Bobst, Barry W.

English

Research Papers in Economics

SOUTHERN  JOURNAL OF AGRICULTURAL  ECONOMICS  JULY,  1973
EFFECTS OF LOCATION  BASIS  VARIABILITY  ON
HEDGING  OF SLAUGHTER  HOGS IN  THE SOUTH*
Barry W. Bobst
The  location  basis  variability  aspect  of hedging  While the  study  is strictly  applicable  only to one
commodities  in futures  should be of especial concern  period  of  time,  calendar  year  1971,  and  to  the
to  Southern  hog producers  who  might  contemplate  particular  markets  considered,  the  results  indicate
hedging in the live hog futures market. Location basis  virtually  no  trace  of  location  basis  variability.
variability  affects  hedgers  who,  like  Southern  hog  Variances  of hedging results in the  Southern markets
producers,  are  distant  from  designated  futures  studied  were  not  significantly  different  from
contract  delivery  points  and  cannot,  as  a  practical  variances in the delivery-point  market.
matter,  make (or  take)  physical  delivery to discharge MARKETS AND  GRADES  STUDIED'
their obligation under  a futures contract.  To liquidate
hedges,  Southern  producers  would  have  no  real  Three  Southern  hog  markets  were  selected  for
alternative  but  to  market  hogs  locally  and purchase  use  in  the  study.  These  were  the Western  Kentucky
offsetting  futures contracts.  Any change in the spatial  (Purchase  Area) buying  stations, the Southeast direct
relationship  of hog  prices  between  the time a  hedge  market  (southwestern  Georgia  and  adjacent  areas  of
was  placed  and  when it was  lifted  causes  a disparity  Alabama  and  Florida),  and  the  North  Carolina
between  the  intended  and  actual  outcome  of the  auctions.  By Southern standards,  these  are regions of
hedge,  hence,  the  term  location  basis  variability.  concentrated  slaughter  hog  production  and
Hedgers  with  access  to  a  delivery-point  market  are  marketing, and their markets  have  the virtue of daily
more  or less  insulated  from its effect,  because of the  price  reports.  In  selecting  the  delivery-point
delivery  option.  Since  hedging  is  presumably  comparison  market,  the  par  delivery  market  of
conducted to reduce the effects of price variability on  Peoria,  Ill.,  was passed  over in  favor of Omaha, Neb.,
the  enterprise,  location  basis  variability  stands  as  a  which is  also  a  delivery market, but  at  a  50  cent per
potential  barrier  to  the  usefulness  of  hedging  to  hundredweight  discount,  according  to  current
Southern hog producers.  contract  specifications.  Omaha  was  selected  over
The  question as to whether  this potential barrier  Peoria because  of the apparent  wider dissemination of
is  an  actual barrier  is  essentially  an  empirical  one.  Is  Omaha  market  prices  in  Southern  news  media  and
location  basis  variability  in Southern  markets  in fact  because  of  its  long  standing  as  a  premier  livestock
significant?  That  is,  if  one  were  to  compare  the  market.  For  these  reasons,  Southern  producers
results of hedging hogs  on feed in the South with the  interested  in hedging are perhaps  more likely to look
results  obtained  by  producers  with  access  to  a  to Omaha as a basis of comparison.
delivery-point market, holding grades constant, would  Prices  in  the  Kentucky  buying  station  market
one find  significant differences  in the variances of the  and  the Southeast  direct market  are reported  on the
results?  The  purpose  of this  paper  is  to  report  the  U.S.  grading  system,  as  is  Omaha.  North  Carolina
findings of just such an inquiry.  auctions,  however,  are  reported for  "North Carolina
Barry  W.  Bobst  is  associate  professor  of agricultural  economics at the University of Kentucky.  The author acknowledges  the help
of Dr.  John  Ikerd,  North  Carolina  State  University,  and  market  news  reporters  in  Kentucky  and  Georgia for their  assistance  in
conducting the study.
