Optimal Hedging Strategies for the U.S. Cattle Feeder

Abstract

Multiproduct optimal hedging for sinlulated cattle feeding is conlpared to alternative hedging strategies using weekly price data for 1983-95.Out-of-sample means and variances of hedged feeding margins using estimated hedge ratios for four coimnodities suggest that there is no consistent domination pattern among the alternative strategies, leaving the hedging decision up to the agent's degree of risk aversion. However, all hedging strategies significa~ltly reduce the feeding margin's means and 1 ariances compared to no hedging. with variance reduction always exceeding 50%. Hedging results appear quite sensitive to the data set and its size. Key U'ovds: cattle feeding, hedge ratios, hedging strategies, nlultiproduct hedging, optimal hedging The beef industry represents a major economic activity in the United States economy. Within that industry, the cattle feeding segment is characterized by v.ide swings in profits. According to Jones, net returns from finishing yearling steers in Kansas ranged from a loss of $120 to a profit of $178 per head during the period from 198 1 through 1994. This high profit volatility is due principally to multiple market price risks. Cattle feeders bear the risk of unfavorable price movements both in the illput markets, comprised of feeder cattle, feed (corn and soybean meal), and interest costs, and in the output market, fed cattle. Trapp and Cleveland found that volatility in the market prices for both fed and feeder cattle explained 65.5% of the production margin volatility, compared to 22% attributable to production risks. The high volatility in market prices raises an obvious need for price risk management. Numerous studies have shown that hedging some or all of the inputs and output in cattle feeding provides considerable success in managing these price risks, resulting typically in improved and less variable feeding margins. These studies usually employed either a naive hedge (one-to-one), or hedge ratios, computed individually for each commodity. No one has estimated multiple hedge ratios for the cattle feeding production complex as a whole, taking the covariances among Noussino\, 1s a former graduate assistant and Lsuthold is Thomas A. Hieronymus Professor, both In ths Dcpartnlent of Agricultural and Consumer Economics, Unl ersity oTIllinois at Urbana-Champaiyn.