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Will the Shorten Price Discovery Period Prevent the Combo Policy from Offering Revenue Coverage?[1]

Introduction.  The shorter measurement period is more likely to affect lightly traded contracts such as wheat.  The winter wheat Combo requires a minimum of 8 trading days excluding limit move days during the period September 1 through September 15 based on the following rule.

1. Definitions

Additional daily settlement price—Daily settlement prices for full active trading days based on the contract immediately prior and immediately following the appropriate commodity contract, or the contract immediately prior to the appropriate contract, provided the substitute contract(s) are within the same crop year. These prices are used to establish the projected and harvest price when at least 8 average daily settlement prices are not available (Federal Register / Vol. 71, No. 135 / Friday, July 14, 2006 / Proposed Rules, p. 40202).

There must also be a minimum open interest of 25 contracts or substitute the prior future contract prices if there are no approved prices based on the above rule.  For example if the September contract has less than 25 contracts then one would use the approved July futures prices. 

In addition, there must be at least 1 open interest option at the money during the 5 trading days prior to September 16 for setting the volatility.  If unavailable, one would assume RMA would use the volatility from the prior contract or from a similar market, i.e. substitute Chicago volatility for Kansas City.  In the past they did substitute Chicago for Kansas City when the KCBOT at the money wheat option did not trade.  However, I do not find anything in the propose rules that specifies the substitution procedure if the option is not trading.  It was suggested the substitution procedure for prices would also apply to options but if it is not clearly defined then legal opinions may prevent the option price substitution.  As written, one could clearly interpret the substitution rule as futures prices only and not option prices.

Testing the 2 Week Price Discovery.  To test the Combo policy method for setting the revenue price election, the 2002 wheat contract was selected.  The 2002 winter wheat base prices were set during the 911 event when the market did not trade for two days (tables 1 and 2).  In a “normal” year there would have been only 9 trading days between September 1 through September 15.  Because of the Labor Day holiday combined with 911 closures there were only 7 approved prices during this period, as result there would have been no approved price for July wheat and under Combo no revenue insurance offered to winter wheat growers, including Kansas unless the rules would allowed the price from August 31, 2001 to be used.  There appears to be no procedure for measuring prices outside of the September 1-15 time period unless the follow rule allows it.

(c) Additional daily settlement prices will be derived beginning with the latest date defined by the applicable projected price or harvest price definition not qualifying as a full active trading day (Federal Register / Vol. 71, No. 135 / Friday, July 14, 2006 / Proposed Rules, p. 40202).

It is really unclear if this rule would allow RMA to use the price from August 31, 2001 in the base price calculation for 2002 winter wheat.

The KCBOT September futures will be used to set the base price for Nebraska wheat under the Combo policy.  The September 2002 contract for both Kansas City and Chicago did not have 25 open interest contracts so there were no approved prices.  RMA would have substituted July approved prices but there were only seven approved prices and does not meet the minimum number of 8 approved prices unless the above rule would allow inclusion of the August 31, 2001 price (tables 1 and 2).

Option Price Also Required.  Clearly there would have been no September at the money option open interest for setting the volatility, which is also a Combo requirement.  The KCBOT July 2002 at the money wheat option contracts also had no open option interest and therefore no approved base price for winter wheat states based on Kansas City[1].  The CBOT data was not available for checking on the July at the money option open interest.  If there were July wheat options trading in Chicago, it is possible RMA could have substituted the Chicago volatility for Kansas City but that was not specified in the proposed rules.

How Much Information is Provided in a “Thinly” Traded Option?  There is really little reason, if any, not to select the next contract with an at the money option trading to estimate volatility if the September or July at the money option are not trading.  People continue to assume there is an option in the CRC/RA coverage.  CRC was never designed to compete with options but was created as a complement to futures and options. 

