putting it together plus brownstone
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Risk Management for Agricultural Grain CropsTRANSCRIPT
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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
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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)
Copyright Nick Piggott
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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
Copyright Nick Piggott
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Revenue=PriceQuantity=PQ
Price
Quantity
P
Q
Revenue Risk: Manage P Q; Not Just P, Not Just Q.
Quantity
ProducedCopyright Nick Piggott
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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
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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**
Copyright Nick Piggott
Prob(Q>Q*)>Prob(Q>Q**)
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Offsetting Effect of P & Q
Price
Quantity
PH
QL
PL
QH
PH QL= PL QH
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Revenue Uncertainty
Price
Quantity
P
QMin. Rev.
Max. Rev.
Feasible Revenues
Price Uncertainty
Quantity Uncertainty
Copyright Nick Piggott
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Breakeven Revenue[P•Q-Cost=0]
Price
Quantity
BreakevenRevenueLine
Profit
Loss
Expected Revenue
Copyright Nick Piggott
Max. Rev.
Min. Rev. Q
P
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Challenge: Making a Profit
Price
QuantityQ
PLow
PHigh
BreakevenRevenueLine
Profit
Loss
Expected Revenue
Copyright Nick Piggott
P
Q
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Price Risk Management—Locking in a Price (PFC) [Forward Contract]
PricePFC
Eliminates Downside Risk for P
Eliminates Upside Potential
Copyright Nick Piggott
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Price Risk Management—Establishing a Floor (PF)
[Hedging with Put Option]
PriceP
Eliminates Downside Risk for P
PF
Now P PF with Prob.=1
Copyright Nick Piggott
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Price Risk Management: Reduce Likelihood of a Loss
Price
Quantity
P
Q
PLow
PHigh
BreakevenRevenueLine
Loss
Price Floor Truncates Price Distribution at PF
Copyright Nick Piggott
Profit
PF
P
Q
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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
Copyright Nick Piggott
P
Q
PLR
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Marketing Strategies[Price Floor Above PLR With Upside Potential]
Price
QuantityMin. Rev.
Max. Rev.
Feasible Revenues
PLow
PHigh
Eliminates Additional Downside Price Risk
Copyright Nick Piggott
PF
P
Q
PLR
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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
Copyright Nick Piggott
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Establish Min. Level of Q (Qm)[Crop Insurance APH or CRC]
Price
QuantityMin. Rev.
Max. Rev.
Feasible Revenues
Qm
Copyright Nick Piggott
Eliminates Downside Production Risk
P
Q
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Price Outlook—Improved Prices
Price
QuantityMin. Rev.
Max. Rev.Feasible Revenues
PLow
PHigh
Copyright Nick Piggott
P
Q
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Combined--Govt Program, Crop Insurance, and Marketing
Price
QuantityMin Rev.
Max. Rev.
Feasible Revenues
PLow
PHigh
Qm
Copyright Nick Piggott
PF
PLR
P
Q
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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
Copyright Nick Piggott
PF
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Ultimate Goal of Revenue Risk Management
Price
Quantity
Feasible Revenues Profitable &
Upside Potential Preserved
BreakevenRevenueLine
NewMin Rev.
Employ strategies leading to a Min Rev. point that lies to the Right of the Breakeven Revenue Line
OldMin Rev.
Copyright Nick Piggott
P
Q
Max Rev.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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© 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
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-$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
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© 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
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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
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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
Copyright Nick Piggott
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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] .
Copyright Nick Piggott