Kelompok 1 :

Afik Beny A
Fredrick Anthonius T
Michael Yudistira P
Neppa Nurochman A
Ratna Tarisa E
Satrio Sadewo

United Grain Growers Company

Background

Based in Winnipeg, Manitoba, UGG provides

commercial services to farmers and markets
agricultural products worldwide. It was founded in
1906 as a farmer-owned cooperative, and became a
publicly traded company on the Toronto and
Winnipeg stock exchanges in 1993. The company
has both members (farmer) and shareholders.
Of the 15 people on UGG's board of directors, 12
must be "members" who are elected by delegates
representing members from various geographical
regions.

Key Issue
How UGG implemented an Enterprise Risk Management
Proses during the late 1990s.
Identified the exposures
Quantified the exposures (using statistical methods and
Monte Carlo simulation)
Considered alternative method.

UGGs Financial Performance in 1990:

(based on Table 27.3 UGGs balance sheet, income, and cash flow)

EBITDA
Capital Expenditures
Debt
ROE

UGGs Analysis
Environmental liability
The effect of weather on grain
volume

47
exposures
area

6 top
exposures

Counterparty risk (suppliers or

customers not fulfilling
contract)
Credit risk

Commodity price and basis risk

Inventory risk (damage products in
inventory)

UGGs main source of unmanaged risk was from

the weather

Willis Risk Solutions do the estimating for probability distribution of losses

from each of the six exposures to quantify the impact of each source of
risk on UGGs performance.
Conclusion :
UGGs main source of unmanaged risk was from the weather
Risk

Risk Example

Environment
Toxic waste
al liability
Effect of
weather

Impact on
harvested yield,
grain volume

Alternatives

Impact

Frequency

Control and
insurance

Low

Low

Weather
derivatives and
insurance

High

High

High

Low

High

Low

Failure of
Counterpart supplier or
Diversification /
y risk
customers not
contract
fulfilling contract
Diversification /
Credit risk
Payment failure
contract
Commodity
price

Price fluctuation

Future and
option

High

Low

Inventory
risk

Damage to
product in
inventory,
understock /
overstock

Operational
control and
insurance

Low

Low

Business Risk Profile

Result of Regression Analysis of Crop Yield

and Weather Conditions

How weather could impact UGGs Profit :

Weather

Crop
Yields

UGGs
Grain
Volume

UGGs Several Options :

Retention
Weather
Derivatives
Insurance Contract

UGGs
Profit

Risk Management Approach

Retention

One approach is to continue operating as they had been

and not try to reduce their weather exposure. This
approach exposed their profitability to large swing due to
weather variation. The disadvantages from this approach
is:
Debt from external financing will be high.
Company need high equity capital to cover unexpected
low cashflow in any given years, high equity capital will
cost the company with higher tax.
On the next decades, the demand from food processor
will be more sophisticated, UGG need to invest in
technology, information, storage, and transport network.

Weather Derivatives
In the late 1990s, weather derivatives were a relatively new
risk management tool. These contracts were sold in the
over-the-counter (OTC) market by firms such as Enron.
For example, the underlying variable determining the
payoffs could be one or a combination of weather variables,
such as average temperature, rainfall, snowfall, a heat
index, or the number of heating or cooling degree days.
The payoff structure could resemble a put option, a call
option, a swap, or combinations of these structures.

The Insurance Contract Idea

Company could construct an insurance contract that
would pay UGG when its grain shipments were
abnormally low. The obvious problem with such a contract
is the moral hazard problem UGGs pricing and service
also influences its grain shipments.
One solution to this problem was to use industry-wide
grain shipments as the variable that would trigger
payments to UGG. Industry shipments would likely be
highly correlated with UGGs shipments, which would
imply that the basis risk would be minimal.

Weather Derivatives
Using weather index for underlying assets.
As the index increases, expected gross profit increases
(because crop yield and shipment increase).
Derivative contract would pay UGG money (hedge)
when the index is low.
The underlying weather index that determined the
derivative contracts payoff would need to be specified.

