Risk Management in Guar Value Chain
-SIDDHARTH SURANA
Agenda
 Price risk management for value chain
 Practical issues in hedging
 Key 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
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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 exchange
 When you sell the physical commodity, buy back the contract
 Alternatively deliver against futures position
 Loss/gain in the cash market is offset by the gain/loss in the
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futures
Can lift the hedge any time
Can sell the physicals anytime, to anyone
Standardized specs (lack customization but no need for
negotiation)
Ready availability of buyers
Need for Margin and MTM payments
Counter-party risk is guaranteed*
Calculation
 1st Aug.: A farmer is expecting new crop to arrive in
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November
Prevalent price of Nov. contract: Rs 5,000
Farmer wants to lock in the price for his 10MT
expected production of guar
He sells 10MT Nov. expiry guar futures.
Scenarios on 20th Nov.
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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

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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 movement
 Inventory 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 up
 Hedge by buying seed futures
 Lift the hedge when physical is covered in spot market
 Alternatively, can stand for delivery in futures
 Have split/seed stocks- can go short in futures to hedge
Processor/Exporter
 Example: A Guar Powder manufacturer has
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committed an export shipment of 500MT by March
2014
Risk: Splits prices going up
Hedge by splits (Guar Gum) futures
Lift the hedge when physical is covered
Alternatively, can stand for delivery in futures
Risk 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 up
 Domestic consumers can hedge by going long on
guar gum futures
 Foreign buyers?
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No direct access
Fully owned resident subsidiaries can access Indian market
Recap-How to Hedge ?
15
Hedge
starts
Hedge Life
Hedge
ends
• Creating a futures position that is roughly equal to and opposite
to the cash market exposure to be hedged
• Mark-to-market on the basis of price movement in the Exchange
• Minimum Margin to be kept with the exchange
• 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 Based
 Management decides to hedge up to a certain percentage
of Price risk exposure.
 Example - 60% of monthly production
 Incremental hedge percentage based on achievement of
various price targets/forecasts
Statistical method
 Calculating hedge quantity using Historical Hedge Ratio
method
 Hedge to the extent that cash prices is correlated with the
futures’ price
How much to hedge
Dynamic Hedge
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Dynamic hedging is done on the basis of a price forecast
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During periods when favorable price movement is expected,
the hedge is held in abeyance
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Hedge is entered into when adverse price movement is
expected
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Exposed to risk if price views turn out incorrect
Benefits of Hedging
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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 place
 Less variable than overall price
 Relatively predictable, typically narrows, leading to
conversion
Basis
Prices
Cash
Basis
Present
Futures
Expiry
Time
Basis
What causes basis?
 Local demand supply scenario
 Relative storage capacity
 Transportation availability and cost
 Time 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
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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 Risk
 Develop a Hedge Policy
 Controls and Procedures
 Implementation of Hedge Program
 Monitoring, Analyzing and Reporting Risk
 Repeat
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