Futures, Options, LRP Compared

Transcription

1 Futures, Options, LRP Compared Duane Griffith & Jim Johnson Montana State University Extension The software demonstrated today can be downloaded/used at the web site below.

2 Livestock Risk Protection Feeder Cattle Fed Cattle Swine Lamb All these types of livestock are covered by LRP in all Montana and Wyoming counties.

3 What Is The Relevant Comparison Compare as equal a price level as possible Futures versus Strike Price versus Coverage Level You start off with a set of initial conditions in the Futures and Options markets and these determine the LRP Coverage level available. If you change any one of these initial conditions, it implies a change in the information provided by the other markets. The objective is to compare the costs of comparable down side price protection with these products, not to work the system.

4 Examples are Using Livestock Risk Protection for Feeder Cattle 4

5 Example Initial Conditions Feeder Futures as of October was $6.00 expected basis =$ Local cash price October Put Options: used $114 Strike price + $6.00 expected basis = $ Local cash price Premium was $4.55 LRP Coverage price: 26 weeks out was $ Premium was $4.721 ($ after 13% subsidy)

6 Basics All three are based on the futures markets All three use very similar information All three have their own specific requirements All three provide coverage for a single peril, price risk None eliminate other risks such as Sickness, dead loss, disasters, etc.

7 Pros & Cons: Futures Pros: Can minimize transactions costs, if everything goes as planned Provides widest selection of price protection levels to choose from, trades daily Allows implementation of automatic transactions when working with a broker Allows you the opportunity to get to know your lender very well Maybe long conversations with your spouse

8 Cons: Pros & Cons: Futures Lumpy Contract Size Have their own risks Margin calls and additional transaction costs Broker s knowledge of specific markets and commodities Locks in Price Both Ways Eliminates capturing benefits of advantageous price moves Producer subject to Basis Risk

9 Pros & Cons: Options Pros: Locks in price in only one direction Put = price floor Call = price ceiling Eliminates margin call worries Up front transaction costs One time transactions costs Interaction with broker minimal Option expires worthless Exercise option if it has value

10 Cons: Pros & Cons: Options Coverage is Lumpy by contract size Slightly lesser level of price protection alternatives to select from May not be available when you need it Not trading out far enough Producer subject to Basis Risk

11 Pros and Cons: LRP Pros: Can cover small number of head Not lumpy like futures and options contracts One time only transaction at purchase Settles to daily CME index price Do not have to do anything in the markets at termination of insurance period Widely available from insurance agents 13% Subsidy

12 Pros and Cons: LRP Cons: Limited coverage time slots 13, 17, 21, 26, 30, 34, 39, 43, 47, or 52-week periods Limited selection of coverage levels Producer Must establish eligibility More paper work Limit of 1,000 head per endorsement & 2000 head annually No Off-setting Transactions allowed Offset LRP position in the futures and/or options market

13 Livestock Risk Protection, Feeder Cattle, cont. Feeder Cattle Types and Weights Eligible for LRP Feeder Cattle Coverage Insurable Type Steers Weight 1 Steers Weight 2 Heifers Weight 1 Heifers Weight 2 Brahman Weight 1 Brahman Weight 2 Dairy Weight 1 Dairy Weight 2 Target Weight less than 6.0 hundredweight 6.0 to 9.0 hundredweight less than 6.0 hundredweight 6.0 to 9.0 hundredweight less than 6.0 hundredweight 6.0 to 9.0 hundredweight less than 6.0 hundredweight 6.0 to 9.0 hundredweight 13

14 LRP Feeder Cattle Example Contract Data Value Calculation Number of Steers 1,000 hd Producer Expected Weight 800 lb Producer Current Date Feb. 4, 2008 Producer Marketing Date May 5 Producer Insurance Period 13 weeks Producer Expected Ending Value $ cwt RMA Coverage Level 93.60% Producer Coverage Price $ cwt RMA 14

15 LRP Feeder Cattle Example Feeders, Feb. 4, 2008 Contract Data Value Source Insured Value $825,120 1,000 hd x 8 cwt/hd x $103.14/cwt Premium Rate RMA Total Premium $18,232 $825,120 x Subsidy Rate 13% RMA Subsidy Amount $2,370 $18,232 x 0.13 Producer Premium $15,862 $18,232 $2,370 15

16 LRP Example Suppose a producer actually sells 1,000 of 800 pound steers on May 7, Sold the steers for $100.00/cwt The CME-reported actual ending value is $100.00/cwt. Will the producer receive an indemnity

17 LRP Example Answer Yes. Indemnity calculation 1,000 head x 8 cwt/head x ($ $100.00) = $25,120 Revenue from calves 1,000 x 8 cwt/head x $ = $800,000 Plus indemnity of: + 25,210 Less premium of: - 15,862 Net revenue: =$809,348

18 LRP Example Answer Recall that the producers was expecting $ ,000 x 8 cwt/head x $110.19/cwt = $825,120 Without LRP, the producer receives $800,000 With LRP, the producer receives $809,348

19 LRP Versus Options, cont. LRP & Put options both protect price risk. For LRP, the selected coverage price is the producer s price floor. For options, the selected strike price is the producer s price floor. Both LRP & Options require the payment of a premium. LRP an insurance premium is paid to an insurance agent. Options an option premium is paid to a broker.

20 LRP Versus Options, cont. Payouts are received when prices decline below an insured level. LRP- receive an indemnity Options- option premium increases in value and is reflected in the producer s brokerage account

21 LRP Versus Options, cont. No payouts are received if market prices remain above the insured level. LRP No indemnity Options Option premium declines to zero and there is no increase in the producer s brokerage account. Both LRP and options are subject to basis risk. Both products protect the producer from a decline in the CME feeder cattle price index

22 LRP Versus Options, cont. Neither product protects the producer from a decline in the producer s sale price. Disadvantages of options relative to LRP: Need a brokerage account hence brokerage fees Subsidies are not available for option premiums. No price adjustments for varying weights.

23 LRP Versus Options, cont. Advantages of Options relative to LRP: A producer may buy higher price coverage levels than LRP. LRP coverage levels always out of the money More timing flexibility because the producer may sell an option prior to expiration. Can re-purchase an option at any time

24 Information Sources TFC Charts Third party CME and CBT KCBT Kansas City Board of Trade RMA= Risk Management Agency

25 Questions