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Revenue Risk, Crop Insurance and Forward Contracting
Cory Walters and Richard [email protected]
859-421-6354University of Kentucky
Motivation• Marketing experts say the prudent thing to do in the spring is to
use forward contracts in case prices go down
• Crop insurance salespeople say you need crop insurance in case yields go down
• Producers must understand the underlying price-yield relationship• how forward contracting interacts with crop insurance• Implications of buying back over-contracted yield • Paying crop insurance premiums
Motivation• Agricultural production is risky• Revenue is unknown when making the investment
decision • Tools exist to reduce the chance of revenue < cost• For commodity price - futures market (i.e., forward
contracting)• For yield - crop insurance• Revenue policy interacts with futures market
• Higher costs (same acreage)• In 2006 it took $330,000 to produce a crop and • 2013 it takes over a million dollars
• Farm is concerned with two things• Positive expected income and farm survival (making it to the
next year)
Motivation, The Producer• Farm decisions are based upon knowledge.• Farm size, field location (soil type, distance from
farm), planting date (function of soil type and yield history), hybrids are all taken into account
• Expected profit = $266,000. Vacation time! • Is this useful information? Of course not.• Must look at farm through the eyes of uncertainty
Modeling 2013 Revenue Uncertainty
• Corn production. We plan on adding other farm
• Revenue = yield*price• Producer yield data = de-trended field level over 32
years
• Price data = December 2013 futures market options prices
• Cost = current producer corn production costs for 2013• Important: Cost is a function of yield = $.58 per
bushel.
Objective Function• Crop Income = yield*Price + Crop Insurance(yield,
coverage level, unit type, insurance type (base price, harvest price), premium) + hedged yield*hedged price + hedging cost (interest on margin calls)– Complex!– Hedging = futures hedging using margin account– Account for yield and price relationship
• Correlation is approximately -.187• Relationship depends on location within distribution
– If there is a low yield the chances of a higher price are much better than if yield was average» Copulas to adjust relationship as we move away from the average of
the distribution
The Model
•Software: Analytica • Monte Carol simulation through influence diagrams
view of models
• 30,000 runs
• Income is derived from randomly selecting farm level yield and price
2000 2002 2004 2006 2008 2010 20120
20
40
60
80
100
120
140
160
180
200
Proven YieldLinear (Proven Yield)Trend Adjusted Yield
Original APH = 149.53 bu/ACRE
Trend Adjusted APH = 160.53 bu/ACRE
Trend
No Trend
Hedging risk – Margin calls
Price risk
Risk
Average
December 2013 Corn Futures Prices
December 2013 Corn Futures Prices
• Median = around $5.60• 10% chance price is less than $4.00• 10% change price is greater than $7.55 or so
Farm Corn Yield
Farm average = 144.4 bu/acre
Yields in 1983 and 2012. Rare events do happen !
Most years expect yields between 110 and 170 bu/acre
Farm Corn Yield
•Median = around 155 bushels per acre• 10% chance yield is less than 101 b/ac• 10% change yield is greater than 170 b/ac
• Coverage Level: 80%• Revenue Protection (RP) and RP Harvest Price Exclusion
• Zero Income
Crop Income and InsuranceWith no insurance payments difference is the premium
Insurance payments
• 80% coverage, enterprise units does not guarantee positive income• No hedging at this point
Crop Income With and Without Insurance
• Coverage level: 80%• Revenue Protection (RP) and RP- Harvest Price Exclusion
Insurance
Crop Income, Insurance and Hedging
• Coverage Level: 80%• Revenue Protection (RP) and RP Harvest Price Exclusion• Hedging: 50% of expected production using futures only
• HEDGING PLUS INSURANCE (RP, 80% Coverage Level, Enterprise units), 50% hedged reduces chance of less than zero income by about 13%
CDF of Different Coverage Levels with 50% hedged
• Coverage levels and hedging• Benefit when a bad
outcome occurs• Cost when a bad
outcome does not occur
Crop Income, Insurance, Hedging
-700 -600 -500 -400 -300 -200 -100 0100
110
120
130
140
150
160
170
010
2030
4050
6070
8090
100
110
0
1020
3040
5060
7080
90
100
110
010
20304050
6070
8090
100
110
RP
RP-HPE
No Ins
Tail Risk at 1% Percentile
Ave
rage
Inco
me
• At the average income RP provides the highest income because it receives the most subsidy dollars. Insurance beats no insurance because of the subsidy – If you farm forever you will get paid more than you paid in.
0.00 20.00 40.00 60.00 80.00 100.00 120.000
20
40
60
80
100
120
140
160
180
Average Income and Insurance
No InsRPHPE
Percent Expected Yield Forward Contracted
Inco
me
• Insurance contract: Revenue protection, 80% coverage level, enterprise units
Summary• Everyone faces the same futures prices• Results are specific to yield risk faced by this farm• Location, planting dates, soil types, etc…
• Producer must use RP if forward contracting is used
• Results indicate that crop revenue risk (the bad rare event of 1 in 100 years) are reduced when using crop insurance (RP, enterprise units, 80% CL)• For this farm - $292/acre
• Income risk is further reduced by futures hedging • For this farm - $39/acre (30% hedged)
• Producer does not need to hold as much capital in reserves for a bad event
Caution• Portfolio evaluation• March 1st (Base price just set) to last trading day in
November (December futures enter delivery)
• No storage consideration
• No carry or basis consideration
• No continuous hedging decision making
• No option contracts
Insurance Coverage Level Payouts
• Highest coverage level• provides the highest
chance of receiving a payment
• It also costs the most
2013 Premium Subsidies, in Percent
Coverage Level Non-Enterprise Enterprise50% 0.67 0.855% 0.64 0.860% 0.64 0.865% 0.59 0.870% 0.59 0.875% 0.55 0.7780% 0.48 0.6885% 0.38 0.53