LGM-Dairy:
Program Fundamentals
Brian W. Gould
Department of Agricultural and Applied Economics
University of Wisconsin-Madison
University of Wisconsin Extension
November 25, 2013
Overview
 How can dairy producers manage the
volatility of their margins
 Margin ≡ Income over feed costs
 Getting inside the LGM-Dairy BlackBox
 Resources available for advanced
planning
2
Margin Risk Management: Options Based
 How can dairy producers establish a floor on
their Income over Feed Costs (IOFC) using
feed and class III options?
 Class III put option: Creates milk revenue floor
 Feed call option: Establishes feed cost ceiling
Milk revenue floor
IOFC ($/cwt)
$P* Put
Strike Price
$C* Call
Strike Price
IOFC**
IOFC*
Min.
IOFC
IOFC** >
C*
P*
Feed cost ceiling
IOFC < IOFC*
Market Prices
3
Margin Risk Management: LGM-Dairy
 An alternative method for managing margin
volatility: Livestock Gross Margin
Insurance for Dairy (LGM-Dairy)
 Objective: Establish minimum IOFC
 Similar to put/call options strategy except:




No options actually purchased
No minimum size limit
Upper limit: 240,000 cwt over 10 mo./insurance yr
Premium not due until after 11-month insurance
period regardless of number of insured months
 Subsidized premiums
 Pilot program with limited funding (<$20 Mil)
 Reason for flat learning curve
4
LGM-Dairy: An Overview
Historical Use of LGM-Dairy
# of
CWT
Contracts
(000)
Sold
GMG
(000$)
Premium
Subsidy
Prem.
Indem.
Subsidy
Rate
(000$)
(000$)
(000$)
(%)
2008/09
45
402
4,716
287
0
718
0
2009/10
153
1,872
24,915
782
0
281
0
2010/11
1,412 46,173
769,644 25,013
10,736
65
42.9
2011/12
1,771 40,504
704,521 19,153
8,867
1,395
46.3
2012/13
1,698 34,189
664,254 16,878
7,659
1,995
45.4
5,079 123,140 2,168,050 62,113
27,262
4,454
43.9
Total
5
LGM-Dairy: An Overview
2012/2013 Sales
State
Policies
Sold
No.
% of
Total
CWT
Insured
000$
% of
Total
Liabilities
000$
Premiums
% of
% of
000$
Total
Total
Subsidies
Subsidy
% of Rate (%)
000$
Total
NY
MI
WI
46 2.7 2,181 6.4 41,207 6.2 1,017 6.0
167 9.8 2,701 7.9 51,840 7.8 1,137 6.7
742 43.7 10,989 32.1 213,274 32.1 5,179 30.7
475 6.2
545 7.1
2,409 31.5
46.7
47.9
46.5
MN
324
39
1,110 14.5
47.0
42.5
19.1
2.3
4,237 12.4
4,388 12.8
83,081 12.5 2,360
14.0
86,047 13.0 2,222 13.2
944 12.3
CA
92 5.4
707 2.1 13,702 2.1
352 2.1
158 2.1
PA
Total 1,698 ----- 34,189 ----- 664,254 ----- 16,878 ----- 7,659 -----
44.9
45.4
6
LGM-Dairy: An Overview
 We need to differentiate between producer
demand for LGM-Dairy vs. utilization rate
 Producer demand : determined by producers’
willingness to purchase
 Utilization rate
 % of producers using
 determined by Federal funding availability
 Demand is much greater than indicated by
participation rate given funding shortages
 Funding uncertainty has had an impact on contract
designs that has ↓ effectiveness of some contracts
7
LGM-Dairy: An Overview
 LGM-Dairy is customizable with respect to:
 Number of months insured by 1 contract
 1 – 10 months
 % of monthly IOFC (marketings) insured
 0 – 100% of certified marketings
 % coverage can vary across month
 Farm specific insurance characteristics




