HEDGING WITH OPTIONS ON COMMODITY FUTURES CONTRACTS:

A SAFETY-FIRST VERSUS EXPECTED UTILITY APPROACH

by

VICTOR J. GASPAR

B.A. (Econ.), Simon Fraser University, 1989

A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF

THE REQUIREMENTS FOR THE DEGREE OF

MASTER OF SCIENCE

in

THE FACULTY OF GRADUATE STUDIES

(Department of Agricultural Economics)

We accept this thesis as conforming

to the required standard

THE UNIVERSITY OF BRITISH COLUMBIA

July 1994

© Victor J. Gaspar, 1994

In presenting this thesis in partial fulfillment of the
requirements for an advanced degree at the University of British
Columbia, I agree that the Library shall make it freely available
for reference and study. I further agree that permission for
extensive copying of this thesis for scholarly purposes may be
granted by the head of my department or by his or her
representatives. It is understood that copying or publication of
this thesis for financial gain shall not be allowed without my
written permission.

(Signature)

Department of

The University of British Columbia

Vancouver, Canada

Date -‘\. 4
 ABSTRACT
This study evaluates how a decision-maker (such as a farmer) facing
output price risk might use futures contracts and or option contracts on those
futures to hedge against any potential financial risk attributed to volatile output
prices. Two behavioral models are assumed in this study. One where the
decision-maker behaves as an expected utility maximizer and one where the
decisions made are based upon safety-first rules. The expected utility model in
this study is based on the general utility function defined in an article by Lapan,
Moschini, and Hanson (1991). The safety-first model is essentially that of Telser
(1955), but enhanced to include option contracts as an additional hedging tool.
Both decision-making processes have a single-period time horizon. At the
beginning of the period an agent enters the futures and option markets and
places a hedge. At the end of the period, the agent offsets his/her futures
position and sells the commodity in the spot market. The single-period model is
formulated such that a hedger can speculate on the futures price bias, but not
the volatility of the option price.
Results from the two competing models were derived from parameters
calculated using a forecast error method on canola data spanning a ten year
period (1981-90) obtained from the Winnipeg Commodity Exchange. Optimal
hedging results for the two models were derived under varying levels of basis
risk, futures and spot price volatilities, and risk aversion.
In general, results from the expected utility model suggest that under
increased volatility, uncertainty, or aversion to risk leads to a reduced open
speculative position when a positive futures price bias exists. Most interestingly,
unlike the comparative static results derived by Lapan, Moschini, and Hanson
suggesting that if a speculative motive exists then options are used, the results
from this study’s simulations suggest that the use of options are negligible.
 Results from assuming a safety-first decision-maker indicate that options
are always used when speculating on the direction of futures price bias. When
positive futures price biases increase in size, so do the futures and options
positions. The opposite occurs when the bias is decreased or downward. Two
major conclusions can be drawn from the safety-first results. Firstly, optimal
hedging positions seem quite sensitive to “small” variations in the parameters
levels. Secondly, due to the multitude of revenue distributions available from
combining futures and option (which were unobtainable from using only futures)
there is a possibility of very extreme outcomes even though the expected or
average outcome meets the decision-maker’s “safety” requirements.

III
 TABLE OF CONTENTS

Abstract ii

List of Tables vi

List of Figures vii

Acknowledgement Viii

Chapter 1 Introduction 1
1.1 Price Risk and Commodity Markets 1
1 .2 Options versus Futures 4
1.3 Problem Statement 6
1 .4 Study Objectives 8
1 .5 Thesis Outline 8
Chapter 2 The Hedging Contract 10
2.1 TheTheoryof Hedging 10
2.2.1 Hedgingwith Futures 10
2.1.2 Hedging with Options 14

Chapter 3 Review of Hedging Literature 18

3.1 Optimal Hedging with Futures and Options: Expected Utility Model 18
3.1.1 Futures Contract 18
3.1 .2 Commodity Options 20
3.2 Optimal Hedging with Futures: Safety-first Approach 24
3.3 Expected Utility versus Safety-first 25

Chapter 4 Model Specification 30

4.1 Single-period Representation of Revenue 30
4.2 Decision Rules 32
4.2.1 Generalized Expected Utility Model 33
4.2.2 Safety-first Model 34
4.3 Evaluating a Safety-first Model 35

Chapter 5 Empirical Models 40

5.1 Empirical Model Derivation 40
5.1.1 Expected Utility Model 40
5.1.2 Safety-first Model 41
5.2 Model Parameter Requirements 43
5.2.1 Review of Techniques 43
5.2.2 The Forecast Error Method 44
5.2.3 Parameter Estimation 45

iv
Chapter 6 Simulation Results and Implications 49
6.1 Expected Utility Model Results 49
6.2 Results from the Safety-first Model 51
6.2.1 Base Case 51
6.2.2 Sensitivity of the Probability Threshold 57
6.2.3 Variation of the Volatility 58
6.2.4 Variation of the Basis Risk 60
6.2.5 Alternating Strike Prices 62
6.3 Summary of Safety-first Results 63
Chapter 7 Summary and Conclusions 65
7.1 Summary 65
7.2 Conclusions 66
7.3 Restrictions and Further Research 67

References 69
Appendix 1 The Derivation of Unconstrained Optimal Hedge 73
Appendix 2 The Derivation of Equation Al .20 81
Appendix 3 Deriving the Value of a Single-period Option 84

