Kenyon, David E.

Kingsley, Steven E.

English

Research Papers in Economics

SOUTHERN  JOURNAL  OF AGRICULTURAL  ECONOMICS  JULY,  1973
AN  ANALYSIS  OF ANTICIPATORY  SHORT HEDGING
USING  PREDICTED HARVEST  BASIS
David E.  Kenyon and Steven E.  Kingsley
The  use  of  the  futures  market  as  an  aid  in  The  producer's  net  price  ($1.20)  is  the harvest  cash
marketing  farm  commodities  has  been  gaining  in  price  ($1.15)  plus  the  gain  or  loss  on  the  futures
popularity  among  producers.  Current  hedging  contract(s)  ($.05).  Equivalently,  net price is the short
practices  are  largely  based  on average  basis  or basis  futures  price  ($1.25)  plus  the  harvest  basis  ($-.05).
movement  over  some  historical  time  period.  The  Producers  can  use the latter relationship to lock-in on
difficulty with this approach  is  that the  year to  year  a  net  price  any  time  before  harvest  if  he  can
variation  in the  calculated basis  is large and using the  accurately  predict  the  harvest  basis.  With  a  reliable
mean  value  to  predict  basis in a  given  year  does not  estimate  of harvest  basis,  this type of hedge  may be
give  a highly  accurate estimate.  The objectives of this  used to increase  price  and/or  reduce price variability.
study  were:  (1)  to  determine  if regression  analysis  The  key to successful  anticipatory  short hedging
could  be used to  accurately predict  the harvest  basis  is  the  ability to predict the  harvest basis.  Regression
at planting  time, and (2) to evaluate the performance  analysis  was  used  to  predict  the  harvest  basis  at
of  alternative  hedging  strategies  using  historical  planting  time.  This  predicted  basis  was then used to
average  basis estimates versus basis estimates  based on  predict  the  net  price  at  harvest.  The  mean  and
regression analysis.  standard  deviation  of  actual  net  price  for  several
Anticipatory  hedging as defined by Working  may  hedging  strategies  were  computed  and  compared  to
be  carried  out  either  in response to  expected future  evaluate  the  relative  performance  of the  alternative
needs  (anticipatory  long  hedging)  or  in  response  to  strategies.
expected  future  sales  (anticipatory  short  hedging)
PROCEDURE [3].  A  producer  uses  anticipatory  short  hedging by
selling  a futures contract(s)  before harvest and buying  The  analysis  pertained  to producers  of corn and
the contract(s)  back at  harvest  when the cash grain is  soybeans  in  the  Richmond,  Virginia  area.  End  of
sold.  The  transactions of an anticipatory  short hedge  month cash prices at Richmond and Chicago,  Chicago
example are summarized  in Table  1.  futures  prices,  and open  interest  data were gathered
Table  1.  ANTICIPATORY  SHORT HEDGING  TRANSACTIONS
Cash Grain Transactions  Futures Transactions
April 30 -Plant corn  Sell December  future @ $1.25 bu.
October  15 -Sell  corn @ $1.15 bu.  Buy December  future @ $1.20 bu.
Return of cash corn  = $1.15 bu.  Gain on futures  = $.05  bu.
Net Price = $1.15  +$.05  = $1.20a
aCommission  charges are not considered throughout this paper to simplify presentation.
David  E.  Kenyon  is  assistant  professor  and  Steven  E.  Kingsley  was  a  research  assistant  in  agricultural  economics  at  Virginia
Polytechnic  Institute and State University. The authors wish to thank David  L.  Holder for his helpful comments.
