NCCC-134
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Contracting, Captive Supplies, and Price Behavior
Ming-Chin Chin and Robert D. Weaver
Year: 2002
 

Abstract

Theoretical and simulation results clarify the role of procurement contracting in determining spot price levels and volatility. A generic model determines market share across quality. Actual supply is specified as price dependent and stochastic. Simulation examines the sensitivity of price level and volatility to extent of forward contracting, risk aversion, and ability to adjust spot market demand (recontracting). The results show that as forward contracting increases mean spot price decreases and variance increases. This effect increases as risk aversion decreases and as extent of recontracting adjustment in spot demand decreases.

 
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An Evaluation of Crop Forecast Accuracy for Corn And Soybeans: USDA and Private Information Services
T. M. Egelkraut, P. Garcia, S. H. Irwin, and D. L. Good
Year: 2002
 

Abstract

Using 1971-2000 data, we examine the accuracy of corn and soybean production forecasts provided by the USDA and two private services. All agencies improved their forecasts as the harvest progressed, and forecast errors across the agencies were highly correlated. Relative accuracy varied by crop and month. In corn, USDA 's forecasts ranked as most accurate in all periods except in August during recent times, and improved more markedly as harvest progressed. In soybeans, forecast errors were very similar with the private agencies ranking as most accurate in August and September and making largest relative improvements in August during recent times. The USDA provided the most accurate October and November forecasts.

 
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Inventory and Transformation Risk in Soybean Processing
Roger A. Dahlgran
Year: 2002
 

Abstract

This study examines strategies for hedging processing operations generally and uses soybean processing as a specific example. The approach assumes a mean-variance utility function but because of the focus on hedging, the analysis concentrates on risk minimization with risk defined as the variance of the processing margin from its currently expected level. We find that risk so defined contains three components. These are (1) the risk of input/output cash price misalignment at the time of transactions, (2) the risk resulting from the firm's inability to utilize inputs and produce outputs in proportion to the mix that minimizes risk in cash market transactions, and (3) the risk of price change during the time between the purchase of inputs and the sale of outputs. The first two risk components are transformation risk while the third is inventory risk. The relationships between inventory and transformation risks were examined using daily price data from January 1, 1990 through March 23, 2000. Our analysis indicates that inventory risk is the largest of the three components, it increases in a roughly linear relationship with the temporal separation between pricing of inputs and outputs, it is the risk that is hedged with usual hedging models, and that hedging reduces this risk by a proportion of its amount. Consequently, even when hedged, processors face risks that increase with the time that separates the pricing of inputs and outputs and this risk is far larger than the risk of product transformation. In soybean processing, the proportion of risk eliminated through hedging reaches a peak for process lengths of one week with gradual declines thereafter. We also find that the risk-minimizing hedge ratios for soybean meal and soybean oil depend on the length of the anticipated hedging period.

 
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Assessing the Cost of Beef Quality
Cody Forristall, Gary J. May, and John D. Lawrence
Year: 2002
 

Abstract

The number of U.S. fed cattle marketed through a value based or grid marketing system is increasing dramatically. Most grids reward Choice or better quality grades and some pay premiums for red meat yield. The Choice-Select (C-S) price spread increased 55 percent, over $3/cwt between 1989-91 and 1999-01. However, there is a cost associated with pursuing these carcass premiums. This paper examines these tradeoffs both in the feedlot and in a retained ownership scenario. Correlations between carcass and performance traits resulted in economic tradeoffs that change across input costs and quality grade premiums and discounts. Feedlot profitability was largely determined by marbling, carcass weight, and feed efficiency. Carcass weight was most important at a low C-S spread. However, at average C-S spread and higher, marbling became the largest determinate of feedlot profits, and its importance increased with the C-S spread. Carcass weight and feed efficiency influence on feedlot profitability declined at higher C-S spreads. Rib-eye area was the fourth most important variable and declined in importance as marbling increased in importance. There is some indication that cows with lower feed costs also produce the most profitable calf for the feedlot, and vice-versa. The data suggests that cow size and marbling score are negatively correlated. The current trend toward wider C-S spreads and rewarding higher quality grading cattle places greater emphasis on marbling ability of calves. These correlations and results suggest that higher marbling is associated with lower cost cows to maintain.

