Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and impact of them.
Risk has many forms, but in the business of food and agriculture, shifts in supply or demand and natural causes like weather or disease create significant risk.
Many participants in the food and agriculture industry have risk. Corn growers are impacted by rainfall and the cost of fuel, while grain millers are at risk of securing enough corn to fulfill their contracts with corn chip manufacturers. Meanwhile the chip manufacturers are at risk of lower demand for snacks. Common to all of these businesses is price risk.
Price risk naturally transfers other risks. If demand is low, price will fall. If disease strikes and supplies fall, prices rise. Since profits and sustainability depend on whether you sell or buy at or above break-even values, price risk management is a crucial discipline in any successful business.
In the food and agricultural industries, these businesses generally protect against higher prices.
In the food and agricultural industries, these businesses generally protect against lower prices.
There are many “tools” to manage price risk. Contracting, Insurance and Hedging are common price risk management tools. While these tools are different, they share a common element: a transfer of risk from one party to another.
In the marketplace, there are businesses that have naturally offsetting risks. A crop producer at risk of lower prices for his corn crop may consider contracting to sell it to a neighbor with a hog operation who is at risk of higher prices on the feed he needs to purchase for his livestock.
The same crop producer may also be concerned over the possibility of adverse weather wiping out his production during the growing season—especially if it has already been committed for sale. Various insurance products provide for this type of catastrophic protection, or other forms of coverage in the event of a loss.
Hedging is an activity that reduces or offsets risk. In our work, a hedge is a position established in the futures market in an attempt to offset exposure to adverse price risk ahead of physical contracting in the cash market.
Hedging works because there is a relationship between the price fluctuation in the local, physical market and the price fluctuation in the futures market. In order for the futures contract to be used as a hedge, the measure of how a futures price changes relative to a cash price must be sufficiently high—typically around 90% or better. This is referred to as correlation.
In our experience price risk management concepts and strategies are difficult to grasp. Over the years we have refined an approach to teach these concepts using interactive simulations.
For our training programs we divide the group into teams, give each a computer, and conduct an interactive strategy simulation. The competition is friendly and the experience is universally well-received.
Copyright © 2013 Commodity & Ingredient Hedging, LLC. All rights reserved.