Amount and % of marketings insured
Declared feed use: Only protect market-based risk?
Deductible and resulting premium subsidy
Premium specific to farm’s contract design
8
LGM-Dairy: An Overview
 Class III, corn, and soybean meal futures and
options markets used as information source
 Used to determine Expected (forward looking at
time of purchase) and Actual (observed for each
month) prices
 No futures market transactions
 Actual farm prices not used
 No local basis added to prices
 What does the insured Class III based IOFC mean
in-terms of farm mailbox IOFC?
 What is your Class III and feed basis?
9
LGM-Dairy: An Overview
 Prior to LGM-Dairy contract purchase
producer knows:
 All expected milk price and feed costs for
months in proposed contract
 The Class III-based IOFC floor that would be
established for insured production
 Since floor is based on Chicago prices what does
this IOFC protection mean in terms of producer’s
actual mailbox-based IOFC?
10
LGM-Dairy: Expected Feed Use
 Expected feed use converted to Corn
(Energy) and SBM (Protein) equivalents
 Allowable range of feed equivalents:
 Corn: 0.13 – 1.36 bu/cwt of milk
 SBM: 1.61 – 26.00 lb/cwt of milk
 Program default feed coefficients can be used:
 Corn: 0.5 bu/cwt SBM: 4.0 lbs/cwt
 No auditing of declared feed use
 Many producers only declare purchased feed
 Using minimum feed amounts → approximate
a weighted average put option
11
LGM-Dairy: An Overview
 Total Expected Gross Margin (TEGM) =
Total contract Expected value of milk – Total
contract Expected feed costs
 = Sum of monthly (Expected milk prices x
Insured milk) – Sum of monthly (Expected
feed prices x Insured feed use)
 1 TEGM per contract regardless of the number
of months insured
 One month’s low margin can offset another’s
relatively high value as only total value matters
(i.e., TEGM)
12
Total Expected
Gross Margin
Expected Milk
Expected
Income
Feed Cost
CME
Class III
CME
Corn
CME
SBM
Profile of % Coverage
Over Contract Life
Expected Milk
Marketings
Declared
Feed Use
Program
Rules
Contract
Design
Market
Data
Producer
Data
LGM-Dairy: Expected Prices
 All 10 months of Expected Prices are known at sign-up
Expected Prices = Average of
futures settle prices on these days
Insurance signup period
Obtain March ʹ14 – Dec ʹ14
Expected Prices
14
LGM-Dairy: An Overview
 Total Gross Margin Guarantee (TGMG) =
TEGM – chosen deductible
 Producer chooses insurance deductible
 Deductible = the portion of insured milk’s Total
Expected Gross Margin not protected
 How much gross margin must go down
before insurance coverage starts
 Program allows $0 - $2.00/cwt Gross Margin to
be excluded from coverage
 Higher deductible → Lower premium
 Producer assumes more risk
15
Total Gross
Margin Guarantee
Total Gross Margin Guarantee (TGMG) =
TEGM – (Deductible [$/cwt] x cwt insured)
= minimum IOFC
Total Expected
Gross Margin
Deductible
Level
Expected Milk
Expected
Feed Cost
Income
CME
Class III

CME
Corn
CME
SBM
Profile of % Coverage
Over Contract Life
Expected Milk
Marketings
Declared
Feed Use
Program
Rules
Contract
Design
Market
Data
Producer
Data
Net
Premium
Total Net Gross Margin
Guarantee
Total Gross Margin
Guarantee (TGMG)
Subsidy
Deductible Subsidy Deductible Subsidy
($/cwt)
(%)
($/cwt)
(%)
Total Expected
Gross Margin
Deductible
Level
0.00
18
0.60
31
0.10
19
0.70
34
0.20
21
0.80
38
0.30
23
0.90
43
Expected Milk
Expected
0.40
25
1.00
48
Income
Feed Cost
0.50
28
1.10 – 2.00
50
CME
Class III
CME
Corn
CME
SBM
Profile of % Coverage
Over Contract Life
Expected Milk
Marketings
Declared
Feed Use
Program
Outcome
Program
Rules
Contract
Design
Market
Data
Producer
Data
LGM-Dairy: Expected Prices
 As noted above, prior to purchase
producer knows all expected prices
 Insurance sold after Friday’s futures markets
have closed
 → Need to evaluate TGMG under alternative
contract designs
 Chosen deductible rates
 Coverage months and % coverage
 Alternative declared feed amounts
 Should Use LGM-Dairy Analyzer for
planning well in advance of purchase date
18
LGM-Dairy: Actual Prices
 As an insurance contract matures RMA
needs to determine actual monthly milk
value and feed costs
 Use the same production and feeding profile
used when contract was purchased
 Only prices change
 Need actual Class III, corn and SBM prices
19
LGM-Dairy: Actual Prices