Appendix 4 Derivation of the Safety-first Probability Constraint 87

Appendix 5 Derivation of the Safety-first Model Objective Function 95

v
 LIST OF TABLES

1 .1 Futures position assumed after the option is exercised 3

2.1 Hedging under a constant basis 12
2.2 Hedging scenario under a weaker-than-expected basis 13
2.3 Hedging under an unfavorable futures price move 13
2.4 Hedging with a long put option 15
5.1 Forecast error statistics for September and October (1981-90) 47
5.2 The standard deviations for September and October 48
6.1 Optimal futures and option positions under various scenarios 50
6.2 Summary table of safety-first model results 64

vi
 LIST OF FIGURES

1.1 Canola spot prices for 1984 .1

1.2 Payoff diagram for a short futures and a long put 4
1.3 Distribution of revenues under alternative hedge scenarios 6
2.1 Low basis risk 16
2.2 Moderate basis risk 17
2.3 High basis risk 17
3.1 Telser’s figure 1 25
3.2 Measuring risk by probability of loss versus variance 28
4.1 Creating a synthetic long call option 31
4.2 Cummulative density functions under an upward price bias 36
4.3 Tangency condition for maximization 37
4.4 Feasible regions under varying bias 38
4.5 Model summary 39
6.1 Feasible regions: base case and alternate futures price biases 53
6.2 Payoff of the base case and alternatives 55
6.3 Optimal hedge payoffs for varied biases 56
6.4 Reduce the probability threshold to 10 percent 57
6.5 Payoff for lower probability threshold at 10 percent 58
6.6 An increase in the standard deviation to 1.25 59
6.7 Increase the standard deviation to 1.25 60
6.8 Higher and lower basis risk 61
6.9 Payoff diagram for high and low levels of basis risk 62
6.10 Feasible region under higher and lower strike prices 63

vii
 ACKNOWLEDGEMENT

I would like to extend a many thanks to my principal advisor, Jim

Vercammen for all his help, guidance and personal interest in my thesis topic. I
would also like to thank my two other committee members Vasant Naik and
George Kennedy for their input. Their time and effort was much appreciated.

In addition, I would like to thank the staff, Kathy and Retha. A special
thanks go to Gwynne Sykes for her help with obtaining materials on my research
topic. I am also grateful to: Susie Latham for being my sounding board at
7:30am coffee breaks at the Ponderosa Cafeteria; my brother, Carlos for putting
up with my constant questioning of mathematical and statistical concepts; and
Victoria Watson for her immense help in preparing for my thesis defense.

Finally, cheers to all my fellow grad students of which I have had the
pleasure of interacting (or not interacting) with.

“There was a one-lot trader named Fred,

who tried to reduce risk with a spread.
But the spread was his demise-
He overdid position size,
trading not one but ten instead.”

--Author unknown

viii
 CHAPTER 1 INTRODUCTION
Ii Price Risk and Commodity Markets
Historically agricultural commodity prices have displayed a more volatile
behavior than the prices of non-agricultural goods and services. This difference is
illustrated in the following graph which shows the spot price (per metric tonne) of
canola traded on the Winnipeg Commodity Exchange [WCE] during 1984. In the
period between May and July, the spot price was highly volatile. Indeed, prices
rose by approximately 70 percent within that brief period of time.

Figure 1.1 Canola spot prices for 1984

800

700.

aDo,
a)
C
= 500

a)
a)
C.
0

200.

100

0
Jan ‘ Feb ‘ Mar • Apr • May Jun • Jul • Aug • Sep ‘ Oct ‘ Nov • Dec

This high degree of variability can be attributed to two major causes:

production uncertainty and stock shifting. Output uncertainty for an agricultural
product is due to a variety of effects including adverse weather conditions, and
biological factors such as pests and disease. Stocks are important because
production is normally seasonal and anticipated supply or demand shocks are
instantly reflected in the current price. For example, if during the growing season

1
a major producing region of soybeans is flooded, then expected soybean
production will be lower. Producers, processors, speculators will have an
incentive to hold on to their current stocks longer since the future value of those
stocks will increase. Coupling these supply effects with a generally inelastic
demand for agricultural commodities can lead to very large price swings; thus,
exposing an agricultural firm (producer, processor) to potentially high levels of
financial risk.
The emergence of Chicago commodity markets during the 1800’s allowed
an agent to hedge against unfavorable price movements by locking in a price in
advance through a forward contract. However, these forward contracts were not
standardized according to quality or delivery time and agents did not always fulfill
the contract commitments. In 1865, the Chicago Board of Trade (CBOT)
alleviated this problem by making available futures contracts which, unlike the
forward contracts, were standardized according to quantity, quality, and time and
place of delivery (CBOT, 1989). In Canada, the main commodity exchange is the
Winnipeg Commodity Exchange [WCEJ. Following its inception in 1887 as “The
Winnipeg Grain and Produce Exchange”, the WCE introduced futures contracts on
wheat, oats, and flaxseed in 1904. Barley futures were offered in 1913, followed
by rye in 1917. In 1963, canola (CANadian Oil Low Acid; otherwise known as
rapeseed) futures with a Vancouver delivery were introduced (Hore, p.83).
A futures contract is simply a standardized legal agreement to make or take
a deferred delivery of a specified quantity and quality of particular commodity. The
settlement is to occur at a pre-determined time and location for a previously
agreed upon price. An individual entering the futures market with a buy position is
said to have a long position. Alternatively, if the agent enters the market in a sell
position, then she is said to have a short position. If the agent’s futures position is
short (long), then when the contract matures the holder can either make (take)

2
delivery of the commodity, or she can offset her position by buying (selling) back
the futures contract at the price which the contract is currently trading at. In
practise, the use of offsetting contracts is the most common occurence with actual
deliveries of the commodity occurring only a small percentage of the time. This
flexibility is the major advantage of a futures contract over a forward contract.
In recent years, commodity options have become available on the major
exchanges and have provided the producers and processors of these
commodities with an additional risk managing tool.
An option on a futures contract is a contractual agreement that is traded on
commodity exchanges through a trading system similar to that of futures.
However, unlike futures contracts, an option on a futures contract gives the holder
the right, but not the obligation, to enter the futures market under either a long or
short futures position at a pre-determined price. A call option requires the seller to
deliver a long futures position to the purchaser of the option. A put option requires
the seller to deliver a short futures position to the purchaser of the option.
Therefore the buyer of an option, known as having a long option position, has the
right to a sell (in the case of a put option) or buy (in the case of a call option) a
futures contract at a pre-specified price before the particular futures contract has
matured. The pre-specified price is known as the strike or exercise price of the
option contract. The futures positions assumed by the contract holder when the
option is exercised are summarized in Table 1 .1 below.

