RISK-RETURNS OF COTTON AND SOYBEAN ENTERPRISES FOR MISSISSIPPI COUNTY, ARK
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1 AAES Research Series 521 RISK-RETURNS OF COTTON AND SOYBEAN ENTERPRISES FOR MISSISSIPPI COUNTY, ARK.: A COMPARISON OF ALTERNATIVE MARKETING STRATEGIES WITHIN A WHOLE FARM FRAMEWORK G. Rodríguez, A. McKenzie, and L. Parsch 1 RESEARCH PROBLEM In the state of Arkansas, crop production represents an important agricultural sector of the economy. However, crop farmers have to make production and marketing decisions without knowing with certainty future price and output. Therefore, farmers must make their decisions in an environment of uncertainty where time is also a decisive factor. Thus, the relative performance of different production and marketing strategies in terms of risk-returns is of great interest to farmers, and is the primary objective of this study. BACKGROUND INFORMATION Farmers are typically assumed to be in general risk-averse and to have a certain trade off between risk and estimated revenue. For crop farmers, revenue comes from crop sales and government support payments. According to Hanson et al. (1999) as a result of the change in the role of the government after the 1996 farm bill, farmers have greater responsibility for using their own risk-management programs. The price support programs were reduced, generating a riskier situation for crop farmers selling their products. Given this prevailing economic climate, it is important to direct research focus on the ability of marketing and hedging strategies to reduce return risk for cotton and soybeans farmers in Mississippi County, Arkansas. 1 Research Specialist, associate professor, and associate professor, respectively, Department of Agricultural Economics and Agribusiness, University of Arkansas at Fayetteville. 270
2 Summaries of Arkansas Cotton Research 2003 RESEARCH DESCRIPTION Thirty-seven marketing strategies developed in this study are summarized in Table 1. Each strategy represents a portfolio (combination) of different hedged (cash and futures) positions for cotton, soybeans, and crop mix enterprises. The possibility of utilizing hedging strategies adds potential further risk-reduction benefits to the crop-mix enterprise. Cash only strategies are also included as a means of comparing hedging effectiveness. Each strategy is analyzed in terms of net returns generated on a per-acre basis. The simulation model characterizes the risk-return profiles faced by cotton and soybean producers in Mississippi County, Arkansas. Yield data were gathered from the National Agricultural Statistics Service (NASS). Alternatively, cash price data were obtained from the Memphis cash market in Tennessee and futures price data were obtained from the New York Cotton Exchange (NYCE) and the Chicago Board of Trade (CBOT). Yield and price data were collected for the years Production costs were calculated from budgets generated by the Arkansas Cooperative Extension Service (CES). Simulated distributions of net returns above total costs for cotton and soybean crop enterprises under different marketing strategies are evaluated using stochastic dominance with respect to a function (SDRF). Under this approach, the different marketing (hedging) strategies associated with different crop enterprises can then be ranked in terms of their risk-return characteristics. The marketing dates for the 37 strategies are determined by the respective harvest time for each crop. Out of the 37 strategies, six are cash positions and 31 are hedged positions that begin in June for soybeans and in May for cotton, and end with sale dates in November and December, respectively. As such, the hedging strategies simulate traditional hedges, initiated at planting time and offset at harvest time. The variation in the strategies is based upon the level of hedging, or the proportion of expected production covered by hedging. RESULTS AND DISCUSSION The SDRF ranking of the 37 marketing strategies is presented in Table 2 using a RAC of zero (risk-neutral) and a RAC of 0.5 (extremely risk-averse). This table also shows the rank for each marketing strategy with respect to the different enterprise types for the two different RAC levels. Assuming risk neutrality (RAC = 0), cash-only and hedging strategies (1 to 8) associated with cotton only enterprises would be preferred to equivalent hedging strategies (9 to 16) for soybeans-only enterprises. These cotton strategies ranked in the first eight positions. The equivalent soybean strategies ranked in the last eight positions with the exception of strategy 15 (naive soybeans hedge 100% futures position against 100% cash position), which ranked 29 th. Strategies for crop-mix enterprises (strategies 17 to 31) ranked from 11 th (strategy 29) to 26 th (strategy 31, the optimal revenue risk-minimizing strategy). 271
