Project Assignment
Assume it is late December and you are the risk manager for the Comfy Cabin business at Place of Ponds, Inc. Your job is to not only identify and mitigate risks to the business, but also communicate those risks to management, who may or may not have a grasp of commodity price risk or "fancy" hedging tools like futures.
Part I
1. Describe as simply as possible, the kind of risk facing Comfy Cabin in 2017. Everything you need to know has already been described.
2. Hypothetically, how could Comfy Cabin change its pricing strategy (i.e. do something other than a fixed price on final goods sold to retailers) to mitigate risks to its bottom line without using futures?
3. Calculate Comfy Cabin's total annual component pounds used to make pudding.
a. Milkfat pounds
i. Convert milkfat pounds to butter pounds
b. Nonfat dry milk pounds (NFDM)
4. Suppose you choose to use butter and nonfat futures to manage risk. Calculate the total number of futures contracts needed to cover all milk components used in making pudding.
a. Butter contracts per month
b. NFDM contracts per month
c. Can you perfectly hedge exposure? Why or why not?
5. Suppose you choose to make use of Class IV futures to manage risk, in addition to butter and NFDM futures. Calculate the number of Class IV contracts you would need to cover:
a. Butter exposure
i. What does that do to your NFDM exposure?
ii. How would you address that?
b. NFDM exposure
i. What does that do to your butter exposure?
ii. How would you address that?
Part II
Good risk managers recognize the need to tolerate some levels of risk. For example, it can make sense to wait on hedging risk when you perceive a strong likelihood that market prices will move in favor of your exposures. In the case of Comfy Cabin, physical short exposures mean that margins expand when prices fall and contract when prices rise. Hedging shelters Comfy Cabin's margins from price movements; once the exposure is covered you are stuck with it. Your superiors should co-own these decisions with you, even in situations when your financial position goes negative and your hedged margin is smaller than an exposed margin would have been. Managing risk involves choosing when to lock your costs (and/or sale prices depending on your business).
Good risk managers also recognize the importance of making or exceeding budget. Sometimes futures don't offer this opportunity. This puts the risk manager in a difficult position. Should you lock up costs now to avoid getting hit with higher prices tomorrow or should they wait and see if futures will fall before committing the business to being over-budget (perhaps even unprofitable)?
1. Look at 2017 futures prices in mid-December 2016.
a. Compare the total material cost at futures prices with the 2017 budget. Are they favorable or unfavorable vs budget?
2. Look at historical prices of butter, and NFDM (Class IV prices are completely driven by butter and NFDM so no need to study it). Chart the historical prices over the past 15 years.
a. Do prices have seasonal patterns (typical certain months are higher than others)?
b. How do recent prices compare to historical prices?
c. How do futures prices compare to historical prices?
3. Studying price histories gives the risk manager context for current market prices.
a. Do you think the price levels offered by futures are likely? There is no right or wrong answer here, as long as you provide logic to it.
b. Based on the 15-year history, what is the lowest annual NFDM and butter prices (list the annual price and the associated year for each)
i. Assume you did not hedge and prices in 2017 mirrored those historic lows. Calculate the total cost of Comfy Cabin's butter and NFDM needs in 2017 at those low prices and show the magnitude of the benefit vs. budget.
ii. Assume that in mid-December 2016 you hedged all your 2017 risk using NFDM and butter futures. What would have been the total value of those futures contracts if 2017 prices matched the 15 year historic lows? (You can look at the annual average price of butter and NFDM futures and difference them from the annual average spot price) Give a total dollar amount and $/lb. gain/loss.
c. Based on the 15-year history, what is the highest annual NFDM and butter prices (list the annual price and the associated year for each)
i. Assume you did not hedge and prices in 2017 mirrored those historic highs. Calculate the total cost of Comfy Cabin's butter and NFDM needs in 2017 at those low prices and show the magnitude of the benefit vs. budget.
ii. Assume that in mid-December 2016 you hedged all your 2017 risk using NFDM and butter futures. What would have been the total value of those futures contracts if 2017 prices matched the 15 year historic lows? (You can look at the annual average price of butter and NFDM futures and difference them from the annual average spot price) Give a total dollar amount and $/lb. gain/loss.
4. Decision time. It is December 15, 2016. You know your annual budget for buying all your milk needs for 2017. You know what the absolute best and worst commodity prices have been in the last 15 years and how each of those would have affected your ability to meet 2017's budget if those year repeated. Typically, you'd expect to see prices somewhere in between best and worst case scenarios. If you beat the market with your management strategy you could get a pat on the back or maybe even a raise. If you take undue risks you could lose your job. If you get close to budget, you'll have done you job. How risk averse are you? Assume you superiors do not understand your job very well, and will give you too much credit for major success or failure.
a. State your choice to hedge some, none, or all your risk today, and clearly describe your reasons. Note: There is no need to look up historical spot prices in 2017 - this isn't a quiz on your ability to predict markets. It is an exercise in making, communicating, and defending risk management choices with limited insight into what the future holds.
b. Which contracts did you use (NFDM, butter, Class IV)?
c. On a scale of 1-10 how risk averse do you consider your decision to be?
d. How might your behavior be influenced by your boss's level of understanding of how risk management works?
5. Extra Credit: There are three forms of basis risk not focused on in the assignment. The clues for two are found somewhere in the first 3 pages of this document. The third clue is found within the assignment portion of this document. Identify and briefly discuss how or whether the different basis risks can be managed.
Attachment:- Case Study - Managing Risk for Consumer Packaged Goods.rar