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«Price, Yield and Enterprise Revenue Risk Management Analysis Using Combo Insurance Plans, Futures and/or Options Markets Authors: Duane Griffith, ...»

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Click on the second menu item, “Production and Revenue.” Figure 12 is a screen capture of the information requested for the expected revenue for Crop #1. After completing these entries, click on the drop down menu again and choose each menu item in sequence. The third and fourth menu items allow entry of pre-harvest operating inputs. Figures 13 and 14 are screen captures when the third and fourth menu items are selected. The last screen, Figure 15, allows the user to enter harvest operating costs and estimates total operating costs per acre and the breakeven cost of production on a per bushel basis. After entering appropriate data in each of these screens, the user can then enter the estimated cost of production, Figure 15, on the General Input tab. The software uses this data to estimate Net returns per acre for the commodity and risk management strategy being analyzed.

This software does not require you estimate a cost of production. You can enter your own estimate or set the cell for the cost of production value to a zero.

Figure 11. Screen capture of the first screen in Cost of Production for the Crop #1 sub tab.

Click on the menu bar for … -- Crop #1 and select the second menu item “Production and Revenue.” Figure 12 is displayed.

Figure 12. Screen capture of the second screen after selecting the Production and Revenue item off of the drop down menu in the upper right corner of Cost of Production for the Crop #1 sub tab.

Figure 13. Screen capture of the third screen after selecting the Preharvest Operating Costs – First Screen item off of the drop down menu in the upper right corner of Cost of Production for the Crop #1 sub tab.

Figure 14. Screen capture of the fourth screen after selecting the Preharvest Operating Costs – Second Screen item off of the drop down menu in the upper right corner of Cost of Production for the Crop #1 sub tab.

Figure 15. Screen capture of the fifth screen after selecting the Harvest Operating Costs & Results item off of the drop down menu in the upper right corner of Cost of Production for the Crop #1 sub tab.

Pop up Caution Messages:

To this point, the examples have stuck with our perfect world base case scenario. This is rarely the case and this software has a couple of cautions that “pop up” if certain conditions are met.

There are three instances where these occur. Two deal with divergence of prices from the RMA Harvest Price. The user must enter the “RMA Harvest Price @ Harvest/Sale/Offset,” the “Spot Futures Price at Harvest/Sale/Offset” and the “Actual Cash Price Received at Harvest/Sale/Offset.” Theoretically, if the markets are efficient providers of price signals, these three prices should all maintain a “normal” relationship. However, normal means different price levels for different crops and regions within the U.S. Since the timing of calculations for the RMA Harvest Price and selecting a Spot Futures at harvest can differ, these two prices can also differ. We would not expect these two prices to differ by a large amount. If so, it means that there were large moves in the futures markets up or down shortly after the time period RMA used to calculate the average for the RMA Harvest price. If there were large moves, the spot futures could be significantly different than the average. This type of volatility would almost impossible to predict. While if is possible, this is unlikely.

Figure 16 is a screen capture which shows two pop up “caution” messages when the user enters a Spot futures at harvest time that differs by more than 10% (+/-) of the RMA Harvest Price and/or the Actual Cash Price at harvest differs by more than 20% (+/-) of the RMA Harvest Price. If these messages appear as you enter data, it does not mean something is definitely wrong, it means the price relations may be unusual. If the price relationships reflect typical conditions for the crop and region, or if current conditions are unusual for a variety of reasons, ignore these pop up cautions. A similar set of messages is also displayed on the Summary Results tab when one or both of these caution messages is triggered.

Figure 16. Sample data that trigger the caution pop up messages on the General Inputs tab.

Risk Management Scenarios:

Risk management strategies for crop producers fall into three categories, government, insurance, and marketing tools. Government programs provide a minimal amount of price/revenue protection with the loan rate or loan deficiency payment (LDP). Crop insurance products may or may not include price protection, but cover yield risk. Formal price risk management tools exist that may or may not include standardized futures and options contracts. Weather and other environmental conditions, insects, diseases, etc., eventually determine grains supplies on a local and national level and when combined with market forces, determine prices for a given commodity.

Crop insurance underwent major changes prior to the 2011 crop year. Most of the major crops with multiple insurance products available were affected by implementation of the new Common Crop Insurance Policy basic provisions, commonly referred to as the “Combo” policy.

The Combo policy combines existing insurance products (APH, CRC, RA, and IP) into one policy with separate plans. The Combo policy also standardizes various methods of calculating premium rates and coverage levels used for the insurance policies it replaces.

Winter wheat is the first primary small grains crop affected by the Combo Policy in Montana.

Other crops with a fall insurance deadline, September 30th, (alfalfa seed, apiculture, forage production, and pasture, rangeland, and forage (PRF), Rainfall Index) are not affected by the Combo changes.

The Combo policy uses yield coverage levels and two price points to determine indemnity payments for the YP, RP-HPE and RP plans. The two price points are the RMA Projected Harvest Price and the RMA Harvest Price.

In addition to standardizing the beginning base price for yield and revenue protection plans, basis is no longer factored into the projected price for Combo plans. As such, the RMA Projected Harvest Price and the RMA Harvest Price will likely be larger than the expected local cash price at harvest. The premium for yield protection will also likely be higher than what would otherwise be expected because of the higher price level used for the guarantee calculation.

Comparative Risk Management Analysis: Combo Plans, Futures and Options

The base case scenario built into this software is for a Montana dry land small grain operation.

This scenario is built around a perfect world example and includes a perfect hedge and production outcomes that exactly match expected production for winter wheat in Hill County Montana. The base case is intended to make it easy to follow numbers and calculations throughout the software before more complicated scenarios are run. Additional scenarios are presented below which deviated from the base case. These scenarios help analyze the effectiveness of the Combo plans, marketing tools and combinations of these risk management tools to protect the bottom line, Net Revenue after all marketing costs and cost of production for the crop. Figure 17 is a screen capture of the base case scenario.

