Melvin Brees
Farm Management Specialist
University of Missouri Extension

 

 

 

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Please send your comments and send suggestions to Melvin Brees, Farm Management Specialist, University of Missouri Extension, #1 Courthouse Square,  Fayette, MO 65248, call 660-248-2272, or send messages by e-mail to: breesm@missouri.edu.
August 25, 2000

"Protecting the LDP?"

The loan deficiency payment (LDP) was intended primarily as a convenient safety net or price support tool. It allows producers to by-pass the CCC loan process and still receive the loan price for their grain. The LDP is roughly the difference between local cash prices (actually the posted county price [PCP] determined by a USDA formula) and the loan price. The LDP can be claimed and the grain sold on the cash market, supporting net price at (approximately) the county loan price.

The LDP process also provides speculative opportunities. Collecting the LDP when the PCP is very low results in a larger LDP. If a producer collects the LDP and delays selling the grain until prices improve, the larger LDP along with improved prices result in a net price higher (maybe much higher) than the county loan price. In reality, this strategy involves speculating on both lower and higher prices to claim the LDP and sell the grain. This is not necessarily a bad business decision, but it is important to understand that a speculative strategy assumes risk instead of reducing risk.

The problem with the LDP is that, to collect it, the grain must be harvested. If prices bottom out prior to harvest, such as some analysts think might happen this year, the LDP shrinks as prices improve and the opportunity to get the largest LDP slips away before the grain can be harvested. This possibility causes some to look for ways to "protect" or "lock-in" the LDP.

The most common suggestion for protecting the LDP is to purchase a call option. This strategy is based on the expectation that an increase in futures price will be reflected in a higher PCP and reduced LDPs. Gains on a call option would offset the reductions in the LDP and in effect "protect" the LDP. If prices go lower, the option expires and any resulting larger LDP could still be claimed. Other variations of this strategy include buying futures or a combination of buying futures and buying a put option (synthetic call).

The most obvious risks would be the cost of the option premium and limited price increases that are insufficient to recover the premium. There are other risks because an increase in futures price doesn't necessarily mean a change in the LDP. Basis cannot be protected in the futures (options) market and it influences the PCP--thus affecting the LDP. For example, futures might decline or trade in a narrow range, producing no option gains, and basis could improve increasing the PCP and reducing the LDP. With no option gains, the "protection" would not work! Even if futures prices increased (resulting in option gains) and basis also improved, the option gains would not offset all of the reduction in the LDP--providing only partial protection in this case.

A strategy to "protect" or "lock-in" the LDP may have some merit and could reduce the risk of missing out on a large LDP. However, using it is often only a part of a marketing strategy that also involves speculating on both higher and lower prices. It is important to understand how all parts of the strategy work and the pitfalls associated with them. --Melvin


University of Missouri ExtensionDecisive Marketing - August 25, 2000
http://outreach.missouri.edu/agconnection/DCT/DM000825.html -- Revised: April 20, 2004
breesm@missouri.edu