A comparison of optimum grain hedging strategies using commodity options and futures contracts: an application of portfolio theory

Abstract

Commodity options add a new dimension to grain farmers’ marketing alternatives. Producers of pain can now effectively ensure themselves a floor price without the risk of production shortfalls resulting in losses due to overhedged positions.

The purpose of this study was to determine optimum hedge levels using both commodity options and futures contracts and then compare the hedging tools given various location, crop mix, and levels of financial leverage. The study used portfolio theory where hedging strategies were simulated over time and minimum-variance hedge levels determined. Crop diversification and financial leverage were addressed using Quadratic Programming techniques. Selected strategies were tested over a new data set.

Commodity options are superior to futures contracts as a hedging tool for early season hedges. This was particularly true for crops with highly variable yields. The results also indicate that commodity options are a viable alternative for reducing long-run income variation and that crop diversification reduced income variation but did not reduce the overall need to hedge.

The study presented here is unique in a number of ways. Initially, very little if any published work is available on hedging pain with commodity options contracts. Secondly, the study addresses hedging strategies under the realm of production uncertainty. Finally, the study demonstrates there are E-V efficient alternatives to strict cash sales.