January 2006

How to Make More Money and Reduce Variability!

Ana R. Rios and George F. Patrick

Many corn and soybean producers in Indiana hesitate to price their crop before harvest because of concerns about not being able to fulfill their contract. Some producers do not buy crop insurance because they feel they have never had a loss large enough to collect an indemnity. Typically, risk management strategies involve giving up some potential return to reduce variability, especially to protect against low returns. However, Indiana producers who do not forward price their crops and carry crop insurance appear to be missing out on the opportunity for both higher average net revenues and lower downside risks.

A recent study analyzed pre-harvest pricing and insurance alternatives for a farm with a corn and soybean rotation in three geographical areas. Three counties were chosen: Elkhart County in Northern Indiana; Carroll County , in Central Indiana; and Posey County , in Southwest Indiana . The strategies which provided the highest net farm revenues and greatest downside protection (highest 5% VaR value) were identified for each county. Marketing strategies and crop insurance strategies were considered separately, and in combinations. A number of strategies both increased average returns and decreased downside risk relative to the benchmark strategy of cash sale at harvest and no insurance during the period analyzed.

Overview of the Model

The example farms were “typical” farms of 1,500 acres in a 50/50 corn/soybean rotation. Prices for the 1986 to 2001 period were measured in real 2001 dollars and yields assumed 2001 technology levels. To reflect the current farm policy legislation, the 2002-03 loan rates and target prices were used. Crop insurance premiums and subsidies reflected the 2002-03 period. To represent how a farm's net revenue can change under various growing and price conditions, a year between 1986 and 2001 was selected at random. The chosen year's prices were used in revenue calculations with the farm's corn and soybean yields based on deviations from the average farm level yields for that year. This simulation process was repeated 1,000 times leading to many possible potential new revenue outcomes under alternative risk management strategies.

Risk Management Strategies

Mechanical marketing strategies, crop yield and crop revenue insurance, and combinations of marketing strategies and crop insurance were the risk management strategies considered. Mechanical marketing strategies involved selling specified quantities of expected production on specific dates with no adjustments for market conditions. Strategies considered included cash sale at harvest, cash forward contracts, hedging with futures contracts, and hedging with put option contracts. Marketing strategies were implemented at 33%, 66%, and 100% of the estimated ten year moving average Actual Production History (APH) yields. APH and Group Risk Plan (GRP) were crop yield insurance products included. The crop revenue insurance products included in the analysis were Crop Revenue Coverage (CRC), Revenue Assurance (RA), Income Protection Plan (IPP) and Group Risk Income Protection (GRIP). Alternative crop and revenue insurances were analyzed at different coverage levels and price elections. Combinations of marketing strategies and crop insurance coverage (synthetic revenue insurance) were evaluated to determine whether it would be less expensive and/or more effective to combine strategies rather than using the crop revenue insurance products available. The 74 risk management strategies considered in the analysis is presented in Table 1 with their identifying abbreviations.

Strategy Evaluation

Revenue was based on farm level production and harvest prices, LDPs and CCPs, gains or losses from marketing strategies, and insurance indemnity payments. We did not explicitly consider costs of production and direct government payments in the calculation of net farm revenue under the assumption that these costs and payments were constant across strategies. Therefore, net farm revenue was determined by gross revenue less variable costs of risk management (premiums, commissions, and interest) for each strategy. The benchmark for risk management strategy evaluation was a no insurance, cash sale at harvest strategy.

Risk management strategies are compared using two criteria: average net revenue and downside risk (the possibility of a disaster). Producers would be expected to prefer strategies which have higher average net revenue to lower average net revenue. Downside risk is measured by the dollar amount of net revenue received in the worst year out of 20, a disaster year. This is referred to as the 5% Value-at-Risk (VaR) and there is a 5% chance that net revenue would be less than that amount. Therefore, risk averse producers would prefer strategies with higher values of 5% VaR over strategies with lower 5% VaR, if the strategies have similar net revenues.

Results

Table 2 shows the dollar amount of average net revenue per acre and 5% VaR for the benchmark strategy of cash sale at harvest with no insurance in each county. Carroll County had the highest average revenue, $352 per acre, reflecting the higher yield levels as compared with Elkhart and Posey Counties . Elkhart County 's 5% VaR of $152 per acre was the lowest in both absolute and relative terms at 54.2% of the average revenue. For comparisons among strategies, the average net revenue and 5% VaR are presented as a percentage of the benchmark (no insurance, cash sale at harvest) strategy in each county. Thus, strategies with values that exceed 100 out performed the benchmark strategy on that criterion.

