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Chapter 9 Managing Other Hedging Risks

Chapter 9 Managing Other Hedging Risks. Compensating Balances. The comparison between the potential cash market loss and the potential gain from mitigating the cash market risk via a price-based derivative on the same commodity should be similar.

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Chapter 9 Managing Other Hedging Risks

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  1. Chapter 9Managing Other Hedging Risks

  2. Compensating Balances • The comparison between the potential cash market loss and the potential gain from mitigating the cash market risk via a price-based derivative on the same commodity should be similar. • The real reason to mitigate a cash risk is the total value that is at risk. • Convert compensating balances into dollar equivalency. • All that matters for the hedger is mitigating cash streams.

  3. Cross Hedging • After applying dollar equivalency, other agricultural risks that may not have traditional futures, options, or swaps become manageable. • Hay producers can mitigate the price risk if hay price is correlated to the price of corn. • Hay and corn prices must be tightly related to one another. • See Figure 9-2.

  4. Hedging Ratios • Defined: The action of adjusting the number of derivative contracts to achieve matching cash streams with the cash position. • These ratios are often developed with past historical information. • Risk minimizing ratios are hedging ratios that are developed to compensate for basis changes with futures as the hedging tool. • Difficult to use hedging ratios on small cash positions. • Figure 9-3 illustrates a hedge with hedging ratios.

  5. Supplemental Insurance Hedge • Supplemental insurance hedging is the idea of increasing the coverage level via derivatives. • The general idea is based on some predetermined value calculated on historical production records and an average cash market price or some set futures price. • Difficult to hedge against as the production loss is event specific. It would require a derivative that produces a positive cash stream when there is a negative event.

  6. Portfolio Hedging • Several financial products are packaged together such that the risk of a single instrument changing in value is offset with another that changes in value the opposite way. • The traditional agricultural portfolio model is crops and livestock.

  7. Weather Derivatives • Currently only heating and cooling days have futures contracts. • There has been a small push historically for such contracts due to crop insurance and governmental support programs.

  8. A Final Word on Hedging • All types of risk management involve trade-offs between cash streams and the risk associated with each cash stream. • The goal is to have them cancel out. • It is important to focus on managing the risk, not on the tools used.

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