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The Livestock Gross Margin Insurance Program for Dairy: Potential for Future Research?

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.

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The Livestock Gross Margin Insurance Program for Dairy: Potential for Future Research?

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  1. 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

  2. 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

  3. LGM-Dairy: An Overview • Livestock Gross Margin Insurance for Dairy (LGM-Dairy) • 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

  4. WA ME MT ND VT OR MN NH NY ID MA SD WI CT WY MI RI PA IA NV NJ CA NE OH MD DE IN IL UT WV CO VA MO KS KY NC TN OK AZ NM AR SC AL MS GA TX LA FL LGM-Dairy: An Overview • Who is Eligible to Participate? LGM-Dairy eligible states shown in yellow

  5. 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

  6. 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

  7. 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

  8. 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 (-) • Expected Milk Price (+) • Corn and Meal Prices (-) • Expected Price Volatility Over Contract Period (+) Determined by Producer Determined by Futures/Options Settle Prices at Sign-up and Beyond Producer Control

  9. LGM-Dairy: Program Characteristics • Example of One Possible Insurance Strategy • Purchase Insurance in February Possible Production Months Covered 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)

  10. LGM-Dairy: Program Characteristics GMG Gross Margin Guarantee AGM Actual Gross Margin IND Indemnity PREM Premium Cost EGM Expected Gross Margin DL Deductible Level AMR Actual Milk Revenue AFC Actual Feed Cost EMR Expected Milk Revenue EFC Expected Feed Cost CME Actual Class III Price Settlement CBOT Actual Feeds Costs Settlement EMP Expected Class III Price SMB State Milk Basis ECC Expected Corn Cost ESC Expected SBM Cost Policy Rules CBOT SBM Futures CME Class III Futures SCB State Corn Basis CBOT Corn Futures Exogenous Data Producer Data/Decision TM Target Marketings EFQ Expected Feed Quantity

  11. 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

  12. LGM-Dairy: Wisconsin Example • Farm characteristics • 250 milk cows • Average per cow productivity: 19,769 lbs • 2007 WI 200-499+ herd size category average →

  13. 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)

  14. LGM-Dairy: Wisconsin Example

  15. Calculation of Expected Prices • With January 28th insurance purchase date • Expected Price Measurement Period (EPM): January 26th, 27th and 28th • To determine the Gross Margin Guarantee at contract sign-up we need: • Expected monthly milk and feed prices • Producer elected deductible Purchase Insurance

  16. 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

  17. Calculation of Expected Gross Revenue • With the estimation of 10 expected Wisconsin All-Milk price values one can • Calculate Expected Gross Revenue (EGR) at sign-up • 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

  18. Calculation of Expected Gross Revenue Note: [ 1] and [2] obtained from previous table [3] = [1] * [2]

  19. 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

  20. Calculation of Expected Corn Price Note: [4] = ([1]+[2]+[3])/3, [5] = weighted average with weights based on months from contract expiration, [7] = [5]+[6]

  21. Calculation of Expected Corn Cost Note: [ 1] and [2] obtained from previous tables, [3] = [1]*(2000/56)* [2]

  22. Calculation of Expected SBM Cost Note: [1] and [2] obtained from previous tables, [3] = [1]* [2]

  23. 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

  24. Calculation of Gross Margin Guarantee (GMG) Note: [3] = [1] + [2], [6] = [4] – [3] – [5], $1.00 GMG/cwt deductible assumed

  25. Calculation of Insurance Premiums • There is NoProducer Premium Subsidy • RMA simulates 5,000 Class III, corn grain and SBM prices using data obtained from EPMperiod • Correlated prices • Options → Variance Futures → Means • Generates 5,000 simulated total gross margins • For each simulation, determine payout where Insurance Payout = Max(0, TotalGMG – SimulatedTotalGMG) • Premiums = Avg. of 5,000 Simulated Payouts + 3%

  26. 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

  27. Insurance Premiums and Deductible Level (Jan. ′09 Example) Note: % ↓ measured from $0 Deductible level

  28. Relative GMG and Insurance Premiums (Jan. ′09 Example)

  29. Effect of Deductible on Premium and GMG (Jan. ′09 Example) GMG Premium $0: $397,406 $34,629 $0.70: $368,369 $21,571 $1.50: $335,184 $11,394

  30. Relative Premium Value and Deductible (Jan. ′09 Example)

  31. Simulated Probability of Positive Indemnities (Jan. ′09 Example) Payout probability ↓ with higher deductible as GMG decreases

  32. 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 priorto 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

  33. 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 priorto last trading day of a particular futures contract • Averaged over these three days

  34. 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

  35. 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)

  36. A Cost Comparison of LGM-Dairy With Options-Based Revenue Management • We can compare the net costs of the two programs

  37. A Cost Comparison of LGM-Dairy With Options-Based Revenue Management • We can compare the net costs of the two programs Note: Under the options based strategy we reduce the options costs by the % reduction in GMG observed under the LGM-Dairy scenarios.

  38. 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

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