Soybean Hedge Ratios for Eastern South Dakota Producers Facing Production and Price Uncertainty

Abstract

Optimal hedges with production and price uncertainty for Eastern South Dakota soybean producers are investigated. Assuming a constant absolute risk aversion utility function and jointly normally distributed futures prices, cash prices, and yields, optimal pre-planting hedges are estimated with county level yield data and varying degrees of risk aversion. Soybean Hedge Ratios for Eastern South Dakota Producers Facing Production and Price Uncertainty In the past, few agricultural producers have made use of the futures market to manage their risk exposure. With the passage of the Freedom to Farm Act more producers will be looking for alternatives in their marketing practices to protect themselves against an expected increase in price variability. The percentage of expected production that should be hedged, the hedge ratio, has been investigated by many researchers (McKinnon 1967, Heifner 1972, Peck 1975, Grant 1989). It has been shown that the typical negative correlation between price and yield creates a 'natural hedge' which allows a producer to manage risk without hedging 100% of expected production (McKinnon 1967 and Grant 1989). At pre-planting time, soybean producers face uncertainty in the harvest cash price as well as in the final quantity of production. Accordingly, pre-planting optimal hedge ratios are to be computed by taking into consideration the variances in the yield, harvest futures price, and harvest cash price as well as the correlations among these factors. The objective of this paper is to determine optimal hedge ratios for soybean producers facing production uncertainty in Eastern South Dakota. The greater yield variability is relative to price variability, the smaller the optimal forward sale will be. Also, the more effective the natural hedge, the smaller the forward sale will be. The more important demand fluctuations are relative to supply variations in determining local price, the smaller will be the effect of the natural hedge and the larger will be the optimal forward sale (McKinnon, 1967, pp 851-52). 2 Lapan and Moschini (1994) proposed a general framework which allows for optimal hedge ratio determination under varying conditions. Following their approach, we consider a competitive producer with a constant absolute risk aversion (CARA) utility function facing both production and price risk. It is assumed that the futures settlement price is correlated with, but not the same as the cash price. Futures prices, cash prices, and yields are assumed to be jointly normally distributed. RISK AVERSION An individual's attitude towards risk is affected by several factors, including current wealth, investment diversity and personality factors. A commonly used measure of risk aversion is a coefficient of relative risk aversion which represents a measure of the elasticity of marginal utility. The greater the risk aversion of an individual, the more curved is his/her utility function implying that the individual receives less utility from increased wealth with risk (Newberry and Stiglitz, 1981). The risk aversion coefficient can be expressed as a relative risk premium. The relative risk premium is approximately equal to one-half the square of the coefficient of variation of income times the coefficient of relative risk aversion (Newberry and Stiglitz, 1981, p 73). METHODOLOGY The general hedge ratio suggested by Lapan and Moschini (1994) is composed of speculative and pure hedge components. The speculative component reflects the individual's estimation of bias in the futures price. When the futures market is unbiased,