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Valuing Counter-Cyclical Payments: Implications for Producer
Risk Management and Program Administration
Gerald E. Plato, David W. Skully, and D. Demcey Johnson
Economic Research Report No. (ERR-39), February 2007
The 2002 Farm Act instituted a new program called counter-cyclical
payments.The payments supplement the incomes of producers with
established base acres in wheat, soybeans, upland cotton, corn,
grain sorghum, barley, oats, rice, or peanuts. Eligible producers
receive payments when a designated crop’s marketing-year
average price falls below its effective target price, which
is established by legislation. Counter-cyclical payments are
tied to a fixed production base rather than actual production.
Thus, producers cannot augment their payment amounts by changing
their planting decisions.
The counter-cyclical payment rate after a marketing year ends
equals the effective target price minus the larger of the marketing-year
average price for a commodity and the commodity’s national
marketing loan rate, a price level specified in the Farm Act.
Each month, USDA updates the forecasts of the marketing-year
average prices (published in the World Agricultural Supply and
Demand Estimates (WASDE) report). The October and February forecasts
are used to calculate advance counter-cyclical payments for
the current marketing year.
What Is the Issue?
USDA’s current method for estimating expected counter-cyclical
payment rates produces unintentionally biased estimates because
it does not consider the variability of marketing year prices.
Estimates with positive bias increase the risk of overpayment
to producers who accept advance payments. According to statute,
producers must reimburse the Government for any overpayments,
which can lead to cash-flow problems for producers.
What Did the Study Find?
A model developed for this analysis improved upon the USDA
method of estimating counter-cyclical payment rates by accounting
for the variability in market price forecast errors. This enhanced
method produced unbiased estimates. Forecasters and producers
can also use the model to calculate the probabilities of repayment.
Producers can use call options on commodity futures contracts
to hedge against losses in expected counter-cyclical payments.
Hedging, however, is only moderately effective and varies by
commodity.
How Was the Study Conducted?
The model developed here uses an approach based on option pricing
theory to derive an unbiased estimate of expected counter-cyclical
payments and the probabilities that advance payments will have
to be repaid. Data required to run the model included the policy
parameters in the 2002 Farm Act, a forecast of a crop’s
marketing-year average price, and an estimate of forecast variability
(based on the past history of WASDE forecasts).
This report also describes a simulation exercise to evaluate
hedging opportunities. Expected counter-cyclical payments were
hedged with call options on futures contracts. In principle,
by hedging with call options, producers can reduce the risk
of lower counter-cyclical payments (due to a price increase),
while retaining potential gains in payments (from a price decline).
Simulated price data—both marketing-year average and futures
contract price forecast and outcome—were used to estimate
expected payoffs from the hypothetical hedge. The correlations
and variances of the simulated prices matched those found in
historical price data.
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