199for  the time period 1955 to 1971.  Three time periods  approached  since  theoretically  the  cash  price  and
within  a production  year were selected to study basis  futures  price must  be equal in the delivery month  [1,
movement  between planting  and harvest.  The periods  3,  4, 5].  The  larger the basis is at the beginning of the
were  chosen  to  start  at  alternative  planting  dates  time  period,  the  more  the  basis  will  change  as  the
(March  31,  April  30,  and  May  31)  and  end  at  delivery  month  is  approached.  Thus, the  change  in
approximate  harvest  date  (October  15).  With  three  basis  from  planting  to  harvest  is  a  function  of the
time  periods  and two  crops,  six regression  equations  initial  basis  [3].  Thus,  the  change  in the  Richmond
were  needed  to  predict  harvest  basis  for  each  time  basis  (AB)  is  a  function  of  the  Chicago  futures
period and crop.  contract  price  at  planting  (FP1)  and  the  Richmond
-THE  MODEL  cash price  at planting (RC1), the two variables which
determine  the  Richmond  basis.  The  Chicago  cash
The following variable  notation was used:  price  at  planting  (CC 1)  and  the  residual  of  open
NP  =  Net price.  interest  (OIR)  with respect  to a linear trend line were
RC1 =  Richmond cash price at planting.  also  included  to  reflect  the  national  supply  and
RC2=  Richmond  cash price at harvest,  demand situation.
FP1 =  Chicago  futures contract price at  planting.  The  futures  contract  months  traded  were
FP2 =  Chicago  futures contract  price at harvest.  selected  as  close  after  harvest  as  possible  to  permit
B 1 =  Richmond basis at planting.  the  maximum amount  of convergence in the cash and
B 2 =  Richmond  basis at harvest.  futures  prices.  The  better  the  convergence  the more
The  net  price  received  by  producers  using  accurately  harvest basis can be predicted as a function
anticipatory hedging is defined as:  of the  initial  basis  at planting.  This  criterion lead  to
(1) NP = RC2 + FP1 - FP2. the  selection  of  the  November  futures  soybean
Since the Richmond basis at harvest (B2) is:  contract  and the December  futures corn contract.
(2) B 2 = RC2 -FP 2 Open  interest  in  corn  and  soybeans  futures
the equation for net price (1) reduces to:  contracts  has been growing  annually at a rate of 25  to
(3) NP = FP1 + B2. 30% during  the time  period covered by the study. To
Estimated  net price (NP)  at  each planting date is  eliminate  this  trend,  open  interest  was  regressed
determined  by  replacing  B2 ain  equation  (3)  by  an  against  a time  trend variable  and the residuals  of this
estimate  of  harvest  basis  (B2)  obtained  through  equation were  included as  an independent  variable in
regression  analysis  based  only  on  information  predicting  the  change  in  basis.1 These  residuals
available  at planting time.  indicate  an above or below  normal demand for grain.
Thus, estimated net price is defined as:  Regression  analysis  was  used  to  predict  the
(4) NP = FP1 +B2. change  in  the Richmond  basis that  occurs  during the
The  development  of a model  to estimate the net  time  periods  using  the  four  variables  considered
price  a producer  receives  for an anticipatory hedge is  abov.  That is:
dependent  upon  his  ability  to  predict  the  harvest  (5)  AB =(FP 1 , RC1, CC,  OIR)
basis  at  planting  time,  since  the  estimated  net price  where  AB,  FP 1,  RC1,  and  CC1 are  as  defined
equals  the  futures price at planting  plus the estimated  previously  and  OIR is the  residuals of the  predictive
harvest basis,  equations  for  open  interest.  The  variables  FP1 and
The  estimated  Richmond  basis  at harvest (B2) is  RC 1 were  used  instead  of B  (B  =  RC  - FP)  in
calculated  byadding theinitial basis at planting (B)  equation  (5)  since  they  improved  the  predictive
to  the  predicted  change  in  basis  (13)  between  power  of the equations.
planting  and harvest  (B2 =  B 1 + AB).  The preThe  results  of the  estimated  equations  for corn
Richmond  at  harvest  is  then  added  to  the  futures  and  soybeans  are  shown  in  Tables  2  and  3
price at  planting to obtain the  estimated  net price as  respectively.  Most  of the  variables  mentioned  above
indicated  in equation (4).  were  significant  at  the  5  percent  level  with  the
exception  of Chicago cash price in the corn equations
PREDICTING  CHANGF  IN  AS  and open interest  residuals  in the soybean  equations,
therefore  these  variables  were  dropped  from  the
The  Chicago  basis  (Chicago  cash  price  minus  respective  equations.  The corn and soybean equations
Chicago  futures  contract  price)  will tend to approach  explain  approximately  75-80  percent  and 95 percent,
zero  as the delivery month  of the  futures  contract  is  respectively,  of  the  variation  in  change  in  basis
1The  simple  linear regression  explained  approximately  70  percent of variation in the growth of open interest contracts
during 1955-71.