 
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Risk Aversion, Uncertainty Aversion, and Variation Aversion in Applied Commodity Price Analysis
Darren L. Frechette and Fang-I Wen
Year: 2002
 

Abstract

Standard models of hedging behavior assume that either hedgers wish to minimize net price variation or they wish to balance variation versus profits. These models treat variation as risk and fail to distinguish between variation that is random and variation that is not random over time. Newer models of decision making differentiate between random and nonrandom variation somewhat, but they inadequately distinguish variation from risk. This paper reviews the distinctions among variation, uncertainty, and risk and calculates optimal hedge ratios for two models addressing the distinction. Empirical optimal hedge ratios typically decline toward zero when variation aversion is included in the models. These results may help explain why hedgers commonly hedge less than recommended by the standard models.

 
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Cattle Feeder Perceptions of Livestock Mandatory Price Reporting
Sarah Grunewald, Ted Schroeder, and Clement E. Ward
Year: 2002
 

Abstract

Because of the significant investment in the mandatory price reporting program (MPR) by the USDA and by packers, it is important to understand what producers believe about its effectiveness. This study reports results from a survey of feedyards located primarily in Kansas, Nebraska, Texas, and Iowa. Results indicate a diversity of opinion regarding MPR effectiveness. On average producers are neutral to negative regarding the value of MPR to them. Interestingly, feedlot characteristics appear to have little systematic relationship to the manager's perceptions regarding the usefulness of MPR.

 
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Causality and Price Discovery: An Application of Directed Acyclic Graphs
Michael S. Haigh and David A. Bessler
Year: 2002
 

Abstract

Directed Acyclic Graphs (DAG's) and Error Correction Models (ECM's) are employed to analyze questions of price discovery between spatially separated commodity markets and the transportation market linking them together. Results from our analysis suggest that these markets are highly interconnected but that it is the inland commodity market that is strongly influenced by both the transportation and commodity export markets in contemporaneous time. However, the commodity markets affect the volatility of the transportation market over longer horizons. Our results suggest that transportation rates are critical in the price discovery process lending support for the recent development of exchange traded barge rate futures contracts.

 
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Hedging Price Risk in the Presence of Crop Yield and Revenue Insurance
Olivier Mahul
Year: 2002
 

Abstract

The demand for hedging against price uncertainty in the presence of crop yield and revenue insurance contracts is examined for French wheat farms. The rationale for the use of options in addition to futures is first highlighted through the characterization of the first-best hedging strategy in the expected utility framework. It is then illustrated using numerical simulations. The presence of options is shown to allow the insured producer to adopt a more speculative position on the futures market. Futures are shown to be performing, in terms of willingness to receive. Options are weakly performing when futures markets are unbiased, while they are more performing when futures markets are biased.

 
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Can Structural Change Explain the Decrease in Returns to Technical Analysis?
Willis V. Kidd and B. Wade Brorsen
Year: 2002
 

Abstract

Returns to managed futures funds and Commodity Trading Advisors (CTAs) have decreased dramatically during the last several years. Since these funds overwhelmingly use technical analysis, this research examines futures prices to determine if there is evidence of a structural change in futures price movements that could explain the reduction in fund returns. Bootstrap tests are used to test significance of a change in statistics related to daily returns, close-to-open changes, breakaway gaps, and serial correlation. Results indicate that several statistics have changed across a broad range of commodities indicating futures price fluctuations have changed. The lower price volatility, decreased price reaction time, and decreased serial correlation may partly explain the lower returns from technical analysis.