3 AAES Research Series 521 The most preferred strategy was the cotton 100% cash position with no hedge (strategy 1). On the other hand, the equivalent 100% cash soybeans position with no hedge (strategy 9) ranked in last position. When the degree of risk is irrelevant, a farmer would prefer marketing strategies associated with cotton enterprises as they generated the highest net returns. Alternatively, when a farmer is extremely risk averse (RAC = 0.5), strategy 1 ranked 34 th. Therefore for a cotton enterprise with extreme risk aversion, results imply that selling in the harvest-time cash market would be one of the least preferred marketing strategies. Under the extreme riskaversion assumption, the SDRF criterion used in this study give cotton enterprise strategies a low ranking. This is due to the fact that net revenues generated by selling in the harvest-time cotton cash market have a large standard deviation and the minimum potential loss associated with any hedging level is large (ranging from $110/ac up to $140/ac). Short hedging is moderately effective only at low levels of coverage (e.g., 25%, 33% and 50% hedging strategies are preferred to the cash marketing strategy). In contrast, marketing strategies associated with soybean enterprises are preferred when farmers are extremely risk-averse. However, this result is not attributable to effective hedging. The larger the amount of expected production covered by short-hedging, the poorer the strategy s performance. The best strategy for a soybeans-only enterprise is to simply sell in the cash market without hedging (strategy 9 which ranks 2 nd overall). Thus, the preference for marketing strategies associated with soybean enterprises over strategies associated with cotton enterprises may be attributed to the low standard deviation of net returns and to the relatively small minimum potential loss ($80/ac) generated by selling in the soybean harvest cash market. The most preferred risk reducing strategy (assuming extreme risk aversion) is crop-mix hedging strategy 31, the optimal revenue risk-minimizing strategy). However, this strategy was desired from a statistical model and would not likely be used in an applied setting. In summary, under the SDRF criterion, hedging is ineffective for soybean enterprises, while hedging at moderately small levels (25% to 50% short hedges) is preferred to a cash marketing strategy for cotton enterprises. Diversification may reduce risk but may also reduce the level of returns. SDRF provides a good approach to analyze the potential benefits of diversification in this risk-return tradeoff framework since it takes into account both the level of returns as well as the risk associated with those returns when ranking strategies. 272
4 Summaries of Arkansas Cotton Research 2003 PRACTICAL APPLICATION The importance of this study is highlighted by the fact that no other preharvest row-crop marketing studies have been conducted for the state of Arkansas using crop-mix hedging strategies. In addition, previous Arkansas studies, which have analyzed revenue risk (i.e., yield risk and price risk), have used a simplified model to explain the impact of price variability on revenue risk by assuming farmers receive a seasonal average cash price. The results of this study show that existing marketing tools in the form of futures price hedging can be used to reduce revenue risk (i.e., yield risk and price risk) for Mississippi County cotton farmers. LITERATURE CITED Hanson, Steven D, Myers, Robert J., and Hilker, James H Hedging with futures and options under a truncated cash price distribution. Southern Agr. Econ. Assoc. 31(Ma31:
5 AAES Research Series 521 Table 1. Cotton, soybeans, and crop-mix marketing strategies examined for Mississippi County, Ark., in Number Cash position Hedge position 1 Cash position Hedge position a b c d e f g h i A negative number indicates a short hedge position and vice-versa a Naive cotton hedge 100% cotton cash, 100% cotton futures b Optimal risk minimization hedge ratio for 100% cash cotton c Naive soybean hedge 100% soybean cash, 100% soybean futures d Optimal risk minimization hedge ratio for 100% soybean cotton e 100% hedges for proportional cash positions in cotton and soybean f Optimal risk minimization hedge for proportional cash positions in cotton and soybean g Optimal price risk minimization hedge for 100% soybean h Optimal price risk minimization hedge for 100% cotton 274
6 Summaries of Arkansas Cotton Research 2003 Table 2. Rankings of 37 marketing strategies based on SDRF for cotton, soybeans and crop-mix enterprises in Mississippi County, Ark., in Cotton position Marketing stragety Soybean position Risk-aversion coeficient (RAC) Rank Cash Hedge Cash Hedge Neutral Extremely risk-averse
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