetting </li></ul></ul><ul><li>This is not easy! Remainder of presentation takes a graphical approach. </li></ul><ul><ul><li>Simplified. Provides a start to formulating an integrated risk management strategy for revenues </li></ul></ul>Copyright  Nick Piggott
  • 4. Revenue=Price  Quantity=P  Q Price Quantity P Q Revenue Risk: Manage P  Q; Not Just P, Not Just Q. Quantity Produced Copyright  Nick Piggott
  • 5. Price is a Random Variable Price P* Price (P) is a draw from this distribution Probability Density Function P** Prob( P >P*)>Prob( P >P**) Range Max Min Copyright  Nick Piggott
  • 6. Quantity Produced [Harv. Ac  Yield/Ac] is a Random Variable Quantity Q* Actual Production (Q) is a draw from this distribution Probability Density Function Range Max Min Q** Copyright  Nick Piggott Prob( Q >Q*)>Prob( Q >Q**)
  • 7. Offsetting Effect of P & Q Price Quantity P H Q L P L Q H P H Q L= P L Q H Copyright  Nick Piggott
  • 8. Revenue Uncertainty Price Quantity P Q Min. Rev. Max. Rev. Feasible Revenues Price Uncertainty Quantity Uncertainty Copyright  Nick Piggott
  • 9. Breakeven Revenue [ P •Q-Cost=0 ] Price Quantity Breakeven Revenue Line Profit Loss Expected Revenue Copyright  Nick Piggott Max. Rev. Min. Rev. Q P
  • 10. Challenge: Making a Profit Price Quantity Q P Low P High Breakeven Revenue Line Profit Loss Expected Revenue Copyright  Nick Piggott P Q
  • 11. Price Risk Management—Locking in a Price (P FC ) [Forward Contract] Price P FC Eliminates Downside Risk for P Eliminates Upside Potential Copyright  Nick Piggott
  • 12. Price Risk Management—Establishing a Floor (P F ) [Hedging with Put Option] Price P Eliminates Downside Risk for P P F Now P P F with Prob.=1 Copyright  Nick Piggott
  • 13. Price Risk Management: Reduce Likelihood of a Loss Price Quantity P Q P Low P High Breakeven Revenue Line Loss Price Floor Truncates Price Distribution at P F Copyright  Nick Piggott Profit P F P Q
  • 14. Government LDP Payments: [ Price Floor at Loan Rate (P LR )] Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Eliminates Some Downside Price Risk with Price Floor at P LR Copyright  Nick Piggott P Q P LR
  • 15. Marketing Strategies [ Price Floor Above P LR With Upside Potential] Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Eliminates Additional Downside Price Risk Copyright  Nick Piggott P F P Q P LR
  • 16. Production Risk Management—Establish Min. Level of Q (Q m ) [Crop Insurance APH or CRC ] Quantity Q Eliminates Downside Risk for Q Q m Now Q m Q with Prob.=1 Copyright  Nick Piggott
  • 17. Establish Min. Level of Q (Q m ) [ Crop Insurance APH or CRC ] Price Quantity Min. Rev . Max. Rev. Feasible Revenues Q m Copyright  Nick Piggott Eliminates Downside Production Risk P Q
  • 18. Price Outlook—Improved Prices Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Copyright  Nick Piggott P Q
  • 19. Combined--Govt Program, Crop Insurance, and Marketing Price Quantity Min Rev. Max. Rev. Feasible Revenues P Low P High Q m Copyright  Nick Piggott P F P LR P Q
  • 20. Combined--Govt Program, Crop Insurance, and Marketing Price Quantity P Q Max Rev. Feasible Revenues P Low P High Min Rev. Quantity Protection Price Protection Copyright  Nick Piggott P F
  • 21. Ultimate Goal of Revenue Risk Management Price Quantity Feasible Revenues Profitable & Upside Potential Preserved Breakeven Revenue Line New Min Rev. Employ strategies leading to a Min Rev. point that lies to the Right of the Breakeven Revenue Line Old Min Rev. Copyright  Nick Piggott P Q Max Rev.
