5 pp., 2 tables, 1 diagramLivestock Risk Protection policies offer price risk insurance to cattle producers. Hedging with an LRP policy is one way to secure an acceptable price now for a commodity that will be produced or marketed some time in the future

Bevers, Stan

Pena, Jose G.

Thompson, Bill

Texas A&M University

1Hedging Cattle with an LRP Policy
Risk Management
E-473
RM4-13.0
11-08
*Assistant Professor and Extension Economist, Professor and Extension Economist, and 
Professor and Extension Economist, The Texas A&M System.
William Thompson, Stan Bevers and Jose Peña*
Livestock producers have always had to man-
age in uncertain environments. Price uncertain-
ty is as common an issue as uncertain rainfall 
patterns for Texas cattle producers. Livestock 
Risk Protection (LRP) policies were introduced 
by the Risk Management Agency (RMA) of 
USDA to provide single peril, price risk insur-
ance. Policies can be purchased for feeder cattle, 
fed cattle and lambs, though here we will dis-
cuss only the two cattle policies. In many ways 
LRP policies are similar to Chicago Mercantile 
Exchange (CME) put options. LRP policies can 
be effective hedging tools for livestock produc-
ers.
Basics of Hedging
Hedging is the process of trying to secure an 
attractive or acceptable price now for a com-
modity that will be produced or marketed some 
time in the future.  
Futures Selling Hedge
A futures selling hedge involves selling one 
or more futures contracts as a proxy for a sale to 
occur in the future. If a producer were planning 
to sell a group of feeder cattle he purchased 
for grazing winter pasture, he might sell an 
April CME feeder cattle contract to “lock in” 
a price in November for his cattle to be sold in 
April. When the cattle were sold on the local 
cash market, the producer would offset or buy 
back his outstanding futures contract. If the 
cattle market decreased while this hedge was 
in place, hedge profi ts (difference between what 
the original position was sold for and the lower 
price paid when it was bought back) would off-
set the lower cash price received when the cattle 
were sold. Conversely, if prices increased while 
the hedge was in place, hedge losses (difference 
between what the original position was sold for 
and the higher price paid when it was bought 
back) would offset the increased cash price. 
Several characteristics of a futures selling 
hedge have discouraged many producers from 
using it. If a producer sells a futures contract 
and futures prices increase, margin calls will be 
required to assure the commodity broker that 
the producer will have the fi nancial resources to 
re-purchase the higher priced contracts. These 
margin calls are diffi cult to plan for when creat-
ing cash fl ow projections. Producers are also 
discouraged from using a futures selling hedge 
because they may miss a potentially higher net 
price if the overall market increases.      
 Hedging With a Put
A put establishes a price fl oor and protects 
the buyer against lower prices. It gives the buyer 
of the put the right, but not the obligation, to 
sell a specifi c futures contract at a fi xed price on 
or before the expiration date of the put. The use 
of a put option in lieu of a futures selling hedge 
offers producers two main advantages. The fi -
nancial obligation associated with the put is met 
as soon as the initial premium is paid, and if 
prices increase, the producer will be able to par-
2ticipate in the market rally. If the futures market 
rises above the strike price, the option will be al-
lowed to expire worthless and the producer’s net 
price will be the increased cash market price less 
the option premium paid. If futures prices drop 
below the selected strike price, the producer can 
use the increased value of the option to supple-
ment the reduced cash price received for the 
calves sold.
Producers have long felt that options have 
three distinct drawbacks. Put options can be 
relatively expensive, especially when a signifi -
cant portion of the total premium is associated 
with the time value of the put. At times, light 
trading may mean that a seller for an option 
at the desired price cannot be found. In other 
cases the competitive open trading for options 
may mean that option prices have changed 
before a producer can get his option bought 
at the desired price. The fi xed contract size of 
CME futures contracts makes them unwieldy 
for small to mid-sized producers.  A single CME 
Feeder Cattle contract could be used to hedge 
the anticipated market price of approximately 
67 head of feeder cattle weighing an average of 
746 pounds. The “lumpy” size of CME futures or 
options can leave producers signifi cantly over or 
under hedged. Table 1 presents contract speci-
fi cations of CME Feeder Cattle and Live (Fed) 
Cattle contracts.
LRP policies
LRP policies are single-peril insurance poli-
cies intended to protect against a price decrease 
in the overall market. After completing the 
policy application, producers select a coverage 
price, endorsement length, and the specifi c 
number of head and expected target weight 
of the cattle to be sold. The coverage price is a 
percentage of the expected ending value. These 
values and the associated rates are based on the 
current day’s closing futures prices, volume and 
