Put options on the futures market can reduce the risk of low hog prices, but some producers are uncomfortable using the futures market. A new pilot program in Iowa may provide those producers, and eventually others, with an alternative to options.

USDA will be reviewing a pilot program to test the prospect of price insurance on hogs. The program, proposed to start in July, would limit the downside price risk, while keeping opportunities open on the high price end.

"The insurance is essentially an exotic put option," says Bruce Babcock, Iowa State University agricultural economist. "This is an opportunity for producers who have considered buying options in the past, but have held back because of concerns about either their
broker's or their own ability to play the market."

The price insurance also has benefits not found on the futures market, says Babcock. For instance, the price insurance is available for six-month periods and it covers every month, not just certain contract months. The insurance can exactly match the quantity of hogs you have to sell, rather than having a pre-determined contract size. This lets you have a single contract rather than five or six contracts, says Babcock.

In addition to insuring the price of your hogs, the Iowa program would account for feed prices. So, you can protect the price of your hogs and hedge feed costs at the same time.

This program also has advantages over packer contracts, says Babcock. For one thing, the rates and premiums are reviewed by experts around the world, to insure that fair rates are available. This also allows you to understand how premiums and rates are set. Packer contracts have taken a different approach. Packer contracts typically limit your upside price potential, while the insurance will not.

The premiums that you pay to cover your insurance needs vary depending on your individual situation. The premiums are set by a formula using price levels at the beginning of a period (designated as Jan. 15 and July 15), price volatility for the next six months and your individual marketing plan. If your marketing plan has more hogs being sold toward the end of the six-month period, the premium will be higher because there is more price risk involved.

For example if you had 100 hogs to be marketed during February and the margin was $72.50 per hog, you would be guaranteed $7,250. (To see how margins are reached see sidebar.) Since all your hogs were sold in the first month of the coverage contract, the premium would be low, set at $156 or about $1.56 per hog, says Babcock.

However, if you had 100 hogs sold in early July, the premium would be $649 or $6.49 per hog to guarantee a total price of $85.01 per hog. Since the sale occurred in the last month of the coverage contract and is six months away, the premium is higher due to increasing price volatility. Babcock says the standard deviation from the expected price is nearly 25 percent as high one month into the contract as it is six months out.

The insurance would be offered through crop insurance companies. Any company that offers crop insurance will be allowed to sell livestock price insurance, but it's too early to know which companies will offer the options. Farm Bureau Mutual Insurance Co. and American Agrisurance have worked to help get the program approved, and both have said they will offer the livestock insurance when it is approved.

Coverage levels are available at 90 percent, 95 percent and 100 percent of the expected gross margin. The program will be offered only in Iowa at its inception, but pilot programs can be expanded fairly quickly, if there is interest in them, says Babcock.

He notes that a producer should look at his ability to withstand the downside of the price cycle, to determine if he needs price insurance. Babcock also says the program would not benefit anyone who's vertically integrated or has a close and detailed relationship with a packer.

This program is similar to all insurance in that most of the time you will pay the premium and hope you don't need to collect. However, when you do need it, you'll be glad you had it.

In 1998, this program would have paid out five times the premium collected. Of course, that's the exception. The premium is designed to break-even over time, but it may be worth considering as the market approaches another downturn in the price cycle.

Do the Math

The livestock price insurance program would allow you to guarantee your marketing margins for a premium. This program uses a formula that estimates your margin using the futures prices for hogs, corn and soybean meal.

For example, say the April lean-hog contract is $54.66 per hundredweight, corn futures are $2.13 per bushel and the soybean meal price is $164.80 per ton. John Lawrence, Iowa State University agricultural economist, estimates it takes 13.22 bushels of corn and 188.52 pounds of soybean meal to finish a hog at 250 pounds. Here's what this equation would look like:

(2.5 x 0.74) 54.66 – (13.22 x 2.13) – (188.52_2000) 164.80 = $57.43

In this example, your gross margins would be $78.73 per hog. Under the insurance program you would be guaranteed $78.73 per hog, if you had taken out full coverage, even if the hog's value dropped to $70. If the price of hogs rose, putting your returns at $85, you would get that price and the insurance would not come into play. At 95 percent coverage you would be guaranteed $74.79 per hog; at 90 percent coverage you'd get $70.86 per hog.