 
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The Information Content of Implied Volatility from Options on Agricultural Futures Contracts
Mark R. Manfredo and Dwight R. Sanders
Year: 2002
 

Abstract

Agricultural risk managers need forecasts of price volatility that are accurate and meaningful. This is especially true given the greater emphasis on firm level risk measurement and management (e.g., Value-at-Risk and Enterprise Risk Management). Implied volatility is known to provide a readily available, market based forecast of volatility. Because of this, it is often considered to be the "best" available (e.g., optimal) volatility forecast. However, many studies have provided evidence contrary to this claim for many markets (Figlewski). This research examines the forecasting performance of implied volatility derived from the Black-1976 option pricing model in predicting 1-week volatility of nearby live cattle futures prices. Unlike many studies of implied volatility, this research takes a practical approach to evaluating implied volatility, namely from the perspective of an agribusiness risk manager who uses implied volatility in risk management applications, and thus needs to understand its forecasting performance. This research also uses a methodology that avoids overlapping forecast horizons. As well, the methodology focuses on forecast errors that can reduce interpretive issues that can arise from traditional forecast evaluation procedures. Results suggest that implied volatility derived from nearby options contracts on live cattle futures is a biased and inefficient forecast of 1-week nearby futures price volatility, but encompasses all information provided by a time series forecast (i.e., GARCH). As well, our results suggest that implied volatility has improved as a forecast of 1-week volatility over time. These results provide practical information to risk managers on the bias, efficiency, and information content of implied volatility from live cattle options markets, and provide practical suggestions on how to adjust the bias and inefficiency that is found in this forecasting framework.

 
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A Decision Model to Assess Cattle Feeding Price Risk
Gary J. May and John D. Lawrence
Year: 2002
 

Abstract

Traditional break-even/fed cattle price projections do not provide adequate risk information to feeders, investors, lenders, and other stakeholders interested in cattle feeding decisions. The objectives of this study were two-fold: 1) develop a spreadsheet model that could estimate the net income distribution surrounding a cattle placement decision based on historical errors of futures based price forecasts, and 2) determine whether information generated from the model can be used to improve placement and marketing decisions. To accomplish objective 1, model was developed that could estimate the income distribution around a pen of cattle under a cash speculating and short hedge pricing strategy. Distribution estimates were based on 7 alternative forecast horizons and were derived from historical forecast errors. To accomplish objective 2, decision rules were developed that allow the feeder to specify the maximum probability he/she is willing to risk losing a specified level of income. These decision rules were compared to random and naive decision rules by simulating the outcomes over 168 discrete six months feeding periods between 1987 and 2000. Risk averse decision rules were successful in signaling highly unprofitable feeding periods, but also filtered out highly profitable feeding periods.

 
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Dynamic Risk Management Under Credit Constraints
Gerald G. Nyambane, Steve D. Hanson, Robert J. Myers, and Roy J. Black
Year: 2002
 

Abstract

The vast majority of previous studies on farmers' optimal risk management behavior have used static models and on the most part ignored use of borrowing and lending as an alternative method of managing risk In this paper we develop a stylized multi-period risk management model for a risk averse farmer who can use revenue insurance to manage risk and also borrow and lend subject to a credit constraint. The model is applied to an example farm from Adair County in Iowa and the results provide three important messages. First, contrary to the full coverage of actuarially fair insurance result expected from using purely static analysis, at low revenues, insurance coverage may not be taken in the absence of debt. Second, if debt is available, full coverage will be taken at all revenue states and, third, premium wedges at reasonable levels have larger impact on coverage if debt is available because they eliminate the incentive to use insurance. Results also show that use of borrowing and lending for consumption smoothing reduces extant risk by approximately 77% while use of insurance only reduces risk by approximately 30%.

 
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Weather Derivatives: Managing Risk with Market-Based Instruments
Timothy J. Richards, Mark R. Manfredo, and Dwight R. Sanders
Year: 2002
 

Abstract

Accurate pricing of weather derivatives is critically dependent upon correct specification of the underlying weather process. We test among six likely alternative processes using maximum likelihood methods and data from the Fresno, CA weather station. Using these data, we find that the best process is a mean-reverting geometric Brownian process with discrete jumps and ARCH errors. We describe a pricing model for weather derivatives based on such a process.

