United Grain Growers
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Transcript of United Grain Growers
United Grain Growers Limited (A)
Syndicate 5 (Ape Syndicate)Yuliana Irmina 29110389Decky Prasakti 29110391
Resti Athayani 29110402Ronaldo Bagus Putra 29110404Lamya Nur Zahidah 29110406Harry Riusxander 29110408
Wisnumurti Rahardjo 29110412
Background
• United Grain Growers (UGG) is one of the Canada oldest grain distributors in Canada.
• The agriculture business was risky. Anything that affected the quantity of grain shipped had a material impact on the firm’s revenues, profits and cash flow.
• UGG was still faced with the problem of how to deal with the biggest risk: the weather
• UGG has to identify the principal risks of the corporation’s business and ensuring the implementation of appropriate systems to manage these risks.
Grain Distribution
The industry is quite volatile, characterizes by boom and bust cycles, and its roots in
the forces of supply and demand in the global market
Agriculture and in particular industry was
one of civilization’s oldest industries
Grain supplies were variable due to natural
forces such as pests, disease and weather.
To reduce volatility, many countries create policies in
Canada for wheat (barley and oats/board gain) regulated by Canadian Wheat Board (CWB)
that mandated monopsony
Grain distributor like UGG were important
intermediateries between the farmer and the end
market.
Three largest distributor in
1998 were Saskatchewan Wheat Pool, Agricore, and
UGG
The Canadian agriculture industry was under
pressure from several directions, and many
farmers disagreed with CWB policies and its monopsony power.
In 1995, goverment repealed legislation that kept gain transportation cost fixed (and low) for
many years, and reviewing other grain
transpotation and distribution systems.
United Grain Growers
Established in 1906
1993 restructured itself as a public corporation
Issued limited voting common shares on Toronto Stock Exchange
Strategy:To modernize its grain handling businessTo provide farmers with services beyond grain handling
Core Division
Grain Handling Merchandising
Since 1993, derive about 70% of its income from
grain operation
UGG spent about $65 million on acquiring and
building its non-grain handling business
Build new HTP elevators, upgrade existing elevator,
funding activities
Initial Public Offering
1955- New Industry regulation- Poor harvest contribution
- Railroads began consolidating routes- Distributors can set their own tariffs
- Higher grain prices
- Four out of the five major competitors lost money in the handling business- UGG had to take $12.5 million charge to close 93 country elevators
The Industry Climate
Alberta Pool Manitoba Pool ElevatorsTakeover UGG
Rather than suffer substantial dilution of their existing investment, the bidders withdrew their offer
Two bidders merged from Agricore
The Industry Climate
• UGG formed a strategic alliance with Archer Daniels Midland Company
• UGG also formalized a partnership with Marubeni Corporation
ADM would gain “a secure grain supply for its processing operations”
UGG could “plan more efficiently for future transportation and grain handling demands, and increase market shares
The Industry Climate
The Willis Report1992, shareholders successfully sued their directors because the firm did not hedge it's grain risk when prices were
fallingEmerging interest in risk management
prompted UGG to participate in a benchmarking review of best risk
management practices in its Treasury department
On site Risk Brainstorming
February 11, 1997, twenty UGG senior managers and other employees met for an on site risk brainstorming, with task :
1. to identify the risk the firm faced2. to rank them, by polling the group, in
relative importance to the firm
Willis AttentionWillis focused its attention on the first group of six which included :
A. commodity price riskB. inventory management riskC. customer and supplier counterparts
riskD. account receivable and credit riskE. environmental riskF. weather risk
Earnings at Risk (EaR)Which had been developed by the financial community, to describe aggregate risk.
EaR expressed a "worst-case" loss, set against a benchmark of expected profit, within a specified confidence or probability level.
CHARMCHARM (Comprehensive Holistic All Risk Model) generated graphical output in several formats to highlight the various aspect of each risk.
The most general format was a probability distribution showing the probability of incurring a loss as a function of the size of the dollar loss .
Cox had the information to do something to improve the firm's risk management performance and potentially reduce UGG's long term cost of risk
What to do about the weather ?
• Five of the six risk could be managed through traditional methods.
• But about the weather risk ?– No financial products that would effectively
mitigate the weather risk– Innovation to mitigate : weather derivatives pay
a specified amount of money as a function of a particular weather characteristic
Six Major RiskRisk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested yields
11.5 Weather Derivatives and Insurance
Environment Toxic waste 2.5 Insurance and control
Counterparty Failure of Supplier 4.3 Diversification/Due diligence/Contract
Credit Payment Failure 1.6 Diversification/Due diligence/Contract
Inventory Spoilage of Inventory, UnderStock/OverStock
2.2 Operational Control, and Insurance
Commodity Price Fluctuation 11.9 Futures and Options
List of RiskBusiness interruption
Cargo/marine exposure
Civil disturbance
Commodity basis/ price
Competition
Consumer preferences
Contractual no-performance
Credit/receivables
Counterparty
Directors & officers exposure
Data accuracy
Disease/spoilage
Computer system failure
Employee injury
Employee liability
Employee performance /fidelityenvironmental
Foreign exchange
Head office catastrophe
Industrial espionage
Intellectual property
Interest rates
Inventory
Labor strike
Leverage (too much or too little)Loss of key personnel
Mergers and acquisition
Major property exposure
Pension plan performance
Process compliance/execution
Product liability
Product performance
Quebec separates from Canada
R&D ventures
Regulatory (CWB, transportation)
Stock market crash
Strategic planning
Technology (choice, use of)
transportation
unionization
weather
Willis Group Assessment
41 Risks
The Major Risks are
1 Weather
2 Environment Liability
3 Counterparty
4 Credit
5 Inventory
6 Commodity
The modeled yields, in turn, explained approximately 94% of the variability of UGG’s grain handling earning. The yield depends on the rain according to the regression equation Yield=15.5+0.0577*Rain, R-squared = 43%.
