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The Livestock Gross
Margin Insurance Program for Dairy:
Potential for Future Research?
Brian W. Gould
Associate Professor
Department of Agricultural and Applied Economics
Victor E. Cabrera
Assistant Professor
Department of Dairy Science
Dairy Price Risk: What are the Alternatives
How Can Producers Control Milk Price Risk?
Forward Fixed Price Contracts via Cheese Plant
2008 Farm Bill: Private Firms Can Offer Fixed
Price Forward Contracts
Minimum Price Contracts with Cheese Plant
Similar to Use of Class III Put Option
Traditional Hedging and Options Strategies
Class III Futures Contract: Milk from average
Wisconsin dairy farm with 125 cow herd
LGM-Dairy: An Overview
Livestock Gross Margin Insurance for Dairy (LGMDairy)
Available Starting in August 2008
Protects Against Unanticipated Declines in Gross
Margins Where
Gross Margin = Milk Revenue – Feed Costs
Purchased from Crop Insurance Agents Selling Federal
Crop Insurance Products
LGM-Dairy: An Overview
Who is Eligible to Participate?
WA
MT
ME
ND
OR
VT
NH
NY
MA
CT
RI
MN
ID
SD
WI
WY
MI
PA
IA
CA
NV
NE
UT
IL
IN
WV
CO
KS
AZ
NJ
MD DE
OH
MO
NC
TN
OK
NM
VA
KY
AR
SC
MS
TX
AL
GA
LA
FL
LGM-Dairy eligible states
shown in yellow
LGM-Dairy: An Overview
LGM-Dairy Similar to Combined Use of:
Put Option to Control Milk Price Downside Risk
Call Options to Control Feed Cost Upside Risk
LGM-Dairy is Customizable as to:
Size of Operation
Up to 240,000 cwt Over 10 Months
1,500 Head Using Average Wisconsin Yield
Months Insured (From 1 to 10 Months)
% of Monthly Gross Margins Covered
Gross Margin Deductible Range: $0 - $1.50/cwt
LGM-Dairy: Definition of Gross Margin
Definition of Gross Margin
Gross Margin = Total Value of Covered Milk – Total
Purchased Feed Costs
Feed Does Not Actually Need to be Purchased
but Valued as if Was
Both Milk Value and Feed Cost NOT Based on
Actual Farm Prices
Milk Price: State All-Milk Price
Feed Prices: State Corn Price
U.S. Soybean Meal Price
LGM-Dairy: Definition of Gross Margin
Expected Feed Use Over Contract Period Converted to
Corn and Soybean Meal Equivalents
Any Reasonable Conversion System Acceptable
UW Understanding Dairy Markets Website has
Conversion Software Available
Spreadsheet
Web-Based
Feed Equivalents Need to be in Very Broad Ranges:
Corn: 0.00364–0.02912 Tons/cwt
• 0.13 – 1.04 bu Corn equivalent/cwt Milk
Soybean Meal: 0.000805–0.006425 Ton/cwt
• 1.61 – 12.85 lb Meal equivalent/cwt Milk
LGM-Dairy: Program Characteristics
What Impacts Total Insurance Contract Premium?
