K-State LRP Workshops

1. K-State LRP Workshops James Mintert, G. Art Barnaby Jr., Kevin Dhuyvetter Department of Agricultural Economics Kansas State University

2. KSU LRP Workshops Purpose: Improve Cattle Producers’ Risk Management Skills Teach producers • How LRP works • How to forecast basis • Provide experiential learning opportunity to workshop participants involving use of crop insurance, LRP, cash contracting, & Put Options

3. LRP Workshop Partners • RMA • K-State Ag. Economics Department • Kansas Farm Management Associations • Kansas Livestock Association

4. Importance of Partners • RMA • Funding for Program Development & Delivery • K-State Ag. Economics Department • Develop & Deliver Program • KLA & KS Farm Management Associations • Target Audience Identification • Program Promotion

7. Marketing The Program • K-State Press Release • Direct mail to Extension Clientele by County Extension • Magazine Advertisement • KLA Stockman, reaches about 8,000 producers • KLA Weekly Newsletter • Calendar of upcoming KLA events • Direct mail to all producers in KLA database • Direct mail to all Kansas Farm Management Association members that have a cattle operation • Radio promotion on K-State’s daily “Ag Today” radio program

8. Workshop Format Workshops Divided Into Two Parts Part One Presentations • How LRP works • Comparing LRP with CME Put Options • Improved basis forecasting

9. Workshop Format Workshops Divided Into Two Parts Part Two • Experiential Case Farm Workshop • Cow-Calf, Grain Farm Operation • Participants provided background information • Provided four decision periods • Make crop insurance decision • Make crop and cattle marketing decisions

10. Part One: LRP-What Is It? • Livestock Risk Protection Insurance • LRP for feeder cattle available in KS • Provides protection against a decline in CME Feeder Cattle Price Index while you own cattle • CME Feeder Cattle Price Index is a 7 day weighted average of cash feeder cattle prices across the U.S. • LRP for slaughter cattle is also available in KS • Provides protection against a decline in the 5 Area Weighted Average Price reported by USDA

11. How Does LRP Work? • CME Feeder Cattle Index is used to cash settle Feeder Cattle Futures • Since both CME Feeder Cattle futures and LRP use the CME Feeder Cattle Index to settle, purchase of LRP for Feeder Cattle is similar (but not identical) to purchasing a CME Feeder Cattle put option • USDA’s 5 Area Weighted Average Price is used to settle LRP for Fed Cattle • Purchase of LRP for Fed Cattle is similar (but not identical) to purchasing a CME Fed Cattle put option

12. How Does LRP Work? To use LRP to protect against a price decline, • you would purchase LRP insurance for a particular set of cattle (# of hd. & ending wt.) • you must choose • Coverage Price (this is similar to an option’s Strike Price) • End Date (e.g., the date coverage ends) • Price you pay is known as LRP premium

13. LRP Feeder Cattle Premium Calculation Example • To calculate actual LRP premium you must know • Number of cattle ready for market (weighing less than 9.0 cwt) on End Date • Target Weight per head • Ownership share in cattle

14. Premium Calculation Example • Producer selects a coverage price which is a % of the Expected End Price published by RMA • Assume producer selects $100 per cwt. coverage price (e.g., 92% of RMA’s expected ending price) • For this coverage price, the rate is 1.449% • The premium subsidy is 13 percent

15. Premium Calculation Example • 100 head * 7 cwt = 700 cwt. • 700 cwt. * coverage price ($100) = $70,000 • $70,000 * insured share (1.00) = $70,000 Insured Value

16. Premium Calculation Example • $70,000 * rate of .01449= $1,014 Total Premium • $1,014 * .13 (subsidy) = $132 subsidy • $1,014 (total premium) minus $132 subsidy = producer premium of $882 = $1.26/cwt. premium

17. Calculating Indemnity • Indemnity is payable if actual ending price is less than coverage price • Calculate indemnity by: • Multiplying number of head by target weight (in live cwt.) • Subtract actual ending price from coverage price • Multiplying total weight by difference between actual ending & coverage price

18. Indemnity Calculation Example Our example • An operation has 100 head of fed cattle • Has a target weight of 7.00 cwt. per head • Insured share is 100 percent

