Module 10

Corn Yield Futures and Options

Sergio H. Lence, Iowa State University

Topics

• Introduction
• I. Corn Yield Futures Contracts
• Examples of Corn Yield Futures Hedges
  • Example 1. Producer Hedging with Price Futures and Corn YFCs
  • Example 2. Grain Elevator Hedging Throughput with Corn YFCs
• Additional Considerations for Yield Futures Contracts

• II. Options on Corn YFCs
• Examples of Using Options on Corn Yield Futures for Risk Management
  • Example 3. Producer Hedging with a Combination of Corn Price and Yield Put Options
  • Example 4. Grain Elevator Hedging Throughput with Options on Corn YFCs
• Additional Considerations for Yield Put Options
• End of Module

Introduction

I. Corn Yield Futures Contracts

Since 1995 it has been possible to trade futures contracts on corn yields at the Chicago Board of Trade (CBOT). Corn yield futures are similar to traditional futures contracts. The only difference is that they are traded in units of $100 times the market-determined forecast of corn yield. For example, an expected corn yield of 140 bushels per acre (bu/ac) translates into a value of $14,000 per corn yield futures contract (YFC). Assuming a corn price of $2.60 per bushel, each corn YFC would then represent about 38.5 acres (ac) {14,000/(140 * 2.60)} worth of corn production. In other words, for risk management purposes a producer could use one corn YFC to provide yield protection for 38.5 acres of corn at a $2.60 price. The number of contracts needed varies with the expected price.

There are corn yield futures for the U.S. and for Iowa, Illinois, Indiana, Ohio, and Nebraska. The maturity months traded are September and January, with trading occurring until the last business day of August and December, respectively. At maturity, the respective contracts are settled using the official USDA monthly estimate of corn yield for the U.S. and the states named above. The tick size is 0.1 bushel-per-acre-harvested, or $10 per contract. To open a corn yield futures position, the CBOT requires a hedger to post an initial margin of $200 per contract and a speculator to deposit $270 as initial margin. CBOT's maintenance margins are $200 per YFC for either hedgers or speculators.

Examples of Corn Yield Futures Hedges (or go to Topics )

In the same manner that price futures contracts may be used to protect from price risk, corn yield futures can be used to reduce production risk. Two examples illustrate this point: 1) a corn producer hedge and 2) a corn elevator throughput hedge.

Example 1. Producer Hedging with Price Futures and Corn YFCs (or go to Topics )

Consider a producer in Jasper County (Iowa) on March 1, 1998 who plans to grow 500 acres of corn. The farmer expects a yield of 145 bu/ac, so that his/her total expected production is 72,500 bushels of corn. At that time, January Iowa corn yield futures are at 142 bu/ac, which implies $14,200 per contract (142 * $100). In addition, December corn futures are trading at $2.65 per bushel and the expected harvest time basis in Jasper County is 29 cents/bu. The farmer plans to profit nicely if yields and prices at harvest time end up near or better than these levels. However, he/she is also worried about poor yields and/or prices turning expected profits into losses.

If the producer is mostly concerned about production risk, he/she may want to consider hedging with corn YFCs. To determine the number of YFCs to sell, the farmer needs a price forecast for his/her planned corn production. The number of YFCs to sell is calculated by using the formula: # YFC = {Expected cash price ($/bu)}/{Multiplier ($100)} * acres hedged * fraction hedged. For example, if the farmer expects the corn price to be about $2.36/bu (equal to the corn futures price of $2.65/bu minus an expected basis of 29 cents/bu) and wants to hedge the whole crop (fraction hedged = 1.00), he/she should sell 12 corn YFCs:

# YFC = (2.36 $/bu)/($100) * 500 acres * 1.00 = 12 contracts

If the producer is not hedging his/her price risk, a more conservative approach would be to hedge production risk by selling fewer than 12 corn YFCs (for example, 9 contracts or a fraction hedged of 0.75). This would reduce his/her exposure in the event of low prices.

Assuming that on March 1 the producer sells 9 corn YFCs, the realized revenue depends on the actual production, price, and corn yield futures at harvest time. For example, if on October 15, actual yield equals expected yield (145 bu/ac), actual price equals expected price ($2.36 per bushel), and actual corn yield futures equal the corn yield futures on March 1 (142 bu/ac), gross income is $170,785.

