Title: Optimal Hedging with Futures Contracts
Key Personnel: Ai Di. (Graduate Student) and Getu Hilu (Associate Professor)
Purpose: This study determines optimal hedging with futures contracts and their effectiveness with a focus on joint hedging decisions for cattle exporting farms in Alberta and Ontario based on input and output prices and exchange rate futures.
Issues: With the potential decline in government support programs, market-based risk management strategies have become increasingly important to producers, in particular to producers engaged in exporting to other countries. When engaged in international trade, hedging the commodity price and the exchange rate with futures contracts are widely used to manage risks for many importing firms or farms. The main U.S. based futures markets for commodities and currencies is Chicago Mercantile Exchange (CME) Group. Our study are important for three primary reasons. We first determine the optimal hedge ratio. Second, we assess the effectiveness of using nearshore (i.e., U.S. based) futures contracts to manage risk in the feeder cattle industry. Third, given our results we may be in a better position to explain whether U.S. based futures contracts are useful tool for producers in risk management. For example, beef producers who use futures markets to reduce market risk may have a better method for determining hedging positions, because methods such as MGARCH incorporate more information than hedge ratios estimated using traditional techniques. Fourth, if producers chose to adopt futures market, more effective/efficient hedging strategies can lead to better use of futures markets and increased social welfare.
Model/Method: Expected utility (i.e., mean-variance) model is used to develop theoretical relationship. Econometric estimation (e.g., bivariate GARCH and MGARCH) is used to obtain estimates of parameters of interest.
Results: This study demonstrates that optimal hedge ratios using futures contracts for Ontario and Alberta feedlot operators were low for live cattle and feeder cattle, and shows that the risk reduction from using US based live and feeder cattle futures was lower than 30% in most cases.