Bobst, Barry W.

English

Research Papers in Economics

SOUTHERN  JOURNAL  OF AGRICULTURAL  ECONOMICS  DECEMBER,  1973
LOCATION  BASIS  VARIABILITY EFFECTS ON
SLAUGHTER  CATTLE HEDGING  IN THE SOUTH AND  SOUTHERN  PLAINS*
Barry W.  Bobst
Location basis  variability is  a matter of potential  Thus,  location basis variability  can  add an  increment
concern  to livestock  producers  who  contemplate  the  of  risk  for  the  distant  hedger,  reducing  the
use  of  livestock  futures  contracts  as hedging  devices  effectiveness  of hedging as a risk-averting device.
and  who  are  removed  from  a  designated  futures  Location  basis  variability  is  not  theoretically
contract  delivery  point.  Recent  attention  has  been  inherent  in  the  situation  of  a  distant  hedger  but
given  this  problem by  Heifner  [3]  in  an analysis of  depends  rather  on the  nature  of spatial competition.
minimum-risk  hedging  ratios  for  cattle  and  hogs,  In  perfectly  competitive spatial markets, price  change
among  other  commodities,  in  which  measures  of  will  be  reflected  simultaneously  across  the  spatial
risk-shifting  effectiveness  were  generated  for  price  surface,  leaving  differentials  along  the  surface
comparison  among  locations.  Heifner  found  no  unchanged.  These  differentials  reflect spatial patterns
significant  differences  among  locations  for  either  of  supply  and  demand  and  transfer  and  exchange
cattle  or  hogs,  indicating  that  location  basis  costs.  In theory, they change  only as these  underlying
variability  is  not  a  significant  factor  for  these  factors  change.  In the real world,  however,  leads and
commodities.  Using  a  somewhat  different  approach,  lags  in price  change can occur, and some markets may
and  a  different  set  of markets  and  time  frame, the  be  isolated  from minor  price  fluctuations  that  occur
author  [1]  came to the same conclusion for slaughter  in  others.  In  a  broad  national  market  such as exists
hogs  in  the  South.  Results  obtained  for  slaughter  for  beef  cattle,  price  differentials  tend  to  be
cattle,  however,  are  somewhat  at  variance  with the  maintained  over  time,  but this does not  exclude the
findings reported  by Heifner.  These  results  and their  possibility  of  temporary  fluctuations  which  could
interpretation  are the subject of this paper.  cause  location basis variability to occur.
The  concept  of location basis  variability is fairly  The  existence  and  magnitude  of location  basis
straight-forward.  Location  basis  is  the  price  variability  is,  therefore,  an empirical question.  While
differential between  a local cash market and a futures  there are a  number of ways to measure location basis
contract  delivery point. Basis  variability  results from  variability,  the  method  adopted  in  this  study  was a
fluctuations  in  this  differential.  Hedgers  who  have  direct  comparison of hedging  revenue  variances.  If it
access  to  the  delivery  market  tend  to  be  insulated  can be shown that  price  variances among markets are
from  its  effect  by,  the  delivery  option  and  the  not  significantly  different  from  one  another,  then
consequent  tendency  for  cash  and  futures  prices  to  differences  in  hedging  revenue  variances  between  a
converge  as futures  contracts  mature.  For hedgers in  delivery  point  market  and  distant  markets  can  be
distant  markets,  however,  delivery  is  not  a  practical  ascribed  to  location-related  factors.  To  anticipate  a
option,  so  that  any  difference  between  the  price  bit,  no  significant  differences  in  cash market  price
differential  expected  at the placement  of a hedge and  variances  for  choice  steers  were  found  among  the
the  actual  differential  experienced  upon  lifting  it  markets studied, but significant  differences in hedging
causes  a  deviation  in  results  from those  anticipated.  revenue  variances were found.
Barry W.  Bobst is  associate  professor of agricultural economics  at the University  of  Kentucky.
*Kentucky Agricultural Experiment Station Article  No.  73-1-74.
