1. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Risk Management in Agriculture: A Guide to Futures, Options, and Swaps Lowell B. Catlett James D. Libbin

2. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 1 Introduction

3. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation General overview of agricultural risks and an introduction to the basic tools to manage market risk General overview of agricultural risks and an introduction to the basic tools to manage market risk Key Terms Key Terms

4. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Basic Agricultural Risk Overview Overview Risks are everywhere: Risks are everywhere: –positive and negative –evaluation and acceptance of proper risk to obtain a profit

5. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Agricultural Risks Weather risk and biological risk are universally known by farmers as production risk. Weather risk and biological risk are universally known by farmers as production risk. Marketing Risk Marketing Risk Policy Risk Policy Risk Major goal is to frame marketing price risks within the larger framework of other agriculture risks. Major goal is to frame marketing price risks within the larger framework of other agriculture risks.

6. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Managing Agricultural Risks Risks are managed either proactively or by accepting the outcomes. Risks are managed either proactively or by accepting the outcomes. –accepting risks –management of risk

7. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Production Risks Weather and biological risks Weather and biological risks –can be proactively managed in some cases. –sometimes simply must be accepted in others.

8. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Marketing Risks Two major marketing risks: Two major marketing risks: –Structural risks are associated with the market channel. –Price risk is the risk of price movement.

9. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Tools of the Trade Securitization is the procedure to identify, quantify, and structure a risk into a financial instrument (security) Securitization is the procedure to identify, quantify, and structure a risk into a financial instrument (security) Securitized Agricultural Risks Securitized Agricultural Risks

10. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Forward Contracts Two parties agree upon contract terms and set a price for the product. Two parties agree upon contract terms and set a price for the product. If the contract has a retrade clause, it is considered strong; if it lacks a retrade clause, it is considered weak. If the contract has a retrade clause, it is considered strong; if it lacks a retrade clause, it is considered weak. The risk of finding a market for the product is reduced. The risk of finding a market for the product is reduced. A major risk of a forward contract is from a large move in the market price or a default risk. A major risk of a forward contract is from a large move in the market price or a default risk. –One of the parties involved may not fulfill the terms of the contract.

11. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures Contracts Contracts are traded on a central exchange and are regulated by the Commodity Futures Trading Commission (CFTC). Contracts are traded on a central exchange and are regulated by the Commodity Futures Trading Commission (CFTC). Contract terms are prespecified and standardized. Contract terms are prespecified and standardized. All contracts are retradable (strong). All contracts are retradable (strong).(continued)

12. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures Contracts (continued) All contracts are leveraged. All contracts are leveraged. –margin –margin call All contracts are very liquid due to being standardized and strong. All contracts are very liquid due to being standardized and strong. Offsetting frees parties of contract obligations. Offsetting frees parties of contract obligations. –roundturn

13. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Futures Contracts and Managing Risk Futures contracts are used to manage risk in two ways: Futures contracts are used to manage risk in two ways: –a way to sell or buy a cash commodity –hedging—allows business to operate within the normal cash markets and futures markets simultaneously, managing the risk of price change Derivative: Futures contract is a derivative of the cash market. Derivative: Futures contract is a derivative of the cash market. –directly tied = one-step derivative

14. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Options Contracts Buyer of an option has the right but not the obligation to do something. Buyer of an option has the right but not the obligation to do something. The seller has the obligation to perform as specified in the agreement. The seller has the obligation to perform as specified in the agreement. Buyer of a call has the right but not the obligation to buy. Buyer of a call has the right but not the obligation to buy. Buyer of a put has the right but not the obligation to sell something. Buyer of a put has the right but not the obligation to sell something. Premium—what the buyer pays for this right. Premium—what the buyer pays for this right.(continued)

15. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Options Contracts (continued) Strike price—the price at which the product or service is exchanged at some point in the future Strike price—the price at which the product or service is exchanged at some point in the future Two types of options: Two types of options: –exchange traded options on futures contracts –options on physical commodities (over the counter) If the buyer decides to buy the property, he exercises the option. If the buyer decides to buy the property, he exercises the option. If the buyer decides not to exercise the option, he lets the option expire. If the buyer decides not to exercise the option, he lets the option expire. An option on a futures contract is double derivative, making it a two-step derivative. An option on a futures contract is double derivative, making it a two-step derivative.

16. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Swap Contracts A swap entails the exchange between two or more parties (counterparties) of the cash flows arising from other contracts or entities (notionals). A swap entails the exchange between two or more parties (counterparties) of the cash flows arising from other contracts or entities (notionals). Swap dealers or brokers line up the counterparties and receive a fee for services rendered. Swap dealers or brokers line up the counterparties and receive a fee for services rendered. Swaps allow for the shifting of price risk via cash flow exchanges. Swaps allow for the shifting of price risk via cash flow exchanges. Swaps are not standardized contracts and are not exchange traded. Swaps are not standardized contracts and are not exchange traded.

17. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Hedging Hedging is the process of using futures, options, and swaps to manage price risk. Hedging is the process of using futures, options, and swaps to manage price risk. Hedging is simply having two or more positions in different markets so that the loss in one is offset with a gain in another. Hedging is simply having two or more positions in different markets so that the loss in one is offset with a gain in another. Corn hedging example: Refer to Figure 1-1. Corn hedging example: Refer to Figure 1-1. The cash market and futures market tend to trend together, which allows the cash market to be managed with the futures market. The cash market and futures market tend to trend together, which allows the cash market to be managed with the futures market.

18. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation Speculation and Income Generation Futures, options, and swaps can also be used to speculate market price direction. Futures, options, and swaps can also be used to speculate market price direction. Position or directional speculators are traders or businesses who try to guess in which direction prices will move. Position or directional speculators are traders or businesses who try to guess in which direction prices will move. –Any business activity that has price risk and is not hedged is speculating. Arbitragers are traders who attempt to profit from knowledge about the relationships between two or more markets. Arbitragers are traders who attempt to profit from knowledge about the relationships between two or more markets.

19. © 2007 Thomson Delmar Learning, a part of the Thomson Corporation The Role of Risk Certain risks in agriculture can be directly managed, some only indirectly, and some not at all. Certain risks in agriculture can be directly managed, some only indirectly, and some not at all. Managing risk is not only about offsetting potential loss but also producing potential gain. Managing risk is not only about offsetting potential loss but also producing potential gain. Futures, options, and swaps can manage agricultural risk both for loss protection and income generation. Futures, options, and swaps can manage agricultural risk both for loss protection and income generation.