putting it together plus brownstone

Putting it All Together: Risk Management Decisions

Nick PiggottDept. Agricultural and Resource Economics

North Carolina State University

Email: [email protected]

Webpage: www.ag-econ.ncsu.edu/faculty/piggott/gmark.html

Perquimans, Chowan, Gates Counties

North Carolina

3/19/2009

Copyright Nick Piggott

Agriculture is Risky• Many types of risk

– today’s program focuses on revenue risk

• Risk management education programs typically pigeonhole/isolate the following topics:– outlook (gauging market conditions and possible

risks ahead)– marketing tools (forward contracts, hedging

futures/options)– crop insurance (establishing min. production or

revenues levels)– safety net (govt. programs)


Reality and Challenge • An effective risk management strategy most

likely includes all or some combination of the four components

• The challenge is to first understand each individually, and then second how they interact – interactions might be complementary or

offsetting

• This is not easy! Remainder of presentation takes a graphical approach.– Simplified. Provides a start to formulating an

integrated risk management strategy for revenues


Revenue=PriceQuantity=PQ

Price

Quantity

P

Q

Revenue Risk: Manage P Q; Not Just P, Not Just Q.

Quantity

ProducedCopyright Nick Piggott

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 MaxMinCopyright Nick Piggott

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 MaxMin

Q**


Prob(Q>Q*)>Prob(Q>Q**)

Offsetting Effect of P & Q

Price

Quantity

PH

QL

PL

QH

PH QL= PL QH


Revenue Uncertainty

Price

Quantity

P

QMin. Rev.

Max. Rev.

Feasible Revenues

Price Uncertainty

Quantity Uncertainty


Breakeven Revenue[P•Q-Cost=0]

Price

Quantity

BreakevenRevenueLine

Profit

Loss

Expected Revenue


Max. Rev.

Min. Rev. Q

P

Challenge: Making a Profit

Price

QuantityQ

PLow

PHigh


Profit

Loss

Expected Revenue


P

Q

Price Risk Management—Locking in a Price (PFC) [Forward Contract]

PricePFC

Eliminates Downside Risk for P

Eliminates Upside Potential


Price Risk Management—Establishing a Floor (PF)

[Hedging with Put Option]

PriceP

Eliminates Downside Risk for P

PF

Now P PF with Prob.=1


Price Risk Management: Reduce Likelihood of a Loss

Price

Quantity

P

Q

PLow

PHigh


Loss

Price Floor Truncates Price Distribution at PF


Profit

PF

P

Q

Government LDP Payments: [Price Floor at Loan Rate (PLR)]

Price

QuantityMin. Rev.

Max. Rev.

Feasible Revenues

PLow

PHigh

Eliminates Some Downside Price Risk with Price Floor at PLR


P

Q

PLR

Marketing Strategies[Price Floor Above PLR With Upside Potential]

Price

QuantityMin. Rev.

Max. Rev.

Feasible Revenues

PLow

PHigh

Eliminates Additional Downside Price Risk


PF

P

Q

PLR

Production Risk Management—Establish Min. Level of Q (Qm)

[Crop Insurance APH or CRC]

QuantityQ

Eliminates Downside Risk for Q

Qm

Now Qm Q with Prob.=1


Establish Min. Level of Q (Qm)[Crop Insurance APH or CRC]

Price

QuantityMin. Rev.

Max. Rev.

Feasible Revenues

Qm


Eliminates Downside Production Risk

P

Q

Price Outlook—Improved Prices

Price

QuantityMin. Rev.

Max. Rev.Feasible Revenues

PLow

PHigh


P

Q

Combined--Govt Program, Crop Insurance, and Marketing

Price

QuantityMin Rev.

Max. Rev.

Feasible Revenues

PLow

PHigh

Qm


PF

PLR

P

Q

Combined--Govt Program, Crop Insurance, and Marketing

Price

Quantity

P

Q

Max Rev.

Feasible Revenues

PLow

PHigh

Min Rev.

Qu

antity P

rotectio

n

Price Protection


PF

Ultimate Goal of Revenue Risk Management

Price

Quantity

Feasible Revenues Profitable &

Upside Potential Preserved


NewMin Rev.