*The investigation  reported  in  this  paper  (No.  73-1-5)  is  in  connection  with  a  project  of the Kentucky Agricultural  Experiment
Station and  is published with approval  of the Director.
c/  ' 193top  hogs."  Prices  for  lesser  grades  are not reported.  hedged  in  the  next  succeeding  contract.  Use  of the
"North  Carolina  top  hogs"  do  not  necessarily  15th of a  contract  month as the  cut-off point rather
conform to  U.S.  grade  standards, but they are said to  than  the  20th, when contracts normally expire, was a
be  generally  comparable  to  U.S.  l's and  2's weighing  conservatively oriented procedure and was adopted to
200-220 pounds  [3].  avoid  liquidity problems that might arise closer to the
~HEDGING  MODELS  ^'contract expiration date.
Comparability  of  hedging  results  is  an  issue
Two  hog production and marketing systems were  which merits  some  consideration.  Cash market  price
postulated for purposes of calculating hedging results.  means  and  variances  and  their  hedging  revenue
So far  as hedging is concerned, the two systems differ  counterparts  can  be  generated,  but  are  they
by  the  length  of run  of the  hedge.  The  longer run  comparable  among  markets?  The  answer  is  that
system  was  a  farrow-finish  operation,  in  which  a  differences  among means are to be expected  because
hedge  is placed when pigs are farrowed and lifted 174  of  spatial  differentials  and  differences  in  type  of
days later, when the finished  hogs  are  assumed to be  market  at  which  prices  are  reported.  Variances,  on
marketed.  The  other  system was a specialized  feeding  the  other  hand,  can  be  hypothesized  to  be  equal
enterprise,  in  which  50-pound  feeder  pigs  are  among  markets  for similar grade and weight reporting
purchased  and  fed  to  market  weight.  The  hedge  is  ranges.  This  follows  from  the theory of competitive
placed  when  the  feeder  pigs  are  acquired  and lifted  spatial  price  equilibrium.  For  a  homogeneous
106  days  later,  when the finished  hogs are marketed.  commodity,  the  theory  indicates  that  price  changes
The  lengths  of  the  hedges,  174  and  106  days  will be reflected uniformly  among spatially separated
respectively,  are  derived  from  National  Research  markets,  leaving  spatial price  differentials  unchanged
Council  growth  rate  standards  and  expected  lengths  [1].  Uniform  price  changes  over time result  in  equal
of time  necessary  to achieve  a weight of 225 pounds  price  variances  among  markets.  Differences  among
[5].  means  will,  in  the  simplest  case,  just  equal  transfer
The  general  model  for.  calculating  hedging  costs among markets.
revenue  is as follows:  In the  current  case,  differences  in exchange costs
arising from differences  in types of markets at which
(1)  Rijgt  =  igt + Sjm-Lmt  prices  were  reported  are  also  contained  in  the
observed  prices.  However,  the  commodity  itself
where  Riigt is hedging revenue  in market i for hedging  remains  homogeneous,  with  only  slight  variations  in
system j for hogs of grade g on market date t,  grade  and  weight  ranges  among  markets.  No  scalar
Pigt  is the  cash market price in market i, grade g,  change in the magnitude of price change is involved as
date t,  would  be the  case  if physically transformed  products
Sjm  is the  price at which hogs were  sold short on  were  being  compared,  e.g.  live  hogs  versus  dressed
the  date  corresponding  with  hedging system j  in the  carcasses.  Differential  exchange  costs  will, therefore,
delivery month m futures market, and  behave  in the same manner  as transfer  costs and will
Lmt  is  the  price  at  which  the  same  contract  is  not  affect  price  variances.  The  exceptions  to  this
purchased  on date  t. The  model is  descriptive  of the  argument  are  (1)  major  changes  in  transfer  or
hedging  process  that  was  postulated.  It  allows  for  exchange  costs  which might  have taken place  during
comparisons  of  hedging  with  cash  marketing  on  a  the  study  period,  or  (2)  the  markets  are  not
hundredweight-for-hundredweight  basis  for  purposes  competitive.  While  equality  of  cash  market  price
of measuring  location  and grade  basis  variability.  It  variances  is  not  a  sufficient  condition  to  test these
does  not  provide  for  portfolio-type  analysis  of  larger  issues,  it  is  a  necessary  condition  for  low
hedging  strategies.  Calculation  of  hedging  revenues  location  basis  variability  and is  subject  to  empirical
was  oriented  on  the  marketing  date.  Hedges  were  verification  along  with  the  question  of equality  of
assumed  to  be placed  174 and  106  days prior to the  hedging revenue  variances.
