Agriculture is traditionally one of the highest risk economic activities. In California, many produce farm operations use a rule-of-thumb to manage their seasonal finances–often aiming to contract 80% of their crop in advance to buyers at set prices, and leaving the remaining 20% to be sold at spot prices in the open market. The rationale for this is based on an assumption that costs, and a reasonable margin, can be covered with 80% of production hedged by forward contracts. The hope is the remaining 20% of production will attract high prices in favorable spot markets, leading to substantial profits on sales. Of course, spot prices might not be favorable, in which case any losses could be absorbed by the forward sales.
Steven Slezak, a Lecturer in the Agribusiness Department at Cal Poly, San Luis Obispo, and Dr. Jay Noel, the Agribusiness Department Chair, used @RISK to conduct a case study on an iceberg lettuce producer that uses the rule-of-thumb approach to manage production and financial risks. “We wanted to know if the 80% hedge actually covers costs over the long-term and if there are really profits in the spot market sales. We wanted to know if the return on the speculation was worth the risk. We found the answer is ‘No’.”
Slezak and his colleagues created an @RISK revenue distribution model with inputs such as past revenue, harvest costs, and crop yields. They used StatTools to create the distribution parameters. Next, @RISK was used to simulate combinations of all costs and revenue inputs using different hedge ratios between 100% hedging and zero hedging. By comparing the results of these simulation in terms of their effect on margins, it was possible to determine the effectiveness of the 80% hedging rule of thumb and the value added by holding back 20% of production for spot market sales.
“While growers have to give up some of the upside, it turns out the downside is much larger, and there is much more of a chance they’ll be able to stay in business,” says Slezak. In other words, the cost-benefit analysis does not support the use of the 80% hedged rule-of-thumb. It’s not a bad rule, but it’s not an optimal hedge ratio.
Slezak is a long-time user of @RISK, and has relied on the software to perform economic and financial analysis on a wide range of problems in industries as diverse as agribusiness, energy, investment management, banking, interest rate forecasting, education, and in health care.
Read the complete case study here.