North Dakota State University www.ag.ndsu.edu Crops Family-Youth-4-H Economics-Community-Leadership Home-Lawn-Garden-Trees Environment-Natural Resources Energy Livestock Nutrition-Food Safety-Health
 

Price Risk Management for Canola 
Producers in the Northern Plains - Continued

EB-74, November 2000


Price Analysis - Continued


Correlations and Hedge Ratios

Correlations

Hedging of commodities relies on the relationship or correlation between futures and cash prices. Correlations indicate the degree that prices tend to move in the same direction. Thus, higher correlations between cash and futures prices would indicate that prices move similarly and risk in cash prices can be offset by hedging with futures.

Correlations were estimated among Velva cash canola prices; canola futures prices; soybean, soybean oil, and soybean meal futures prices; exchange rates and Vancouver cash canola prices. The correlations are shown in Table 3 and indicate that changes in Velva cash prices are most closely correlated with canola futures (correlation = .95). Soybean oil futures provide the next best correlation (.86) with Velva cash followed by Soybean futures (.76). These correlations suggest that canola futures should provide the most risk reduction for hedging Velva cash canola.



Table 3. Correlations of prices, August 1993 - July 2000.a 

--------------------------------------------------------------------------------
                Velva   Canola   Soybean  Soyoil   Soymeal  Exchange  Vancouver
                Canola  Futures  Futures  Futures  Futures    Rate     Canola
--------------------------------------------------------------------------------
                Cts/bu   $C/mt    Cts/bu  Cts/lb    $/Ton    $C/$US     $C/mt
Velva Canola     1.00     .95      .76      .86      .57      -.61       .95
Canola Futures           1.00      .66      .87      .44      -.30       .96
Soybean Futures                   1.00      .55      .94      -.49       .65
Soyoil Futures                             1.00      .30      -.37       .79
Soymeal Futures                                     1.00      -.54       .43
Exchange Rate                                                 1.00       --
Vancover Canola                                                         1.00
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
a Dashes indicate that correlation was not significant.



The results in Table 3 are strong evidence in favor of using canola futures to manage price risk. To ensure that hedging in canola futures is the most appropriate strategy, correlations for additional combinations were analyzed.

Correlations were examined for contract values (Table 4) and specific periods (one-month price changes and four-month price changes). Contract values were in U.S. dollars per hundredweight and derived for the contract volumes specified in Table 4. Correlation results for contract values were similar to those for prices.



Table 4. Correlations of contract value in $US, August 1993 - July 2000.a 

--------------------------------------------------------------------------------
                Velva   Canola   Soybean  Soyoil   Soymeal  Exchange  Vancouver
                Canola  Futures  Futures  Futures  Futures    Rate     Canola
--------------------------------------------------------------------------------
Velva Canola     1.00     .96      .76      .86      .57      -.61       .98
Canola Futures           1.00      .71      .87      .53      -.52       .97
Soybean Futures                   1.00      .55      .94      -.49       .74
Soyoil Futures                             1.00      .30      -.37       .83
Soymeal Futures                                     1.00      -.54       .56
Exchange Rate                                                 1.00      -.41
Vancover Canola                                                         1.00
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
a Contract values based on 5,000 bushels in a Velva contract, 20 metric tons 
  in a canola futures contract, 5,000 bushels in a soybean futures contract, 
  60,000 pounds in a soybean oil futures contract, 100 tons in a soybean meal 
  futures contract, $100,000 in an exchange rate contract, and 5,000 bushels 
  in a Vancouver contract.



Correlations for one-month changes indicate that canola futures still provide the strongest relationship and that weaker relationships prevail for soybeans and soybean oil (Table 5). For four-month changes, canola futures and soybean oil futures were stronger than for one-month changes, while soybeans were worse (Table 6).