Actual prices based on futures settlement
prices at futures contract expiration
 Actual price = Average futures contracts settle
prices from 3 days prior to futures contract’s
last trading day
 Last trading day for corn and SBM is last
business day prior to the 15th
 Class III futures contract’s last trading day:
 Will usually be on a Tuesday
 The day prior to the Class III price announcement by
USDA: Announcement typically on a Wed not later
then the 5th of the month following production
20
LGM-Dairy: Actual Gross Margin
 Total Actual Gross Margin (TAGM) =
Total Actual contract milk value – Total
Actual contract feed cost
 TAGM = Sum of monthly (Actual milk prices
x Insured milk) – Sum of monthly (Actual
feed prices x Insured feed use)
 Note there is not a monthly determination of
actual monthly gross margin
 → Only 1 TAGM regardless of months insured
 → A month with a low IOFC can be offset by a
month with a relatively high IOFC value
21
 Actual prices based on futures settlement prices at expiration
Actual price = Average futures contracts settle prices from 3 days prior to
futures contract’s last trading day
Total Actual
Gross Margin (TAGM)
Final futures
settlement prices
Actual Milk
Actual Feed
Income
Cost
Final CME
Class III
Final CME Final CME
SBM
Corn
Profile of % Coverage
Over Contract Life
Expected Milk
Marketings
Declared
Feed Use
Program
Rules
Contract
Design
Market
Data
Producer
Data
LGM-Dairy: Actual Prices
Settle prices used to calculate
Actual March Corn/SBM prices
Settle prices used to calculate
Actual July 2014 Class III price
Last Corn/SBM
trading day
Last July 2014
Class III trading day
23
LGM-Dairy: Indemnity Determination
 If TGMG > TAGM → An insurance indemnity
will be generated
 Payout amount = TGMG – TAGM
 → i.e., Market did not live up to expectations
 Again: Only 1 indemnity calculation per contract

When is the indemnity determination made
 After last actual price is available from RMA
 May be 1 – 2 months after last covered month
 Corn Example: Sept/Dec futures contracts vs.
Oct/Nov LGM coverage months
24
Net
Premium
Total Net Gross Margin
Guarantee
?
Total Gross Margin
Guarantee (TGMG)
Subsidy
Total Expected
Gross Margin
Deductible
Level
Insurance
Payout
Total Actual
Gross Margin
Expected Milk
Expected
Actual Milk
Actual Feed
Income
Feed Cost
Income
Cost
CME
Class III
CME
Corn
CME
SBM
Final CME
Class III
Profile of % Coverage
Over Contract Life
Expected Milk
Marketings
Declared
Feed Use
Program
Outcome
Final CME Final CME
SBM
Corn
Program
Rules
Contract
Design
Market
Data
Producer
Data
LGM-Dairy: When Purchased?
 LGM-Dairy can be purchased monthly if
funds available
 Each contract can cover up to 10 months
 Purchase period starts no earlier than 4:30
pm CDT on last business Friday of month
 Starts: 4:30 pm CDT, October 26th
 Sales will start on the half hour if data not
available at 4:30 (e.g. 5:00 pm, 5:30 pm, etc.)
 Purchase period ends at 8:00 PM CDT the
next day, e.g., Saturday Oct. 27th
 Why planning by both agent and producer is
needed well in advance of contract purchase
26
LGM-Dairy: Coverage Calendar
 Hypothetical insurance strategy
 Purchase insurance on Jan 31st – Feb 1st
By rule: No coverage the
month after purchase
Jan
′14
Purchase
Jan 31st
– Feb 1st
Feb
′14
No
Coverage
Production
Coverage
Mar
′14
Apr
′14
May
′14
Jun
′14
Jul
′14
Aug
′14
Sep
′14
Oct
′14
Nov
′14
Dec
′14
1
2
3
4
5
6
7
8
9
10
Insurance Contract Period
25%
25%
20%
20%
Hypothetical LGM Contract
27
LGM-Dairy: Summary
 LGM-Dairy a flexible insurance program
 Need not insure all months or production
 Could make sense to overlap contracts
 Substantial premium subsidies
 Similar to combined use of Class III puts
and corn/SBM calls
 Premiums are very sensitive to chosen
deductible
28
LGM-Dairy: Summary
 Major Drawbacks
 Short sign-up window at the end of each month
 Need to wait until after the last actual price
determined before indemnity evaluated
 Very limited funding
 Purchasers want a 10 month contract due to funding
uncertainty: Should not use this design due to
contract valuation
 Would like to have a multi-month purchase risk
management strategy
 Question as to the impact of margin insurance
program being considered in the new Farm Bill29
Contact Information
 The Univ. of Wisconsin Dairy Marketing Website:
http://future.aae.wisc.edu
 Livestock Gross Margin Insurance:
http://future.aae.wisc.edu/lgm_dairy.html
 To join the LGM-Dairy Mailing List:
http://future.aae.wisc.edu/lgm_dairy.html#5
 Brian W. Gould
(608)263-3212
[email protected]
30