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Creating a Risk Management Plan

May 02, 2011

Here are seven key questions to ask yourself in developing your hedging strategy.

By Will Babler, First Capitol Risk Management, LLC
In my previous article, we discussed selecting the right hedging tool at the right time. Another important aspect of applying the right tool at the right time is to do so consistently. We have found that this is best done by planning ahead and documenting objectives, limits and organizational control points in a written hedging policy. When it comes to hedging, as in other aspects of managing a dairy, failing to plan is planning to fail.
Here are some key questions that should be answered in a good risk management policy.
1.       What is the purpose of the plan?
The purpose of a risk management plan, or policy, is to drive intentional decision-making. When a game plan has been written down on paper and approved by a management team or board of directors, it empowers the decision-makers in the organization. The purpose section of any plan should include an acknowledgement of commodity risk and the explicit statement that commodity transactions will be taken for the purpose of managing risk and not speculating.
 
2.       What is my hedging strategy?
In our view, a hedging strategy should encompass two ideas: 1) to minimize risk; and 2) to capture opportunity. Making this clear statement in a risk management policy sets the framework for how decisions will be made relative to selecting hedge positions.
 
3.       What are my position limits?
There is a huge universe of potential tools that can be used to manage commodity risk. Depending on experience and risk tolerance, a hedger should limit this universe of tools to the ones that will be most useful for their particular situation. This section should determine which markets are allowed (i.e. corn, milk, soybean meal, etc.) and what types of position can be taken (futures, options, option spreads, marginable positions, etc.). In addition to qualitative limits on markets and position types, this section of the policy could also set specific quantity limitations on how many open contracts can be held for any particular category of position.
 
4.       What budget am I willing to spend on hedging?
Closely tied to position limits in any hedging plan is the hedging budget. Setting a budget for option premiums has several benefits. Budgets provide the ability to plan for cash flows as well as restrict the possible choices of hedging tools so that the range of decision points is reduced. This drives timely decision-making. Budgets should account for a hedger’s risk tolerance and financial capacity as well as values that historically would be practical to execute in the market.
 
5.       What profit targets do I want to hit?
This is the million-dollar question: Essentially how much risk do I want to take and at what level am I comfortable taking a profit? This section of a risk management plan is unique to every dairy based upon its risk tolerance, financial capacity and operational performance. Managing commodity risk and margins is effectively managing the profitability of your business. Setting profit targets can be based on looking at historical performance, equity return expectations or financing and debt coverage requirements. A good policy will lay out specifics as to what profit-margin levels are worth scaling into and for what volume of total production.
 
6.       What financing requirements does my plan create? 
There may be significant financing requirements associated with hedging, depending on the tools allowed in the position-limits section of a hedging plan. Provisions should be made for periodically stress-testing open positions for possible variation margin requirements as well as for stress-testing potential new hedges prior to their execution.
 
7.       Who is responsible for the plan?
Finally, the plan should lay out clearly who in each organization is responsible for the various tasks that the plan will require. This section would identify who is authorized to make decisions, initiate trades and transfer funds. Other details such as reporting, disclosure and accounting should also be addressed in this section of the plan.
 
Conclusion
Over time, we have seen that the most successful hedgers are those who act consistently and decisively. Having a written risk management policy is one way to drive that behavior and potentially replicate their success. Markets aren’t interested in waiting for any individual to make a decision about what they should do.
 
With increased volatility in prices and margins, it is increasingly important to act decisively. Taking decisive action is much easier when the emotion has been removed through planning where everyone in the organization is in agreement as to hedging objectives. We strongly advise seeking out experienced advisors and putting pencil to paper to create a written plan before embarking on any hedging endeavor.
 
Will Babler is a principal partner at First Capitol Risk Management, LLC. Contact him at 815-777-1129 or at wbabler@firstcapitolrm.com. Visit the company’s website at www.firstcapitolrm.com.
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