The Heritage Foundation

Backgrounder #414 on Agriculture

March 7, 1985

March 7, 1985 | Backgrounder on Agriculture

Agricultural Options: An Alternative to Federal Farm Programs

(Archived document, may contain errors)

414 March 7, 1985 A GRICULTURAL OPTIONS AN ALTERNAT1,VE TO FEDERAL FARM PROGRAMS INTRODUCTION has changed signi.ficantly in the past half-century. Changed too are the environment in which the U.S. agricultural industry operates and the needs of the industry. Yet current fede r al agriculture programs are essentially those developed to-deal with the agricultural problem of the 1930s The production and marketing of U.S. agricultural commodities In an attempt to make federal farm programs relevant for the 1980s, the Reagan Adminis t ration is proposing a Farm Bill that will reduce government's influence on agriculture and move the industry toward a market-based system system should be the agricultural options market. Agricultural options are contracts that give farmers the right to s e ll at a predetermined price during some period in the future. The options are a private sector device that can give the farmer price pro tection similar to that which he now gets from federal agricultural programs A key feature of this The primary objecti v e of these programs has been to assure price and income stability to farmers. In essence, agricultural programs have insured farmers against a decline in the price "they This study is the fifth in a Heritage series on agriculture by Bruce Gardner, "Agricu lture's Revealing--and Painful--Lesson for Industrial Policy," Heritage Foundation Backgrounder No. 320, January 3, 1984; E.C.

Pasour, Jr The High Cost of Farm Subsidies Heritage Foundation Backgroun der No. 388, October 22, 1984; E. C. Pasour, Jr The Free Market Answer to U.S. Farm Problems," Heritage Foundation Backgrounder No. 389, October 30 1984; and Thomas GreMeS Helping U.S. Farmers Sell More Overseas," Heritage Foundation Backgrounder No. 411, February 27, 1985 It was preceded 2 will get 'from sell i ng their crops. In the past, such insurance was not available through the private sector. Agricultural options were banned in the U.S. for almost 50 years This changed last October 29, when the Commodity Futures Trading Commission allowed such options for trading in the U.S. under an agricultural options pilot program. Now options can be used as insurance against commodity price declines, instead of farmers obtaining such insurance paid for by America's taxpayers.

Agricultural options give the agriculture industry an important new risk-management tool. They can protect farmers for example, from adverse and rapid price declines while allowing farmers to profit from price rises. Because agricultural options can be used to establish minimum prices, they repre sent an alter native method to expensive governmental agricultural programs of achieving certain policy goals, such as stabilizing farm income.

Economists have noted, in fact, that federal price support programs and target price programs currently availabl e for pro ducers of many agricultural commodities are actually a form of option markets. The Department of Agriculture guarantees a target price and a loan price to farmers who participate in the program, but allows them to sell their commodities in the m a rket if higher prices are available--just as the options markets do for such commodities as cattle, corn and soybeans. The difference is that farmers enjoy this federal price protection at essentially no cost because the taxpayers pay for differences betw een the target price and the price established in the market. There is no mechanism, moreover, for these target prices to adjust with changes in market conditions, nor for the costs to be spread throughout the farming industry.

Instead of expensive governm ent price insurance programs farmers could buy options which are traded competitively A comprehensive private option market could form the foundation of a transition from a government-influenced agricultural sector to the "market-based agriculture industr y that Agriculture Secretary John Block is advocating. Agricultural options can be used to stabilize farm income and free farmers from many uncertainties regarding prices--without many of the costly federal programs.

There are, however, political and practical obstacles to a more \\ market oriented agriculture sector. Farmers would object for example to such a proposal because they would have to pur chase the price protection that they currently receive essential free from U.S. taxpayers. Yet, the obstacles m ay be made manage able if the transition from government programs to the use of agricultural options is gradual The benefits from using agricultural options in place of government programs would be significant b 1) The elimination of price support program s and their resFrictions on price movements.would allow the market 3 to give tion of accurate price signals for the optimal alloca resources. As a result U.S. asricultural commodities could become more competitiGely. priced in world markets, causing an inc r ease in U.S. exports 2) The use of agricultural options instead of agricultural price support programs would provide farmers more flexibility and more control in determining how much price protection they needed for their price risk management. Farmers wo uld then have an incentive to economize in risk management 3 Taxpayers would no longer be burdened with the cost of providing price protection to farmers. Instead, farmers who want price protection would pay for it themselves.

