«Price, Yield and Enterprise Revenue Risk Management Analysis Using Combo Insurance Plans, Futures and/or Options Markets Authors: Duane Griffith, ...»
Scenario #1: Figure 17 is a screen capture of the Summary Results using the base case scenario values. This scenario is our perfect world scenario with a text book hedge example and a perfect production year as previously shown in Figures 3 and 8. Figure 17 indicates that Hedging, Puts, and Calls are not active, they are set to Off. The actual yield also equals our expected and APH yield. This scenario also assumes a level of production (acres times yield per acre) that matches an even number of Futures/Options contracts, in this case, 8 contracts at 5,000 bushels each. This eliminates over or under hedged positions with respect to expected total production.
There are several rows of estimated results on the Summary Results tab. We encourage you to familiarize yourself with this table before working through all of the scenarios. For the purpose of comparative analysis, two rows serve as the bottom line. The first is the Net Cash Price Per Bushel Harvested Yield @ Harvest/Sale/Offset and the second is the Actual Net Income Per Acre (Actual Yield * Actual Net Price). For comparative analysis purposes, the net price per bushel row is based on harvested yield per acre, unless the actual yield is set to zero. If actual yield is zero, the results displayed for the Net Cash Price Per Bushel… shows the Net revenue received per acre for each plan. In this instance, the Net Combo Indemnity Received Per Acre and the Net Cash Price Per Bushel… are the same number. A pop up message also alerts you to this circumstance. Using actual yield as a common denominator across alternatives allows an apples to apples comparison of protection levels, even though by their design, the Combo plans and futures and options markets provide different levels of protection.
The cash result is the highest at $128 per acre because there were no production problems and no crop insurance expenses. The three COMBO choices have a net income that reflects the different costs of insurance coverage for each plan. The premium for each plan is prorated over the bushels harvested, which reduces the net price received per bushel harvested and the net income per acre. Thus, the most expensive product, Revenue Protection, has the lowest net income in our base case scenario. While the base scenario is illustrative of how the software works for analysis purposes, the software was designed to help analyze more real world examples, reflecting what happens under different price and yield scenarios using different combinations of risk management tools and strategies.
Figure 17. Base case scenario.
Scenario #2: Actual yield at harvest is reduced to coverage levels of 28 bu. per acre (40 APH * 70% coverage election). Lower the RMA Harvest Price and the Spot Futures Price at Harvest to $7.15 so they both match the RMA Projected Harvest Price. Set the Actual Cash Price Received at Harvest/Sale to $6.45, which keeps the expected and actual equal at -$.70. With these parameters, no Combo plan pays an indemnity. Actual yield is at, not below, the 70% coverage level selected and the RMA Harvest Price equals the RMA Projected Harvest Price. Figure 18 shows the results with these parameter values. Actual net income per acre has fallen due to the decrease in the actual price from $7.70 to $6.45. The Cash column net income per acre is positive, but only $.60. The net income per acre for all of the Combo plan is negative due to their premium values being larger than the Cash net income per acre.
Figure 18. RMA price and yield levels at the trigger points for an indemnity payments.
Scenario #3: Leave the actual yield at 28 bushels and decrease the RMA Harvest Price and the Spot futures price at harvest to $6.00 per bushel. Lower the Actual Cash price received to $5.30 to maintain a -$.70 basis. The RP-HPE and the RP Combo Plans pay the same indemnity as the RMA Harvest Price falls below the RMA Projected Harvest Price of $7.15 per bushel. This software displays the “Net Indemnity” which is the total indemnity minus the premium paid per Combo Plan, so the net indemnities are not the same. For the sake of illustrating that these two plans pay the same indemnity, zero out the premiums for the RP-HPE and RP plans on the General Inputs tab. The net indemnity then becomes the total indemnity and the Summary Results tab shows the RP-HPE and RP indemnities are identical. With the actual yield set at 28 bushels, YP does not pay an indemnity regardless of how low the RMA Harvest Price is set.
Figure 19. Actual yield set to the yield coverage level selected and with RMA Harvest Price and the Spot futures at harvest set to $6.
