Derivatives and Farming: Fate Brought Them Together
John Bohill (Junior Sophister)
Price support has been the prevalent method of subsidisation
of farmers' incomes over recent decades. A movement is underway,
however, to dismantle these protectionist structures. In this
paper, John Bohill examines the present treatment of risk in the
agricultural sector and looks at the prospects for a competitive
'We should have thought of it a million years ago - in
Samuel Beckett, Waiting for Godot
The Common Agricultural Policy (CAP) has succeeded for many years
in obscuring market realities from the average European farmer.
A cosy protective cushion has been placed around him, and he is
unwilling to let it go. However, with the reform of this function
of the European Union (EU), risk is about to re-enter the European
agricultural arena. This paper will outline these risks, and analyse
current methods for dealing with them in existing free-market
systems. Actuarial and financial advances suggest new avenues
in the search for risk hedges in agriculture; these will be evaluated.
Finally, implications for a newly unstable EU farming market and
the resulting impact on Irish farmers will be proposed.
Farming - A Risky Business
'Risks to farm revenues come from two sources: prices
and yields. When both prices and yields are insured, so is the
product of the two, farm revenues.'
President Clinton, Economic Report to Congress, February 1995
[quoted in Financial Times, February 15th 1995]
In the absence of all support, the farmer absorbs, over a substantial
time-period, all the uncertainties in getting the seed to harvest.
This may be mostly contingent on weather conditions, since the
farmer may eliminate other risks through diligent work in the
fields. However, it has often been seen that a farmer cannot rely
on hard work alone, and so must provide for risk. This paper divides
price and product risk in the following terms.
Consider a farm producing corn, which has just experienced frost
and has 25 percent damage. If all farmers - or even a significant
area producing corn - face the same turn in the weather, the price
will be positively affected (the quantity supplied has gone down,
assuming normal demand-supply characteristics). Of course, not
all farmers face the same weather conditions, and so our farmer's
future income clearly depends on its relative producing performance
over the year. Weather movement is a stochastic process: its value
changes over time in an uncertain way. It is generally accepted
that the farmers trade is in growing corn, and not in risk/return
economics; he would therefore attempt to remove the stochastic
variable from his income calculations. Strategies for doing this
are explained below.
Complete inability to produce in a specific area due to 'acts
of God' must be treated differently, even though it may
be considered an extreme form of 'price risk'. Since
nothing is supplied, the level of price is irrelevant; the farmers
income is nil. The 'production risk' comes under the
umbrella of conventional insurance, since the occurrence of such
catastrophes is rare, but the consequences are sometimes vast
(as seen in the Netherlands recently). Low risk, high (negative)
return occurrences must have policy implications also, since the
welfare of the nation could be at stake. The potato famine for
example, whilst a repeat occurrence is implausible for other reasons,
has important lessons for modern agri-business.
To sum up, therefore, if it is assumed that it is in the farmers
interest to remove stochastic variable from his income, we may
proceed to develop policy on this basis.
Existing Treatment of Price Risk
The Common Agricultural Policy (CAP) has been the major form of
price support (and by association, income support) for the farming
community in recent European history. It has been a considerable
drain on resources, and has almost driven the Community to bankruptcy.
Its budgetary weight is a result of the European love affair with
the pastoral culture, and it is only in recent years that reason
has been heeded. The reforms proposed in 1992 promised a reduction
of 30 percent in guaranteed farm commodity prices over three years,
to be compensated by area aid, which would be unrelated to production.
Since then, results have been promising: British farmers have
seen an increase in real income of 15 percent since the mid-eighties,
stocks of beef and arable land have decreased, and there was a
budget surplus at the end of 1994. Despite a large drop in prices
in 1993, the stabilisation achieved last year is set to continue.
The foreseen hike in expenditure by the Agricultural Department
of the Commission is mostly due to the enlargement of the Union.