 
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Emerging IP Markets: The Tokyo Grain Exchange Non-GMO Soybean Contract
Joe L. Parcell
Year: 2002
 

Abstract

This research provides an overview of the development of the Tokyo Grain Exchange non-GMO soybean contract as an identity preserved futures contract. The development of this contract is unique, relative to the development of other new futures contracts, in that a mature conventional soybean futures contract exists. Particular attention was given to established necessary conditions for the development of a new futures contract. In evaluating these conditions it was determined that since inception of the Tokyo Grain Exchange non-GMO soybean futures contract the contract has functioned like a mature futures contract. This is unique in comparison to results of other studies evaluating the development of futures contracts. Furthermore, the lack of a well defined and liquid cash non-GMO soybean market does not appear to have hampered the development of the non-GMO futures contract.

 
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Modeling Contract Form: An Examination of Cash Settled Futures
Dwight R. Sanders and Mark R. Manfredo
Year: 2002
 

Abstract

This research presents an intuitive interpretation and expression for pricing cash settled futures contracts. In particular, the choice of the averaging period for the underlying cash index is evaluated. For example, the averaging period for the Lean Hog futures contract is two days, whereas it is thirty days for the F ed funds contract. Does the choice of the averaging period make a difference? Under certain assumptions, the behavior of the futures price prior to entering the expiration or averaging interval is independent of the length of the interval for storable commodities, but it is not for non-storable commodities.

 
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Hedging Spot Corn: An Examination of the Minneapolis Grain Exchange’s Cash Settled Corn Contract
Dwight R. Sanders and Tracy D. Greer
Year: 2002
 

Abstract

This research examines the potential basis behavior and hedging effectiveness for the Minneapolis Grain Exchange's (MGE) cash settled corn contract. MGE futures cash settle to the National Corn Index (NCI) calculated by Data Transmission Network (DTN). Focusing on seven regions in Illinois, the data suggest that NCI Futures offer potential advantages over the existing Chicago Board of Trade (CBOT) corn futures. In particular, nearby basis variability could be reduced by nearly one-half from 8.8 cents per bushel to 4.5 cents per bushel, and hedging effectiveness may increase from an average of 80% for the CBOT to 93% for the NCI.

 
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Pricing and Hedging European Options on Futures Spreads Using the Bachelier Spread Option Model
Matthew P. Schaefer
Year: 2002
 

Abstract

The Bachelier model for pricing options on futures spreads (OFS) assumes changes in the underlying .futures prices and spread follow unrestricted arithmetic Brownian motion (UABM). The assumption of UABM allows for a convenient analytic solution for the price of an OFS. The same is not possible under the more traditional assumption of geometric Brownian motion (GBM). Given the additional complexity of methods for pricing and hedging OFS using GBM such as Monte Carlo simulation and binomial trees, it is worth investigating how results from the Bachelier model compare to these other methods. The Bachelier model is presented and then extended to price an OFS with three underlying commodities. Hedge parameters for both models are provided. Results indicate that for OFS with sufficiently low volatility, differences between the Bachelier model and methods assuming GBM are quite small.

 
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A User's Guide to Understanding Basis and Basis Behavior In Multiple Component Federal Order Milk Markets
Cameron Thraen
Year: 2002
 

Abstract

What are the general ideas behind a futures contract price and the concept of the Basis calculation? The Class 3 milk futures contract traded at the Chicago Mercantile present opportunities for you to forward price your milk if your milk is pooled in a multiple component market such as Federal Order #33. The use of a Class 3 or Class 4 milk contract allows a producer to forward price the butterfat, protein and other solids components of his milk production in multiple-component pricing federal orders or to forward price butterfat and skim in fat/skim federal order markets. Using the futures instruments to protect against uncertain market prices is a new revenue management tool for the dairy industry. Likewise, the use of a Class 3 or Class 4 contract allows a dairy product manufacturer (buyer of liquid milk) to forward price the butterfat, protein and other solids components of his liquid milk needs to protect against rising prices. The use of futures markets to accurately forward price milk either as an output or as an input necessitates that one must know the relative cash price/futures price relationships that are captured in what is called basis. This article will define the general concept of basis as it is used in futures and options markets and how it can be calculated for a milk producer who intends to use Class 3/4 futures contracts as a means to hedge against price declines in a multiple component market. The focus in this paper will be on the Class 3 futures contract and to multiple-component Federal Order markets. The use of the other class contract, the Class 4 futures contract, raises additional issues and will be discussed in a sequel to this paper.

