© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 9 Managing Other Hedging Risks

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Compensating Balances The comparison between the potential cash market loss and the potential gain from mitigating the cash market risk via a price-based derivative on the same commodity should be similar. The comparison between the potential cash market loss and the potential gain from mitigating the cash market risk via a price-based derivative on the same commodity should be similar. The real reason to mitigate a cash risk is the total value that is at risk. The real reason to mitigate a cash risk is the total value that is at risk. Convert compensating balances into dollar equivalency. Convert compensating balances into dollar equivalency. All that matters for the hedger is mitigating cash streams. All that matters for the hedger is mitigating cash streams.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Cross Hedging After applying dollar equivalency, other agricultural risks that may not have traditional futures, options, or swaps become manageable. After applying dollar equivalency, other agricultural risks that may not have traditional futures, options, or swaps become manageable. Hay producers can mitigate the price risk if hay price is correlated to the price of corn. Hay producers can mitigate the price risk if hay price is correlated to the price of corn. – Hay and corn prices must be tightly related to one another. See Figure 9-2. See Figure 9-2.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Hedging Ratios Defined: The action of adjusting the number of derivative contracts to achieve matching cash streams with the cash position. Defined: The action of adjusting the number of derivative contracts to achieve matching cash streams with the cash position. These ratios are often developed with past historical information. These ratios are often developed with past historical information. Risk minimizing ratios are hedging ratios that are developed to compensate for basis changes with futures as the hedging tool. Risk minimizing ratios are hedging ratios that are developed to compensate for basis changes with futures as the hedging tool. Difficult to use hedging ratios on small cash positions. Difficult to use hedging ratios on small cash positions. Figure 9-3 illustrates a hedge with hedging ratios. Figure 9-3 illustrates a hedge with hedging ratios.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Supplemental Insurance Hedge Supplemental insurance hedging is the idea of increasing the coverage level via derivatives. Supplemental insurance hedging is the idea of increasing the coverage level via derivatives. The general idea is based on some predetermined value calculated on historical production records and an average cash market price or some set futures price. The general idea is based on some predetermined value calculated on historical production records and an average cash market price or some set futures price. Difficult to hedge against as the production loss is event specific. It would require a derivative that produces a positive cash stream when there is a negative event. Difficult to hedge against as the production loss is event specific. It would require a derivative that produces a positive cash stream when there is a negative event.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Portfolio Hedging Several financial products are packaged together such that the risk of a single instrument changing in value is offset with another that changes in value the opposite way. Several financial products are packaged together such that the risk of a single instrument changing in value is offset with another that changes in value the opposite way. The traditional agricultural portfolio model is crops and livestock. The traditional agricultural portfolio model is crops and livestock.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Weather Derivatives Currently only heating and cooling days have futures contracts. Currently only heating and cooling days have futures contracts. There has been a small push historically for such contracts due to crop insurance and governmental support programs. There has been a small push historically for such contracts due to crop insurance and governmental support programs.

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation A Final Word on Hedging All types of risk management involve trade- offs between cash streams and the risk associated with each cash stream. All types of risk management involve trade- offs between cash streams and the risk associated with each cash stream. The goal is to have them cancel out. The goal is to have them cancel out. It is important to focus on managing the risk, not on the tools used. It is important to focus on managing the risk, not on the tools used.