5. Background
• United Grain Growers (UGG) is one of the Canada oldest grain
distributors in Canada.
• The agriculture business was risky. Anything that affected the
quantity of grain shipped had a material impact on the firm’s
revenues, profits and cash flow.
• UGG was still faced with the problem of how to deal with the
biggest risk: the weather
• UGG has to identify the principal risks of the corporation’s
business and ensuring the implementation of appropriate
systems to manage these risks.
6. The industry is quite volatile,
characterizes by boom and
bust cycles, and its roots in
the forces of supply and
demand in the global market
Agriculture and in
particular industry was
one of civilization’s
oldest industries
Grain supplies were
variable due to natural
forces such as pests,
disease and weather.
7. To reduce volatility, many
countries create policies in
Canada for wheat (barley and
oats/board gain) regulated by
Canadian Wheat Board (CWB)
that mandated monopsony
Grain distributor like UGG
were important
intermediateries between
the farmer and the end
market.
Three largest
distributor in
1998 were
Saskatchewan
Wheat Pool,
Agricore, and
UGG
8. The Canadian agriculture
industry was under
pressure from several
directions, and many
farmers disagreed with
CWB policies and its
monopsony power.
In 1995, goverment
repealed legislation that
kept gain transportation
cost fixed (and low) for
many years, and
reviewing other grain
transpotation and
distribution systems.
9. United Grain Growers
Established
in 1906
1993
restructured
itself as a
public
corporation
Issued
limited
voting
common
shares on
Toronto
Stock
Exchange
Strategy:
To modernize its
grain handling
business
To provide
farmers with
services beyond
grain handling
Core Division
Grain Handling Merchandising
Since 1993, derive about
70% of its income from
grain operation
UGG spent about $65
million on acquiring and
building its non-grain
handling business
Build new HTP elevators,
upgrade existing elevator,
funding activities
Initial Public Offering
10. 1955
- New Industry regulation
- Poor harvest contribution
- Railroads began consolidating routes
- Distributors can set their own tariffs
- Higher grain prices
- Four out of the five major competitors lost money in the handling business
- UGG had to take $12.5 million charge to close 93 country elevators
The Industry Climate
11. Alberta Pool
Manitoba Pool
ElevatorsTakeover UGG
Rather than suffer substantial
dilution of their existing
investment, the bidders withdrew
their offer
Two bidders merged from
Agricore
The Industry Climate
12. • UGG formed a strategic
alliance with Archer
Daniels Midland
Company
• UGG also formalized a partnership
with Marubeni Corporation
ADM would gain “a secure grain supply
for its processing operations”
UGG could “plan more efficiently for
future transportation and grain handling
demands, and increase market shares
The Industry Climate
13. The Willis Report
1992, shareholders successfully sued their
directors because the firm did not hedge it's
grain risk when prices were falling
Emerging interest in risk management
prompted UGG to participate in a
benchmarking review of best risk management
practices in its Treasury department
14. On site Risk
Brainstorming
February 11, 1997, twenty UGG senior managers
and other employees met for an on site risk
brainstorming, with task :
1. to identify the risk the firm faced
2. to rank them, by polling the group, in
relative importance to the firm
15. Willis Attention
Willis focused its attention on the first group of
six which included :
A. commodity price risk
B. inventory management risk
C. customer and supplier counterparts risk
D. account receivable and credit risk
E. environmental risk
F. weather risk
16. Earnings at Risk (EaR)
Which had been developed
by the financial
community, to describe
aggregate risk.
EaR expressed a "worst-
case" loss, set against a
benchmark of expected
profit, within a specified
confidence or probability
level.
17. CHARM
CHARM (Comprehensive Holistic All Risk Model)
generated graphical output in several formats to
highlight the various aspect of each risk.
The most general format was a probability
distribution showing the probability of incurring
a loss as a function of the size of the dollar loss .
Cox had the information to do something to
improve the firm's risk management performance
and potentially reduce UGG's long term cost of
risk
18. What to do about the weather ?
• Five of the six risk could be managed through
traditional methods.
• But about the weather risk ?
– No financial products that would effectively
mitigate the weather risk
– Innovation to mitigate : weather derivatives
pay a specified amount of money as a function of
a particular weather characteristic
19. Six Major Risk
Risk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested
yields
11.5 Weather Derivatives
and Insurance
Environment Toxic waste 2.5 Insurance and control
Counterparty Failure of Supplier 4.3 Diversification/Due
diligence/Contract
Credit Payment Failure 1.6 Diversification/Due
diligence/Contract
Inventory Spoilage of Inventory,
UnderStock/OverStock
2.2 Operational Control,
and Insurance
Commodity Price Fluctuation 11.9 Futures and Options
20.
21. List of Risk
Business interruption
Cargo/marine exposure
Civil disturbance
Commodity basis/ price
Competition
Consumer preferences
Contractual no-
performance
Credit/receivables
Counterparty
Directors & officers
exposure
Data accuracy
Disease/spoilage
Computer system failure
Employee injury
Employee liability
Employee performance
/fidelity
environmental
Foreign exchange
Head office catastrophe
Industrial espionage
Intellectual property
Interest rates
Inventory
Labor strike
Leverage (too much or too
little)
Loss of key personnel
Mergers and acquisition
Major property exposure
Pension plan performance
Process
compliance/execution
Product liability
Product performance
Quebec separates from
Canada
R&D ventures
Regulatory (CWB,
transportation)
Stock market crash
Strategic planning
Technology (choice, use of)
transportation
unionization
weather
23. The modeled yields, in turn, explained approximately 94% of the variability of UGG’s
grain handling earning. The yield depends on the rain according to the regression
equation Yield=15.5+0.0577*Rain, R-squared = 43%.
