Optimal hedging with agricultural options in a portfolio context : information and efficiency
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Date
1989
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Abstract
The three-year pilot program initiated by the Commodity Futures Trading Commission (CFTC) in 1981 led to trading in options on agricultural futures on a number of commodities starting in late 1984 and early 1985. This research examines the effect of option trading on the underlying futures contracts, investigates the temporal relationship between option and futures markets, and finally explores the ability of various choice criteria to identify the efficient set when options are incorporated into the portfolio. Because risk-reduction can be accomplished more successfully with options rather than with futures, it is essential that a better understanding of issues associated with options trading be achieved. Results based on intervention and econometric analysis indicate that futures contracts have declined following the introduction of option trading. Additional insight provided by the estimated equation is useful in identifying structural variables that may explain variations in futures contracts. One of these variables represents the difference between the cash price and the effective loan rates. It is found to be negatively related to futures contracts. Sequential flow of information between the option and futures markets was also hypothesized and tested. An F-test on the significance of the causal (independent) variable was carried out a la Granger and Sims. Empirical evidence clearly indicates that there is unidirectional causality from futures contracts to soybean put option contracts. An apparent causal relation between corn call contracts and its underlying futures contracts does not pass the out-of-sample test criterion. In the tradition of the mean-variance framework, the two-asset problem was extended to a three-asset problem, where the third asset is an option. Classical constrained maximization methods were used to solve for the optimal levels. Multiple hedge ratios are derived and conditions for which these ratios will collapse to the two-asset case are enumerated. The covariance between assets is shown to be an important element. Empirical applications indicated that the hedge ratios are different when options are included in a portfolio. Mean-variance and stochastic dominance methods are used to identify the size of the efficient set. The mean-variance efficient set is found to be smaller than the stochastic dominance set. This is largely because stochastic dominance methods are distribution free.
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Typescript (photocopy).
Keywords
Major agricultural economics