From the Train the Trainer Handbook:

Introduction
The Fair Agriculture Improvement and Reform Act, better known as the Freedom to Farm Act, has changed the marketing environment for producers. Combine this with the fact that we re seeing increased global competition and the net result appears to be a market orientation with greater volatility.

While it s always been in the best interest of the producer to have a marketing plan, the potential for increased price volatility now makes creating a marketing plan a vital part of production agriculture.

I would define a marketing plan as one that takes into account a producer s financial situation, risk tolerance level, the timing of his cash flow needs and his production costs. The main reason for creating a plan is to establish a price for selling wheat, in an organized, disciplined fashion. Of course, there are many ways that a producer can actually price his crop. He can use cash sales, forward cash contracts, store his wheat and sell it later or use a range of alternatives with futures and options.

When the organizers of this conference approached the Kansas City Board of Trade about participating, we were quite pleased that a futures exchange was offered the opportunity to get involved. Since the Kansas City Board of Trade has been in the risk management business for more than 120 years, I believe we have something to offer in the dialogue about risk management heading into the next century.

The Advantages of Exchange-Traded Products
As the need for risk management tools has grown, so has the number of tools available to the industry. From cash hybrids to crop insurance to other customized products, each has a role to play in helping agribusiness cope with volatility. Even with all the new tools, though, futures and options still provide some of the most efficient and effective means of risk management in the marketplace today. And they should certainly be considered an important component of any risk management strategy.

Let s look at some of the reasons exchange-traded products can be an important part of producer risk management plans.

Basically, there are three groups that look over the shoulders of traders at all times. The federal government regulates all futures exchanges through the Commodity Futures Trading Commission. Then, the National Futures Association regulates registration of commodity traders as individuals and then the exchange itself watches and monitors every trade that takes place there. The KCBT s rules and regulations are explicit in their demands and requirements on those who trade the exchange's contracts, and are clearly spelled out to the parties involved. In addition, the KCBT s clearing corporation ensures that traders can finance their actions by requiring margin. The clearing corporation effectively becomes the buyer to every seller and the seller to every buyer. The first line of defense against rule violations comes from the exchange itself, which has a team of investigators who oversee all trading on the floor. In many products traded off-exchange, this same degree of regulation and protection simply cannot be equaled.

Risk management is the principal reason for the existence of futures exchanges. But the ability to manage risk is possible mainly because of a fundamental process that takes place on the trading floor every day - the process of price discovery. Through price discovery, a producer, elevator, exporter, importer, processor or any other agribusiness operator can determine the price at which a futures or options contract has traded at any given time. This very public availability of price information, this transparency, is not available for many off-exchange products.

The prices discovered on exchange trading floors are available worldwide, creating an open-information situation where no single player can dominate the market. Producers can price their product before it is even produced, and end users can establish a price for their anticipated supply needs long before they have the supply in hand. Many industries only wish for such opportunities.

In agribusiness we should take advantage of these highly-regulated, open-market, exchange-traded products whenever it is appropriate to do so. The question then becomes: just when is it appropriate?

I"m not here today to tell anyone exactly what is appropriate in their individual situation. Each producer has different risk management needs. And those needs will even change from one year to the next. But there is an important point I want to get across about the appropriate use of futures and options for hedging purposes. That point is this: hedging should not become a risk in and of itself. Let me repeat, as much as possible, hedging should not become a risk in and of itself.

The Nature of Hedging
By its very nature, hedging should reduce risk through ensuring price protection against adverse market moves. Each situation is unique, because of factors such as input costs, storage capacity, local growing and transportation conditions. As a result, each operation may have different goals and different factors that influence its hedging strategy. But for any operation, if its true purpose is indeed to hedge and only to hedge, then its futures and options trades should be made for the primary intent of reducing price risk. A true hedger should not look at his futures or options trade solely in terms of the profit or loss it shows on paper. He must also keep the profit or loss in his cash position in mind. For a true hedger, the trade has served its purpose if it meets his goal of establishing a price for his product in an environment that can sometimes see dramatic price swings from one minute to the next.

It's only human nature to want to sell at the market peak, or buy at the low point of the year. But human nature is not the same thing as hedging nature. In hedging, futures and options are used to smooth out market ups and downs, not to try to make a killing by capturing them. By hedging with exchange-traded products, a producer can manage price risk. This is not to say, though, that speculating should be avoided. Speculators provide liquidity to the markets and give hedgers someone to trade with.