200Table 2.  RICHMOND CHANGE IN  BASIS  EQUATIONS  FOR CORNa
Time  Constant  Explanatory Variables
Period  Term  FP1b  RC1c  OiRd  R2 de  Syxf
Regression Coefficients
First  49.19  .50599  -.91231  .000384  .735  1.92  5.26
(2.707)8  (-5.590)  (2.121)
Second  59.83  .22352  -.73885  .000456  .814  1.96  4.55
(1.107)  (-5.052)  (2.819)
Third  52.76  .45617  -.89485  .000239  .788  2.17  5.56
(1.863)  (-5.531)  (1.764)
aThe  dependent  variable  is the change in the Richmond  basis from the beginning to the end of the time
period.
bFP1 is the closing price of the December  futures contract  on the beginning  date of the time period.
CRC1 is the closing Richmond  cash price on the beginning date of the time period.
dOIR is the difference  between actual and predicted open interest as estimated by a linear equation.
ed is the Durbin-Watson  Statistic.
fSy'x is the standard error of the estimate.
gNumbers in parenthesis  are t ratios.
Table 3.  RICHMOND CHANGE IN BASIS  EQUATIONS  FOR SOYBEANSa
Time  Constant  Explanatory Variables
Period  Term  FP1b  RC1c  CC1d  R2 de sy xf
Regression Coefficients
First  13.110  .79892  -.43946  -.45559  .959  1.72  2.96
(11.513)8  (4.325)  (-4.999)
Second  7.676  .81272  -.51459  -.37336  .971  1.48  2.67
(11.835)  (-5.707)  (6.224) 
Third  12.21  .88441  -.55506  -.42285  .949  1.87  3.71
(9.488)  (4.093)  (-3.724)
aThe  dependent  variable is the change in the Richmond basis from the beginning to the end of the time
period.
bFP1 is the closing price of the November  futures contract  on the beginning  date of the time period.
CRC1 is the closing Richmond  cash price  on the beginning  date of the time period.
dCC1 is the closing Chicago  cash price on the beginning date of the time period.
ed is the Durbin-Watson  Statistic.
f Sy'x is the standard error of the estimate.
gNumbers in parenthesis are t ratios.
between planting  and harvest.  The higher  R2 for the  month of November  for soybeans  and December  for
soybean  equations  is  due  to  the  futures  contract  corn.  Since  the  cash  and  futures  markets  prices
months  traded.  All  futures  transactions  were  in  the  converge  as  the  delivery  month  approaches,  this
201convergence  was better for soybeans since the harvest  IV.  Hedged if Expected Net Price is Greater Than the
date of October  15  was  closer to the  delivery month  Average  Harvest  Cash  Price for  the  Previous
of soybeans than for corn.2 Three Years
The regression equations indicate that the change 
in  the Richmond  basis  is  directly proportional to the  Te  isn  e  is thege
if NP >  AC2 where  AC2 is the average cash price price  of  the  futures  contract,  and  inversely  I  at  harvest  during  the  last  three  years.  This proportional  to  the  cash  prices.  The  higher  the  t  lo  e 
strategy  attempts  to  lock-in  on  expected  net futures  contract price  is at  the  beginning of the time  p  s gate  tn  ecent  pis  in  an  tt  t 
period,  the  smaller  the  negative  change  in  basis.  r  graer  n rent  rs  an a  t
guarantee  higher  returns.  If  NP  <  AC2,  the Conversely,  the  higher  the  cash  prices  are  at  the  u  h  <  c2
producer  does  not  hedge  and  receives  the  cash beginning  of the  time  period,  the more negative  the  prce  rest
price at harvest. basis  will change.  The coefficient of the open interest
variable  is  positive  indicating  that  if  a  larger  than
normal  amount  of  commodity  is  hedged  for  the  THE RESULTS
month  of  delivery  of the  futures  contract,  then the  Table  4  contains  the  mean  and  standard
basis will have a smaller negative change.  deviation  of  actual  net  price  and  the  standard
