1. LGM-Dairy: A Wisconsin Example Eastern Wisconsin Farm Management Update Seminar Brian W. Gould Associate Professor Department of Agricultural and Applied Economics Victor Cabrera Assistant Professor Department of Dairy Science/ UW-Extension University of Wisconsin-Madison

2. http://future.aae.wisc.edu/lgm_dairy.html

3.  Example Detailed in Policy Briefing Paper of Gould, Mitchell and Cabrera (2008)  Farm Characteristics  150 Head Operation  Average Yearly Productivity 19,305 lbs/cow 19,305 lbs/cow  Insurance Contract Purchased on May 29 th  Cover Gross Margin Over July 2008 – April 2009  Initially Assume $0 Deductible LGM-Dairy Example: Assumptions

4.  10-Month Production Period  Per Cow Productivity Changes by Month Using 2007 Wisconsin Values  Amount of Feed Expected to be Used 327.9 Tons Corn Equivalent 327.9 Tons Corn Equivalent 42.4 Tons Soybean Meal Equivalent 42.4 Tons Soybean Meal Equivalent  Expected Price Measurement Period  May 23 rd, May 28 th, & May 29 th  Wisconsin Basis Added to Class III and Corn Prices to Convert to Wisconsin All-Milk and Corn Price LGM-Dairy Example: Assumptions

5. Month Prod/Cow (lbs) Target Marketings (lbs) Corn Equivalent (Tons) SBM Equivalent (Tons) July ‘08 1,675251,25034.324.43 Aug ‘08 1,645246,75033.714.35 Sep ‘08 1,575236,25032.274.17 Oct ‘08 1,600240,00032.794.24 Nov ‘08 1,550232,50031.764.10 Dec ‘08 1,600240,00032.794.24 Jan ‘09 1,630244,50033.404.31 Feb ‘09 1,470220,50030.123.89 Mar ‘09 1,640246,00033.614.34 Apr ‘09 1,615242,25033.094.28 Total19,3052,895,750327.8542.35

6.  Given May 29 th Purchase Date and Associated Expected Price Measurement Period We Calculate for the Insurance Period Expected :  Wisconsin All-Milk Prices  Wisconsin Corn Grain Prices  Soybean Meal Prices  Given Expected Price, Target Marketings and Expected Feed Use  Obtain Expected Gross Margin Guarantee (GMG) GMG = Expected Total Gross Margin – Deductible GMG = Expected Total Gross Margin – Deductible LGM-Dairy Example: Assumptions

7. Month Class III Settle Price ($/cwt) Milk Basis ($/cwt) [5] All Milk Price ($/cwt)[6] Target Market. (cwt) [7] Total Revenue ($) [8] May 23 [1] May 27 [2] May 28 [3]Avg.[4] July ‘08 21.4221.3821.2421.351.1122.462,51356,431 Aug. ‘08 21.2521.2821.1321.221.1622.382,46855,223 Sep. ‘08 21.1621.1221.0021.091.3722.462,36353,062 Oct. ‘08 20.7920.7020.5720.691.7722.462,40053,904 Nov. ‘08 20.6820.5820.4520.571.9122.482,32552,266 Dec. ‘08 20.5920.5020.3520.481.7722.252,40053,400 Jan. ‘09 19.8519.8519.8019.831.9421.772,44553,228 Feb. ‘09 19.2019.2419.2419.231.7921.022,20546,349 Mar. ‘09 19.2019.2219.2019.211.9421.152,46052,029 Apr. ‘09 18.9018.9018.9018.901.4020.302,42349,177 Note: [4] = ([1] + [2] + [3])/3 [6] = [4] + [5] [8] = [6] * [7] [6],[7] are rounded values Calculation of Expected Milk Price and Revenue

8. Month Corn Settle Price ($/bu) Basis ($/bu) [6] Price ($/bu) [7] May 23 [1] May 27 [2] May 28 [3]Avg[4] Imputed [5] July ‘08 6.005.985.925.975.97-0.125.85 Aug. ‘08 6.03-0.155.88 Sep. ‘08 6.136.116.056.106.10-0.115.99 Oct. ‘08 6.14-0.155.99 Nov. ‘08 6.19-0.186.01 Dec. ‘08 6.276.256.196.246.24-0.226.02 Jan. ‘09 6.28-0.146.14 Feb. ‘09 6.33-0.136.20 Mar. ‘09 6.46.396.336.376.37-0.176.20 Apr. ‘09 6.31-0.116.20 May ‘09 6.256.476.416.386.38-0.126.26 Note: [4] = ([1] + [2] + [3])/3 [5] = weighted average [7] = [5] + [6] Calculation of Expected Corn Price

