Analysis of selected short hedging strategies for Texas wheat and corn producers

Abstract

Since 1984, wheat and corn producers have had a new risk management strategy, commodity options, available to them. This research evaluates the performance of selected short hedging strategies, including options and futures. Nine routine strategies, six managed strategies, and two portfolio strategies were evaluated by crop season from 1977-1986. These hedging strategies were based on either selling futures, buying at-the-money (ATM) put options, buying cost of production (COP) put options, writing ATM call options, or writing out-of-the-money (OTM) call options. Participation in government farm programs in conjunction with hedging was examined in terms of the financial condition of a representative Texas Northern High Plains irrigated wheat, dryland wheat, and irrigated corn farm using simulation. Farms in the study area faced significant yield variability. Results for irrigated and dryland wheat showed that all routine strategies gave higher mean net returns and a lower standard deviation than not hedging. When hedging irrigated com, buying ATM and COP puts gave higher mean net returns and a lower standard deviation than not hedging. Buying ATM and COP puts were the dominant routine strategies when hedging each of the crops. Managed strategies were based on a seasonality index of futures prices for determining the hedge placement date or a rolldown procedure when hedging with puts. Buying ATM and COP puts were the dominant managed strategies for each crop. Placing hedges using a seasonality index compared to placing hedges at planting increased net returns by at least 7 percent and lowered the coefficient of variation (CV) by at least 7 percent for the dominant strategies. Using a rolldown procedure when buying puts lowered mean net returns by at least 29 percent and increased the CV by at least 2 percent for each of the crops. When using portfolio strategies to hedge irrigated or dryland wheat, the portfolio strategy was the only hedging strategy with negative mean net returns. When hedging irrigated corn, the portfolio strategy had positive mean net returns and was ranked below only the buy ATM and COP put strategies. For each crop evaluated, participating in government farm programs and hedging with ATM or COP puts placed according to a seasonality index emerges as superior to all other strategies evaluated. Put options appear to be a useful new strategy, especially for producers faced with significant yield variability.