73MARKETS  AND LENGTHS OF HEDGES STUDIED  correspond  to feeding  periods  required to carry light,
medium,  and heavy weight  feeder  steers to a finished
Three  fed  cattle  markets  in  the  South  and  weight of 1,000-1,050 pounds,  as shown by National
Southern  Plains  were  selected  for  use  in  the  study.  Research Council rate of gain standards  [5].
These  were  Kentucky,  Georgia,  and  the  Southern
Plains  region  of  Texas  and  Oklahoma.  Omaha  was
selected  as  the  contract  delivery  point  reference  HED  GM
market.  Prices  used for the four markets were weekly
average  prices  as reported by the USDA Market  News
The procedure  used to  calculate hedging revenue
Reporting  Service.  Futures contract  prices  used were
was as follows:
weighted  weekly  averages  of  daily  prices.  Minor 
reporting  differences  occur in  the  cash  price  series.  (1)  Rijt =Pit + Sjm-Lmt
Prices  for  Omaha  and Kentucky  are  reported  from  where:
terminal  market  sales  while  Georgia  prices  are  Rijt  is  hedging  revenue  in  market  i  for  hedging
reported  on  an  at-plant  direct  basis,  and  Southern  period j in week t,
Plains  prices  are  reported  F.O.B.  feedlot  with  a  4  Pit is the average price for choice steers in market
percent  shrink. While these reporting  differences have  i, week t,
some  minor  effect  on the  level of price  differentials  S-m  is the price at which cattle were sold short in
among  markets,  no  effect  on  variances  occurs.  No  the  week  prescribed  by  hedging  period  j  in the
scalar  change  in reporting  basis  is involved  as would  delivery month m contract, and
be  the  case  in  live-weight  versus  carcass-weight  Lmt is the  price at which the same  contract was
comparisons.  purchased in week t.
A  total  of  21  successive  live  cattle  futures  The  model  is  descriptive  of the hedging  process that
contracts  and  their  hedging  results  were  observed  was  postulated, with calculation of hedging revenues
from  January  1969  to  June  1972.  This  period'  being  oriented  on the  marketing  date.  Hedges  were
encompassed  a  structural  change  in  the  live  cattle  assumed to be placed  routinely at the weekly average
futures  contract  in that,  beginning  with  the  August  price  30,  21,  and  13  weeks  prior  to  the  marketing
1971  contract,  Omaha became the par delivery point.  date.  Choice  steer  futures  contracts  are  established
Before,  Omaha  had been a delivery point but at a 75¢  for  delivery  every  other  month,  February  through
per  hundredweight  discount.  At  the  same  time,  December.  For  marketings  in  a  delivery  month,
Guymon,  Oklahoma,  which is  in the  Southern Plains  hedges were assumed  to be placed in that contract up
marketing  region,  was designated a delivery point at a  to  the  week  containing  the  20th of the month, the
$1  per  hundredweight  discount.  The  discontinuity  date on which contracts  normally  expire.  Marketings
caused by this  structural change was accounted for in  for  the  latter  part  of the month were hedged in  the
the  analysis  by  the  use  of within-contract  variances  succeeding  contract,  as  were  marketings  in  the
only, that  is,  the  variances within  the 2-month  span  following month.
of each contract.  Since  the change  occurred between  The model takes an ex post view of the hedging
contracts,  this  procedure  abstracted  from  its effect.  process,  in which results are measured on the basis of
The  Southern  Plains market  was  considered  to be a  realized  revenues.'  Hedging  revenues  are  compared
distant market despite the location of a  delivery.point  on  a  hundredweight  for hundredweight  basis,  so  the
within it.  Justification  for this lay in the fact that the  model does not provide for portfolio-type analyses of
delivery  point  was  established  only for the  last year  hedging  strategies,  such  as  the  derivation  of
of the 3-1/2  year study period and because, as shown  hedged/unhedged  inventory  ratios.  The  model
by  Crow,  Riley,  and  Purcell  [2],  the  delivery  abstracts  from  commission  charges  and  interest
discount  is  so  unrealistically  large  as to  render  the  charges on margin  deposits since  these would tend to
point ineffective  anyhow.  be equal in all markets.
