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Managing Hedging Risks: Strategies for Mitigating Cash Market Risks in Agriculture

This chapter explores techniques to manage hedging risks associated with agricultural cash market fluctuations. It discusses the importance of compensating balances and the conversion into dollar equivalency, emphasizing the primary goal of mitigating cash streams. Cross hedging, where correlated agricultural commodities help manage risk without traditional futures, is highlighted. The chapter also covers hedging ratios, supplemental insurance hedging, and portfolio hedging to offset risks through diverse financial products. The focus is on risk management and the importance of navigating trade-offs in cash streams.

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Managing Hedging Risks: Strategies for Mitigating Cash Market Risks in Agriculture

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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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