Risk Tolerance
There is no rule of thumb when it comes to managing risk as everyone has a different risk tolerance. Managing price risk is best compared with buying car insurance. Most people take out comprehensive insurance on a new car as they believe the risk of damaging the car and being hit with a hefty repair bill is worth offsetting with the insurance premium. As the car is devalued with age, some people will drop the comprehensive policy in favour of a third party policy as they believe that the cost of insurance outweighs the expected benefit. The risk of an accident has not necessarily decreased, but the cost of an accident is lower and these people are comfortable with this level of risk.

The decision on whether to use futures is similar. Producers will weigh up the costs and benefits and come to a conclusion based on their willingness to accept risk. The various risks and their associated considerations are discussed below.

Adverse price
The risk of adverse prices is the main reason that producers use futures. By selling MLA/SFE Beef futures the producer is protecting themselves from the risk that the Eastern Young Cattle Indicator (EYCI) will be lower at sale time than the futures market is currently predicting.

The beef producer is reducing the risk to their business of prices falling. Many producers, generally sceptical of futures markets, will worry that when they lock in the EYCI using futures, they are also reducing their exposure to higher prices. This is true; but this is the cost of using futures. Every insurance policy has a cost; the decision to participate in the futures just depends on whether you believe the potential cost outweighs the potential benefit.

To get past this issue, producers need to remember that the price that is locked in on the futures market should allow the producer to meet profit targets. When the EYCI is locked in, the major component of price is secure, and producers can then start to concentrate on the other risks to which their business is exposed.

Basis Risk
Basis risk has been discussed in previous articles, but to quickly recap; basis is the difference between the EYCI and the price of the cattle being sold. For example, if the EYCI on the day of the sale is 350¢/kg dwt and the cattle are sold for 360¢/kg dwt, the basis is +10¢/kg dwt. This basis component of price is generally lower than the EYCI and therefore is also a lower risk than the EYCI. There are, however, ways to manage this risk and avoid getting caught out.

The best thing you can do is some research into historical basis levels for the particular cattle type at the particular time of year. Basis fluctuates throughout the year and can be predicted with reasonable accuracy. Just because you lock in futures at 360¢/kg dwt against your cow sales, does not mean you will get 360¢/kg dwt for you cows. Basis for cows is often about -80¢/kg dwt, so locking in the EYCI at 360¢/kg dwt means you could expect a net price of about 280¢/kg dwt for the cows assuming you have accurately predicted basis.

The risk of basis being lower or higher than expected can be managed by some forward thinking about supply and demand for the particular cattle type relative to the EYCI. For example, following a severe drought during which many producers were forced to liquidate some breeding stock, you might expect demand for cows to be higher than average due to increased demand for, and low supply of restocking cows.

If you would like to lock in basis to remove this risk, a basis contract might be useful. Many feedlots are now offering basis contracts where they agree to pay a premium above the EYCI at delivery. Therefore if, when the cattle are delivered to the feedlot, the EYCI is at 355¢/kg dwt, and the basis contract is for a 20¢/kg dwt premium, the price paid will be 375¢/kg dwt.

MLA are about to release a standard forward contract that includes a basis contract option. This will simplify the process, enabling more producers to start negotiating basis contracts between themselves; formalising paddock sales, and allowing price risk management for sales negotiated in advance.

Margin Risk
The idea of a Margin is enough to send many would be hedgers running. A margin is the cash required by your broker once the futures contract has been traded to guarantee your involvement and prevent you reneging on contracts. Without margins or some form of guarantee, the futures market would fail.

After trading a futures contract, if the market moves against you (i.e. up for sellers and down for buyers) you will be required to pay a margin to cover this movement. If the market moves in your favour, someone else will be paying a margin to you. This ensures that at all times every contract is even, and if someone defaulted on a contract no one would be out of pocket.

Margins can cause problems for a businesses cash flow, particularly if there is a large movement in the market. These cash issues are short lived however, because as the market is rising, the value of your beef is also rising, so the money will be eventually returned to you when the cattle are sold.

Margin risk can be dealt with in two ways; you can make sure your bank understands what you are doing and ask it to provide a low interest line of credit to finance the margin calls and help manage your risk, or you can use Beef Swaps.

Beef Swaps operate in much the same way as beef futures however there is no margining. Instead the bank will ask for security to guarantee your position.

However you go about managing your margin risk, remember it is a necessary part of the forward market and can work in your favour.

Production Risk
Production risk covers a whole gamete of smaller risks. These include, but are not limited to; frost, flood, drought and disease. Production risk is important to consider when determining how much of you production should be hedged. If you hedge 100% of you expected steer sales and disease kills 20% of you steers you will end up over hedged. This effectively turns you into a speculator rather than a hedger. Let's say you hedge 100 steers and 20 of them die. The 20 head that you forward sold (and subsequently died) are a direct loss to the business but the value of loss to the business will be determined by the futures market. If the futures market rises the value of the lost animals effectively increases, thereby increasing your loss. This is not a pleasant scenario.

To avoid this scenario, production risk should be continually assessed. As the sale date nears the risk of loss will decrease, and so the proportion of cattle hedged can be increased.

Summary
Managing the risks in an agricultural business can be a daunting task; however futures should be viewed as a tool to assist in managing risk rather than as a risky proposition in their own right. Understanding how futures relate to other risks can help put it all into perspective.

The adverse price risk, the basis risk and the margin risk discussed in this article, all pale into insignificance when compared with production risk. A secure price should be seen as an asset rather than a risk. An asset that can help with forward planning and give you a better understanding of your exposure to production risk and how much you can afford to spend on supplementary feed, vaccinations and insurance to manage your production risk.