All-Wheat yield in Saskatchewan and the July precipitation for 1960 through 1992
Comprehensive Holistic All Risk ModelCHARM
CHARM plot showing the probability distribution of earning with and without the impact of the weather. When the weather risk is removed, the variation in EBIT is smaller, as shown by the lighter curve, though expected value is the same. The probability showing incurring a loss as a function of the size of the dollar loss.
Definition: What is Value at Risk?
• Summary statistic that quantifies the exposure across many assets/liabilities classes to market risk.
• Identifies ‘How Much’ one can loses if adverse market conditions prevail.
• Captures diversification or Portfolio Effect. • Measurisk Approach
– Full Monte-Carlo Valuation-based without approximations– Risk calculation based on evaluation of log changes in market instruments– Method allows modeling of entire distribution of expected profits and
losses and shape of risk surface over time and tail risk
Nasdaq Drop 95% VaRAsian Flu
Nasdaq Drop
Euro Rally
Earnings at Risk and Corporate Treasury
• Longer time horizon than traditional asset management
• Multi-Step Monte Carlo• More data needed to define covariance matrix
• View of multiple time horizons (I.e. Each quarter of the fiscal year)
• Quantify risk across business lines• Ability to optimize trading activities - view
impact of different hedging strategies
Earnings at Risk
• Measure of earnings volatility• Income Statement Perspective• Used to define risk appetite• Can help answer “What should be hedged?”• Focus on market moves to:
– FX Rates– Interest Rates– Commodity Prices
• Perspective: Basket of Exposures (“Portfolio Effect”)
The Estimation of the 6 Major Risks
Risk Instance(s) Earning at Risk Possible Alternatives
Weather Impact on harvested yields
11.5 None
Environtment Liability
Toxic waste 2.5 Insurance
Counterparty Faliure of Supplier 4.3 Diversivicaiton/DD/Contract
Credit Payment Failure 1.6 Diversivicaiton/DD/Contract
Inventory Spoilage of Inventory, UnderStock/OverStock
2.2 Operational Control
Commodity Price Fluctuation 11.9 Insurance/ Futures
1. Weather
•Its effect on grain volume would disturb the Business
2. Environmental Liabilities
•The Toxic waste released to external environment could raise social risk and could raise penalty from government
3. Credit
•The Failure of UGG Partner to pay their Debt to UGG would Disturb UGG Cash Flow
4. Commodity
•The Fluctiation of Commodity Price could result a severe disturbance to UGG business
5. Couterparty Exposure
•The Probability of UGG Suppliers (Upstream and Downstream) not to meet their contract obligation
6. Inventory
•The Understock condition might result the loss of market opportunity•The Overstock inventory would result higher risk since the grain price are very fluctuative
The top 6 Risk based on its severe risk
Weather Risk ExposureALTERNATIVE RISK
MANAGEMENT APPROACHES1
Retention
Weather Derivatives
The Insurance Contract Idea
Retention
• First, UGG had been and planned to continue making large investments in storage facilities (grain elevators).
• Second, the variability in its cash flows caused UGG to hold extra equity capital as a cushion against unexpected low cash flows in any given year.
• Third, although much of UGG’s current business could be characterized as a commodity business, UGG tried to distinguish itself from competitors by creating products 7 with brand names and by providing on- going services to customers
Weather Derivatives• Weather derivatives were a relatively new risk management tool.• A contract could be tailored on a number of dimensions to meet the
specific needs of the buyer.• For simplicity, the illustration assumes that the relationship between
gross profit and the weather index is linear. Since low values of the weather index correspond to low expected profits for UGG, a derivative contract that would pay UGG money when the index is low would provide a hedge.
• Hedging their weather risk with derivatives was feasible, but it suffered from several difficulties. Although Willis had performed a sophisticated analysis of the effect of weather on UGG’s gross profit, the results of this analysis had to be converted into a desired contract structure.
Illustration of a Weather Derivative
The Insurance Contract Idea• UGG knew that the primary reason weather was important was
because weather affected UGG’s grain shipments.• The obvious problem with such a contract is the moral hazard
problem – UGG’s pricing and service also influences its grain shipments.
• One solution to this problem was to use industry-wide grain shipments as the variable that would trigger payments to UGG.
• UGG also considered the possibility of integrating grain volume coverage with UGG’s other insurance co
• Willis then contacted several major commercial insurers, including a division of the large reinsurer Swiss Re, called Swiss Re New Markets. Located in New York, this group structured innovative risk financing deals for commercial entities.
Risk Assessment to the weather problem
Estimate probability distribution of and correlation among losses
Measure the expected loss individually and in combination on ROE, EVA, EBIT
Changes in weather was ranked the highest source of risk
Grain volume and lagged crop yields highly positively correlated
Relationship between weather and gross profitWeather >>> Crop Yields >>>> Grain Volume >>>>
Gross Profit
Environment Liabilities, Credit, Commodity, Conterparty and Inventory Risk Exposure
2Environment Liabilities-Insurance- Increase Control
3Credit- Diversivication of parnership to avoid
depedency with limited number of partners- Be more selective to choose partner
4Commodity-Futures- Options
5Counterpart- Diversivication of parnership to avoid
depedency with limited number of partners- Be more selective to choose partner
6Inventory-Increase Control- Insurance
Suggestion and Conclusion
We propose the use of insurance for the weather uncertainty (option 3) due :
1. Broader Loss Coverage, not only weather risk 2. The premium of insurance cost can be reduced3. Company would much more safe