Understanding the Implied Volatility (IV) Factor in Crop Insurance

Abstract

Each year, RMA resets the Projected Prices (PP) and Implied Volatility Factors (IV) that are used in the determination of crop insurance guarantee levels and premium costs. For much of the cornbelt, the Projected Prices are established based on the average of the settlement prices of the crop’s associated harvest-period futures contract during the month of February.1 Other regions with different growing seasons and different sales closing dates use different time intervals, but the principle is to average a set of the market’s estimates of future prices to establish an indemnification price that is intended to be highly correlated with expected revenue from the insured crop. The implied volatility factor, or IV plays a related role in that it is used to convey the market’s best information about the riskiness around the projected price, or in other words, the probabilities that the prices will deviate and by how much from the projected prices. The final IV factor, in contrast to the PP is determined by averaging the implied volatilities of near the money options over the final 5 trading days of the PP determination interval. High IVs indicate greater uncertainty, or higher likelihoods for larger price movements, and lower IVS signal more market confidence that the futures prices will remain in a smaller range. Taken together, the IVs and the projected prices imply a particular underlying price distribution that along with other features, is used to “price” crop insurance. The purpose of this farmdoc daily article is to help better understand the IV concept, demonstrate implications for pricing, and relate to the market’s information about potential price movements prior to harvest.