Closed-loop solution for optimal sequential hedging and forward contracting in U.S. hog production

Pa, Chung
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University of Guelph

Vertical coordination via contractual arrangements has become an important marketing alternative for U.S. hog producers. At present, the most common forward contract is the formula-pricing method, which does not minimize market risk exposure. Many studies have focused on managing spot price risk alone. It is also important to consider contract value risk in designing optimal hedging strategies. This study develops a multiperiod model in which hedge adjustments are allowed. The two major marketing alternatives specified in the model are to sell in the spot market or to forward contract using formula pricing. The effectiveness of CME live/lean hog futures hedging is assessed for its ability to reduce both spot price and contract value risks. To proxy the underlying forward contract value, the American put-call parity (APCP) technique is used. The conceptual framework considers a mean-variance utility function that is maximized sequentially to obtain optimal forward contract and hedge ratios. The closed loop solution guides the dynamic information flows between decision stages via three essential features: sequential dependence, feedback, and anticipated revision. The empirical model considers a multivariate ARMA-GARCH framework that estimates the time series of APCP values, live hog prices, and futures gains/losses simultaneously with the conditional (time-varying) variance-covariance structure. This provides a superior forecasting tool to capture the second-moment dynamics for computing optimal forward contract and hedge ratios. The simulation results recommend significant upward hedge adjustments on average. This reflects the time-varying pattern of optimal hedge ratios. The low initial hedge ratio--in contrast with results of Mathews and Holthausen (1991)--may well signify that hedging could be initiated reasonably four months before delivery. The optimal forward contract ratios indicate in almost all instances that hogs should be marketed entirely in advance. This concurs with the increasing trend toward contract marketing observed over the years. To evaluate the futures hedge performance under the closed loop solution, the percentage improvement in utility is compared with two other alternative portfolios of no hedging and non-adjustable MGARCH hedging. The findings indicate that the closed loop solution is able to achieve the best utility outcome especially in volatile market situations.

hog production, United States, closed-loop, sequential hedging, forward contracting