Know Your Market
Know How Your Risk Management Plan Will Impact Your Business
Nov 18, 2013
You should be able to easily see what you’re investing into a risk management strategy and what you’re getting in return.
By Katie Krupa, Rice Dairy
Recently I was talking with a dairy producer who had used risk management in the past but was displeased with his results. With some further discussion of his past hedge strategy, I realized that he wasn’t sure what exactly he had done and, more importantly, he had no idea what type of protection he had for his dairy business. He had essentially put money into risk management program with no understanding of the level of protection he was receiving. He, like many producers, had a hard time understanding the tangible benefit of the risk management strategy he utilized.
This is something that should be addressed to every producer when he or she is establishing a risk management program. Whenever you invest time and money into something, you should know what you are getting.
With dairy risk management, that becomes more difficult since there are many moving pieces to the puzzle. The general idea is that producers should be able to easily see what they’re investing into a risk management strategy and what they are getting in return. For example, a $0.25 premium cost for an options strategy may protect your Class III milk price at $17.00 on the downside. This is a very important start to understanding your strategy.
But it’s only a start. It’s good to take this to the next level to understand what a $17.00 Class III price means for your business’s income. Adding in your production costs and your potentially hedged feed ingredients will enable you to see your potential profit per cwt. Therefore, the $0.25 per cwt. investment that’s protecting Class III at $17.00 may be protecting an anticipated profit of $1.00 per cwt.
The concept may sound simple: Understand the per-cwt. projected profit margin (or even limited loss) you are protecting with your risk management plan. But unfortunately this is rarely done. Most producers do not utilize a risk management program that allows them to see what they are protecting (profit/loss potential), and then the ability to go back and historically review their results.
Many producers would benefit from using a program/broker/consultant that provides an easy-to-read, risk-management plan analysis. What I mean by this is that many producers don’t have the ability to do a sensitivity analysis on their risk management plan. That includes the ability to review your risk management plan and ask, "What if milk price drops to $14, or increases to $22? How will that impact my bottom line?"
Having a model on paper will ideally make your risk management decisions easier to make because you can easily see the financial impact of the strategies you are reviewing. Additionally, many producers tend to get caught up in the amount of money they "spent" on their risk management program rather than the amount of coverage they received. Having a program that will show you how much money you invested into your risk management plan and how much coverage you had in return will theoretically make your decisions easier, and make you feel better about your decisions after the fact.
While not all producers need a detailed program to understand the long-term benefit of the risk management programs they are using, many producers find an easy-to-read analysis helpful to their understanding of their risk management program. I recommend finding a broker and/or program that can provide you with detailed enough information for you to comfortably make your risk management decisions. Also, I would periodically suggest going back and reviewing how your employed risk management plan performed. Did you get enough downside protection? Did you get enough of the upside potential of market? Was your actual milk price received what you expected and did it satisfy the financial needs of your business?
When working with risk management, it’s not about more information. It’s about more useful information. Understanding how your risk management plan impacts the financial strength of the business is crucial for your business and your future success using risk management programs.
Katie Krupa is a broker with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. You can reach Katie at firstname.lastname@example.org.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.