Abstract
AbstractCrop revenue insurance is unique, because it involves a guarantee subsuming yield risk and highly systematic price risk. This study examines whether crop insurers could use options instead of, or in addition to, assigning policies to the Commercial Funds of the USDA Federal Crop Insurance Corporation (FCIC) as per the Standard Reinsurance Agreement (SRA) to hedge the price risk of revenue insurance policies. The behavioral model examines the optimal hedge ratio for a crop insurer with a book of business consisting of corn Revenue Protection (RP) policies. Results show that a mix of put and call options can hedge the price risk of the RP policies. The higher optimal hedge ratios of call options as compared to put options imply that the risk of increased liability due to upside price risk can be hedged using options better than downside price risk. This study also analyzed the combination of options with the SRA at 35, 50, and 75% retention levels. The zero optimal hedge ratios at each retention level and the negative correlation between RP indemnities and the option returns when the crop insurer mixed options and SRA suggest that the purchasing of options provides no additional risk protection to crop insurers beyond what is provided by the SRA despite retention limits.
Highlights
Revenue insurance is unique in that the guarantee subsumes a highly systematic price risk
We find that the optimal hedge ratio is zero and option returns are negatively correlated with Revenue Protection (RP) indemnities when the crop insurer mixed options and Standard Reinsurance Agreement (SRA) to hedge the price risk, thereby indicating that United States Department of Agriculture (USDA) SRA is a clear substitute for options
This section is divided into two main sections: a) summary statistics of simulated quantities, including prices, option premiums, yields, and the company’s book of business and b) optimal hedge ratios under different scenarios
Summary
Revenue insurance is unique in that the guarantee subsumes a highly systematic price risk. These findings suggest that USDA could protect crop insurers only against the downside price risk, while the option market could be used to hedge the upside price risk. This leads to the possibility of a restructured SRA that lets the private sector to handle the price risk of revenue insurance. We report our findings and answer whether a crop insurer could use options alone or in combination with the SRA, to hedge the price risk inherent in revenue insurance policies
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