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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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Scenario #7: The scenario starts with all the parameter values of our base case. The Hedge and Put columns are checked (active) but the bottom line for these columns indicates a net income less than the cash market, Figure 23. The portion of the table outlined in blue shows the profit or loss for each futures market alternative. In this scenario, the Spot Futures Price at Harvest/Sale/Offset is a negative two cents a bushel. This is the brokerage and interest costs, entered by the user, for trading the futures contracts. The Puts column shows a negative $.29 cents per bushel loss ($.27 per bushel premium plus $.02 per bushel brokerage and interest cost). Calls are not active in this scenario. The bottom row of the table shows the net income on a per acre basis. Both the Hedge and Puts columns are less than the Cash column due to the trading costs incurred for the eight contracts necessary to cover expected production. In this scenario, both the Hedge and the Puts have acted just like insurance. They were implemented to protect against down side price risk and they were not needed, so the loss is the comparable to an insurance premium.

Scenario #8: Starting with the parameters of the base case, Scenario #7, lower the Spot Futures as harvest to $6.00. As you lower the price, the basis changes to a positive $1.70 because the Actual Cash Price Received at Harvest/Sale is still $7.70. For now set the Actual Cash price received to $5.30 so the basis remains as at our expected -$.70. As you lower these prices, two messages appear on the screen to caution you that the price relationships between the RMA Harvest Price, the Spot futures and the local cash price may not be representative of what you might expect, however it does not mean there is something wrong, Figure 24.

At this point, only the Spot futures and local cash price have changed, but the RMA Harvest price remains at $8.40. These messages will disappear if the RMA Harvest Price is lowered to within 10% (+/-) of the Spot futures price, Figure 25. There is a wider margin on the cash price caution message, 20% (+/-) of the RMA Harvest Price, to account for basis. Lower the RMA Harvest Price to $6.00 so it matches the Spot futures at harvest. Note that lowering the RMA Harvest Price has no effect on the results calculated for the Hedge or Put columns, Figure 24 and 25.

With a Spot futures at harvest of $6.00 and a Spot Harvest Time Futures-Preproduction… of $8.40, the Hedge shows a profit of $2.38 per bushel. Net income per acre is $127.20 while the Cash net income is only $32.00 per acre. As a marketing tool, the Hedge maintained the net income per acre to within $3.00 per acre of our base case scenario for Cash, Figure 17.

Put options do not provide as much down side price protection due to the premium paid for the Put option. In this scenario, the Put option strike price is $6.50 and results in a Net Cash Price Per Bushel Harvested Yield @ Harvest/Sale/Offset of $5.51, which provides a higher net income per acre, $40.40, than just cash marketing, $32 per acre, when the cash price per bushel is $5.30.

Figure 24. Caution messages when price relationships may be suspect.

The relative performance of a Hedge and Put alternatives will depend on the strike price selected and the premium paid to obtain a particular strike price. The lower the Put strike price relative to the hedge price, the less price protection offered when using a Put option.

Figure 25. RMA Harvest Price set to $6.

00 to eliminate caution messages.

Scenario #9: For illustrative purposes and to gain understanding of the relative price protection levels offered by the futures and options markets with respect to cash markets, find the prices the futures and options markets would have to offer to provide an equivalent net income per acre to cash marketing. In our base case scenario, the actual cash price received at harvest is $7.70. In order for the net income per acre for the futures and option alternatives to be equivalent to the cash market alternative, the futures and options Net Predicted Cash Floor (Ceiling) Price per Bushel must equal $7.70. For the base case scenario, a Hedge at $8.42 with a $.02 trading cost and a negative -$.70 basis makes the Net Predicted Cash Floor (Ceiling) Price per Bushel equal to $7.70. The actual net income per acre is then $128.00 for both the Cash and the Hedge alternative. Any combination of a strike price, minus a premium and trading costs for a Put that equaled $7.70 would also make the net income per acre, using a Put, equal $128.00.

