Hedging to protect crop revenue
During short crop years, corn and soybeans prices often peak early and then decline throughout the remainder of the marketing year.
This suggests that producers may wish to consider pricing some grain before harvest. This is particularly true for farmers who insured using Revenue Protection (RP) insurance, as there may be concern that the harvest-time contracts will peak before the harvest price determination period during October, leading to lower crop insurance payments than implied by current levels of futures prices. Futures markets can be used to hedge up to the yield guarantee implied in RP policies.
Mechanics of RP Insurance
RP is a revenue product that uses the higher of the projected or harvest price in setting its guarantee. The RP guarantee equals the Trend-Adjusted Actual Production History (TA APH) yield times the higher of the projected or harvest price times the coverage level. Payments occur when revenue is below the revenue guarantee, where revenue equals actual yield times harvest price. When revenue is below the guarantee, payment equals the revenue guarantee minus actual revenue.
Projected prices in 2012 are $5.68 per bushel for corn and $12.55 per bushel for soybeans. Harvest prices are averages of settlement prices during the month of October using the December 2012 contract for corn and the November 2012 contract for soybeans. Currently, prices on these contracts are higher than projected prices. In mid-July, the December corn contract is trading between $7.50 and $8.00 per bushel and the November soybean contract is trading between $16.50 and $17.00 per bushel. Harvest prices most likely will be above projected prices and RP's guarantees will be based on harvest prices.
When harvest price is above the projected price, RP essentially becomes yield insurance that makes payment when actual yield is below the TA APH yield times the coverage level. In these cases, the insurance payment equals the yield shortfall times the harvest price. Take, for example, a farm with a 175 TA APH yield and an 80% coverage level RP policy. This farm essentially has a yield guarantee of 140 bushels per acre (175 TA APH yield x .80 coverage level). If yield is 100 bushels per acre, this farm will get paid on 40 bushels, with the payment equal to 40 bushels times the harvest price. As long as futures price remain above the projected price, reductions in futures prices from current levels will result in lower insurance payments and vice versa. The possibility of lower prices leads to incentives to hedge up to the yield guarantee.