A Comparative Evaluation of Cash Flow and Batch Profit Hedging Effectiveness in Commodity Processing

Agribusinesses make long-term plant-investment decisions based on discounted cash flow. It is therefore incongruous for an agribusiness firm to use cash flow as a plant-investment criterion and then to completely discard cash flow in favor of batch profits as an operating objective. This paper assumes that cash flow and its stability are important to commodity processors and examines methods for hedging cash flows under continuous processing. Its objectives are (a) to determine how standard hedging models should be modified to hedge cash flows, (b) to outline the differences between cash flow hedging and profit hedging, and (c) to determine the effectiveness of hedging in reducing cash flow variability. A cash flow hedging methodology is developed. This methodology is similar to that used for batch profit hedging. This methodology balances the daily cash flow destabilizing effect of futures positions against the periodic cash flow destabilizing effect of cash price changes. The resulting cash flow hedges are simulated for soybean processors. These hedges are less effective than batch profit hedging. The reduction in cash flow variance achieved through hedging, though small, is nonetheless statistically significant.Agribusiness, Marketing,

Online Homework for Agricultural Economics Instruction: Frankenstein’s Monster or Robo TA?

This paper describes the programming required for online homework, evaluates its use, and presents methods for student identification and for processing student input. Online homework applications were evaluated in a real class setting. Generally, online homework is cost effective for large classes that have numerous assignments and repeated usage. Online homework appears to increase learning through increased student study-time allocations. Students felt that online homework made course website interaction more productive. They also indicated that online homework increased their perception of the value of lectures and that its use in other courses would be welcome. All findings were highly statistically significant.computer-aided instruction, economics teaching methods, instruction cost effectiveness, online homework, Teaching/Communication/Extension/Profession, A220, G130, Q100,

The Relative Performance of In-Sample and Out-of-Sample Hedging Effectiveness Indicators

Hedging effectiveness is the proportion of price risk removed through hedging. Empirical hedging studies typically estimate a set of risk minimizing hedge ratios, estimate the hedging effectiveness statistic, apply the estimated hedge ratios to a second group of data, and examine the robustness of the hedging strategy by comparing the hedging effectiveness for this "out-of-sample" period to the "in-sample" period. This study focuses on the statistical properties of the in-sample and out-of-sample hedging effectiveness estimators. Through mathematical and simulation analysis we determine the following: (a) the R2 for the hedge ratio regression will generally overstate the amount of price risk reduction that can be achieved by hedging, (b) the properly computed hedging effectiveness in the hedge ratio regression will also generally overstate the true amount of risk reduction that can be achieved, (c) hedging effectiveness estimated in the out-of-sample period will generally understate the true amount of risk reduction that can be achieved, (d) for equal numbers of observations, the overstatement in (b) is less that the understatement in (c), (e) both errors decline as more observations are used, and (f) the most accurate approach is to use all of the available data to estimate the hedge ratio and effectiveness and to not hold any data back for hedge strategy validation. If structural change in the hedge ratio model is suspected, tests for parameter equality have a better statistical foundation that do tests of hedging effectiveness equality.out-of-sample, post sample, hedging, effectiveness, forecasts, simulation, Agribusiness, Agricultural Finance, Demand and Price Analysis, Farm Management, Financial Economics, Marketing, Research Methods/ Statistical Methods, Risk and Uncertainty,

TECHNOLOGY IN THE AGRICULTURAL ECONOMICS CLASSROOM: ARE WE ON THE RIGHT PATH?

This paper surveys the extent and application of Internet-enhanced course instruction in agricultural economics. We find that roughly thirty percent of agricultural economics courses have websites and that the purpose of these websites is to distribute course documents. We argue that this application substitutes readily for traditional teaching methods. According to production economics principles, introduction of an input that substitutes readily for an existing input will not increase production. Therefore, we would not expect course websites used in this manner to greatly enhance learning. We briefly discuss Internet-based tools that offer greater potential benefits than simple document distribution.Teaching/Communication/Extension/Profession,

Hedging Cash Flows from Commodity Processing

Agribusinesses make long-term plant-investment decisions based on discounted cash flow. It is therefore incongruous for an agribusiness firm to use cash flow as a plant-investment criterion and then to completely discard cash flow in favor of batch profits as an operating objective. This paper assumes that cash flow and its stability is important to commodity processors and examines methods for hedging cash flows under continuous processing. Its objectives are (a) to determine how standard hedging models should be modified to hedge cash flows, (b) to outline the differences between cash flow hedging and profit hedging, and (c) to determine the effectiveness of hedging in reducing cash flow variability. A cash flow hedging methodology is developed. This methodology is similar to that used for batch profit hedging. This methodology balances the daily cash flow destabilizing effect of futures positions against the periodic cash flow destabilizing effect of cash price changes. The resulting cash flow hedges are simulated for soybean processors. These hedges are less effective than batch profit hedging. The reduction in cash flow variance achieved through hedging, though small, is nonetheless statistically significant.Agribusiness, Marketing,

Transaction Frequency and Hedging in Commodity Processing

This study examines the effect of transaction frequency on profit and cash flow risk for firms that periodically purchase inputs, continuously transform inputs into outputs, and periodically sell output. Soybean-processing profit and cash flows are computed for unhedged, direct-hedged, and risk-minimizing-hedged processing with up to 52 transactions per year. Findings include: (a) higher transaction frequencies result in lower unhedged profit and cash flow risk and lower hedging effectiveness, (b) anticipatory hedging provides less risk protection than product-transformation hedging, (c) stabilizing cash flow stabilizes annual profits but the converse does not hold, and (d) hedging profits makes cash flow more variable.process hedging, risk management, soybean crushing, Agribusiness,

TRANSACTION FREQUENCY, INVENTORIES AND HEDGING IN COMMODITY PROCESSING

This study examines hedging strategies for commodity processors generally and soybean crushers specifically. Processors require hedging strategies built around processing multiple batches each year. Each batch requires the purchase of inputs, transformation of inputs into outputs, and sale of the resulting output. The more batches processed, the greater the transaction frequency, the smaller each batch's size. Increased transaction frequency reduces risk because of the smaller batch size. This study distinguishes between batch (accounting) profits and periodic profits (cash flows). Traditional hedging models have focused on batch profits but we argue that hedging cash flows are also a legitimate hedging target because (a) discounted cash flow is the capital investment decision criterion, (b) costs are associated with managing working capital, (c) cash flow and profits converge in annual aggregation, and (d) stabilizing periodic cash flow stabilizes annual profits but the converse does not hold. Weekly cash and futures prices from 1990 through 2003 are used to compare averages and standard deviations of direct-hedged and unhedged profits and cash flows with transaction frequencies of 1, 2, 4, 13, 26 and 52 weeks. Our findings are as follows. (1) Increased transaction frequency reduces the variance of unhedged profits and cash flows. Two effects account for this. Both profit and cash flow risks are reduced by smaller batch size associated with increased transaction frequency but only profit risk is reduced by closer integration of input and output markets as transaction frequency increases. (2) As transaction frequency increases, the amount of hedgeable risk declines (finding 1) and the effectiveness of traditional hedges also declines. (3) Anticipatory hedging of soybean processing does not offer much risk protection. (4) Traditional hedging of batch profits tends to destabilize periodic cash flows. Several areas meriting additional investigation are also discussed.Agribusiness, Marketing,

COMPLETE FLEXIBILITY SYSTEMS AND THE STATIONARITY OF U.S. MEAT DEMANDS

A Rotterdam demand model is used to detect evidence of structural change in beef, pork, and chicken demands. The demand model is partially inverted prior to estimation to account for meat supply fixity. Estimation uses a likelihood maximization routine applied to 1950 through 1985 annual data. The results suggest severe disruption in the meat markets in the 1970s. A comparison of the 1980s and the 1960s elasticity structures reveals that income and cross-price elasticities are nearly the same but direct price elasticities are lower and are trending toward even more inelasticity. Implications for pricing and risk management are discussed.Demand and Price Analysis, Livestock Production/Industries,

INVENTORY AND TRANSFORMATION RISKS IN SOYBEAN PROCESSING

This study examines strategies for hedging processing operations generally and uses soybean processing as a specific example. The approach assumes a mean-variance utility function but because of the focus on hedging, the analysis concentrates on risk minimization with risk defined as the variance of the processing margin from its currently expected level. We find that risk so defined contains three components. These are (1) the risk of input/output cash price misalignment at the time of transactions, (2) the risk resulting from the firm's inability to utilize inputs and produce outputs in proportion to the mix that minimizes risk in cash market transactions, and (3) the risk of price change during the time between the purchase of inputs and the sale of outputs. The first two risk components are transformation risk while the third is inventory risk. The relationships between inventory and transformation risks were examined using daily price data from January 1, 1990 through March 23, 2000. Our analysis indicates that inventory risk is the largest of the three components, it increases in a roughly linear relationship with the temporal separation between pricing of inputs and outputs, it is the risk that is hedged with usual hedging models, and that hedging reduces this risk by a proportion of its amount. Consequently, even when hedged, processors face risks that increase with the time that separates the pricing of inputs and outputs and this risk is far larger than the risk of product transformation. In soybean processing, the proportion of risk eliminated through hedging reaches a peak for process lengths of one week with gradual declines thereafter. We also find that the risk-minimizing hedge ratios for soybean meal and soybean oil depend on the length of the anticipated hedging period.Crop Production/Industries,

Hedge Effectiveness Forecasting

This study focuses on hedging effectiveness defined as the proportionate price risk reduction created by hedging. By mathematical and simulation analysis we determine the following: (a) the regression R2 in the hedge ratio regression will generally overstate the amount of price risk reduction that can be achieved by hedging, (b) the properly computed hedging effectiveness in the hedge ratio regression will also generally overstate the amount of risk reduction that can be achieved by hedging, (c) the overstatement in (b) declines as the sample size increases, (d) application of estimated hedge ratios to non sample data results in an unbiased estimate of hedging effectiveness, (e) application of hedge ratios computed from small samples presents a significant chance of actually increasing price risk by hedging, and (f) comparison of in sample and out of sample hedging effectiveness is not the best method for testing for structural change in the hedge ratio regression.out of sample, post sample, hedging, effectiveness, forecasts, simulation, Agricultural Finance,