Brorsen, B. Wade

Townsend, John P.

English

Research Papers in Economics

Cost of Forward Contracting
Hard Red Winter Wheat
John P. Townsend
B. Wade Brorsen
Presented at Western Agricultural Economics
Association 1997 Annual Meeting
July 13-16, 1997
Reno/Sparks, Nevada
July 1997Cost of Forward Contracting Hard Red Winter Wheat
John P. Townsend
B. Wade Brorsen
John P. Townsend is a Ph.D. candidate and B. Wade Brorsen is a regents professor in the
Department of Agricultural Economics at Oklahoma State University.Cost of Forward Contracting Hard Red Winter Wheat
Abstract
Two methods were used to determine the cost of forward contracting hard red
winter wheat. One hundred days before delivery, the parametric method estimated the cost
of forward contracting at four cents and the nonparametric estimated costs at 10 cents.
  Producers have been encouraged by academians, lenders, and extension
professionals to reduce price risk using futures or forward contracting. A key assumption
of those advocating these methods of risk protection is that the benefits outweigh the
costs. The costs of such protection however, have been omitted or assumed to be zero for
most of these discussions. Lence has shown that considering hedging costs can lead to
quite different hedging recommendations than assuming zero transaction costs. Brorsen
and Anderson found that none of the 24 extension marketing economists surveyed agreed
that farmers who forward contract production will receive a lower average price than
those who do not. They also found only one extension marketing economist who
disagreed with the statement that pre-harvest hedging strategies are available which allow
a producer to, on average, receive a higher price than always selling at harvest. Given that
the views of extension economists contrast strongly with the limited empirical research
available, there appears to be a need for further research on this issue. 
While some of the costs of hedging are widely acknowledged, the exception being
liquidity costs, the costs of forward contracting are not so obvious. The purpose of this
paper will be to determine the average costs associated with forward contracting hard red
winter wheat at an Oklahoma terminal elevator. Brorsen, Coombs, and Anderson
determined the costs of forward contracting wheat based on Gulf elevator basis bids. This
article expands on that idea by using Arkansas River terminal elevator prices. Gulf bids
may underestimate the costs of forward contracting at a local elevator.
Forward contracting and hedging are services offered to producers to reduce price
risk. Like many services, there is a cost to using this service. In hedging, the cost consists2
of margins, liquidity costs, brokerage fees, and paperwork. Barkley and Schroeder argue
forward contracting also contains these fees built into the basis bid offered by the elevator
since the elevator is now assuming the price risk from the producer. Since forward
contracts lack the margin requirements and the marking to market feature of futures
contracts, forward contracts have greater default risk and collection costs. Elam and
Woodworth found that forward contracting has costs for producers and that the net price
received for forward contracts ranged from 18 cents less than the net price from hedging
10 months to delivery to 2 cents less than the net price from hedging 1 month from
delivery.
Two analysis techniques were chosen. The parametric determined forward contract
price as a linear and quadratic function of year dummy variables and number of days to
delivery with the nonparametric, a seven day moving average of daily basis (cash price -
futures price) was used to estimate the weekly average of basis.
 
