Stochastic analysis of selected hedging strategies for cotton in the Texas Southern High Plains

Abstract

The most significant problem facing agriculture is price volatility. Farm prices are very unstable as evidenced by the wide swings in Texas cotton prices and by Congress approving Ad Hoc disaster payments in each of the past four years to help farmers. Farmers have risk management tools in the futures and options markets that could help them with the problems they face regarding price volatility. Questions remain about how they should hedge their crops, when they should hedge, and in which market they should hedge their commodity. The purpose of this thesis is to analyze alternative marketing strategies in both the futures and options markets. A simulation model was developed to simulate weekly cash and future prices and option premiums for cotton in West Texas. The model was simulated to analyze the economic consequences of alternative hedging strategies. For the analysis, the hedging strategies were tested for both long and short crop years. In a long crop year all eight hedging strategies resulted in lower relative risk (coefficient variation) then the cash sales strategy. In a short crop year the relative risk on receipts was reduced slightly for only three of the eight hedging strategies. In conclusion, this study reveals that West Texas cotton farmers could better manage price risk by using a marketing strategy that involves the uses of the futures market for cotton. In short crop years risk averse decision makers would prefer to hedge their crop in December. In long crop years producers who are risk averse and moderately risk loving would prefer to use a marketing strategy that calls for purchasing puts on the options market.