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Private agricultural options and government price supports.

The federal government has actively attempted to stabilize and increase farmers' incomes for well over half a century. Despite a dramatic acceleration in federal expenditures to assist farmers in the last decade, primary producers continue to fail in record numbers. These problems together with the persistence of federal budget deficits have focused considerable interest among policy analysts on federal agricultural support programs. Some even suggest that government programs be substantially reduced or eliminated and replaced with private market arrangements to deal with primary producers' exposure to price and income risk. Encouraging producers to use hedging instruments like options contracts is one such alternative.

The primary purpose of this paper is to examine the relationship between newly available agriculturally based options contracts and current government guarantees to producers. To do this, the authors examine the costs of current price support programs which have initiated this debate. Then trends in the use of private agricultural options are examined. Finally, the problems associated with substituting put options for price support systems are evaluated.

The introduction in 1984 of options contracts based on primary agricultural commodities offered farmers and other industry participants an alternative method of managing the risk associated with unstable price. Agricultural options had been legally banned since the 1930's due to a lack of effective regulation. Their reintroduction was related to the popularity of these financial instruments in other fields and the general trend to deregulation and greater reliance on market arrangements during this time period. Agricultural options instruments were promoted as a way to improve efficiency in agriculture by facilitating more effective price risk transfer. However, the difficulties experienced by farmers in the last decade and the high cost of existing government farm support programs have given rise to serious evaluation of long run policy alternatives. Some argue that agricultural options could provide the basis for substantial deregulation of agriculture and reduced government involvement while providing price and income risk protection for farmers.

At the time of their introduction the U.S. farm sector, like most basic commodity industries, was highly depressed due to both industry specific factors and general macroeconomic forces. Deteriorating international marketing conditions and a highly overvalued dollar in foreign exchange markets, financial market instability and high interest rates, exposed most primary producers to extreme uncertainty even by the historic standards of these volatile industries. These severe problems and the federal government response swelled federal government agricultural support expenditures.

The current recovery in international demand and the reduction in surplus stocks has improved conditions in U.S. agriculture and modestly reduced government financial outlays to support agriculture. Nevertheless, political concern with federal government budget deficits continues to make agricultural subsidies a likely target of budget cutters. These concerns have created an environment conducive to change. For example, recent farm bills further reduce federal farm support expenditures and signal continued concern about the cost of existing programs. Given our historic commitment to stabilizing farm incomes, cheaper and possibly more efficient alternatives to current farm programs merit interest. These goals require innovation with respect to dealing with market risk. [TABULAR DATA OMITTED]

Social Costs of U.S. Agricultural Price Supports

Federal government involvement with agriculture began with the Agricultural Act of 1933. While the focus of agricultural programs changes periodically, these programs include price support and target price systems, deficiency payments, acreage diversion and storage arrangements, and various types of income maintenance programs. A more complete review and evaluation of government's role is provided by [3,4,18].

Federal government expenditures to stabilize commodity prices and farmer income are provided in Table 1 for the time period 1980 through 1988.[1] This table shows total government spending on all USDA functions as well as the spending for Federal Farm Income Stabilization policies. In 1980, $34.8 billion was spent on farm income stabilization. By 1986 total USDA spending was $58.7 billion with approximately fifty per cent for income stabilization programs.

The federal stabilization outlays depicted in Table 1 are based upon government commodity target prices and Commodity Credit Corporation (CCC) loan rates. Target prices are generally set by government policy makers at levels to yield sufficient income to primary grain producers. Loan rates, on the other hand, are the prices at which primary producers can borrow against their commodities from the government. In the mid-1980's loan rates for wheat and corn and other crops were lowered dramatically in order to reduce government surplus stocks acquired in earlier years because of excessively attractive loan rates. Further, the goal was to improve the competitive position of U.S. agricultural producers in world grain markets which had badly deteriorated in the first part of the decade.

To make these changes acceptable to the farm community, income transfers to farmers were geared to the difference between the set target prices and substantially lower cash market commodity prices. Farm producers received the difference in direct 'deficiency' payments. These policy changes, while highly successful in lowering market prices and reducing commodity stocks under government control, resulted in substantial increases in government expenditures.

Other revealing dimensions of the problems with U.S. agriculture and government support programs are shown in Tables 2 and 3. These tables provide data for the decade of the 1980's on the number of farms, farm incomes and the costs of the federal farm programs. Table 2 indicates that the number of farms declined by almost 10% between 1980 and 1988 despite record subsidies during this period. This represents a continuation of the secular declining trend in farm employment.[2] Productivity growth in the agricultural sector coupled with very low price elasticity and income elasticity of primary product demand has resulted in continuous declines in the number of farmers. During the 1980's highly leveraged producers, generally the newest entrants into farming or those who expanded too quickly, failed in record numbers. These farm failures threatened the entire farm credit system and required a federal bailout similar to the much better publicized Savings and Loan bailout.

