Recently, we received a call from a lender who had attended one of our seminars with a concern reviewing a client’s account statement. The lender’s client was a crop producer who raises corn and soybeans, and the lender was questioning one of the positions in the client’s account. The crop producer had purchased a call option against new-crop corn that was soon to be harvested this fall. Understanding from our class that a hedge should be in the direction of risk the client faces in the market, the question was obvious: if this client is growing corn, doesn’t he want to protect against lower prices? How does a call option help him therefore if the market is moving lower given that the call will lose value in a declining market?
While the above statement is true, it raises a few questions regarding what the actual risk is in the cash market. For example, has the crop already been priced with a counterparty in the local market such as an elevator or ethanol plant? This may present a scenario where the producer would want to protect the equity in the sale that will not be realized until the corn is actually harvested and delivered to the counterparty.
As an example, let’s assume that this particular producer had established a hedge-to-arrive contract with a local elevator back in the spring when they were planting their corn at a price of $5.00/bushel based on the CBOT December futures contract. By late summer, December corn had declined down to a low of $3.20/bushel. While the producer is still entitled to the $5.00/bushel sale they established on the hedge-to-arrive contract, they also are sitting on $1.80/bushel worth of unrealized equity at that point in time which cannot be secured because the crop is yet to be harvested and delivered to the local elevator.
One way of protecting this unrealized equity would be to purchase a call option on the exchange. For a fixed premium which at the time may have cost around 10 or 15 cents/bushel, the producer could have locked in the difference between where they established their sale at $5.00 back in the spring and where the market was now trading around $3.20 in the early fall. If the market were to continue declining, they would lose the fixed premium paid for the call option but they are still protected to lower prices through the hedge-to-arrive contract they have at their local elevator. If the market were to instead move higher though as it has during October and November, they effectively have locked in the difference between the strike price of their call and where they established the hedge-to-arrive sale less the cost of the call option’s premium.
What if they didn’t previously establish a sale with a local counterparty such as with a hedge-to-arrive contract at the elevator? As another example, let’s assume that this particular crop producer purchased revenue protection insurance on their corn ahead of planting. The general feature of this insurance policy is that they are guaranteed a minimum level of revenue per acre on up to a maximum of 85% of their actual production history, which we will assume in this example has averaged 180 bushels per acre historically. The average closing price for December corn futures is calculated during the month of February to establish the threshold at which the revenue protection will trigger. For this year, that average price for December corn futures during the month of February was $4.61/bushel. This means that if the producer is purchasing revenue insurance on 85% of their actual production history, they are guaranteed no worse than $705.33/acre ($4.61/bushel futures price * 180 bushels/acre * 85% APH), regardless of their yield or the price of corn at harvest. They therefore would receive an indemnity payment if their actual revenue per acre is less than $705.33 at harvest, which is determined by their actual yield multiplied by the average of December corn futures during the month of October.
Let’s now assume it is late summer again and this particular producer has been advised by his crop scout that conditions were favorable during pollination and the corn is projected to yield at least 5% above historical trend. As in the hedge-to-arrive example, December corn futures are now trading at $3.20/bushel. Should prices hold at this level through the month of October when the average December futures price is recalculated for the purpose of establishing potential indemnity payments, this producer would be looking at revenue of $608/acre which would be equivalent to the $3.20/bushel December futures price multiplied by the 190 bushel/acre yield being projected in late September.
In this example scenario, the crop producer is looking at a difference between their expected revenue per acre and the revenue guaranteed by their insurance of $97.33/acre. Dividing this by their expected yield of 190 bushels/acre would be the equivalent of 51.23 cents/bushel of unrealized equity in their insurance policy that they can’t tap because we are not yet through the month of October. Another way of thinking about this is to calculate at what futures price there would no longer be an indemnity payment available, assuming the producer actually harvests a 190 bushel/acre yield. If the producer is guaranteed revenue of $705.33/acre and we divide this revenue by 190 bushels per acre, the resulting price is just over $3.71/bushel. Therefore, if the market is trading at $3.20/bushel in late September, there is over 50 cents/bushel in potential unrealized indemnity payments that could be protected by purchasing a call option or call spread to bridge this difference.
Given that the producer paid for the insurance back in the spring which now has real value, it would make sense that they might consider protecting this value through the exchange. Like the hedge-to-arrive example, if the market continues moving lower into harvest, they are still guaranteed minimum revenue through their insurance policy and they simply lose the premium paid for the option. If the market recovers however as it has done, then it may well be worthwhile to have purchased a call option to protect this value. Another historical example of protecting higher prices against long physical ownership would be loan deficiency payments or LDP’s that were common in the past decade prior to the ethanol era. Future examples may include how a dairy producer would secure unrealized value in the Margin Protection Program or MPP. Regardless of the situation, the starting point of any hedge is always to evaluate where the risk would be in the open market. In the case of revenue received for an operation’s production, that risk may not always be to lower prices.