volatility, and they correspond to different en-
dorsement lengths. Endorsement lengths are in 
increments of about 30 days and can range from 
13 to 52 weeks, though they are seldom available 
for more than 34 weeks into the future. If, at the 
ending date of coverage, the actual end value 
has dropped below the selected coverage price, 
the producer will need to fi le an indemnity 
claim within 60 days. RMA subsidizes all quoted 
premiums at a rate of 13 percent. 
It is crucial for producers to understand that 
the ending value of the LRP contract is not the 
cash price received or a closing futures price as 
of the end date of the policy. The LRP feeder cat-
tle policy uses the Chicago Mercantile Exchange 
(CME) feeder cattle price index as the actual 
end value. This cash-settled commodity index 
is a mathematical calculation that averages the 
headcounts, weights and prices from numerous 
Feeder cattle Live cattle
Trade unit 50,000 pounds 40,000 pounds
Contract months traded
Jan, Mar, Apr, May, 
Aug, Sep, Oct, Nov
Feb, Apr, Jun, Aug, Oct, Dec
Contract months listed 8 6
Trading hours 9:05 a.m. - 1:00 p.m. CST 9:05 a.m. - 1:00 p.m. CST
Daily limits $0.030/lb, $1,500 $0.030/lb, $1,200
Table 1. Contract specifi cations for CME futures contracts.
3livestock sales across the nation to determine its 
settlement price. The LRP fed cattle policy uses a 
weekly weighted average of the slaughter cattle 
prices in fi ve areas, as reported by the Agricul-
tural Marketing Service (AMS). This creates a 
slightly different basis calculation from tradi-
tional (local cash price minus futures price) basis 
calculations.
LRP and CME Put Option 
Comparisons
LRP policies have many similarities to put 
options offered on CME futures contracts. 
As with a put option, producers are purchas-
ing downside price protection while retaining 
upside potential.  Table 2 illustrates the similar 
calculations used to determine the minimum 
net sales price for feeder cattle being hedged 
with LRP or put options. It is assumed that local 
market basis is $2 under the CME futures price. 
In this example, the LRP and the put option will 
provide a minimum sale price or fl oor of $101.77 
per cwt and $102.66 per cwt, respectively. If 
futures prices increase above $108 (put option) or 
the CME Feeder Cattle Index rises above $107.90 
in the case of the LRP policy, producers will be 
able to realize a higher price, less the cost of the 
respective risk management tool. 
Figure 1 illustrates the relationship between 
an un-hedged position (local price), a futures 
hedge, an LRP policy and a put option. The put 
option and LRP policy use the data presented 
in Table 2. The un-hedged position is simply the 
futures price less the estimated basis and is used 
to illustrate the risk of an unprotected price de-
crease, or the economic cost of each of the three 
risk management strategies. The futures hedge 
was initiated at $108 per cwt and includes esti-
mated commission costs. The horizontal line of 
the futures hedge illustrates that once the hedge 
position is initiated, the net price received by the 
producer will remain constant subject to changes 
in the expected basis. Figure 1 also illustrates the 
similarities of using an LRP policy or a CME put 
option to protect against a price decrease dur-
ing the production process. If the futures price 
rises above $108 per cwt, producers will realize a 
price that is above the fl oor they created with the 
LPR policy or put option. At prices above $108 
per cwt, the difference between the local market 
price and the LRP or put option price is the cost 
of the respective premiums. 
LRP policies also have these advantages: 
They provide coverage in months when • 
CME contracts are not available.
They instill confi dence that the policy • 
can/will be purchased at the rates quoted 
by RMA on their Web site.
All LRP premiums are tax deductible.• 
LRP Put option
Coverage/strike price ($/cwt)                 $107.90  (99.9%)                      $108.00
Less: Producer paid premium ($/cwt)                 $   4.00251                      $    3.10
        Expected basis ($/cwt)                 $  -2.00                      $   -2.00
        Commission and interest ($/cwt)                 $   0.12702                      $    0.2427
Minimum expected net sales price ($/cwt)                 $101.77                      $102.66
Table 2. Calculation of minimum net selling price for feeder cattle to be marketed in May 
2008—price as of January 18, 2008.
 1RMA subsidy of 13 percent has been deducted from premium. 
 2Interest only, RMA pays all sales commissions and other administrative costs.
4Other more complex strategies involve buying 
a put option to establish a fl oor under the price, 
and then selling either another put option (Bear 
Put Spread) or a call option (Window) to reduce 
the net cost of the purchased put. It would be 
possible to buy an LRP policy, and then use 
either of the above strategies, based on market 
outlook, to reduce the cost of the LRP policy. 
Since the expiration of the LRP and option con-
tracts will not coincide, and the sale of an option 
carries substantial risks, you should be very cau-
tious when mixing or combining these products.
LRP Disadvantages as a 
Hedging Tool
LRP policies cannot be purchased for cover-