Three  lengths  of  hedge  were  postulated  for  Hedging  revenues  were  generated  on  a  weekly
purposes  of  the  study.  These  were  a  long-term  basis  for the  study  period, and pooled variances  were
(30-week),  a  medium-term  (21-week),  and  a  calculated  for  comparisons  between markets.  Pooled
short-term  (13-week)  hedge.  These  hedge  lengths  cash market price variance is defined as:
1An  ex  ante view  of  hedging  can  also  be adopted,  as  shown  in  [1  ]  and  elsewhere,  in which  hedge  placement  is  the
reference  period for  measuring  results. Ex ante measures  have the advantage  of being independent  of length of hedge, but on the
other  hand they  are  dependent  on the  hedgers' basis expectations. Since expectations  cannot be measured  from market data, the
ex post formulation was adopted here.
7.4MTm  M  Inspection  of the  standard  deviations  presented
(2)  Var(Pi)  =2  (Pit  - im)2 Tm-M  in  Table  1 indicate  something  of what  occurred  to
mt  m  hedging revenue  variances  as the  length of hedge was
m  1 ,2, ..  .M  altered.  Compared  to  cash  markets,  it  can  be  seen
t  ,2,...  m  that the  30-week  hedge  caused  a general reduction in
where:  revenue  variances,  though  the  reduction  was
Var(Pi)is  within-contract  pooled  variance  for  proportionately  greatest  for  Omaha.  As  length  of
price in market i,  hedge was reduced, to  21  weeks and then to  13, there
Pim  is  average  price  in  market  i  for  cash  was  a  tendency  for  revenue  variances  to  increase,
prices corresponding to contract  m,  although,  with the  exception of the Georgia  market,
M  is  the  number  of  contracts  observed  they remained  below the  corresponding  cash market
(21), and  price  variances.  Revenue  variances  for  Omaha
Tm  is the  number of cash prices associated  remained  below  those  for  other  markets,  with the
with contract m.  exception  of  the  21-week  hedge  in  the  Southern
Pooled hedging  revenue  variance  is  defined in  similar  Plains.  This  exception  will  be  discussed  in  the  next
fashion as:  section.  Increasing  revenue  variance  is accounted  for
MTm  M  by a  tendency for  futures  contract  price  variances to
(3)  Var(Rij) =22  (Rijt - Rijm)  /  Tm - M  increase  as the  contracts  approached  maturity.  That
mt  m  is,  prices  at  which  the  shorter-length  hedges  were
m  =  1,2, ...  M  placed  tended  to  be  more  variable  than  some weeks
t  =  1,2..  Tm  before,  when  the  longer-length  hedges  were  placed,
where:  even  though  the  contract  maturity  dates  were  the
Var(Rij)is  within-contract  pooled  hedging  same.
revenue  variance  in  market  i  for
hedge length j,
Rijm  is  the  mean  hedging  revenue  in  INTERPRETATION  OF HEDGING
market  i,  hedge  length j,  in  contract  REVENUE VARIANCES
m,  and  other  variables  are  as
previously  defined.