Agricultural options can provide an alternative to price support and target price programs. A full options market would complement the free market measures already proposed in the Reagan Administrationls new Farm Bill.

AGRICULTURAL OPTIONS TRADING Although the trading of agricultural commodity options began in the U.S. in the mid-19th century, trading of regulated domestic commodity options was banned by,the Congressional Commodity Act of 1936 In 1982 Congress passed the Futures Trading Act which per mitted agricultural options tradi ng under the regulation of the Commodity Futures Trading Commission (CFTC). The CFTC approved the first agricultural option contracts in October 1984'and trading began in that month.

Under CFTC rules, each exchange is allowed to trade options on two agricu ltural futures contracts. Options are now traded on corn, wheat, cotton, live cattle, soybeans, and hog futures contracts.2 tions regarding the number of options per exchange. If they are lifted, options on additional agricultural futures contracts probab l y will begin trading The CFTC is expected to consider lifting the restric By permitting agricultural options trading, Washington is spurring development of an important risk management tool for the The regulated domestic commodities included most, if not all, of the major agricultural commodities produced domestically (for example, corn and wheat).

Options on sugar futures contracts are also traded. However, because sugar was not a regulated domestic commodity, sugar options began trading under the earlier options pilot program 2 4 nation's farmers. It even may be possible, say some economists to allow agricultural options to replace agricultural price support and target price program Mechanics of Trading Agricultural Options4 An agricultural option on a f u tures.contract (as currently traded in the U.S is a contract which gives the buyer the right to buy or sell a particular futures contract at a predetermined price anytime during the life of the option. A futures contract is an agreement to buy or sell an i tem at some specified future dqte. The.seller of the option has the obligation to acquire the opposite futures position at the same predetermined price, if the buyer exercises his right Two types of options exist. A "call" option gives the buyer of the op t ion the right to buy a futures contract, and the seller of the option the obligation to sell the futures contract A put1' option gives the buyer of the option the right to sell a futures contract and the seller of the option the obligation to buy the futu r es contract. The predetermined price at which the futures contract will be acquired is called the llexercise'l price or the I'strike price. The price of the option itself, called the premium, is the amount that the buyer pays the seller to assume the obli gation.

Assume, for example, that there is a 20C-per-bushel premium for a put option on the November 1985 soybean futures contract with a strike price of $6.00 per bushel. What this means is that the buyer of that put option pays 20C per bushel to the sell er for the right to sell a November soybean futures contract at 6.00 per bushel during the life of the option.5 If the price of the November soybean futures contract remains above 6.00 during the life of the option--that is, if traders expect the market p r ice in November to be above $6.00--the buyer will not exercise his option In this case he will be able to sell a futures Bruce L. Gardner Commodity Options for Agriculture American Journal of Agricultural Economics, December 1977, pp. 986-992;.Bruce L. Ga r dner The Governing of Agriculture (Lawrence, Kansas: The Regents Press of Kansas, 198l pp. 107-112; Michael T. Belongia Commodity Options: A New Risk Management Tool for Agricultural Markets Federal Reserve Bank of St. Louis Vol. 65, No. 6, June/July 1983 , pp. 5-15; Todd E. Petzel Alternatives for Managing Agricultural Price Risk: Futures, Options and Government Programs," Studies in Economic Policy AEI, November 1984.