The picture of reform may seem promising, for both farmers and
taxpayers. However, in the case of UK farmers, some of the increase
in income may be derived from the devaluation of Sterling, since
they receive their support payments in ecu. Greater structural
change is needed. Efficient farmers produce too much, while those
who would be pushed out in a competitive market are encouraged
to remain. In 1991, 80 percent of the support funds were going
to 20 percent of the farming community, showing a scheme flawed
in its welfare implications. Land set-aside projects, tax co-responsibility
levies, and the lowering of inflation-adjusted support payments
only remove farming from market realities. Similarly, the movement
from price support to direct payments per area farmed, or livestock
quality owned serve only to place the burden of subsidy on the
taxpayer, rather than the consumer.
In the United States, price supports are also under attack. This
year Congress cut US Dollar10 billion of the budget, and in polls,
tax-wary farmers have even welcomed reforms (only 37 percent of
them are in favour of the current system). Most observers believe
it would be cheaper to guarantee 70 percent of normal crop revenues:
a saving of US Dollar4.2 billion over five years is estimated.
Since the subsidy overhaul, there has been no decline in farm
income. However, a more graduated re-structuring of the industry
is taking place. Production is more centralised and more idle
land is used. Farms are diversifying and an increase in grain
exports is expected.
There are already price guarantee techniques in place in the US
which require no intervention. Futures and option are traded on
the Chicago Board of Trade (CBoT), the Chicago Mercantile Exchange
(CME) and the New York Mercantile Exchange (NYMEX) based on agricultural
denominators. All are sufficiently liquid - the CBoT is the world's
largest exchange - to be a viable replacement for price supports
for the farmer. Consider again our corn farmer. If he wishes to
hedge risk for his September harvest, he may go short on 5000
bushel futures contracts at CBoT. The selling price is pre-set,
with an obligation to transact on the settlement date. Alternatively,
he may put a long option on corn. If the price is lower than the
selected strike price at September (a 'European' option),
he will receive a cash premium. If the price is significantly
higher, he may decide not to exercise his option, and receive
the higher market price regardless.
Under multilateral agreements derived from the Uruguay round of
GATT, a world market price for commodities is on its way. Export
subsidies on the EU side will disappear, and the market-influenced
regime of the United States should begin to step in. It is therefore
likely that 'conventional' derivatives will enjoy greater
prominence in European markets, and liquidity should improve.
Farmers and farming groups/co-ops should understand the technology
prior to this, ensuring a painless transition.
Existing Treatment of Production Risk
There have been significant bubbles in the re-insurance markets
in the past. Lloyds has exposed its 'names' to risks
of which they have been ignorant and the government is frequently
called in as a re-insurer of last resort, when the market breaks
down. It has been well-documented that people generally under-estimate
the risk of catastrophe, and so never 'get round' to
insuring themselves. The government, which is sometimes seen as
an outside benevolent trust, face pressure to move in and 'bail
out' the unfortunates. On the other side of the Atlantic,
Congress now requires farmers to have United States Department
of Agriculture (USDA) insurance, before any price support is paid.
This will increase crop insurance liabilities in existing re-insurance
markets from US Dollar13 billion to US Dollar40 billion. The
need for re-insurers is greater but they cannot be found, except
behind the closed doors of Lloyds. In some instances in 1993,
farmers were grossly under-insured for catastrophes. As a result,
the USDA decided to give aid to farmers with insurance losing
35 percent of their crop, and to those without insurance losing
40 percent. The corruption caused by such governmental aid schemes
has also been cause for alarm: in Georgia, for instance, it was
found that farmers sat on their own compensation committees! It
has therefore been necessary for the Government to search for
an adequate escape route.