A  better  understanding  of  how  location  basis
RESULTS  variability  affects  hedging  revenue  can  be  gained by
examining  the  components  of  hedging  revenue
Results  of the  analysis  are summarized  in Table  variance.  These  coponents  can  be  derived  from
1.  Means  and  standard  deviations  of  cash  market  equation(l)andareasfollows:
prices  and hedging revenues  for the four  markets  are  (4)  Var(Pijt)  = Var(Pit) + Var(Sjm) + Var(Lmt) +
presented.  Means  are included  as a  matter  of general  2 Covar(Pt, Sjm)-2 Covar(PitLt)
interest,  but  the  primary  focus  of the analysis  is  on  -2  Covar(Sjm,.Lmt)
the variances.  F-ratios  calculated  for Bartlett's test of  where  the  variables  are  as  previously  defined.  Of
equality  of  variances  are  presented  in the right-hand  primary  interest  is  the  covariance  term  linking  cash
column  of  the  table.  They  refer  to  the  variances  market  prices  with prices  at  which futures  contracts
(standard  deviations  squared)  appearing  on  their  are covered,  Covar (Pit, Lmt). This is the term which
respective  rows.  All  standard  deviations  in the table  shows  how  closely  local market  prices  are  tracking
were  calculated  from  pooled  within-contract  with  futures  market  prices  as  the  futures  contract
variances  for the variables indicated,  nears  maturity.  Because  of  the  delivery  option, this
At  the  5  percent  level  of  significance,  no  relationship  can  be  expected  to be  fairly  close  in a
differences  were  found  between  cash  market  price  delivery  market.  It  may be close in distant markets as
variances.  On the  other  hand, differences  were  found  well, but if so, the linkage works through the delivery
between  hedging  revenue  variances  for  all  three  market  rather than with the  futures market  directly.
hedging  periods  at  the  same  level  of  significance.  Covariances  can  be  further  decomposed  to
These  results  indicate  that  location  basis  variability  correlation  coefficients,  which  provide  standardized
was  a  factor in the distant  markets  during  the  study  measures  of the  cash-futures  price relationships.  The
period.  Cattle  feeders  in  these  markets  apparently  correlation  coefficients  for the cash  market-maturing
could  not have  hedged as effectively during the study  futures  contract  price  relationships  for  the  four
period as feeders with access to the Omaha  market.  markets were  as follows:
75Table 1. CHOICE  STEER  PRICE  AND  HEDGING  REVENUE  SUMMARY  STATISTICS  FOUR  MARKETS,
JANUARY  1969-  JUNE  1972
F-Ratio,
Southern  Bartlett's
Item  Omaha  Kentucky  Georgia  Plains  Testa
-- ----------------  dollars per hundredweight -----------------
Price
Mean  31.13  31.12  31.75  31.01
Std. Dev.  .86  .94  .87  .97  1.10
Hedging Rev.
(30 Weeks)
Mean  28.65  28.63  29.15  28.49
Std. Dev.  .64  .78  .82  .76  3.28*
Hedging Rev.
(21  Weeks)
Mean  29.07  29.06  29.60  28.92
Std. Dev.  .74  .85  .94  .75  4.96*
Hedging  Rev.
(13 Weeks)
Mean  29.64  29.62  30.20  29.49
Std. Dev.  .74  .85  .93  .87  2.66*
No.  of
Observationsb  179  182  160  180
a*Significant  at the 5 percent  level. Critical value of F is 2.60.
bThe  study  period  covered  182  weeks.  Variance  estimates  were  obtained  for  each  contract  in  each
market, despite missing observations.
1.  Omaha  ...........  .+.76  large  to  reduce  revenue  variance  to  a  level  equal to
2.  Kentucky  ........  . .+.69  that  at  Omaha.  It  seems  perverse  to  find  that what
3.  Georgia  ...........  .+.58  amounts  to  a  negative  price  forecast  will  reduce
4.  Southern Plains  . ..  . . .+.72  variance  and so  improve  hedging  effectiveness,  but it
While the  differences  between these  coefficients were  is  nevertheless  so.2  This  seeming  quirk  may explain
not large,  such  differences as did exist were amplified  the  disparity  between  Heifner's  results  and  the
by a  multiplier  of 2  and  were  primarily  responsible  findings  of this  study with  respect  to  the  Southern
for  differences  in  hedging  revenue  variances  among  Plains  market.  Heifner  found  little  difference  in
markets.  As  was  to  be  expected,  Omaha  had  the  hedging  effectiveness  between  Omaha  and  the
highest  correlation  coefficient,  indicative  of  its  Southern  Plains,  but  he  assumed  a  4-month  hedge
delivery point status.  which was  terminated prior to the delivery month  [3,
It  is another  covariance  term which explains the  p.  22].  Thus,  Heifner's  hedge  placements  were  at
low  variance  for  the  21-week  hedge in the  Southern  about the same  point in time as in the 21-week hedge
Plains.  The  covariance  between  cash prices and prices  used in this study. Little is known about the behavior
for  hedges  placed  21  weeks  previously,  Covar  (Pit,  of  choice  steer  futures  prices  over  the  life  of  a
Sjm),  in  this  market  was  negative  and  sufficiently  contract,  but  it  is  conceivable  that  length  of hedge