The line between hedging and speculating can be a fine one. So, it is highly important for someone using futures and options to assess their goals for particular trades and trading strategies. You need to have these goals in mind when you make a trade. Is your goal to try to pick the top or bottom of the market and thereby enhance potential profits? In trying to outguess the market, this is a form of speculation. Or is your goal to try to protect the profitability of your business by locking in a favorable price? I would call this a form of hedging because you are trying to lessen the risk that price changes could reduce or eliminate your profit potential.

Needless to say, there are a number of ways in which risk management through hedging can be accomplished.

Why Futures and Options Work in Price Risk Management
Let's start with the straightforward use of futures and options themselves, and expand from there. I"m sure most of you in this audience are quite familiar with futures and options, and with the basic concepts behind them. But let me quickly review a few things you need to keep in mind.

The main reason futures work as a hedge against price risk is their relationship to the cash market. The fact that a futures contract eventually could result in delivery of grain is seldom actually realized. But nonetheless, it helps to keep the futures price based in the reality of what is happening in the cash market. Without this correlation, futures would be of much less use in hedging actual cash market transactions. With this correlation, a futures contract should move toward convergence with the actual cash price approaching expiration.

The more that futures and cash prices correlate, the more effective a futures hedge is as a risk management tool. This same principle applies to options. Options give the holder the right, but not the obligation, to buy or sell the underlying futures contract at a specific price. Therefore, the correlation between futures and cash prices is key to the effectiveness of an options hedge as well.

Of course, the cash price that correlates with the futures contract for many operators is not the same as the price in their local market. At the Kansas City Board of Trade, for example, our wheat futures are based on Kansas City delivery, with a 12-cent discount for Hutchinson, Kansas, delivery. Now in a perfect world, if I was a producer in, say, Colby, Kansas, my local cash price would always be at the same differential to the KCBT wheat price, let s say 20 cents under. I could then achieve a perfect price hedge.

But as we all know, the world is far from perfect. In reality, local conditions such as transportation availability, storage, and proximity to major markets are going to impact the Colby price. The resulting cash price is often something that still correlates well with, but does not move identically with, the futures price.

What point am I trying to make with all this? Actually, there are two. The first is that it is vitally important for an operator to know his basis risk and its historical relationship with the futures market. Only with this knowledge can he develop the most effective hedging strategy possible for his situation.

The second point is perhaps even more important, and it is this: futures and options markets work as a price hedging tool because of their correlation with the underlying cash market. We have continued to try to improve upon this correlation through actions such as adding a new delivery point. As long as futures markets are able to maintain and improve upon this grounding in the cash market I believe they will continue to serve a useful purpose well into the next millennium.

How Futures and Options Work in Risk Management
Now that we ve talked about the reasons why futures and options offer an important risk management tool for agribusiness, let's move on to examining exactly how futures and options work in risk management. Again, we"ll start with a straightforward look at each product.

Futures and options have different attributes that make them useful for risk management in different ways. Futures, for example, are binding in respect to delivery. A futures contract must either be offset before its delivery period or be delivered against. Because of this binding agreement, the futures contract is grounded in the cash market and should converge with actual cash prices as its delivery period approaches. As I mentioned earlier, it is this grounding in the cash market that is critical to the usefulness of a futures contract as a hedging tool.

However, the vast majority of participants in grain futures markets do not use them as a method for actually procuring or selling physical supplies of grain. Instead, for most hedgers, futures are used as a substitute transaction for the cash market that helps to smooth out price risk and fluctuation.

For example, an elevator operator may purchase wheat from a producer at a set price today, but may not be able to turn around and sell that wheat to an end user such as a flour mill until weeks later. Without futures, the elevator operator is exposed to the risk that during the time the wheat sits in storage, its price will decrease and he will be forced to sell the wheat for less than he paid to buy it from the producer.

But with futures, the operator can use a futures contract as a substitute transaction. After buying wheat from the producer the elevator operator can sell a futures contract. Then when the wheat is actually sold to the flour mill, the futures contract can be bought back. If the price of wheat in the cash market has declined, that loss should be offset by a gain in value in the futures position, and if the cash price has risen, that gain would offset losses on the futures side. The end result is price protection.

Options, on the other hand, can be looked at by agribusiness as price insurance. Because options give the right, but not the obligation, to buy or sell wheat futures at a specific strike price, they do not have the same delivery requirement as a futures contract. The options premium can be paid to insure against an adverse price move without limiting the potential for profit. Just as with insurance, an option can simply expire unused if the adverse price move which it insured against does not occur.

Futures and options also can be used in tandem to manage price and profit risk. For example, a grain elevator with a large short or sell position in the futures market may be concerned about the possibility of the market making a large move upward. The elevator could buy deep out-of-the-money call options, helping to insure against extreme losses on its futures position at a known cost.

