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Profit Margin Hedging

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  • Kim, Hyun Seok
  • Brorsen, B. Wade
  • Anderson, Kim B.

Abstract

Some extension economists and others often recommend profit margin hedging in choosing the timing of crop sales. This paper determines producer’s utility function and price processes where profit margin hedging is optimal. Profit margin hedging is shown to be an optimal strategy under a highly restricted target utility function even in an efficient market. Although profit margin hedging is not the optimal rule in the presence of mean reversion, it can still be profitable if prices are mean reverting. Simulations are also conducted to compare the expected utility of profit margin hedging strategy with the expected utility of other strategy such as always hedging and selling at harvest strategies. A variance ratio test is conducted to test for the existence of mean reversion in agricultural futures prices process. The simulation results show that the expected utility of profit margin hedging strategy is highest. The paired difference tests for the profit margin hedging and other two strategies shows that the expected utilities of profit margin hedging strategies are not significantly different from those of always hedging strategy, but are significantly different from those of selling at harvest strategy except when the transaction cost is considered. The results of variance ratio test indicate that there is little evidence that futures price of wheat follows mean reverting process.

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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 37570.

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Date of creation: Apr 2007
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Handle: RePEc:ags:nccsci:37570

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Keywords: expected utility; mean reversion; profit margin hedging; target;

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Cited by:
  1. Hatchett, Robert B. & Brorsen, B. Wade & Anderson, Kim B., 2010. "Optimal Length of Moving Average to Forecast Futures Basis," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 35(1), April.
  2. Sanders, Daniel J. & Baker, Timothy G., 2012. "Hedgers’ Participation in Futures Markets Under Varying Price Regimes," 2012 Annual Meeting, August 12-14, 2012, Seattle, Washington 124872, Agricultural and Applied Economics Association.

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