Table 1.1 Futures position assumed after the option is exercised

Call Option Put Option

Buyer assumes long futures position short futures position

Seller assumes short futures position long futures position

3
 Both call and put options can be either European or American options.
European options only allow the holder to exercise the option when the futures
contract reaches maturity; whereas, the holder of an American option can exercise
it any time while the option is valid.

1.2 Options Versus Futures

Even though futures contracts enable a hedger to protect against downside
price risk, they also prohibit the possibility of gaining from a price rally. Option
contracts, on the other hand, can provide the agent with similar downside price
risk protection and allow the agent to benefit from any upside potential. The cost
of this added flexibility is in the form of an option premium (i.e., the option must be
purchased at a positive price). Figure 1.2 below illustrates more clearly the
differing payoff structure of a futures contract, option contract and an unhedged
position.

Figure 1.2 Payoff diagram for a short futures and a long put

Net selling price unhedged

‘t
per contract

::::t

premium {
0{ futures price
basis

4
 The hedging scenario in Figure 1.2 is for the specific case of hedger who
wishes to lock in a future selling price (e.g., farmer, exporter) under the
assumption that the spot and futures price are perfectly correlated.
1 The diagram
displays three potential strategies undertaken by the agent. If the agent decides
not to hedge any of her spot position, then the price that she receives depends on
what the futures price is at the time of sale. This relationship is represented by the
45 degree line in Figure 1 .2. If the agent were to go short in the futures market,
and contract for the amount of stocks held, then she would lock in a net selling
price equal to the futures selling price less the basis. This is shown as the
horizontal line. In the third strategy, the agent holds a long put option. The long
put option provides the agent with the same upside potential as the unhedged
case (less the premium) once the futures price exceeds the strike (exercise) of the
option (K). Alternatively, when the futures price is below the strike price, then the
long put option locks in a net selling price equivalent to that of the short futures
position less the value of the premium.
An alternative method of differentiating the two hedging tools is compare
the probability density functions [PDF] of revenues for a particular hedging
strategy. This allows one to explicitly examine the effects of varying amounts of
basis risk on the distribution of revenues for the hedging agent. Figure 1.3,
illustrates the distribution of returns assuming joint normally distributed spot and
futures prices with a less than perfect correlation. Three cases are depicted: the
agent (i) remains unhedged, (ii) hedges with only short futures, and (iii) hedges
with only put options. The agent’s decision to use only futures contracts as a
hedging tool allows the agent to essentially lock in a price, thus bringing in the tails

1 The difference between the spot and futures price is known as the basis. It can be positive or
negative and represents the cost of storage, insurance, interest on invested capital, and
transportation costs. If the spot and futures price always move in tandem then the basis does
not change overtime meaning that there is no basis risk

5
of the revenue distribution, (i.e., implying a small variance of revenues). This
strategy is vastly different from the no hedge strategy which leaves the hedger
open to the full brunt of the potential price risk. As evidenced by the flatter and
more dispersed revenue distribution. If the agent decides to use only commodity
options then relative to the case of hedging with futures, the PDF skews to the
right and shifts to the left.

Figurel .3 Distribution of revenues under alternative hedge scenarios

hec cn)y
Gpticns heccnIy

Revenues

1.3 Problem Statement

Given the volatile nature of commodity prices, agricultural firms and
producers have an incentive to insure against price risk. A futures contract is a
tool which can be used for this purpose. However, with the recent introduction of
options on futures contracts, and agent has an additional and more flexible risk
managing tool at his disposal. It is important to determine the conditions when

6
one hedging tool will be chosen over another and when both will be used
simultaneously.
There exists substantial literature which determines optimal hedging
strategies using futures contracts. Conversely, relatively few studies have
evaluated the same problem by incorporating both futures and options. One
reason is that from a theoretical perspective, when futures are available options
are redundant (i.e., will not be used) under the standard assumptions of no price
biases, no output uncertainty and conventional expected utility maximization,
(Lapan, Moschini, and Hanson [LMH], 1991). Thus, when a futures price bias
(incentive for speculation) does not exist, an agent will chose the hedging tool
which is the most efficient at reducing the variability of the expected payoff. Given
the linear relationship between the spot and futures price and the linearity of the
payoff of a futures contract (as a function of its price), then a futures contract is
more effective at reducing the variance of expected returns than is an option
contract (which has a non-linear payoff--as is illustrated in Figure 1 .3).
This result is unusual given the evidence of a recent survey of Iowa farmers
suggesting that the number of producers hedging with options is equal to that of
futures (Sapp, 1990). A more recent study of Montana farmers found that 14% of
crop farmers use futures and 19% use options; alternatively, 6% of livestock
farmers used futures and 11% use options (Sakong et al, 1993).
One explanation as to the popularity of options over futures is that farmers
may not be behaving as expected utility maximizers. In fact, results from a recent
producer survey indicate that the use of safety-first decision rules may important to
agricultural firms.
2 The survey performed by Patrick et al. (as cited in Atwood et

2 Safety-first decision rules are part of the lexicographic family (sequential ordering of multiple
goals) of utility functions. A safety-first rule specifies that a decision maker will act in manner
such that a preference for safety is followed. Once this safety objective is met, the decision
maker’s goal involves a profit-oriented course of action.