Amount of Milk and Feed Insured (+)
Proportion of Gross Margin/cwt Not Covered Under
LGM-Dairy Contract (-)
Determined by Producer
Expected Milk Price (+)
Corn and Meal Prices (-)
Expected Price Volatility Over Contract Period (+)
Determined by Futures/Options Settle
Prices at Sign-up and Beyond
Producer Control
LGM-Dairy: Program Characteristics
Example of One Possible Insurance Strategy
Purchase Insurance in February
Possible Production Months Covered
Feb ′09
Purchase
at End of
Month
Mar
′09
Apr
′09
May
′09
Jun
′09
Jul
′09
Aug
′09
Sep
′09
Oct
′09
Nov
′09
Dec
′09
Jan
′10
1
2
3
4
5
6
7
8
9
10
No
Coverage
Covered
Months
Insurance Contract Period
Apr
May
Jun
Sep
Oct
Have from 4 pm (EDT) on 3rd to last business day of
purchase month to 9 am (EDT) on the following day to
make purchase decision(i.e., 17 hour-period)
Nov
LGM-Dairy: Program Characteristics
GMG
AGM
IND
Gross Margin Guarantee
Actual Gross Margin
Indemnity
EGM
DL
Expected Gross Margin
Deductible Level
EMR
EFC
Expected Milk Revenue
Expected Feed Cost
EMP
SMB
ECC
Expected
Class III
Price
State
Milk
Basis
Expected
Corn
Cost
ESC
PREM
Premium
Cost
AMR
AFC
Actual Milk Revenue
Actual Feed Cost
CME
CBOT
Actual
Class III
Price
Settlement
Actual
Feeds
Costs
Settlement
Expected
SBM
Cost
Policy Rules
CME
Class III
Futures
SCB
CBOT
State
Corn
Basis
Corn
Futures
CBOT
SBM
Futures
Exogenous Data
TM
EFQ
Target Marketings
Expected Feed Quantity
Producer Data/Decision
LGM-Dairy: Program Characteristics
Premium Estimates Available via RMA Website
www.rma.usda.gov/tools/premcalc.html on Purchase
Day
UW has developed an unofficial web-based premium
calculator using current futures and options
http://future.aae.wisc.edu/premium/
You Want to Purchase a Contract, How are Expected
Prices Determined?
Futures Settle Price Averaged Over 3rd, 4th and 5th
Last Business Days of Insurance Purchase Month
Corn, Soybean Meal and Class III Futures
LGM-Dairy: Wisconsin Example
Farm characteristics
250 milk cows
Average per cow productivity: 19,769 lbs
2007 WI 200-499+ herd size category average
→
Herds
% of Herds
% of Prod.
Avg. Yield
1-29
1,900
13.2
1.5
11,586
30-49
3,600
25.0
10.0
16,092
50-99
6,100
42.4
29.0
17,778
100-199
1,800
12.5
18.5
19,310
200-499
750
5.2
19.0
19,769
500+
250
1.7
22.0
24,750
Total
14,400
100.0
100.0
19,305
LGM-Dairy: Wisconsin Example
Purchase insurance in Jan. → possible 10-Month
insurance period: Mar `09 – Dec `09
Cow productivity changes by month
Based on Wisconsin monthly yield profile
Amount of feed expected to be used
966 tons Corn equivalent
213 tons SBM Equivalent
Insure 100% of production (extreme example)
LGM-Dairy: Wisconsin Example
Month
Prod./Cow
(lbs)
Production
(cwt)
Corn Equiv.
(Tons)
SBM Equiv.
(Tons)
Mar `09
1,685
4,213
98.1
21.7
Apr `09
1,645
4,113
95.8
21.1
May `09
1,736
4,340
101.1
22.3
Jun `09
1,675
4,188
97.6
21.5
Jul `09
1,696
4,240
98.8
21.8
Aug `09
1,675
4,188
97.6
21.5
Sep `09
1,609
4,023
93.7
20.7
Oct `09
1,630
4,075
94.9
20.9
Nov `09
1,615
4,038
94.1
20.8
Dec `09
1,625
4,063
94.7
20.9
Total
16,591
41,481
966.3
213.2
Calculation of Expected Prices
With January 28th insurance purchase date
Expected Price Measurement Period (EPM):
January 26th, 27th and 28th
Purchase Insurance
To determine the Gross Margin Guarantee at contract
sign-up we need:
Expected monthly milk and feed prices
Producer elected deductible
Calculation of Expected Prices
Monthly expected prices for Mar`09 - Dec`09
Expected Wisconsin All Milk price
= Expected Class III prices + Wisconsin [All-Milk
– Class III] Basis
Expected Wisconsin Corn Grain price
= Expected Corn prices + Wisconsin [Corn Price
Received – Corn Futures] Basis
Expected U.S. Soybean Meal prices (no local basis)
Calculated from futures settle
prices on January 26th – 28th
Calculation of Expected Gross Revenue
With the estimation of 10 expected Wisconsin All-Milk
