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 1.How LRP works 2.Comparing LRP with CME Put Options 3.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 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 How Does LRP Work?

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 $ 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 Under livestock reports Or use link on AgManager

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 Comparing LRP with CME Put Option Premiums for Similar Coverage 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

27 Comparing LRP with CME Put Option Premiums for Similar Coverage 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

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

29 Comparing LRP with CME Put Option Premiums for Similar Coverage Add in 12 point CAT load and Calculated premiums are “about the same” as the LRP premium set by RMA Little effective net subsidy from 13% subsidy Any “effective subsidy” will be similar to no commissions being charged to producers

30 Improving Basis Forecasting

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

32 Basis patterns will vary by cattle weight

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

34 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 How do we use basis?

35 Where does “expected” basis come from? Basis forecast = f (historical basis) Research has generally shown there is little benefit to complex fundamental models compared to historical averages. “Optimal” historical averages è Livestock, 3-yr or 4-yr average Forecasting basis

36 Basis as it relates to put options Put option strike (97.9%) $ 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

37 Basis as it relates to LRP LRP coverage level (93.9%) $ 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)

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

39 Should forecasts consider current basis?

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

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

Basing Forecasts Solely on Current Information Reduces Accuracy

43 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. Basis Conclusions

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47 Setting Up The Case Farm Participants are provided Enterprise budgets for –Grain sorghum –Cow-calf –Steer backgrounding

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50 Setting Up The Case Farm Participants must make crop insurance coverage selection at outset

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May 17 th Scenario

$2.30$-.40$0.13$1.77 YES / NO

$2.30$-.40$0.13$1.77 YES / NO15,000 10,000 BU. FORWARD CONTRACT, and 5,000 BU. With a PUT I UNDERSTAND FORWARD CONTRACT & WANTED TO COMPARE WITH PUT

$2.30 $0.13 5,000 $ ,000 $19,500

June 28 th Scenario For Calf Sales in October 2006

YES / NO110 head Forward Contract 10 weaning steer calves, 10 LRP, & 1 Oct Put COMPARE LRP with a PUT

61 $108$8$2.62$ $ $1$1.59$111.97

June 28 th Scenario For Feeder Sales in February 2007

YES / NO80 head FORWARD CONTRACT 10 Feeders, 10 LRP & 1 Mar PUT

65 $96$1$4.56$92.44 $96.69-$3$4.23$89.46

$108 $1,309 1 $96 $2,278 1 $ $ $96.69 $ Calves60 Steers 50,000#/90Hd = 555# steer 50,000#/60Hd = 833# steer Total of 150 steers priced using 1 Oct put & 1 Mar put and 20 steers priced using LRP

$ $ $ $7,760

68 Additional Marketing Decisions Milo decision in late July Calf-Feeder Cattle Decision in late October Harvest yields drawn from distribution in late October Results from CME put options, LRP insurance, forward contracts recorded

July 26 th Scenario For Milo Sales

YES / NO20,000 10,000 BU. FOWARD CONTRACT & 10,000 with PUT PROFITABLE PRICE NO $3.20$-.40$0.35$2.45

$2.30 $0.13 5,000 $ ,000 $19,500 $3.20 $ ,000 $ ,000 $24,000

Oct. 25 th Scenario For Calf Sales

YES / NO10 head Cash Sale 10 steers at weaning

$108 $1,309 1 $3,000 $1,691 $96 $2,278 1 $ $ $15.59 $ $96.69 $ Steers $23.93

$96$1$3.09$91.91 $93.73-$3$2.17$88.56

YES / NO80 head FORWARD CONTRACT 10 Feeders, 10 LRP & 1 PUT

$108 $1,309 1 $3,000 $1,691 $96 $2,278 1 $96 $1,543 1 $ $ $23.93 $15.59 $96.69 $ $93.73 $ $ Total of 120 steers priced using 2 Mar puts and 20 steers priced using LRP 60 Steers

$ $6,195 $ $7,760 $ $5,775 $ $7,680

50, $108,000

50, $108,000 $7,000

50, $0 $108,000 $7,000

$108 $1,309 1 $3,000 $1,691 $96 $2,278 1 $96 $1,543 1 $ $ $23.93 $15.59 $96.69 $ $93.73 $ $155.90

$108 $1,309 1 $3,000 $1,691 $96 $2,278 1 $112 -$2,166 $96 $1,543 1 $112 -$1,431 -$1,906 $ $ $23.93 $15.59 $96.69 $ $93.73 $ $155.90

$108 $1,309 1 $3,000 $1,691 $96 $2,278 1 $112 -$2,166 $96 $1,543 1 $112 -$1,431 -$1,906 $ $ $23.93 $15.59 $96.69 $ $33.85 $93.73 $ $ $ $2, $ $338.5-$ $0.00

