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MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN AGRICULTURE

MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN AGRICULTURE. Garth A. Baker Director of Research, Caribbean Institute for the Mathematical Sciences “ Nothing is more practical than a good theory” -- Descartes. PARTICIPATING INSTITUTIONS ( March 8. 2004 )

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MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN AGRICULTURE

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  1. MATHEMATICAL PROGRAMMING FOR RISK MANAGEMENT IN AGRICULTURE Garth A. Baker Director of Research, Caribbean Institute for the Mathematical Sciences “ Nothing is more practical than a good theory” -- Descartes

  2. PARTICIPATING INSTITUTIONS ( March 8. 2004 ) Dominica Banana Producers Limited ( DBPL ) Nature Island Pineapple Producers Association ( NIPPA ) Caribbean Agricultural Research and Development Institute (CARDI) Caribbean Institute for the Mathematical Sciences ( CIMS )  OECS Export Development Unit ( OECS-EDU )  Dominica Export Import Agency ( DEXIA )  Windward Islands Crop Insurance Limited ( WINCROP ) Centre de Cooperation Internationale en Recherche Agronomique pour le Development ( CIRAD ), Paris, France EMPLOY SCIENTIFIC RESEARCH TO PILOT BUSINESS INITIATIVES IN THE FORM OF JOINT VENTURES DOMINICA QUANT–CONSORTIUM ON AGRICULTURE

  3. SUBSISTENCE FARMINGINTERNATIONALLY COMPETITIVE Revive the banana industry Diversification (pineapples) OPTIMIZATION OF PRODUCTION qWhat does the market want? qOrganize production to fit the market. Take the “guesswork” out of production qUse accurate, scientific crop forecasting

  4. PROTECT INVESTMENTS . qAffordable catastrophe insurance. Can fine structure modeling for the Caribbean improve catastrophe insurance pricing? qHedge market risk with financial instruments. Take the “uncertainty” out of export marketing. qAffordable insurance for crops other than bananas. • Affordable comprehensive insurance, including coverage for drought, flood and possibly disease.

  5. REGIONAL CONSOLIDATION qLower production costs. qAcquire greater market share. qDistinguish Caribbean product; aim for niche market. qOptimal transportation networks: dynamic scheduling

  6. “The only thing that is certain is that nothing is certain.” Pliny the elder Historia Naturalis “ Common sense is not so common.”   Voltaire  “ A fool must now and then be right by chance.” William Cowper Conversations

  7. RISK PREDICTION AND MANAGEMENT • qQuantitative determination or estimate of Risk • Determine probabilistically all possible cases between the extremes: • Maximum Likelihood Scenario • Worst Case Scenario qInsurance qReinsurance qAlternative Risk Transfer Securitization of Agricultural Insurance Risk qPortfolio Management Fixed income securities / Hedge Funds

  8. PUT OPTIONS “ Most business and financial transactions are “ a gamble “ wherein the buyer hopes to be buying low, and the seller hopes to be selling high. One side is always doomed to disappointment.” Peter Bernstein, economic consultant, 1996. “Every act of production is a speculation in the relative value of money and the good produced.” Frank Knight, economist, 1977. Farmers stand to benefit from high sale prices and are vulnerable to low sale prices; in symmetric contrast, supermarkets/ processors tend to benefit from low sale prices and high sale prices are threatening to them.

  9. CONTRACTS • I. Each farmer pays the bank a premium, say 3 Arawak, for the right to sell the produce ( through or to the bank) at the prearranged price of 100 Arawak, within a designated period of time, say up to December 31. The farmer has the option to exercise this right to sell at the specified price or not, during the period of validity of the contract. Should the farmer opt to sell, the bank is legally bound to make the purchase.

  10. CONTRACTS II.Each supermarket/processor pays the bank a premium, say 5 Arawak, for the right to buy the produce (through or from the bank) at the prearranged price of 100 Arawak, during the period up to January 1. The supermarket/processor has the option to exercise this right to buy at the specified price or not, during the period of validity of the contract, and should the supermarket/processor opt to buy at any such time, the bank is legally bound to effect the sale.

  11. LOW SALE PRICE • If the actual market sale price at the time of sale, (December 31,) is below 100, say 70, then: •       The bank pays the difference, 30, to the farmer • The farmer obtains 100 – 3 = 97 •   The supermarket/processor “looses” their premium, but in effect pays 70 + 5 = 75, thus making a profit of 25.

  12. HIGH SALE PRICE • If the actual market sale price happens to be above 100, say 122, at the time of purchase, (January 1), then: • The bank pays the difference, 22, to the supplier. • The supermarket pays 100 + 5 = 105, in effect. • The farmers “loose” their premium, but in effect sell at 122 – 3 = 119, yielding a profit of 19.

  13. OPTION PRICING Fischer Black -----Arthur D. Little Myron Scholes ----M.I.T. 1973 Robert Merton ----M.I.T. time,interest rates,price spread,volatility 1997 Nobel Prize in Economics Louis Bachelier , These, Universite Paris, 1900 Chicago Board Options Exchange, April 1973

  14. A B C ● ● ● X Y Z Investment Bank Insurance/Reinsurance Securities Exchange ( OECS/ CARICOM ) FARMERS MARKETERS SUPERMARKETSPROCESSORS REGULATORY BODY What types of contracts are best suited for hedging market risk in agriculture (volatility) to protect OECS producer – marketing – processing chain ? How are these contracts to be managed and overseen, with transparency and international legal credibility?

  15. CIMS Perspective on Risk Management at the Macro-Level • Portfolio Management alla Markowitz (1954 ) Diversification should be pursued based upon optimization critera, taking into account both market information and agro-ecological conditions and economic and social constraints. i.e. “ market driven optimization of production”: however, what is to be optimized is the performance of the portfolio as a whole over time. The relevant question is: What (diverse) combination of crops yields optimality? Value at Risk type analysis. • Insurance and other financial instrumentsfor macro-level risks. • Computer simulation for “stress analysis”: test all the “what if” scenarios; credit risks, credit futures, “credit options”? • Special financial conglomerate for macro-level finance, insurance and reinsurance. Credit Bank / Insurer / Reinsurer / Securities Trader / Trade Finance . . . expand WINCROP? • Regional Portfolio Optimisation?

  16. Alan Greenspan, Chairman of the Federal Reserve Board: Lecture at the University of Utha, November 1994 “ There are some who would argue that the role of the bank supervisor is to minimize or even eliminate bank failure; but this view is mistaken in my judgment. The willingnessto take risk is essential to the growth of a free market economy . . . [I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized.”

  17. SOOTHSAYER: Beware the ides of March. CAESAR: He is a dreamer; let us leave him – Julius Caesar, Act I, Scene II

  18. DUKE SENIOR ( in exile ) Sweet are the uses of adversity; Which, like the toad, ugly and venomous, Wears yet a precious jewel in his head; As You Like It Act II, Scene I.

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