marketing  date.  If  a  hedge  fell  on  a  weekend  or
holiday,  it  was  placed  on  the  next  available  date.  HEDGING REVENUE RESULTS
Hedges  were  assumed  to  be  lifted  on  the  date  hogs  Hedging  revenues were calculated  on a daily  basis
were  marketed  or  on the  next  available  date  in the  for  calendar  year  1971  for  the  two  postulated
few cases where holidays  did not coincide.  production-marketing  systems.  Means  and  variances
Hedges  were  placed  in  contracts  for  delivery  in  of cash hog prices  and  hedging  revenues  for the four
the marketing  month,  up to the  15th of that month,  markets  in  1971  are  presented  in Table  1. Bartlett's
and  in  the  succeeding  contract  after  the  15th.  test  of equality  of variances  was employed to test the
Marketings  in  months without futures contracts were  hypotheses  of  equality  of variances  of cash  market
194Table  1.  HOG PRICE AND  HEDGING  REVENUE  SUMMARY  STATISTICS,  BY  GRADE,  FOUR MARKETS,
1971
--dollars per  cwt. and (dollars  per cwt.)
2
A.  Omaha Terminal Market  (252 observations)
Grade  U.S.  1-2  U.S. 1-3  U.S. 2-4
(200-220  lbs.)  (200-240  lbs.)  (240-270  lbs.)
Cash Market
Mean  19.31  19.03  18.36
Variance  2.39  2.45  2.45
Hedging  Revenue
1.  Farrow Finish
Mean  20.36  20.09  19.41
Variance  2.57  2.61  3.01
2.  Feeder Pig-Finish
Mean  19.25  18.97  18.29
Variance  4.58  4.78  5.20
B.  Kentucky  Buying  Stations.a (254 observations)
Grade  U.S.  1-3  U.S. 2-4  U.S. 24
(200-240  Ibs.)  (190-240  lbs.)  (240-260  lbs.)
Cash Market  Price
Mean  18.56  18.14  17.73
Variance  2.72  2.79  2.85
Hedging Revenue
1.  Farrow-Finish
Mean  19.61  19.20  18.79
Variance  2.83  2.88  2.89
2.  Feeder  Pig-Finish
Mean  18.48  18.07  17.66
Variance  4.77  4.81  4.84
C.  Southeast  Direct (251  observations)
'Grade  U.S. 1-2  U.S. 2-3  U.S. 24
(200-230  lbs.)  (190-240  lbs.)  (240-270  lbs.)
Cash Market  Price
Mean  18.46  17.83  17.33
Variance  2.52  2.62  2.66
Hedging Revenue
1.  Farrow-Finish
Mean  19.51  18.88  18.39
Variance  2.97  3.06  3.10
2.  Feeder Pig-Finish
Mean  18.41  17.77  17.28
Variance  4.81  4.88  4.90
D.  North Carolina  Auctions (242  observations)
Grade  North Carolina
Top  Hog
Cash Market  Price
Mean  17.96
Variance  2.71
Hedging Revenue
1. Farrow-Finish
Mean  19.03
Variance  2.98
2.  Feeder  Pig-Finish
Mean  17.91
Variance  4.79
aA  fourth grade of heavy  hogs is reported for Kentucky but  not  included here.
i95prices  and  of  hedging  revenue  variances.  For  the  where  Uigt  is  the  measure  of  the  magnitude  of
latter,  tests  were  made  by  hedging  system,  as  it  is  hedging  error. Substituting  equations (1) and (2)  into
evident  from  inspection  of  Table  1  that  the  equation (3), the hedging error function reduces  to
feeder-finish  system had considerably  higher  variances
than the  farrow-finish  system.  Computed  F-ratios for  (4)  Uigt  igt -Lt  -C
Bartlett's  test  for  cash  market  prices,  the
farrow-finish,  and  the  feeder  pig-finish  systems  for  Note  that  the  length  of hedge  does  not  affect
the highest  grade  range  reported  in each market were  hedging  error  except  as  it  affects  expectations.