$ $6,195 $ $7,760 $ $5,775 $ $7,680 -$2,262 Round Number

$ $6,195 $ $7,760 $ $5,775 $ $7,680 $ $138, ,700 -$2,262 $6,195 $5,775 $15,440 $138,240 $163,388 $10,900 $114,300 $125,200 $38,188

50, $38,188 $0 $108,000 $7,000

50, $38,188 $0 $108,000 $7,000

Closing Corn Option Prices on Back of yellow sheet

$2.30 $0.13 5,000 -$0.09 $0.04 -$450 $3.20 $ ,000 $ ,000 $19,500 50,000 2,700 20,000 27,300 $ ,000 $24,000

Closing Corn Option Prices on Back of yellow sheet

$2.30 $0.13 5,000 -$0.09 $0.04 -$450 $3.20 $ ,000 $0.45 $4,500 $0.80 $4,050 $0.00 $ ,000 $19,500 50,000 2,700 20,000 27,300 $ ,000 $24,000 $ ,300 $54,600 $43,500 $54,600 $102,150 $2.16$102,150(50,000-2,700 = 47,300)

$102,150 50, $38,188 $0 $108,000 $7,000 $50,

101 LRP Summary LRP does not guarantee a cash price LRP protects against a negative change in CME Cash Index Price LRP does NOT guarantee the basis Policy does not cover any other peril

102 LRP Summary LRP premiums are similar to comparable CME put options –This means USDA subsidy does not provide an incentive to buy LRP vs. CME Put Options Orders are filled at the stated premium –Deferred options are sometimes thinly traded & it’s difficult to execute option transactions at quoted premiums

103 LRP Advantages  Insure the exact number of head that you choose  Flexible contract size matches “small” operations vs.  Feeder cattle futures that represents about 67 steers weighing 750 pounds  Live cattle futures that represents about 33 steers weighing 1200 pounds  Can incrementally minimum price a few head at a time

104 Producer’s LRP Disadvantages Cannot exercise or cancel LRP contract –Inability to cancel contract inhibits marketing flexibility –Also an issue if cattle are sold early because of drought damaged pastures. Can not roll up the LRP coverage in a rising market –CME options offer flexibility of “rolling up” coverage Contracts only offered in 4 week increments –Lack of flexibility creates extra basis risk

105 Producer’s LRP Disadvantages Coverage is always greater than 5% out of the money and in some cases almost 10% If company exceeds its premium limit, producers with that company’s policy can not buy additional SCEs even though other companies still have capacity to sell

106 LRP Advantages for Lenders Lenders may prefer LRP over a put to cover loan collateral Producers can’t cancel the coverage LRP is insurance, so Lenders can take a security interest in the contract

107 Who Attended The Workshops? Cow-Calf Operation50% Cattle Backgrounding Operation42% Cattle Feeding Operation21% Ag. Lender18% Crop Insurance Agent6% Commodity Broker1% Other15%

108 How Effective Are The LRP Workshops? Participant Evaluation Results On a scale of 1 (very useful) through 5 (not useful), 1. How would you rate the overall usefulness of the workshop? How would you rate the usefulness of the "case farm" exercise? 1.79

109 How Effective Are The LRP Workshops? Participant Evaluation Results On a scale of 1 (very useful) through 5 (not useful), 3. Would you recommend this workshop to others who have a stake in the cattle business? 1.63

110 How Much Did Participants Learn? Pre & Post Workshop Reviews 1.Are there any limitations regarding how many head of feeder cattle can be insured via LRP for Feeder Cattle? If so, what are the limitations? 2.Who can you purchase LRP insurance from? 3.When purchasing LRP Insurance for Feeder Cattle, what is the maximum insurance coverage price that you can purchase for your feeder cattle on any given day? 4.What published price is the LRP Expected End Value for feeder cattle base on?

111 How Much Did Participants Learn? Pre & Post Workshop Reviews 5.Assume that you purchased LRP Insurance for 50 head of steers that you own and that you expect the steers will weigh 800 lbs at the end of the coverage period. Also assume that your Coverage Price is $104/cwt and that the CME Feeder Cattle Index value during the ending week is $100/cwt. What indemnity, if any, will you receive from your LRP insurance policy? 6.Have you ever used CME put options?

112 How Much Did Participants Learn? Pre & Post Workshop Reviews Participants that had used options previously earned higher scores on pre- workshop review than participants that had no options experience 47% correct vs 37% correct

113 How Much Did Participants Learn? Pre & Post Workshop Reviews

114 Where Do We Go From Here? Anticipate conducting more workshops in fall and winter Workshop improvements consider modifying structure so the entire workshop focuses on case farm with short lectures integrated within the case farm at “teachable moments”

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