Despite these serious problems farm income actually increased during this time period, but growing amounts of this net income was related to direct government support payments. Table 3 indicates that average net income per farm peaked in 1987 at $25,909. While the distribution of payments to farmers varies based on farm size, overall farm dependency on the government had dramatically increased. Only four percent (or $528) of net farm income was from government payments in 1980. By 1987 thirty percent (or $7,727) of average net farm income was from government payments.

The high costs associated with federal guarantees and subsidies, the increased dependence of farmers on these programs, and the continued decline in the number of farmers has focused the attention of critical analysts on reforming current programs. Many critics of current arrangements argued that government involvement in agriculture is a primary cause of these reoccurring problems in this sector. Repackaging and adjusting existing programs fails to address current problems. Further, farm policy changes are often implemented without concern for their overall economic effects. Given our historic concern with farm income stability, the need exists for investigating and developing more efficient mechanisms of dealing with producer exposure to price and income risks. The next section of the paper deals with options contracts on agricultural commodities which some believe could be useful in providing price risk protection to farmers and thereby providing the basis for further deregulation of agriculture. [7,19,22] [TABULAR DATA OMITTED]

Trends in the Use of Private Agricultural Options

Modern agriculturally based options contracts began in 1984 after new rules of conduct were approved and implemented. Options contracts can either be put or call options. A put option conveys the right, but not the obligation, to sell the related commodity at a specified price referred to as the strike price on or before a set date in the future. Call options convey the right to buy the underlying real asset. Both put and call options trade simultaneously at several different strike prices and expiration dates. Option buyers pay the writer or seller of the option a premium for this option contract and their financial risk is limited to the premium paid to the seller.

Producers who hedge with put options insure some minimum price for their commodity. Should market prices of their crops decline, the value of their put option would increase and offset the revenue declines experienced in the cash markets. Unlike futures contracts or privately arranged forward sell contracts, the options instrument yields the opportunity to benefit if favorable price movements should occur before the contract expires. If the market price of the underlying agricultural commodities rise, producers who hedged with put options would not exercise the option and would take advantage of more attractive market prices.

Another attractive feature of the options contract is that in the event of crop failure, the put option does not obligate the producer to make delivery. This eliminates the output risks associated with crop failure which could inhibit participation in alternative hedging programs like futures contracts or privately arranged forward contracts. These, and other characteristics of options contract makes them relatively attractive to potential hedgers.[3]

The size of the option premium paid by the options buyer reflects all available market information about future prices of the underlying commodity. The greater the probability of a price decline or the greater the uncertainty about future cash market prices, the higher the price of the put option. The theory of options price determination is based on the work of Black and Scholes [1], Black [2] and others and will not be repeated here. In general, these authors demonstrate that the option price or premium is a function of the time remaining to expiration or the time value of the option, the price volatility of the underlying commodity, and other characteristics of the options contract.

While agricultural producers and other holders of inventories would generally hedge with the purchase of put option contracts in order to protect against price declines, a variety of more complex hedging strategies are possible with the options instrument.[4] In general, a farmer would purchase put option contracts early in each production period and offset or sell his positions after production and marketing decisions were completed. The number of contracts purchased must cover all or a substantial portion of the 'expected' output. The effectiveness of the option hedge does not imply that producers would receive higher prices for their output on average. Stabilizing year to year prices and eliminating excessively low prices would be sufficient to justify hedging for risk averse producers.

The attractive features of put options appears to make them preferable to producers than alternative hedging instruments like forward selling contracts or futures contracts. However, the general acceptance of hedging instrument by agricultural producers and holders of inventories is not clear. Trading volume of both options contracts and the related futures contracts for several commodities has grown substantially in the 1980's but publicly available data does not differentiate between hedging and speculative activity. Speculative activity in these financial instruments is very attractive due to the high amount of leverage associated with low margin requirements. Speculation, while vital in providing liquidity to these financial instruments, has always been a topic of concern to primary producers and their representatives.[5]

Put Options and Government Price Supports

Given the uncertain nature of both supply and demand conditions in agriculture, primary producers are continuously exposed to revenue risk. The revenue risk is associated with both price and output uncertainty. Revenue uncertainty can be conceptually described with a probability distribution which specifies the probability associated with receiving different levels of revenue in any given production period. Government support programs attempt to eliminate undesirable revenue outcomes and reduce revenue risk. Additionally, government programs often try to shift the entire probability distribution of revenue outcomes to more favorable ones.

