Impact of Cash Settlement on Feeder Cattle Basis

Abstract

The feeder cattle futures contract specifications were changed in 1986 from physical delivery to cash settlement. The Chicago Mercantile Exchange expected this change to reduce basis variability and improve the ability of hedgers to predict basis. This study analyzes the basis for individual lots of feeder cattle before and after cash settlement. Basis equations were estimated by breed, sex, weight, grade, and season. These equations were used to predict basis. The results indicate basis variability was not reduced and hedger ability to forecast basis, in general, was not improved significantly under cash settlement compared to physical delivery. Cash settlement for feeder cattle futures began with the September 1986 contract. The Chicago Mercantile Exchange (CME) instituted cash settlement basically for three reasons. First, physical deliveries under the old system averaged approximately 25% of average month-end open positions during 1978 to 1985 (Paul). These deliveries caused the CME grader-scheduling problems at delivery points, dissatisfied traders over grades assigned to delivered cattle, and increased costs for traders and the CME. Second, because of multiple delivery points, long traders never knew where delivery would occur, hence both long speculation and long hedging were discouraged (Cohen and Gorham). Third, local market basis relationships were volatile, reducing hedging effectiveness and interest (Ernst). Hence, the CME introduced cash settlement as a means of eliminating physical deliveries, encouraging long participation by speculators and hedgers, and increasing hedge participation by reducing basis variation. The purpose of this article is to analyze the impact of cash settlement on the variability and predictability of feeder cattle basis. Before the introduction of cash settlement, Cohen and