price values one can
Calculate Expected Gross Revenue (EGR) at signup
EGR is the product of expected All-Milk price
times covered milk production
Covered production could be less than allowable
target as elected by the producer
Different price and covered production each
month
Calculation of Expected Gross Revenue
Month
Expected WI
All Milk Price
($/cwt)
[1]
Mar `09
12.00
4,213
50,556
Apr `09
12.17
4,113
50,055
May `09
12.45
4,340
54,033
Jun `09
13.22
4,188
55,365
Jul `09
14.22
4,240
60,293
Aug `09
15.18
4,188
63,574
Sep `09
15.84
4,023
63,724
Oct `09
16.27
4,075
66,300
Nov `09
16.58
4,038
66,950
Dec `09
16.52
4,063
67,121
41,481
597,972
Total
Covered
Expected
Marketings
Gross
(cwt)
Revenue ($)
[2]
[3]
Note: [ 1] and [2] obtained from previous table [3] = [1] * [2]
Calculation of Expected Feed Costs
With calculation of expected feed prices for each month
Multiply each months covered feed equivalents times
the expected price to obtain expected feed costs
Covered feed equivalents equal to total feed
equivalents multiplied by % of production
covered
Unlike Class III contracts, corn/soybean meal futures
contracts may not exist for every month of insurance
contract
Calculation of Expected Corn Price
Month
Expected WI
Corn Futures Settle Prices ($/bu) Imputed
Price
Basis Corn Price
Jan 26 Jan 27 Jan 28 Avg. $/bu) ($/bu)
($/bu)
[1]
[2]
[3]
[4]
[5]
[6]
[7]
Mar `09 3.9375 3.7750 3.8450
----------Apr `09 ------
3.85
3.85
-0.17
3.68
------
3.91
-0.11
3.80
May `09 4.0475 3.8850 3.9950
3.96
3.96
-0.12
3.84
----------Jun `09 -----Jul `09 4.1525 3.9925 4.0625
----------Aug `09 -----Sep `09 4.2575 4.0950 4.1650
----------Oct `09 ---------------Nov `09 -----Dec `09 4.3900 4.2300 4.3000
------
4.02
-0.12
3.90
4.07
4.07
-0.12
3.95
------
4.12
-0.15
3.97
4.17
4.17
-0.11
4.06
------
4.22
-0.15
4.07
------
4.26
-0.18
4.08
4.31
4.31
-0.22
4.09
Note: [4] = ([1]+[2]+[3])/3, [5] = weighted average with weights based
on months from contract expiration, [7] = [5]+[6]
Calculation of Expected Corn Cost
Expected WI
Covered
Expected
Corn Price
Corn Equiv. Corn Cost
Month
($/bu)
(tons)
($)
[1]
[2]
[3]
Mar `09
3.68
98.1
12,893
Apr `09
3.80
95.8
13,001
May `09
3.84
101.1
13,865
Jun `09
3.90
97.6
13,594
Jul `09
3.95
98.8
13,938
Aug `09
3.97
97.6
13,838
Sep `09
4.06
93.7
13,587
Oct `09
4.07
94.9
13,794
Nov `09
4.08
94.1
13,712
Dec `09
4.09
94.7
13,833
Total
966.4
136,056
Note: [ 1] and [2] obtained from previous tables, [3] = [1]*(2000/56)* [2]
Calculation of Expected SBM Cost
Month
Mar `09
Apr `09
May `09
Jun `09
Jul `09
Aug `09
Sep `09
Oct `09
Nov `09
Dec `09
Imputed
Price
($/Ton)
[1]
312.13
311.85
311.57
311.94
312.30
309.43
300.43
285.70
284.70
283.70
Total
SBM
Equiv
(Ton)
[2]
21.7
21.1
22.3
21.5
21.8
21.5
20.7
20.9
20.8
20.9
213.2
Total Cost
($)
[3]
6,773
6,580
6,948
6,707
6,808
6,653
6,219
5,971
5,922
5,929
64,510
Note: [1] and [2] obtained from previous tables, [3] = [1]* [2]
Calculation of Gross Margin Guarantee
Summary of information required for enrollment:
Estimation of expected milk prices and feed costs
Statement of insured marketings
Monthly target marketings (TMi)
Desired coverage % (Coveri)
Statement of expected feed use
Deductible ($ GMG/cwt):
Given above, one can calculate Gross Margin Guarantee
(GMG) = Expected total gross margin –
deductible*covered milk marketings
Calculation of Gross Margin Guarantee (GMG)
Month
Corn
SBM
Costs ($) Costs ($)
[1]
[2]
Feed
Costs ($)
[3]
Revenue
($)
[4]
Deductible
($)
[5]
GMG
($)
[6]
Mar `09
12,893
6,773
19,666
50,556
4,213
26,677
Apr `09
13,001
6,580
19,581
50,055
4,113
26,361
May `09
13,865
6,948
20,813
54,033
4,340
28,880
Jun `09
13,594
6,707
20,301
55,365
4,188
30,876
Jul `09
13,938
6,808
20,746
60,293
4,240
35,307
Aug `09
13,838
6,653
20,491
63,574
4,188
38,895
Sep `09
13,587
6,219
19,805
63,724
4,023
39,896
Oct `09
13,794
