Low market prices for corn and soybeans have triggered two federal price support programs

Babcock, Bruce

Hayes, Dermot

English

Low market prices for corn and soybeans have triggered two federal price support programs.</p

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6        CENTER FOR AGRICULTURAL AND RURAL DEVELOPMENT          FALL 1998Iowa Ag ReviewLow market prices for corn and soybeans have triggered two federalprice support programs.• One program is a Loan DeficiencyPayment (LDP) that pays producersthe difference between county levelprices (posted county prices) andthat county’s loan rate on a datechosen by the producer (so long asthe producer still owns the grain).• The second program is the tradi-tional loan program whereby theproducer puts grain in storage anduses the grain as collateral on aloan. The producer receives thecounty-specific loan rate for allbushels he or she puts into storageunder this program. If market pricesexceed the loan rate plus accruedinterest within nine months, theproducer can repay the loan and sellthe crop. If this price increase doesnot occur, the producer can keep thedifference between the loan rate andthe posted county price on the dayof sale. That is, the producer repaysthe loan at a price that is lower thanthe loan rate.What should you, as a producer, do?You can enroll in the loan program, or youcan take a LDP, but you cannot do both. Ifyou take the LDP you can sell the grain atharvest, store it at your own risk, or storeit and contract for future delivery. If weknew for sure what the markets weregoing to do in the coming months, thenthere would be a single best answer.Without the benefit of perfect foresight,we must deal with probabilities. We canuse existing information to say what ismost likely to be the correct response.Consider a producer in Union County,Iowa, who has 10,000 bushels of corn.The loan rate in Union County is $1.77per bushel.  Suppose at harvest, the cashprice is $1.69, the December futuresprice is at $1.99, and the July futuresprice is at $2.25. (All of these priceswere accurate representations of ex-pected conditions at harvest in UnionCounty as of Sept. 1, 1998.)  For the sakeof simplicity, assume that the local priceis measured accurately by the postedcounty price and that this price is always$.30 below the nearby futures price.  Atthese prices, storage is encouraged.There is a return of $.26 from storinggrain from harvest to July.  Typicalstorage costs of $.01 per bushel permonth implies a net return to storage of$.17 per bushel.CHOICE ONESell at harvest and take the LDP or usethe loan program.If you sell at harvest, you get thecounty price plus the LDP.  Together thiswill equal the loan rate. Alternatively youcan guarantee yourself this same amountby putting the grain under loan in the loanprogram. The difference between theseoptions is that selling at harvest meansthat you will be out of the market,whereas putting the grain under loanallows you to benefit if market pricesincrease to a level above the loan rate,plus interest. This option of selling at ahigher price, combined with the priceguarantee of the loan rate, means that youwill always be better off storing the grainunder loan than taking the LDP andselling cash grain.  In other words, beingin a position to benefit from upside pricemovements without having to worry aboutdownside movements is better than notbeing in the market.We can go further and actually placevalues on these two outcomes. If you takethe LDP and sell at $1.69, you get $1.77per bushel or $17,700 for the 10,000bushels. If you put the grain in the loanprogram, you will also get $17,700;however, you also will have somepossibility of making more if marketprices strengthen. Using option pricingtheory (the loan program is equivalent toa free put option) and current optionquotes, we have calculated this additionalvalue to be $2,229.  In other words, thetotal expected payout from the loanprogram is $19,929 versus a value of$17,700 from selling today and taking theLDP.CHOICE TWOUse the loan program or take the LDPand store at your own risk.The loan program clearly dominatesthe cash sale option. But the producercould choose to take the LDP and storethe grain outside of the loan program.The comparative advantage and disad-vantage of the loan program versus thisprivate storage option is less straightfor-ward.The private storage option allows theproducer to take full benefit of the LDPand to take full advantage of any marketprice increase.  In fact, if the producerknew that prices were going to strengthen,then private storage works better than theloan program.  However, if prices fall,then the opposite will be true. While wecannot say for sure which decision is best,it is possible to assign probabilities tovarious price outcomes and compare theexpected values of each of the twoalternatives.Figure 1 illustrates what the futuresand options markets are telling us aboutlocal prices in July.  The horizontal axisreports the prices that are possible.  Theheight of the bar shows us the chancesthat a certain price will materialize. Ascan be seen, the futures market is tellingus that local prices around $1.95 are mostlikely, with low chances of prices above$2.70 or below $1.20.Using the price distributions in figure1 and accounting for storage costs, theexpected value of the private storageoption is $19,400 compared to $19,929under the loan program. This comparisonwould favor the loan program by an evengreater amount if we adjusted theseoutcomes for the additional risk associatedwith the private storage option.  That is,under the private storage option, youwould be exposed to the full effect of aprice drop to $1.20 per bushel, whereasunder the loan program, you would receivethe loan rate of $1.77.Note that many producers plan toutilize the private storage option becausethey believe that the government will notallow market prices to fall much further orLoan Deficiency Payments or the Loan Program?–By Dermot J. Hayes and Bruce A. BabcockFALL 1998        CENTER FOR AGRICULTURAL AND RURAL DEVELOPMENT   7Iowa Ag Reviewbecause they believe that the July futuresprice is going to rise.  This decision turnsthe farmer into a speculator.  Many whoplan to follow the private storage routewould be uncomfortable selling put optionsor going long on the Chicago Board ofTrade July futures, yet they will exposethemselves to exactly as much risk underprivate storage.  This does not mean thatspeculation is wrong; indeed marketoutcomes may show that the privatestorage option was the correct course tofollow.  It does, however, argue thatfarmers should not confuse speculationwith risk management.CHOICE 3Use the loan program or take the LDP,store, and lock in a futures price.An alternative to private storage is totake the LDP and store the grain, but thenuse the futures market to lock in a Julyprice. If the futures market allows you to“sell” the privately stored grain at a Julyprice that is greater than the loan rate, thenyou could take the LDP and secure anadvantage of the relatively high futuresprice.Whether or not this option returns morethan the expected value of putting the grainunder loan depends on the July futuresquote in comparison with current cashprices. When the July futures price is closeto the current price, it will not be possible tolock in a premium, and the loan programwill dominate.  When the July futures priceis much higher than current cash markets,then taking the LDP and locking in a Julyprice may return more than using the loanprogram.  Figure 2 makes this comparisonfor a wide range of July futures and localprices.The comparison shown in Figure 2 isrelevant to situations outside of UnionCounty and for a much wider range ofprices than those used in the introduction.For example, the extreme left-hand valueshows a local price of $1.25 (thiscorresponds to a nearby futures price of$1.55).  At this price, then, a July futuresprice above $1.70 will make it worth-while to stay out of the loan program.  Atany July price below this value, the loanprogram will dominate. If the local priceis $1.65 (corresponding to a nearbyfutures price of $1.95), then the break-even July futures price is $2.60.  Al-though this seems like a largedifferential, we must add to the postedcounty price the cost of storage, theexpected basis, and the market value ofthe implicit put option that comes withthe loan program.It is unusual for the futures market toshow a large enough storage premium tomake it worthwhile to take the LDP andlock in a futures price.  However, thefederal government may decide toartificially force down posted countyprices in order to make the LDP a moreattractive option. Figure 2 shows what thedifferential needs to be in order to makethe posted county price a more attractiveoption than the loan rate. 

Loan Deficiency Payments or the Loan Program?

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Loan Deficiency Payments or the Loan Program?

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