The $170,785 revenue figure is calculated as follows:

Given "normal" conditions, the producer would have obtained $171,100 in gross income without hedging production risk, versus $170,785 gross income from the corn yield futures hedging strategy. The $315 difference is the price paid by the farmer to protect against production risk. Although not hedging production risk leads to higher profits with favorable yields, the opposite is true when yields are unfavorable.

Gross income outcomes under alternative scenarios can be computed the same way. Table 1 shows revenue outcomes of hedging production risk by selling 9 corn YFCs, along with the respective gross incomes from (i) not hedging, (ii) hedging price risk with 10 price futures contracts, and (iii) hedging both price and production risk with 14 price futures contracts and 12 corn YFCs. It is assumed throughout that basis on October 15 equals the expected basis (29 cents/bu), and that corn yield futures move up or down by the same amount as the farmer's yield does.

Table 1 provides five important insights:

• The highest ($278,400) as well as the lowest ($72,000) gross incomes are associated with no hedging. That is, no hedging provides the highest potential for profits from high prices, but also exposes the producer to the greatest risk of losses from low prices.

• Hedging with yield futures stabilizes gross income for a given price, but gross income still fluctuates greatly due to price variability. That is, selling yield futures protects against production risk but not against price risk.

• Hedging with price futures stabilizes gross income for a given yield, but yield variability may result in quite uncertain gross income. In other words, selling price futures protects against price risk but not against production risk.

• Hedging with both price and yield futures provides the least variable gross income of these alternatives. Gross income may fluctuate from a low of $143,090 to a high of $183,890. In this instance, protection against both price and production risks is achieved.

• Hedging with yield futures protects from low yields but prevents the producer from taking advantage of high yields. In order to obtain protection from poor yields while retaining the potential gains from good yields, the producer may want to buy yield put options rather than sell YFCs. Yield options are discussed in a later section.

Example 2. Grain Elevator Hedging Throughput with Corn YFCs (or go to Topics )

Consider the case of the manager of an elevator with an average throughput of 6.25 million bushels of corn per year. The elevator draws corn from an area with an average yield of 125 bu/ac (a basis of 10 bu/ac under the U.S. corn yield). Hence, under normal conditions all the production from 50,000 acres (6,250,000/125) is required to reach the elevator's throughput. The elevator's gross revenues are $0.10/bu handled, its variable costs amount to $0.02/bu handled, and its fixed costs equal $300,000/year.

Facing the risk that poor yields may cause throughput to fall substantially, on April 1, 1998 the manager considers the possibility of using corn YFCs to hedge the elevator's throughput. He/she calculates the number of corn YFCs to sell by means of the following formula:

# YFCs = {Elevator's gross margin ($/bu)}/{Multiplier ($100)}* {Throughput to Hedge (bu)}/{Corn Yield Futures Quote (bu/ac)}

Assuming that the manager wants to hedge the average throughput level and that U.S. January corn YFCs are trading at 135 bu/ac on April 1, the manager should sell 37 corn YFCs:
# YFC = ($0.10/bu-$0.02/bu)/($100) * (6,250,000 bu)/(135 bu/ac) = 37

Suppose the manager sells 37 U.S. January corn YFCs, and that growing conditions for corn are less than optimal because of dry weather. As a result, on October 15, 1998 U.S. January corn yield futures trade at 82 bu/ac and the actual average corn yield in the elevator's area is only 72 bu/ac, or 53 bu/ac below the local average. Due to the fall in corn yields, the 50,000 acres that would normally provide the elevator's average throughput of 6.25 million bushels only produce 3.6 million bushels (72 * 50,000).

The analysis below shows that if the manager did not hedge, the elevator would have lost $12,000. In contrast, by hedging with yield futures the elevator's losses would have been turned into profits of $182,805 due to a gross income of $194,805 from the yield futures position:

It is worth noting that, even though the formula shown previously to calculate the number of YFCs for an elevator to sell is simpler to use, a more precise formula for such purpose is the following:

# YFC = {Elevator's Gross Margin ($/bu)}/{Multiplier ($100)}* {Throughput to Hedge (bu)}/{Avg. Local Corn Yield (bu/ac)}

The two formulas give the same result when the average local corn yield is equal to the corn yield futures quote. However, in those situations in which the average local yield is substantially different from the yield futures quote, it is recommended to use the more precise formula.

