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MF-2267 Livestock Economics
Cross Hedging
C ull cow sales are an
Cull Cows Cross Hedging
important component of Because no futures
cow-calf producer profitabil- contract for cull cows exists,
ity, representing 15 to 25 a cross hedge is necessary to
percent of ranchers’ gross hedge cull cows. Cross
income. Cow-calf producers, hedging involves hedging a
cow feeders, and processors commodity in a futures
face significant price risk. contract of a different
For example, from January commodity. Generally,
1995 to December 1996, when hedging cash com-
Dodge City Boner cull cow modities in similar futures
prices ranged from $29.41 commodity contracts, a
per hundredweight to $48.00 hedging relationship of one-
per hundredweight Similar to-one is assumed (i.e., the
variability prevails across Department of Agricultural Economics
futures quantity equals the
other locations and cow cash quantity being hedged).
grades. Given this variability, it is
important that cow-calf producers, cull
Lean Beef Futures However, this may not be appropriate
when cross hedging because the cash
cow feeders, and cow processors have Contracts and futures prices might not change on
some mechanism to manage price risk. The 90-percent lean, boneless beef a one-to-one basis. For example, cull
Currently, there is no futures contract is to be traded in 20,000- cow prices and 90-percent lean,
market in which to directly hedge cull pound increments and will be cash boneless beef futures prices may
cows. One alternative is to use live settled based upon the volume- change differently than one-to-one
cattle futures as a cross hedge. weighted, 5-day average, USDA because they represent different, but
However, the Chicago Mercantile wholesale price. The weighted average related, commodities. This implies
Exchange (CME) is introducing a new settlement price will be based on different quantities of cash commodity
futures contract that provides better transactions for fresh 90-percent lean, are needed to minimize risk associated
risk protection for cull cows than live boneless beef, at Omaha, Neb., and with value changes in the hedged
cattle futures. Texas-Oklahoma. The cash settled relative to cash position. To determine
90-percent lean, boneless beef price will be calculated using volume- the size of the futures position to take
futures is the new contract being weighted prices from the five most for a given cash position, a hedge ratio
offered by the CME. This new futures recent trading days, which are reported needs to be estimated. The hedge ratio
contract provides producers, packers, by the USDA Market News on the provides an estimate of the size of the
processors, and retailers the opportu- National Carlot Meat Report. Options futures position relative to the cash
nity to reduce their price risk by on this futures contract will expire on quantity needed to minimize hedged
hedging in a commodity market more the same day and time as the futures. price risk.
closely linked to cull cow prices. The The exercise price will be specified in
purpose of this bulletin is to explain 2-cent-per-pound intervals. The new Cow Markets Analyzed
how to cross hedge cull cows in the futures contract will be traded with Several geographic cull cow market
90-percent lean, boneless beef futures expiration months of February, April, locations were analyzed to determine
contract and to examine the associated June, August, October, and December. differences in the hedge relationship.
hedging risk. This analysis uses Trading will cease on the sixth to last Weekly cull cow price data for Sioux
weekly data from several locations and business day of each contract month, Falls, S.D.; Sioux City, Iowa; and
across several cow grades. except in December, when it will end Oklahoma City, Okla., were collected
on the tenth business day. from the United States Department of
Kansas State University Agricultural Experiment Station and Cooperative Extension Service
2
Agriculture Livestock, Meat, and Wool
Table 1. Cross Hedge Estimates for Hedging Cull Cows in 90-percent Lean, Boneless Beef
Market News for the period of 1991 Futures, 1991-1996.
through 1996. In addition, Torrington,
Wyo. and Dodge City, Kan. weekly Location/ Hedge No.
cull cow price data were compiled from Quality Grade Ratioa Constant RMSPEb R-Square Obs.