1.60,  1.06, and 0.31  respectively.  The critical value of  Hedging  error  is  composed of the  realized basis  (Pigt
F(3,oo)  at  the  5% level  of significance  is  2.6,  well  - Lmt)  less the  anticipated  basis (C).  The anticipated
above  the  computed  ratios.'  Similar  tests  for  the  basis cannot be measured  from market data, since it is
heavier,  lower  grades  of  hogs  came  to  the  same  in  the  mind  of  the  hedger.  The  realized  basis
conclusion.  component  can  be  measured,  however,  and  is
It  is  evident that variances of hedging revenues in  comparable  among  markets.  Means  and  variances  of
the  Southern  markets  were  no  larger  than  in  the  realized  bases  for  the  markets  under  study  are
contract  delivery  point  market,  Omaha.  Location  presented  in Table  2.
basis variability  was no  barrier to the hedging of hogs  Two salient observations  can be made from  Table
on  feed  in  the  Southern  markets  in  1971.  So  far  as  2.  One  is that the  realized  basis variances  are small -
variability  is  concerned,  producers  in  these  markets  around  one-half  as  large  as  cash  market  prices
could have  hedged  as effectively  as their colleagues  in  variances.  While  total  hedging  error  variances  may variances.  While  total  hedging  error  variances  may
the Omaha area.  differ  from  the  realized  basis  variances,  depending
upon  the  skills  of hedgers,  the  data  indicate  that
hedging  could  have  shifted  risk  away  from  hog
HEDGING ERROR  producers,  a  conclusion which is not conveyed by the
hedging  revenue  variances.  Price  risk, in the sense of a
One  further point needs to be taken up, and that  dispersion  of actual from expected  results, could have
is the  absolute  sizes of the hedging  revenue variances  been reduced.
in  Table  1.  These  variances  were  consistently  larger  The  other  thing to be  noted from Table  2 is that
than cash  market  variances,  so  one might be tempted  realized  basis  variances  are  virtually  equal  among
to  argue  that  the  analysis  has  shown that  Southern  markets.  Only  one outlying  value  is to be found, and
producers  could  have  hedged  just  as  that  is at  Omaha for  U.S. 24 hogs weighing 240-270
INEFFECTIVELY  as  in  the  Omaha  area.  This  pounds.  These  hogs  are  too  heavy  to be eligible  for
apparent  contradiction  is  reconciled  through  the  delivery  against  futures  contracts,  and  their  basis
concept  of hedging  error.  As Professor  Hieronymous  variance  was  considerably  higher  than  for  other
puts  it, "hedging  is  done  with  a view to the market,"  grades.  Evidently  the price  differentials among grades
meaning  that  hedgers  hold  some  price  expectations  are much more rigid in the Southern markets, because
when  they  place  a  hedge  [2].  In  futures  market  their realized  basis  variances  for heavy  hogs were the
parlance,  this  is  an  expectation  of  a  basis,  as  in  same  as for lighter ones. The equality of realized  basis
equation 2:  variances among markets supports the conclusion that
there  was  no  inherent  location  basis  variability
(2)  E(Rijgt) = Sjm + C  working  against  Southern  producers  in  1971.
Southern  hog  producers  could  have  conducted
where  C is the anticipated basis,  which reflects spatial  hedging  programs  with  no  disadvantage  compared
or grade  price  differentials  and,  perhaps, the hedger's  with their Midwestern  colleagues.
own  price  forecast.  The  anticipated  basis  is  the
differential  which  relates  the  futures  price  to  the
CONCLUDING  REMARKS hedger's own situation.  CONCLUD  G REMARKS
Hedging  error  is  the  difference  between  received  The  findings  of this  study do  not  comprise  an
and expected hedging revenues,  or  advocacy  of hedging,  nor  did  the  study  attempt  to
derive  hedging  strategies.  Routine  hedging  activities
(3)  Uigt = Rijgt -E(Rijgt)  were postulated  in order  to generate hedging revenue
iWhile not actually  infinite, the numbers of degrees  of freedom in the denominator of the F-ratios are very high because
of the large numbers of observations  and the nature of Bartlett's test.
