Backgrounder Update #39
March 2, 1987
(Archived document, may contain errors)
A WELCOME ENDORSEMENT OF AGRICULTURE OMONS
(updating Backgrounder No. 414, "Agricultural options: An Alternative to Federal Farm Programs," March 7, 1985.)
The Commodity Futures Trading Commission (CFTC) on January 6 voted to allow agricultural options to trade permanently on U.S. exchanges. Such agricultural options give farmers the ability to obtain a minimum selling price for crops, which can increase price and income stability. Although a small step, the creation of a permanent agricultural options market could prove very significant. By providing farmers with a private sector means of stabilizing their fluctuating incomes, an options market eventually may reduce the need for expensive federal support programs.
Though once banned, agricultural options have been trading since October 1984 under a CFTC pilot program. options are now available on futures contracts in such commodities as corn, wheat, cotton, live cattle, soybeans, and hogs. The Commission's January decision reflects the success of the pilot program. Last year, for example, more than 750,000 contracts traded in options on soybean futures and more than 500,000 contracts in options on corn futures. The value of the physical commodities underlying these contracts totalled more than $25 billion based on average prices received by farmers during the 1985-1986 marketing year.
With agricultural options now available, there is less need for government price support programs to provide price stability for farmers. Washington no longer needs to restrict the level and variability of commodity market prices. Farmers and others in the agribusiness can now achieve the benefits of price stability by trading in option markets.
Currently, farmers can be guaranteed a minimum selling price by participating in government price support programs and meeting all set-aside restrictions. Example: farmers participating in the grain program are guaranteed a minimum price (known as the "loan rate") when they sell their output. Under this program, the government stands
ready to buy as much of the annual crop as farmers want to sell at the loan rate. If the market price exceeds the loan rate, farmers sell their production in the open market.
The agricultural option markets provide farmers an alternative means of obtaining a minimum selling price. similar to those who participate in the federal price support program, farmers who buy "put" options in the market obtain the right to sell at a particular price to the private seller of the option contract. This gives the farmer a guaranteed price, but still allows him to profit from higher market prices, if they are available, by forgoing his option.
Agricultural options offer benefits over government agricultural programs. Among them:
1) Agricultural market prices no longer would be elevated and thus distorted by government, and so would provide accurate market signals which would allow the best uses of resources. U.S. agricultural commodities then could become more competitively priced, reducing U.S. consumer prices and stimulating U.S. farm exports.
2) U.S. taxpayers no longer would be required to buy agricultural surpluses and bear their storage costs.
3) Farmers wanting protection from the risk of price and income fluctuations would pay the market-determined price for such protection. Essentially, the purchase of a put is like buying insurance. Those reaping the benefits of price risk protection thus would pay the full cost of such protection, instead of forcing consumers and taxpayers to pick up the tab. Of course, if Congress wants to guarantee farmers a minimum income each year at the expense of other Americans it could still do so. The full cost of this subsidy would have to be explicit; it could not be partly hidden, as it now is, in higher prices.
Many farmers, of course, would object to options because they would have to pay for the price protection that they now receive at taxpayer expense. But if transition from government programs to agricultural options were gradual, farmers could be given time to make the necessary adjustment. To start this transition, Congress should gradually lower price support levels, which would encourage greater use of options. The Department of Agriculture also could make greater efforts to educate farmers on the availability and benefits of options, perhaps through the use of existing USDA county agents.
Agricultural options can provide farmers with protection from price fluctuations and can do so in a superior way to the current price support program. Use of options would lead to a better allocation of resources, increased farm exports, and reduced price support costs to the taxpayer.
Prepared for The Heritage Foundation by Kandice H. Kahl, Associate Professor, Department of Agricultural Economics and Rural Sociology, Clemson University