Transaction Frequency, Inventories and Hedging in Commodity Processing

Abstract

This study examines hedging strategies for commodity processors generally and soybean crushers specifically. Processors require hedging strategies built around processing multiple batches each year. Each batch requires the purchase of inputs, transformation of inputs into outputs, and sale of the resulting output. The more batches processed, the greater the transaction frequency, the smaller each batch's size. Increased transaction frequency reduces risk because of the smaller batch size. This study distinguishes between batch (accounting) profits and periodic profits (cash flows). Traditional hedging models have focused on batch profits but we argue that hedging cash flows are also a legitimate hedging target because (a) discounted cash flow is the capital investment decision criterion, (b) costs are associated with managing working capital, (c) cash flow and profits converge in annual aggregation, and (d) stabilizing periodic cash flow stabilizes annual profits but the converse does not hold. Weekly cash and futures prices from 1990 through 2003 are used to compare averages and standard deviations of direct-hedged and unhedged profits and cash flows with transaction frequencies of 1, 2, 4, 13, 26 and 52 weeks. Our findings are as follows. (1) Increased transaction frequency reduces the variance of unhedged profits and cash flows. Two effects account for this. Both profit and cash flow risks are reduced by smaller batch size associated with increased transaction frequency but only profit risk is reduced by closer integration of input and output markets as transaction frequency increases. (2) As transaction frequency increases, the amount of hedgeable risk declines (finding 1) and the effectiveness of traditional hedges also declines. (3) Anticipatory hedging of soybean processing does not offer much risk protection. (4) Traditional hedging of batch profits tends to destabilize periodic cash flows. Several areas meriting additional investigation are also discussed.