Table 5. Correlations of one-month price changes, August 1993 - July 2000.a 

----------------------------------------------------------------------
                 Velva   Canola   Soybean  Soyoil   Soymeal  Exchange
                 Canola  Futures  Futures  Futures  Futures    Rate
----------------------------------------------------------------------
                 Cts/bu   $C/mt   Cts/bu   Cts/lb    $/Ton    $C/$US
Velva Canola      1.00     .83      .50      .62      .24       --
Canola Futures            1.00      .56      .70      .29       --
Soybean Futures                    1.00      .59      .86       --
Soyoil Futures                              1.00      .27       --  
Soymeal Futures                                      1.00       --
Exchange Rate                                                  1.00
----------------------------------------------------------------------
----------------------------------------------------------------------
a Dashes indicate that correlation was not significant.



Table 6. Correlations of four-month price changes, August 1993 - July 2000.a 

----------------------------------------------------------------------
                 Velva   Canola   Soybean  Soyoil   Soymeal  Exchange
                 Canola  Futures  Futures  Futures  Futures    Rate
----------------------------------------------------------------------
                 Cts/bu   $C/mt   Cts/bu   Cts/lb    $/Ton    $C/$US
Velva Canola      1.00     .87      .43      .74       --       --
Canola Futures            1.00      .51      .69       --       --
Soybean Futures                    1.00      .38      .84       --
Soyoil Futures                              1.00       --       .27
Soymeal Futures                                      1.00       --
Exchange Rate                                                  1.00
----------------------------------------------------------------------
----------------------------------------------------------------------
a Dashes indicate that correlation was not significant.



This analysis shows that the indicators of current Velva cash canola prices and longer term price changes, from best to worst, are canola futures, soybean oil futures, soybean futures, and soybean meal futures.



Hedge Ratios

Hedge ratios were derived for hedging Velva cash canola with canola futures only and with combinations of canola futures, exchange rates, and soybean oil futures. These were also estimated for hedging during specific time periods. The hedge ratios were based on historical price data and prices that were converted to a common currency, $US, before the hedge ratios were estimated.

Hedge ratios were estimated for contracting 5,000 bushels (2,500 hundredweight) of canola using the value of futures contracts (this would indicate the number of futures contracts to use to hedge 2,500 hundredweight of a farmer's production). A hedge ratio of 4.76 contracts of canola futures was derived. Using this ratio, about 97 percent of the variability in prices could be eliminated (Table 7).



Table 7. Estimated hedge ratios, based on August 1993 - July 2000 data in $US, and 
hedging effectiveness for alternative hedging strategies. 

----------------------------------------------------------------------
                             Hedge Ratio
                   ---------------------------------
                    Futures Contracts   Futures Cwt
                    per 5,000 Bushels     per Cwt         Hedging
Hedge Strategy         Production       Production     Effectiveness
----------------------------------------------------------------------
WCE Canola Futures        4.76             0.84a            .97
----------------------------------------------------------------------
CBOT Soyoil Futures       1.56             0.37b            .94
----------------------------------------------------------------------
Multi Market Hedge in:
  WCE Canola              3.84             0.68             .93
  CBOT Soybeans           0.17             0.20
  CBOT Soyoil             0.27             0.06
  Exchange Rate           0.09
----------------------------------------------------------------------
Implied Hedge Ratios for WCE Canola Futures Derived through Simulationc
----------------------------------------------------------------------
Rolling 5-Month Change    5.10             0.9
----------------------------------------------------------------------
Preharvest (May-Aug),     9.07             1.6
November Contract 
----------------------------------------------------------------------
Postharvest (Aug-Feb),    2.83             0.5
March Contract 
----------------------------------------------------------------------
Postharvest (Aug-Apr),    7.93             1.4
May Contract 
----------------------------------------------------------------------
----------------------------------------------------------------------
a 4.76 * 20 MT * 22.046 / 2,500 = .84 where 22.046 is the number of 
  hundredweight in a metric ton and 2,500 is the number of 
  hundredweight equivalent to 5,000 bushels.
b 1.56 * 600 / 2,500 = .37 where 600 is the number of hundredweight 
  in a soybean oil futures contract and 2,500 is the number of 
  hundredweight equivalent to 5,000 bushels.
c These were simulated and not estimated with regression analysis so 
  no effectiveness was derived.



The ratio indicates that 4.76 canola futures contracts should be used to hedge 5,000 bushels (2,500 hundredweight) of canola. Alternatively, .84 hundredweight of canola futures should be used to hedge each hundredweight of production.* In other words, hedging 84 percent of production minimizes risk. Again, the emphasis with hedge ratios is on minimizing risk, not maximizing returns.

