Hedging Effectiveness around U.S. Department of Agriculture Crop Reports

By McKenzie, Andrew; Singh, Navinderpal | Journal of Agricultural and Applied Economics, February 2011 | Go to article overview

Hedging Effectiveness around U.S. Department of Agriculture Crop Reports


McKenzie, Andrew, Singh, Navinderpal, Journal of Agricultural and Applied Economics


It is well documented that "unanticipated" information contained in United States Department of Agriculture (USDA) crop reports induces large price reactions in com and soybean markets. Thus, a natural question that arises from this literature is: To what extent are futures hedges able to remove or reduce increased price risk around report release dates? This paper addresses this question by simulating daily futures returns, daily cash returns, and daily hedged returns around report release dates for two storable commodities (corn and soybeans) in two market settings (North Central Illinois and Memphis, Tennessee). Various risk measures, including "Value at Risk," are used to determine hedging effectiveness, and "Analysis of Variance" is used to uncover the underlying factors that contribute to hedging effectiveness.

Key Words: analysis of variance, storage hedging, United States Department of Agriculture Crop Reports, value at risk

JEL Classifications: Q13, D81

Futures markets have two primary functions in agricultural commodity markets: (1) a price discovery role and (2) a price risk management role. In order to perform the price discovery role, futures markets require fundamental supply and demand information. One of the most important sources of information futures traders and market agents use to appraise the balance of supply and demand of agricultural commodities are USDA reports. Recent research has shown that com and soybean futures prices continue to react to the release of new information contained in USDA crop reports (Good and Irwin, 2006; McKenzie, 2008). In addition, Milonas (1987) found that the release of crop reports resulted in significant cash price responses for these same markets. Given that both futures and cash prices react significantly to the release of USDA report information, there is potential price risk associated with storing commodities when reports are released. Futures hedging effectiveness to reduce this price risk is determined by co-movements (correlations) in cash and futures prices. If movements in cash and futures prices are highly correlated and basis (defined as the difference between cash and futures price) is stable, hedging will be effective. However, if reports illicit different price responses (in terms of magnitude and speed of adjustment) in futures and cash markets, then basis will become more volatile and hedging effectiveness will be compromised. In particular, cash price reactions, and hence, hedging effectiveness, may differ substantially across regions. For example, hedging performance around report release dates may be significantly worse for mid-south (deficit) grain markets, which typically experience more volatile basis levels than their mid-west (surplus) counterparts. In fact, in extreme circumstances, if cash and futures prices become disconnected and basis variability increases, it is not inconceivable that unhedged positions could generate smaller losses than their hedged counterparts.

The theory of storage or cost-of-carry model and spatial integration models provide theoretical reasons as to why geographical basis differences, both in terms of basis levels and basis changes, may exist (McKenzie, 2005). In addition to variations in local supply and demand for grain, basis will differ substantially across cash market locations based upon factors such as the marginal convenience yield from storing an additional unit of inventory, the marginal physical cost of storage, the physical delivery cost associated with fulfilling the terms of the futures contract, interest rate cost associated with storage, and the transportation cost between markets.

Fortenbery and Zapata (1993) also shed some light on why the link between cash prices and futures prices may differ across locations. They examined cointegration between North Carolina corn and soybean cash markets and their respective futures markets, and found that markets were not consistently cointegrated across their sample period, which would have implications with respect to basis dynamics in these markets. …

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