Universidade Presbiteriana Mackenzie

When to Get in or Get Out: Analysis of Coffee Planting in Brazil

Carlos Eduardo Cardoso, Mackenzie Presbyterian University, Brazil Diogenes Manoel Leiva Martin, Mackenzie Presbyterian University, Brazil Emerson Fernandes Maral, Mackenzie Presbyterian University, Brazil Eduardo Kazuo Kayo, University of Sao Paulo, Brazil Herbert Kimura, Mackenzie Presbyterian University, Brazil

Universidade Presbiteriana Mackenzie

2

I THE PROBLEM

COFFEE PRICES ARE UNCERTAIN OF

COFFEE PLANTING REQUIRES 3 YEARS INVESTMENT BEFORE STARTING PRODUCTION BRAZIL IS A TRADITIONAL COFFEE PRODUCER COFFEE CAN BE HELD UNTIL PRICES INCREASE

Universidade Presbiteriana Mackenzie

3

II POSSIBLE BEHAVIOR OF PRODUCERS

Straight production from generation to generation (heuristic)

Get in when prices are at the top and get out at the bottom of each cycle (herd) Get in when price is higher than total unit costs and get out when prices are lower than variable unit costs (neoclassical) Use Entry/Exit algorithm to maximize profits (real options)
Universidade Presbiteriana Mackenzie
4

III OBJECTIVE OF THE RESEARCH

To investigate whether or not Real Options Entry/Exit algorithm is the best choice Model suggested by Luong and Tauer (2006) based in Dixit and Pindyck Algorithm
(Dixit, A. e R. Pindyck. Investment under Uncertainty. 1994) Universidade Presbiteriana Mackenzie
5

III OBJECTIVE OF THE RESEARCH

Research hypothesis 1. H01: Coffee prices are mean reverting

2. H02: Entry/Exit triggers of Dixit and Pindyck algorithm is the best choice

Universidade Presbiteriana Mackenzie

6

IV THE MODEL

The value of the entry option is equal to the value of the activation of the production of coffee and equals the normal return on the investment in the crop; The value of the exit option is equal to the value of the abandonment of production for a period and equals the normal Discounted Cash Flow of a producing crop plus the normal return on the investment;
Universidade Presbiteriana Mackenzie
7

IV THE MODEL At Entry and Exit points:

Investor is neutral between active and inactive project, thus value of an active project less the value of an inactive project equals the sunk/abandonment costs

V1 ( L) V0 ( L) X ,
The transition condition is that the derivatives of the values of the Entry and Exit options are equal

V1' ( L ) V0' ( L) 0.
Under these assumptions its possible to solve the model and obtain a system of four simultaneous equations and four unknowns

Universidade Presbiteriana Mackenzie

8

IV THE MODEL
Variable V0 V1 P Meaning Value of an inactive project Value of an active project Unit price

m
s C

Average percent increase in market price

Variance in percent increase in market price Variable cost of a unit of production

K X
r

Unrecoverable fixed unit cost per unit Abandonment cost per unit
Opportunity cost of capital

H
L

Entry trigger
Exit trigger
Universidade Presbiteriana Mackenzie
9

IV THE MODEL
H C AH BH K , (r m ) r 1 AH 1 BH 1 0, (r m ) L C AL BL X , e (r m ) r 1 AL 1 BL 1 0. (r m )
Universidade Presbiteriana Mackenzie
10

V RESULTS
The coffee price process is mean reverting

US$ per 60 kg sack

850 750 650 550 450 350 250 150 50 -50

Price in US$ per 60kg sack

US$ /sack dec2005

Year

Universidade Presbiteriana Mackenzie

11

V RESULTS
Calculation parameters m - Average percent increase in market price 2 Variance in percent increase of market price - Parameter of the solution of the differencial equation - Parameter of the solution of the differencial equation C Variable cost per unit 0,090389328

0,169156056 -1,413624 1,344910 86,98

K Unrecoverable fixed unit cost

X Abandonment cost per unit r - Opportunity cost of capital

19,82
-7,85 0,1608

Universidade Presbiteriana Mackenzie

12

V RESULTS
System equations solved using MAPLE software

Results in US$ per sack

H = 114.4344120, L = 67.73908916
A = 57042.94620, B = 1.933323125

For the series of deflated prices H = 113.62 and L = 67.16

Universidade Presbiteriana Mackenzie

13

V RESULTS
US$ per 60 kg sack
Pric in US$ per 60 kg scak

300 250 200

US$ / sack Nominal

150 100 50 0

H
L

Year

Universidade Presbiteriana Mackenzie

14

V RESULTS Sensitivity Analysis

Summary of Sensitivity Analisys Variable C K X Initial Final Value Value 1% 20% 0,01 0,2000 0,05 0,50 70 120 10 30 -19,82 5 % Hi Hf % Li Lf % 1900% 111,58 115,18 3,23% 66,33 68,11 2,69% 1900% 116,94 111,56 -4,60% 69,40 65,68 -5,36% 900% 91,40 119,24 30,46% 76,18 65,78 -13,65% 71% 94,32 153,01 62,22% 53,65 95,60 78,19% 200% 101,94 122,00 19,68% 76,05 63,82 -16,08% -125% 90,16 121,14 34,36% 90,16 61,39 -31,91%

Universidade Presbiteriana Mackenzie

15

VI CONCLUSION
Dixit e Pindyck 113,62 67,16 jan-76 may-92 nov-92 feb-01 feb-05 dec-05 Straight Entry and Neoclas Productio Exit in peaks sical n pico superior 106,80 pico inferior 86,98 mar-77 jan-76 jan-76 nov-83 jul-87 dec-05 jan-86 jun-88 out-87 aug-89 mai-89 feb-90 sep-92 nov-90 jul-94 oct-92 sep-02 apr-93 jun-05 aug-93 dec-05 aug-00 jan-05 dec-05 (7.046) 22.895 (25.038)

Approach H - Entry price L - Exit price Entry Exit Entry Exit Entry Exit Entry Exit Entry Exit Entry Exit Results in US$
Source: T he authors

30.836

Obs. Exit price after starting harvest considered up to the end of harvest

Universidade Presbiteriana Mackenzie

16

VII FINAL REMARKS AND EXTENSIONS

The algorithm can be expanded to handle price floor

Luong an Tauer (2006) found evidence in favor of a random walk instead of a mean reversion in the vietnamese market where subsidies are granted for producers The method can be applied to other commodities

Universidade Presbiteriana Mackenzie

17