Forward Contracting of Wheat
An elevator may forward contract the wheat supplied by the producer to another
user, a mill,  a grain exporter, or even a feed mill. The end user may choose to sell the
equivalent amount of grain in the futures market to protect against a drop in prices.
Elevators also may hedge the grain for sale at a later date. In both cases the elevator
forward contracts grain to protect against two things, an increase in grain prices  and grain
shortages. Although this protection depends on the ability of the producer to deliver3
against the contract. The formula for forward contract price received by the farmer is
forward contract price = Kansas City wheat July futures prices
+ Arkansas River basis bid 
Adding the Arkansas River basis bid to the July futures price yields the forward
contract price. Brorsen, Coombs, and Anderson, argued that elevator managers may
include an extra cushion in the forward contract bid to compensate for possible increased
transportation costs. The Gulf bids reflect contracts between elevators while our data
reflect contracts between and elevator and a farmer. The elevators may be less likely to
default on the contract than a farmer. Thus, the forward contracting costs found here for
Arkansas River prices are expected to be higher than Gulf prices used by Brorsen,
Coombs, and Anderson.
Data
Data are Arkansas River (Catoosa, Oklahoma) forward contract bids for hard red
winter wheat from 1986-1994. The data are available for every day a bid was offered by
the elevator to the last delivery day. On many days, there was no interest in forward
contracting and so no bids were offered. Prices were freight on buyer (FOB) Arkansas
River for delivery in the last half of June. In addition to the terminal elevator’s bids the
data also include Kansas City July hard red winter wheat futures. The basis was defined as
(forward contract price - Kansas City futures). One observation was removed, June 15,
1988, due to the forward contract bid’s failure to adjust to a large increase in both the4
Gulf forward contract price and Kansas City futures price. The next day the Arkansas
River price had adjusted. The first bids recorded in each year varied in time from 180 days
to delivery to 276 days before delivery, as illustrated in figure 1. 
Figure 1. The days when an Arkansas River forward contract wheat price was quoted vs. 
Days to delivery.
Much theoretical work and applied work on “optimal” marketing strategies assumes
hedging or forward contracting is done at harvest. Only during 1991 were prices even
quoted at planting so the data in figure 1 do not support this assumption. Since seed bedsARFCPit ’ "0 % "1GFCPit % "2KCFUTit % "3DELit % j
10
j’4
"jDji
5
(1)
must be prepared and fertilizer is usually applied before planting, the decision to plant
wheat was made even earlier. 
The data for the parametric method includes all available bids. Many of these early
bids were isolated with few or no bids following for long periods of time. For the
nonparametric method, missing values needed to be eliminated. Bids were considered too
isolated to be used if less than 50% of the days over a period of time contain an
observation. After the missing river data points were deleted, the existing Arkansas River
bids were regressed against the Gulf bids and days to delivery to obtain predicted
Arkansas River bids where the gulf prices were present in the data set. From the remainder
of the data set, 210 observations had the necessary information from the day of the
observation to allow a river price to be estimated using regression. The Gulf prices should
differ from the Arkansas River prices by the cost of transportation between the two points.
Therefore, if the cost of transportation could be estimated, then viable estimates of the
Arkansas bids could be determined. The data points available from the Arkansas River
were regressed against several variables using ordinary least squares (OLS), the formula
is:
where ARFCP  is the Arkansas River price of forward contracts, GFCP  is the Gulf  it it
forward contract price, KCFUT  is the July Kansas City futures prices, and D  are crop it ji6
year dummy variables. DEL  is the number of days to delivery. The samples where the it
river price, gulf price, and futures price were present were used in the regression to
calculate the coefficients used to estimate the missing river prices. The predicted values
were substituted into the data set to fill in missing values and give values of Arkansas
River bids. These predicted values were filled in to avoid large data gaps, empty spaces,
and to allow the 7 day moving average to be calculated without any missing values in the
plots. Therefore, 210 observations were filled in.
Procedure
 Both parametric and nonparametric methods are used to estimate the cost. The
nonparametric method has the advantage of no functional form, while the stricter
restrictions and functional form of the parametric model yields more precise estimates.
The general function of the nonparametric model is
forward contract price = f(time to delivery)
The nonparametric model calculated a seven-day moving average for the forward contract
bids across all the years of the data set to yield a seven day moving average across years
for the contract bids.
The parametric model was estimated using a maximum likelihood estimator (MLE)
in SHAZAM. The general model is:
 ARFCPit ’ "0 % "1DELit % "2DEL
2
it% j
10
j’4
"jDji
&.02815 ( days delivery & .0001236 ( days delivery 2
7
(2)
where ARFCP  is the forward contract price in year i, t days from delivery, D  is a dummy it ji
variable, the value is one if the year equals i, zero otherwise, DEL  is number of calendar it