ALTERNATIVE HEDGING STRATEGIES  deviation  between  expected  and  actual  net  price
(SNP  NP).  The  data  in  Table  4  apply  only  to the Four alternative  hedging strategies were specified  PN.  e  pl  only  t
to  compare  the  mean,  variation  in  net  price,  and  second time  period, that is hedged placed on April 30 to  compare  the  mean,  variation  in  net  price,  and  . l 'J.^  .^~  ',i. . ~and lifted on October 15. difference  between  actual  and  predicted  net  price
For  corn,  the  results  indicate  that  strategies  II, when  harvest  basis  was  predicted  by  the  historical  I  a  - i  o  t 
III,  and  IV  involving  use  of  the  futures  market average  method  versus  regression  analysis. Unhedgedd  i  e  e  r 
production  was  used  as  a  base  for  evaluating  the  produced both higher  net prices and smaller standard
performance  of the strategies,  deviations  in  net  price  than  realized  in  the  cash performance  of the strategies.
market  during 1955-71.  Strategy III appears to be the
I.  Unhedged Production  "best"  strategy of those considered,  since it produced
Under  this  strategy,  the  producer  does  not  the mean price  equivalent  to strategy II with a much
use  the  futures  market  and  sells  in  the  cash  maller  standard  deviation  between  what  the
market  at harvest.  Expected  net price and actual  producer  at  planting  time  expected  the  net price to
net  price  are  equivalent  under  this strategy and  be  at  harvest  compared  to  the  actual  net  price  at
equal to the harvest cash price.  harvest  (6.63  versus  3.97  cents  per  bushel).3 This
reduction  in the standard deviation between expected
II.  Completely  Hedged Production  Using Average  and actual net price  is due to the increased  accuracy
Basis  with  which  the  harvest  basis  was  predicted  using
This  strategy  assumes  that  planting  occurs  regression  analysis  in  strategy  III  in  comparison  to
on April 30  and  all production is hedged on that  using  the  mean  historical  basis  in  strategy  II.  In
date  and that the hedge  is lifted on October  15.  contrast  to  generally  accepted  thought,  strategies  II
Expected  net price is equal to:  and  III  indicate  that  in  comparison  to  cash  price
~(6)  NP =  FP~1~  + B 2 -alone  it  would  have  been  profitable  to  hedge  corn
where  B2 is the  average  of the harvest basis  for  production  automatically  at planting  during the time
the three previous  years.  Actual net price (NP) is  period covered by this study
defined in equation (3).  The  evaluation  of the  strategies  for  soybeans  is
more difficult  since  all of the  strategies  involving the
III.  Completely Hedged Production Using Predicted  futures  market  (II,  III,  and  IV)  reduced  actual  net
price  in  comparison  to  cash  price,  but  they  also
This  strategy  is  identical  to  strategy  II  reduced  the  standard  deviation  of actual  net  price.
except  that  the  harvest  basis  predicted  by  the  The  lower  mean price under  strategies  II,  III, and IV
regression  analysis  (B2)  is  substituted  for  B2 in  is due largely  to  a generally  upward trend in soybean
equation (6).  prices  over the period of study. Strategy IV generated
2The  cash  and  futures  prices  in  markets other than Chicago  may not converge to zero as the closing date of the futures
contracts  approaches,  but they will  converge  to  a local  average  basis  reflecting  the local  supply and demand situation relative to
Chicago.
3There  are  many alternative  strategies  possible  and  each  individual producer  selects among the strategies in relation to
his own economic situation.  Therefore,  no attempt is made to identify  the "best" strategy.
