-SIDDHARTH SURANA

Risk Management in Guar Value Chain

Agenda

Price risk management for value chain

Practical issues in hedgingKey Elements of a hedge program

Guar Value Chain

Farmer Traders Processor/ Exporter

End User/

Importer

Farmer

Grow guar in hope of good prices

but..What if all the farmers think alike?How to protect against price fall?

Guar Marketing Options

Sell in Cash (Spot) Market

Enter a Forward sale contract

Hedge in a futures

Buy ‘Put’ options (Not really an option currently)

Sell in the Cash Market

Guess when the highest price will come Sell when you need the cash Sell a little bit throughout the year Sell when price reaches a target Sell by a certain date-whatever be the

price Aren’t all the above features of S..... ?

Forward Contracts

• Fixed price contract for a set delivery location, date, quantity and quality

• Contracts can be:• Pre-harvest (production unknown)• Post-harvest (production known)

Lock in a sure price (but give up a gain if the prices increases later) Can contract for any quantity, quality, place and date-provided you

find a buyer Search cost, negotiation on specification Can’t lift the hedge Can’t sell your produce to anyone else Counter-party risk?

Hedging with futures

Sell futures contract on a commodity exchangeWhen you sell the physical commodity, buy back the

contractAlternatively deliver against futures positionLoss/gain in the cash market is offset by the gain/loss in

the futuresCan lift the hedge any timeCan sell the physicals anytime, to anyoneStandardized specs (lack customization but no need for

negotiation)Ready availability of buyersNeed for Margin and MTM paymentsCounter-party risk is guaranteed*

Calculation

1st Aug.: A farmer is expecting new crop to arrive in November

Prevalent price of Nov. contract: Rs 5,000Farmer wants to lock in the price for his 10MT

expected production of guarHe sells 10MT Nov. expiry guar futures.Scenarios on 20th Nov.

Spot price =4800=Nov. futures price Gain on Futures position=Rs 200/Qtl Realization from cash sale= Rs 4800 Net price=4800+200=5000

Calculation

Scenario on 20th Nov. Spot price =5200=Nov. futures price

Loss on Futures position=Rs 200/Qtl Realization from cash sale= Rs 5200 Net price=5200-200=5000

Spot Price=5000=Nov. futures Gain/Loss on Futures position=0 Realization from cash sale= Rs 5,000 Net price=5,000

Trader

Exposure to flat price movementInventory price risk

Can sell futures to the extent of guar stock Keep rolling-over till the time of physical sale

Forward commitment Go long on futures Once physical is covered, lift the hedge

Processor/Exporter

Exposed to both sides-RM prices and Finished goods

Example: Split miller has committed a powder plant 50 MT of guar split to be supplied in January.

Exposure to seed prices going upHedge by buying seed futuresLift the hedge when physical is covered in spot

marketAlternatively, can stand for delivery in futuresHave split/seed stocks- can go short in futures to

hedge

Processor/Exporter

Example: A Guar Powder manufacturer has committed an export shipment of 500MT by March 2014

Risk: Splits prices going upHedge by splits (Guar Gum) futuresLift the hedge when physical is coveredAlternatively, can stand for delivery in futuresRisk to powder prices: No direct contract but

can be hedged with gum futures (only if you have ready stocks).

End User/Importer

Risk: Guar gum prices going upDomestic consumers can hedge by going long

on guar gum futuresForeign buyers?

No direct access Fully owned resident subsidiaries can access Indian

market

Recap-How to Hedge ?15

Hedge starts

• Creating a futures position that is roughly equal to and opposite to the cash market exposure to be hedged

Hedge Life

• Mark-to-market on the basis of price movement in the Exchange

• Minimum Margin to be kept with the exchange

Hedge ends

• The profit (loss) in the cash position is offset by equivalent loss (profit) on the futures position

• End result is a locked-in price irrespective of marker movement

How much to hedge

Rule BasedManagement decides to hedge up to a certain

percentage of Price risk exposure.Example - 60% of monthly productionIncremental hedge percentage based on achievement of

various price targets/forecasts

Statistical methodCalculating hedge quantity using Historical Hedge

Ratio methodHedge to the extent that cash prices is correlated with

the futures’ price

How much to hedge

Dynamic Hedge Dynamic hedging is done on the basis of a price

forecast During periods when favorable price movement is

expected, the hedge is held in abeyance Hedge is entered into when adverse price movement

is expected Exposed to risk if price views turn out incorrect

Benefits of Hedging

Stability of earnings & secured minimum operating margin;

Monetise value of unused commodity Reduced cost of borrowing from banks Increased access to credit as confidence of

repayment increases Capacity building for improved risk

management also strengthens marketing / financial knowledge

Practical Issues in Hedging No Hedge is perfect but all hedges cost money

Duration and Quantity mismatch

Duration mismatch (Futures expiries are on standard dates) If timing of cash market exposure (buy/sell) is known in advance,

use futures that most closely matches the same When timing of cash market exposure is not known, or if far month

contracts are not sufficiently liquid, hedge in the near contract and keep rolling

Quantity mismatch (Futures have standard lot size) Try to match futures and cash position as closely as possible

Basis

The difference between the cash price and futures price of a commodity.

Basis = Spot price – Futures price

Basis is:Specific to time and placeLess variable than overall priceRelatively predictable, typically narrows, leading to

conversion

Basis

Basis

Prices

Present ExpiryTime

Futures

Cash

Basis

What causes basis?Local demand supply scenarioRelative storage capacityTransportation availability and costTime to expiration (cost of carry)Quality differential

Possible Solutions

Enter into Basis quoted contract with your supplier or buyer

If you have entered into a contract to supply, you can buy corresponding futures (and hope for the basis to remain favorable)

Basis forecasting methods Current basis Last year same time Last 3 years' average Current basis adjusted for cost of carry

Key Elements of a Hedge Program

Identify, Analyze and Quantify Market RiskDevelop a Hedge PolicyControls and ProceduresImplementation of Hedge ProgramMonitoring, Analyzing and Reporting RiskRepeat

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