On estimation of the hedge ratio in management of price risk of agricultural commodities

Abstract

It is often the case that producers and users of agricultural commodities hedge the exposition in a commodity (e.g. an expected purchase, expected sale, commodity held on stock, commodity being processed) with a derivative position in another, highly correlated market variable. The main reason is that while the commodity traded in a public derivative market, such as CBOT, is highly standardized, spot markets exist for a wide variety of types of that commodity (e.g. different cultivated species, different classes, different qualities etc.). In general, prices of various types of the commodity traded in the spot markets can be regarded as functions of the price of the standardized commodity. When an open position in the non-standardized type y of the commodity is hedged, using the standardized derivative x, the basic risk-management issue is to estimate the hedge ratio between y and x (or, more generally, the long-term average price relationship between y and x) properly in order to minimize risk and subsequent losses. The hedge ratio is usually estimated from historical market data. We address the question of long-term stability of the hedge ratio and propose a new method for estimation of the hedge ratio allowing an improvement of the hedging relationship using stability analysis. We illustrate the method by an example. We also present a user-friendly visualization technique for the method.