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Optimal risk management strategies for a cattle backgrounding operation in the Peace River area

University of British Columbia

Backgrounding cattle is risky. Large amounts of short-term capital are required to buy feeders and feedstuffs, and a ten month cost-revenue gap makes financial planning difficult. In addition, finished cattle prices are volatile and, frankly, unknown at the time the management places its feeders. Income risk and financial risk must be addressed by the management. Several strategies are available to reduce return risk, including anticipatory hedging with cattle futures contracts, placing custom feeders, placing feeders at different months and investing off-farm. This study developed a shot-term decision making model for a backgrounding operation that addresses the interaction between feeder ownership options, the feeder placement month, cash flow requirements, hedging alternatives, off-farm investments, the line of credit and the management's degree of risk-aversity. The following backgrounding issues were examined: (1) whether participation in a classical hedging program with Feeder and Live Cattle contracts would result in lower farm return variability and would increase owned feeder placements, (2) whether managements would be deterred from using hedging strategies if a gradually increasing downward BIAS was introduced, (3) whether managements would be deterred from using hedging strategies if margin calls had to be deposited during the hedging period and (4) to what extent cash flow constraints would affect the management's decision set. The literature of decision making under uncertainty was reviewed to determine the approach which would best accommodate the backgrounding management's risk concerns. The Expected Value-Variance analysis was identified to formulate these management concerns in a mathematical programming context. A quadratic programming model was chosen to derive the expected return and return standard deviation frontiers (risk-efficient frontiers). The participation in an anticipatory hedging program provided a compelling risk management tool for reducing the backgrounding operation's return variability. Compared to the no-hedging case, the standard deviation of returns was almost cut by half for the hedging case. The introduction of a downward BIAS reduced hedging ratios drastically, whereas margin calls hardly effected the use of hedging. Custom feeders proved themselves essential in closing the typical cost-revenue gap in backgrounding and, despite offering the lowest returns, enabled the backgrounder to engage in more risky activities.

Thesis/Dissertation

application/pdf

2009-02-10

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http://hdl.handle.net/2429/4374

Agricultural Economics

University of British Columbia

UBCV

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