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Closed-Loop Solution For Optimal Sequential Hedging And Forward Contracting In U.S. Hog Production

Author

Listed:
  • Pa, Chung
  • Turvey, Calum G.
  • Meilke, Karl D.

Abstract

This paper developes a multiperiod model in which hedge adjustments are allowed. The two major marketing alternatives specified in the model are to sell in the spot market or to forward contract using formula pricing. To proxy the underlying forward contract value, the American put call parity (APCP) technique is used. The conceptual framework considers a mean-variance utility function that is maximized sequentially to obtain optimal forward contract and hedge ratios. The closed loop solution guides the dymanic flow of information between decision stages via three essential features: sequential dependence, feedback, and anticipated revision. The empirical model considers a multivariate ARMA-GARCH framework that estimates the time series of A{CP values, live hog prices, and future gains/losses simultaneously with the conditional (time-varying) variance-covariance structure. This provides a superior forecasting tool to capture the second-moment dynamics for computing optimal forward contract and hedge ratios. The simulation results recommend significant upward hedge adjustments on average. This reflects the time-varying pattern of optimal hedge ratios. The optimal forward contract ratios indicate in almost all instances that hogs should be marketed in entirely in advance. The effectiveness of CME live/lean hog futures hedging is assessed for its ability to reduce both spot price and contract value risks under under the closed loop solution. The percentage improvement in utility is compared with two other alternative portfolios of no hedgig and non-adjustable MGARCH hedging. The findings indicate that the closed loop solution is able to acheive the best utility outcome especially in volatile market situations

Suggested Citation

  • Pa, Chung & Turvey, Calum G. & Meilke, Karl D., 2002. "Closed-Loop Solution For Optimal Sequential Hedging And Forward Contracting In U.S. Hog Production," Working Papers 123572, University of Guelph, Department of Food, Agricultural and Resource Economics.
  • Handle: RePEc:ags:uguewp:123572
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