Hedging Downside Risk to Farm Income with Futures and Options: Effects of Government Payment Programs and Federal Crop Insurance Plans

The high proportion of government payments in total crop farm income and the purchase of subsidized crop insurance have changed the income distribution of U.S. crop farmers. As a result, the risk management behaviors of U.S. crop farmers are affected by these programs in terms of the use of private market risk management tools, such as futures and options. The objective of this research is to investigate the effects of the government payments and federal crop insurance policies on the usage of futures and options by crop farmers from a downside risk management perspective. Results in this study suggest that both yield insurance and revenue insurance creates more hedging demands for futures. But revenue insurance decreases the buying of put options at the same time. Loan deficiency government payments substitutes largely for the hedging role of put options while Counter Cyclical payments substitutes futures hedge. This research contributes the literature by proposing to use a downside risk hedge model, the second-order lower partial moment (LPM2) hedge model, to investigate the interaction of government and private risk management tools used by crop farmers. This study also initiatively applies the conditional kernel density method and the copula approach in the data simulation process. The conditional kernel density method generates county yield and farm yield with the same conditional pattern as revealed in the historical yields. The copula simulation allows the crop yield and prices have more flexible joint distributions other than bivariate normal.