Risk Management u Major thrust in agriculture u Change in government programs u Management is not avoidance –No risk, no reward –Too much risk and you may not be in business to receive the reward.

Risk definition u A chance of an unfavorable outcome –Not certain –Something you want to avoid u Production risk –Yield, efficiency, deathloss, fire, spoilage – Price risk u For most commodities price risk is greater than production risk

Revenue risk u Revenue = P x Q –Production risk impacts Q –Price risk impacts P u In the aggregate P and Q are inversely related u Reduce production risk with management and insurance u Hedging can reduce price risk

Hedging definition u Holding equal and opposite positions in the cash and futures markets u The substitution of a futures contract for a later cash-market transaction

Preharvest hedging example u A farmer will have 50,000 bushels of corn to sell after harvest –The farmer is long the cash market »Damaged by a price decline

Preharvest hedging example u To have an equal and opposite hedge the farmer would sell 10 corn futures contracts that expires near the expected marketing time. –The farmer would short the futures »The futures position would benefit from a price decline

Preharvest hedging example Step 1: Know cost of production Step 2: Convert futures price to local price using the basis For this farmer the historic basis for December corn is $0.25 under the board. Dec $2.84 =>$2.59 Adjusting for commission$2.58

Preharvest hedging example u Step 3: Call broker and place order to sell 10 Dec Corn contracts at the market u Step 4: Broker calls to confirm fill u Step 5: Send margin money to broker –$400 x 10 = $4,000

Preharvest hedging example u Account is settled every day and the farmer must maintain $400/contract in margin account. u Farmer will receive margin calls if the price moves higher than his futures position ($2.84).

Preharvest hedging example u November: farmer harvests 50,000 bu u Prices could have gone up or down u Basis could be wider or narrower than expected

Hedging example Higher Prices Dec Corn futures =$3.06 Basis as expected-$0.25 Cash corn$2.81 Futures position $ $0.23 Net price$2.58

Hedging example Lower Prices Dec Corn futures =$2.70 Basis as expected-$0.25 Cash corn$2.45 Futures position $ $0.13 Net price$2.58

Hedging example Basis Change Dec Corn futures =$2.70 Basis is wider-$0.30 Cash corn$2.40 Futures position $ $0.13 Net price$2.53 Difference is due to basis change

Hedging results u In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis. u Basis estimation is critical to successful hedging

The Storage Hedge u Store grain at harvest for sale a later date u Protect against adverse price change u Help earn a carrying charge –Storage, interest

The Storage Hedge TimeCash July FutBasis Nov 1$2.40$2.85$0.45 Actionstoresell July 1$2.70$3.00$0.30 Actionsell buy Gain/loss+$0.30-$0.15+$0.15 Net gain from storage hedge is +$0.15 and is equal to the change in basis

The Storage Hedge u Gain from a narrowing basis u Futures increased less than cash u Watch for historically wide basis to begin storage hedge in hope that the basis will narrow u The futures position protects against falling prices during storage period

Forward Contracts u Contract for delivery –Defines time, place, form u Tied to the futures market –Buyer offering the contract must lay off the market risk elsewhere –The buyer does the hedging for you

Forward contract advantages u No margin account or margin call u Working with local people u Flexible sizes u Known basis u Tangible u Simple

Forward contract disadvantage u Inflexible –Replace price risk with production risk –Difficult to offset –Must deliver commodity u Buyer “takes protection” –The known basis may be wider