«Price, Yield and Enterprise Revenue Risk Management Analysis Using Combo Insurance Plans, Futures and/or Options Markets Authors: Duane Griffith, ...»
As previously indicated, this software is distributed with an example of a perfect Hedge. Data entered on the General Inputs tab is repeated on the Futures tab as well as other tabs in the software, Figure 4. The graph shows estimates of Projected Cash Price at sale time over a range of possible basis values at sale time. The graph is dynamic. As values are changed on the left edge of the display, the graph also changes. This page of the software calculates before and after results using values set by the user. On this page, in the upper right corner, the “after” results are calculated. Since the initial example is a perfect hedge, the predicted net price when the hedge was placed, $7.68 is also the net price received after the hedge is lifted. The Futures price at purchase equals the Futures price at sale/offset and the cash price at sale results in a basis which equals the expected basis at purchase. In this example, if the hedge was not placed, the producer would have received the $7.70 cash price at sale time. However, with the hedge, the net price at sale is $7.68, adjusting for the $.02 per bushel hedge transaction cost.
In this example, expected production also allows purchasing an even number of contracts for 100% price protection coverage on the expected production. In short, everything works out as planned, a very rare occasion.
Since this is rare, the user can change any numbers with a blue background to get a feel for how the futures markets work. Changing a number in any location it is displayed, changes that number in every location in the software. For example, the initial value of “Spot Harvest Time Futures-Preproduction-NOT RMA Avg.” on the General Inputs tab is $8.40. This is also the value shown on the Futures tab labeled “Futures @ Purchase--$/bu.” If you change this value on the futures tab, it is also changed on the General Inputs tab. The futures price at harvest turned out to be $8.405 and the cash price at harvest was $7.70 which means the actual basis at harvest equaled the expected basis, -$.70. As expected, production also conveniently matches an even number of contracts so the expected production is not over or under hedged in this example.
Figure 4. Screen capture of the Futures tab in the software.
Both the Futures and Options tabs in this software can be used independently from the rest of the program. The input variables necessary to estimate the beginning position and the ending variables at the time the hedge is offset are all on this page. The outcome of taking a position in the Futures markets and offsetting this position at the appropriate time, given the variables specified by the user, are shown on this page. While this tab can be used as a standalone tool, information on this tab is also carried forward to the Summary Results tab. On the Summary Results tab, the last three columns in the side-by-side comparison display the Futures and Options risk management alternatives. However, on this tab, the default position for the futures and options are Off, Figure 7. The row labeled Net Predicted Cash Floor (Ceiling) Price Per Bushel shows the Futures/Options expected net prices that would be in effect if a position was taken in the market. These net prices will always match the net prices on the Futures and Options tabs. The row labeled Net Cash Price Per Bushel Harvested Yield @ Harvest/Sale/Offset does not show the same number for the ending result that is shown on the Futures and Options tab. On the Futures tab, this number is $7.68. For Put Options tab, this number is $7.41 and for the Call options this number is $7.53. The reason these numbers are different on the Summary Results tab is that these columns are not active by default on this tab while on the Futures and Options tabs, the ending result is displayed as if a “position” in the commodities markets had been established. When in the Off position, trading costs and profits or losses from the market transactions are ignored and the “Cash Price” at harvest is used. This creates a slightly different calculation for the beginning and ending net prices received for Futures, Puts and Calls on the Summary Results page than is shown on the Futures and Options tabs. To make the results shown on the individual tabs match exactly, you must use the check boxes on the Summary Results page to activate those alternatives. Once activated the ending net income figures will match those displayed on the Futures and Options tab, but only when the actual yield equals the expected yield. As trading costs and profits or losses from the futures and options are prorated over the actual yield to make the alternatives comparable, an actual yield that is different than the expected yield will also make the final results for the futures and options columns different than what is displayed on the Futures and Options tabs.
The Options Tab: Put Options
The Options tab contains two sub tabs, one for Puts and the other for Calls. Calculations shown for Puts and Calls on the Options tab can also be used as a standalone application. All of the information necessary to estimate outcomes after taking a position in the Options markets is included on the Options tab. Results displayed estimate the outcome given the values of variables set by the user. Puts and Calls must be “turned on”, Figure 7, in order for information displayed on the Summery Results comparative analysis to match the results for Puts and Calls displayed on the Options tab.
Figure 5 is a screen capture of the display for the Puts sub tab. The Puts tab is the default display. Producers often shy away from Hedging in the Futures markets because that eliminates any upside price potential. Puts are Options contracts that allow producers to establish price floors for a given commodity that does not exclude upside potential in price movements. As with the Futures tab, users can change several parameters initially entered on the General Inputs tab. These include the Strike price and premium for a specific Put, the expected basis and the transactions costs (brokerage and interest) for trading in the Options markets. The graph on this page is also dynamic. When some of the variables are changed, the graph reflects the specific set of outcomes for each variable changed. Some variables do not affect the graph as they are specific to the conditions when the Put expires or is exercised.
With the perfect hedge as our initial example, the Put expires worthless. The floor set by the Put was $5.51 (Strike price of $6.50 minus the premium, $.27 and brokerage costs, $.02 and expected basis, -$.70). The right hand column, “Conditions @ Option Exercise/Expire” shows the Profit or Loss from the Option to be a negative $.29 ($.27 premium plus $.02 brokerage). The Futures price at the beginning and ending of the time period were identical, $8.40. A $7.70 cash price means the actual basis equaled the expected basis, -$.70. In short, a perfect world outcome for a Put option, which in reality would be very rare.