For more discussion on the mechanics of trading agricultural options, see for example Be longia, op. cit David E. Kenyon, "Farmers' Guide to Trading Agricultural Commodity Options," USDA Agricultural Information Bulletin No. 463 (Washington, D.C., April 1984);or Randall E. Sheldon and Jin W. Choi Agricultural Options," unpublished paper, Chic a go Board of Trade, January 1983 Throughout this paper, transaction costs are ignored for simplification 5 contract at a higher price by selling in the futures market a loss of 2OC per bushel and the seller has a profit of 20C per bushel. directly and lett i ng his option expire worthless.6 The buyer has If the November soybean futures price, however, falls to 5.50 during the life of the option, the buyer can exercise his option, selling a November soybean futures contract at 6.00 Because he can buy back the f utures contract at the market price of 5.50 he can make a profit of 50C per bushel on his futures contract. After deducting the option premium of 20C, the option buyer will have a net profit of 30C per bushel. If the buyer exercises his option in this cas e, the seller is obligated to buy a futures contract at 6.00 Because he can sell the futures contract at the market price of 5.50, he loses 50C per bushel.

However, he received a 2OC premium for selling the option, thus cutting his net losses to 30C per bushel in this case.

The premium is the maximum amount that the buyer can lose from his option transaction, because he will not elect to exercise the option if he can obtain the desired futures position at a more favorable price by transacting in that market directly.

Similarly, the premium is the maximum amount that the seller will gain from his option transaction. Because the option seller is obligated to act at the buyer's election, the seller's potential losses are virtually limitless.

The size of the premium is determined competitively by supply and demand in the market premium equals the market's determination of the expected value of the option--that is, it is equal to the probability that the option will be exer cised multiplied by the expected gain if it is exercised In a competitive market, the For example, if there is a 50 percent chance that the market price will be $6.20 and a 50 percent chance that the market price will be $5.80, then in a competitive marke t one would expect the premium for a put option with a strike price of $6.00 to be lOC per bushel. The premium value is calculated by multiplying the probability that the market price will be below 6.00 which is the probability that the option will be exer c ised (0.5) by the expected gain if exercised 6.00-$5.80 Options as an Insurance Policy Buying an option is like buying insurance. One pays the premium and has the right to obtain a specified asset if a parti Throughout this paper, for simplicity it is ass u med that the only way an option buyer may liquidate his option contract is through exercise. In reality, the buyer of an option may offset his option contract in the option market prior to the expiration of the contract and receive part of the premium tha t he originally paid. 6 cular event occurs. In the case of fire insurance, the buyer receives an amount equal to the value of the property minus .any stated deductibles if the property is destroyed by fire If the property is not destroyed by fire, the insu r ance policy becomes worthless at the end of the specified term and the buyer simply loses the premium as'the price of his (unused) protection. The buyer of insurance, in other words, is paying the premium to guarantee himself against a loss of assets duri n g the period. If the property is destroyed by fire, the insurance company will pay the insurance buyer the value of the property is not destroyed by fire, the buyer will continue to own the property If the property Similarly a farmer may buy a put option to protect himself from low revenues caused by commodity price decline A soybean farmer, for example, may pay a premium of 20C per bushel for a put option with an exercise price of 6.00 to protect himself from soybean price declines below 6.

00. If soybean prices increase to $7.00 when the farmer wishes to sell his soybeans, he obviously will not exercise his option to sell his crop for 6.

00. He simply will sell his soybeans in the cash market for 7.

00. His net revenue will be 6.80 per bushel--$7.00 minus the 2OC cost of the option.

If soybean prices fall below 6.00 when the farmer wishes to sell his soybeans, he can exercise his option. The farmer will then receive a futures contract with a built-in profit equal to the difference between 6 and the mark et price. Although the farmer will sell his soybeans in the cash market at the market price (which is below $6),the profits from his option contract will offset the lower revenue cause.d by the cash price decline.

Thus the farmer can assure himself, in advance of the $6.00 soybean price stated'in the option contract. His total revenue in this case will be 5.80 per bushel (that is 6.00 minus the 20C option premium).