The RMA volatility measure for RA is based on American options that contain the right to exercise the option so that it can be cashed in on any trading day without accepting a discount.  It addition the American option is priced based on the spot market and liquidated on a spot market.  CRC/RA price risk is based on an Asian option.  The strike is a monthly average price on a deferred harvest contract and not on a spot market.  The Asian option is not settled on a spot market but a monthly average price during the month prior to the harvest futures contract’s expiration month. 

In addition, there are only two points on the yield curve where the insured has an Asian option.  The insured has an Asian put option at the insurable yield trigger (coverage percentage times actual production history).  The insured also has an Asian call option at zero yield and these are the only two points on the yield curve that the grower has an Asian option.

At zero yield the Asian put expires worthless and the entire claim is paid by the yield coverage, if the price has fallen.  As the yields increase from zero the value of the Asian put option starts to erode.  Once yields exceed the insurable yield by a greater percentage than the percentage price decrease the Asian put expires worthless even though prices have fallen.

The insured has an Asian call at zero yield.  If prices increase the value of the Asian call starts to erode as the yield increases from zero.  Once yields equal the insurable yield or greater the Asian call expires worthless.

So why use the volatility measure from American options to price and Asian option that is only valid at two points on the yield curve?  In any case there is no reason to deny revenue coverage because the at the money option is not trading on the new crop futures contract.  In the case of wheat the option market is often a very thin test because in many years there are only a few options with open interest as was the case for the July 2002 KCBOT wheat contract, which had no open interest.  Because of how the volatility value is being used one should simply measure the volatility from the prior contract, even if that means going to several prior contracts before the at the money option is trading.   

Futures Price Limit Moves.  Looking ahead there are only 9 trading days schedule during September 1-15, 2007 and 2012.  The short trading period will occur every 6 years.  Trading days were eliminated in 2001 because of terrorism but it is also possible that trading days would be eliminated because the market made a lock limit move based on the following rule. 

(d) RMA reserves the right to omit any daily settlement price or additional daily settlement price if market conditions are different than those used to rate or price revenue protection (For example, the trading hits the limits imposed by the Commodity Exchange) (Federal Register / Vol. 71, No. 135 / Friday, July 14, 2006 / Proposed Rules, p. 40202).

Market limit moves, terrorism, or 100 other less likely events could cause the markets not to trade for two or more days, and then the minimum 8 prices will not be met.  This also raises the question why would one eliminate price limit moves from the average?  We know that a limit move up has established the minimum price because it will require a higher price for a trade to occur.  Why ignore this information that is being provided by the market?  The reverse is true for a limit down move.

For example, assume that in the year 2012, only three years after the introduction of Combo, the market fails to trade during the base price discovery period for KCBOT wheat.  The simple average price in the example was $3.54 when the limit price moves are included.  Under the RMA proposed Combo rules, September 13 and 14 limit price moves would be excluded from the average.  With those exclusions the RMA procedure does not meet the minimum require of 8 approved prices.  It is unclear if the RMA proposed rules would allow including the August 31 price, but in the example it was included to generate the 8 RMA approved prices.  So which price, $3.54 or $3.40 better reflects the market?  The simple average or the average of the RMA approved prices (Table 3)?

Avoid These Pitfalls.  To avoid all of these pitfalls, RMA could change the measurement period from September 1-15 to the 10 trading days with approved prices prior to September 16.  That will give the same number of trading days in all future guarantees and avoid years with reduce trading days like 2001, 2007, and 2012 etc.  It will also allow using trading day(s) in August if there are not 8 trading days with approved prices between September 1-15.  The 8 trading day minimum would need to be retained because there might not be 10 approved prices even if one were able to use prices from August.  However it is unlikely there would be less than 10 prices because if there are less than 10 approved trading days, then one would substitute the prior contract’s prices, i.e. substitute July prices for the September contract prices. 

