Risk Management Tools for Crops: Spreadsheets for Market Risk Management Clarity Presentation at: 2000 Southern Region Agricultural Outlook Conference Atlanta, GA, September 25-27, 2000 Presented by: Charles Curtis, Jr. Extension Agricultural Economist Clemson University Risk Management Tools for Crops: Spreadsheets for Market Risk Management Clarity Charles Curtis, Jr. Extension Ag Economist Clemson University After several years of conducting standard crops marketing workshops, I became frustrated with trying to adequately help agribusinesses wade through the swamp of computations necessary to review (as our research colleagues would put it) “M” alternative marketing strategies over the “N” potential price outcomes in the future. After all, one of the reasons my audience attended was to gain some insight into which of the “M” alternatives (or combination thereof) might be worth considering now. Further, I found that the timing of this part of a typical workshop was at the end. A summary of concepts was necessary but the audience’s capacity to absorb much more was limited. I felt I was simply asking too much of the typical farmer after six to eight hours of an intensive workshop. We had intensively shown them the “trees.” The frustration came in trying to finalize a view of the “forest.” Basic Strategy Review I needed help in bring the experience back around to seeing all the tools available and how they would work as the market moved. We had looked at the “M” marketing alternative “trees” in depth. As an example, let’s look at what we’d typically covered on hedging – just one of the alternative “trees” in the “forest.” What are futures contracts and markets? What’s hedging as compared to speculation? What’s a margin call? How does basis movement interact with the hedge strategy? How do you calculate the results of a hedging strategy if the market goes up? What if the market goes down? What if the basis strengthened or weakened? What are the advantages & disadvantages of hedging? In my book, that’s a detailed look at one tree! Then you throw in the rest of the “trees;” cash forward contracting, basis contracting, minimum price contracting, hedge-to-arrive contracts, delayed pricing contracts, purchasing put options, buying call options to re-open the top. How do you calculate the results of these strategies if the market goes up or goes down? That’s a lot to remember if some or all of this was new to you today. (After all, don’t we spend the better part of a semester on this with college kids?) I felt something additional was needed. The answer I hit upon was neither earth-shatteringly brilliant nor unique. It was as simple as recognizing that my “students” could better concentrate on the “forest” concepts if they were freed from the burdensome nature of worrying about every “tree. “ So I let the computer help. I wrote a few crop-specific spreadsheets that remove the mundane calculations and allows a look at the results of a series of strategies at differing price outcomes. The spreadsheets are designed with an input section in which the user can place today’s relevant market information. These data are necessary to calculate price that a given strategy will yield. All strategies are preharvest strategies. The strategy list examined by the spreadsheet is not “all inclusive” but includes: 1. 2. 3. 4. 5. 6. Cash sale at harvest Basis contract now and sell at harvest Short Hedge Cash Forward Contract Put option purchase Call option purchase with a Cash Forward Contract Results of these six basic marketing strategies are computed over a range of eleven potential price outcomes at harvest; five lower price scenarios, one scenario of prices staying the same and five higher price scenarios. The resultant table is structured: Price Down Strategy 1 : Strategy 6 The data are also graphed. Price the Same Strategy M/Price N Price Up A Work in Progress The original strategy spreadsheets developed have been modified and enhanced numerous times. The matrix discussed above provides objective information on what will happen if following strategy M as prices change to varying degrees. One subsequent addition made has been to add information on the probability of prices changes. This idea was borrowed from George Shumaker and John McKissick of the University of Georgia who pioneered much of the integration and use of price probability into market strategy choice. From them, I hit on the idea of adding price probabilities derived from the current options market. Now the spreadsheet can provide not only the consequence of price change but also a comparative-static look at the probability of price change. The basic matrix now enforces current futures plus or minus two standard deviations as the upper and lower price bound. Another improvement has been the addition of Loan Deficiency Payment estimates as prices rise and fall. While computationally easy to add to the information, it became essential as crop prices approached and fell below loan rates. It became quite apparent that producer focus on LDP levels had to be addressed. An interesting exercise has been to review the graphs of market strategy response to price changes when LDP’s are added. I was not taught to expect bowl-shaped strategy results curves over the relevant range of probable prices when I first studied market risk management as a student. Where to from here? Next versions planned will include a post-harvest set of strategies to address questions like “Should I sell & ‘pop’ now or store till (month) while I hold out for the larger LDP?” Any comments or corrections are solicited from those who might want to utilize these simple spreadsheets.