Teaching Price Risk Management with Real-time Simulation

John Van Sickle Food & Resource Economics Dept.

&

Mary Sowerby Animal Sciences Department

Observation 1

• Many commodities –corn, wheat, soybeans,beef and pork –have a long tradition of producers using futures and options for risk management, especially in the Midwest.

Observation 2• Some commodities (dairy in particular) and

some regions of the United States,lack tradition and “wisdom” gained from long-time useof the futures market for risk management.

Observation 3• Result: Fear!

Based on: - lack of personal experience and - observed bad experiences of others.

• Even those with knowledge of theoretical concepts for managing risk with futures and options often:- lack the discipline or - fear implementing risk management strategies (pulling triggers).

Milk Price VolatilityMonthly Class III Milk Prices Jan 2004 – Dec 2010

1 2 3 4 5 6 7 8 9 10 11 120

5

10

15

20

25

2004200520062007200820092010

Range of potential outcomes highlight the risk associated with milk price

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec0.00

5.00

10.00

15.00

20.00

25.00

Ave+2SD (95%)Ave+.67SD (50%)AverageAve-.67SD(50%)Ave-2SD(95%)

Program Objectives• Teach dairy producers the concepts of risk management

with futures and options for managing their milk and feed price risk.

• Give producers the experience, ‘feel’ and knowledge of implementing risk management practices by using FACTSim with ‘real-time’ markets to make trades.

• Expose producers to risk management alternatives with Livestock Gross Margin Dairy insurance (LGM Dairy).

Interested Clientele

• Since February, 2009, 40 people have attended one or more of 24 Dairy Risk Management meetings.– 28 dairy producers– 2 bankers– 3 feed mill managers– 3 dairy industry sales reps– 2 insurance agents– 1 journalist– 1 commodity trader

Producer Clientele Stats

• Owned farms with between 400 and 4,000 milking cows.

• Between ages 28 and 65.• From 6 Florida counties and one Georgia county.• Some raised most of their own forage, others did

not.• All purchased grain for their cattle.• Advanced booking only previous risk management

strategy.

Most Interested Clientele

• Core group of 4 dairy producers and one ADM sales rep were most interested. - All were college educated.- Between age 28 and 40.- 2 were partners of their own 500 cow dairy.- 1 partnered with his father (600 cows).- 1 partnered with an established producer (700 cows).

Base Knowledge and Action

• Initially none of the participants had ever used the futures market or options for risk management of feed or milk.

• Booking feed ahead was used by some as a risk management strategy.

• None had used LGM Dairy insurance. • All accepted whatever price of milk their coop paid.

Initial Producer Deterrents to Implementing Risk Management Practices

• Feeling that Hedging not needed when market for milk is low.

• Lack of cash flow for margin requirements and working with uninformed bankers.

• Family generational disagreements.

Initial Producer Deterrents to Implementing Risk Management Practices

• Fear (futures market seemed riskier than accepting mailbox price).

• What if – there’s a margin call and banker pulls support, or there are missed opportunities for larger profits, etc.

First Objective – Teach Hedging Fundamentals

• Understanding risk and its potential impact on their operation

• Hedging with futures – taking a position in a futures contract opposite to position held in the cash market

• Simple options hedge – buying puts for products you produce to protect against downside price risk. Buying calls for required inputs to protect against rising input costs

• Advanced options hedge – Fencing to lock in a range of potential price outcomes

First Objective – Teaching Hedging FundamentalsFlorida Monthly Milk Basis

Minimum Basis '95-Present

Average Basis '95-Present

Maximum Basis '95-Present

Basis Standard Deviations '95-

Present

Coefficient of Variation '95-

PresentMonth

$2.63 $4.39 $6.67 0.96 21.82 Jan

$1.81 $4.43 $10.05 1.92 43.43 Feb

$1.79 $4.02 $7.66 1.51 37.51 Mar

($0.92) $3.55 $5.54 1.68 47.22 Apr

$0.91 $3.48 $5.88 1.35 38.90 May

$1.83 $3.69 $6.20 1.12 30.41 Jun

$0.74 $4.01 $7.16 1.81 45.10 Jul

$0.43 $4.24 $7.57 2.05 48.41 Aug

$1.68 $4.16 $8.13 1.89 45.43 Sep

$1.59 $4.85 $7.89 1.79 36.93 Oct

$2.09 $5.62 $8.93 2.17 38.64 Nov

$2.52 $4.56 $7.24 1.52 33.45 Dec

Objective 2 – Teach market fundamentals and give producers the experience and feel of implementing

risk management strategies • Teach market fundamentals by keeping them

apprised of current outlook and highlighting factors impacting the outlook.

• Use FACTSim to give them experience at implementing risk management strategies with futures and options.

This Presentation provides an overview of the FACTSim Financial & Agricultural Commodity Trading Simulation. Use the arrow key to move forward and back in

the presentation

The Trade Homepage provides an overview of the status of your account. It provides a statement on your current cash position and profits, plus a summary of news items posted by the Instructor of the group.

The Trader Homepage also shows the current status on current open positions and;

a listing of the 5 most recently queued

positions to be opened.

Objective 3 – Expose producers to Livestock Gross Margin Insurance - Dairy

Livestock Gross Margin Insurance Dairy Cattle (LGM Dairy) provides operators of all sizes a chance to manage price risk associated with milk price and feed cost.

Producer Changes in Risk Management

• Advanced BookingAll producers felt better prepared to make advanced

booking decisions based on: - fundamentals they learned about the markets as

they used FACTSim for trading and - discussed the markets during training sessions.

Producer Changes in Risk Management

• Risk management with futures and options– Producers increased their use of futures and

options, but still struggled with financing margin requirements and family fears about futures and options.

Producer Changes in Risk Management

• Risk management with LGM Dairy Insurance– The forced decision points in insurance facilitated

pulling triggers.– Previous training on risk management made it

easier to understand LGM Dairy Insurance. – All were implementing some level of risk

management with LGM Dairy Insurance.

Conclusion 1

• Farmers are anxious to learn new risk management strategies, but need training on ‘pulling triggers’, i.e., implementing strategies.

– FACTSim helps bridge this issue.

Conclusion 2

• FACTSim has given agricultural producers knowledge and experience for implementing new risk management strategies.

– FACTSim provides a platform for communication and training.

Conclusion 3

• LGM Dairy Insurance is a good alternative for implementing risk management practices. - Risk management training developed the foundation for understanding and implementing LGM Dairy insurance.

Teaching Price Risk Management with Real-time Simulation

John Van Sickle - sickle@ufl.eduFood & Resource Economics Dept.

Mary Sowerby – meso@ufl.eduAnimal Sciences Department