Scenario #10: This scenario looks at the effectiveness of the futures and options markets with low prices and yields that fall below expectations. Figure 26 shows the starting point for this scenario. The RMA Harvest Price and Spot futures price are at $6.00 per bushel. Actual cash price is $5.30 per bushel which maintains the basis at $-.70. With actual yield at 20 bushels per acre, the Hedge preforms significantly better than the Cash market alternative. With a Put option strike price of $6.50, the option still makes enough money to make it more attractive than the Cash alternative. As you would expect, with prices held constant at the levels indicated, the relatively ranking for net income per acre does not change, even if yield is reduced to zero.

Figure 26. Effectiveness of marketing tools with low prices and yields.

Scenario #11: The scenarios to this point have held the expected basis constant at -$.70 per bushel by changing both the Spot futures at harvest and the Actual cash price received. This software allows you to explore how basis variability can affect the final results across all alternatives. Set the variable values and check boxes as displayed in Figure 26. Now assume the basis changes from -$.70 to -$1.00 (weakens) between the time a Hedge or Put is placed and harvest/sale/offset. To illustrate this, set RMA Harvest Price and the Spot futures at harvest to $6.30. The Actual Basis at Harvest will show -$1.00. If the Actual Cash Price Received at Harvest/Sale is changed to reflect a change in the basis the net income per acre for all of the alternatives change. Net income per acre is driven off the Actual Cash Price Received at Harvest/Sale value, but adjusted when necessary. It is difficult to see the impact of basis variability on the various alternatives on the Summary Results page. Table 1, is included here to help illustrate the difference between the price change and a basis change. While the cash alternative absorbs the entire per bushel change in price, the Hedge alternative absorbs only the change in basis from -$.70 to -$1.00. This change is a negative $12.00 per acre (-$.30 basis change * 40 bushels per acre). As a reminder, this scenario includes an exact match with expected and actual production and eight contracts exactly match total production of 40,000 bushels. If this was not the case, there is either an over hedged or under hedged position, and the net income per acre are adjusted accordingly with profits or losses from the marketing tools.

Table 1. Basis variability effects on net income per acre.

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Combinations of Combo Policy Plans and Futures and Options Markets:

As indicated previously, this software allows evaluation of one or more of the Futures and Options alternatives in any combination with the Combo policy plans. The scenarios below help illustrate possible combinations of an overall risk management strategy.

Scenario #12: Figure 27 provides a starting point for this set of scenarios. Both the RMA Harvest Price and the Spot futures are $6.00. The basis is held at -$.70, so the cash price is $5.30. Yield is 40 bushels. Net income per acre for the Cash, and all of the futures and options columns is $32.00. These values are the same because the Futures and Options columns are not active. The combo plans are all active and reflect a net income per acre that differs from the Cash column by the premiums paid for each Combo plan.

Figure 27.

Scenario #13: In our base case scenario, the Spot Harvest Time Futures – Preproduction –NOT RMA Avg. is $8.40. This is a $1.25 per bushel increase over the RMA Projected Harvest Price of $7.15 and reflects what actually happened after the fall sales closing date in 2010 for wheat in Montana. This provides an opportunity to add another tier of price protection to try and capture some portion of the $1.25 increase. Click on the check box in the Hedge column to activate the Hedge alternative. Figure 28 illustrates the addition of the Hedge at $8.40 per bushel. The Hedge alternative shows a positive $127.20 return per acre and all of the Combo plans show a big jump in net income per acre. This jump is due to the inclusion of the Hedge results in each of the Combo columns. Any time a Hedge, Put or Call alternative is checked, these columns become active and the results from any active alternative are included in each of the Combo plans. Note however, that none of the Combo plans paid an indemnity with this combination of prices and yields. The added revenue in the Combo columns comes entirely from profits on the Hedge.

Figure 28. Addition of a Hedge to scenario 12.

