Revenue Risk, Crop Insurance and Forward Contracting C ory Walters and Richard Preston cgwalters@uky.edu 859-421-6354 Un

1. Revenue Risk, Crop Insurance and Forward ContractingCory Walters and Richard Prestoncgwalters@uky.edu859-421-6354University of Kentucky

2. 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

3. 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

4. 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

5. 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.

6. 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

7. Price-Yield Relationship

8. 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

9. Price Risk and Uncertainty December 2013 Corn Futures Prices Risk Price risk Hedging risk – Margin calls Average

10. 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

11. Farm Corn Yield Yields in 1983 and 2012. Rare events do happen ! Most years expect yields between 110 and 170 bu/acre Farm average = 144.4 bu/acre

12. 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

13. Crop Income and Insurance With no insurance payments difference is the premium Insurance payments • Coverage Level: 80% • Revenue Protection (RP) and RP Harvest Price Exclusion • Zero Income • 80% coverage, enterprise units does not guarantee positive income • No hedging at this point

14. Crop Income With and Without Insurance • Coverage level: 80% • Revenue Protection (RP) and RP- Harvest Price Exclusion Insurance

15. 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%

16. 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

17. Crop Income, Insurance, Hedging

18. 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. • Insurance contract: Revenue protection, 80% coverage level, enterprise units

19. 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

20. 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

21. Insurance Coverage Level Payouts • Highest coverage level • provides the highest chance of receiving a payment • It also costs the most

22. Revenue Protection, Enterprise Units, No Hedging

23. 2013 Premium Subsidies, in Percent

24. Crop Income With and Without Insurance • Coverage Level: 65% • Revenue Protection (RP) and RP Harvest Price Exclusion Insurance Insurance