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 future.

'We should have thought of it a million years ago - in the nineties'

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.

Price Risk

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.

Production Risk

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 Answer?

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 flourishing.

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.


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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

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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.