Employ strategies leading to a Min Rev. point that lies to the Right of the Breakeven Revenue Line

OldMin Rev.


P

Q

Max Rev.

Grain Futures Markets Provide Information

• Today's best guess of what prices will be in the future

• All forward pricing relies on futures prices • Participants register by taking a position in

the market• Examples: Soybeans, Corn, and Wheat

Incorporates Information from Around the World

• A farmer in North Carolina who expects a bumper crop

• A farmer in Australia who is exporting his crop• Opinions regarding the next USDA report• A feedlot in Iowa that expects to need more grain• Opinions of production in other countries and their

stocks

Why Do Futures Markets Work?

• A large number of participants

• Standardized: Quantity, Quality, Delivery Time and Place

• Easy entry and exit at a low cost

• Reduces the cost of doing business

Market Participants Differ in Important Ways

Different goals and objectives --• Hedgers: Shift unwanted risk

• Farmer who produces grain• Miller who needs grain

• Speculators: Willing to assume some risk• An individual investor• Mutual Funds

What is a Futures Contract?

• Legally binding agreement to buy and sell a commodity in the future

• Only variable is price– Determined on the futures exchange

floor• This price once agreed upon does not

change and is the price paid and received at the delivery date

It Takes Two To Have A Contract

Needs to be a buyer and seller for each contract

• SELLER (called the short) agrees to deliver the specified quantity at the agreed upon price at the designated date in the future

• BUYER (called the long) agrees to purchase the specified quantity at the agreed upon price at the designated date in the future

What is an option?

• 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

• For this right you must pay a premium

• Put Option: the right to SELL

• Call Option: the right to BUY

Hedging• Trading futures with the objective of

reducing or controlling risk• Give up chance for additional profits due

to favorable price changes in return for a reduction in risk exposure to adverse changes in prices

PRICE PROFITS

RISK REDUCTION

Potential Hedgers• Potential hedgers: Anyone who must enter the cash

market sometime in the future– Grain farmers wanting to reduce exposure to

price declines before selling their grain (short)– A miller wanting to reduce exposure to price

increases before purchasing grain (long)

• Requires taking an opposite position in the futures market than your position in the cash market

The Basic Principle of HedgingGains and losses in the cash position must be offset by gains and losses in the futures position

C a s h F u t u r e s N e tM a r k e t M a r k e t R e s u l t

G a i n L o s s N e u t r a l

L o s s G a i n N e u t r a l

A Key Concept For Forward Pricing

• BASIS: The difference in the local cash price and the current price for a futures price for a particular month

Basis = Cash Price - Futures Price

• Why does basis exist?– Costs of storing– Cost of transportation

© Piggott, Shumaker, Curtis

BASIS• Reflects the local supply and demand

situation

• When basis is strong (relative to historical levels) local demand is greater than local supply

• When basis is weak (relative to historical levels) local supply is greater than local demand

-$0.35

-$0.30

-$0.25

-$0.20

-$0.15

-$0.10

-$0.05

$0.00

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Average Soybean Basis Elizabeth City 1980-2007

© Piggott, Shumaker, Curtis

RECOMMENDED MARKETING STRATEGIES FOR DIFFERENT FUTURES PRICE AND BASIS RISK

SITUATIONS

Strong Current Basis

Weak Current Basis

Low CurrentFutures

Price

High CurrentFutures

Price

Basis Contract Cash Forward Contract

Do Nothing NowBuy Put Option

Futures HedgeBuy Put Option

What Have We Learned? • There are tradeoffs with adopting a forward

price strategy of forward contracting or hedging

• Benefits– Reduced Price Risk

• Costs– Give up the possibility of larger profits in a

favorable cash market

Final Thoughts

• Risk management is NOT free and will never prove to be the most profitable strategy in every marketing year.

• Over a longer horizon [6 to 10 years] an effective risk management plan will provide less volatile returns.– Potentially avoiding a catastrophic marketing year

• Establishing profitable minimum revenues and leaving upside potential is the key. – Most viable instruments to do this are: put options,

CRC insurance, basis contracts


NASCAR ANALOGY

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.

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] .


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