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Inventory and Transformation Hedging Effectiveness in Corn Crushing

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  • Dahlgran, Roger A.
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    Abstract

    In response to the development of the U.S. ethanol industry, the Chicago Board of Trade (CBOT) launched the ethanol futures contract in March 2005. This contract is promoted by the CBOT as allowing ethanol producers to hedge corn crushing using strategies similar to those used in soybean crushing. The similarities end, however, when the lack of short-term correlation between corn and ethanol prices is compared to the strong correlation between soybean and soy product prices. This contrast motivates the examination of the price risk management capabilities of the CBOT’s ethanol futures contract. Standard hedging methodology is applied to weekly cash and futures price data from March 23, 2005 through March 7, 2007. Findings include (1) for two- to eight-week hedging horizons, the ethanol futures contract effectively hedges ethanol inventory price risk. The effectiveness of the hedge increases with the hedging horizon. Thus, ethanol producers and brokers can use the ethanol futures market to reduce the price risk of holding ethanol inventories. (2) Contrary to anecdotal evidence, ethanol futures are not significantly inferior to gasoline futures for hedging ethanol price risk and for a four-week hedge they are significantly superior to gasoline futures. Thus, ethanol producers and brokers get greater price risk protection from hedging with ethanol futures than with gasoline futures. (3) The corn crushing hedge, utilizing corn and ethanol futures contracts, is an effective means to “lock in” a processing margin. The effectiveness of this hedge increases as the hedging horizon increases. Finally, to understand the processing hedge, the corn crush hedge and the soybean crush hedge were compared. I found that (4) the price risk of corn crushing is greater than that of soybean crushing and the effectiveness of corn crush hedging exceeds that of soybean crush hedging. This difference is explained by the high correlations in the soybean complex.

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    Bibliographic Info

    Paper provided by NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management in its series 2007 Conference, April 16-17, 2007, Chicago, Illinois with number 37557.

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    Date of creation: Apr 2007
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    Handle: RePEc:ags:nccsci:37557

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    Keywords: ethanol futures; hedging; cross hedging; corn crushing; processing hedge;

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    1. Dahlgran, Roger A., 2005. "Transaction Frequency and Hedging in Commodity Processing," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 30(03), December.
    2. Anderson, Ronald W & Danthine, Jean-Pierre, 1981. "Cross Hedging," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1182-96, December.
    3. Anderson, Ronald W & Danthine, Jean-Pierre, 1980. " Hedging and Joint Production: Theory and Illustrations," Journal of Finance, American Finance Association, vol. 35(2), pages 487-98, May.
    4. Rahman, Shaikh Mahfuzur & Turner, Steven C. & Costa, Ecio de Farias, 2001. "Cross-Hedging Cottonseed Meal," Journal of Agribusiness, Agricultural Economics Association of Georgia, vol. 19(2).
    5. Roger A. Dahlgran, 2000. "Cross-hedging the cottonseed crush: A case study," Agribusiness, John Wiley & Sons, Ltd., vol. 16(2), pages 141-158.
    6. Franken, Jason R.V. & Parcell, Joseph L., 2003. "Cash Ethanol Cross-Hedging Opportunities," Journal of Agricultural and Applied Economics, Southern Agricultural Economics Association, vol. 35(03), December.
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