You can also use the toggle button to display the bushel buy calculations. This pop-up shows the premium differences between plans and the number of bushel, at a given cash harvest price, it would take to increase your coverage from one plan to another. This pop-up also shows the difference in net indemnity paid does not change between the RP-HPE and RP plans for this scenario.
Scenario #4: Figure 20 shows the results when the RMA Harvest Price and the Spot Futures price at harvest are at 200% of the RMA Projected Harvest Price of $7.15, $14.30 in this scenario. Set the Actual Cash Price at harvest to $13.60 to maintain a basis of -$.70. Set the actual yield to the coverage level of 28 bushels. With these settings, no Combo Plans pay an indemnity, including the RP plan. This is due to the actual yield being set at the coverage yield level. This situation also illustrates the importance of the yield coverage level selected in determining when Combo Plans start to pay.
Figure 20. RMA Harvest price at capped levels, yield at coverage level selected.
Now, decrease the actual yield to 27 bushels and you will see that all Combo Plans pay indemnities. With the actual yield set to 27 bushels, lower the RMA Harvest Price below $14.30 by clicking on this number, holding the left mouse button down while dragging downward. You can also double click on this number and type in a new number. As you lower the RMA Harvest Price, The RP indemnity starts to decrease, but indemnity payments for the other two plans do not change until the RMA Harvest Price falls below $7.15. As you “drag” the price below $7.15, both the RP-HPE and the RP indemnity payments change, but the YP plan’s indemnity payment does not change. Now set the RMA Harvest Price and the Spot futures price at harvest to $7.00 and change the Actual cash price at harvest to $6.30 to maintain the -$.70 basis. Leave the actual yield set at 27 bushels. Caution: To assure that estimates for all of the Combo and marketing alternatives show accurate results, make sure you change all the relevant variables for each situation, in this instance holding the basis at -$.70.
Click and drag the RMA Harvest Price up to increase this price level. Both RP-HPE and RP increase their indemnity payment until you hit the $7.15 RMA Project Harvest Price level. As you continue to drag upward, increasing the RMA Harvest Price above $7.15, only the RP indemnity changes. If you continue to increase the RMA Harvest Price, the RP indemnity will increase until you reach the $14.30 price level. This is 200% of the $7.15 RMA Projected Harvest Price. Once this cap is reached, for the RMA Harvest Price, the RP indemnity is maxed out for any given yield below 28 bushels in this scenario.
Scenario #5: Click on the button. This resets all values you have changed to the original values that were loaded when you first opened the program, including changing back to the Introduction screen tab. Click on the Summary Results tab and then on the Display/Hide Market variables at harvest/sale/offset checkbox. Set the actual yield to 20 bushels. Go to the general inputs tab and set all three insurance premiums to zero. Go back to the Summary Results tab. Note that YP and RP-HPE now pay the same indemnity but RP is higher as the RMA Harvest price is set at $8.40, Figure 21. The reason for this is that YP and RP-HPE are both limited by the $7.15 RMA Projected Harvest Price. RP allows the insurance coverage to increase as the RMA Harvest Price varies between $7.15 and $14.30, in this scenario. Change the RMA Harvest Price to $7.15. Now all three combo plans pay the exact same indemnity.
Figure 21. Zero premium payments, YP and RP-HPE have the same indemnity, RP higher.
Scenario #6: Work back through each of the previous scenarios and use the button with each scenario. This may add some additional understanding of the Combo plans and the protection they provide under various price and yield combinations. Click on the button before you start.
One example for the Bushel Buy-Up Calculator is illustrated here. In our Base Case, the premiums for the three plans are $7.50 (YP), $9.80 (RP-HPE), $11.60 (RP). The premium difference from YP to RP-HPE is $2.10. Using the expected cash price estimate at harvest time of $7.70 ($8.40 spot futures plus a negative -$.70 basis), the buy up in bushels of grain is.2987 of one bushel ($2.30 divided by $7.70 =.29870). The buy up from YP to RP is an extra $4.10 premium per acre. This converts to.5324 of one bushel ($4.10 divided by $7.70).
