VALUE AT RISK: AGRICULTURAL PROCESSOR PROCUREMENT AND HEDGING STRATEGIES

Abstract

Agricultural firms that use Value at Risk (VaR) tend to be the large diversified corporations. The benefits of VaR in the agricultural industry are not limited to large conglomerates; however, and this study provides empirical examples of how mid to large sized commodity end-users can use VaR to quantify price risk exposure. By reporting price risk in terms of dollars as a single summary statistic, VaR provides a more intuitive measure of risk for decision makers, especially when the distribution of portfolio value changes is non-normal. VaR also separates downside from upside potential by focusing on the left-hand tail of a portfolio's distribution of returns. The purpose of this study is to demonstrate how VaR can be applied to the portfolio of a hypothetical U.S. bread baking company. Six of the bakery's prominent commodity inputs were considered, including flour, bakery shortening, and sugar. Mill feed price risk was also included since it is commonly a component of flour pricing agreements. In one case, a portfolio of costs and the risk of procurement cost changes are measured. In another case, output price risk was included and represented white pan bread prices as a price risk variable. This portfolio contains both cost and revenue items, and the risk of payoff changes resulting from input and output price changes is considered. In another case, the VaR for a Mexican flour milling company was modeled inclusive of the effect of foreign exchange risk. In each case, different hedging instruments were considered for use in various hedging strategies. Though VaR can be utilized by decision makers for numerous management aspects, in the cases analyzed in this study VaR estimates are used to quantify the price risk associated with different hedging strategies. While risk reduction is the primary reason for hedging, it is not the only aspect that management must consider. Numerous other aspects enter into the decision, which are not represented in the VaR statistic. Therefore, VaR is a valuable tool for measuring the risk exposure of these firms, but in no way does it tell the whole story.