-SIDDHARTH SURANA
Risk Management in Guar Value Chain
Agenda
Price risk management for value
chain
Practical issues in hedging
Key Elements of a hedge program
Guar Value Chain
Farmer Traders Processor/ Exporter
End User/
Importer
Farmer
Grow guar in hope of good prices
but..
What if all the farmers think alike?
How to protect against price fall?
Guar Marketing Options
Sell in Cash (Spot) Market
Enter a Forward sale contract
Hedge in a futures
Buy ‘Put’ options (Not really an option currently)
Sell in the Cash Market
Guess when the highest price will come Sell when you need the cash Sell a little bit throughout the year Sell when price reaches a target Sell by a certain date-whatever be the
price Aren’t all the above features of S..... ?
Forward Contracts
• Fixed price contract for a set delivery location, date, quantity and quality
• Contracts can be:• Pre-harvest (production unknown)• Post-harvest (production known)
Lock in a sure price (but give up a gain if the prices increases later)
Can contract for any quantity, quality, place and date-provided you find a buyer
Search cost, negotiation on specification Can’t lift the hedge Can’t sell your produce to anyone else Counter-party risk?
Hedging with futures
Sell futures contract on a commodity exchangeWhen you sell the physical commodity, buy back the
contractAlternatively deliver against futures positionLoss/gain in the cash market is offset by the gain/loss
in the futuresCan lift the hedge any timeCan sell the physicals anytime, to anyoneStandardized specs (lack customization but no need
for negotiation)Ready availability of buyersNeed for Margin and MTM paymentsCounter-party risk is guaranteed*
Calculation
1st Aug.: A farmer is expecting new crop to arrive in November
Prevalent price of Nov. contract: Rs 5,000Farmer wants to lock in the price for his 10MT
expected production of guarHe sells 10MT Nov. expiry guar futures.Scenarios on 20th Nov.
Spot price =4800=Nov. futures price Gain on Futures position=Rs 200/Qtl Realization from cash sale= Rs 4800 Net price=4800+200=5000
Calculation
Scenario on 20th Nov. Spot price =5200=Nov. futures price
Loss on Futures position=Rs 200/Qtl Realization from cash sale= Rs 5200 Net price=5200-200=5000
Spot Price=5000=Nov. futures Gain/Loss on Futures position=0 Realization from cash sale= Rs 5,000 Net price=5,000
Trader
Exposure to flat price movementInventory price risk
Can sell futures to the extent of guar stock Keep rolling-over till the time of physical sale
Forward commitment Go long on futures Once physical is covered, lift the hedge
Processor/Exporter
Exposed to both sides-RM prices and Finished
goods
Example: Split miller has committed a powder
plant 50 MT of guar split to be supplied in January.
Exposure to seed prices going up
Hedge by buying seed futures
Lift the hedge when physical is covered in spot
market
Alternatively, can stand for delivery in futures
Have split/seed stocks- can go short in futures to
hedge
Processor/Exporter
Example: A Guar Powder manufacturer has committed an export shipment of 500MT by March 2014
Risk: Splits prices going upHedge by splits (Guar Gum) futuresLift the hedge when physical is coveredAlternatively, can stand for delivery in futuresRisk to powder prices: No direct contract but
can be hedged with gum futures (only if you have ready stocks).
End User/Importer
Risk: Guar gum prices going upDomestic consumers can hedge by going long
on guar gum futuresForeign buyers?
No direct access Fully owned resident subsidiaries can access Indian
market
Recap-How to Hedge ?15
Hedge starts
• Creating a futures position that is roughly equal to and opposite to the cash market exposure to be hedged
Hedge Life
• Mark-to-market on the basis of price movement in the Exchange
• Minimum Margin to be kept with the exchange
Hedge end
s
• The profit (loss) in the cash position is offset by equivalent loss (profit) on the futures position
• End result is a locked-in price irrespective of marker movement
How much to hedge
Rule BasedManagement decides to hedge up to a certain
percentage of Price risk exposure.Example - 60% of monthly productionIncremental hedge percentage based on achievement
of various price targets/forecasts
Statistical methodCalculating hedge quantity using Historical Hedge
Ratio methodHedge to the extent that cash prices is correlated
with the futures’ price
How much to hedge
Dynamic Hedge
Dynamic hedging is done on the basis of a price
forecast
During periods when favorable price movement is
expected, the hedge is held in abeyance
Hedge is entered into when adverse price movement
is expected
Exposed to risk if price views turn out incorrect
Benefits of Hedging
Stability of earnings & secured minimum operating margin;
Monetise value of unused commodity Reduced cost of borrowing from banks Increased access to credit as confidence of
repayment increases Capacity building for improved risk
management also strengthens marketing / financial knowledge
Practical Issues in Hedging No Hedge is perfect but all hedges cost money
Duration and Quantity mismatch
Duration mismatch (Futures expiries are on standard
dates) If timing of cash market exposure (buy/sell) is known in advance,
use futures that most closely matches the same
When timing of cash market exposure is not known, or if far month
contracts are not sufficiently liquid, hedge in the near contract and
keep rolling
Quantity mismatch (Futures have standard lot size) Try to match futures and cash position as closely as possible
Basis
The difference between the cash price and futures
price of a commodity.
Basis = Spot price – Futures price
Basis is:
Specific to time and place
Less variable than overall price
Relatively predictable, typically narrows, leading to
conversion
Basis
Basis
Prices
Present ExpiryTime
Futures
Cash
Basis
What causes basis?
Local demand supply scenario
Relative storage capacity
Transportation availability and cost
Time to expiration (cost of carry)
Quality differential
Possible Solutions
Enter into Basis quoted contract with your supplier or
buyer
If you have entered into a contract to supply, you can
buy corresponding futures (and hope for the basis to
remain favorable)
Basis forecasting methods Current basis Last year same time Last 3 years' average Current basis adjusted for cost of carry
Key Elements of a Hedge Program
Identify, Analyze and Quantify Market Risk
Develop a Hedge Policy
Controls and Procedures
Implementation of Hedge Program
Monitoring, Analyzing and Reporting Risk
Repeat
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