19. Indemnity Calculation Example • Expected End Price for appropriate insurance period is $109.25 per live cwt. • Producer selects a coverage price of $100 per cwt. (e.g., 92% of Exp. End Price) • Actual End Price is $80 per cwt. (e.g., CME Feeder Cattle Index = $80 on End Date)

20. Indemnity Calculation Example • Subtracting actual ending price of $80 from the coverage price of $100 = $20/cwt. • Recall that 100 head * 7.00 cwt = 700 cwt. • Multiplying 700 cwt. by $20/cwt = $14,000 • Multiplying $14,000 by insured share of 1.00 = indemnity payment of $14,000

21. Indemnity Calculation Example • What happens if actual ending price = $105? • Subtracting actual ending price of $105 from the coverage price of $100 = neg. $5/cwt. • Therefore, no indemnity payment is made to producer • This is analogous to a put option that expires worthless

22. LRP Coverage Prices & Levels • Price guarantees change daily • Premiums change daily • Coverage available ranges from 70% to about 95% of Expected Ending Price, but maximum guarantee on most days is less than 95%

23. Premium • Producer may obtain premium quotes via RMA’s Premium Calculator available on USDA-RMA’s web site • Premium must be paid on day LRP insurance is purchased for coverage to be provided • Rates available at http://www.rma.usda.gov/tools Under livestock reports Or use link on AgManager www.agmanager.info/livestock/marketing

24. LRP Coverage Availability • Available from about 5 p.m. until 9 a.m. Central Time during the week • Not Available on Federal holidays • Not Available if RMA web site down

26. LRP & Put do NOT expire on the same date, most of the time LRP & Put do not have the same expected price or strike value LRP is an European Option, no right to exercise So one can NOT compare cash cost because they do not have the same coverage & expiration dates Comparing LRP with CME Put Option Premiums for Similar Coverage

27. LRP priced using option pricing model Calculate implied volility from current CME option premiums Calculate current “fair market” option premium for LRP based on LRP expiration date, European option, LRP expected market price, and LRP strike Comparing LRP with CME Put Option Premiums for Similar Coverage

28. Comparing LRP with CME Put Option Premiums for Similar Coverage LRP Premium = $2.58

29. Improving Basis Forecasting

30. What is Basis? Mathematically: Basis = Cash price – Futures Price Generally, basis is more predictable than cash or futures prices due to: • Convergence • Futures and cash prices move together (same fundamental conditions generally affect both markets) • Year-to-year stability

31. Basis patterns will vary by cattle weight

32. And There’s A Difference Between Cash Index (LRP) Basis and Futures Basis

33. How do we use basis? Basis = Cash Price – Futures Price Basis + Futures Price = Cash Price Exp. Cash Price = Exp. Basis + Futures Price Risk managers need basis forecasts LRP users replace futures price with LRP coverage price minus premium

34. Basis as it relates to put options Put option strike (97.9%) $96.00 + Expected basis 3.50 − Premium 2.13 = Expected minimum sale price $97.37 Based on May FC futures of $98.02 on 2/11/05 and expected selling date of mid May

35. Basis as it relates to LRP LRP coverage level (93.9%) $92.29 + Expected basis 4.00 − Premium 1.21 = Expected minimum sale price $95.08 Based on LRP quotes on 2/11/05 and ending date of 5/13/05 (expected ending value = $98.31, 13 week endorsement)

36. How should you forecast basis? • Average over several years (years may vary depending on commodity) • Average = expected value • Measure variability (risk) • Historical range (highs and lows), standard deviation • Variability measure indication of risk

37. Should forecasts consider current basis?

38. ? 4-wk ahead forecast ? 8-wk ahead forecast Should forecast consider current basis? How much should we “adjust” forecast by and how will this adjustment vary by time?

39. Including Current Information Improves Forecasts But Value Declines As Forecast Horizon Increases

40. Basing Forecasts Solely on Current Information Reduces Accuracy

41. Basis Conclusions • Basis is generally more predictable than prices. • Very important when thinking about basis to make sure relevant/correct prices are used. • Ignoring missing data in a multiple year average may lead to poor forecasts • Basis is often forecasted using historical basis information, but incorporating “current” information can improve forecast accuracy.

45. Setting Up The Case Farm • Participants are provided Enterprise budgets for • Grain sorghum • Cow-calf • Steer backgrounding

46. Setting Up The Case Farm • Participants must make crop insurance coverage selection at outset

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50. May 17th Scenario