It has come to the attention of HighGround that some market participants have been evaluating strategies to arbitrage the difference in value between their DRP or LRP coverage and the value of options on futures contracts with a similar settlement procedure to extract the subsidy from these insurance programs. Please read our full write-up explaining the dangers and HighGround's take.
Since the addition of Dairy Revenue Protection (DRP) in 2018, the approach that many dairy producers take to price risk management has greatly changed. Prior to DRP, the primary insurance offering that most dairy producers utilized was Livestock Gross Margin – Dairy (LGM-Dairy) which only utilizes a Class III milk price and is only available on a monthly basis. Beyond that, producers could utilize a forward contracting program, take positions in exchange-traded futures and options at the Chicago Mercantile Exchange (CME) or via an over-the-counter swap. DRP provides coverage against declines in both milk price and milk yield. Customizable pricing options allow producers to correctly protect their pay price based both their utilization and even their herd’s specific components. With attractive subsidy rates and premiums that are deferred to the end of the coverage period, DRP quickly became a popular tool for producers to manage their price risk.
In 2020, the USDA-RMA announced that subsidy rates and head limits for Livestock Risk Protection (LRP) would be increasing in 2021. LRP provides price protection for feeder cattle, fed cattle, and swine. The increase in subsidy rates and head limits has greatly increased producer interest in the program. It has come to the attention of HighGround that some market participants have been evaluating strategies to arbitrage the difference in value between their DRP or LRP coverage and the value of options on futures contracts with a similar settlement procedure to extract the subsidy from these insurance programs.
Undermining the Purpose of Insurance
The Federal Crop Insurance Corporation (FCIC) is the government-owned corporation managed by the USDA’s Risk Management Agency (RMA). These entities are tasked with promoting the economic stability of agriculture though an array of crop insurance products. The subsidies provided in these insurance products are designed to make them more accessible for producers, not to be exploited. Purchasing insurance coverage with the intention of offsetting said coverage to arbitrage the spread in value between the two instruments undermines the purpose of the insurance. A strategy like this is the antithesis of the mission of the FCIC and the USDA-RMA. Actions like this are viewed as abuse and threaten the legitimacy of both DRP and LRP moving forward. HighGround and its affiliates discourage this type of activity for any market participants.
Settlement Differences Diminish the ‘Opportunity’
At first glance, it is easy for someone to get the impression that an arbitrage “opportunity” exists since the mechanics of DRP and LRP coverage are very similar to a long put option on the futures contracts which the insurance products derive their price. Since the premiums for the insurance coverage are being obtained at a reduced rate due to subsidies from the USDA, an insured may think they could simply offset their coverage by simultaneously selling a put option in the contract month(s) and at a strike price that is like their insurance coverage. Since the premium collected for the put options on those futures contracts is greater than what they have paid for the insurance coverage, they would effectively be collecting the difference. Some have referred to this practice as “subsidy harvesting”. There are some major differences in the settlement of these insurance products and CME futures and options which should deter anyone from attempting this.
DRP provides coverage for both milk price and milk yield. When establishing coverage, the expected milk price is based on the quarterly average of the settlement prices for CME futures and the expected yield is based on the USDA’s forecasted yield which will differ for every state and coverage period. These variables are combined with the insured’s declared production that they would like to cover to determine and expected revenue value. At the end of the coverage period, an actual revenue number is determined. The actual milk price value is the quarterly average of the Class and Component prices announced by the USDA. The difference between the expected milk price on and the actual milk price at the end of the coverage period is typically going to make up the lion’s share of the variance between expected and actual revenue, but the yield adjustment factor makes the net result dependent upon more than just price.
The settlement of CME futures and options is based on the announced monthly Class and Component prices from the USDA (price only). There are similar issues between the settlement of LRP coverage and Live Cattle futures and options at the CME. LRP settles to the 5 Area Weekly Weighted Average Directed Slaughter Cattle report, while cattle futures and options at the CME settle to the contract values themselves since they are physically deliverable.
Due to the differences between the settlement of these insurance products and CME futures and options, this arbitrage “opportunity” tends to not line up as one might anticipate and often carries more risk than potential reward.
Futures and options trading involves substantial risk and is not suitable for all investors. All material distributed by HighGround Trading LLC shall be construed as a solicitation for entering into a derivatives transaction. While every effort is made to ensure the accuracy of the data within this report, HighGround Dairy makes no guarantees as to the accuracy of the information contained herein.