Financial engineering for the farm problem

Abstract

Purpose – The purpose of this paper is to provide a general discussion of how techniques from financial engineering can be used to investigate the economic costs of farm programs and to aid in the design of new financial products to implement margin protection for dairy farmers. Specifically the paper investigates the Milk Income Loss Contract (MILC) and the Dairy Margin Protection (DMP) program. In addition the paper introduces the concept of the Milk to Corn Price ratio to protect margins. Design/methodology/approach – The paper introduces and reviews the tools of financial engineering. These include the stochastic calculus and Itô's Lemma. The empirical tool is Monte Carlo simulations. The approach is part pedagogy and part practice. Findings – In this paper the authors illustrate how financial engineering can be used to price complex price stabilization formula in the USA and to illustrate its use in the design of new products. Practical implications – In this paper the authors illustrate how financial engineering can be used to price complex price stabilization formula in the USA and to illustrate its use in the design of new products. Social implications – Farm programs designed to protect dairy farmers margins are designed in a seemingly ad hoc fashion. Assessments of programs such as MILC or DMP are conducted on an ex-post basis using historical data. The financial engineering approach presented in this paper provides the means to add significant depth to the assessment of such programs which can be used in conjunction with Monte Carlo simulation to identify alternative model structures before they are written into law. Originality/value – This paper builds upon an existing literature. Its originality is in the application of financial engineering techniques to farm dairy policy.