In the elevator example, the precise formula indicates that the elevator's manager should sell 40 (instead of 37) YFCs to hedge the average throughput of 6.25 million bushels:
# YFCs = ($0.10/bu-$0.02/bu)/($100) * (6,250,000 bu)/(125 bu/ac) = 40.

Gross incomes from various alternative yield scenarios are provided in Table 2.

This table shows that:

• Hedging with corn YFCs greatly reduces the variability in gross income. For the scenarios shown, gross income without hedging fluctuates between a loss of $12,000 and a profit of $300,000 whereas, by hedging with 40 YFCs, gross income ranges from $158,600 to $238,600. The elevator would automatically hedge with price futures.

• If there is no yield basis risk and the cost assumptions are met, the elevator would be able to lock-in a gross income of $198,600 by hedging with 40 corn YFCs. Given that the elevator's average gross income is $200,000, the cost of locking-in gross income is $1,400. Such a cost is due to the commissions on futures purchases and sales (1400 = 40 * 35).

The greater the yield basis risk, the less effective is hedging with YFCs to stabilize gross income. Yield basis risk is the risk that the expected local corn yield minus the futures yield quote at the time of selling YFCs will be different from the actual local corn yield minus the futures yield quote at the time of buying back the YFCs. For example, if the actual local corn yield minus the futures yield quote on October 15 is 10 bu/ac smaller (greater) than the expected local corn yield minus the futures yield quote on April 1, gross income from hedging with 40 YFCs ends up being $158,600 ($238,600) instead of $198,600.

By hedging with YFCs, the elevator obtains income protection in years of poor yields, but it must also forego high profits in years of high yields. The elevator's manager might want to buy yield put options rather than sell YFCs if he/she wants protection from low yields while retaining high profit potential from good yields. Yield options are the topic of a later section.

Additional Considerations for Yield Futures Contracts (or go to Topics )

As shown in the elevator example, hedging with YFCs will reduce yield risk only if yield basis risk is relatively small. It is always the case that the greater the yield basis risk, the less effective will be hedging with YFCs for yield risk reduction purposes. In general, the more closely a yield futures contract tracks the hedger's relevant yield, the smaller will be the corresponding yield basis risk. The yield basis variability for an elevator would tend to be considerably less than for individual farmers.

To illustrate the concept of yield basis risk, Figure 1 depicts corn yields in Jasper County (Iowa), in Iowa, and in the U.S. from 1972 through 1996. Note that yields in the three locations do not move exactly in lockstep, but tend to do so. Also, yields in Jasper County are more closely associated with Iowa yields than with U.S. yields as confirmed by the respective correlations, which are a statistical measure of association. The correlation between yields in Jasper County and yields in Iowa is 0.90; the correlation between Jasper County yields and U.S. yields is 0.85. (Note: A correlation of 1 indicates perfect positive association, and a correlation of 0 indicates no association whatsoever). Corn producers/ elevators in Jasper County will typically encounter less yield basis risk with Iowa YFCs than with U.S. YFCs. Thus corn producers/elevators in Jasper County are better advised to hedge yield risk using Iowa YFCs.

Basis risk varies geographically within states and from state to state. Also, yield basis risk at the individual producer/elevator level is typically greater than at the county level. This is true because many point-specific yield risks which are very important at the local level, such as hail losses, are irrelevant at the county or state levels as they average out over larger geographic areas. Hence, to determine the potential effectiveness of hedging yield risk with a particular YFC, a potential hedger should carefully assess the extent to which his/her yields move in tandem with such a contract.

For corn producers in major producing areas who consider hedging yield risk, another important issue to consider is the partial "built-in" hedge that often exists because years of high yields tend to exhibit low harvest prices, whereas years of low yields tend to be characterized by high harvest prices. This pattern is illustrated in Figure 2, which plots corn yields and October corn prices from 1979 - 1996 for Illinois. There is a clear negative association between yields and harvest prices as shown by a high negative correlation of -0.71. (Note: A correlation of -1 indicates perfect negative association; a correlation of 0 indicates no association whatsoever).