The first alternative in the Summary Results table, Figure 17, is “Cash.” This alternative assumes no risk management tools of any type are used to mitigate risk. Post production net income per acre is calculated using the actual cash price and yields at harvest time entered by the user. Expected total revenue per acre is also calculated using the APH yield, spot futures (pre-production or pre-harvest) entered by the user and the expected basis. In our perfect world example, the predicted local cash price at harvest equals the actual cash price at harvest, expected yield equals harvest yield so expected total revenue equals actual total revenue.

In the base case, all Combo Policy Plans columns are active, (check boxes are checked) so the results shown in these columns show how each plan performs as the relevant variables change.

Note also that each of these three columns includes the rows labeled Profits/Losses From market tool name Prorated Over Actual Production (per Bu.) for Hedges, Puts and Calls. The Base Case scenario shows these rows for all columns on the Summary Results tab as zeros.

These values will always display zero unless you activate the Hedge, Puts, Calls using the check boxes shown in Figure 17. By turning one or more of the Hedge, Puts, or Calls columns on, it will then display the effectiveness of that individual tool in the last three columns, and the results of each of these tools, when turned on, is also shown in the Combo columns. This allows you to evaluate possible combinations of available tools. The Profit/Losses… for all Combo plans and marketing tools is prorated over the actual yield so the side-by-side comparison of these alternatives is valid. If the Hedge, Puts, or Calls have no value given harvest time conditions, then the transactions cost, a negative number, for each of these alternatives are prorated over actual yield. This flexibility is demonstrated in the risk management scenarios provided below.

Combo Policy Plan Parameters Established in the Base Case Scenario:

A brief summary of the base case scenario is provided for each Combo Policy Plan. This summary includes the revenue protection levels established when a plan in purchased and discusses the key parameters that will vary the final level of Price/Yield/Revenue protection provided by each plan.

1. Combo Yield Protection Plan: (YP) o The maximum revenue guarantee established in the base case scenario is $200.20 per acre (40 * 70% = 28 bu. yield protection level times the $7.15 RMA Projected Harvest Price).

o Only yields below the selected protection level will affect the final indemnity paid.

o Changing the RMA Harvest Price has no effect on potential indemnities under this plan.

2. Combo Revenue Protection with Harvest Price Exclusion: (RP-HPE) o The revenue guarantee established with this plan is the APH yield times the coverage level times the RMA Projected Harvest Price. In this example, the revenue guarantee would be $200.20 (40 bu. * 70% * $7.15), the same as YP o The difference between this plan and the Yield Protection plan is that any combination of actual yield and RMA Harvest Price that is below the revenue guarantee will result in an indemnity, i.e., it is not just yield driven.

 When RMA Harvest Price is below the RMA Projected Harvest Price  Actual yield, may be above or below, the yield coverage level selected, 70% = 28 bushels in our base case,  RP_HPE plan pays the same indemnity as the RP plan, however the net indemnity will differ due to the premium difference between the plans.

3. Combo Revenue Protection: (RP) o This plan allows a producer to take advantage of increasing prices after the sales closing date.

o The revenue guarantee established with this plan is the higher of the RMA Projected Harvest Price established before the sales closing date or the RMA Harvest Price at the end of the insurance period, capped at 200% of the RMA Projected Harvest Price, times the APH yield times the yield coverage level selected.

o In the base case scenario, the minimum revenue guarantee is $7.15 * 40 *70% yield election = $200.20.

o The maximum possible indemnity using the base case parameters is $400.40 per acre ($7.15 * 200% *40 * 70%).

o This software displays the Net Combo Indemnity Received for each plan, not the total indemnity. The RP premium of $11.60 per acre in this example results in a net indemnity of $388.80 ($400.40 minus $11.60) if the maximum indemnity is reached.

o If you set yield to zero and the RMA Harvest Price to $14.30, the RP indemnity will display $388.80.

o Increasing the RMA Harvest Price above $14.30, for this example, does not increase the RP indemnity as $14.30 is 200% of the RMA Projected Harvest Price.

o Any combination of actual yield and RMA Harvest Price, capped at 200% of RMA Projected Harvest Price that results in a revenue estimate above the minimum and below the maximum will result in an indemnity payment.

o When the RMA Harvest Price is at or below the RMA Projected Harvest Price, the RP plan pays the same indemnity as the RP-HPE plan.

Scenario Descriptions:

Several scenarios are provided below to explore how these marketing tools manage risk individually or when combined. A few of the values used for different variables in the base case were held constant throughout the scenarios presented below. This helps simplify the number of scenarios presented here, but we encourage you to explore how these variables may affect your decisions. Screen captures from the software show results for most scenarios, but in some instances the user is encouraged to explore particular situations. Screen captures show values of key variables used in most scenario.

Variables held constant across scenarios are:

• APH yield equals expected yield and is 40 bushels.

• Yield election level is held at 70%.

• Price election level is held at 100%.

• Premium costs for YP, RP-HPE and RP are constant for the coverage levels selected.

• The Put strike price and premium are constant at $6.50 and $.27 respectively.

• The Call strike price and premium are constant at $10.00 and $.15 respectively.

• Cost of production is constant at $4.50 per bushel.

Scenarios presented are divided into three categories. The first include scenarios related only to the Combo Policy Plans. The second are those related only to the Futures and Options marketing tools. The third are those that combine Combo plans and marketing tools into an overall risk management strategy.

First Category of Scenarios: Combo Policy Plans

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