Considerations for Individual Operations
These examples illustrate some general, basic ways in which futures and options can be used to hedge price risk. But I feel compelled to point out that each individual hedger, whether he be a producer, elevator, end user, exporter or some other market participant, must assess his own individual situation when planning any risk management strategy, including the use of futures and options.

As I mentioned earlier, one of the key areas that varies from operation to operation is basis. The basis correlation with the futures market for a hard red winter wheat producer in southern Kansas, for example, may be much higher than for a producer located in an area that typically has less impact on national production. And knowledge of the local basis and its correlation with futures can be very important in establishing a risk management plan. Other factors that can impact risk management strategies include size of operation, variable production risks, and storage availability.

Personal preferences play a major role as well, both in storage decisions for producers as well as in any other risk management decision in agribusiness. Just as with making personal or business financial decisions, an individual or an agriculture-related business must decide for itself how much risk it is willing to bear without protection or insurance. For some, the level may be significantly higher than it is for others. The important thing is that risks are assessed and are understood, and that a conscious decision is made regarding to what degree those risks will be borne.

Accounting for Both Price and Yield Risks
When discussing the risks that face agriculture, many in agribusiness have traditionally divided them into two primary reas, price risk and yield risk. They offer one strategy, such as futures and options, to deal with price risk, and another strategy, such as crop insurance, to deal with yield risk. There is nothing particularly wrong with this; price and yield are indeed among the most significant risk exposures for many in agriculture today, and in both cases, the recommended tools can be used in sound ways to manage that risk. But what I would like to submit to you today is that we should look at things in a new light. Yield and price are but parts of the same whole, the whole of risk management. And these parts do not exist separately from one another, but are in fact related and should be looked at together in the total risk management equation.

What does this mean in the practical terms of actually devising and evaluating an ongoing risk management strategy? A great deal. Use of traditional products such as futures and options and crop insurance can and should be viewed in a new light. They are risk management tools that can be used together to protect profit potential. They can be part of a strategy that is constantly being revised and reevaluated based on both market-wide and firm-specific condition changes, both for the short- and long-term benefit of the business.

I have already discussed some of the basic principles of futures and options and the ways in which they can be used to manage price risk. Other speakers today will discuss some of the basic principles of crop insurance and the ways that it can be used as a fundamental hedging tool. But what I would like to discuss with you now is how exchange-traded futures and options and crop insurance can, and often should, be looked at as working together.

To start with, price and yield have a definite correlation, based on the precept that as one goes up the other goes down, and vice versa. But this correlation can vary significantly from one geographical area and one type of farm to another, just as basis levels and their correlation with futures markets can vary from one location to another.

For example, a large hard red winter wheat producer in western Kansas might find that price and yield typically have a high negative correlation for his operation. When his yields are low, futures prices on the Kansas City Board of Trade, and in turn the cash prices he receives for his crop, tend to move higher. And when his yields are high, futures prices on the Kansas City Board of Trade usually move lower. But this may simply not be true to the same extent for another hard red winter wheat producer. That producer may be in an area that is not traditionally associated with large amounts of winter wheat production. The area may not help to define the national average in terms of yield, and may have a lower correlation with futures prices as well.

In both cases, yield and price still are significant risk exposures for each producer. But the extent to which they relate to one another is quite different. An assessment of an operation's risk exposures can help to determine what combination of price tools such as futures and options and yield tools such as crop insurance is appropriate.

Exchange-traded futures and options and crop insurance products also can be used in tandem to help establish a price for a crop before it is produced. For example, some operators in the past may have been hesitant to sell futures to lock in a price for the crop ahead of time, before the crop is actually grown. But, perhaps those producers would be comfortable selling futures to lock in a price ahead of time on the portion of their crop that is insured.

This is an example of exchange-traded products and off-exchange products working hand in hand. Crop insurance is but one of the tools that can be used in conjunction with futures and options to help achieve risk management goals. I believe there will be many more such examples in the years to come.

Other areas that may come to the forefront in coming years include things such as revenue assurance, increased use of forward contracting, labor risk management and hybrid cash contracts which combine use of exchange-traded futures and options with other tools.

In some cases those operators trying to manage risk themselves will use futures and options directly as a part of integrated strategies. In other cases, the parties working with them, such as elevators and other contract writers, will use futures and options to manage the risk that has been transferred in their direction.

Another risk management tool producers can consider is a minimum price contract, or MPC. Simply put, an MPC guarantees that the buyer will pay the producer a minimum cash price in exchange for the delivery of a fixed number of bushels, with the upside price potential tied to the movement of the underlying futures price. So, if the underlying futures should rally before the grain is delivered, the producer would have the right to re-price his wheat at a higher price.

