Given what’s happened in the markets in the past couple of months, it’s a good time to revisit risk: how to think about it, how to manage it and its practical impact on marketing and hedging.
As the coronavirus was unleashing its effects on the markets, I was also reading an interesting book called An economist walks in to a brothel: and other unexpected places to understand risk by Allison Schrager. In a nutshell, it’s about uncertainty versus risk and how to deal with these similar but different concepts.
It’s a good reminder of what we try to do in the markets every day whether marketing grain, hedging currencies or managing investment portfolios.
First of all, let’s compare risk to uncertainty. Risk and uncertainty are often used interchangeably but they are different. In her book, she says: “Risk estimates everything we think might happen, but there are also all the things we never imagined could happen – the difference between risk (what can be estimated) and uncertainty (the things we never anticipate). Risk is our guess about what the future holds. More precisely, it is the range of things that might happen and how probable each event is. The hard part is knowing what constitutes a reasonable range.”
Then there’s also the related concept of volatility. Volatility is more of a mathematical definition of how much a market will likely move in the future based on past fluctuations. Schrager admits that “the past is a lousy way to predict the future. That’s the thing about predicting the future based on the past, it works until it doesn’t because the market keeps changing and estimates based on old data no longer tell you much of anything. What is difficult is knowing when you need to update your data.”
This gives us an idea of risk, uncertainty and volatility. The next logical step is what to do about them. This is where hedging and risk management come in.
As highlighted throughout the book, “risk management is our best guess of what will happen and risk management stacks the odds in your favour. But all this assumes our estimate of risk is a good one. We can anticipate most of the risky possibilities, but what about the remaining uncertainty, the things we never saw coming? How can we plan for the unimaginable? The best way to deal with uncertainties is to go into battle prepared and educated. Risk measurement and risk management offer the most valuable ways to deal with risk and uncertainty. The key is to still be prepared to change strategies and be ready for the unexpected. We have some control over how a risk plays out. The solution to surprise lies not in predicting the nature of the future, but the ability to recuperate swiftly from the initial surprise.”
Whether it’s options, futures, deferred delivery or basis contracts, hedging strategies need to be flexible and work in conjunction with your physical inventory, expected production and any cash sales. If you sell some wheat, you may also need to adjust your hedge positions so your physical wheat is balanced with your revenue management strategies. Also, you’ll want to make a plan B, C and D for your hedging strategies ahead of time, not in the heat of the battle since that’s not always the best time to make decisions. Option strategies are a great farm marketing tool since they are very flexible and can provide a wide range of prices you are happy with based on break-even and profitability levels.
Hedging and revenue management strategies aren’t a free lunch since they are a form of ‘insurance.’ The book goes on to point out that hedging involves taking less risk at the cost of less reward. You give up some of your expected gains, because you are taking less risk.
What takes skill is knowing exactly how to find the right balance between risk and reward, or knowing exactly how much risk to take. So, we won’t get all the highs but we avoid some of the lows. And don’t just weigh the odds of a single play. Consider how hedging factors into the entire game since your pricing decisions won’t necessarily work out every time, but rather over time.
Bottom line, hedging is not a perfect solution or a magic bullet. However, it does allow you to replace risk and uncertainty with a process so you can build prices you want for your farm over time. Hedging can help you make extra money and reduce risk. This can pay salaries, build up equity, create a capital cushion to offset bad years and ultimately make your business more robust. It can be challenging to hedge extreme market price moves so having cash and investment reserves, a strong balance sheet, operational flexibility and access to capital all help manage the risks of a farming business.
My own bigger-picture definition of risk is the consequences of not meeting your goals. Hedging can help you meet those goals. Like most types of protection, options and futures may have some costs associated with them but they can give you the downside protection you need with the upside potential you want. Ideally, this lets you capture more in the good years, mitigate the bad years and improve revenues over the long run.