Agricultural Marketing ECON 337: Agricultural Marketing Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356 1

Cross Hedging Not all markets have relevant actively traded futures contract Either the futures market does not exist, or perhaps it is very illiquid Examples: Sorghum

Cross Hedging If the market you are interested in has no futures contract, but its price is highly correlated with a traded commodity you can hedge with the related contract Sorghum: Cereal grain used for feed, but has no futures contract Price is highly correlated with the price of corn Can hedge with the corn contract if you are a producer or consumer of sorghum

Cross Hedging What is the biggest condition for a successful cross hedge? Correlation between the commodity you want to hedge, and the traded commodity

Cross Hedging If your cross hedge is successful you will have

Cross Hedging Divide through by

Cross Hedging Divide through by If S and F are perfectly correlated, then the hedge ratio should equal 1

Cross Hedging If S and F are not perfectly correlated, then you should not hedge 1:1 with the related contract What hedge ratio should you use?

Cross Hedging Want to estimate how price changes in our commodity are related to price changes in the traded commodity

Cross Hedging Want to estimate how price changes in our commodity are related to price changes in the traded commodity Proper hedge ratio is the estimate of in the regression above

Cross Hedging This means that we should only hedge 65% of our sorghum

Class web site: http://www2.econ.iastate.edu/faculty/hart/Classes/econ337/Spring2018/index.htm