Evaluating Risk Management Tools for Agribusiness: A California

Evaluating Risk Management

Tools for Agribusiness: A

California Perspective

Palisade 2012 Risk Conference – Las Vegas, NV – November 7 & 8

Mark Manfredo, Ph.D Morrison School of Agribusiness and Resource Management

College of Technology and Innovation

Arizona State University

overview

background

Calif. ag risk

environment

case study

random

thoughts

background: my experience with @RISK

consider financial variables with and without the use of active risk management

In @RISK examine output distributions with and

without risk management

California Agriculture Risk Management Conference, Sacramento, CA May 18, 2012

• Conference sponsored by Cal Poly SLO and Farm

Credit West.

• Objective was to inform agribusinesses and their

lenders on issues of risk management.

California ag risk environment: a cornucopia of risks

tremendous value &

diversity of California

agriculture

More than 350 commercial crop and livestock

commodities produced in California.

numerous factors that impact prices and yields and ultimately revenue or costs

no “cookie cutter” approach for risk management in CA agribusiness

Diversification, futures, options, cash forward contracts,

and insurance (crop insurance) – but not all available for

California’s diverse crop and livestock enterprises.

case study: navel oranges in Fresno County, CA

strategies simulated:

1. no risk management

2. forward contract

3. yield insurance

4. forward w/ yield insurance

5. revenue insurance

Focus on the resulting distribution of per acre

revenue (price x yield)

risk measurement -

uncertainty of outcomes

vs. just bad outcomes?

Risk managers and academics alike consider both the

uncertainty of outcomes (good and bad) and probability of

bad outcomes when measuring risk

therefore best risk management scenario – reduce standard deviation, shift or truncate VaR, and increase mean

mean

5%

VaR = $20

VaR = $40

5%

No Risk Management

Risk Management

mean

1. no risk management

Serves as the “straw man”

Price Yield per Acre Revenue per Acre

Year ($/carton) (cartons) (price x yield)

1990 $5.04 290 $1,461.74

1991 $4.36 627 $2,730.46

1992 $3.16 768 $2,429.89

1993 $3.99 642 $2,559.71

1994 $3.91 594 $2,322.54

1995 $3.68 628 $2,311.04

1996 $4.68 646 $3,023.28

1997 $4.42 682 $3,014.44

1998 $5.23 324 $1,694.52

1999 $3.28 626 $2,053.28

2000 $4.99 546 $2,724.54

2001 $6.44 492 $3,168.48

2002 $3.99 627 $2,501.73

2003 $5.30 581 $3,079.30

2004 $4.91 638 $3,132.58

2005 $4.81 671 $3,227.51

2006 $5.67 489 $2,772.63

2007 $5.23 638 $3,336.74

2008 $6.70 490 $3,283.00

2009 $6.69 608 $4,067.52

Mean $4.82 580 $2,744.75

Std. Deviation $1.03 115.60 $607.09

Use “Distribution Fitting” to fit appropriate Price and Yield input distributions

Price ($/Carton) – Inverse Gaussian

Yield (Cartons) – Logistic

Revenue ($/ac) Draw 1: $5.04 x 290 = $1,461.60 Draw 2: $3.25 x 768 = $2,496 : : Draw 5000: $6.75 x 490= $3,307.50

Price ($/ctn) Draw 1 = $5.04 Draw 2 = $3.25 : : Draw 5000 = $6.75

Yield (ctn/ac) Draw 1 = 290 Draw 2 = 768 : : Draw 5000 = 490

correlation = -0.486

Examine risk measures of revenue with and without risk management

Monte Carlo Simulation

2. forward contract

Seller / buyer agree upon a fixed price to deliver (receive)

a given quantity of commodity at a later date. Remains a

popular tool for price risk management.