An insightful approach is to view current government support programs, aimed at stabilizing producer prices and revenues, as implicit put option arrangements. For example, Marcus and Modest [17] indicate that the price support system can be interpreted as providing put options to the program beneficiaries. Government loan programs allow producers to take advantage of either the cash market or support prices for their output. Producers' use of these programs does not prevent repayment of government loans should market prices become more attractive. If cash prices decline below loan rate prices, the government bears the risk since producers are not required to repay the outstanding loans and the crops are defaulted to the government.

This implicit put option feature of the government support programs is provided free or at some minimum cost associated with compliance in acreage divergence programs. The cost to the government of these guarantees are not known until market prices of the underlying commodities are determined. On the other hand, private market put options are only available at premiums which can be substantial to compensate private risk takers. These premiums are paid by the purchaser of the put option contracts who hedges his output.

Further, government support programs are frequently used to influence cash market prices or to transfer income to primary producers. Options markets on the other hand do not generate cash market prices that differ from market conditions. Relatedly, private options contracts expire within a relatively short period of time while government support programs provide longer term price and income guarantees. However, when cash market conditions remain depressed for an extended period of time, government policy makers can and have lowered loan rates in order to reduce surplus stocks. As discussed earlier, recent farm bills have lowered loan rates and thereby market prices in order to improve international marketing conditions. This resulted in lower and more competitive grain prices but historic levels of government outlays to farmers.

Finally, while farmer purchases of put option contracts in any single year would be similar to the risk transfer and price stabilization effect associated with government support programs, the exercise prices attached to put option contracts vary dramatically from year to year. Gregorowicz and Moberly [9] demonstrated that inter-season put option prices are as volatile as the prices of the associated commodities. Constant year to year exercise prices for the put option contract could only be made available at exorbitant premiums in years of low agricultural prices. Hedging with put options in order to reduce price risks is only effective between the time the contract is entered into and the time the contract is liquidated or expires and the crop is sold. Therefore, the options instrument provides only short run price protection.

The turbulence in agricultural markets in the past decade and the severe criticisms aimed at current policy encouraged the Department of Agriculture to sponsor studies investigating the efficiency of private risk shifting arrangements like options. A study by Irwin et al [15] simulated the effects of existing programs and a variety of options hedging programs on producer revenue, consumer costs, and taxpayer costs in the U.S. corn market. Their results suggested that options based programs may be attractive candidates for replacing existing programs since they provide revenue protection at lower costs to taxpayers. However, these results were based on a number of highly restrictive assumptions. Further, the study concluded that producers are able to manage only short run price risks with options hedges.

Given these factors, private options contracts are definitely not as attractive to most primary producers as current government support programs. Schertz [22], Leorn [16], Marcus and Modest [17] offer suggestions to integrate private options with current government programs. For example, the government could subsidize the purchase of put options by farmers. Support payments to small farmers could be geared to the costs of the put options premiums. Additionally, education programs dealing with marketing strategies and risk management techniques could encourage participation in private hedging arrangements.

Alternatively, the attractiveness of private market put options could be increased through higher compliance costs for participation in government support programs. A premium could be imposed on the implict put option risk transfer feature of government programs. This would force participants to pay for the benefits received.

Large scale producers who are only marginally attracted to current government programs could be completely weaned from government support programs. Larger producers generally use more sophisticated marketing strategies which incorporate risk management techniques. These producers currently are more likely to use the options markets and other hedging tools in their attempts to stabilize revenues and plan production.

A number of other strategies could be devised to alter current cost and benefits of option contracts as risk management tools and government support programs. The willingness of policy makers and the agricultural industry to reduce government's role in influencing resource allocation, prices and producer incomes is the central issue in this choice.

Conclusion

The persistence of large federal government budget deficits and the reoccuring crises in agriculture continue to force an examination of alternatives to current government price and income support programs. The high cost of current support programs, increasing farmer dependency on these programs, and the continued decline in the number of farmers are exposing the serious shortcomings of current arrangements. Given our historic commitment to stablizing the incomes of small farmers, a critical need persists for developing cheaper and more efficient mechanisms to deal with producer exposure to price and income volatilty. Put option contracts on agricultural commodities offer risk transfer and price stabilization effects similar to those of government support programs. Encouraging farmer use of these hedging instruments could provide the basis for reduced government involvement in agriculture.

Endnotes

(1.) For historic expenditures data going back to the 1930's, see Rapp [21].

(2.) Daly [6] provides long term historic data on farm employment.

(3.) For a complete analysis of agricultural option contract characteristics see Hoffman et all [12] and Gardner [7].

(4.) More complex alternative hedging strategies are discussed by Paul [20], Houser and Eales [13], and Houser and Anderson [14].

(5.) A recent book by David Greising and Laurid Morse [10] provides an entertaining but informative review of the historic and recent speculative excess in these and related markets.

References

[1.] Black, Fisher, and Myron Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, Vol. 81, No. 23, May/June 1973, pp. 637-654.