7
al., 1988) involved 149 agricultural producers in twelve states and many producers
responses “indicated what could be interpreted as substantial ‘safety-first’
considerations in their decision making”. The emergence of safety-first decision
rules in economic literature is not a recent one. Telser (1 955) used a safety-first
approach to evaluate hedging strategies using futures contracts.

1.4 Study Objectives

With producer surveys showing results of both the higher use of options
than futures and presence of safety-first decision making behavior. The major
objectives of this study are:
1. To develope a one-period hedging model which incorporates safety-first
decision rules and hedging with both futures and options. The safety-first
model is similar to one developed by Telser.
2. Contrast the safety-first model to the stamdard expected utility hedging
model.
3. Compare optimal hedging results from both models through simulations using
parameters estimated from canola price data obtained from the Winnipeg
Commodity Exchange.

1.5 Thesis Outline

Chapter Two will describe a typical scenario of a farmer who faces price
risk and must decide which is the most beneficial marketing objective for his
operation. Some of the relevant literature involving hedging with both futures and
options will be discussed in Chapter Three. In Chapter Four the theoretical
models are defined, and some of the basic safety-first theory is introduced. The
derivation of the empirical models and the various parameters required for the
models is included in Chapter Five. Chapter Six discusses the simulation results

8
derived from the empirical models. Lastly, Chapter Seven summarizes the results,
provides conclusions and offers suggestions for further research and the potential
drawbacks of the study.

9
 CHAPTER 2 THE HEDGING CONTRACT

This chapter begins with a description of the motivation for hedging using
futures and/or options via an analysis of a case farm. Following this, the
implications of basis risk for the effectiveness of the hedge is examined.

2.1 The Theory of Hedging

The concept of hedging is based on the principle that prices in the cash
market and the futures market tend to move together. Although this relationship
may not be a perfect, it is usually sufficiently close such that a farmer can reduce
his price risk in the cash market by taking an opposite position in the futures
market. By pursuing such a strategy, losses in one market are countered by
gains in the other market. This is better explained through an example.

2.1.1 Hedging with Futures

1
Let us assume that a canola farmer has seeded her crop in May and is
expecting to harvest it in September. In July, the farmer examines her crop and
expects to have a crop yield of 1000 tonnes of #1 canola. Satisfied with the
current price of a January futures contract trading on the WCE (i.e., after
subtracting the basis, the price that remains will be sufficient to cover the per
tonne cost of production) she decides to hedge her entire crop against price risk
by selling (going short) 50 twenty-tonne contracts of January canola which she
will offset after harvest. The following discussion provides a detailed description
of the hedging procedure:

1Much of this section indirectly relies on material published in the Commodity Trading Manual
published by the Chicago Board of Trade.

10
 STEP 1: The farmer must open an account with a Futures Commodity
Merchant. This involves the filling in and signing of: a new client
commodity application form, a margin form, a risk disclosure form, and in
the case of a hedger, a hedging agreement. The hedging agreement
confirms that all the trades made by the farmer will be for the sole
purpose of hedging. Speculative trades must be done through a different
account where they will be margined at the full speculative margin.
STEP 2: In July, the farmer places a hedge order for 50 twenty-tonne #1
canola futures contracts with a January delivery which are trading at $350
per tonne. The farmer expects the cash price at the time of delivery to the
local elevator to be $325 per tonne. The farmer has based this
expectation upon the expected value of the basis which she believes will
equal the current basis. Once the hedge order is placed, the farmer must
provide an initial margin. The initial margin required by the WCE in this
case would be (50 contracts @ $450) $22,500 or $22.50 per tonne.
Margins set by the Futures Commodity Merchant are sometimes more
stringent than those of the WCE.
STEP 3: In October, the farmer offsets her position by purchasing 50
twenty-tonne January canola futures contracts at $375 per tonne, and she
sells her canola to the local oilseed elevator for $350 per tonne.
Table 2.1 below summarizes the farmer’s transactions and derives her net
selling price for a single contract when the basis is constant. Notice that, by
entering the futures market the farmer has locked in a net selling price
equivalent to the cash price she suspected would exist in October at the time of
the delivery to the elevator. This is known as a “perfect hedge”. Had the farmer
not entered the futures market she would have received $325 per tonne, which
is an inferior strategy.

11
Table 2.1 Hedaina scenario under a constant basis

cash market futures market basis

July expected price of sell Jan. canola -$25

canola is $350/t futures @ $375/t
October sell harvested buy Jan. canola -$25
canola @ $325/t futures @ $350/t
Change $25/t loss $25/t gain 0.0

Amount received from cash sale of canola $325/t

Gain from futures market transaction $25/t

Net selling price $350/t

Of course, to assume that the basis remains constant may be overly

simplistic, especially when time and/or local supply and demand factors can
greatly affect the volatility of futures prices. Table 2.2 shows how the farmer will
do when the basis is not constant. A weaker-than-expected (widening) basis
can reduce the effectiveness of the short hedge. Alternatively, if the basis was
stronger-than-expected (narrowing) then the short hedge would have been more
effective. A simplification made in both Table 2.1 and Table 2.2 scenarios is that
the futures price movement is favorable, If it was not favorable, then not only
might the farmer be required to post additional margin money, but she would be
better off not entering the futures market. This scenario is shown in Table 2.3
below.

