Academic journal article Journal of Agricultural and Resource Economics

Structural Change in Forward Contracting Costs for Kansas Wheat

Academic journal article Journal of Agricultural and Resource Economics

Structural Change in Forward Contracting Costs for Kansas Wheat

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Farmers looking to eliminate preharvest price risk may choose between using the futures market and forward contracting. Their choice is likely to be influenced by the relative cost of these two methods. The transaction costs of hedging are typically considered to be measured by opportunity cost of margins, liquidity costs, brokerage fees, and added paperwork. The cost of forward contracting is not as easily measured, but is typically defined as wider implied basis relative to expected or historical harvest basis.

A farmer using the futures market to hedge risk of grain price movements will eliminate downside futures price risk, but will remain exposed to basis risk. A short hedge only offers full coverage of a cash position if the expected value of the basis when the hedge is lifted equals the actual basis. Basis risk in this case implies either a wider harvest basis (net loss to the farmer) or a narrower harvest basis (net gain to the farmer).

Entering into a forward contract offered by a local elevator allows farmers to transfer both futures price risk and local basis risk. Their risk is reduced to production risk (having a crop to deliver) and any difference between the forward contract price and the price paid by crop insurance in the event of crop loss.1 Elevators commonly deal with this transfer of risk by taking an o^setting short position in the futures market for the bushels they have agreed to purchase. Transferring risk (and the costs associatedwith hedging) from the farmer to the elevator does not occur without some intended charge to the farmer on the part of the grain elevator.

The volatility of basis for wheat in Kansas has dramatically increased in the past five years relative to historic levels. Figure 1 shows the average nearby basis for wheat at four Kansas locations: Topeka, Hutchinson, Beloit, and Garden City. Visual inspection of the chart suggests that from January 2005 to the fall of 2007, basis generally followed a seasonal pattern with an average basis across all four locations of -$0.240/bushel. The standard deviation of the basis across the four locations during this time period was $0.203/bushel. In the fall of 2007, the pattern shifted noticeably, with less well-defined seasonal patterns and an average basis of -$0.688/bushel. The standard deviation of the basis jumped to $0.362/bushel, suggesting a possible structural shift in local basis. The implications of this shift in volatility of local wheat basis include reduced accuracy of basis forecasts and increased risk from unexpected movements in the basis for hedgers.

This increase in basis volatility has implications for the level of price risk protection offered by futures and options contracts. Only forward contracts, which transfer basis risk to the elevator offering the forward contract, fully protect producers from both downside price and basis risk.2 Previous research has estimated the costs of forward contracts for wheat in the Great Plains to range between six and nine cents a bushel (Townsend and Brorsen, 2000; Taylor, Dhuyvetter, and Kastens, 2003). These estimates use data collected prior to the fall of 2007, thereby re^ecting a period of relatively stable basis levels. Given the dramatic increase in basis volatility over the past five years, an updated estimate is warranted.

This study determines the e^ect of increased volatility of wheat basis on the cost of forward contracting wheat. Using historical forward contract bids from eighteen Kansas elevator locations, we estimate a random effects model of the forward contracting costs charged by elevators to cover their transaction costs, basis forecasting errors, and risk exposure from hedging forward contracts. Results indicate that increases in the volatility of basis, the July wheat futures price, changes in the available market information as harvest approaches, and realized returns to the elevator from forward contracting in previous years all in^uence their pricing strategies for forward contracts. …

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