Figure 1 demonstrates how a farmer's revenue changes when he purchases put options.8 The st raight line shows the farmer's revenues if he sells his commodity on the open market at the prevailing price: his revenues per bushel are always equal'to the selling price. The dashed line shows the farmer's revenues if he buys the put option with a strik e price of 6.00 and a In this example, the difference between cash and futures prices (called the basis) is assumed to be zero. That is, the cash and futures prices are assumed to be equal at all times. Although this assumption is un realistic, it simplifi es the example considerably. The inclusion of a non-zero basis would not change the major point demonstrated in the example--that put options allow farmers to limit their losses if prices fall but permit them to take advantage of price increases..

Similar graphs have been used by Gardner in "Commodity Options for Agricul ture" and by Belongia. w I OX I8 premium of 20C. The horizontal segment of the dashed line shows that the farmer is guaranteed $5.80 per bushel (the strike price minus the option premium) for all market prices below 6.

00. And the sloping segment of the dashed line shows that the farmer will receive the prevailing price minus the option premium for all prices above $6.

00. Thus, by buying a put option, a farmer can limit his losses if prices fall--while still taking advantage of a price increase.

At any point in time, options having different strike (or exercise) prices are traded Because higher selling prices are more valuable than lower selling prices, the premium for put options increas es as the strike price increases. For example, on January 4, 1985 (with the March 1985 soybean futures contract closing at $5.735), the closing premiums for,the various put options on the March 1985 soybean futures contract were as follows Strike Price Pr emium bushel C/bushel 550 3 575 12.5 600 30 625 53 65 0 76.5 A farmer could thus compare the costs of different levels of price protection and decide how much protection he is willing to buy. The more price protection he sought, the higher the cost.

Options thus enable farmers to purchase the right to a guaranteed price and still be able to take advantage of higher prices. In addition, options enable farmers to purchase the amount of price protection that they are willing to buy. Such options, sugges t the evidence, can replace existing agricultural programs and create the resulting market would be far superior to chirent policies CURRENT U.S AGRICULTURAL POLICIES Observes University of Missouri professor of agricultural economics Bruce Bullock Farm pr o grams have been justified on grounds that (a) price support programs are necessary to keep farm family income on par with nonfarm family income, and (b without government intervention agricultural prices would fluc tuate too widely and create hardships fo r both producers and consumers. Ir9 J. Bruce Bullock, "Future Directions for 'Agricultural Policy, I' American Journal of Agricultural Economics, Vol. 66, No. 2, May 1984, p. 234. 9 The evidence indicates that the first goal is inappropriate today. Althoug h incomes.of farmers have been significantly Jess than incomes of nonfarmers historically, the incomes are now approximately equivalent.1 A goal of rigid price stability, moreover, is inappropriate for agricultural policy. Price stability created by restri c ting the market distorts market signals and prompts misallocations of resources, as fanners grow too much or too little in response to artificial prices. To be sure, policies preventing very large price and income swings caused by unusual circumstances ma y be justified on the grounds that they would prevent large erratic adjustment costs that might put many efficient and careful farmers out of business A variety of programs have been and are used to accomplish the goals of agricultural policy. In particula r major programs have been developed to increase the demand for U.S. agricultural commodities and therefore increase the price received by the farmer. Examples include export subsidies, import restrictions, U.S. food donations to other countries (P.L. 480) and food distri bution programs in the U.S. such as the school lunch and food stamp programs.

Programs also have been sought to decrease the supply of U.S. agricultural commodities, thereby increasing prices and thus the income received by farmers. Exampl es of these include acreage allotments and set-aside programs in which the farmers are given incentives to let some farmland lie idle. Other programs, such as price supports, prevent the price from falling below a certain level by having the government bu y excess supply at that price.

And there are programs to subsidize farm income by guaranteeing producers a certain price for their production by having the government pay them any difference between the target price and the market price.