9. Month Soybean Meal Settle Prices ($/ton) May 23 [1] May 27 [2] May 28 [3]Avg.[4] Imputed Price [5] July ‘08 336.60335.00343.70338.43338.43 Aug. ‘08 338.00337.70345.80340.50338.13 Sep. ‘08 335.00336.50342.00337.83337.83 Oct. ’08 327.50329.00333.70330.07330.07 Nov. ’08 329.82 Dec. ’08 327.00329.00332.70329.57329.57 Jan. ‘09 327.60329.50334.00330.37330.37 Feb. ‘09 332.15 Mar. ‘09 331.30333.00337.50333.93333.93 Apr. ‘09 334.93 May ‘09 333.30335.00339.50335.93335.93 Note: [4] = ( [1] + [2] + [3] )/3 [5] = weighted average Calculation of Expected SBM Price

10. Month Corn Costs ($) [1] SBM Costs ($) [2] Feed Costs ($) [3] Revenue ($) [4]GMG($)[5] July ‘08 7,167 1,5008,66756,43147,764 Aug. ‘08 7,080 1,4728,55255,22346,671 Sep. ‘08 6,900 1,4088,30853,06244,754 Oct. ‘08 7,018 1,3988,41653,90445,488, Nov. ‘08 6,817 1,3538,17052,26644,096 Dec. ‘08 7,045 1,3968,44153,40044,959 Jan. ‘09 7,327 1,4258,75253,22844,476 Feb. ‘09 6,667 1,2927,95946,34938,390 Mar. ‘09 7,445 1,4508,89552,02943,134 Apr. ‘09 7,330 1,4328,76249,17740,415 Total 70,796 14,12684,922525,069440,147 Calculation of Gross Margin Guarantee (GMG) Note: [3] = [1] + [2], [5] = [4] – [3], and $0 Deductible Assumed

11.  Premiums Based on Futures and “At-The Money” Options During Expected Price Measurement Period  As Shown Above Mean Price Obtained from Futures Over Expected Price Measurement Period  Standard Deviation Obtained from Options Options Costs → Implied Volatility via Modified Version of Black-Scholes Model Options Costs → Implied Volatility via Modified Version of Black-Scholes Model Calculation of Insurance Premiums

12.  With No Premium Subsidy  Expected Indemnities Should Equal Premiums  RMA UndertakesMonte Carlo Simulations of Gross Revenues Based on Probability Distributions for Class III, Corn and Soybean Meal Prices Based on Probability Distributions for Class III, Corn and Soybean Meal Prices Assumed Lognormal Distribution for All Prices Assumed Lognormal Distribution for All Prices Mean and Std. Deviations Obtained via Above Mean and Std. Deviations Obtained via Above One Official Matrix of Random Price Draws One Official Matrix of Random Price Draws Premiums = Average of Simulated Payouts + 3% Premiums = Average of Simulated Payouts + 3%  RMA Premium Calculator Website: http://www3.rma.usda.gov/apps/premcalc/ Calculation of Insurance Premium

13.  Producer Can Elect Alternative Total Gross Margin Deductibles  May 2008 Example Premiums Decrease at Faster Rate then GRM as Deductible Levels Increase Premiums Decrease at Faster Rate then GRM as Deductible Levels Increase  Premium vs. Gross Revenue Reduction Depends on  Volatility at Sign-Up  Expected Margins at Sign-up Calculation of Insurance Premium

14. DeductibleGMGPremium Rate ($/cwt) [1] Total($)[2]Total($)[3] % ↓ [4]Total($)[5] [6] % of GMG % of GMG[7] Per Cwt ($) [8] 00440,145-----29,235-----6.641.22 0.102,400437,745-0.5527,956-4.386.391.16 0.307,200432,945-1.6425,498-12.785.891.06 0.5012,000428,145-2.7323,174-20.735.410.97 0.7016,800423,345-3.8220,983-28.234.960.87 0.9021,600418,545-4.9018,940-35.224.530.79 1.1026,400413,745-6.0017,033-41.744.120.71 1.3031,200408,945-7.0915,271-47.773.730.64 1.5036,000404,145-8.1813,618-53.423.370.57 % ↓ measured from $0 Deductible level

15. Calculation of Insurance Premium GMG Premium $0: $440,145 $29,235 $0.70: $423,345 $20,983 $1.50: $404,145 $13,618

16.  LGM-Dairy Has Standard Indemnity Stream  Indemnity = Max[0, GMG – AGM[ GMG = Gross Margin Guarantee GMG = Gross Margin Guarantee AGM = Actual Gross Margin AGM = Actual Gross Margin  As of this Date We Can Only Evaluate Performance For July and August  The Following Table Shows Evaluation Times Determining Indemnities