Insurance Contract
Insurance contract that would pay UGG when its grain
shipment were abnormally low.
To avoid moral hazard, Industry wide grain shipment
as the variable that would trigger payments to UGG.
Industry shipment would likely be highly correlated
with UGGs shipment

Insurance becomes a more appropriate choice

for several reasons
weather is not directly connected to the UGG grain
shipment,
And the average result of the determinant coefficient is
below 0.70 so there are other factors that can affect the
model
there is the possibility of sampling error for using historical
data.
Basis risk: risk from an imperfect hedge, meaning cash flow
from derivative might not match cash flow of UGG's loss.

Q&A
1. The correlation coefficient between industry grain shipment and
UGGs grain shipments

CORREL(ind, UGG)= 0.936132354

2. The correlation coefficient between crop yields and UGGs grain
shipments

CORREL(UGG, crop yields)= 0.881406831

3. Given that any method of reducing the weather risk exposure will be
costly, what are the benefits to UGGs diversified owners from reducing
the weather risk? In other words, what characteristics of UGGs
operations and strategy would make risk reduction potentially beneficial
to UGGs owners who hold well-diversified portfolios?
Benefits to UGGs diversified owners from reducing the weather risk.
Reducing the volatility in its cash flows.
Reduce the likelihood of going into financial distress.
UGGs shareholders can increasing the likelihood that they will receive a
return on their past investments.
Increase the willingness of business partner to work with UGG.

4. Should UGGs rather unique ownership structure influence the

decision to reduce the weather risk exposure?

UGG company has both members and shareholders.

Farmers or an individual can be both a member and a shareholder.
Members have control right, but not entitled to share in any profit and
distribution of the company.
Members that elected as a UGGs board of director would influence the
decision to reduce the weather risk exposure.

5. How could the parties structure a weather derivative to cover the

exposure? More specifically, what would be the underlying index? Would
the contract be a put, call, or forward? Would they buy or sell? Would a
separate contract for each province and/or each crop be needed?

Construct an index that can be used for the underlying of the derivative
contract such as regression analysis which show correlation between crop
yields and temperature or precipitation in one of the province.
If the index were constructed as described above, then purchasing a put
option would help UGG hedge its wheat volume exposure.
Since the regression coefficients vary across crops within a given province
and across provinces, UGG might need a separate contract for each crop
and each province.
Another possibility is to aggregate across provinces and have a derivative
contract for each type of crop.

6. How could the parties structure an insurance contract to cover the

grain volume exposure? More specifically, how would a loss be defined?
And, what would be the payment to UGG conditional on a loss?
The primary reason weather was important because weather affected UGGs
grain shipments.
How to construct insurance when its grain shipments were abnormally low:
Using industry-wide grain shipments as the variable that would trigger
payments to UGG, so the insurance would pay UGG when its grain
shipment is below than industry-wide grain shipment (multiplied to 15%,
based on UGGs market share).
Then, loss would be defined by the difference between UGGs shipments
minus Industry shipments, the negative number of result indicate a loss of
UGG.

7. Advantage and disadvantage using integrated grain volume coverage

with the firms other insurance coverages (bundling or separate policy).
Advantage :
It can reduce fixed administrative costs paid to insurers.
Fewer policies are negotiated and then fixed costs are reduced
Disadvantage :
Too much analyzing the risk (exposure and correlation) that means
increase cost.
The lack of competition could increase the loading.
reduce the quality of services provided.
Moral Hazard

8. Ignoring cost differences, are there any advantages of insurance

contract approach versus the use of weather derivatives?

The Advantage is the insurance contract use industry-wide grain shipments

as the variable that would trigger payments to UGG.
Basis risk is minimum because UGG and industry shipment is highly
correlated.
Weather derivates relies on statistycal analysis which mean there is still
sampling error that makes actual result deviate with expected result.