Managing Risk In Volatile Markets

CANADA - The current high level of volatility and uncertainty in the cattle markets has underscored the need for disciplined risk management plans and strategies for Alberta cattle feeders.
calendar icon 12 July 2011
clock icon 4 minute read

High levels of volatility in the futures markets is another not-so-subtle reminder that even the most seasoned market analysts cannot predict the future. The recent unexpected up and down moves and their related financial and psychological influences can sometimes cause even seasoned hedgers to lift their positions at inopportune times.

“Between April 4 and the first of June 2011, August live cattle futures dropped over $20 per hundred weight (cwt) causing aggressive risk managers to feel very comfortable in their short futures positions,” says Bruce Viney, business development – risk specialist with Alberta Agriculture and Rural Development.

“Since the first of June the market has surged back over $11 per cwt adding optimism to cash markets and placing many of those short hedge positions into margin call situations.

“Some cattle feeders currently follow disciplined risk management programs that have strategies to deal with both sudden drops and sharp rallies without too much reliance on the often subjective opinions of outside market analysts. While market analysis is a key part of risk management plan design and execution, the objective of a risk management plan is to provide the disciplined action plans that will help let feedlot managers sleep at night regardless of which way the markets may move.”

Higher level uncertainty, along with greed and fear-motivated decisions, also contribute to higher option and insurance premiums. While analysts generally cannot predict market prices in this type of extreme volatility, there is still tremendous value in analyzing the market fundamentals and technicals.

“Analysing the fundamentals will approximate the supply and demand equilibrium price while technical analysis will aid in the timing of decisions and the execution of risk management strategies,” says Mr Viney. “In this day and age with index funds, programmed trading and instantaneous information exchange, effective timing and execution can significantly improve profitability and reduce managerial stress.

“A common question put to market analysts concerns where the market is going. If there are analysts out there who can consistently predict the market, you can bet they aren’t going to tell you; at any price. In reality, the field of market analysis is not rocket science and any producer can quickly learn to evaluate the supply and demand information and historical or ‘technical’ price activity.”

Many professional analysts rely solely on technical analysis which is simply an assessment of trends and chart patterns that show the price movements as the market adjusts to new supply and demand equilibrium levels. Fundament analysis is more mathematically intensive and is generally left to academics and professional firms that have detailed economic models and access to large amounts of data. Both types of analysis are useful and important for producers to incorporate into their own market analysis and strategy execution.

“An important part of any successful risk management program is the manager’s own opinion of the market,” adds Mr Viney. “Even though that opinion will often be just as wrong as most professional analysts, knowing when it is wrong and having predefined strategies to deal with adverse situations will add to the business bottom line. When a market seems to be acting irrationally, producers should be reminded of the famous quote by British economist John Maynard Keynes: ‘Markets can remain irrational longer than you can remain solvent.’ Thus, having contingency plans and alternate decision paths are important to financial health.”

For some producers, futures and options contracts may be appropriate risk management tools to deal with adverse price moves. For other producers, futures and options may actually increase their financial risk and reduce their business profitability. Cattle price insurance is another unique tool that can add value to many risk management programs from time. Regardless of the specific marketing or risk management strategy, producers have traditionally been able to improve their cash market buying and selling decisions by using timely and consistent information from their market analyst.

A common thread among successful business risk managers is their ability to execute a disciplined risk management plan that is consistent with their overall business and marketing objectives. Those risk management plans generally involve considerably more than just market analysis and a price forecast. They involve identifying the sources of risk and assessing the impact of those risk events on their bottom line and business risk tolerances. Then by applying specific strategies to deal with the sources of risk, emotional and reactionary decisions are minimised.

The same philosophy applies to assessing and capturing opportunities that may arise from unforeseen positive information and market shocks. In bull markets, having strategies to deal with upside market moves can be very important in capturing opportunities. A successful risk management plan has disciplined strategies in place to minimise the typical greed and fear emotions in dealing with unexpected market moves in either direction.

“To assist producers in calculating the financial risk associated with a pen or lot of cattle, Alberta Agriculture has developed the FIR$T computer software programme,” says Mr Viney. “Producers can apply their own assessment of future market prices and price volatility in order to calculate various financial statistics. These results can compare the profitability and returns to equity for different feeding and pricing scenarios. The programme uses stochastic simulation techniques to calculate the probability or likelihood of achieving those financial return levels.”

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