The cost to buy up from RP-HPE to RP is.23337 of one bushel ($11.60 minus $9.80 = $1.80 divided by $7.70). Once the premiums are estimated and entered in this software for any given level of coverage selected, they will not change unless the coverage level changes.
Figure 22. Bushel Buy up calculations pop-up.
Futures and Options Markets scenarios:
This set of scenarios explores using a Hedge, Put and/or Call Option as a standalone means of protecting price and revenue risk. It may be useful to cover up the Combo Policy Plan columns before you start these scenarios, Figure 23. This allows you to evaluate just the Futures and Options marketing tools as standalone tools. Click on the grey colored check box to the right of the Combo Policy column heading ( ) on the Summary Results page. Use the check boxes in the “Futures & Options” columns as necessary to activate one or more of these marketing alternatives. When you click on any of the gray check boxes, they turn orange and a check mark is displayed to let you know that alternative is active. Figure 23 is a screen capture of the starting setup for the futures and options scenarios. This is the base case with the combo columns covered and Hedging and Put options activated. When activated, thes columns show the results of each of these individual alternatives. Activating the Hedge and Put marketing alternatives also includes the profit or loss from each marketing alternative in each of the Combo plans. This allows analyzing risk management strategies that combine the Combo insurance plans with the marketing alternatives. The portion of the screen that is outlined in blue contains the profit or loss from the marketing alternatives and the interaction affects for the marketing alternatives with the Combo plans. This is another reason to cover up the Combo Plan options if you wish to look at just the marketing alternatives.
One of the considerations necessary to get an apples to apples comparison of the marketing alternatives is the lumpy nature of commodities contracts. Wheat contracts are 5,000 bushels per contract. The transaction costs of trading commodity contracts are typically stated in cents per bushel traded. Premium costs of Options contracts are also stated in cents per bushel traded. This makes calculating estimated net price per bushel for the futures or options contract straight forward. In our perfect world scenario with actual production equaling expected production which equals an even number of commodity contracts, the per bushel calculation follows all the way through to the end. However, if actual yield is less than expected yield or the number of contracts used to protect price does not exactly equal production levels due to the lumpy 5,000 contract size, adjustments are made before comparing the outcomes from market alternatives to those of the Combo policy plans. Adjustment is made on the Net Cash Price Per Bushel Harvested Yield @ Harvest/Sale/Offset row. All costs of trading contracts, gains or losses on the marketing alternatives, premiums paid for insurance or commodities contracts and indemnities received from each Combo policy are prorated over the actual harvested bushels. All of the information for the marketing alternatives down to that row are based on contract bushels, and are not completely comparable to the Combo policy alternatives.
For the Futures & Options columns, the row labeled Percent of Production Insured/Price Protected & Yield Insured indicates 100% coverage level for the marketing alternatives, in our perfect world scenario.
Figure 23. Starting Point for marketing scenarios.
For marketing alternatives, variables that will affect the results are the Spot Harvest Time Futures-Preproduction-NOT RMA Avg., the Put and Call Strike prices and premiums, the Spot Futures Price at Harvest/Sale/Offset and the Actual Basis at Harvest. This program allows the user to select values for both the Spot futures at harvest and the local cash price at harvest.
The difference in these two values, cash minus futures, is the basis. Changing either of these two price inputs changes the basis. However, the price a producer receives is determined when the Actual cash price at harvest time is set. Adjustments are made to the actual cash price if appropriate. An example would be prorating Hedge gains or loss over harvested bushels and adjusting the actual cash price by the prorated amount.
Due to the flexibility of implementing price protection strategies, using Futures and Options can occur anytime from prior to the start of the production process through harvest. This means that the Spot Futures prices can be significantly different than the RMA Projected Harvest Price or the RMA Harvest Price. While this is unlikely, this actually happened within a few weeks of the fall sales closing date for wheat in Montana. The flexibility to implement the futures and options marketing tools throughout the production cycle provides a much greater selection of price levels to choose from than is offered by the RMA average prices on the fixed sales closing dates by commodity for the Combo policy. However, the commodities markets only provides price protection, just one component of total revenue and the producer is still subject to basis risk when using the commodity marketing alternatives.