12
Table 2.2 Hedging scenario under a weaker-than-exgected basis

cash market futures market basis

July expected price of sell Jan. canola -$25

canola is $350/t futures @ $375/t

October sell harvested buy Jan. canola -$35

canola @ $315/t futures @ $350/t

Change $35/t loss $25/t gain -$10

Amount received from cash sale of canola $3151t

Gain from futures market transaction $25/t

Net selling price $3401t

Table 2.3 Hedging under an unfavorable futures price move

cash market futures market basis

July expected price of sell Jan. canola -$25

canola is $325/t futures @ $3501t
October sell harvested buy Jan. canola -$25
canola @ $350/t futures @ $375/t

Change $25/t gain $25/t loss $0.0

Amount received from cash sale of canola $350/t
Loss from futures market transaction $25/t

Net selling price $325/t

In Table 2.3 the futures price has increased unfavorably from $350 per
tonne to $375 per tonne. The farmer has lost $25 per tonne by entering into the

13
futures market. Fortunately, this loss is compensated by an equivalent gain in
the cash market. This ensures a net selling price equal to the price expected by
the farmer in July. However, in this scenario the farmer would have been better
oft not to have entered the futures market because he could have received a net
selling price of $350 per tonne. This returns us back to the discussion in
chapter one where it was said that one of the drawbacks of futures contracts was
that they “prohibit the possibility of gaining from a price rally.” In this case, the
flexibility of an option on the futures contract becomes beneficial.

2.1.2 Hedging with Options

Because farmers who hold options are not required to exercise them, they
can benefit from the gain in the cash market and simultaneously avoid the
effects of any unfavorable movement in the futures price. The cost of this added
flexibility is reflected in the purchase price of the option, referred to as the option
premium. Table 2.4 describes the potential benefits from purchasing (going
long) a put option with a $375 per tonne strike price, a $15 per tonne premium,
and an expected basis of $25 per tonne under various potential futures price
realizations.

14
Table 2.4 Hedging with a long put option
Jan. futures Actual Cash Put option Net selling
price in Oct. basis price gain/loss price
($/t) ($/t) ($/t) ($/t) ($/t)

300 -25 275 +60 335

325 -25 300 ÷35 335
350 -25 325 ÷10 335
375 -25 350 -15 335
400 -25 375 -15 360
425 -25 400 -15 385

One can see from the example in Table 2.4 that under a constant basis,
no matter how far the futures price is below the strike price, the farmer will
always lock in a floor price of $335 per tonne.
2 If the futures price exceeds the
strike price of $375, then the farmer can receive a net selling price equivalent to
the current cash price for canola less the option premium. In this respect, the
option contract is similar to conventional insurance.
The discussion above evaluated the effects of hedging under specific
strategies and under various basis relationships. Figures 2.1, 2.2, and 2.3 --which
are similar to Figure 1 .3-- provide an alternative means to illustrate hedging
scenarios under increasing levels of basis risk. As the basis risk increases, the
revenue PDF for each hedge type becomes flatter, more elongated, and closer to
the no hedge PDF. This implies that when the basis risk is high, the use of either
futures or options is not really as effective for hedging against price risk. With
relatively low basis risk, the futures and option contracts provide the hedger with

2 Notice that this floor price is lower than that established by entering the futures market, but this
strategy allows the farmer to gain if prices move upwards. Also, note how the scenarios of table
2.4 translate into the payoff diagram (figure 1.2) of chapter one.

15
very different outcomes. These differences disappear as the basis risk becomes
large.

Figure 2.1 Low basis risk

F utur hec cnly

Oia,s
no hece

R even ues

16
Figure 12 Moderate basis risk

cØicns hecs cray

futures hedge cnly

nohec

Revenues

Figure 2.3 High basis risk

Futures hececnIy

cpncns heccnIy
no hedge

Revenues

17
 CHAPTER 3 REVIEW OF HEDGING LITERATURE

This chapter begins by examining the evolution of optimal hedging theory

which is primarily concerned with futures contracts only. Two competing
hypotheses (standard expected utility maximization and the safety-first
approach) are discussed. The second section reviews the literature which
incorporates both futures and options on futures into the hedging model.

3.1 Optimal Hedging with Futures and Options: Expected Utility Model
3.1.1 Futures Contracts
The original notion of an optimal hedge referred to the case where the
decision maker [DMJ would take an equal but opposite position in the futures
market as that taken in the cash or spot market. In other words, if you expected
to have (or held in a warehouse in the case of an exporter) Xtonnes of canola
then you would hedge an equal amount in the futures market. Johnson (1959-
60) and Stein (1961) were amongst the first studies to use modern portfolio
theory as a means of deriving optimal hedging strategies.
1 Their studies showed
that under certain situations the optimal hedge could be less than unity (i.e., the
‘traditional hedge’). More recently, studies by Rolfo (1980), Chavas and Pope
(1982), KahI (1983), Anderson and Danthine (1983), Meyer and Robinson
(1988), and others have continued the use of the mean-variance [MV] framework
of portfolio theory when determining the optimal hedging decisions using futures
contracts.
The results obtained by Johnson and Stein do not necessarily follow
those of expected utility maximization except under special conditions. This

1 Stein’s method of optimization was based on previous work done by Tobin (1958). In addition,
Markowitz (1959) had done research in the area of portfolio selection in a mean-variance
framework.

18
relationship can be shown by deriving the optimal hedge expected utility
framework. Under the assumption of either a quadratic utility function (Tobin,
1958), a normally distributed attribute (Samuelson, 1970), or a random attribute
which is an affine transformation of a single random variable (Meyer, 1987), then
the mean-variance objective function can be expessed as,

U(7t) = E(t)+?Var(7t) (31)

where ‘jt is the expected return from the portfolio of assets, and ? represents the
Arrow-Pratt measure of absolute risk aversion (a positive value denoting a risk
averse individual). For the case of two risky assets, the agent’s cash position
and the corresponding futures position, then the expected return from the
portfolio can be expressed as (where the superscripted bars denote expected
values),

E(t)=XS(
—
2sl)+XfCf—f) (3.2)

where X and X are the spot and futures positions respectively; 2’ 2 the end of
f
period spot and futures prices; s
1 , f1 are the spot and futures prices at the
beginning of the period. Similarily, the variance of returns is,

Var(t) = Xa + Xo. + 2
XXo (3.3)

where represent the variance of the end-of-period spot price, the

variance of the end-of-period futures price, and the covariance of the end-of
period spot price and futures price.

