Using futures and option contracts to manage price and quantity risk: A case of corn farmers in central Iowa

Li-Fen Lei

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: The overall objective of this study is to examine the optimal responses of a risk-averse corn producer to price and quantity risks within a framework where both futures and option contracts are available as risk management tools. The corn farmer is selected as a representative decision maker because corn is the most important crop in Iowa;Numerical techniques are used to solve the expected utility maximization problem for the corn producer. In forming his subjective probability distributions about random variables, the farmer is assumed to predicate output which will be sell to cash market at a later date and use futures and put options to hedge against the risk associated with his cash position. To decide the optimal hedging strategy, the farmer also makes predictions on the cash, futures, and option prices prevailing at the end of period. Optimal positions are obtained for three scenarios: (1) the producer considers only futures, (2) the producer considers only put options, (3) the producer considers both futures and put options as risk management tools. Comparative static results regarding the impact of model parameters such as frame size, risk attitudes, price levels, and price variances on the optimal solution are then examined. The access values of futures, options, and futures-and-options added to the producer are computed based on the concept of certainty equivalent;The optimal solution indicates that put options are used not only as for hedging purpose but also as speculative tools. From hedging standpoint, however, the option market offers no additional benefit to the expected utility maximizing producer if futures contracts are already in use;The access values added to the corn producer show that the futures contracts have a greater value to the producer than does the option contracts. The primary factors determining the access value of options are farm size, the variability of prices, and the level of risk aversion.

Date: 1992-01-01
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