2 For a somewhat  similar effect  in portfolio  analysis, see  Markowitz  [4, pp. 113-114].
76'has  some  quasi-forecasting  effect  on  revenue  might  be  forthcoming  from  these  markets  and  so
variability.  should be  concerned  to the  futures trading fraternity
as well as to cattle feeders.
CONCLUDING REMARKS  A final  word  should  be  said  about  the hedging
revenue  means  in  Table  1.  They were  all  lower than
This  study  has  shown  that  location  basis  their  respective  cash  market means,  which  quantifies
variability  was  a  significant factor in  three Southern  what is obvious to the most  casual observer of cattle
and  Southern Plains markets  for choice  steers during  prices  over the past  few years:  that  hedging has been
the  period  1969  to  mid-1972.  Hedgers  in  these  a  money-losing  proposition.  Cash  prices  have  been
markets would not have been able to operate with the  rising,  and  futures  prices  have  persistently
same  degree of risk-shifting effectiveness as hedgers in  underestimated  the  increase.  This  might be taken  as
the  Omaha  area.  This  does  not  mean  that  hedging  evidence  of bias  in  the  price  formation  process  for
would have  been totally  ineffective  in these markets.  choice  steer  futures.  On  the  other  hand,  it  seems
Variances  of  hedging  revenues  were  consistently  more  likely  that  it  is  symptomatic  of  the  general
below  their  respective  cash  price  variances  in  forecasting  problem  that  has  plagued  the  livestock
Kentucky  and  the  Southern  Plains.  In  Georgia,  industry  in  recent  years,  in  which  cattle  and  beef
however, this was only true for the 30-week hedge.  It  prices  have  been  persistently  underestimated.  Since
is clear that location basis variability reduces the level  futures  markets  are  more  nearly  places  where
of  potential  hedging  activity.  Analyses  such  as  forecasts  are  put  into  effect  than  where  they  are
Heifner's  show  that  optimum  hedged/unhedged  made,  it  is  not  surprising  that  choice  steer  futures
inventory  ratios  vary  inversely  with the risk-shifting  prices  should  suffer  the  same  forecasting  malady  as
effectiveness  of the hedge  [3, p.  29].  Thus, location  the rest of the industry.
basis  variability  reduces  the  supply  of  hedges  that
REFERENCES
[1]  Bobst,  Barry  W.,  "Effects  of Location  Basis  Variability  on Hedging  of Slaughter  Hogs  in the  South,"
Southern Journal of  Agricultural  Economics, Vol. 5, No.  1. July  1973, pp.  193-198.
[2]  Crow,  Richard  J.,  John  B.  Riley,  and  Wayne  D. Purcell,  "Economic  Implications of Nonpar  Delivery
Points  for  the  Live  Cattle  Futures  Contracts,"  American Journal of Agricultural Economics,
54:111-115,  Feb.  1972.
[3]  Heifner,  Richard  G., Hedging Potential in Grain Storage and Livestock Feeding, Agricultural  Economic
Report  No. 238, Jan.  1973.
[4]  Markowitz,  Harry  M., Portfolio Selection,  Yale  University  Press,  Cowles  Foundation  Monograph  16,
1959.
[5]  National  Research  Council,  Nutrient Requirements  of  Domestic  Animals:  Number  4,  Nutrient
Requirements of Beef Cattle, 4th Rev.  Ed., Washington, National  Academy of Sciences,  1970.
77

LOCATION BASIS VARIABILITY EFFECTS ON SLAUGHTER CATTLE HEDGING IN THE SOUTH AND SOUTHERN PLAINS

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