The cattle market has seen an increase in price volatility in recent years. This increased volatility translates into greater risk and uncertainty for cattle producers. For a risk seeking individual, more volatility means a possibility of receiving higher returns on his cattle. However, for risk adverse individuals, increased volatility is something to be avoided if at all possible.
Forward price contracts and futures market contracts are used by producers to help manage this price volatility. However, while each of these alternatives limits downside price risk, they also limit any upside potential. Options on futures were created to help producers limit downside risk while still being able to take advantage of upside market moves.
Livestock Risk Protection (LRP) insurance is another tool producers have to insure against lower prices and still take advantage of higher prices. LRP insurance is very similar to a put option. However, with feeder cattle put option contracts must be purchased in 50,000 lb. increments, but with LRP insurance, a producer can insure as few cattle as he or she wishes.
The way in which LRP insurance works is really quite simple. At the time the insurance is purchased, an expected ending value is estimated. This expected value is basically the current futures price of the cattle, for the month in which they will be sold. The producer then chooses which level of coverage he desires. This level can be between 70% to 95% of the expected ending value. The premium is then calculated based upon the level of coverage chosen.
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