Some industry people would have argued for an average base price based on approved trading days that are closer to 20 days than 10 days so that any price outlier would have less impact on the approved base price.  It would also seem reasonable for RMA to have applied the same standard for measuring the base price to measuring the harvest price that currently is based on the monthly average price rather than a two week average.  The same definition could be provided on the harvest price.  The harvest price could be defined as the 10 (20?) trading days prior to July 1 with approved prices.  That would use the same number of price discovery days for the harvest price as the base price.

Liability Limit.  These issues are less important than the liability limit of 160 percent of base price.  RA-HPO had unlimited liability, which was probably to generous but the 160 percent is too limiting.  If the limit were too increased to 200 percent there will be little chance that payments would be any larger than they will be under the proposed 160 percent limit.  However, there would be additional value to growers because it is not uncommon for major price moves during the summer months.  If this were to occur the price might exceed the 160 percent limit and then lenders might become concern about the loss of the hedge position.  Setting the limit at 200 percent would greatly reduce the possibility that growers would lose their hedge position with little (probably none) cost to RMA.

Finally if the base price definition is not met, require an emergency Board approval for the elimination of the revenue insurance should be required because the rule below would automatically remove revenue insurance from the market. 

(e) For the projected price, if the average daily settlement price cannot be calculated by the procedures outlined in these price provisions, no revenue protection coverage will be available.

RMA will be able to watch the market and will know if there is likely to be a problem with the 10 trading days and can alert the Board ahead of the decision.  But if the Board must okay elimination of revenue coverage, it will also give the Board a chance to look at any alternative that would provide a revenue offer if the price definitions are not met.  A recent example was when the Board approved using the CBOT option market for setting RA winter wheat volatility because the KCBOT July at the money option did not trade. 

Multiple Benefits.  The provision appears to eliminate collecting crop insurance and any ad hoc disaster aid benefits.  If insured farmers are prevented from receiving ad hoc disaster payments they will reduce their purchase of crop insurance.  Congress is the one who decided to provide the extra benefits.

In addition, growers who buy GRIP/GRP coverage would have their payments reduced or eliminated when they have a crop and receive GRIP/GRP payments.  But farmers must cover the loss if they suffer a crop loss but the county does not suffer a loss and therefore triggers no payment from GRIP/GRP coverages.  So if farmers must carry the risk of no payment when they have a crop loss, then one must let farmers capture the gain when they receive a payment but have no crop loss.  Otherwise GRIP/GRP does not work and should be taken off the market (not the author’s suggestion).

35. Multiple Benefits.

(b) The total amount received from all such sources may not exceed the amount of your actual loss. The amount of the actual loss is the difference between the total value of the insured crop before the loss and the total value of the insured crop after the loss.

            (1) For crops for which revenue protection is not available:

            (i) The total value of crops for which you have an approved yield before the loss is your approved yield times the highest price election for the crop;

(ii) The total value of crops for which you have an approved yield after the loss is your production to count times the highest price election for the crop;

(iii) If you have an amount of insurance, the total value before the loss is the highest amount of insurance available for the crop; and

(iv) If you have an amount of insurance, the total value after the loss is the production to count times the price contained in the Crop Provisions for valuing production to count.

            (2) For crops for which revenue protection is available and:

                        (i) You elect yield protection:

(A) The total value of the crop before the loss is your approved yield times the highest projected price for the crop; and

(B) The total value of the crop after the loss is your production to count times the highest projected price for the crop; or

                        (ii) You elect revenue protection:

(A) The total value of the crop before the loss is your approved yield times the higher of the highest projected or harvest price for the crop (If you have elected the harvest price exclusion option, the highest projected price for the crop will be used); and

(B) The total value of the crop after the loss is your production to count times the highest harvest price for the crop.

Interested parties may send their written comments and opinions on these proposed rule changes until the close of business on September 12, 2006.  Those comments will be “considered” when the rules are made final (Federal Register / Vol. 71, No. 135 / Friday, July 14, 2006 / Proposed Rules, p. 40194).