* 4.76 WCE canola contracts is equivalent to 4,197 bushels (4.76 * 20 MT * 2204.62 / 50 = 4,197 bushels where 2204.62 is the number of pounds in a metric ton and 50 is the number of pounds in a bushel of canola). This 4,197 bushels is equivalent to 84 percent of 5,000 bushels.


When hedging production with soybean oil futures, the hedge ratio is 1.56 contracts to 5,000 bushels production (Table 7). This strategy would provide less risk reduction (controlling 94 percent of price variability) than the canola futures strategy.

Hedges placed in multiple markets were examined using combinations of canola futures, soybean futures, soybean oil futures, soybean meal futures, and foreign exchange rate futures; however, these provided little if any additional risk reduction over a strategy using canola futures only (Table 7).

Alternative hedge ratios were examined for time periods farmers would traditionally use hedging strategies. These are provided to give an indication of how additional risk could be controlled, and to indicate how hedge ratios can change depending on the specific time period it is placed. Four periods were examined.

First, a rolling hedge using canola futures was placed throughout the year and held for a period of five months. This hedging strategy was simulated using a range of hedge ratios.

Results from the simulation reveal the tradeoff between risk and returns from these hedge ratios. Since the goal of hedging is to minimize risk, an optimal hedge ratio of .9 is indicated (Table 7 and Figure 25).

Figure 25.

This hedge ratio (.9) provides the lowest level of risk (standard deviation = .21 $/Cwt). This means 100 hundredweight of farm production should be hedged with 90 hundredweight of canola futures to minimize risk.

Using a higher hedge ratio (1.2) results in a higher return measured as the net change in the value hedged (-.000169 $/Cwt), but with a higher level of risk (standard deviation = .23 $/Cwt). Similarly, using a lower hedge ratio (.7 ) results in a lower return (-.0002 $/Cwt) and higher levels of risk (standard deviation = .223 $/Cwt).

The change in return was very small within the range of hedge ratios analyzed (.5-1.2). However, the change in risk has important management implications. Also, only price risk is evaluated, not revenue risk, which would also consider variability of yields and loss/gains from hedging more than projected production.

Second, hedges were examined that were placed in May and removed in August using the November canola futures, which is similar to the period a production hedge would be placed. In this May to August hedge, a hedge ratio of about 1.65 is indicated (Table 7). The maximum reduction in risk would occur when 100 hundredweight of farm production is hedged with 165 hundredweight of canola futures.

A third case was a postharvest strategy where a purchase was made in August and held to February in the March canola futures to replace sold production. In this August to February strategy, a hedge ratio of .5 is indicated (the maximum reduction in risk would occur when 100 hundredweight of farm production is hedged with 50 hundredweight of canola futures).

The fourth example is also for a postharvest strategy where May canola futures are purchased in August and held to April. In this August to April hedge, a hedge ratio of 1.4 is indicated (the maximum reduction in risk would occur when 100 hundredweight of farm production is hedged with 140 hundredweight of canola futures).



Implications of Hedge Ratios

Due to the high correlation between Velva cash prices and canola futures, the best hedging strategy from a risk reduction perspective is opposite positions held in cash and canola futures. Although traditionally hedges are 1:1, risk could be reduced further in this case by using a hedge ratio of about .8 to .9. Risks could be reduced further by adding positions in other contracts including foreign exchange and soybean oil. However, the added risk reduction potential of these is relatively small and would most likely be offset by the additional transaction costs required for the additional futures positions.

 

|  Back to Contents  |  Continue  |

 

 

EB-74, November 2000

 

County Commissions, North Dakota State University and U.S. Department of Agriculture cooperating. North Dakota State University does not discriminate on the basis of age, color, disability, gender expression/identity, genetic information, marital status, national origin, public assistance status, sex, sexual orientation, status as a U.S. veteran, race or religion. Direct inquiries to the Vice President for Equity, Diversity and Global Outreach, 205 Old Main, (701) 231-7708. This publication will be made available in alternative formats for people with disabilities upon request, 701 231-7881.