Document Type

Article

Publication Date

7-15-1997

Keywords

agricultural economics, grain production, farming business & management

Abstract

In the past, few South Dakota agricultural producers have made use of the futures market to manage their risk exposure. According to a survey, conducted in 1970, only eleven percent of South Dakota producers used futures contracts and five percent used options to market their grain (Shane). The need for producers to become more market-oriented has increased with the passage of the 1996 Freedom to Farm Act. The Freedom to Farm Act gives producers increased flexibility to adjust production based on market incentives. Prices are expected to become more volatile due to changing market conditions over the next few years. Consequently, the farming business is expected to become more competitive, and managing exposure to risk will be critical to farm survival. Research has shown that a hedge can be effective without the futures position being equal to the cash position. The typical negative correlation between price and yield creates a 'natural hedge' which allows a producer to manage risk exposure without hedging one hundred percent of expected production (McKinnon 1967 and Grant 1989). The percentage of expected production that should be hedged, known as the hedge ratio, has been debated in the literature. Two different approaches have been taken by researchers. With the first approach, researchers estimate the optimal hedge ratio that results in minimum revenue variance. The second approach focuses on maximizing utility which depends on the level of expected revenues as well as revenue variance. Optimal hedge ratios are computed by taking into consideration the variance of yields, futures market prices, and local spot prices as well as the correlations among these factors. Different simplifying assumptions by different researchers have led to alternative approaches for computing optimal hedge ratios. The objective of this study was to determine optimal hedge ratios for corn producers in eastern South Dakota. Optimal hedge ratios were determined, under various assumptions, at regional and county levels. The findings of this study can be used by producers to determine appropriate levels of hedge application based on local conditions. Findings will also reveal how large a natural hedge is provided to producers through the correlation between spot prices and yield. The correlation between the local cash price and the futures market price will also influence the effectiveness of using a hedge to manage risk.

Comments

Economics Research Report No. 97-3

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