Hedge Effectiveness of Texas Live Cattle

Abstract

Cattle feeders face a multitude of challenges when raising their product. There is constant morbidity and mortality biological risk inherent in livestock feeding, coupled with the risk of negative weather conditions, and highly variable input prices. However, the greatest risk typically facing the fed cattle industry is price risk. In order to mitigate output price risk, producers look to hedging in the futures market. Hedges can effectively reduce price and revenue risk, although basis risk remains. Hedging is normally thought of as a risk management strategy rather than an effort to garner huge futures market returns. The main aim of hedging is assumed to be the minimization of the variance of the return on the portfolio. Hedging becomes particularly important in the fed cattle industry because fed cattle are ‘non-storable’ both in a definition’s sense, and a literal sense. An optimal hedge is a variance minimization tool. This paper uses an optimal hedge and a common 1:1 fed cattle price hedge using Texas cattle prices, over the 2010-2014 period to determine which hedge provides the most price protection. Additionally, the effects of different hedge lengths with regard to net price were estimated.