| Abstract: | Improvement of returns, and decrease of the risk of obtaining those returns, is of considerable importance to individuals and firms involved with the cattle feeding industry in Texas. Commodity futures options, as components of pre-planned, objective hedging strategies can increase mean levels of returns. In the process of earning those returns, options also provide favorable variance characteristics, implying that risk is decreased for the hedger using options in comparison to cash marketing or hedging with futures contracts. Simulation of nine hedging strategies over a twelve year period (1972-1983) led to the discovery of two methods which generated returns significantly greater than those available from cash market operation. The first strategy, based on a technique developed by Helmuth (1981), increased returns by an average of nearly ten dollars per head. The Helmuth strategy relies on a signal generated when live cattle futures prices exceed estimated breakeven costs of cattle feeding. A second method, which relied on an extended planning horizon to allow for hedging of inputs (corn and feeder cattle), provided an increase in returns of over fourteen dollars per head compared to the cash market operation. Examination of methods of computing cattle feeding costs determined that a method based on the use of linear programming to develop least-cost feed formulations was superior to methods used by either USDA or Pluhar (1983). The least-cost method lowered the cost of cattle feeding estimate relative to the other methods, and was also normally distributed, whereas the other methods did not follow a normal distribution. Futures prices for the three commodities used in this study were lognormally distributed when adjustments were made for recent price variability. The use of the Black (1976) option pricing model was therefore validated since two critical assumptions (lognormal prices and inclusion of price volatility) were satisfied. |
|---|