 
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Actual Farmer Market Timing
B. Wade Brorsen and Kim B. Anderson
Year: 2002
 

Abstract

One maxim that has been circulating among farmers is that most farmers sell in the lower third of the market. This maxim is soundly rejected using data from Oklahoma elevators. In fact, roughly half of producers sell in the upper third of the market. Thus, there does not seem to be a great need for producers to hire a market advisor to do their marketing for them. But, some farmers do store longer than is optimal and they could be encouraged to sell sooner after harvest. In the short run, farmers sold after price increases and held after price decreases. Price movements in the days after a large number of sales were no different than price movements after few sales. While farmers are noise traders in the short run, it does appear that they are responding to long-run market signals. Even though there may be room for improvement, it appears that farmers are doing a good job of deciding when to sell their wheat.

 
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Non-expected Utility Theories: Weighted Expected, Rank Dependent, and, Cumulative Prospect Theory Utility
Jonathan Tuthill and Darren Frechette
Year: 2002
 

Abstract

This paper discusses some of the failings of expected utility including the Allais paradox and expected utility's inadequate one dimensional characterization of risk. Three alternatives to expected utility are discussed at length; weighted expected utility, rank dependent utility, and cumulative prospect theory. Each alternative is capable of explaining Allais paradox type problems and permits more sophisticated multi dimensional risk preferences.

 
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Can Structural Change Explain the Decrease in Returns to Technical Analysis?
Willis V. Kidd and B. Wade Brorsen
Year: 2002
 

Abstract

Returns to managed futures funds and Commodity Trading Advisors (CTAs) have decreased dramatically during the last several years. Since these funds overwhelmingly use technical analysis, this research examines futures prices to determine if there is evidence of a structural change in futures price movements that could explain the reduction in fund returns. Bootstrap tests are used to test significance of a change in statistics related to daily returns, close-to-open changes, breakaway gaps, and serial correlation. Results indicate that several statistics have changed across a broad range of commodities indicating futures price fluctuations have changed. The lower price volatility, decreased price reaction time, and decreased serial correlation may partly explain the lower returns from technical analysis.

 
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Bovine Spongiform Encephalopathy (BSE): Risks and Implications for the United States
John A. Fox and Hikaru Hanawa Peterson
Year: 2002
 

Abstract

Mad cow disease has caused two disruptions in European beef markets--first in the U.K. in 1996 following the announcement of a link to new variant Creutzfeldt-Jacob Disease in humans, and the second in late 2000 following the discovery of "homegrown" cases of the disease in Germany and Spain. In September 2001 the disease was discovered in Japan where it also resulted in an immediate and substantial reduction in beef demand. The disease has not been found in the U.S. but the current scope of detection efforts provides little assurance that it does not exist at a very low level. The U.S. has taken a number of precautionary measures to reduce both the risk of importing the disease and the risk of the disease spreading if it were to appear. Those measures include a ban on the feeding of ruminant protein to ruminants--a measure that the General Accounting Office concluded was not being adequately enforced and which failed to halt the disease in the U.K. We present an overview of BSE in the U.K., the EU, and Japan and present an argument for implementing additional precautionary measures in the U.S.

 
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Option Pricing on Renewable Commodity Markets
Sergio H. Lence and Dermot Hayes
Year: 2002
 

Abstract

The paper motivates and proposes a closed form option pricing model for markets such as grains or livestock where the price level can be expected to revert to expected production costs. The model suggests that traditional option pricing models will overprice long term options on these markets.

 
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