Managing Risk in the Beef Cattle Industry Presentation to: AAEA Annual Meeting Red Deer, Alberta May 4, 2006

Managing Risk in the Beef Cattle Industry Presentation to: AAEA Annual Meeting Red Deer, Alberta May 4, 2006 Price

Introduction Our involvement began with the U.S. Livestock Risk Protection (LRP) program Recent border closure underscored shortcomings of using U.S. risk management products Recognized from the outset that no single risk management tool will appeal to all Alberta cattle producers Think long term! Where does the industry want to be 10 years from now?

Background Alberta cattle producers perceive their price risk as having 3 components: –CME futures –C$/US$ exchange rate –Basis Currently there is no single risk management tool that captures all 3 components No mechanism at all to manage basis risk

Approaches to Managing Price Risk Self insurance Diversification Reliance on government support Exchange-traded futures (CME) Exchange-traded options (CME) Forward currency market Forward cash contracts Insurance-based products

Cattle Price Insurance Program (CPIP) Background Original pre-feasibility study completed for ABP Subsequent funding was provided by the federal Private Sector Risk Management Partnerships Program (PSRMP) Insurance-based product versus financial derivative Price-related insurance is the fastest growing form of insurance in agriculture today

CPIP Basic Structure -CPIP offers insurance for various delivery periods and coverage levels…throughout the year -The orientation is that of a private insurance policy, not a government support program -Premiums and coverage levels adjust to the underlying market -The producer chooses the number of pounds to insure for each period and the coverage level -The producer pays the premium up front -The payout or indemnity is based on the difference between the Insured Price and the Index Settlement Value as of the claim date

Sample CPIP Premium Sheet

CPIP – Benefits -Insurance is a concept that is well understood and possibly more user-friendly -CPIP is based on Alberta cattle prices and will be effective under any border scenario - i.e., basis risk is covered -bundling of CME, C$/US$ and basis risk into one product -CPIP is a simple program from the producers perspective -Participation is voluntary

CPIP – Benefits (cont) -CPIP is very flexible in terms of the coverage provided -CPIP provides a predictable level of protection and easily calculated payout -CPIP can be used for disaster protection or margin management -CPIP has a fixed cost to the producer and no potential for margin calls -CPIP requires producer to think proactively about his price risk

CPIP – Key Challenges -Requires cultural change in producer attitudes toward risk -Requires construction of fed and feeder cattle indices for policy settlement -Feeder cattle are more complex and likely require more than one product -Some deficiencies in feeder cattle price data -Quantifying border risk is problematic for a private insurer

Index Design -Insurance product depends on a viable underlying index -CanFax only viable data source for fed cattle -Auction markets key data source for feeder cattle -Historical indices were created back to Note: Index can provide a platform for a variety of risk management products!

Policy Rating Methodology -CPIP similar to a put option -Underlying model used is Bermuda-Asian (FinCAD) -Non-tradability -Key inputs -volatility -forward price -Premiums are 75-85% of comparable American style options (based on recommended methodology) -Pricing border risk always reverts to the assumption used for the probability of it occurring

Summary Price insurance is one possible approach to developing a made-in-Alberta risk management product Fed and feeder cattle price indices may spawn other risk management products over time