5,971
19,766
66,300
4,075
42,460
Nov `09
13,712
5,922
19,633
66,950
4,038
43,279
Dec `09
13,833
5,929
19,762
67,121
4,063
43,295
Total 136,056
64,510
200,566
597,972
41,481
355,925
Note: [3] = [1] + [2], [6] = [4] – [3] – [5], $1.00 GMG/cwt deductible assumed
Calculation of Insurance Premiums
There is No Producer Premium Subsidy
RMA simulates 5,000 Class III, corn grain and
SBM prices using data obtained from EPM period
Correlated prices
Options → Variance Futures → Means
Generates 5,000 simulated total gross margins
For each simulation, determine payout where
Insurance Payout = Max(0, Total GMG –
Simulated Total GMG)
Premiums = Avg. of 5,000 Simulated Payouts + 3%
Calculation of Insurance Premiums
We have developed in-house premium software
Official random draws: Aug. 08+
Simulate our own random draws: Jan. 00-July 08
On-Demand software system
RMA website provides official premiums at sign-up
For January 2009 example:
Premiums decrease at a faster rate then GMG as
deductibles increase
Premium vs. Gross Revenue reduction depends on
price volatility at sign-up expected gross margins
Payout probability decreases with higher deductibles
Insurance Premiums and Deductible Level
(Jan. ′09 Example)
Deductible
GMG
Rate
($/cwt)
[1]
Total
($)
[2]
Total
($)
[3]
0
0
0.10
Premium
%↓
[4]
Total
($)
[5]
Per CWT
($)
[6]
%↓
[7]
397,406
-----
34,629
0.835
-----
4,148
393,258
-1.0
32,490
0.783
-6.2
0.30
12,444
384,962
-3.1
28,497
0.687
-17.7
0.50
20,741
376,665
-5.2
24,876
0.600
-28.2
0.70
29,037
368,369
-7.3
21,571
0.520
-37.7
0.90
37,333
360,073
-9.4
18,588
0.448
-46.3
1.10
41,481
351,777
-11.5
15,926
0.384
-54.0
1.30
53,925
343,481
-13.6
13,533
0.326
-60.9
1.50
62,222
335,184
-15.7
11,394
0.275
-67.1
Note: % ↓ measured from $0 Deductible level
Relative GMG and Insurance Premiums
(Jan. ′09 Example)
GMG and Premium ($) Per CWT
10.00
0.90
9.50
0.80
0.70
0.60
8.50
0.50
8.00
7.50
GMG/cwt ($)
0.40
Premium/cwt ($)
0.30
7.00
0.20
0.0
0.2
0.4
0.6
0.8
1.0
Deductible ($/cwt)
1.2
1.4
Prem/cwt
GMG /cwt
9.00
Effect of Deductible on Premium and GMG
(Jan. ′09 Example)
Deductible, Premium and GMG Changes
0
% Decrease from Base
-10
-20
GMG Premium
$0: $397,406 $34,629
$0.70: $368,369 $21,571
-30
-40
$1.50: $335,184 $11,394
-50
-60
% Change Prem/cwt
-70
% Change GMG/cwt
-80
0.1
0.3
0.5
0.7
0.9
1.1
Deductible ($/cwt)
1.3
1.5
Relative Premium Value and Deductible
(Jan. ′09 Example)
Premium as % of GMG
9.00
8.25
% of GMG
7.50
6.75
6.00
5.25
4.50
3.75
3.00
0.0
0.2
0.4
0.6
0.8
1.0
Deductible ($/cwt)
1.2
1.4
Simulated Probability of Positive Indemnities
(Jan. ′09 Example)
Effect of Deductible on Payout Probability
55.0
Payout probability ↓
with higher deductible
as GMG decreases
Probability of Payout
50.0
45.0
40.0
35.0
30.0
25.0
20.0
0.0
0.2
0.4
0.6
0.8
1.0
Deductible ($/cwt)
1.2
1.4
Determining Actual Indemnities
Actual Prices Known → Calculate Actual Gross Margin
(AGM) = Actual Revenue – Actual Feed Costs
Actual Prices determined each month over contract
life as futures contracts expire
Similar to expected prices, actual prices are statewide
averages not your farm price
Uses settle prices on futures contracts 1,2, and 3 days
prior to last trading day of a futures contract
LGM-Dairy Actual Indemnity:
Actual Indemnity = Max[0, Total GMG
– Total AGM]
Total Refers to Sum Over All Contract Months
Determining Actual Class III and Feed Prices
Actual Class III and feed prices
Determined each month over insurance contract life
Uses settle prices on futures contracts 1,2, and 3
days prior to last trading day of a particular futures
contract
Averaged over these three days
A Cost Comparison of LGM-Dairy With
Options-Based Revenue Management
LGM-Dairy similar to a bundled option
How do LGM-Dairy costs compare to the costs of
setting a similar revenue floor via use of Class III puts
and Corn/SBM calls?
