Short hedge performance of cotton options

Abstract

Options on cotton futures provide a new risk management strategy for cotton producers. This study examines the performance of options in a short hedging framework. The effects of various option short hedges on net returns and survivability of a Texas Southern High Plains cotton farm from 1975 through 1984 were estimated assuming two levels of yield variability and two levels of initial debt. Six crop season price risk management strategies were compared. All hedges were placed at planting and lifted at ginning. No attempt was made to manage the hedges, so returns resulting from this naive implementation of hedging strategies are conservative. Buying puts at the money was the most preferred strategy, while writing calls at the money or at cost of production were the least preferred strategies. Rank ordering of these hedging strategies for all performance measures used was not generally affected by level of initial debt or by level of yield variability. Relative ranking of short futures and puts at cost of production were affected somewhat by debt and yield variability, depending on the performance measure used. Net present value of net returns from hedging with puts at the money using the delta exceeded the returns from not hedging by 58% to 88%, depending on initial debt and yield variability. Further, this advantage moved from 58% to 66% under low initial debt, and from 74% to 88% under high initial debt, as yield variability moved from low to high, respectively. All six strategies were used to define an optimal portfolio for each crop year using quadratic programming. The portfolios were developed for the high yield variability scenario, and sensitivity of results to level of risk aversion was investigated. Portfolios performed moderately well with respect to survivability and profitability of the farm. They were preferred to shorting futures and writing calls, but were less preferred than buying puts or no hedging. Using the delta, or neutral hedge ratio, with puts at the money increased profitability and survivability, while using it with puts at cost of production decreased those performance measures.