Can Multiyear Rollover Hedging Increase Mean Returns?

Article excerpt

Both market advisors and researchers have often suggested multiyear rollover hedging as a way to increase producer returns. This study determines whether rollover hedging can increase expected returns for producers. For rollover hedging to increase expected returns, futures prices must follow a mean-reverting process. To test for the existence of mean reversion in agricultural commodity prices, this study uses a longer set of price data and a wider range of test procedures than past research. With the use of both the return predictability test from long-horizon regression and the variance ratio test, we find that mean reversion does not exist in futures prices for corn, wheat, soybean, soybean oil, and soybean meal. The findings are consistent with the weak form of market efficiency. Simulated trading results for 3-year rollover hedges provide additional evidence that the expected returns to the rollover hedging strategies are not statistically different from the expected returns to routine annual hedges and cash sale at harvest.

Key Words: market efficiency, mean reversion, random walk, rollover hedging

JEL Classifications: Q13, G13

When agricultural commodity prices are unusually high, producers are tempted to try to lock in prices for several years of production at high levels. Some have argued that producers can capture the benefits of higher prices over an extended period of time by multiyear rollover hedging (Gardner; Kenyon and Beckman). Rollover hedging recommendations are sometimes made in the popular press and extension literature when crop prices are high. For example, Farm Journal economist Bob Utterback recommended the following strategy (Utterback, p. 7).

The trigger for selling multiple years' crops is a close in the lead-month futures below the 18-day moving average; we'll buy September put options two strikes in the money. My plan is to price 100% of expected 1997 production when the trigger is tripped, and the '98 and '99 crops if the trigger occurs above $4. Then we'll convert the put options to futures when weather scares are past, and just keep rolling them forward.

The available empirical literature (Conley and Almonte-Alvarez; Gardner; Huang, Turner, and Houston; Kenyon and Beckman; Turner and Heboyan) has mostly found that rollover hedging increases mean returns but has used sample sizes that are too small to be conclusive and has not included significance tests. The literature has also given scant consideration to the connections between rollover hedging, the efficient market hypothesis, and the underlying stochastic process.

A survey of extension marketing economists found that a majority of extension economists did not disagree with the statement that rollover hedging can increase expected returns (Brorsen and Anderson). Lence and Hayenga used a large sample size and found that it is infeasible for hedge-to-arrive contracts involving interyear rollover hedging to lock in high current prices for crops to be harvested one or more years in the future. Yet, their results still leave open the possibility of a small increase in returns.

Rollover hedging is different from standard hedging1 in that it involves continuously switching from a nearby futures contract to a more distant futures contract. In rollover hedging, the hedger first opens a position in a nearby futures contract and later closes it while simultaneously opening the same position with a more distant futures contract. Interestingly, in the finance literature (e.g., Ross), rollover hedging is considered a way to lock in the long-run equilibrium value and is viewed solely as a means of reducing risk. Only in the agricultural economics literature is rollover hedging considered a way to increase mean returns.

For rollover hedging to increase expected returns, futures price movements should follow a mean reversion process in which price gradually moves toward its underlying fundamental value whenever it deviates from the underlying value. …