Hedging Using Futures Markets
With RP insurance, futures contracts can be used to hedge up to the TA APH yield times the coverage level, with the offset for hedging changes coming from a combination of changes in crop revenue and insurance payments. This will be illustrated in the following situation:
- RP crop insurance for corn has been purchased at an 80% coverage level
- The TA APH yield is 175 bushels
- The cash price in October will be 10¢ below the October futures price
- The October futures price will be the harvest price for the RP product
- Hedging will occur at 140 bu. (175 bu. TA APH yield x .80 coverage level)
- The current December contract price is $7.80
- Actual yield will equal 100 bu.
December corn contracts are sold now so that 140 bu./acre are hedged at $7.80/bu. These futures contracts will be purchased in October. Gains and losses are illustrated for a case in which the December contract is $1 lower at $6.80/bu. and $1 higher at $8.80/bu.
$6.80 futures price: At a $6.80 futures price, revenues from cash sales, crop insurance and hedging gains or losses are:
- Crop revenue equals $670/acre (100 yield x $6.70 cash price (10¢ below futures price))
- RP payments equal $272/acre (40 bu. shortfall x $6.80 settlement price)
- Hedging gain equals $140/acre (140 bu. x ($7.80 sale - $6.80 purchase))
- Total revenue is $1,082/acre ($670 crop revenue + $272 RP payment + $140 hedging gain)
$8.80 futures price: At an $8.80 futures price, the following revenues occur:
- Crop revenue equals $870/acre (100 bu. yield x $8.70 cash price (10¢ below futures price))
- RP payments equal $352/acre (40 bu. shortfall x $8.80 settlement price)
- Hedging gain equals -$140/acre (140 bushels x ($7.80 sale - $8.80 purchase))
- Total revenue is $1,082/acre ($870 crop revenue + $272 RP payment - $140 hedging loss)
In both cases, revenue is that same at $1,082. Hedging the entire APH now will lock in the sum of crop revenue and the insurance guarantee. Note that the actual yield does not have much impact on total revenue. Lower yields than those illustrated above will result in lower crop revenue and higher RP payments and vice versa. Slight differences in revenue as yields are lowered exist because of the basis between the cash and futures prices.