All-Wheat yield in Saskatchewan and the July precipitation for 1960 through 1992
24. Comprehensive Holistic All Risk Model
CHARM
CHARM plot showing the probability distribution of earning with and without the
impact of the weather. When the weather risk is removed, the variation in EBIT is
smaller, as shown by the lighter curve, though expected value is the same. The
probability showing incurring a loss as a function of the size of the dollar loss.
25. Definition: What is Value at Risk?
• Summary statistic that quantifies the exposure across many
assets/liabilities classes to market risk.
• Identifies ‘How Much’ one can loses if adverse market conditions
prevail.
• Captures diversification or Portfolio Effect.
• Measurisk Approach
– Full Monte-Carlo Valuation-based without approximations
– Risk calculation based on evaluation of log changes in market instruments
– Method allows modeling of entire distribution of expected profits and
losses and shape of risk surface over time and tail risk
Nasdaq Drop 95% VaRAsian Flu
Nasdaq Drop
Euro Rally
26. Earnings at Risk and Corporate Treasury
• Longer time horizon than traditional asset
management
• Multi-Step Monte Carlo
• More data needed to define covariance matrix
• View of multiple time horizons (I.e. Each quarter
of the fiscal year)
• Quantify risk across business lines
• Ability to optimize trading activities - view
impact of different hedging strategies
27. Earnings at Risk
• Measure of earnings volatility
• Income Statement Perspective
• Used to define risk appetite
• Can help answer “What should be hedged?”
• Focus on market moves to:
– FX Rates
– Interest Rates
– Commodity Prices
• Perspective: Basket of Exposures (“Portfolio Effect”)
28. The Estimation of the 6 Major Risks
Risk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested
yields
11.5 None
Environtment
Liability
Toxic waste 2.5 Insurance
Counterparty Faliure of Supplier 4.3 Diversivicaiton/DD/Cont
ract
Credit Payment Failure 1.6 Diversivicaiton/DD/Cont
ract
Inventory Spoilage of Inventory,
UnderStock/OverStock
2.2 Operational Control
Commodity Price Fluctuation 11.9 Insurance/ Futures
29. 1. Weather
•Its effect on grain volume
would disturb the Business
2. Environmental
Liabilities
•The Toxic waste released to
external environment could
raise social risk and could
raise penalty from
government
3. Credit
•The Failure of UGG Partner
to pay their Debt to UGG
would Disturb UGG Cash
Flow
4. Commodity
•The Fluctiation of
Commodity Price could
result a severe
disturbance to UGG
business
5. Couterparty Exposure
•The Probability of UGG
Suppliers (Upstream and
Downstream) not to
meet their contract
obligation
6. Inventory
•The Understock condition
might result the loss of
market opportunity
•The Overstock inventory
would result higher risk
since the grain price are
very fluctuative
The top 6 Risk based on its severe
risk
31. • First, UGG had been and planned to continue making
large investments in storage facilities (grain elevators).
• Second, the variability in its cash flows caused UGG to
hold extra equity capital as a cushion against
unexpected low cash flows in any given year.
• Third, although much of UGG’s current business could
be characterized as a commodity business, UGG tried
to distinguish itself from competitors by creating
products 7 with brand names and by providing on-
going services to customers
32. • Weather derivatives were a relatively new risk management tool.
• A contract could be tailored on a number of dimensions to meet
the specific needs of the buyer.
• For simplicity, the illustration assumes that the relationship
between gross profit and the weather index is linear. Since low
values of the weather index correspond to low expected profits for
UGG, a derivative contract that would pay UGG money when the
index is low would provide a hedge.
• Hedging their weather risk with derivatives was feasible, but it
suffered from several difficulties. Although Willis had performed a
sophisticated analysis of the effect of weather on UGG’s gross
profit, the results of this analysis had to be converted into a desired
contract structure.
34. The Insurance Contract Idea
• UGG knew that the primary reason weather was important was
because weather affected UGG’s grain shipments.
• The obvious problem with such a contract is the moral hazard
problem – UGG’s pricing and service also influences its grain
shipments.
• One solution to this problem was to use industry-wide grain
shipments as the variable that would trigger payments to UGG.
• UGG also considered the possibility of integrating grain volume
coverage with UGG’s other insurance co
• Willis then contacted several major commercial insurers, including a
division of the large reinsurer Swiss Re, called Swiss Re New
Markets. Located in New York, this group structured innovative risk
financing deals for commercial entities.
35. Risk Assessment to the weather problem
Estimate probability distribution of and correlation
among losses
Measure the expected loss individually and in
combination on ROE, EVA, EBIT
Changes in weather was ranked the highest source of
risk
Grain volume and lagged crop yields highly positively
correlated
Relationship between weather and gross profit
Weather >>> Crop Yields >>>> Grain Volume >>>>
Gross Profit
36. Environment Liabilities, Credit, Commodity,
Conterparty and Inventory Risk Exposure
2
Environment Liabilities
-Insurance
- Increase Control
3
Credit
- Diversivication of parnership to avoid
depedency with limited number of partners
- Be more selective to choose partner
4
Commodity
-Futures
- Options
5
Counterpart
- Diversivication of parnership to avoid
depedency with limited number of partners
- Be more selective to choose partner
6
Inventory
-Increase Control
- Insurance
37. Suggestion and Conclusion
We propose the use of insurance for the weather
uncertainty (option 3) due :
1. Broader Loss Coverage, not only weather risk
2. The premium of insurance cost can be reduced
3. Company would much more safe