For risk management purposes, there are at least two reasons why it is relevant to know whether yields and prices are negatively associated. First, if such a negative association exists, hedging only yield risk (but not price risk) would tend to provide high gross income in years of poor yields and low gross income in years of good yields. As stated earlier, stabilization of gross income requires hedging with both yield and price futures contracts. Second, the stronger the negative association between prices and yields, the fewer YFCs and price futures contracts a producer who wants to stabilize gross income would need to sell. This is true because the stronger the negative association between prices and yields, the more they tend to offset each other naturally (thereby providing a more stable revenue).

Another issue to consider before trading in YFCs, either to speculate or to hedge, is their liquidity. Market liquidity is a key factor in the successful use of futures as hedging or speculative risk management tools. Highly liquid markets allow one to trade at any time without causing significant price movements. In contrast, selling (buying) in illiquid markets is likely to be accompanied by price decreases (increases), which represent additional trading costs. Unfortunately, the volume of operations and the open interest in corn YFCs are very low at the present time, suggesting potential liquidity problems. This observation is particularly true for contracts involving yields for the states of Illinois, Indiana, Ohio, and Nebraska.

Finally, yield futures are of potential value even for those who choose not to trade them because they provide a market-based yield forecast. If yield futures are trading at values too high (low) relative to the market expectations, speculators are likely to sell (buy) YFCs expecting to profit from such occurrences. In doing so, they will exert a downward (upward) pressure on yield futures quotes, which tends to restore parity between yield expectations and yield futures values. Yield forecasts are useful for market participants whose operations depend crucially on the volume of the corn crop, such as elevators, grain transportation companies, and corn processors.

II. Options on Corn YFCs (or go to Topics )

Options on corn YFCs are traded at the CBOT for various state and U.S. contracts. The premium (cost) to buy yield options is determined by the interaction of demand and supply at the market. Buyers of yield options must pay a premium but unlike buyers of YFCs, do not post initial margins and are not subject to margin calls. Sellers of yield options must deposit an initial margin and may face margin calls much like those trading in YFCs. Strike yields are listed in 5 bushel-per-acre-harvested intervals to bracket the underlying YFC.

Examples of Using Options on Corn Yield Futures for Risk Management (or go to Topics )

In the same way that price options may be used to manage price risk, options on yield futures may prove useful to hedge yield risk. Those who want protection from yield risk while retaining the ability to profit from high yields should consider buying yield put options. The following examples show how this can be accomplished.

Example 3. Producer Hedging with a Combination of Corn Price and Yield Put Options (or go to Topics )

Consider the producer of Example 1 using both price options and yield options to protect against price risk and production risk. For example, if the farmer wants to hedge 85% of the expected gross revenue with January yield puts, he/she should buy 10 yield put contracts:

# of yield put contracts = {Expected cash price ($/bu)}/{Multiplier ($100)} * acres hedged * fraction hedged = (2.36 $/bu)/($100) * 500 ac * 0.85 = 10 contracts

Assume also that the farmer buys 12 December price puts (60,000 bu) to hedge 85% of the expected production.

To illustrate gross revenue outcomes, assume that on March 1 the January Iowa corn YFCs trade at 142 bu/acre, and that the corresponding yield puts with a strike yield of 140 bu/ac sell at a premium of 8.4 bu/acre, or a cost of $840 per contract (8.4 bu/ac * $100 multiplier). Also, the December corn futures price is $2.65 per bu and the puts with a strike price of $2.60 have a premium of 22 cents/bu. Suppose further that, on October 15, (i) local yields and prices turn out to be as expected, (ii) futures prices and futures yields trade at the same levels as on March 1, (iii) price put options with a strike price of $2.60 per bu trade at a premium of 8 cents/bu, and (iv) the premium on yield put options with a strike yield of 140 bu/ac is 0.4 bu/ac. For this scenario, the calculations below show that gross income is $153,160:

Table 3 summarizes the gross income outcomes from hedging with both types of put options simultaneously, along with the gross income from (i) the unhedged position, (ii) hedging production risk with 9 January yield put contracts, and (iii) hedging price risk with 10 December price put contracts.

