Essays on basis

Daniel J Sanders, Purdue University

Abstract

Grain markets in the U.S. are composed of the national-level futures market and many local spot markets, each of which trades on its own unique information. Local prices, known as basis, have seen increased volatility since 2005, as have the futures markets. This dissertation examines basis levels, volatility, risk management and producer responses to these new market conditions. We first address the issue of developing accurate basis forecasts. Reliable expectations of future basis levels are important to effective marketing plans and integral components in classical hedging. We employ regime-switching models to forecast basis and take advantage of these models' ability to approximate changing volatility structures. Using basis data from Ohio, we find that both regime-transitioning and single-regime time series econometrics models provide better short-run basis forecasts than moving average models. For longer forecasts that generally extend more than one month into the future, however, the simple five-year moving average models provide better results. Moreover, although the regime-changing models provide a statistically better fits to the data ex-post, they do not impart any advantage over simpler autoregressive models. Despite the increased levels of basis volatility that have been observed since 2005, producer basis hedging remains a little utilized management tool. To better understand this reaction, we construct a theoretical model that explains the motivation to hedge as a function of producer risk aversion and market parameters. We find that the decision to store is determined by risk aversion, the expected profit from storage and the volatility in the futures market. The hedging ratio, in turn, is a function of the risk premium for hedging relative to the profit from storage and the futures volatility relative to the basis volatility. To validate this, we construct a simulation using basis data from two locations, which show that basis hedging drops precipitously as the risk premium increases from 0 to 5 cents per bushel and disappears completely for large premiums. Finally, we consider the impact that volatility might have on hedgers' participation in the futures markets themselves. Increasing price volatility in the futures market, as well as non-convergence in basis, can reduce hedgers' optimal levels of participation. We evaluate changes in hedgers' participation by observing the changing relationship between their futures market positions and their physical grain stocks using a regime-transitioning model, a new methodological approach. In the Chicago wheat market, we find stable levels of incremental hedging that significantly decline when futures price volatility is high and when delivery basis weakens significantly. Additionally, hedging participation has declined in recent years, coinciding with the commodity price boom. In the Kansas City wheat contracts, in contrast, we find that hedging behavior increased with high futures prices and, surprisingly, with increased futures price volatility. Overall, we estimate apparent changes in hedgers' market participation which could notably impact the health of the futures markets over time.

Degree

Ph.D.

Advisors

Baker, Purdue University.

Subject Area

Agricultural economics

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