United Grain Growers Limited (A)

Syndicate 5 (Ape Syndicate)Yuliana Irmina 29110389Decky Prasakti 29110391

Resti Athayani 29110402Ronaldo Bagus Putra 29110404Lamya Nur Zahidah 29110406Harry Riusxander 29110408

Wisnumurti Rahardjo 29110412

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.

Grain Distribution

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.

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.

Three largest distributor in

1998 were Saskatchewan Wheat Pool, Agricore, and

UGG

The Canadian agriculture industry was under

pressure from several directions, and many

farmers disagreed with CWB policies and its monopsony power.

In 1995, goverment repealed legislation that kept gain transportation cost fixed (and low) for

many years, and reviewing other grain

transpotation and distribution systems.

United Grain Growers

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 businessTo 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

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 Pool Manitoba 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

The Willis Report1992, shareholders successfully sued their directors because the firm did not hedge it's grain risk when prices were

fallingEmerging interest in risk management

prompted UGG to participate in a benchmarking review of best risk

management practices in its Treasury department

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 faced2. to rank them, by polling the group, in

relative importance to the firm

Willis AttentionWillis focused its attention on the first group of six which included :

A. commodity price riskB. inventory management riskC. customer and supplier counterparts

riskD. account receivable and credit riskE. environmental riskF. 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.

CHARMCHARM (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

What to do about the weather ?

• 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

Six Major RiskRisk 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

List of RiskBusiness 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 /fidelityenvironmental

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

Willis Group Assessment

41 Risks

The Major Risks are

1 Weather

2 Environment Liability

3 Counterparty

4 Credit

5 Inventory

6 Commodity

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 ModelCHARM

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/Contract

Credit Payment Failure 1.6 Diversivicaiton/DD/Contract

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. Couterparty Exposure

•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

Weather Risk ExposureALTERNATIVE RISK

MANAGEMENT APPROACHES1

Retention

Weather Derivatives

The Insurance Contract Idea

Retention

• 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

Weather Derivatives• 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.

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 profitWeather >>> Crop Yields >>>> Grain Volume >>>>

Gross Profit

Environment Liabilities, Credit, Commodity, Conterparty and Inventory Risk Exposure

2Environment Liabilities-Insurance- Increase Control

3Credit- Diversivication of parnership to avoid

depedency with limited number of partners- Be more selective to choose partner

4Commodity-Futures- Options

5Counterpart- Diversivication of parnership to avoid

depedency with limited number of partners- Be more selective to choose partner

6Inventory-Increase Control- Insurance

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 reduced3. Company would much more safe