  • 22. Grain Futures Markets Provide Information <ul><li>Today's best guess of what prices will be in the future </li></ul><ul><li>All forward pricing relies on futures prices </li></ul><ul><li>Participants register by taking a position in the market </li></ul><ul><li>Examples: Soybeans, Corn, and Wheat </li></ul>
  • 23. Incorporates Information from Around the World <ul><li>A farmer in North Carolina who expects a bumper crop </li></ul><ul><li>A farmer in Australia who is exporting his crop </li></ul><ul><li>Opinions regarding the next USDA report </li></ul><ul><li>A feedlot in Iowa that expects to need more grain </li></ul><ul><li>Opinions of production in other countries and their stocks </li></ul>
  • 24. Why Do Futures Markets Work? <ul><li>A large number of participants </li></ul><ul><li>Standardized: Quantity, Quality, Delivery Time and Place </li></ul><ul><li>Easy entry and exit at a low cost </li></ul><ul><li>Reduces the cost of doing business </li></ul>
  • 25. Market Participants Differ in Important Ways <ul><li>Different goals and objectives -- </li></ul><ul><li>Hedgers: Shift unwanted risk </li></ul><ul><ul><ul><li>Farmer who produces grain </li></ul></ul></ul><ul><ul><ul><li>Miller who needs grain </li></ul></ul></ul><ul><li>Speculators: Willing to assume some risk </li></ul><ul><ul><ul><li>An individual investor </li></ul></ul></ul><ul><ul><ul><li>Mutual Funds </li></ul></ul></ul>
  • 26. What is a Futures Contract ? <ul><li>Legally binding agreement to buy and sell a commodity in the future </li></ul><ul><li>Only variable is price </li></ul><ul><ul><li>Determined on the futures exchange floor </li></ul></ul><ul><li>This price once agreed upon does not change and is the price paid and received at the delivery date </li></ul>
  • 27. It Takes Two To Have A Contract <ul><li>Needs to be a buyer and seller for each contract </li></ul><ul><li>SELLER (called the short) agrees to deliver the specified quantity at the agreed upon price at the designated date in the future </li></ul><ul><li>BUYER (called the long ) agrees to purchase the specified quantity at the agreed upon price at the designated date in the future </li></ul>
  • 28. What is an option? <ul><li>An option gives one the right , but not the obligation , to purchase or sell a particular commodity at a certain price for a limited period of time </li></ul><ul><li>For this right you must pay a premium </li></ul><ul><li>Put Option: the right to SELL </li></ul><ul><li>Call Option: the right to BUY </li></ul>
  • 29. Hedging <ul><li>Trading futures with the objective of reducing or controlling risk </li></ul><ul><li>Give up chance for additional profits due to favorable price changes in return for a reduction in risk exposure to adverse changes in prices </li></ul><ul><ul><li>PRICE PROFITS </li></ul></ul><ul><ul><li>RISK REDUCTION </li></ul></ul>
  • 30. Potential Hedgers <ul><li>Potential hedgers: Anyone who must enter the cash market sometime in the future </li></ul><ul><ul><li>Grain farmers wanting to reduce exposure to price declines before selling their grain ( short ) </li></ul></ul><ul><ul><li>A miller wanting to reduce exposure to price increases before purchasing grain ( long ) </li></ul></ul><ul><li>Requires taking an opposite position in the futures market than your position in the cash market </li></ul>
  • 31. The Basic Principle of Hedging <ul><li>Gains and losses in the cash position must be offset by gains and losses in the futures position </li></ul>
  • 32. A Key Concept For Forward Pricing <ul><li>BASIS: The difference in the local cash price and the current price for a futures price for a particular month </li></ul><ul><li>Basis = Cash Price - Futures Price </li></ul><ul><li>Why does basis exist? </li></ul><ul><ul><li>Costs of storing </li></ul></ul><ul><ul><li>Cost of transportation </li></ul></ul>
  • 33. BASIS <ul><li>Reflects the local supply and demand situation </li></ul><ul><li>When basis is strong (relative to historical levels) local demand is greater than local supply </li></ul><ul><li>When basis is weak (relative to historical levels) local supply is greater than local demand </li></ul>© Piggott, Shumaker, Curtis
  • 34.  
  • 35. RECOMMENDED MARKETING STRATEGIES FOR DIFFERENT FUTURES PRICE AND BASIS RISK SITUATIONS © Piggott, Shumaker, Curtis Strong Current Basis Weak Current Basis Low Current Futures Price High Current Futures Price Basis Contract Cash Forward Contract Do Nothing Now Buy Put Option Futures Hedge Buy Put Option
  • 36. What Have We Learned? <ul><li>There are tradeoffs with adopting a forward price strategy of forward contracting or hedging </li></ul><ul><li>Benefits </li></ul><ul><ul><li>Reduced Price Risk </li></ul></ul><ul><li>Costs </li></ul><ul><ul><li>Give up the possibility of larger profits in a favorable cash market </li></ul></ul>
  • 37. Final Thoughts <ul><li>Risk management is NOT free and will never prove to be the most profitable strategy in every marketing year. </li></ul><ul><li>Over a longer horizon [6 to 10 years] an effective risk management plan will provide less volatile returns. </li></ul><ul><ul><li>Potentially avoiding a catastrophic marketing year </li></ul></ul><ul><li>Establishing profitable minimum revenues and leaving upside potential is the key. </li></ul><ul><ul><li>Most viable instruments to do this are: put options, CRC insurance, basis contracts </li></ul></ul>Copyright  Nick Piggott
  • 38. NASCAR ANALOGY <ul><li>To become Nextel Cup Champion you want to do well in every race (run in the top five) and avoid hitting the wall and getting a DNF. You also want to give yourself the opportunity to win and be with the leaders in the final laps. </li></ul><ul><li>The same is true with marketing. If you can establish a minimum revenue above your breakeven level then you will avoid a loss in any year [hitting the wall]. You also put yourself in a position to lock in a better than average profit if the opportunity arises in a given marketing year [taking the checkered flag] . </li></ul>Copyright  Nick Piggott

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