Problems With Cur rent Agricultural Programs There are several significant problems with these programs 1) They are very expensive. The costs of agricultural programs were $3 billion in 1981 10 billion in 1982,11 and $28 billion (including the Payment-in-Kind Program in 19 8 3.12 lo "Per capita disposable income of farm operators has averaged 88 percent of non-farm income over the past 10 years Given the favorable tax treatment of farmers, there is no longer any basis for arguing that farm incomes need to be supported relativ e to nonfarm incomes. A major reason for the closing of the income gap between farm and nonfarm families has been the increased access of farm families to nonfarm sources of income."

Ibid p. 235.

G. Edward Schuh Future Directions for Food and Agricultural Trade Policy American Journal of Agricultural Economics, Vol. 66, No. 2, May 1984, p. 242 l1 l2 Economic Report of the President, February 1984. 10 The minimum price established by U.S. agricultural price support programs at times is above the world comp e titive price. By restricting the natural decline of prices, agricultural programs have caused U.S commodities to become uncompetitive in international markets, thus reducing U.S. farm sales abroad.l3 Most of the benefits of agricultural programs accrue to the owners of large farms, who have larger incomes on the average than nonfarmers. In fact, half of the direct federal payments in agriculture go to only 15 percent of the farmers, generally the large agribusi nesses.14 In addition, the program benefits a c crue to owners of specialized farm. resources (primarily farmland owners) because the prices of these resources are bid up as the expected profit from using these resources in production increases.15 Agricultural programs tend to raise prices of agricul t u ral commodities, thus raising food prices.16 THE OPTIONS ROLE IN AGRICULTURAL POLICY With the introduction of trading in agricultural options the market offers some of the benefits provided now by agri cultural programs--but at no cost to the taxpayer. Ag r icultural options will not increase the price artificially, but will provide producers who participate in the market a minimum price that they will receive for their commodity. Agricultural options could be used instead of price support and target price p rograms to provide income stability for farmers.

Maryland professor of agricultural economics Bruce Gardner argues that the price support program currently in use for grains is really a put option market in disguise.17 Farmers who partici pate in the progr am and meet all set-aside restrictions are guaranteed the loan rate for their production, because the govern l3 l4 l5 Thomas Grennes Helping U. s. Farmers Sell More Overseas Heritage Founda tion Backgrounder No. 411, February 27, 1985.

E. C. Pasour, Jr The High Cost of Farm Subsidies Heritage Foundation Backgrounder No. 388, October 22, 1984, p. 1.

For a discussion of the capitalization of program benefits, see for example, E. C. Pasour, Jr Cost of Production: A Defensible Basis for Agricultural Price Sup ports?" American Journal of Agricultural Economics For example, estimates indicate that the U.S. sugar program costs U.S consumers more than $1.9 billion in one year through higher sugar prices Vol. 62, NO. 2, May 1980, pp. 244-248. l6 I 11 ment is willin g to buy as much of the production as is available at the loan rate. Thus, the participating farmer in effect is the buyer or holder of a put option with the loan rate as the strike price. The government is in effect the seller or I'writerll of the option A major difference-between a market-traded option and the price support program, however, is the cost to the participants.

In the price support program, the premium is not market determined it is politically determined and essentially paid by U.S. taxpayer s The only cost to the farmer is forgone profits from the harvest which could have come from the land required to be set aside.

Gardner adds teeing the farmer higher prices.l8 with two strike pr target price) and that target prices are also put options, g uaran a minimum price but allowing him to profit from In effect, the government program is an option ices (one at the loan rate and the other at the with different maturities.

Genuine agricultural options could be used instead of price support programs to guarantee a price floor to -farmers. Instead of receiving a disguised put option from the government for participating in a government program, farmers could buy authentic put options traded competitively, with the cost carried by the industry itself, no t the taxpayer.

Advantages of Using an Options Market A private options market would have many advantages over the current agricultural programs. Among them The trading of agricultural options by farmers would not prevent the price from moving to its equil ibrium market level. Thus, options would allow the market to give accurate price signals for the optimal allocation of resources. Price support programs, on the other hand, restrict market prices from moving to their equilibrium levels at times. As a resu l t, they send misleading market signals and create a costly misalloca- tion of resources. This means higher costs to consumers. I In an options market, the individuals seeking price protection pay for the protection. Farmers would pay for the guaranteed pr ice floor. Under a price support program, the cost of the program is borne largely by the taxpayers, while farmers reap most of the benefits.

