The Effect of Crop or Revenue Insurance on Optimal Hedging

The emergence of new risk management tools such as revenue insurance has dramatically expanded the tools from which producers may choose to manage revenue risk. Little is known regarding how these products interact with market-based risk management tools such as futures and options. Our analysis addresses this issue by examining optimal futures and put ratios under increasing levels of insurance coverage. Four alternative insurance designs are examined. Two are yield triggered and two reflect currently available revenue insurance designs. The analysis is conducted by using a revenue simulation model which incorporates four random variables: futures price, basis, county yield, and farm-county yield differences. Optimal hedge and at-the-money put option ratios are derived for an expected utility maximizing corn producer in four distinct geographical regions. Revenue insurance tends to result in slightly lower hedging demand than would occur given the same level of yield insurance coverage. To the extent that producers would switch from yield insurance to revenue insurance there would be a decline in the demand for hedging. If a person were to go from being uninsured to the purchase of one of the insurance designs, we find that the revenue products result in a hedge ratio that is at least as high as the uninsured case when considering the permissible levels of coverage.