What is in this article?:
The final feature discussed – harvest price – is a constructed average price available at the approximate time of harvest and is used to settle insurance contracts against a standard price thought to be applicable for a broad set of marketing purposes, and serving as a reasonable index for the price of crops actually grown that year. It is constructed by averaging the settlement prices for the December corn and November soybean futures contracts during the month of October, under a process similar to that for the establishment of the projected prices.
Option contracts expire at different dates however, and thus the implied volatilities taken from option prices must be adjusted to be proportional to the interval of time over which the crop insurance is in force. By convention, the middle of the harvest price monitoring period is used to define the end of the option volatility interval.
The technical approach to correct a longer-dated implied volatility is first to square the implied volatility, then multiply by the proportion of time between the date observed and the middle of the harvest price month compared to the overall implied volatility interval, and then takes the square root to convert back to a measure with a natural interpretation as the standard deviation during the insurance window. The final volatility factor used in premium setting applications is then constructed by averaging the result of this process over the final five trading days of February (rather than the entire month), rounded to two digits.
For illustration, if the projected prices and volatility factors were established at this moment on Feb. 1, they would result in the use of the implied price distributions shown in figure 1 below. Table 1 that follows provide implied probabilities associated with various percentiles. For example, that the market views that there is a 25% chance that corn (soybean) futures prices will be below $4.96 ($11.65) on average in October, and that there is a 25% chance that they will be above $6.74 ($14.85) at that time. Other values can likewise be identified that correspond to areas under the curves shown in the figure. Of course, the specific values will change as the prices evolve in February, but the concept remains that the insurance costs reflect the possibilities of different outcomes weighted by their implied likelihoods in a manner as shown in the table and figures below.
These are simply starting values or initial estimates of the projected prices and volatility factors that will be fully determined during the month of February. Changes during the month are particularly important for at least two reasons. First, the average may differ from the futures prices that exist and are available for market planning by the end of the month. For example, suppose prices trend steadily upward during February and the resulting average projected prices used to establish insurance values are below the current futures prices around March 1. In that case, there is already an increased likelihood that the harvest prices will be higher than the projected prices and insurance products that include harvest price options for guarantee increases are therefore relatively more attractive.
If, however, prices generally decline in February, then the projected price will be above the market's estimate of actual value and the use of insurance will start somewhat more "in the money" or more likely to result in payments. Secondly, the prices and volatilities can have large impacts on the premiums paid and the guarantee levels available for insurance.