Strategies with Highest Average Revenue

Figure 1 presents the risk management strategy with the highest average net revenue and its corresponding 5% VaR as percentages of the benchmark strategy in each county. In Elkhart County , the strategy with the highest net revenue, about 111% of the benchmark, came from forward pricing all expected production on March 15 using futures. The highest average net revenue in Carroll County also involved selling 100% of expected production on March 15 using futures while Posey County used put options. The 5% VaRs for these strategies range from about 106% of the benchmark strategy in Posey County to about 117% in Elkhart County . In all three counties, the strategy with highest average net revenue involved marketing strategies, and provided both higher average net revenue and lower downside risk than the benchmark of cash sale at harvest with no insurance.

Strategies with Highest VaR

For producers primarily concerned about downside risk, the possibility of a disaster, Figure 2 presents the strategy in each county with the highest net revenue in the worst year out of 20. These 5% VaR values and their corresponding average net revenues were also presented as percentages of the benchmark strategy. In all three counties, strategies with the highest 5% VaRs involved crop insurance. These strategies provided a substantial increase in the 5% VaR, while also providing slightly higher average net revenue than the benchmark strategy. In Elkhart County , CRC at 85% coverage level provided more than 40% increase in downside risk protection and similar average net revenue to the cash sale at harvest, no insurance strategy. Thus, producers in all these counties improved their downside risk protection without sacrificing average returns.

Using Marketing Strategies

Figure 3 shows the average net revenue and 5% VaR associated with different levels of cash forward contracts, as a percentage of expected production, established in March and June in Carroll County . In general, forward contracting in March resulted in a higher average net revenue and less downside risk than June forward contracting. Producers got a higher average return and better downside protection by pricing on March 15 rather than June 15. This was consistent with the Wisner et al. analysis of income increasing pre-harvest marketing strategies. However, pricing a higher proportion of expected crop reduced the downside risk protection, 5% VaR values were lower. As a higher percentage of the crop is committed, the probability of having a crop shortfall and having to purchase grain to meet the contract commitment increased. Compared to cash sale at harvest, forward contracting in March resulted in higher average net revenue, but generally greater downside risk. Forward contracts established in June provided both lower average net revenue and lower downside protection than the benchmark strategy of cash sale at harvest with no insurance. This is the type of strategy which producers will want to avoid.

Crop Insurance

Average net farm revenue and 5% VaR of some crop insurance strategies in Elkhart , Carroll and Posey Counties are presented in Table 3. Compared to cash sale at harvest, there were crop insurance strategies, such as APH and CRC in Elkhart and Carroll Counties that provided slightly higher mean net farm revenues, but substantially increased protection against downside risk. In contrast, the APH and CRC insurance strategies in Posey County had slightly lower mean net revenues and the downside protection provided was less than the cash sale at harvest with no insurance strategy. In part, this may be due to premium rates in Posey County that were nearly double those of the other counties analyzed.

Average net farm revenues and 5% VaRs for some GRP insurance strategies are also presented in Table 3. The net farm revenues associated with the GRP insurance was essentially the same as that of the cash sale at harvest, no insurance strategy. GRP slightly increased the 5% VaR for Carroll County , but had no effect in Elkhart County . In Posey County , the 5% VaR was slightly reduced relative to the benchmark strategy. These results suggest producers in Posey County may need to evaluate the risk management aspects of crop insurances as single strategies more carefully than producers in Elkhart and Carroll Counties .

Effects of Combining Strategies

Producers can combine pre-harvest pricing with crop insurance and have a form of synthetic revenue insurance. Average net farm revenue and 5% VaR of CRC and some combinations of pricing and insurance strategies are presented in Table 4 for Elkhart , Carroll, and Posey Counties . All of the strategies presented provided both higher average net revenues, with the exception of CRC in Posey County , and lower downside risk than the benchmark strategies of cash sale at harvest with no insurance. The improvement in downside protection was greatest in Elkhart County , the county with the largest downside risk. The improvement ranged from 113% to 141% of the cash sale at harvest, no insurance strategy.

The improvement in downside protection was generally greater than the increase in average net revenue in all three counties. For example, APH at 100% price election and 75% coverage level combined with futures contracts established in March provided a 9% to more than 30% increase in downside risk protection but less than 10% increase in average revenue. It is unusual that risk management can provide both greater downside protection and higher average returns.

The performance of GRP in conjunction with the use of futures contracts presented a contrast to GRP as a stand-alone risk management strategy. Both average net farm revenues and 5% VaRs of GRP were higher than CRC in all three counties. In contrast to the northern counties, GRP with pre-harvest futures or puts provided higher average revenue than APH and futures in Posey County .