19
 Now substituting equations (3.2) and (3.3) into (3.1) and differentiating
with respect to X
1 (assuming that the spot position is given; hence, known by the
agent) then solving out for the futures positions one obtains the following
relationship,

(3.4)
X o 2Xa

If the second (speculative) component of equation (3.4) equals zero due to no

price bias (i.e., fj =4) then the optimal hedge equals the first component. The
Johnson-Stein mean-variance technique of minimizing risk via the variance of
the portfolio is equivalent to an expected utility maximization only under the
special circumstance of no price biases.
One benefit of this approach is that the optimal hedge can be derived
empirically by regressing futures prices on spot prices and using classical linear
regression to derive the slope coefficient (covariance of spot and futures relative
to the variance of futures) which is equivalent to the ‘optimal hedge’ from MV
2
analysis.

3.1.2 Commodity Options

With the introduction of commodity options on the major U.S. exchanges
in the early 1980’s, there was a need to examine how one could use options as

2 Considerable controversy has arisen around this technique because

of the debate as to
whether the data used should be in the form of price levels, price changes, or percentage
changes. Both theoretical and statistical arguments have been forwarded as support to either of
the three forms (e.g., Bond et al., 1987; Benninga et aL, 1984; Witt et al., 1987; Shafer, 1993). In
addition, statistical detection of serial correlation (e.g., Herbst et al., 1989) and autoregressive
conditional heterosckedastic errors (e.g., Sephton, 1993, or for a bibliography: Bollerslev, 1992)
have meant the use of more complex techniques of deriving the risk minimizing optimal hedge.

20
an additional risk management tool. Ritchken (1985) investigated how single
period MV utility maximizers might respond when they include Black-Scholes
[BS] priced options in their investment opportunity set. What he found was that
portfolios which lie on the MV efficient set include primarily short rather than long
positions in the options market; thus, making the joint assumption of mean-
variance and Black-Scholes pricing theoretically inconsistent. One study which
incorporated the use of both hedging tools was undertaken by Wolf (1987). He
considered an optimal hedging strategy in the case of a linear MV model and a
logarithmic utility function. Within the MV framework Wolf derived comparative
static results both with and without basis risk. The logarithmic utility function was
used in his simulation analysis of optimal portfolios. Wolf’s initial assumptions
were that the DM has a fixed position in the physical commodity and that the
spot price was nonstochastic. The results under these assumptions were:
• A DM which has a long futures position and faces fairly priced options will sell
a call or purchase a put. The opposite was true for a short futures position.
• A DM will purchase a call (put) option to guard against any adverse price
movements when he holds a short (long) futures position. He will sell the call
(put) in order to generate income against an adverse price move for a long
(short) futures postion.
Once the initial assumptions are relaxed, Wolf concludes that:
• In the absence of basis risk and with fairly priced hedging instruments, the
DM uses only futures since options are redundant.
Although Wolf’s analysis provides useful insights, the validity of his results
are questionable because the MV model may be inappropriate in his context.
This is because the distribution of profits become truncated when options are

21
introduced into the portfolio.
3 Realizing this weakness in the standard MV
model, Ladd and Hanson, (1991) provide an alternative method that is based on
the generalized expected utility analysis. Their model assumes that there are no
transaction costs, basis risk, margin calls, and that the DM has an exponential
utility function which displays constant absolute risk aversion (CARA). Firstly,
they derive an income density function which is the sum of two truncated normal
distributions. This is to account for the truncation which occurs when options are
included in the hedging process. Secondly, Ladd and Hanson build a factorial
model which is used to determine the input variable levels required for use as
substitutes for market factors in their income density function. Finally, they
numerically integrate and optimize their generalized expected utility model for
each set of estimated market factors. The following are a few of Ladd and
Hanson’s major results:
• If either the futures or options markets are considered to be biased then the
DM will speculate by increasing their position in the options market and
decreasing (increasing) their position in short (long) futures.
• The availability of an options market in addition to a cash and futures market
has no or little value when the markets are unbiased or biased --within a
$0.04 deviation.
Ladd and Hanson conclude by saying:

From a speculative standpoint, futures and options contracts some what

offset one another, and allowing the DM to speculate in both markets
does not add much value to the DM over allowing him to speculate in just
one market.”

Including options in a DM’s portfolio can violate any three sufficiency conditions of a MV
representation of expected utility maximization: (i) a DM exhibiting a concave utility function with
a normally distributed random variable; (ii) the utility attribute is an affine transformation of a
single random variable; (iii) the DM has a quadratic utility function, (Ladd and Hanson, 1991).

22
 Following Ladd and Hanson, is an article by Lapan, Moschini, and Hanson
(LMH, 1991). They use an expected utility maximization approach and
through comparitive statics determine a number of results under the
presence and absence of price biases. In addition, their single-period model
allows for basis risk and assumes that the DM has an exponential utility
function exhibiting CARA characteristics. Some of their more relevant results
were:
• If both futures and options prices are unbiased and spot and futures prices
are correlated, then the DM will hedge a proportion () of their output in the
futures market, and no options will be used.
4
• If futures prices are unbiased, and the relationship between the spot and
futures prices is linear, then a futures contract provides a superior hedge to
an option because of the futures linear payoff versus the options non-linear
payoff. Thus, in this case, the use of options is redundant.
• If there are perceived biases in the futures prices and/or options premiums
and it is also assumed that there is no basis risk and that the hedger is fully
hedged, then options are used in combination with futures to speculate on
the perceived biases.
Bullock and Hayes (1992) modify Wolf’s original model by endogenating
the variance-covariance matrix of portfolio returns. In their model, they
examined both scenarios, with and without basis risk. Unlike Wolf, they do not
allow for the use of both call and put options since a call option can be created
synthetically via a combination of a futures contract and a put 5
option. From
their model without basis risk, they derived the following observations:

Where the proportion () is equal to Cov[b,p]Nar(p) where b is the spot price and p is the
futures price at the end of the period.
For more information on this combination and other strategies, see Cox and Rubinstein (1985).