17. Month Class III Corn Soybean Meal Last Trading Day Actual Price Measurement Period Last Trading Day Actual Price Measurement Period Last Trading Day Actual Price Measurement Period Jul ‘08Jul 31Jul 28 – 30Jul 14Jul 9 – 11Jul 14Jul 9 – 11 Aug ‘08Sep 4Aug 29,Sep 2–3----- Jul 9 – 11 Sep 9 – 11 Aug 14Aug 11 – 13 Sep ‘08 Oct 2 Sep 29–Oct 1 Sep 12 Sep 9 – 11 Sep 12 Sep 9 – 11 Oct ‘08 Oct 30 Oct 27 – 29 ----- Sep 9 – 11 Dec 9 – 11 Oct 14 Oct 9,10,12 Nov ‘08 Dec 4 Dec 1 – 3 ----- Sep 9 – 11 Dec 9 – 11 ----- Oct 9,10,12 Dec 9 – 11 Dec ‘08 Dec 31 Dec 28 – 30 Dec 12 Dec 9 – 11 Dec 12 Dec 9 – 11 Jan ‘09 Jan 29 Jan 26 – 28 ----- Dec 9 – 11 Mar 10 – 12 Jan 14 Jan 10,12,13 Feb ‘09 Feb 26 Feb 23 – 25 ----- Dec 9 – 11 Mar 10 – 12 ----- Jan 10,12,13 Mar 10 – 12 Mar ‘09 Apr 2 Mar 30–Apr 1 Mar 13 Mar 10 – 12 Mar 13 Mar 10 – 12 Apr ‘09 Apr 30 Apr 27 – 29 ----- Mar 10 – 12 May 11 – 13 ----- Mar 10 – 12, May 11 – 13

18.  Are There Indemnities for July and August?  Data From Actual Price Measurement Period Determining Indemnities July Actual Price Measurement Period Class III ($/cwt) Corn ($/bu) Soybean Meal ($/T) 28-Jul18.229-Jul6.839-Jul435.50 29-Jul18.2310-Jul6.7510-Jul445.80 30-Jul18.1911-Jul6.8011-Jul453.90 Average18.21Average6.79Average445.07 Basis1.11Basis-0.12 Actual Price 19.32 6.67 445.07

19.  Are There Indemnities for July and August?  Data From Actual Price Measurement Period Determining Indemnities August Actual Price Measurement Period Class III ($/cwt) Corn ($/bu) Soybean Meal ($/T) 29-Aug 17.289-Jul6.839-Sep 5.2911-Aug332.50 2-Sep 17.2110-Jul6.7510-Sep 5.2212-Aug341.70 3-Sep 17.3011-Jul6.8011-Sep 5.2213-Aug359.50 Average17.26 Average6.79Average 5.24Average344.57 Basis1.37Basis-0.12Basis-0.11 WI Price 18.63 6.67 5.13 344.57

20.  Lets Calculate the Actual Gross Margins (AGM)  July: AGM = $19.32*2,513 – $6.67*(2000/56)*34.32 AGM = $19.32*2,513 – $6.67*(2000/56)*34.32 – $445.07*4.43 = $38,404 GMG = $22.46*2,513 –$5.85*(2000/56)*34.32 GMG = $22.46*2,513 – $5.85*(2000/56)*34.32 –$338.43*4.43 = $47,772 – $338.43*4.43 = $47,772 Indemnity = $9,368 Indemnity = $9,368  Aug: AGM = $18.63*2,468 – $5.90 *(2000/56)*33.71 AGM = $18.63*2,468 – $5.90 *(2000/56)*33.71 – $344.57*4.35 = $37,377 GMG = $22.38*2,468 – $5.88*(2000/56)*33.71 GMG = $22.38*2,468 – $5.88*(2000/56)*33.71 – $338.13*4.35 = $46,684 – $338.13*4.35 = $46,684 Indemnity = $9,307 Indemnity = $9,307 Determining Indemnities

21.  LGM-Dairy is Designed to be a Flexible Insurance Program  Need not Insure All Months or All Monthly Production  Can be Thought of as a Combination of the Use of a Put on Class III and Call on Feed Costs  Premium May be Considered Reasonable  Premiums May Be Very Sensitive to Deductible Chosen LGM-Dairy: Summary

22. Contact Information  Univ. of Wisconsin Dairy Marketing Website/LGM- Dairy Section: http://future.aae.wisc.edu/lgm_dairy.html  USDA’s Gross Margin Insurance Program for Dairy: What is it and Can it be Used for Risk Management, B. Gould, P. Mitchell and V. Cabrera  Brian W. Gould (608)263-3212bwgould@wisc.edu Victor Cabrera (608)265-8506vcabrera@wisc.edu