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MARGIN-AT-RISK for AGRICULTURAL PROCESSORS: FLOUR MILLING SCENARIOS a Thesis Submitted to the Graduate Faculty of the North Dako

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MARGIN-AT-RISK for AGRICULTURAL PROCESSORS: FLOUR MILLING SCENARIOS a Thesis Submitted to the Graduate Faculty of the North Dako MARGIN-AT-RISK FOR AGRICULTURAL PROCESSORS: FLOUR MILLING SCENARIOS A Thesis Submitted to the Graduate Faculty of the North Dakota State University of Agriculture and Applied Science By Daniel Vincent Oberholtzer In Partial Fulfillment of the Requirements for the Degree of MASTER OF SCIENCE Major Department: Agribusiness and Applied Economics February 2011 Fargo, North Dakota North Dakota State University Graduate School Title Margin-at-Risk for Agricultural Processors: Flour Milling Scenarios By Daniel V. Oberholtzer The Supervisory Committee certifies that this disquisition complies with North Dakota State University's regulations and meets the accepted standards for the degree of MASTER OF SCIENCE Approved by Department Chair: Date ABSTRACT Oberholtzer, Daniel Vincent, M.S., Department of Agribusiness and Applied Economics, College of Agriculture; Food Systems, and Natural Resources, North Dakota State University, February 2011. Margin-at-Risk for Agricultural Processors: Flour Milling Scenarios. Major Professor: Dr. William Wilson. Historic market volatility has made risk management decisions by firms in the agricultural supply chain more challenging. Market risk measurement methods, such as Value-at-Risk, were developed in the financial industry to objectively measure, and thus better comprehend, market risk's effect on positions. This thesis gives a thorough background of the issues involved with risk measurement. Different scenarios were then used to demonstrate how the risk measurement method can be applied to the agricultural . processmg margm. In this thesis, the flour milling margin was used to demonstrate how a firm can incorporate sophisticated risk analytics into its risk management decision making process. Multiple scenarios were developed to account for different situations faced by flour millers. Ocean freight, exchange rate risk, futures price risk, basis risk and flour price risk are all included to provide examples of how market risk measurement can be beneficial to industry participants. ll1 ACKNOWLEDGMENTS I would like to thank my adviser, Dr. Bill Wilson, for his guidance and support during the process of completing this thesis. He sets a standard of hard work and success for all of his students. I have immensely appreciated the opportunity to work with him. Also, I'd like to thank all of my committee members, Dr. Saleem Shaik, Dr. Ryan Larsen and Dr. Ruilian Tian, for their time and helpful guidance. Also, Mr. Bruce Dahl deserves thanks as well. His experience proved invaluable to the completion of this thesis. I would also like to thank my family. Without the support of them, I would not have been able to accomplish a master's degree. Also, I would like to thank my girlfriend, Rachel Carlson, for all of her support. IV TABLE OF CONTENTS ABSTRACT ......................................................................................................................... iii ACKNOWLEDGMENTS ................................................................................................... iv LIST OF TABLES ............................................................................................................. viii LIST OF FIGURES·············································································································· X CHAPTER I. PROBLEM STATEMENT. ........................................................................... I Introduction ..................................................................................................................... I Market Volatility ....................................................................................................... 3 Evolution of Risk Measurement ............................................................................... 8 Problem Statement .......................................................................................................... 9 Processor Hedging .................................................................................................... 9 Objectives ..................................................................................................................... 11 Methodology ................................................................................................................. 11 Organization .................................................................................................................. 12 CHAPTER II. BACKGROUND AND PREVIOUS STUDIES ......................................... 13 Introduction ................................................................................................................... 13 Evolution of Risk Measurement ................................................................................... 14 Portfolio Theory ...................................................................................................... 14 Option Pricing ......................................................................................................... 16 Significant Events in the Financial Industry ........................................................... 16 Estimating Volatility ..................................................................................................... 20 Simple Moving Average ......................................................................................... 20 V Exponentially Weighted Moving Average ............................................................. 21 Generalized Autoregressive Conditional Heteroskedasticity ................................. 23 Implied Volatility .................................................................................................... 25 Estimating Correlation .................................................................................................. 25 Correlation and Copulas ......................................................................................... 25 Criticism of Value at Risk ............................................................................................ 27 Academic and Industry Criticisms .......................................................................... 27 Value at Risk, Market Crashes and the Popular Press ............................................ 30 Previous Studies in Agri-Business Risk Management ................................................. 33 CHAPTER III. TECHNICAL AND MANAGERIAL ISSUES ......................................... 37 Introduction ................................................................................................................... 37 Value at Risk Computation ........................................................................................... 38 Steps to Computing Value at Risk .......................................................................... 38 Quantitative Parameter Decisions ........................................................................... 40 Computational Distributions ......................................................................................... 43 Non-Parametric Distributions ................................................................................. 43 Parametric Distributions ......................................................................................... 44 Value at Risk Methods .................................................................................................. 4 7 Characteristics of the Parametric Method ............................................................... 48 Characteristics of the Historical Simulation Method .............................................. 50 Characteristics of the Monte Carlo Simulation Method ......................................... 51 Stress Testing ................................................................................................................ 52 VI Coherent Risk Measures ............................................................................................... 54 From Value-At-Risk to Margin-At-Risk ...................................................................... 55 CHAPTER IV. MODEL AND EMPIRICAL PROCEDURES ......................................... 57 Introduction ................................................................................................................... 57 Prototypical Milling Scenarios ..................................................................................... 57 Scenario #I-North American Competitive Market.. ............................................... 58 Scenario #2-International Regulated Market.. ........................................................ 61 Scenario #3-International Regulated Market With Forex Risk .............................. 64 Empirical Model ........................................................................................................... 64 Distribution and Simulation Procedures ....................................................................... 67 Model Data and Distribution Selection ........................................................................ 68 CHAPTER V. RESULTS .................. : ................................................................................ 78 North American Competitive Market Scenario ............................................................ 79 International Regulated Market .................................................................................... 83 International Regulated Market With Forex Risk ......................................................... 86 Summary ......................................................................................................................
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