Scenario #14: Change the actual yield to 20 bushels per acre leaving all other variables as in Figure 28. Figure 29 shows the results of the yield change. With yield at 20 bushels, the Combo plans all pay an indemnity and all show a positive net income per acre while Cash net income is a negative -$74.00 per acre. The Hedge alternative is still active and profits from the Hedge are providing enough revenue to make all the Combo plans and the Hedge alternative show positive returns. If the Hedge was not active, the Combo plans would not show a positive net income per acre. To verify this, uncheck the Hedge alternative. Figure 30 shows the results when the Hedge is not active.

Figure 29. Change the actual yield to 20 bushels with all other variables as in Figure 28.

Figure 30. Hedge alternative is not active, all other parameter values as in Figure 29.

Scenario #15: Start with the same set of values shown in Figure 28. Click the check box for the Hedge to make it inactive and to prevent a doubling up of Hedge and Put alternatives. Click the check box for the Put to make it active, Figure 31. The Put option strike price is $6.50 with a premium paid of $.27 per bushel. Since this Strike price is much lower than the $8.40 Spot futures price, the downside price protection provided by the Put is much less than the $8.40 futures price. The Cash Market still shows a net income per acre of -$74.00 and the YP column, and the Put columns are both negative. While the Put provided enough protection to keep the net income per acre for the RP-HPE and RP alternatives positive, they are much lower than with the Hedge alternative.

Figure 31. Effectiveness of Put option versus A Hedge.

Scenario #16: This scenario explores what might happen when an individual farm experiences very low yields. Start with the variable values shown in Figure 31. Change the yield to 5 bushels per acre. The results of these changes are shown in Figure 32. While the yield was very low for this farm, the relevant prices were also low. The net income per acre for the Combo policy plans are relatively the same, ranging from, $3.45 with YP to $6.90 with RP-HPE. Now click the check box in the Hedge column to active the Hedge. Figure 33 shows the results with the Hedge active. Even though the Hedge column now shows a -$58.30 net income per acre, when profits from the Hedge are combined with the Combo plans, all of the Combo plan columns show large positive numbers. The combination of using the hedge and a combo plan provides a significant safety net in this scenario. This management strategy only exists because the jump in futures prices after the sales closing date on Sept. 30th.

Figure 32. Very low yields with only the Combo plans active.

Figure 33. Activated the Hedge alternative with all other parameters as shown in Figure 32.

Scenario #17: This scenario explores what might happen with a large scale disaster, U.S. wide or globally, that would affect both yields and prices. For this scenario, increase the RMA Harvest Price and the Spot Futures at harvest time to $12.00 per bushel and the Cash Price to $11.30 per bushel, which maintains the basis at -$.70. Decrease the yield to 5 bushels per acre.

Figure 34 shows the results of these values. For this set of circumstances, it is clear the RP Combo plan, which provides protection if the RMA Harvest Price increases (capped at 200% of the RMA Projected Harvest Price) is superior to either the YP or RP-HPE plans. Now click the check box in the Hedge column to activate the Hedge alternative. Figure 35 shows the results of implementing a Hedge at $8.40 when it looked like that might have been a good alternative, but as prices rose to $12.00, losses on the Hedge outweigh the indemnities paid by the Combo plans and all active alternatives have a negative net income per acre.

Figure 34. Very low yields with a large jump in prices due to large scale disaster.

Figure 35. Adding a Hedge to the results shown in Figure 34.

Scenario #18: This scenario explores the opportunities to protect against adverse upward price moves when you have hedged, or forward contracted for delivery of grain at harvest time.

Start with the values as shown in Figure 36. To protect against upward price movements, a producer can also use Call options. This is a typical strategy used when producers forward contract grain for harvest time delivery but do not want to suffer the consequences of a significant yield loss when it is time to deliver. To make good on their contracts, producers may have to purchase grain at high prices to meet their required delivery amount. Click on the check box in the Call options column and leave the Hedge check box active. Figure 36 shows the results of using a Call option to protect against the risks of severe yield losses in conjunction with higher prices. In this scenario, the Call Strike price was $10.00 and the premium for that strike price was $.15. As a reminder, the future and options prices used here were actually available on the day that the $8.40 Spot futures price was available. Using a Call option in combination with the RP Combo plan shows a positive net return per acre of $69.30.

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