the United States Department of Sioux Falls
Agriculture, Agricultural Marketing Commercial 0.398 2.934 6.00 0.89 305
(49.49)c (3.20)
Service, Livestock Market News in
Torrington and Dodge City, respec- Breaker 0.348 5.716 6.18 0.87 306
tively. Prices were collected for (44.66) (6.45)
Commercial, Breaker, Boner, and Boner 0.347 2.910 5.85 0.89 306
Cutter cow grades. Prices for Commer- (50.34) (3.71)
cial cows in Oklahoma City and Dodge Cutter 0.380 -2.958 6.28 0.91 306
City were not used because of infre- (54.16) (-3.71)
quency of quotes. Sioux City
Live cattle weekly average closing Commercial 0.350 8.396 6.43 0.84 306
futures prices for the nearby contract (40.52) (8.54)
were collected from the CME. Histori- Breaker 0.380 4.437 6.21 0.88 306
cal futures price data for the newly (46.14) (4.74)
approved CME 90-percent lean,
Boner 0.382 3.021 6.34 0.88 306
boneless beef contract do not exist. (46.62) (3.25)
Therefore, the 5-day moving-volume-
weighted average of 90-percent lean, Cutter 0.412 -2.743 7.38 0.87 307
(45.60) (-2.67)
boneless beef price series, the prices at
which the contract will cash settle, was Oklahoma City
used as a proxy for the closing cash- Breaker 0.332 6.705 5.25 0.90 299
(50.79) (9.01)
settled lean futures price and was
obtained from the National Carlot Meat Boner 0.347 5.391 5.09 0.91 302
Report (USDA) provided by the CME. (54.38) (7.44)
Cutter 0.366 2.921 5.60 0.90 302
Results (52.49) (3.69)
Hedge ratios for hedging cull cows Dodge City
with the 90-percent lean, boneless beef Breaker 0.358 5.870 7.25 0.84 205
contract are reported in Table 1. (32.63) (4.74)
Hedging risk (basis plus hedge ratio)
Boner 0.339 8.479 5.80 0.87 278
can be determined by the R-squares (43.43) (9.56)
and root mean squared percentage
errors (RMSPE) reported. Locations Cutter 0.408 -1.862 6.75 0.89 300
(48.60) (-1.95)
with R-squares closer to 1.0 and
RMSPEs closer to 0.0 have lower risk Torrington
associated with hedging in the lean Commercial 0.278 14.281 8.37 0.70 298
(26.54) (11.94)
futures contract. When the R-square is
close to 1.0 and the RMSPE is small, Breaker 0.279 14.192 8.30 0.71 301
the cull cow price is highly correlated (27.04) (12.07)
with the lean futures price and basis Boner 0.322 8.713 8.18 0.78 309
risk is low. Torrington tends to have (32.68) (7.77)
slightly lower R-square values for all Cutter 0.328 4.679 8.63 0.79 303
quality grades, ranging from 0.70 to (33.79) (4.24)
0.79, than the other four locations. a
Hedge Ratio represents pounds of futures per pound of cull cow hedged.
Across the remaining locations, the R- b
RMSPE is root mean squared percentage error which is RMSE as a percentage of the
square values range from 0.84 to 0.91, respective average cull cow price.
c
with the strongest relationship occur- Numbers in parenthesis are t-statistics for testing whether parameter is different from zero.
ring in Oklahoma City.
3
No particular quality grade results contracts, indicating basis risk would Hedge Ratio Example
in the highest R-square across all be much lower using 90-percent lean, An example of how the hedge ratio
locations. In general, however, the boneless beef than the alternatives. could be used to hedge cow sales in
Boner grade has the lowest RMSPE in A couple of limitations regarding the 90-percent lean, boneless beef
all locations except Torrington with an these results are important to consider. futures contract is described here.
average of 6.66 percent. This means First, because the 90-percent lean, Suppose a cull-cow feeder wanted
that, on average, about two-thirds of boneless beef futures market was not to reduce price risk by hedging the
the time, the net price received from yet trading, futures prices for these selling price of cull cows in Dodge
cross hedging cull cows in lean futures commodities did not exist. Therefore, City, Kan., using the December 90-
will be within 6.6 percent of the the 5-day, volume-weighted, moving- percent lean, boneless beef futures
expected price. Although there were average, USDA boxed-beef cash price contract. In June, the futures price is
differences between locations and data, to which these contracts will cash $110 per hundredweight and the hedge
quality grades, the hedge ratios were settle, were used as proxy variables for ratio for Dodge City Boner cows is
similar across both attributes. The mean the unavailable futures prices for each 0.339 (Table 1). The expected cull
hedge ratio was 0.353 with a standard respective commodity. How close the cow price (EP) could be calculated
deviation of 0.037. This ratio indicates futures prices will track these cash using the following equation:
that when placing a hedge, the futures price series, especially in nondelivery
contract quantity needed is 0.353 times months, is not yet known. If cull-cow ΕΡ = β0 + β1 (90%Lean, Boneless beef)
the cash quantity being hedged. prices are not as highly correlated with
A related Kansas State University 90-percent lean, boneless beef futures Where β0 is the constant from the
study determined which futures prices as they are with the settlement regression, and β1 is the hedge ratio.