The dollar amount of the increases in average net revenue ranged from about $22 per acre in Elkhart County to over $27 per acre in Carroll and Posey Counties . Increases in net revenues in a disaster year, the 5% VaRs, ranged from about $27 per acre in Posey County to over $62 per acre in Elkhart County .

Summary and Conclusions

Risk management typically involves giving up some income to reduce variability, especially downside variability. Results of this study, which considered the 1986-2001 period, suggest that producers could have gotten both higher average net revenue and less downside risk. The magnitudes of the potential improvements were substantial, $22 to $27 per acre or $33,000 to $40,500 on a 1,500 acre farm similar to those analyzed.

Early forward contracting (March 15) resulted in higher average net revenues and higher 5% VaR values (less downside risk) than late forward contracting (June 15). In some counties, late forward contracting resulted in lower average net revenue than selling at harvest. In general, contracting a higher proportion of expected crop increased both average net revenue and downside risk.

Some of the crop insurance products analyzed may provide both higher average net revenue and lower downside risk than cash sale at harvest with no insurance. Increases in average net revenue were generally small and resulted from the crop insurance premium subsidies.

Combining marketing strategies with crop insurance to produce a form of synthetic revenue insurance improved both average net revenues and 5% VaRs in all three counties. These synthetic revenue insurances generally outperformed CRC, but do require greater management as producers must be concerned with both crop insurance and marketing strategies. The effects of risk management strategies on average net revenue and downside risk differ among geographical locations. Combinations of strategies involving APH outperformed GRP in Elkhart and Carroll Counties , while the situation was reversed in Posey County .

Our results suggest corn and soybean producers in Indiana should avoid a “do-nothing” strategy because there are multiple risk management strategies that have provided both higher average net revenue and less downside variability in the historic study period. However, producers should consider the specific provisions of crop and revenue insurance products (prevented planting, replant coverage, optional units, etc.) in evaluating risk management strategies in their individual circumstances.

Table 1. Risk management strategies

a Marketing strategies are referred to using the abbreviation followed by percentage of expected production hedged or forward contracted.

b Strategies involving insurance alternatives are referred to using the abbreviation followed by insurance coverage level.

Table 2. Average net revenue and 5% VaR of cash sale at harvest, no insurance strategy

Figure 1. Strategies with the highest net farm revenue and the corresponding 5% VaR as a percentage of cash sale at harvest, no insurance strategy.

 Figure 2. Strategies with the highest 5% VaR and the corresponding net farm revenue as a percentage of cash sale at harvest, no insurance strategy.

 Figure 3. Carroll County : mean net farm revenue and 5% VaR of March vs. June marketing strategies as a percentage of cash sale at harvest with no insurance.

Table 3. Average net farm revenue and 5% VaR (in parentheses) of selected crop/revenue insurance strategies as a percentage of the cash sale at harvest, no insurance strategy in Elkhart , Carroll, and Posey Counties .

Table 4. Average net farm revenue and 5% VaR (in parentheses) of selected combination risk management strategies as a percentage of the cash sale at harvest, no insurance strategy in Elkhart , Carroll, and Posey Counties .

References

Collins, Kurt J., James G. Pritchett and George F. Patrick, “Crop and Revenue Insurance Alternatives,” Purdue Agricultural Economics Report, September 2001a, p. 5-12. http://www.agecon.purdue.edu/extension/pubs/paer/archive.asp

Collins, Kurt J., James G. Pritchett and George F. Patrick, “Protecting Farm Revenues with Pre-Harvest Pricing and Insurance,” Purdue Agricultural Economics Report, December 2001b, p. 12-16. http://www.agecon.purdue.edu/extension/pubs/paer/archive.asp

Rios, Ana R., and George F. Patrick. “Evaluating Risk Management Alternatives for Indiana Crop Producers.” P aper presented at AAEA annual meeting, Montreal , Canada , July 27-30, 2003 .

http://agecon.lib.umn.edu/cgi-bin/pdf_view.pl?paperid=9031&ftype=.pdf

Rios Galvez, Ana R. “Evaluating Risk Management Alternatives for Indiana Crop Producers.” M.S. thesis, Purdue University , 2003.

Wisner, Robert N., E. Neal Blue, and E. Dean Baldwin. “Pre-harvest Strategies Increase Net Returns for Corn and Soybean Growers.” Review of Agricultural Economics , Vol. 20, No. 2 Fall/Winter 1998, 288-307.

For further details of the simulation model, see Rios or Collins, et al. 2001b, in the References.

For further information on crop and revenue insurance, see Collins, et. al.2001a, in the References.

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The Valuation of Bull Characteristics





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