196Table 2.  REALIZED  BASIS  STATISTICS FOR HEDGING REVENUES,  BY GRADE,  FOUR MARKETS,  1971
-dollars  per cwt. and (dollars per cwt.)2
A.  Omaha Terminal Market
Grade  U.S. 1-2  U.S. 1-3  U.S. 2-4
(200-220  lbs.)  (200-240  lbs.)  (240-270  lbs.)
Mean  -0.78  -1.05  -1.73
Variance  1.48  1.53  1.85
B.  Kentucky Buying  Stations
Grade  U.S. 1-3  U. S  2-4  U.S. 2-4
(200-240  lbs.)  (190-240  lbs.)  (240-260 lbs.)
Mean  -1.52  -1.94  -2.35
Variance  1.49  1.48  1.44
C.  Southeast Direct
Grade  U.S. 1-2  U.S. 2-3  U.S. 2-4
(200-230 lbs.)  (190-240 lbs.)  (240-270  lbs.)
Mean  -1.61  -2.25  -2.74
Variance  1.45  1.46  1.47
D.  North Carolina Auctions
Grade  North Carolina
Top Hog
Mean  -2.11
Variance  1.47
variances  attributable  to location.  The  findings show  increasing  from  year  to  year.  As to  the question  of
that  hedging programs  could have been carried out in  spatial relationships,  the ones existing  in 1971  appear
the  South  in  1971  as  effectively  as  in the Midwest.  fairly  normal  to  this  observer.  They  can  change,  of
This  equality of hedging opportunity would  seem to  course.  The  Louisville  case  comes to mind, where the
make  it worthwhile  to pursue  hedging  strategies that  spread between  Louisville and Indianapolis practically
might  fit  into  Southern  hog  production  and  reversed  itself  in  a  matter  of  days  [4].  This  came
marketing systems.  about  because  of  a  collapse  of  competition  at
The  fact  remains,  of  course,  that  there  are  no  Louisville,  from  which  a  lesson  may  be  drawn  for
delivery  points  in  the  South,  so  continuing  equality  prospective  hedgers.  They  may  well  find  hedging  in
of hedging opportunity depends upon liquidity in the  live  hog  futures  to  be  a  rewarding  and  effective
hog  futures  market  and  stability  of  spatial  price  management  tool, but  they will need to  have as lively
relationships  in  the  cash  markets.  The  liquidity  an interest  as ever in maintaining  competition in their
outlook  is  promising,  since both trading  volume and  local markets.
open  interest  in  the  futures  contracts  have  been
197REFERENCES
[1]  Bressler,  Raymond  G., Jr., and  Richard  A. King,  Markets, Prices, and Interregional Tade, New York, John
Wiley & Sons,  Inc.,  1970, pp. 89-92.
[2]  Hieronymous,  Thomas  A., Economics of Futures Trading, for Commercial and Personal  Profit, New  York,
Commodity Research  Bureau, Inc., 1971,  p. xii.
[3]  Ikerd,  John,  An Economic  Comparison of Midwest and North Carolina  Hog Prices, North Carolina  State
University  Department  of Economics,  Economics  Information  Report  No.  23, June,  1971,  pp. 16-17.
[4]  Love,  Harold  G.,  and  D.  Milton  Shuffett,  "Short-Run  Price  Effects  of a  Structural Change  in a  Terminal
Market for Hogs," Journal  of Farm Economics, 47: 803-812, 1965.
[5]  National  Academy  of Sciences-National  Research Council,  Committee  on  Animal Nutrition, Animal Board,
Nutrient Requirements for Domestic Animals: II,  Nutrient  Requirements  for  Swine,  5th  Rev.  Ed.,
Washington, D.C., Publication  1192, pp. 12, 31.
198

EFFECTS OF LOCATION BASIS VARIABILITY ON HEDGING OF SLAUGHTER HOGS IN THE SOUTH

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