Risk Management for Agricultural Grain Crops

1. Putting it All Together: Risk Management Decisions Nick Piggott Dept. Agricultural and Resource Economics North Carolina State University Email: [email_address] Webpage : www.ag-econ.ncsu.edu/faculty/piggott/gmark.html Perquimans, Chowan, Gates Counties North Carolina 3/19/2009 Copyright  Nick Piggott

4. Revenue=Price  Quantity=P  Q Price Quantity P Q Revenue Risk: Manage P  Q; Not Just P, Not Just Q. Quantity Produced Copyright  Nick Piggott

5. Price is a Random Variable Price P* Price (P) is a draw from this distribution Probability Density Function P** Prob( P >P*)>Prob( P >P**) Range Max Min Copyright  Nick Piggott

6. Quantity Produced [Harv. Ac  Yield/Ac] is a Random Variable Quantity Q* Actual Production (Q) is a draw from this distribution Probability Density Function Range Max Min Q** Copyright  Nick Piggott Prob( Q >Q*)>Prob( Q >Q**)

7. Offsetting Effect of P & Q Price Quantity P H Q L P L Q H P H Q L= P L Q H Copyright  Nick Piggott

8. Revenue Uncertainty Price Quantity P Q Min. Rev. Max. Rev. Feasible Revenues Price Uncertainty Quantity Uncertainty Copyright  Nick Piggott

9. Breakeven Revenue [ P •Q-Cost=0 ] Price Quantity Breakeven Revenue Line Profit Loss Expected Revenue Copyright  Nick Piggott Max. Rev. Min. Rev. Q P

10. Challenge: Making a Profit Price Quantity Q P Low P High Breakeven Revenue Line Profit Loss Expected Revenue Copyright  Nick Piggott P Q

11. Price Risk Management—Locking in a Price (P FC ) [Forward Contract] Price P FC Eliminates Downside Risk for P Eliminates Upside Potential Copyright  Nick Piggott

12. Price Risk Management—Establishing a Floor (P F ) [Hedging with Put Option] Price P Eliminates Downside Risk for P P F Now P P F with Prob.=1 Copyright  Nick Piggott

13. Price Risk Management: Reduce Likelihood of a Loss Price Quantity P Q P Low P High Breakeven Revenue Line Loss Price Floor Truncates Price Distribution at P F Copyright  Nick Piggott Profit P F P Q

14. Government LDP Payments: [ Price Floor at Loan Rate (P LR )] Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Eliminates Some Downside Price Risk with Price Floor at P LR Copyright  Nick Piggott P Q P LR

15. Marketing Strategies [ Price Floor Above P LR With Upside Potential] Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Eliminates Additional Downside Price Risk Copyright  Nick Piggott P F P Q P LR

16. Production Risk Management—Establish Min. Level of Q (Q m ) [Crop Insurance APH or CRC ] Quantity Q Eliminates Downside Risk for Q Q m Now Q m Q with Prob.=1 Copyright  Nick Piggott

17. Establish Min. Level of Q (Q m ) [ Crop Insurance APH or CRC ] Price Quantity Min. Rev . Max. Rev. Feasible Revenues Q m Copyright  Nick Piggott Eliminates Downside Production Risk P Q

18. Price Outlook—Improved Prices Price Quantity Min. Rev. Max. Rev. Feasible Revenues P Low P High Copyright  Nick Piggott P Q

19. Combined--Govt Program, Crop Insurance, and Marketing Price Quantity Min Rev. Max. Rev. Feasible Revenues P Low P High Q m Copyright  Nick Piggott P F P LR P Q

20. Combined--Govt Program, Crop Insurance, and Marketing Price Quantity P Q Max Rev. Feasible Revenues P Low P High Min Rev. Quantity Protection Price Protection Copyright  Nick Piggott P F

21. Ultimate Goal of Revenue Risk Management Price Quantity Feasible Revenues Profitable & Upside Potential Preserved Breakeven Revenue Line New Min Rev. Employ strategies leading to a Min Rev. point that lies to the Right of the Breakeven Revenue Line Old Min Rev. Copyright  Nick Piggott P Q Max Rev.

35. RECOMMENDED MARKETING STRATEGIES FOR DIFFERENT FUTURES PRICE AND BASIS RISK SITUATIONS © Piggott, Shumaker, Curtis Strong Current Basis Weak Current Basis Low Current Futures Price High Current Futures Price Basis Contract Cash Forward Contract Do Nothing Now Buy Put Option Futures Hedge Buy Put Option