23
• The futures contract is the preferred instrument for hedging a fixed inventory
or spot position and the option is the preferred instrument when speculating.
• The futures contract is always the main speculative instrument when
speculating on the mean spot price.
• The put option is the main speculative tool for information on the variance.
With the introduction of basis risk, Bullock and Hayes found that the above
results still hold. In addition, they found that increases in the mean basis level
would induce a DM to hold shorter inventory positions and increases in the
variance of the basis impel the DM to reduce his/her inventory position. Bullock
and Hayes also found that the basis information had no impact on the optimal
option use level and that the futures contract is still the most ideal tool to use
when hedging.
6

3.2 Optimal Hedging with Futures: Safety-first Approach

One decision rule which has mostly overlooked in hedging models, is that
of the safety-first model. Initially developed by Roy (1952) for the case of asset
holding, it was later modified by Telser (1955-6) to include futures. Telser’s
safety-first rule simply stated that a DM maximizes expected returns subject to
ensuring that returns do not fall below some pre-determined disaster level more
frequently than an accepted likelihood.
Similar to the MV studies, Telser found that it was optimal for a DM to
hold some combination of hedged and unhedged stocks depending on a DM’s
expectation of spot and futures price movements and their inter-relationship.

6
A lternatively, Hauser and Eales (1987) use a target-deviation model to evaluate the risk and
return associated with nine most “commonly” used option strategies when the hedger holds a
short futures position. They find that a put option when the hedger is risk averse over outcomes
which fall below the expected hedge price, and risk preferring with outcomes above the expected
hedge price. Two other articles include: Hauser and Andersen, Hauser and Eales, 1986.

24
Telser’s Figure 1 is re-created below (Figure 3.1). Telser states that when gains
are expected from holding both a short hedge and an unhedged stock then the
expected net income will have a negative slope like line (A)and the optimal
combination of hedged and unhedged stocks is given by the tangency of line A
to the elliptic-shaped constraint --point (A’). Also, if a gain is expected from a
short hedge, but not from the unhedged position, then the income line is (B) and
the optimal point becomes (B’). As a third alternative, when gains are expected
from a long hedge position, and losses are expected from holding unhedged
stocks then (C) represents the income line and (C’) is the optimal point. In all of
the cases the expected net income lines increase in the direction of the arrows.

Figure 3.1 Telser’s figure 1

2
X Unhedged Stocks
A

—v

C
B

X 1 Hedged Stocks

3.3 Expected Utility versus Safety-first

Unlike the expected utility model, which is a commonly accepted means of
modelling the behavior of agents under uncertainty via the axioms of von
Neumann-Morgenstern, the use of safety-first models is less common.

25
 Safety-first models are part of the lexicographic family of utility models
which, unlike the expected utility model, have no theoretical base or set of
axioms. Instead, as the word lexicographic suggests, the utility functions of these
can be thought of as a representation of sequential goals. The goal of highest
priority must be met first before a decision maker is allowed to consider the
second goal. The main concept is that a decision maker is first concerned with
satisfying some safety measure, and then once having attained that measure he
can follow a profit maximization objective.
Three main forms of safety-first rules exist according to Pyle and
Turnovsky (1970). However, Anderson (1979) provides an alternative
catagorization which is adopted in this discussion. In the first catagory,
Anderson defines what he calls a safety principle. One of the more familiar
safety principles is that of Roy (1952) which states that a decision maker’s
objective is choosing an action which minimizes the probability of some attribute,
usually profits(it), falling below some specified “disaster” level (d*). In other
words,

MinPr(1u.<d*) (3.5)

The second category is that of safety first rule. This rule was put forth by Telser
(1955-56) and assumes that a decision maker maximizes expected returns E(it),
usually profits, subject to a constraint of the probability of returns not falling
below some crucial probability (y).

Max E(t) s.t. Pr(t d*) ‘y (3.6)

26
Anderson defines the third category as that of a safety fixed rule. Initially
introduced by Kataoka (1963), it involves the maximization of some minimum
return (d*) such that the probability of returns falling below this minimum level is
lower than some crucial value (y).

Max d* s.t. Pr(it d*) ‘ (3.7)

Unlike the expected utility model where risk is commonly (in the simple
two moment case) represented by a distribution’s second moment, either
variance or standard deviation, decisions made using safety-first rules can differ
greatly from variance-based decisions. Figure 3.2 is a good example of how the
two methods will have two different outcomes depending on which the decision
maker is using.
In the first graph of Figure 3.2 there are two distributions of revenue, A
and B. Distribution A has a lower mean revenue (Pa) than distribution B (tb);

however, distribution B has a larger variance (o) than distribution A (a). In

addition, if one is to define (d) as the “disaster” level of revenue (perhaps the
cost of production or the mortgage payment on the farm) the action that results
in distribution A will have a greater likelihood (Ya) of revenues falling below the
critical (d). Alternatively, action B has a distribution with a lower probability
(almost negligible) of revenues exceeding the critical point (d). In other words, if
a decision maker were to use Telser’s safety-first rule (equation 3.6) he would
rank distribution A as a more risky venture than distribution B; whereas, an
expected utility maximizer who is very risk averse (i.e., is only concerned with
minimizing variance) would rank distribution B as more risky than A.

