Managing Risk in the Beef Cattle Industry

1. Managing Risk in the Beef Cattle Industry Presentation to: AAEA Annual Meeting Red Deer, Alberta May 4, 2006

2. Managing Risk in the Beef Cattle Industry Price Presentation to: AAEA Annual Meeting Red Deer, Alberta May 4, 2006

3. Introduction • Our involvement began with the U.S. Livestock Risk Protection (LRP) program • Recent border closure underscored shortcomings of using U.S. risk management products • Recognized from the outset that no single risk management tool will appeal to all Alberta cattle producers • Think long term! Where does the industry want to be 10 years from now?

4. Background • Alberta cattle producers perceive their price risk as having 3 components: • CME futures • C$/US$ exchange rate • Basis • Currently there is no single risk management tool that captures all 3 components • No mechanism at all to manage basis risk

6. Approaches to Managing Price Risk • Self insurance • Diversification • Reliance on government support • Exchange-traded futures (CME) • Exchange-traded options (CME) • Forward currency market • Forward cash contracts • Insurance-based products

7. Cattle Price Insurance Program (CPIP) Background • Original pre-feasibility study completed for ABP • Subsequent funding was provided by the federal Private Sector Risk Management Partnerships Program (PSRMP) • Insurance-based product versus financial derivative • Price-related insurance is the fastest growing form of insurance in agriculture today

9. CPIP Basic Structure • CPIP offers insurance for various delivery periods and coverage levels…throughout the year • The orientation is that of a private insurance policy, not a government support program • Premiums and coverage levels adjust to the underlying market • The producer chooses the number of pounds to insure for each period and the coverage level • The producer pays the premium up front • The payout or “indemnity” is based on the difference between the Insured Price and the Index Settlement Value as of the claim date

10. Sample CPIP Premium Sheet

11. CPIP – Benefits • Insurance is a concept that is well understood and possibly more “user-friendly” • CPIP is based on Alberta cattle prices and will be effective under any “border” scenario • i.e., basis risk is covered • bundling of CME, C$/US$ and basis risk into one product • CPIP is a simple program from the producer’s perspective • Participation is voluntary

12. CPIP – Benefits (con’t) • CPIP is very flexible in terms of the coverage provided • CPIP provides a predictable level of protection and easily calculated payout • CPIP can be used for “disaster protection” or “margin management” • CPIP has a fixed cost to the producer and no potential for margin calls • CPIP requires producer to think proactively about his price risk

13. CPIP – Key Challenges • Requires “cultural change” in producer attitudes toward risk • Requires construction of fed and feeder cattle indices for policy settlement • Feeder cattle are more complex and likely require more than one product • Some deficiencies in feeder cattle price data • Quantifying “border risk” is problematic for a private insurer

14. Index Design • Insurance product depends on a viable underlying index • CanFax only viable data source for fed cattle • Auction markets key data source for feeder cattle • Historical indices were created back to 1990 • Note: Index can provide a platform for a variety of risk management products!

15. Policy Rating Methodology • CPIP similar to a put option • Underlying model used is Bermuda-Asian (FinCAD) • Non-tradability • Key inputs • volatility • forward price • Premiums are 75-85% of comparable American style options (based on recommended methodology) • Pricing “border risk” always reverts to the assumption used for the probability of it occurring

16. Summary • Price insurance is one possible approach to developing a “made-in-Alberta” risk management product • Fed and feeder cattle price indices may spawn other risk management products over time www.gibsoncapital.ca