In an options market, many options with different strike prices are listed for trade. Thus, participants may compare the prices of various amounts of protection Ibid I 12 and decide how much protection they are willing to buy.

Farmers participating in the federal price support program are not given choices of how much protection they seek. They may participate and get the protection stated in the program, and the bill is sent to the taxpayer, or they may choose not to participate.

The Problem with Options The use of agricultural options may be appealing in theory Cost to Farmers: Farmers are accustomed to receiving price but does present some practical problems protection at essentially no cost therefore to losing this subsidy and to the increase in their cost of obtaining price protection. Yet federal agricultural benefits in any event probably will be reduced by deficit sensitive budget cutters. This will force farmers to examine alternatives to traditional programs Farmers would likely object Unfamiliar i ty: Farmers generally are unfamiliar with agricul tural options. The gradual reduction of support prices over time, a the Reagan Administration has already proposed, would provide a steadily increasing incentive for farmers to learn how to use options. In addition, the government initially could allocate money for education, and even subsidize the initial premium paid by farmers, to reduce the adjustment costs.19 permit farmers to obtain the price protection they desire, because options with strike prices t hat they want may not be listed for trading prices relatively close to the current market price seeking price protection at a price level significantly below the current market price would not be able to obtain such protection from the options listed for t rade As trading in agricultural options increases, however, options with strike prices farther from the,market price are likely to be listed ly will list additional strike prices if there is sufficient trading interest If there is sufficient demand for gr eater protection, the market will provide it farmers price protection for sufficiently long periods of time.

Currently, agricultural option contracts are listed for approxi mately six months into the future. Farmers may want price assur ance for several ye ars into the future before making the signifi Degree of Protection: The current options market may not The only options now listed for trading have strike A farmer Exchanges certain Lenqth of Protection: The option market may not offer l9 Obviously, there would be problems in developing and administering such governmental programs to be a low cost way to subsidize the costs to farmers.

A partial tax credit for the premium paid appears 13 cant investments necessary to produce efficiently.20 As trading in options develops, however, options for longer periods of time will be available if there is sufficient demand for such options.

Stabilizing Long-Term Income Although options can be used to provide stability for farm income, options do not support farm prices and thus do not guarantee farm income over the long term.

Because the option market will not significantly affect the price level, the option market will not guarantee farmers a particular price in every year A farmer wishing to guarantee himself $2.00 per bushel may face prohibitively high premium prices for such options if the market generally expects prices to be closer to 1.50 per bushel--or the farmer may find that such options were not even traded If policymakers believe that farmers should be gua ranteed a certain price, whatever market conditions are, then the option market will'not satisfy that goal. But in this case options could be used to stabilize revenues while explicit income transfer payments could be used to guarantee minimum incomes.

Suc h income transfer payments would still misallocate resources because inefficient farmers, who would be forced out of business in a free market, would be subsidized to produce. Even so, such a system of payments would be preferable to current direct market intervention through price support programs, because it would allow the market to allocate the additional production rather than forcing the government to store it at the expense of tax- payers. The use of options and income transfer payments also would b e preferable to acreage allotments or forced acreage set-asides, because these similarly do not cause an inefficient mix of inputs that is found when land is limited by government decree currently are traded on only a few commodities options will probably b e listed for trading when the Commodity Futures Trading Commission-imposed restrictions on the agricultural options pilot program are lifted. Yet, options probably never will be listed for some commodities, such as rye, honey, or asparagus. The demand for such options probably will be too small to create a market. Aqricultural options do, however Exclusion of Certain Commodities: Agricultural options Additional provide an attractive alternative to price support such major U.S. farm commodities as wheat and feed Volume At present, the agricultural options not have sufficient volume and liquidity (that is programs for grains trading may the price 2o A review of historical data shows that real loan rates have decreased as real market prices have declined progr ams have not actually guaranteed farmers profits for future years.