age periods less than 13 weeks. This could be 
problematic if prices increased dramatically 60 
to 90 days before the intended sales date and a 
producer wanted to put a price fl oor under his 
cattle at those higher levels. The fact that LRP 
policies are seldom offered for coverage peri-
ods of more than 34 weeks may also limit their 
usefulness relative to CME futures and options, 
which have contract months listed for nearly a 
full year (Table 1.).  
A valid marketing strategy often employed 
by options users is to “roll up” the minimum ex-
pected selling price when the market rises. This 
involves simultaneously selling or offsetting the 
existing put and purchasing another put with a 
higher strike price, a different expiration date, or 
both. This effectively lifts the minimum expect-
ed selling price while retaining the potential to 
benefi t from further price increases. This is not 
possible with an LRP policy. Once in place, an 
LRP policy cannot be altered, offset or cancelled. 
Another potential disadvantage of trying to 
hedge your expected price with an LRP policy 
could be the limited number of coverage prices 
available for each end date of coverage. This 
becomes more of an issue as the end dates of 
coverage become more distant. Often only one 
or two coverage levels may be available for a 
specifi c end date, and in all cases the coverage 
level is less than the expected ending price. 
This may limit a producer’s ability to buy LRP 
coverage at the desired levels at the time cattle 
are purchased or placed on pasture/feed. CME 
options are available at strike prices both above 
and below the current futures price, giving pro-
ducers considerable fl exibility in tailoring a risk 
Figure 1. Net price received by producer.
Figure 1. Net price received by producer
85
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120
96 98 10
0
10
2
10
4
10
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10
8
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0
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0
May Feeder Cattle Futures Price
$/
cw
t.
Futures Hedge
LRP ($107.9)
Put Option ($108)
Local Price
May Feeder Cattle Futures Price
Educational programs of the Texas AgriLife Extension Service are open to all people without regard to race, color, sex, 
disability, religion, age, or national origin.
Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 
8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Edward G. 
Smith, Director, Texas AgriLife Extension Service, The Texas A&M System.
Produced by AgriLife Communications, The Texas A&M System
Extension publications can be found on the Web at: http://AgriLifeBookstore.org.
Visit Texas AgriLife Extension Service at http://AgriLifeExtension.tamu.edu.
Partial funding support has been provided by the
Texas Corn Producers, Texas Farm Bureau, and
Cotton Inc.–Texas State Support Committee. 
management plan. LRP coverage prices, rates 
and expected ending values, and the number of 
different coverage levels available, can change 
daily.  Producers electing to use LRP poli-
cies may need to be willing to wait until more 
coverage levels are offered, though they will be 
exposed to adverse price movements while they 
wait.
Marketing Strategies
LRP policies should be viewed as another 
tool available to livestock producers. The poli-
cies perform best when used for the right task, 
and can be disappointing when used for a func-
tion they were not designed for.  
Producers should identify their marketing or 
risk management objectives, risk tolerance and 
cost parameters, and combine that with their 
own market outlook and production schedule 
before implementing a marketing plan. Because 
LRP policies offer many of the same advantages 
as options contracts, producers need to become 
adept at evaluating and comparing the numer-
ous LRP coverage levels and possible end dates 
to the array of options contracts available. LRP 
policies could be used for the following pur-
poses:
Establish a minimum average sales price.• 
Insure against a catastrophic event by • 
routinely purchasing LRP coverage at 
low coverage levels.
Scale-up LRP coverage on a limited • 
number of head at a time if the market 
seems to be trending upward, as 
opposed to rolling hedges forward.
Combine LRP policies with a CME • 
option contract to create a spread or 
window strategy.
For more information on the use of futures 
and options for hedging, or for basic LRP infor-
mation, refer to other Texas AgriLife Extension 
Service publications in this risk management 
series.
Anderson, C., J. Smith, D. McCorkle and D. 
     O’Brien. Hedging with a Put Option, 
     L-5250. 
Bevers, Stan, Steve Amosson, Mark Waller 
     and Kevin Dhuvetter. Using a Bear Put 
     Spread, E-487. 
Johnson, Jason L. and Wade Polk. Rolling Up a 
     Put Option as Prices Increase, E-142. 
Sartwelle, James D., Edward Smith, Terry 
     Kastens and Daniel O’Brien. Selling 
     Hedge with Futures, L-5252. 
Thompson, William, Blake Bennett and DeDe 
     Jones. Livestock Risk Protection, E-335. 


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Hedging Cattle with an LRP Policy

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Hedging Cattle with an LRP Policy

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