Using a minimum price contract can accomplish several things. It allows a producer to lock in a price per bushel, thus ensuring himself of a profit, assuming normal production. It also provides him with a way of capturing upside potential should prices rally. MPCs can also provide producers with the courage to market at least a portion of their crop. However, one of the problems with a minimum price contract is that the strategy provides price insurance but it does not offer any production coverage.

Another tool that can be effectively combined with a minimum price contract is Crop Revenue Insurance or other types of insurance such as revenue assurance or income protection insurance. These new insurance products provide producers with protection from catastrophic losses. But by themselves they don t offer a true profit potential. Combining MPCs for price insurance and some type of crop insurance to manage production risk can offer producers a way to create a marketing plan that helps them to manage both price and yield risk.

Keep in mind that there are a variety of ways a producer can accomplish effective risk management. All of the risk management strategies I have touched upon are likely to see increased usage as Freedom to Farm spurs increased interest in risk management.

Stress-Testing
But this increased interest in agricultural risk management, brought on in large part by the change in government attitude, also has helped to spur the creation of completely new areas and tools that can be used for risk management. I believe these new tools offer tremendous opportunity for American agriculture as we move into the next century. Indeed, I confess to being an unbridled optimist when it comes to the ability of American agriculture to compete in the global market.

Despite my self-professed optimism, I feel that I must throw in a word of caution. Risk management methods such as straightforward futures trades have been used by some in the business to manage risk for more than a century. But the infancy of many other new tools, as well as new uses for older tools, mean there is a great deal that is still unknown about how those tools will perform.

Therein lies the need for caution. Just because some of these tools are new or are being used in new ways should not necessarily disqualify them for use to protect profit potential and manage risk. But it should prompt those in agribusiness to explore every possible outcome that they can imagine before making a financial commitment with these tools.

The basis for making any test on a risk management tool, of course, is a thorough understanding of exactly what the tool is and how it works. Let me repeat that: the basis for making any test on a risk management tool is a thorough understanding of exactly what the tool is and how it works. Without that understanding, it is all too easy for producers to find themselves locked into a product that doesn t do at all what they thought it would do. Many of the problems that arose last year with hedge-to-arrive contracts stemmed from the fact that people who were selling the contracts as well as those who were buying them simply didn t understand how they worked.

An astute speaker at another risk management meeting in Kansas City last year called the process of testing a risk management strategy stress-testing. In other words, operators considering the use of various risk management tools and strategies should first run the tools through some what if scenarios to see how they will perform under different market and production conditions. These what if scenarios should include the worst possible situation the operator can imagine encountering. The risk management strategy should then be run through this worst case scenario to see how it might perform. While the chances that the worst case scenario actually will occur probably are very slim, the operator nonetheless will be aware of all possible outcomes.

Agribusiness operators should not only test tools with worst case scenarios, but should also look at the other range of possible outcomes. By comparing how a business might have fared using certain tools to how it might have fared without them, an operator can get some assessment of the value of various tools to his own operation. No two operations are exactly alike, and risk management strategies that may be ideal for one might be of little benefit for another.

It is exactly this difference in risk management exposures among various agricultural businesses, whether by size of operation, type of operation, geographic location or other factors, that has helped to create the variety of risk management tools available today. And there are a variety of resources that can be used to aid operators in performing this stress-testing. Local government offices are a good place to start, and other potential resources could include banks, brokers, elevators, insurers and university extension programs.

Conclusion
You may or may not believe that recent changes in government legislation will truly bring about a revolution in the way agribusiness is practiced in the future. But I believe, and I think most of you would agree with me, there is no doubt that the changes in legislation have helped to bring about increased awareness and interest in risk management throughout the agricultural community. Why else would we be here today?

This increased interest in risk management ultimately should translate into increased use of a host of risk management tools, such as forward contracts, minimum price contracts, various types of insurance products, futures and options. Increased attention to risk management also should translate into more innovation in the ways in which these tools can be used to help control risk.

Will the risk ever be taken completely out of agriculture? I think we all know the answer to that is no. And I don"t think any of us would want that to happen anyway. The risks in a business are often what give those willing to be the risk-takers an opportunity for a greater reward. Instead, our goal in agribusiness risk management must be not to eliminate risk completely, but to reduce it to an acceptable level.

The changes coming about in agriculture in the U.S. and worldwide promise to be a challenge to the industry itself as well as to commodity exchanges that serve it, such as the Kansas City Board of Trade. We intend to pay heed to those changes and do all that we can to assist agribusiness in managing its risk in the best manner possible in the future. I look forward to where the partnership will lead us.