See Bruce L. Gardner. "Consequences of Farm Policies During the 1970s," in Thus, agricultural price support Food and Agricultural Policy-for the 1980s, ed. by D. Gale Johnson (Wash ington, D.C American Enterprise Institute for Public Policy Research 1981). 14 might be significantly affected by orders to buy or sell) to cover the hedging demands of all farmers without producers incur ring substantial price concessions. However, agricultural o ptions have traded for only a few months. Volume, the number of contracts outstanding, and liquidity probably will increase as more people learn about the options markets. Some of the agricultural options surely will grow large enough to accommodate the t otal coverage if required.

Contract Size: The size of current agricultural option contracts may be too large for small farmers to use. Example one option on the soybean futures contract traded at the Chicago Board of Trade represents 5,000 bushels. Farmers producing less than 5,000 bushels or farmers producing an amount not divisible by 5,000 may find the options too inflexible for their use But as the market develops, smaller contract units will become avail able if demand is sufficient--as has occurred i n the case of commodity futures markets.

These practical problems must be solved before certain agricultural programs can be replaced with agricultural options.

However, most of these are short-term difficulties, reflecting the infancy of the market.22 Th e trading of agricultural options can make the transition from a government-influenced agriculture sector to a market-based system less difficult for U.S. farmers. Congress can further reduce the transition costs for farmers by taking the following steps 1 ) gradually reduce the support prices as the Reagan Administra tion proposes, to give farmers time and increasing incentives to learn how to use options instead of government programs and The Mid-America Commodity Exchange currently trades numerous future s contracts which are smaller in size than futures contr.acts traded in other exchanges. For example, Mid-America trades a 1,000 bushel soybean futures contract, whereas the Chicago Board of Trade soybean contract is for 5,000 bushels. Just as Mid-America recognized the demand for small sized futures contracts, that exchange or another exchange will recognize the demand for small-sized options contracts, if it is large enough to justify the development of a market.

Although the focus of this paper has been on the use of agricultural options by farmers, options on feed grain futures contracts also could be used by livestock producers to guarantee themselves a maximum price for their feed. Livestock producers could buy call options on feed grain futures and p u t options on 1i;vestock futures to lock in a minimum feeding margin. In addition, agricultural options could be used by the government to guarantee it a.certain quantity of grain during emergencies. As advocated by Professor Gardner, USDA could by call op t ions to guarantee it grain for emergency aid at predetermined prices, even in times of short crops. See Bruce L. Gardner, The Governing of Agriculture (Lawrence Kansas: The Regents Press of-Kansas, 1981 22 15 2) allocate some of the savings from the reduc ed cost of agricul tural programs for educating farmers on how to use agricul tural options.

CONCLUSION If the U.S. government would allow market forces to operate in agriculture, as the Reagan Administration proposes, resources would be allocated to their most profitable uses, surpluses would be eliminated, and the U.S. would become more competi tive in world agrlcultural markets In addition, government spending for agricultural programs would decline 'significantly.

Now that agricultural options are trading in the U.S a mechanism is available through which farmers can obtain more effective price protection than is currently available through the government's agricultural programs--and at much less cost to the taxpayer. Farmers could use agricultural options to reduce the price variability that they face when they sell their commodi ties without d isrupting market prices and thus market signals.

There will be practical problems in replacing certain agricultural programs with agricultural options. However, if the transition is made gradually instead of abruptly, the adjustment problems will be substantially reduced.

The benefits of using agricultural options instead of price support programs will be better allocation of resources, increased exports and reduced government spending in agriculture A compre hensive private options market could form the f oundation of a transition from a government-influenced agricultural sector to the market-based agricultural industry that the Administration advocates.

Prepared for The Heritage Foundation by Kandice H. Kahl Associate Professor, Department of Agricultural Economics and Rural Sociology, Clemson University The author expresses appreciation to her colleagues at Clemson University North Carolina State University and the Chicago Board of Trade for their comments on an earlier draft of this paper.

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