Forward Contract w/Rule

• forward contract taken if beginning of

season price > long-run average price of

$4.82

• rule necessary as routine forward contract

just yields average price in the long run

=if(I13>=H12,I13,I7)

3. yield insurance (APH)

Actual Production History (APH) – federally subsidized

yield insurance program sold through private crop

insurance agents and administered by USDA Risk

Management Agency.

actual production history (APH)

• basic formula:

yield guarantee = (APH yield x coverage level)

if actual yield < yield guarantee ; indemnity

indemnity = (yield guarantee – actual yield) x

price election

actual production history (APH)

• coverage level and price election are

major determinants of premium

• catastrophic risk protection (CAT) typically

lowest coverage level and price election

– premium 100% subsidized

APH – Average Production History

Premium = $144 per acre after subsidy Revenue per Acre = Price x Yield + Indemnity – Premium Example Adapted from 2013 RMA Commodity Fact Sheet, Citrus – APH

Per Acre Avg. Yield (APH) 596

Coverage Level Percentage 0.75

Yield per Acre Guarantee 447

Price Election $4.82

Example Indemnity

Yield per Acre Actually Produced (Actual Yield) 400

Yield per Acre Loss 47

Gross Indemnity Per Acre $226.54

(zero if actual yield > yield guarantee)

4. forward contract w/

yield insurance (APH)

Manages risk of both price and yield independently.

Forward Contract with APH

• Revenue = Forward Price x Yield +

Indemnity – Premium

5. revenue insurance

(ARH)

Actual Revenue History (ARH) – federally subsidized

revenue insurance program sold through private crop

insurance agents and administered by USDA Risk

Management Agency.

actual revenue history (ARH)

• basic formula:

revenue guarantee = (approved revenue x

coverage level x payment factor)

if actual revenue < revenue guarantee; indemnity

indemnity = (revenue guarantee – actual revenue)

actual revenue history (ARH)

• coverage level is major determinant of

premium

• catastrophic risk protection (CAT) typically

lowest coverage level

– premium 100% subsidized

ARH – Actual Revenue History Approved Revenue $2,876

Coverage Level 0.75

Payment Factor 1.00

Revenue Guarantee $2,157

Example Indemnity

Actual Revenue $1,500

Indemnity per Acre $657

(zero if actual rev > rev guarantee)

Premium = $176 per acre after subsidy Revenue per Acre = Price x Yield + Indemnity – Premium Example Adapted from 2013 RMA Commodity Fact Sheet, Citrus – APH

run the simulation: Monte Carlo – 5000 iterations

@RISK Simulation Results – Fresno County Navels

No Risk Mgt

Forward w/Rule

APH Forward / APH

ARH

Mean $2,878 $3,111 $2,756 $2,988 $2,760

Standard Deviation

$805

$810 $777 $780 $728

Coeff. of Variation

0.280 0.260 0.282 0.261 0.264

VaR(5%) $1,739 $1,867 $1,690 $1,816 $1,981

Minimum $541 $644 $1,034 $1,034 $1,981

1.74 +∞5.0% 95.0% 0.0%

0

1

2

3

4

5

6

0 1 2 3 4 5 6 7 8

Val

ues

x 10

^-4

Values in Thousands ($)

Revenue per Acre - No Risk management

1.981 +∞5.0% 95.0% 0.0%

0

0.000002

0.000004

0.000006

0.000008

0.00001

0.000012

0.000014

0.000016

0.000018

1.5 2

2.5 3

3.5 4

4.5 5

5.5 6

6.5 7

Values in Thousands ($)

Revenue per Acre - ARH

random thoughts: what was learned?

insights from simulation

and ensuing discussion

Risk management beneficial vs. no risk management

Virtues of insurance – revenue insurance shows

promise, but is it worth the premium?

Caveat – true risks may go beyond historical data

what is the best tool for

California agribusiness?

…it depends!

Major questions include the appropriateness of the tool

given the type of operation and risks that need to be

managed, knowledge and comfort level in using a given

tool, and appetite for risk.

THANK YOU!

Mark Manfredo, Ph.D. Morrison School of Agribusiness and Resource Management

College of Technology and Innovation

Arizona State University

manfredo@asu.edu

480.727.1040

@AgriBizProf

Palisade 2012 Risk Conference – Las Vegas, NV – November 7 & 8