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Soy Roy: Risk Premiums?

Updated: 03/26/2014 @ 11:32am

One of the first terms a student of marketing learns is risk premium. The term risk takes on all sorts of meanings depending on the context in which it is used.

When the Iowa casinos opened several years ago, I got comments from friends assuming that because I was sometimes involved with the futures market that I would be excited about having a gambling facility across the river. My standard reply to that inquiry was that slot machines were so slow compared to soybean futures! Besides, I am used to putting $100,000 on top of the ground and betting on rain. That size of a bet is small potatoes today. Back in the 1990s, it was a normal crop investment. I normally win. When betting on rain for the crops, I usually win. Sometimes I win big. Occasionally I lose. In 40 years of farming, I have never lost big. I have come close to a big loss a time or two.   

Risk premium comes into play when dealing with investing for retirement. People not comfortable investing in the stock market look at it as a big gamble compared to bonds or insured CDs. That is certainly a factor when deciding where to invest retirement money. Even in that venue, there is a huge risk that inflation will steal buying power by returning a rate lower than the rate of inflation. The interest rate on a CD that I manage for my local cemetery is .79%. The return on money invested in the University of Nebraska Foundation was 12.9% for the 2013 fiscal year. The question is, which investment is most risky when buying power in the future is considered?

In the grain marketing business, there is risk. Buyers of grain risk that they may not be able to resell or process it for a profit. Farmers who grow the grain risk that they may not be able to grow and sell it for a profit. Both sides add risk premium to the price. For buyers, that premium is called basis. For farmers, the risk premium is bid into the price prior to harvest. The maximum risk exists while the seed is still in the bag. As soon as the seed is planted, the risk begins to diminish. When the combines roll and the crops are safely in the bins, the production risk premium is gone.

The big management issue is when and how to sell the crops while a risk premium exists without being hurt financially if the risk becomes reality. Many tools are available to deal with this challenge. The first thing that comes to mind is crop insurance. It is a good tool. However, there is always a portion of the crop that is not covered. And there is the problem of having sold a crop that the farmer will not be able to deliver. Crop insurance indemnity payments ease the pain, but not eliminate it.

Selling futures to cover price risk is a good tool to cover the downside. Being inexperienced in the use of futures can present a whole additional set of risks until the seller understands the benefits and disadvantages of the futures market. I test my marketing theories by trading a speculative account in the soybean futures market. My method of managing risk is to keep the size of the position at a level at which a disaster in the market will not destroy me financially. The account has, on average, been profitable. Several years ago, I experienced one of those “negative thrills” that all traders hope to avoid. It was a good lesson in money management!

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