united grain growers limited (a)
TRANSCRIPT
United Grain Growers
Limited (A)
Group 1:
ABM11023 Arpit Vinayak
Background
• United Grain Growers (UGG) is one of the Canada oldest grain distributors in Canada.
• The agriculture business was risky. Anything that affected the quantity of grain shipped had a material impact on the firm’s revenues, profits and cash flow.
• UGG was still faced with the problem of how to deal with the biggest risk: the weather
• UGG has to identify the principal risks of the corporation’s business and ensuring the implementation of appropriate systems to manage these risks.
The industry is quite volatile,
characterizes by boom and
bust cycles, and its roots in
the forces of supply and
demand in the global market
Agriculture and in
particular industry was
one of civilization’s
oldest industries
Grain supplies were
variable due to natural
forces such as pests,
disease and weather.
Grain Distribution
Three largest distributor in
1998 were Saskatchewan
Wheat Pool, Agricore, and
UGG
To reduce volatility, many countries
create policies in Canada for wheat
(barley and oats/board gain)
regulated by Canadian Wheat Board
(CWB) that mandated monopsony
Grain distributor like UGG
were important
intermediateries between the
farmer and the end market.
Case Facts
In 1995, goverment repealed legislation that
kept gain transportation cost fixed (and
low) for many years, and reviewing other
grain transpotation and distribution
systems.
The Canadian agriculture industry was
under pressure from several directions, and
many farmers disagreed with CWB policies
and its monopsony power.
Established in 1906
1993 restructured itself as a public corporation
Issued limited voting common shares on Toronto Stock Exchange
Strategy:
To modernize its grain handling business
To provide farmers with services beyond grain handling
Core Division
Grain Handling
Merchandising
Since 1993, derive about 70%
of its income from grain
operation
UGG spent about $65
million on acquiring and
building its non-grain
handling business
Build new HTP elevators,
upgrade existing elevator,
funding activities
Initial Public Offering
United Grain Growers- Trajectory
1955
- New Industry regulation
- Poor harvest contribution
- Railroads began consolidating routes
- Distributors can set their own tariffs
- Higher grain prices
- Four out of the five major competitors lost money in the handling business
- UGG had to take $12.5 million charge to close 93 country elevators
The Industry Climate
Alberta PoolManitoba Pool
ElevatorsTakeover UGG
Rather than suffer substantial
dilution of their existing investment,
the bidders withdrew their offer
Two bidders merged from
Agricore
The Industry Climate
• UGG formed a strategic
alliance with Archer
Daniels Midland Company
• UGG also formalized a partnership with Marubeni Corporation
ADM would gain “a secure grain supply for its processing operations”
UGG could “plan more efficiently for future transportation and grain handling demands, and increase market shares
The Industry Climate
• 1992, shareholders successfully sued their directors
because the firm did not hedge it's grain risk when prices
were falling
• Emerging interest in risk management prompted UGG to
participate in a benchmarking review of best risk
management practices in its Treasury department
The Willis Report
On site Risk Brainstorming
February 11, 1997, twenty UGG senior managers and other employees met for an on site risk brainstorming, with task :
1. to identify the risk the firm faced
2. to rank them, by polling the group, in relative importance to the firm
Willis Attention
Willis focused its attention on the first group of six which included :
A. commodity price risk
B. inventory management risk
C. customer and supplier counterparts risk
D. account receivable and credit risk
E. environmental risk
F. weather risk
Earnings at Risk (EaR)
• Which had been developed by
the financial community, to
describe aggregate risk.
• EaR expressed a "worst-case"
loss, set against a benchmark
of expected profit, within a
specified confidence or
probability level.
CHARM
• CHARM (Comprehensive Holistic All Risk Model) generated graphical
output in several formats to highlight the various aspect of each risk.
• The most general format was a probability distribution showing the
probability of incurring a loss as a function of the size of the dollar loss .
• Cox had the information to do something to improve the firm's risk
management performance and potentially reduce UGG's long term cost of
risk
• Five of the six risk could be managed through traditional
methods.
• But about the weather risk ?
• No financial products that would effectively mitigate the weather risk
• Innovation to mitigate : weather derivatives pay a specified amount of
money as a function of a particular weather characteristic
What to do about the weather ?
Risk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested
yields
11.5 Weather Derivatives and
Insurance
Environment Toxic waste 2.5 Insurance and control
Counterparty Failure of Supplier 4.3 Diversification/Due
diligence/Contract
Credit Payment Failure 1.6 Diversification/Due
diligence/Contract
Inventory Spoilage of Inventory,
UnderStock/OverStock
2.2 Operational Control, and
Insurance
Commodity Price Fluctuation 11.9 Futures and Options
Six Major Risk
Risk Analysis
Business interruption
Cargo/marine exposure
Civil disturbance
Commodity basis/ price
Competition
Consumer preferences
Contractual no-performance
Credit/receivables
Counterparty
Directors & officers exposure
Data accuracy
Disease/spoilage
Computer system failure
Employee injury
Employee liability
Employee performance /fidelity
environmental
Foreign exchange
Head office catastrophe
Industrial espionage
Intellectual property
Interest rates
Inventory
Labor strike
Leverage (too much or too little)
Loss of key personnel
Mergers and acquisition
Major property exposure
Pension plan performance
Process compliance/execution
Product liability
Product performance
Quebec separates from Canada
R&D ventures
Regulatory (CWB, transportation)
Stock market crash
Strategic planning
Technology (choice, use of)
transportation
unionization
weather
List Of Risk
41
RisksThe Major Risks are
1 Weather
2 Environment Liability
3 Counterparty
4 Credit
5 Inventory
6 Commodity
Willis Group Assessment
The modeled yields, in turn, explained approximately 94% of the variability of UGG’s
grain handling earning. The yield depends on the rain according to the regression equation
Yield=15.5+0.0577*Rain, R-squared = 43%.
