Revenue Risk, Crop
Insurance and Forward
Contracting
Cory Walters and Richard Preston
cgwalters@uky.edu
859-421-6354
University of Kentucky
Motivation
• 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.
Motivation, The Producer
• Farms in Hardin County Kentucky. 32 years of
experience. Before returning to the farm Richard was a
physicist at Los Alamos National Lab.
• 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
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.
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 producer 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
The Model
•Software: Analytica
•Monte Carol simulation through influence diagrams
view of models
• 30,000 samples
• Income is derived from randomly selecting farm level
yield
The Model
Trend Adjustment
200
180
160
Uncertainty
140
120
100
80
Proven Yield
No Trend
Price
60
Trend Adjusted Yield
risk
Trend
Hedging
Original APH = 149.53 bu/ACRE
risk –
Margin calls
40
Trend Adjusted APH = 160.53
bu/ACRE
20
0
2000
2002
2004
Average
2006
2008
2010
2012
December 2013 Futures Prices
• Median = around $5.60
• 10% chance price is less than $4.00
• 10% change price is greater than $7.55 or so
Farm Yield
Yields in 1983 and 2012.
Rare events do happen !
Farm average = 144.4 bu/acre
Most years expect yields between
110 and 170 bu/acre
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
December 2013 Futures Prices
• Median = around $5.60
• 10% chance price is less than $4.00
• 10% change price is greater than $7.55 or so
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
Insurance payouts
• Highest coverage level
• provides the best
chance of receiving a
payment
• It also costs the most
Revenue Protection, Enterprise Units
and 50% Hedged
• Coverage levels and
hedging
• Benefit when a bad
outcome occurs
• Cost when a bad
outcome does not
occur
Crop Income, Insurance, Hedging
• Coverage Level: 80%
• Revenue Protection (RP) and
RP Harvest Price Exclusion
• Hedging: 50% of expected
production using futures only
• KEY: HEDGING PLUS INSURANCE (RP, 80% Coverage Level, Enterprise
units), 50% hedged reduces chance of less than zero income by about 13%
Average Income and Insurance
180
160
140
Income
120
100
80
60
40
No Ins
• Insurance contract: Revenue
protection, 80% coverage level,
enterprise units
RP
HPE
20
0
0.00
20.00
40.00
60.00
80.00
100.00
120.00
Percent Expected Yield Forward Contracted
• KEY: At 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.
Risk Protection at the .01 probability level
0.00
0
20.00
40.00
60.00
80.00
Percent Expected Yield Hedged
100.00
120.00
-100
-200
No Ins
-300
RP
-400
HPE
-500
-600
-700
• Insurance contract: Revenue
protection, 80% coverage level,
enterprise units
-800
• KEY: As forward contracting % grows, rare event risk
protection increases as forward contracting increases
from 0 to 20% for RP. Between 20 to 60% rare event risk
protection remains constant and drops as forward
contracting increases past 60%
Summary
• Everyone faces the same futures prices
• Results are specific to yield risk faced by this farm
• Location, planting dates, soil types, etc…
• Results indicate that crop income risk (the very bad rare
events) are reduced when using crop insurance
• For our farm - $292/acre for a 1/100 event
• Income risk is further reduced by futures hedging
• For our farm - $39/acre (30% hedged)
• Combined benefit of $331 per acre
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
Revenue Protection, Enterprise Units,
No Hedging
2013 Premium Subsidies, in Percent
Coverage Level
50%
55%
60%
65%
70%
75%
80%
85%
Non-Enterprise
Enterprise
0.67
0.8
0.64
0.8
0.64
0.8
0.59
0.8
0.59
0.8
0.55
0.77
0.48
0.68
0.38
0.53
Crop Income With and Without Insurance
• Coverage level: 80%
• Revenue Protection (RP) and RP- Harvest
Price Exclusion
Insurance
Crop Income With and Without Insurance
• Coverage Level: 65%
• Revenue Protection (RP) and RP
Harvest Price Exclusion
Insurance
Insurance