The Options Tab: Call Options:
Figure 6 is a screen capture of the Call Options sub tab. Call options are used to establish price ceilings. Call options are typically used by producers that need to protect themselves against rising prices. An example would be a cattle feeder establishing a ceiling on both the feeder cattle they purchase and the corn they feed to these cattle. Grain producers can also use a Call option to protect themselves against sever losses in expected production that would result in rising market prices. This could be part of a strategy that forward contracts or otherwise preprices a portion of production and then uses a Call option to protect against yield losses. This is illustrated later in this publication when several risk management scenarios are demonstrated using this software. The graph on this page is also dynamic and will change as the user changes values for variables displayed on this tab. Profit/Loss on the Call option is -$.17.
Figure 5. Screen capture of the Options tab with the Puts sub tab display.
Figure 6. Screen capture of the Options tab with the Calls sub tab display.
The Summary Results tab brings all of the alternative risk management strategies together for a side-by-side comparison and also allows evaluation of potential combinations of these alternatives. There are several check boxes on this screen. These check boxes are used to toggle a particular display or make a column in the table active. Some of these check boxes are defaulted to the Off (not active) position. These check boxes are a medium gray color. Other check boxes are defaulted to the On (active) position, an orange color with a check mark inside the box. The default to the On position for the Combo plans means the row in the table labeled “Net Combo Indemnity Received Per Acre” displays a number other than zero and that number is included in the net income per acre calculations at the bottom of the table. This screen is initially displayed with the Futures and Options columns of the table hidden, Figure 7. You can unhide these columns by clicking on the check box in the upper right corner of the table, just to the right of the “Futures & Options” heading.
Figure 7. Screen capture of the Summary Results tab displaying the Base Case Scenario without Check Boxes selected and the Futures & Options calculations hidden (Check Box to the right of “Futures & Options” heading is checked).
There are two check boxes in the upper left corner of Figure 7. These are used to display/hide a set of input data related to specific action or time period. These check boxes act as a toggle.
When you click one of these boxes it turns a display on or off and the display stays on or off until you click on the check box again. As some hidden displays use the same screen space, in some instances, one display must be turned off before turning on another display.
Figure 8 shows all columns in the table displayed and variables related to the Combo Policy Plans displayed at the bottom of the screen. These variables were entered on the General Inputs tab and are repeated here. Changing a value here changes it throughout the entire software. Figure 9 shows the variable values related to the Futures and Options markets.
Figure 8. Screen capture of the Summary Results tab with the Check Box for the display of Combo Insurance variables selected and the Futures & Options calculations displayed (Check Box to the right of “Futures & Options” heading is not checked).
Figure 9. Screen capture of the Summary Results tab with the Check Box for the display of marketing tools variables selected and the Futures & Options calculations.
Following the Numbers:
Note that in Figure 9, the Cash column and the columns for Futures, Puts and Calls all have a value of $7.70 for “Net Cash Price Per Bushel Harvest Yield @ Harvest/Sale/Offset.” Since the Futures, Puts and Calls are not active, check box is gray, no profit or loss is displayed in these columns for contracts traded, i.e. these three columns all display results as if all market factors fit the perfect hedge, but without actually establishing a position in the Futures/Options market, all alternatives displayed act as if it was a Cash market. This also means that if you unchecked the check boxes in the Combo plans, these columns would also display a $7.70 price for the Net Cash Price… Try it. The reason the row labeled Net Cash Price… shows a different number on the Summary Results tab is the premiums paid for each Combo plan are prorated over the bushels harvested for every set of circumstances. All alternatives use bushels harvested so calculated results can be compared using a common denominator for all alternatives. As soon as you start changing the base case scenario values with what if analysis, the comparative values for these numbers per bushel and per acre illustrate the effectiveness of each risk management alternative considered.
Cost of Production:
This software also allows the user to estimate operating cost of production for up to two crops.
Figure 10 is a screen capture of the introductory screen for estimating costs of production. The Crop #1 and Crop #2 sub tabs, are identical in their content an procedures, except that two different sets of example data have been entered in the base case scenario. The two sub tabs entering relevant operating inputs and costs for two different crops. Operating costs of production are those incurred during a single production cycle for a particular crop. These costs are also referred to as variable costs as they vary with the level of production, even though they are typically fixed on a per unit basis. For example, a per unit cost is incurred for each additional acre produced, $10.00 per bushel of seed, at one bushel per acre, or $5.00 per acre of herbicide. On a per unit basis, these costs typically remain the same and each additional acre planted incurs the same per acre cost. Cost of Production estimates included in this software ignores fixed costs such as depreciation and land charges. These costs do not vary with the level of production, hence they are not relevant for decision making in the short run.
Figure 10. Screen capture of the Cost of Production screen tab.
Cost of production information is entered in this software in four parts. To start the process, click on the Crop #1 sub tab. The screen clears, Figure 11, and a menu is displayed in the upper right corner. Click anywhere on this drop down menu bar to display the menu items. There are six items total in the drop down menus for Crop #1 and Crop #2, but the first and last menu on each of these lists acts as a label for the menu and also clears the screen, as shown in Figure 11.