Difficult to compare given options lumpiness
Assume options perfectly divisible
Compare costs under alternative deductible levels
Use data for January 2008 LGM-Dairy contract
given availability of actual 10-month price data
A Cost Comparison of LGM-Dairy With
Options-Based Revenue Management
Procedure for determining option premium costs
Use expected prices observed on January 29th to
determine nearby option
To determine ending option value we use final settle
price of futures contract
For missing months, we use average of
surrounding futures contract on last business day
prior to the 15th of the missing month(s)
A Cost Comparison of LGM-Dairy With
Options-Based Revenue Management
We can compare the net costs of the two programs
Class III Put ($/cwt)
Corn Call ($/bu)
SBM Call ($/Ton)
Month
Put
Actual
Class
III
Put
Value
Corn
Call
Actual
Corn
Corn
Call
Value
SBM
Call
Actual
SBM
SBM
Call
Value
Mar `08
17.00
18.00
0
5.00
5.4550
0.4550
340
336.50
0
Apr `08
16.50
16.76
0
5.10
6.0025
0.9025
340
336.60
0
May `08
16.25
18.18
0
5.10
5.8975
0.7975
340
348.00
8.00
Jun `08
16.00
20.25
0
5.20
7.2460
2.0460
350
434.00
84.00
Jul `08
16.25
18.24
0
5.20
6.5700
1.3700
350
452.00
102.00
Aug `08
16.50
17.32
0
5.20
5.6820
0.4820
340
350.00
10.00
Sep `08
16.50
16.28
0.22
5.20
5.4740
0.2740
340
359.00
19.00
Oct `08
16.25
17.06
0
5.10
4.1125
0
330
254.50
0
Nov `08
16.25
15.51
0.74
5.10
3.8025
0
320
265.50
0
Dec `08
16.25
15.28
0.97
5.10
3.5950
0
320
258.50
0
A Cost Comparison of LGM-Dairy With
Options-Based Revenue Management
We can compare the net costs of the two programs
Gross Cost
Gross
Cost/Cwt
Net Cost
Net
Cost/Cwt
$0 Deductible
$63,216
$1.524
$28,461
$0.686
$0.80 Deductible
$58,993
$1.422
$26,560
$0.640
$1.50 Deductible
$55,301
$1.333
$24,898
$0.600
$0 Deductible
$36,107
$0.870
$36,107
$0.870
$0.80 Deductible
$21,147
$0.510
$21,147
$0.510
$1.50 Deductible
$12,144
$0.293
$12,144
$0.293
Put/Call Options
LGM-Dairy
Note: Under the options based strategy we reduce the options costs by
the % reduction in GMG observed under the LGM-Dairy scenarios.
LGM-Dairy: Future Research/Extension Efforts
LGM-Dairy a challenge for producers to understand
given the big black box of how premiums calculated
How can LGM-Dairy complement plant offered
forward/minimum price contracts
Portfolio of risk management strategies
Software systems for on-demand premiums
Still trying to understand dairy producer risk preferences
Farm characteristics
Producer characteristics