Hedging downside risk to farm income with futures and options
Zhang, Rui (Carolyn)
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The high proportion of government payments in total crop farm income and the purchase of subsidized crop insurance have changed the income distribution of U.S. crop farmers. As a result, the risk management behaviors of U.S. crop farmers are affected by these programs in terms of the use of private market risk management tools, such as futures and options. The objective of this research is to investigate the effects of the government payments and federal crop insurance policies on the usage of futures and options by crop farmers from a downside risk management perspective. Acknowledgment of the effects of different government payment programs and crop insurance on hedging can benefit crop farmers so that they can adjust their positions in futures and options accordingly. Understanding such effects can be informative to policy makers in prioritizing government risk management policies. This research contributes to the literature by proposing to use a downside risk hedge model, the second-order lower partial moment (LPM2) hedge model, to evaluate the interaction of government and private risk management tools used by U.S. crop farmers. This study also initiates the application of conditional kernel density method and the copula approach to the crop prices and yields simulating process. The conditional kernel density method generates county yields and farm yields with the same conditional pattern as revealed in the historical yield patterns. The copula simulation allows the crop yields and prices to attain more flexible joint distributions other than being restricted to the multivariate normal distribution. Results in this study suggest that both yield insurance and revenue insurance creates more hedging demands for futures. But revenue insurance decreases the buying of put options at the same time. Loan deficiency government payments substitutes largely for the hedging role of put options while Counter cyclical payments substitutes futures hedge. This study also confirms that the optimal futures hedge in the downside risk hedge model is an under-hedged position compared to the optimal positions based on an expected utility hedge model. Hence, the downside risk hedge model provides a better explanation for the actual futures hedging behaviors of crop farmers.