contract (90-percent lean, boneless price index, the model may underesti- Applying the numbers from Table 1
beef; 50-percent lean; or live cattle mate hedging risk. and the constant to the equation, EP =
futures) provided the least amount of Second, numerous factors affect 8.479 + 0.339 × $110 per hundred-
risk to cross hedge cull cows. Any of cow and cull-cow prices across pens in weight, the expected cull-cow price is
these contracts could be used to hedge a particular auction. This study used $45.77 per hundredweight The number
cull cows, however, the least amount of USDA-reported prices for particular of cows actually hedged per futures
risk would be associated with the 90- markets and cow grades. Price of any contract can be found using a second
percent lean, boneless beef contract. particular pen of cows sold can vary equation:
The R-Squares using 90-percent substantially as quality of the cows
lean, boneless beef suggest a lower- varies. This suggests that on a pen-by- Pounds of cows hedged =
risk hedge than using 50-percent lean pen basis, hedging risk associated with
or live cattle futures. In addition, the cross hedging cull cows using any of Pounds per futures contract
RMSPEs were less than half as large the contracts examined are greater β1
in the 90-percent lean, boneless beef than those presented here using USDA
contract compared to the other two price quotes.
Figure 1. Dodge City, Boner, Cash Prices Against 90% Lean Futures Prices, (1991–1996).
Dodge City, Boner, Cash Cull Cow-Prices ($/cwt)
80
60
B
C
40
20
Estimated Cross Hedge
A Actual Observed Price
0
60 80 100 120 140 160
90% Lean Futures Prices ($/cwt)
4
Using the same hedge ratio, recall moving vertical to the fitted line (point applying this model, the estimated
that one contract of 90-percent lean, B) and then horizontally to the cash hedge ratios indicate that the total
boneless beef is 20,000 pounds, the price (point C), it can be seen, once pounds of cull cows to be hedged
pounds of cull cows to hedge would be again, that the expected cash price is would be roughly three times greater
58,997 (20,000 pounds ÷ 0.339). approximately $45. The hedge ratio is than the total pounds in the lean
Converting this to number of head, the slope of the fitted line, 0.339. This futures contract. Given contract size
using a 1,000 pound cow, yields indicates that when the 90-percent specifications of 20,000 pounds,
approximately 59 cows. lean, boneless beef futures price roughly 60 cows (assuming 1,000
Figure 1 provides a graph of the increases by $1.00 per hundredweight, pounds per head average weight)
cull-cow cash price as a function of the cash cull-cow price typically would be cross hedged per 90-percent
the 90-percent lean, boneless beef increases by $0.34 per hundredweight. lean, boneless beef contract.
futures price. This is an alternative For many cow-calf producers, Implementation of this 90-percent
method with which to forecast the cash hedging 59 cull cows is not feasible. lean, boneless beef futures contract, in
price and hedge ratio for cull cows, For example, in 1996 the average cow general, may allow producers to
given the futures price. herd size was only 39 head (USDA), reduce the risk they face. However,
The cull cow cash prices for Dodge and cow culling rates would typically given contract size specifications, the
City Breakers were plotted from 1991 be less than 20 percent of the herd contract is too large for most cow-calf
to 1996, and an estimated line was annually. Unless individual small producers to use directly. Therefore, to
then fit through these points. To operations are able to combine cull hedge, these producers would need to
determine the expected cash price, cow sales with others, this contract group cull-cow sales with other
move vertically from the futures price, would not be a viable hedging mecha- producers. Alternatively, cow packers
on the horizontal axis, to the fitted nism for them. This contract is more could more readily offer forward
line. Once this point is found, move viable for packers or those feeding contract prices to cow-calf producers
horizontally to the associated cash larger numbers of cull cows. and cull-cow feeders and, by pooling
price on the vertical axis. This will be cows from several producers, offset
the expected cash price for cull cows, Conclusion their risk by cross hedging these
given the futures price. The most viable contract for forward-contracted cows in the 90-
For example, using the futures price hedging cull cows is the 90-percent percent lean, boneless beef contract.
given above, $110 (point A), and lean, boneless beef contract. When
Jennifer L. Graff Ted C. Schroeder Rodney D. Jones
Graduate Research Assistant Professor Extension Agricultural Economist
Department of Agricultural Economics Livestock Production
The authors would like to acknowledge
Robert Murphy at the Chicago
Mercantile Exchange for providing
assistance with data used in this study.
These materials may be freely reproduced for educational purposes. All other rights reserved. In each case, credit Jennifer L. Graff, Ted
C. Schroeder, and Rodney D. Jones; Cross Hedging Cull Cows; Kansas State University; April 1997.
Kansas State University Agricultural Experiment Station and Cooperative Extension Service
MF-2267 April 1997
Issued in furtherance of Cooperative Extension Work, acts of May 8 and June 30, 1914, as amended. Kansas State University, County Extension Councils, Extension
Districts, and U.S. Department of Agriculture Cooperating, Richard D. Wootton, Associate Director. All educational programs and materials available without
discrimination on the basis of race, color, national origin, sex, age, or disability.
File Code: Farm Management 3-2 MS4-97—1.5M; 9-97—1.5M
