The Optimal Hedging Horizon and Application to Dairy Risk Management in the United States

• Agricultural Economics Workshop

Date and Location

Thursday, November 10, 2016, 4:10 PM - 5:30 PM
ARE Conference Room, 2102 Social Sciences and Humanities

Abstract

What makes a risk management program effective? Hundreds of scientific journal articles have been written on the topic, and nearly all of them conflate this question with “how much of the cash position should be hedged?”, seeking thus to find what is known formally as the ‘optimal hedge ratio’. Although there are numerous variations on this theme, all of these articles essentially examine the basis risk. But even if cash price shocks could be perfectly offset by gains in the hedging account, another fundamental question remains ignored by nearly entire scholarly literature on hedging – when should one hedge? When profit margins follow a mean-reverting stochastic process, for a hedging strategy to be effective, hedges should be placed for sufficiently distant contract months. The rational for using distant months is to allow for major shocks to the cash prices, which may have accrued before the hedge initiation, to have little bearing on the expected profit margins for the time period an agent seeks to hedge. We refer to this problem as the optimal hedging horizon and apply the approach to investigate hedging effectiveness in the U.S. dairy sector