A Bayesian Approach to Optimal Cross-Hedging of Cottonseed Products Using Soybean Complex Futures
Rahman, Shaikh Mahfuzur, Dorfman, Jeffrey H., Turner, Steven C., Journal of Agricultural and Resource Economics
Cottonseed crushers face substantial risk in terms of input and output price variability and they are limited in their planning by the lack of a viable futures contract for cottonseed or cottonseed products. This study examines the feasibility of cross-hedging cottonseed products using the soybean complex futures. Different cross-hedging strategies are evaluated for eight time horizons relative to the expected profit and utility of the crusher. A Bayesian approach is employed to estimate both model parameters and optimal hedge ratios, allowing consistency with expected utility maximization in the presence of estimation risk. The results reveal that both whole cottonseed and cottonseed products can be successfully cross-hedged using soybean complex futures. The profitability of cross-hedging cottonseed products depends on the size of the contract, the optimal choice of strategy, the time of hedge placement, and the hedging horizon.
Key words: Bayesian decision science, cottonseed, cross-hedging, risk management
With each hundred pounds of fiber, the cotton plant produces approximately 155 pounds of cottonseed. At present production levels, the national average is around 990 pounds of cottonseed produced per acre of cotton grown [National Cottonseed Products Association (NCPA), 2002]. Less than 5% of the seed must be set aside to plant the following year's crop. The remaining seed is used in the cottonseed processing industry or is fed to cattle. A small amount is exported. When raw cottonseed moves from the gin to a cottonseed oil mill, it is composed of three parts: linters, which are short fibers still clinging to the seed; hulls, a tough, protective coating for the kernel; and the protein-and oil-rich kernel itself. In recent years, industry-wide yields of products per ton of cottonseed have averaged about 320 pounds of oil, 900 pounds of meal, 540 pounds of hulls, and 160 pounds of !inters, with manufacturing loss of 80 pounds per ton (NCPA, 2002).
Thus, the value of cottonseed is determined by the value of the products produced. Of the four primary products produced by cottonseed processing plants, oil is the most valuable. On average, it accounts for about 40-50% of the total value of all four products. Approximately 1.3 billion pounds of cottonseed oil are produced annually, making cottonseed oil the third leading vegetable oil in the United States (NCPA, 2002). Cottonseed meal is the second most valuable product of cottonseed, usually accounting for over one-third of total product value. It may be sold in the form of meal, cake, flakes, or pellets. Cottonseed meal is used principally as feed for livestock and is generally sold at a 41% protein level. Its major value is as a protein concentrate.
Cottonseed hulls are used primarily as feed for livestock. Hulls differ from meal in that they are roughage rather than a protein supplement. In feeding value, hulls are comparable to good quality grass hay and can serve as a practical supplement to pastures. Cottonseed !inters, the short fibers removed from seed as the first step in processing, are sometimes referred to as "the fabulous fuzz." Through mechanical and chemical conversion, they enter a wider variety of end-use products than any of the other products of cottonseed.
Cottonseed products enter markets that are highly competitive. Soybean oil, corn oil, peanut oil, sunflower and safflower oil, and some of the animal fats are competitors of cottonseed oil. Cottonseed meal encounters a similar degree of competition from other protein concentrates, like peanut meal and sunflower meal, but especially soybean meal. Other cottonseed products face similar numbers of potential substitutes. As a result, cottonseed crushers face substantial price risk. With no viable futures market existing for cottonseed oil, meal, hulls, and !inters,1 cross-hedging offers an opportunity to mitigate this risk.
The central hypothesis of this study is that even though no active futures market exists for whole cottonseed and the cottonseed crush, processors can reduce input and output price risk through cross-hedging. …