Lecture 9: Risk, Uncertainty and Future Markets Flashcards Preview

AGEC2102: Agribusiness Marketing > Lecture 9: Risk, Uncertainty and Future Markets > Flashcards

Flashcards in Lecture 9: Risk, Uncertainty and Future Markets Deck (19):
1

Types of agribusiness risk

Outputside
– Product destruction (fire, hail, etc)
– Product yield variability (drought, flood, etc)
– Product value deterioration due to quality deterioration and/or adverse price variation

Inputside
– Supply variability
– Price variability

2

Outline the theory of insurance

- Outsourcing the risk to a third party
- Contingency fund - cash reserves to help manage the fluctuations
- Transfer risk to insurance company

3

Insurance companies

Insurance companies are specialised risk bearers that spread the risk over a wide area and groups of people or businesses

4

Ways to mitigate the risk of supply shocks or changing consumer preferences

– Government price-supporting activities are a mechanism to mitigate price risk
– Some price risk may be offset by vertical integration
– Could also sell product in advance of production, so fixing the price in the present for delivery at a specified future date

5

Small losses, more severe losses and the role of insurance

Small, frequent (e.g. spoilage) - dip into savings, short term loss
More severe, less frequent - access credit markets and borrow to maintain operations
Insurance - extreme losses, more than credit markets can handle

6

General considerations of farm level destruction and yield insurance

– Based on historical data
– Can be farm-based or area based
– Indemnity is triggered if yield, revenue or some other index in a given year is crosses some pre-agreed threshold
– Producer needs to pay some fee, a premium, to participate in the program
– Government may subsidise the program (effectively the norm in the U.S.)

7

Forms of "traditional" insurance possible at farm level

– Named peril insurance – frost, hail and fire (commercially available in Australia)
– Multi-peril insurance – yield focus (limited commercial availability in Australia)
– Crop revenue insurance – protects against any source of revenue loss, i.e. prices and yields (doesn’t exist in Australia)
– Mutual funds or farmer pool – effectively a risk sharing cooperative (doesn’t exist in Australia)

8

What problems face "traditional" insurance?

– Moral hazard occurs where the farmer’s optimal decision may be different with insurance as compared to those without insurance – farmer may act more carelessly with insurance cover.
– Adverse selection relates to situation where farmers that choose to insure at a given rate (premium) are also the ones who are exposed to greater hazard – farmers who don’t face risk, don’t buy insurance.
• Consequence is more expensive insurance products , so government often has to subsidise premiums

9

Modern alternative to "traditional" insurance for farm level destruction and yield insurance

– Weather derivatives – insurance contracts written on rainfall or temperature indexes, with defined payout at an index threshold.
– Area yield and yield index insurance – define index on regional yields or on model of project farm level yeild
• Both offered to some extent in Aus
• Assumption: the index (i.e.rainfall)is strongly correlated with insurance target (i.e. yield), but index might be built on poorly correlated weather station

10

Farm level price insurance

- Number of mechanisms, primarily forward buying/selling
- Future contracts are a highly standardised form of forward selling/buying contract

11

Future contracts

– Trade on an organised exchange centre (ASX, CBOT)
– Specify a product, delivery date, delivery mechanism and
exchange price
– Payments (to and from) are backed by the exchange
– Agreement is backed by a good-faith deposit-margin

12

Future contracts in AUS

• More uncommon, most of the available contracts are written for grains
• Previously, futures markets have operated for cattle and various classes of wool
• Possibly reflects the smaller Australian market, less size and less attractive for traders

13

Spot and futures prices

• Thecashor‘spotprice’istoday’spriceforaproduct delivered today
• The‘futuresprice’istoday’spriceforaproducttobe delivered in the future

14

Relationship between spot and futures prices

- 'Basis' - the difference between the spot and futures price
- For storable commodities there are 3 relationships between spot and futures prices:
1) Spot and futures prices are almost the same (they converge) at contract maturity/expiration – the basis gets close to zero
2) Prior to contract maturity, futures prices are above spot prices by the cost of holding the commodity until contract maturity
3) Futures prices and spot prices tend to co-move

15

Offsetting futures contract

Absolving yourself of the requirement to do anything at all by buying and selling the same number of units

16

Define 'hedging'

- Insuring against future losses by giving up future profits
- Double sided contract which buffers the potential for profits or losses

17

Ft
Ft-1
Bt

Ft-1 - price at which we sell our futures contract initially
Ft - price that we buy back the same units for
Bt - basis (difference between spot and futures price)

18

Hedging: if Ft is higher than Ft-1

- Lose money on futures trade
- But spot price is higher, so make more money on spot trade
- Spot trade offsets losses made in futures trading

19

Hedging: If Ft-1 is higher than Ft

- Make money in futures trade
- But lose money on spot price trade