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Revenue Risk, Forward Contracting and Crop Insurance

Cory Walters and Richard Preston

Summary

The 2012 Kentucky corn crop was significantly reduced due to growing season high heat and dryness while at the same time prices move significantly higher. A number of Kentucky producers are experiencing very low yields with very high prices. However, in many cases this year, harvested yields have fallen below forward contracted levels, resulting in producers buying out those positions. This situation shows the importance of understanding the underlying price-yield relationship and the implications of having to buy back over-contracted yield.
Going into 2013 producers are questioning whether they have the right crop insurance policy, whether they should use forward contracts and how much cash flow is needed if they decide to use forward contracts.

We analyze the coefficient of variation around income by combining yield and price uncertainty with various crop insurance contract s and levels of forward contracting. Results indicate that forward contracting reduces farm income uncertainty up to a certain point (CV minimum). This is because reducing price uncertainty, after some point, increases yield uncertainty. Incorporating crop insurance, especially a revenue protection policy, is effective at reducing uncertainty once a certain level of forward contracting is used. Finally, risk protection, i.e., chances of financial distress, is analyzed with results indicating a very good return on reducing very low probability farm income events through crop insurance and marketing. We have created a case study to teach producers how the crop insurance decision and forward contracting work together to reduce income uncertainty.

Details

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