Comparison of Analytical Approaches for Hedging Agricultural Commoditites

There is little disagreement in the literature that hedging can be an effective risk management tool for agricultural firms. However, when placing a hedge the hedger must determine the futures position to take to offset the price risk on his current or anticipated cash position. When direct hedges are placed (e.g., corn cash position hedged in corn futures) the hedged quantity to cash quantity ratio, or hedge ratio, is often assumed to be 1. However, in instances involving cross hedging (hedging a cash commodity in a different but related futures market) the hedge ratio may deviate significantly from 1 because the prices of the two comodities may not change 1 for 1. Therefore, the hedge ratio should be empirically estimated. Disagreements arise on the best procedure to estimate minimum risk hedge ratio; namely, whether to use cash and future price levels, price changes, or percentage price changes in the estimation process.