[2.] Black, Fisher. "Pricing of Commodity Contracts," Journal of Financial Economics, Vol. 3, No. 1, Jan./Mar. 1976, pp. 167-169.

[3.] Carter, Harold. "Agricultural Policy at the Cross-Roads--Again, Contemporary Policy Issues, Vol. 4, No. 1, January, 1986, pp.48.

[4.] Cochran, Willard. "The Need to Rethink Agricultural Policy in General to Perform Some Radical Surgery on Commodity Programs in Particular," American Journal of Agricultural Economics, Vol. 67, No. 5, December 1985, pp. 1002-1009.

[5.] Curtis, Charles E. Jr., Kandice Kahl and Cathy McKinnel. "Risk-Efficient Soybean Marketing: The Contribution of Commodity Options to the Producing Firm," The Review of Futures Markets, Chicago Board of Trade, Vol. 6, No. 2, July 1987, pp. 176-190.

[6.] Daly, Patricia, A. "Agricultural Employment: Has the Decline Ended," Monthly Labor Review, 104, no. 11, November 1981, pp. 11-17.

[7.] Gardner, Bruce. "Commodity Options For Agriculture," American Journal of Agricultural Economics, Vol. 59, No. 5, December 1977, pp. 986-999.

[8.] Gregorowicz, Philip and H. Dean Moberly, "Speculative Risk Transfer Instruments, Agricultural Options: Historic Record and Future Prospects," Journal of Economics and Finance, Vol. 13, no. 2, Summer 1989.

[9.] Gregorowicz, Philip and H. Dean Moberly, "Agricultural Options As a Risk Management Tool," Mid-American Journal of Business, Vol. 6, No. 1, Spring 1991, pp. 51-57.

[10.] Greising, David and Laurid Morse, "Brokers, Bagmen and Moles, Fraud and Corruption in the Chicago Futures Markets", John Wiley and Sons, NY. 1991.

[11.] Hoag, James. "The Valuation of Commodity Options," Options Pricing: Theory and Application, (Menachem Brenner, ed.) Lexington Books, Lexington, MA, 1983.

[12.] Hoffman, Linwood, Richard Heifner, and Gerald Plato. "Effects of Commodity Options on Crop Producers' Revenue Risk: Implications for Lenders," Agricultural Income and Finance: Situation and Outlook Report, U.S. Depart. of Agriculture, Sept. 1988. pp. 37-43.

[13.] Houser, Robert and James Eales, "Option Hedging Strategies," North Central Journal of Agricultural Economics," Vol. 9, No. 1, Jan 1987, pp. 123-134.

[14.] Houser, Robert and Dane Anderson, "Hedging with Options Under Variance Uncertainty: An Illustration of Pricing New Crop Soybeans," American Journal of Agricultural Economics, February 1987, pp. 38-45.

[15.] Irwin H. Scott, Anne E. Peck, Otto Doerinf III, and B. Wade Brorsen, "A Simulation Analysis of Commodity Options as a Policy Alternative," in Options, Futures, and Agricultural-Commodity Programs: Symposium Proceedings, Bruce H. Wright, editor, Commodity Economics Division, Economic Research Service, U.S. Department of Agriculture. Staff Report No. AGES870911, February 1988, pp. 60-71.

[16.] Leorn, Elmer. "Agricultural Price and Income Policy: A Need for Change," Contemporary Policy Issues, Vol. 4, No. 1, January, 1986, pp. 49-61.

[17.] Marcus J. Alan and David Modest, "The Valuation of a Random Number of Put Options: An Application of Agricultural Price Supports," Journal of Financial and Quantitative Analysis," Vol. 21, No. 1, March 1986, pp. 73-86.

[18.] Moberly, H. Dean. "An Evaluation of Three Proposed Program Designs for the 1985 Farm Bill- A Comment," MidSouth Journal of Economics and Finance, Vol. 9, No. 4, April 1986, pp. 370-39.

[19.] Pasour, E.C. Jr., "Price Support Programs For U.S. Farm Products: A Deregulation Opportunity," Madison Paper Series, The James Madison Institute, Tallahassee, FL, 1988.

[20.] Paul, Allen, Richard Heifner, and Douglas Gordon. "Farmer Use of Cash Forward Contracts, Futures Contracts, and Options," Agricultural Economic Research Service, U.S. Department of Agriculture, May 1985.

[21.] Rapp, David, How the U.S. Got Into Agriculture And Why It Can't Get Out, Congressional Quarterly, Inc., Washington, D.C. 1988.

[22.] Schertz, Lyle. "Agricultural Options and Price Supports: Competitive or Compatible?" Agricultural Economic Research, Vol. 37, No. 2, Spring 1985, pp. 27-30.
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Author:Gregorowicz, Philip; Moberly, H. Dean
Publication:Review of Business
Date:Jun 22, 1992
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