The market-based solution has been a long time coming. On October 18, 1994, the committee of CBoT agreed on the wording of a new kind of contract, to be termed 'area yield options contracts'. There would initially be four
contracts traded: Illinois soya bean, Iowa corn, Kansas winter wheat, and North Dakota spring wheat, based loosely on what are known as 'Catastrophe
Insurance Contracts'. The catastrophe contracts are priced according to a
loss ration based on accumulated claims calculated by the Insurance Services
Office (ISO). If the loss ratio moves up by 1 percent, the settlement price (thevalue of the contract) for each contract goes up by US Dollar250. Despite a
slow start, the contracts are now enjoying steady growth, with six thousand
contracts traded between May and September 1994. This figure is ten times that
traded in 1993. Richard Sandor, the derivatives guru, has said that the form
'is past its infancy and is starting to grow' [quoted in Financial Times, September 8th, 1994]. A shortfall in liquidity is to be
overcome with modification of the contract. Since damage claims are often
unquantified until a year after the catastrophe, there is a move to change the
contracts to yearly, rather than the conventional three month period. This change should attract more of the over-the-counter (OTC) market, which is currently
The techniques learned from the above contracts are to be applied
to crop insurance. A holder of such an 'area yield option'
would select a strike yield, rather than strike price, say 100
bushels of corn per acre. A put would therefore net the holder
a cash payoff if the actual yield was below this figure. Presumably,
existing option pricing techniques would only require minor modification
to be applied here. CBoT and the USDA are counting on the concentration
of the agriculture to form the basis of the success of the contract.
If railroads, co-operatives and processors are dependent on the
location of crop growth, then it will also be in their interest
to trade. The hope, then is that the straining insurance market
could find a new avenue in distributing production risk: there
may be more 'players' in underwriting.
In an intervention-free world, farmers' income is to a large extent
outside their control. Existing remedies for this uncertainty
have all but bankrupted governing bodies. Hence, there is a large
movement away from bureaucracy, and a growing reliance on market-based
solutions. Agricultural risk is conveniently divided between price
and production risk. The former already has a large market devoted
to dividing risk among willing parties in the United States, namely
the commodity futures and options exchanges. There will be an
inevitable move towards this system in Europe as we search for
CAP substitutes and enter a world trading under the jurisdiction
of the World Trade Organistation. Production risk, however, does
not have a proven market-traded solution. The emergence of derivatives
finance has inevitably led to a possible candidate. The initial
trepidation which led CBoT to postpone the launch, has become
optimism due to the forthcoming Republican Farm Bill (1995). The
exchange has thus decided to move ahead with the launching of
one of the contracts, Iowa corn, later this year. Only time will
measure its usefulness, but the logic is unquestionable.
The implications for the Irish farmer will be twofold, and will
occur at different times. As the price support mechanism of CAP
evaporates, world futures and option quotations will become more
pertinent in the lives of farmers and co-operatives. Secondly,
the doubts places over Lloyd's ability to police world insurance
coverage mean a broader market is needed, one which is independent
of tax-sensitive voters. The Area Yield contract is positioning
itself in an immature market prior to these structural changes,
but its eventual global impact could be enormous.
Chicago Board of Trade : Commodity
Trading Manual, Chicago, 1989
Hull, John C.: Options, Futures and Other Derivative Securities, 2nd edn., Prentice Hall, New Jersey, 1993
Matthews, A.: 'Agriculture and Rural Development' in The Economy of Ireland, by John W. O'Hagan (ed), IMI, Dublin, 1991.
The Economist February 11th, 1995: ' Old MacDonald had an Option', London
Financial Times February 14th 1995: 'Blowing Britain's Animal Welfare Trumpet', London
Financial Times, February 15th 1995: 'Brussels Upbeat on
Farm Policy Reforms', London
Financial Times, November 16th, 1994: 'Survey of Derivatives-Reaping Rewards from Catastrophes'
Financial Times, July 14th 1994: 'CBoT Hopes for Big Yield in Crop Insurance Futures', London
Financial Times, September 8th 1994; London
International Business Week, January 9th 1995: 'Full Granaries Don't Mean Full Pockets', McGraw-Hill, New York
International Business Week, January 9th, 1995: 'For Swingers Only - A Wild and Crazy Market', McGraw-Hill, New York
Wall Street Journal, November 21st 1994: 'The Outlook - Some Farmers Favour Ending Crop Subsidies', New York.
Wall Street Journal, August 8th, 1994: 'House Passes Bill
to Cut Farm Disaster-Aid Costs', New York.
Wall Street Journal, October 21st, 1993: 'Disaster Aid Helps Some Even Without Insurance', New York
Wall Street Journal, October 31st, 1994: 'Aid Raid - Crop
Disaster Program has Georgia Farmers Raising Lots of Squash' New York.