202Table 4.  MEAN  AND  STANDARD  DEVIATION  OF ACTUAL  NET  PRICE PER BUSHEL  FOR SELECTED
HEDGING STRATEGIES 
Strategy  XNp  SNp  SNp.  Np  p  SNP  SNp.N
(cents per bushel)
Corn  Soybeans
I  119.00  11.81  - 233.71  31.29 
II  124.21  7.78  6.63  228.70  22.28  4.66
III  124.21  7.78  3.97  228.70  22.28  2.33
IV  120.93  9.64  6.64  200.26  22.87  11.15
aSNp.Np is the standard deviation between expected  net price  and actual net price.
a  lower  net  price  than the  other strategies  since the  III  indicates the  producer  can  lock-in  on a price with
crop was not hedged in years when expected net price  considerable  certainty  in  a  given  year,  the  year  to
was  below  the  average  cash  price  for  the  previous  year  variation  in  actual  net  price  as  indicated by its
three  years.  If  the  upward  trend in  soybean  prices  standard deviation will continue to be quite large.
continues,  the  producer  will  have  to  decide  if the  CONCL
somewhat  lower  returns  (5  cents  a bushel)  are worth
the  9  cent  reduction  in standard  deviation  of actual  This  study indicates  that  regression  analysis  can
net price.  be used  at planting time to predict harvest basis with
The most significant  differences  in Table  4 is that  a  considerable  degree  of accuracy.  Using  regression
between  the  standard  deviation  of expected  versus  analysis  to  predict  the  harvest  basis  produces  an
actual net price of strategies  II and  III  for both corn  estimate  of  expected  net  price  superior  to  one
and  soybeans.  These  two  coefficients  indicate  that  obtained  using  an  average  basis  for  some  historical
using  regression  analysis  to  predict  the  harvest basis  time  period.  In  addition,  the  results  indicate  that
produces  an  estimate  of expected  net  price  superior  producers  in  the  Richmond,  Virginia  area  can  use
to  using  the  mean  basis  for  some  historical  time  some  simple hedging strategies to their advantage.  For
period.  Assuming  the  differences between  actual  and  corn,  it  appears  producers  could both increase  prices
expected  net price  are normally  distributed, strategy  and  reduce  price  variability  by  using  the  futures
III  indicates that  a  producer  can lock-in  on a price of  market.  For  soybeans,  producers  could reduce  price
soybeans  at  planting time with a 95 percent degree  of  variability  at the expense  of somewhat lower returns.
certainty  that he will  receive  a price within five  cents  Additional  research  involving  more  sophisticated
above  or below that  lock-in price. This compares with  hedging strategies  and short-run  cash price  prediction
a  range of approximately  10 cents above or below the  models  might  indicate  even more price  enhancement
lock-in  price  when  a historical  mean basis  is used to  and  stability  could  be  obtained  by  wise  use  of the
predict  the basis in a given year. Even though strategy  futures market.
REFERENCES
[1]  Gray,  Roger  W.,  and  David  J.  S.  Rutledge,  "The  Economics  of Commodity  Futures Markets:  A Survey,"
Review of Marketing and Agricultural  Economics, Vol. 39, No. 4, Dec.  1971,  pp. 57-108.
[2]  Irwin,  H.  S., "Seasonal  Cycles  in Aggregates  of Wheat-Futures  Contracts,"  Journal of Political  Economics,
Vol. 43, Feb.  1935, 34-49.
[3]  Working  H.,  "Futures  Trading  and  Hedging,"  American Economic Review,  Vol.  43, No. 3, June  1953,  pp.
544-561.
[4]  Working  H.,  "Hedging Reconsidered,"  Journal  of Farm Economics, Vol. 35, No. 4, Nov. 1953, pp. 544-561.
[5]  Working, H., "New  Concepts Concerning Futures Markets and Prices," American Economic Review, Vol. 52,
No. 3, June  1962, pp. 431-459.
203I~  ~~~  ~~~  ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

AN ANALYSIS OF ANTICIPATORY SHORT HEDGING USING PREDICTED HARVEST BASIS

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