The key points of Table 3 are as follows:

• The unhedged position gives the highest as well as lowest gross incomes, and therefore exposes the producer to both price and production risks.

• Hedging with both types of options provides a floor to the possible losses caused by low prices and/or poor yields. At the same time, the hedged position has the potential to greatly benefit from favorable prices and/or yields. As shown above, the price to pay for the attractive risk-return profile provided by this put hedge is $17,940 ($9,240 to control for price risk and $8,700 to control for production risk).

• Revenues from hedging with only one type of options are less risky than the unhedged situation, but more volatile than the outcomes achieved by hedging with both types of options.

Example 4. Grain Elevator Hedging Throughput with Options on Corn YFCs (or go to Topics )

Going back to the elevator of Example 2, let's analyze how the manager could have used options to hedge yield risk. To protect against the event of low throughput, the manager could buy put options on yield futures. The number of yield put options to buy is calculated using the same formulas used to obtain the number of YFCs to sell. Hence, in this example the manager would buy 40 yield put options (obtained using the precise formula).

Assume that on April 1, 1998 the manager buys 40 puts on U.S. January corn yield futures with a strike yield of 130 bu/ac at a premium of 5 bu/ac per put. Yields turn out to be poor (72 bu/ac in the elevator's area), so on October 15, 1998 U.S. January corn yield futures trade at 82 bu/ac and the corresponding puts with a strike yield of 140 bu/ac trade at a premium of 48 bu/ac per put. (In most likelihood, the 53 bu/ac premium would be obtained by exercising the puts rather than by selling them back, as options so deep in-the-money are usually not traded.) Having hedged the elevator's throughput with 40 yield puts, the actual gross income turns out to be $157,200:

In contrast, not hedging would have resulted in a loss of $12,000.

Outcomes of alternative scenarios are reported in Table 4. Assumptions underlying this table are that on April 1, 1998 the premiums for yield puts with strike yields of 130 bu/ac, 135 bu/ac, and 140 bu/ac are 5 bu/ac, 8 bu/ac, and 10 bu/ac, respectively.

The significant points from Table 4 are:

• Yield put options allow the elevator to limit the losses due to low yields, while retaining the potential to profit from high yields. For example, with 40 yield puts at a strike yield of 135 bu/ac, the smallest and highest gross incomes are $125,200 and $266,600, respectively. In contrast, gross incomes with no hedging range from -$12,000 to $300,000, and gross incomes from hedging with 40 YFCs range from $158,600 to $238,600 (see Table 2).

• The smaller the yield basis risk, the greater the effectiveness of yield puts in reducing the risk from low yields. According to Table 4, if there were no yield basis risk it would be possible to lock-in minimum gross incomes of $157,200, $165,200, and $177,200 by hedging with puts with strike yields of 130 bu/ac, 135 bu/ac, and 140 bu/ac, respectively.

• The higher the strike yield of the puts used for hedging, the more protection from poor yields they provide but the more limited the potential gains from high yields. For example, gross incomes from hedging with puts with a strike yield of 130 bu/ac vary from a low of $117,200 to a high of $278,600. This compares with gross incomes between $137,200 and $258,600 from hedging with puts with a strike yield of 140 bu/ac.

Additional Considerations for Yield Put Options (or go to Topics )

Yield put options provide great flexibility to manage yield risks, because by choosing from different strike yields the risk manager can effectively select the most convenient combination of cost versus protection. Although not analyzed in more depth due to space limitations, risk managers interested in using YFCs and/or yield options to manage yield risk should explore alternative combinations of strike yields and number of contracts to find those best suited to their particular preferences and financial situations.

As well, the use of yield put options to manage yield risk is subject to similar caveats as the use of YFCs. That is, consideration should be given to

• the magnitude of yield basis risk,
• the possible existence of a negative correlation between yields and prices, and
• the liquidity of the yield options market.

Still another issue to contemplate before hedging with yield puts is their cost relative to alternative yield risk management tools. To illustrate this point, note that for the corn producer in Example 3 the cost of protecting against yield risk is $17.4 per acre (8,700/500). Such a cost seems too expensive for most corn producers, given the costs and characteristics of alternative insurance policies available from commercial crop insurance companies.

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