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Hedging With Futures And Options: A Demand Systems Approach

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  • Frechette, Darren L.
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    Abstract

    The optimal hedging portfolio is shown to include both futures and options under a variety of circumstances when the marginal cost of hedging is non-zero. Futures and options are treated as substitute goods, and properties of the resulting hedging demand system are explained. The overall optimal hedge ratio is shown to increase when the marginal cost of trading options is reduced. The overall optimal hedge ratio is shown to decrease when the marginal cost of trading futures is decreased. The implication is that hedging demand can be stimulated by reducing the perceived cost of trading options, by educating hedgers about options and by initiating programs like the Dairy Options Pilot Program. The demand systems approach is applied to estimate optimal hedge ratios for dairy producers hedging corn inputs in five regions of Pennsylvania.

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    File URL: http://purl.umn.edu/18941
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    Bibliographic Info

    Paper provided by NCR-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management in its series 2000 Conference, April 17-18 2000, Chicago, Illinois with number 18941.

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    Date of creation: 2000
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    Handle: RePEc:ags:ncrtci:18941

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    Web page: http://www.agebb.missouri.edu/ncrext/ncr134/

    Related research

    Keywords: Hedging; Options; Futures; Marketing;

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    1. Viaene, J-M. & De Vries, C.G., 1989. "International Trade And Exchange Rate Volatility," Papers 8905, Erasmus University of Rotterdam - Institute for Economic Research.
    2. Yusif Simaan, 1993. "What is the Opportunity Cost of Mean-Variance Investment Strategies?," Management Science, INFORMS, vol. 39(5), pages 578-587, May.
    3. Lapan, Harvey E. & Moschini, GianCarlo & Hanson, Steven D., 1991. "Production Hedging and Speculative Decisions with Options and Future Markets," Staff General Research Papers 10810, Iowa State University, Department of Economics.
    4. Bond, Gary E. & Thompson, Stanley R. & Geldard, Jane M., 1985. "Basis Risk And Hedging Strategies For Australian Wheat Exports," Australian Journal of Agricultural Economics, Australian Agricultural and Resource Economics Society, vol. 29(03), December.
    5. Turnovsky, Stephen J, 1983. "The Determination of Spot and Futures Prices with Storable Commodities," Econometrica, Econometric Society, vol. 51(5), pages 1363-87, September.
    6. Lence, Sergio H., 1996. "Relaxing the Assumptions of Minimum-Variance Hedging," Staff General Research Papers 5156, Iowa State University, Department of Economics.
    7. Darren L. Frechette, 2000. "The Demand for Hedging and the Value of Hedging Opportunities," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 82(4), pages 897-907.
    8. Lence, Sergio H., 1995. "The Economic Value of Minimum-Variance Hedges," Staff General Research Papers 5053, Iowa State University, Department of Economics.
    9. Hirshleifer, David, 1988. "Risk, Futures Pricing, and the Organization of Production in Commodity Markets," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1206-20, December.
    10. Briys, Eric & Crouhy, Michel & Schlesinger, Harris, 1993. "Optimal hedging in a futures market with background noise and basis risk," European Economic Review, Elsevier, vol. 37(5), pages 949-960, June.
    11. Lapan, Harvey E. & Moschini, GianCarlo, 1994. "Futures Hedging Under Price, Basis and Production Risk," Staff General Research Papers 10041, Iowa State University, Department of Economics.
    12. Castelino, Mark G, 1989. "Basis Volatility: Implications for Hedging," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 12(2), pages 157-72, Summer.
    13. Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-30, June.
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