Enterprise Risk Management

UGG Corporation

Jatin Bahl (11/06) Amit Sukhija (29/06) Nakul Jinsi (143/06) Sneha Singh (52/06)

Facts of the case
A

company named UGG corporation is in the agri business.  It has characteristics of a farmer cooperative, and a public listed company.  Regulated by Canadian Wheat Board (CWB)  Hired Willis group, a risk management consultancy  Their analysis revealed that major risk is from weather fluctuations.  Company has to choose between three alternatives to manage its risk.

About UGG
 Based

in Winnipeg, Manitoba  Provides commercial services to farmers  Listed on Toronto & Winnipeg SE  Has both members and shareholders  4 main business segments:

Structure

UGG Corporation
Forms 80% of the revenue

Grain Handling Services (Mkt. share - 15%)

Crop Production Services

Livestock Services

Communication Services

UGG’s Risk Analysis
 Environmental

liability  Effect of weather on grain volume  Counterparty risk  Credit Risk  Commodity price and basis risk  Inventory risk

Points of consideration
 Huge

earnings volatility of 2 major business units – Grain Handling & Crop Production. (80% of revenue is at stake)
 Std.

Deviation (grain handling – 10,450)  Std Deviation (crop protection – 5,600)
 Huge

capex in 1998-99.  Grain handling and Crop production are most prone to weather risk.

Weather Risk – the lone terror…?
 Environmental

liability – A low severity risk, can

be retained  Counterparty risk – Though frequency is high, the severity (as shown by Willis) is low  Credit Risk – Can be retained (60% revenue comes from CWB)  Commodity price and basis risk – Insignificant (Regulatory mechanism)  Inventory risk – Can be retained or insured.

How weather poses a risk?
Bad Weather
Y = α + β1(time trend) + β2 (Avg. June temp) + β3 (Avg. July precipitation) Average R2 for wheat in three cities = 65%

Low Crop Yields

Average R2 for Oats in three cities = 64%

Industry r = 84%, UGG r = 80%

Low UGG’s Grain Volume
For each tonne of shipments, a gross profit of 21.2 Can Dollars.

Low UGG’s Profit

Grey Areas in the case…
 Why

Crop production services are not taken into account?????  Adjusted R2 would have been more appropriate.
 Average

adjusted R2 wheat in 3 cities = 61%  Average adjusted R2 oats in 3 cities = 60%

Risk Management alternatives
 Risk

Retention  Weather Derivatives  Insurance Contract

Evaluation of all the Alternatives

Risk Retention
 Advantages:
 No

cost will be incurred  Uncertainty over market reaction towards the risk protection
 But

can Risk be ignored:

 Additional

capital requirement  No additional premium for retaining this risk.  Huge capex already done  Fluctuating earnings/CFs will deter the image… …..

………. this is how

Weather Derivatives
  

A weather index can be developed by a weighted average means of temperature and precipitation UGG’s Gross Profit having a linear relationship with this index. Risk can be hedged using weather-put options

Potential Problems:  Feasibility of developing such an index.  Highly illiquid market for such derivative instruments

Insurance Contract
 UGG

getting its grain shipments insured from weather risk.  Payments to be made using industry wide shipment data.
 To

avoid moral hazard

 An

integrated overall insurance policy is also under consideration

Data given
Years 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Industry Output 26871 30392 33142 33905 27183 27443 33322 33435 23364 29682 33376 34374 30989 33489 35898 29877 35663 33921 29729 Industry Crop Yield 30.9 34.7 37.4 33.3 28.6 32.5 40.0 36.3 26.3 31.3 38.4 37.3 37.0 38.0 39.1 38.0 39.0 38.0 36.9 UGG Output 4289 4842 5367 5320 4020 4394 5368 5072 3928 4954 5498 5720 5125 5503 6059 4937 5591 5170 4328

Problems
 Q1:

Correlation between Ind. shipment and UGG shipment – 0.94  Q2: Correlation between Crop yield and UGG shipment - 0.80

Q3:
 Benefits
 

to shareholders

Stable cash flows Prospects of higher RoE

 Benefits
 

to members/farmers

A more focused approach – will be able to think Protection during extreme weather (unfavorable) conditions

Q4:
 Yes,

because

 Since

members own well-diversified portfolios, they will be less inclined towards protecting the company.  Conflict of interest – 2 types
 No,

because

 Regulation,

multitude representation  Therefore, Insurance Policy will be preferred.

Q5:

The profitability of UGG varies with the weather as:

GP*(0.64/21.2) = α + β1(time trend) + β2(Avg. June temp) + β3(Avg. July precipitation)

Thus, the above equation can be modified as:
 

GP = α’ + β1’ (time trend) + β2’ (Avg. June temp) + β3’ (Avg. July precipitation) Where α’, β1’, β2’, β3’ are all modified coefficients derived by multiplying 33.152 with original coefficients.

     

Average Industry Output = 31300, std. dev = 3390, Std. Dev.*3 = 10100 UGG average output = 5025, UGG Mkt Share = 15% Correl = 94% Worst case scenario, Industry Output = 21200t, UGG = 3180t Worst case profit for UGG = 67400, avg profit = 106000 Insurance Cover = 38600 Definition for Loss = Deviation from Avg. Industry Output

Thank You – Questions Please
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