The Infinite Risk of Loss

Elaine Kub
If the stock market had behaved like the new-crop corn market and gained an average return of 2% each trading day since June 15, when December corn futures were as low as $5.06 per bushel, the Dow Jones Industrial Average would presently be about 18,400 points and the S&P 500 Index would be above 1,900. Pretty much everyone would be overjoyed: Retirees could sleep better at night, baby boomers might realistically consider early retirement, companies might embark on aggressive hiring drives, and commentators might stop fretting about the end of the American Dream. Maybe a few speculators who had short-sold some stocks would be ashen faced, but they would be a distinct minority.

1. PRODUCTION RISKSo you'd think a similar joyousness would be resounding across the Corn Belt, and I'm sure the farmers who have decent production prospects this year aren't sad to see a "7" as the first digit on their local corn bids. But underlying any pleasure is a deep streak of anxiety. No producer wants to see his customers or his customers' customers facing long-term economic damage, like ethanol cutbacks or unprofitable livestock production during this extended drought. There are also, of course, the ashen-faced farmers who can't participate in this rally because their crops are dead or dying. Everyone faces risks, and the days of $7 corn and $16 soybeans are the perfect time to take a long, hard look at the three main types of agricultural market risk:
There are farmers in 2012, even in the heart of the rain-fed Corn Belt who haven't seen a severe drought in 24 years, who will experience a total loss of their crop. If they purchased crop insurance, they may stay in business to try again in 2013. Alongside these farmers with zero crop prospects, there are others who will have a disappointing crop. I'm willing to go on the record and say: Even if it starts raining 2 inches a week everywhere for the next month, I don't think the corn (or even the soybeans!) will just snap out of it. I believe there are already irreversible yield losses in these crops, and that it's completely unreasonable to expect nationwide 2012 yields to be above or anywhere near 2011 yield levels. Anyway, each bushel a farmer doesn't raise is one less bushel to contribute revenue to his business and enable him to pay for the costs of production. That's why weather risk / production risk will always be the number-one source of risk in the agriculture industry.
Anyone with a net-long grain position experiences a net financial benefit as grain prices rise, and his major price risk occurs when prices fall. However, he may still experience risks to his capital in a volatile, rising market.
The CME Group currently allows soybean futures to move at a daily price limit of 70 or fewer cents per bushel up or down during any given trading session. But, as a worst-case scenario, let's say you sold one 5,000-bushel soybean futures contract and then the market locked limit up (there were no willing sellers within the day's price limit to allow you to buy out of your position) for three straight days in a row. The daily price limit increases by 50% each day after a grain or oilseed market closes locked-limit-up, so your position could lose 70 cents one day, $1.05 the next day, and $1.57 ½ the next day, for a total loss of $3.32 ½ per bushel (or $16,625 per contract), and there would be absolutely nothing you could do about it. In fact, this carnage could theoretically continue for days on end. It's unlikely... it would be rare... but it could happen. Every futures and options broker should make sure this risk is 100% understood by every client (speculator or hedger).

3. COUNTERPARTY RISKIf they happen in a futures trading account, market losses trigger margin calls for real cash money. But even if these market movements occur and a farmer has hedged his grain with cash forward contracts (no futures), he must still consider that his marked-to-market losses on those sales are effectively irreversible. Let's say he locked in a $12 per bushel price for 2012 soybeans with his local elevator in January. He'll be receiving $3 less per bushel than he could have otherwise received for that contract today, even though he won't have to cough up any margin cash. Grain buyers don't have to agree to let grain producers buy out of cash forward contracts, and even if they do allow it, they can charge punitive rates for the 'privilege.'
Well, this is the big one this week. Within hours of remarking to a client, "If any brokerage firm were going to have MF Global-type troubles, it would probably be on days like today," sure enough I read about the troubles at PFG, a Futures Commission Merchant that the National Futures Association is now investigating for a $220 million shortfall in segregated customer funds. So even if you had perfect foresight and knew that the markets would rally $2 in the past two weeks, and even if you had a positive gain in your trading account, can you ever really be confident that you will receive that cash if your brokerage firm goes bankrupt without sending you the money?
Talk about counterparty risk! Usually in the grain markets, counterparty risk is more tangible: Will this elevator or this ethanol plant pay me for the grain I've delivered? (Or alternatively: Will this farmer who's contracted grain to me actually deliver that grain?) But when the brokerage firms we rely on to manage our financial price risk become risky counterparties themselves, the whole world seems topsy turvy.
I don't have much of a prescription for this challenge. Realize that brokerage firms don't pay interest on the cash in their accounts, so there is no particular benefit to keeping large amounts of cash parked there. Regarding both futures and cash contracts -- consider diversifying your exposure. As with anything, always make sure you understand what you are committing yourself to. Have you read the fine print of every contract you've signed? Counterparty risk can exist without any wrongdoing taking place -- if someone who signs a contract doesn't read that contract, doesn't understand that contract, or just follows an unwise opinion, he can face more risk than he realizes. An opinion can be formed with the best information available at the time, but opinions can change and opinions can be wrong.

Elaine Kub is the author of 'Mastering the Grain Markets: How Profits Are Really Made' and can be reached at, all these risks (production risk, price risk, and counterparty risk) tend to coalesce during the same timeframes, when grain prices are unusually volatile or even just unusually high. It's easier and cheaper for a grain company to finance its trading activities on 1 million bushels of $4 corn than on 1 million bushels of $7 corn, even if the prices themselves aren't mathematically "volatile." That's just part of the systemic risk in the grain markets when high prices appear. Understanding the fundamental practices of the industry will help any trader realize why "good" returns, as much as I like them, aren't necessarily good news for everyone.


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