Hedging malting barley : maximizing expected utility considering price, yield and quality risk

Abstract: Farmers are faced with situations with uncertain outcomes on a daily basis. Production risks stem from uncertainty about the performance of crops and the unpredictable nature of weather. Also, the markets for inputs and agricultural commodities affect the farm to a high degree. Market prices are largely determined by factors which the farmer cannot control and market risks are often significant. Farming is an activity which takes place in an environment characterized by risk and uncertainty to a high degree. Hedging is a risk management tool which is used to reduce price risk exposure. Through hedging, risk is transferred from the producer to investors/speculators who seek risk for the return. Farmers can hedge grain using futures contracts as a method of reducing their income variance. The focus of this study is to evaluate hedging strategies of malting barley when quality risk is considered in addition to yield and price risk. The aim of this study is to investigate how future contracts can be used by Swedish grain producers to maximize their expected utility. The study accounts for yield, price and quality risk exposure. Several different marketing strategies are investigated. The study aims to find the cost of quality risk for malting barley and the expected utility of hedging malting barley for various levels of risk aversion. An applied quadratic risk programming model and mathematical optimization is used to derive expected utility maximizing hedging strategies and crop portfolios. Using crop yield data from two case farms in Uppland and Östergötland and variable costing calculations from Agriwise the covariance matrices of gross margins are developed. The information is used to model fictitious case farms using quadratic risk programming. The optimization problem is solved using a non-linear solving algorithm. Historical price data is Swedish spot and Matif and Liffe futures prices from the time period 2009-2017 and are used to examine the different hedging strategies. The results of this study indicate that a risk averse farmer may reduce his price risk exposure significantly through the practice of hedging malting barley and that the cost of quality risk is no reason not to hedge malting barley. The crop rotations do not change significantly between the almost risk neutral farmer and the extremely risk-averse farmer. The major conclusion of this study is that hedging malting barley is an effective way to maximize expected utility for a risk averse farmer. For a large-scale crop farmer in the mid-Sweden plains areas who is rather risk averse, the value of hedging malting barley is around 2-3 % of total revenue. The cost of quality risk is only 0,2-0,4 % of total revenue in comparison.