days to delivery, and DEL  is the number of days to delivery squared. The Breusch-Pagan it
2
test statistic indicated that heteroskedasticity was present in the model. The HET
command using MODEL=MULT specifying multiplicative heteroskedasticity was used in
SHAZAM to correct for the heteroskedasticity. Therefore, OLS could not be used
without losing efficiency, so a maximum likelihood estimator assuming multiplicative
heteroskedasticity was used.  
Results
The results from the regression analysis of the basis are presented in Table 1. In
interpreting the results, we can imply that the basis is approximated by:
where days to delivery is 100, then  (-.02815)100 - (.0001236)(100) = 4.051 cents per
2
bushel. The cost of forward contracting as calculated at 100 days, which for this paper’s
purposes will be defined as the point at which producers seriously start to forward
contract their grain, is approximately 4 cents.8
The non-parametric analysis is plotted in Figure 2 and shows the basis varying over
a wide range over the entire range of days to delivery. It could be argued that the range of
the basis exceeds 30 cents per bushel. Although as the days to delivery decreases to the
range (<120 days) where most forward contracting occurs, the range of the basis values
decreases, but still has a range of 10 cents. Arguably, still a large value. It is reasonable to
argue that even if only 1/3 of the overall range of the basis is the true value, 10 cents is
still a large per bushel cost for forward contracting. Elam and Woodworth also found
similarly large costs associated with forward contracting soybeans. Elam and Woodworth
found a cost of forward contracting soybeans at 300 days to be 18 cents and at 100 days
approximately 4 cents. Brorsen, Coombs, and Anderson found at 100 days the
nonparametric form yielded a cost of 4 cents/bu. and the parametric form yielded a cost of
3 cents per bushel. The costs here are higher.9
Table 1. Regression Coefficients for basis values as a function of days to delivery, days to 
delivery squared, and year dummy variables
basis basis
cash-futures T cash-futures T
Variable (w/o DEL ) stat. (w/ DEL ) stat.
22
Constant 8.0326* 47.55 7.1296* 29.18
(0.1689) (0.2443)
a
Time to delivery:
Days to delivery (DEL) -0.056203* -38.57 -0.028153* -5.956
b
(0.0014) (0.004727)
Days to delivery  (DEL ) N/A N/A -1.236E-04* -5.383
22
(0.0000229)
Dummy variables:
1987 -1.4969* -4.823 -1.9006* -6.628
(0.3103) (0.2867)
1988 -5.5898* -13.33 -5.5136* -13.49
(0.4194) (0.4088)
1989 -11.66* -34.85 -12.848* -45.48
(0.3346) (0.2825)
1990 -8.3845* -35.21 -8.8636* -42.99
(0.2381) (0.2062)
1991 -0.4288 -0.924 -0.93258* -2.395
(0.464) (0.3894)
1992 8.6753* 29.03 8.5198* 32.80
(0.2988) (0.2598)
1993 0.5385* 1.762 1.2101* 4.923
(0.3057) (0.2458)
1994 8.4416* 33.18 8.4080* 31.62
(0.2544) (0.2659)
Parentheses denote standard errors
a
This variable is defined as the number of days remaining to delivery date where 
b
the delivery date is defined as July 1
*Indicates significance at 5%10
Figure 2. Basis 7 day moving average vs. days remaining until delivery
Conclusions
While the costs of hedging are well documented, the costs of forward contracting
are less researched because of the lack of data on forward contract prices. Five studies
have now determined that the costs of forward contracting are substantially larger than the
cost of hedging. The large costs of forward contracting may indicate an extreme level of11
risk aversion of the part of the elevator or that the elevator has a monopoly on the forward
contract market in the area. It may also mean that default risk and collection risks are high
for forward contracts. Perhaps this should not be a surprise. Williams argues that futures
markets exist partly because of having lower transaction costs than cash markets. The
assumption that producers make forward contracting decisions at planting appears to be
incorrect, as indicated by the scarce number of bids offered earlier than 180 days to
delivery, well after planting.
These findings also have important implications for extension programs and
extension professionals. As Brorsen and Anderson found, most extension professionals
believe that producers who use price risk management tools, hedging or forward
contracting do not receive lower average prices for their commodities than those who do
not. This belief contrasts strongly with the empirical evidence. This suggests extension
professionals should reevaluate the marketing advice they give producers. Forward
contracting is more costly than many people realize.References
Barkley, Andrew P. and Ted C. Schroeder. "Forward Contracts and Risk Mitigation in 
Fed Cattle Markets." Selected paper, American Agricultural Economics 
Association annual meetings, Manhattan, KS, August 1991.
Brorsen, B. Wade, J. Coombs, and K. Anderson. "The Cost of  Forward Contracting 
Wheat." Agribusiness 11(July/August 1995):349-354.                      
Brorsen, B. Wade, and Kim Anderson. "What Do Extension Marketing Economists 
Teach?” unpub. manuscript, Dep. Agr. Econ., Okla. State Univ., 1997.                   
Elam, Emmett and John Woodworth. "Forward Selling Soybeans with Cash Forward 
Contracts, Futures Contracts, and Options." Arkansas Business and Economic 
Review 22(Summer 1989):10-20.
Lence, Sergio H. "Relaxing the Assumptions of Minimum-Variance Hedging." Journal of 
Agricultural and Resource Economics 21(July 1996):39-55.                      
White, Kenneth J. SHAZAM User’s Reference Manual Version 7.0.  Vancouver: Mcgraw-
Hill, 1993.
Williams, J. “Futures Markets: A Consequence of Risk Aversion or Transaction Costs?” 
Journal of Political Economy 95(October 1987):1000-23.

Cost of Forward Contracting Hard Red Winter Wheat

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics