THE ROLE OF ORGANIZED EXCHANGES AND STANDARDIZED CONTRACTS IN MARKETING NEW COMMODITIES

Agribusiness,

The Inconvenience Cost: A Portfolio Approach to Non-Convergence Between Cash and Futures Prices

Cash and futures prices should reach equality, or converge, upon contract maturity. Traders can impose convergence during the delivery month through arbitrage behavior: either making or taking delivery on futures contracts. If convergence is not predictable, a futures market fails to provide a clear storage signal to potential inventory holders and reduces the attractiveness of hedging. Recent convergence problems in domestic commodity markets demonstrate the existence of persistent, significant arbitrage opportunities over the second half of the last decade. Yet, terminal elevator operators—perhaps the only participants with the capacity to do so—have not arbitraged away these riskless returns by making enough deliveries. This model demonstrates conditions under which a profit maximizing warehouseman foregoes available arbitrage. We find that making delivery involves substantial opportunity costs, which stem from the loss of managerial control over warehouse space. We refer to the inconvenience of losing such control as the inconvenience cost.Convergence, Arbitrage, Portfolio Theory, Storage, Agricultural Finance, Financial Economics, Risk and Uncertainty, G11, D21, Q14,

Cash Settlement of Lean Hog Futures Contracts Reexamined

In 1997 the Chicago Mercantile Exchange replaced its live hog futures contract with a cash settlement mechanism based on a Lean Hog Index. Although cash settlement was expected to increase the use of the contract as a hedging tool, producers and packers are concerned that convergence between cash and futures prices is not occurring and that the volatility of the lean hog contract basis has increased in recent years. The purpose of the paper is to reexamine cash settlement of lean hog futures contracts as a hedging tool, focusing on basis behavior and management of basis risk. We also investigate alternative hedging instruments that take into account location differences between regional cash prices and the CME lean hog index. Our results indicate that basis has widened and its variability prior to expiration has increased in the cash settlement period. Nevertheless, there is no evidence that ex-ante basis risk has increased, suggesting that the ability to forecast basis prior to expiration has not decreased with cash settlement. Our findings indicate that a contract on a regional basis can reduce producer price risk and may increase market returns. The benefits of a regional basis appear to accrue from providing the producer with an opportunity to manage the variability in returns associated with both the price level and basis.basis behavior, cash settlement, ex-ante basis risk, lean hogs futures contract, regional basis, Agricultural Finance,

Managing Price Risk in Volatile Grain Markets, Issues and Potential Solutions

During 2008 extreme price volatility in grain markets led to country elevators incurring unprecedentedly large margin calls on their futures hedges. As a result elevators’ traditional liquidity sources and lines of credit were stretched to breaking point. This article explores the potential liquidity benefits of making available an Over-the-Counter Margin Credit Swap contract to grain hedgers. The swap would enable hedgers to draw upon sources of capital outside the farm credit system to provide liquidity needed to make margin calls. Simulation results clearly show that a Margin Credit Swap contract would provide significant liquidity benefits to hedgers during volatile periods

Managing Price Risk in Volatile Grain Markets, Issues and Potential Solutions

During 2008 extreme price volatility in grain markets led to country elevators incurring unprecedentedly large margin calls on their futures hedges. As a result elevators’ traditional liquidity sources and lines of credit were stretched to breaking point. This article explores the potential liquidity benefits of making available an Over-the-Counter Margin Credit Swap contract to grain hedgers. The swap would enable hedgers to draw upon sources of capital outside the farm credit system to provide liquidity needed to make margin calls. Simulation results clearly show that a Margin Credit Swap contract would provide significant liquidity benefits to hedgers during volatile periods.elevator, hedging, margin, swap, Agribusiness, Agricultural Finance, Crop Production/Industries, Risk and Uncertainty, G32, G13, Q14,

The Inconvenience Cost: A Portfolio Approach to Non-Convergence Between Cash and Futures Prices

Cash and futures prices should reach equality, or converge, upon contract maturity. Traders can impose convergence during the delivery month through arbitrage behavior: either making or taking delivery on futures contracts. If convergence is not predictable, a futures market fails to provide a clear storage signal to potential inventory holders and reduces the attractiveness of hedging. Recent convergence problems in domestic commodity markets demonstrate the existence of persistent, significant arbitrage opportunities over the second half of the last decade. Yet, terminal elevator operators—perhaps the only participants with the capacity to do so—have not arbitraged away these riskless returns by making enough deliveries. This model demonstrates conditions under which a profit maximizing warehouseman foregoes available arbitrage. We find that making delivery involves substantial opportunity costs, which stem from the loss of managerial control over warehouse space. We refer to the inconvenience of losing such control as the inconvenience cost