All-Wheat yield in Saskatchewan and the July precipitation for 1960 through 1992
Comprehensive Holistic All Risk Model
CHARM
CHARM plot showing the probability distribution of
earning with and without the impact of the weather.
When the weather risk is removed, the variation in
EBIT is smaller, as shown by the lighter curve,
though expected value is the same. The probability
showing incurring a loss as a function of the size of
the dollar loss.
Definition: What is Value at Risk?
• Summary statistic that quantifies the exposure across many assets/liabilities classes to
market risk.
• Identifies ‘How Much’ one can loses if adverse market conditions prevail.
• Captures diversification or Portfolio Effect.
• Measurisk Approach
• Full Monte-Carlo Valuation-based without approximations
• Risk calculation based on evaluation of log changes in market instruments
• Method allows modeling of entire distribution of expected profits and losses and shape of risk
surface over time and tail risk
Nasdaq Drop 95% VaRAsian Flu
Nasdaq Drop
Euro Rally
Earnings at Risk and Corporate Treasury
• Longer time horizon than traditional asset management
• Multi-Step Monte Carlo
• More data needed to define covariance matrix
• View of multiple time horizons (I.e. Each quarter of the fiscal year)
• Quantify risk across business lines
• Ability to optimize trading activities - view impact of different hedging strategies
Earnings at Risk
• Measure of earnings volatility
• Income Statement Perspective
• Used to define risk appetite
• Can help answer “What should be hedged?”
• Focus on market moves to:
• FX Rates
• Interest Rates
• Commodity Prices
• Perspective: Basket of Exposures (“Portfolio Effect”)
The Estimation of the 6 Major Risks
Risk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested
yields
11.5 None
Environtment
Liability
Toxic waste 2.5 Insurance
Counterparty Faliure of Supplier 4.3 Diversivicaiton/DD/Co
ntract
Credit Payment Failure 1.6 Diversivicaiton/DD/Co
ntract
Inventory Spoilage of Inventory,
UnderStock/OverStock
2.2 Operational Control
Commodity Price Fluctuation 11.9 Insurance/ Futures
1. Weather
• Its effect on grain volume would disturb the Business
2. Environmental Liabilities
• The Toxic waste released to external environment could raise social risk and could raise penalty from government
3. Credit
• The Failure of UGG Partner to pay their Debt to UGG would Disturb UGG Cash Flow
4. Commodity
• The Fluctiation of Commodity Price could result a severe disturbance to UGG business
5. CouterpartyExposure
• The Probability of UGG Suppliers (Upstream and Downstream) not to meet their contract obligation
6. Inventory
• The Understock condition might result the loss of market opportunity
• The Overstock inventory would result higher risk since the grain price are very fluctuative
The top 6 Risk based on its severe risk
• First, UGG had been and planned to continue making large investments in
storage facilities (grain elevators).
• Second, the variability in its cash flows caused UGG to hold extra equity
capital as a cushion against unexpected low cash flows in any given year.
• Third, although much of UGG’s current business could be characterized as a
commodity business, UGG tried to distinguish itself from competitors by
creating products 7 with brand names and by providing on- going services to
customers
Retention
• Weather derivatives were a relatively new risk management tool.
• A contract could be tailored on a number of dimensions to meet the specific needs of the buyer.
• For simplicity, the illustration assumes that the relationship between gross profit and the weather index is linear. Since low values of the weather index correspond to low expected profits for UGG, a derivative contract that would pay UGG money when the index is low would provide a hedge.
• Hedging their weather risk with derivatives was feasible, but it suffered from several difficulties. Although Willis had performed a sophisticated analysis of the effect of weather on UGG’s gross profit, the results of this analysis had to be converted into a desired contract structure.
Weather Derivatives
Illustration of a Weather Derivative
The Insurance Contract Idea
• UGG knew that the primary reason weather was important was because weather affected UGG’s grain shipments.
• The obvious problem with such a contract is the moral hazard problem – UGG’s pricing and service also influences its grain shipments.
• One solution to this problem was to use industry-wide grain shipments as the variable that would trigger payments to UGG.
• UGG also considered the possibility of integrating grain volume coverage with UGG’s other insurance co
• Willis then contacted several major commercial insurers, including a division of the large reinsurer Swiss Re, called Swiss Re New Markets. Located in New York, this group structured innovative risk financing deals for commercial entities.
Risk Assessment to the weather problem
Estimate probability distribution of and correlation among losses
Measure the expected loss individually and in combination on ROE,
EVA, EBIT
Changes in weather was ranked the highest source of risk
Grain volume and lagged crop yields highly positively correlated
Relationship between weather and gross profit
Weather >>> Crop Yields >>>> Grain Volume >>>> Gross
Profit
1Environment Liabilities
-Insurance
- Increase Control 2Credit
- Diversivication of parnership to avoid depedency with limited number of partners
- Be more selective to choose partner
3Commodity
-Futures
- Options
4Counterpart
- Diversivication of parnership to avoid depedency with limited number of partners
- Be more selective to choose partner5Inventory
-Increase Control
- Insurance
Environment Liabilities, Credit, Commodity, Conterpartyand Inventory Risk Exposure
Suggestion and Conclusion
We propose the use of insurance for the weather
uncertainty (option 3) due :
1. Broader Loss Coverage, not only weather risk
2. The premium of insurance cost can be reduced
3. Company would much more safe
Thank You