27
Figure 3.2 Measuring risk by probability of loss versus variance
7
Figure 3.2.a: Ya >Tb, a<o, d = “disaster” level of revenue

Distnbution A

I
I / \/
Distribution B
2’ I /
Ii -.

&
0
I, \

\ ,‘ :
\
A :
/1
/ I --
-5-.-- -

d Jib
Revenue

Figure 3.2.b: y >y, ()X <(3)z distribution’s skewness

I \S

\S

2 Distribution X /
Distribution Z
.0
0
0.

/
/ 5:
\ S

/ S

d =
Revenues

In graph 3.2.b., there are again two distributions (X and Z) of differing

shape. In this case, both distributions have equal means (i.t=) and equal
variances (a = at), but they are skewed in different directions. Distribution X is

Diagrams are based upon those depicted in Young (1984 p.33).

28
negatively skewed ([J3]< 0) and distribution Z is positively skewed ([l’3]> 0). It
is useful to once again make a comparison on how a decision maker may
evaluate the riskiness of either action based upon behaving in either a safety
first fashion or an expected utility manner. One would expect that a safety-first
agent would rank the action responsible for distribution X as riskier venture
> y. whereas the risk or variance minimizer would be indifferent between the
two actions.

29
 CHAPTER 4 MODEL SPECIFICATION
In this chapter a model of a hedger who wishes to lock in a futures
position then offsets that position at a later date is developed. This is followed
by a discussion of the behavior of two hedging agents who follow two different
decision making rules. One agent decides his optimal hedging strategy by the
maximizing the expected utility of the revenues derived from the futures and/or
options position. The other agent bases his decision upon the maximization of a
safety-first rule.

4.1 Single-Period Representation of Revenue

At the beginning of the period 0
(t
) , the agent decides to hedge a traction
of his operation’s output by taking a short position in the futures market and
either purchasing or selling a put option. At end of the period 1
(t
), the agent lifts
the hedge by offsetting his position in the futures market and then exercising the
option if it has value.
This study will consider the use of put options as an agent’s hedging tool
and not call options because calls are redundant when in the presence of both
futures and put options. In other words, one can create a call option
synthetically via the combination of a put option and a futures contract. This
inter-relationship is best exemplified using a diagram. In Figure 4.1, the long
futures and long put option positions (designated by the dark solid lines) are
combined to artificially create the long call (dotted line) with a strike price Kand a
premium of r.

30
 Figure 4.1 Creating a synthetic long call option

Long

+ - Long call

Profit per
contract
0
Futures price

Long put

Given these assumptions, one can define (similarly to Lapan, Moschini,

and Hanson) the random end-of-period revenue function as:

Ibv+(f—p)x÷(K—p—r)z f p<K (4.1)

by+(f—p)x—rz if pK

where:
t — end-of-period revenue
b end-of-period cash price
y end-of-period output (exogenous)
f — futures price at the beginning of the period
p — futures price at the end of the period
x proportion of output hedged in futures (x >0 buying x<0 selling)
,

r the price of the put option (premium)

z proportion of output hedged in options (z>0 buying, z.<0 writing)
K — strike (exercise) price
In the two-state revenue equation above, the revenue expression in the first-
state occurs when the futures price (p) is below the option contract strike price

31
(K). The second-state occurs when the futures price exceeds the strike or
exercise price.
There are a number of assumptions made regarding the general
representation of the above end-of-period revenue:
1. There are no costs of production (or profits are stated as net of production
costs), and production (y) is exogenous and equals one.
1
2. The premium of the put option (r), is assumed to be the compounded value
(using the market or riskless rate of interest) of the premium forgone at the
time the hedge is placed 0
(t
) .
3. There are of no transaction/brokerage costs, no transportation costs, and no
margins required.
4. There is no constraint on the agent’s ability to borrow to finance the cost of
the futures and options contract(s), and he does not face any borrowing
costs.
5. The exercise price of the option is exogenous.
6. The agent produces a single output.
7. The futures and option contract units are perfectly divisible.

4.2 Decision Rules

This section discusses the general model used to compare hedging with
options versus futures. The general model allows for either standard expected
utility maximization or a safety-first approach (maximizing expected revenue
subject to a safety-first constraint).

1 Although output uncertainty is an important

factor, it is ignored here due to the added
complexity to the model. Some studies which touch upon the topic of hedging when both price
risk and output risk are allowed for include: Rolfo (1980), Chavas and Pope (1982), Grant (1985)
and more recently Sakong, Hayes, and Hallam (1993).

32
4.2.1 Generalized Expected Utility Model
If an agent has a revenue function similar to equation (4.1), and he/she is
an expected utility maximizer, then the agent will choose his/her futures and/or
options position so as to satisfy the following objective:

max E[U(t)] = 2
)]+E[UOt
1
E[U(t
) ]
K (4.2)
=JJU(7tV..K...p) f(b,p)dpdb + S )f(b,p)dpdb
0
5U(rc..

where
the utiltiy of revenue when the option has value (v),(i.e., the
futures price is below the strike price.
U(ico) the utility of revenue when the option has no value (v), (i.e., the

futures price is above the strike price.

f(b,p) joint distribution of cash price (b) and futures price (p).
U(t)-exp(-Ait) where A Arrow-Pratt level of risk aversion.
Equation (4.2) states that the agent will maximize expected utility of revenue;
where 1
E[U(t
) ] and 2
E[U(it
) } are the expected utility of revenues when the
futures price falls below and above the option strike price, respectively.
Similarly to LMH, results from the maximization of equation (4.2) are
dependent on an agent’s perception of future prices and option values. Lapan,
Moschini, and Hanson found that without price biases there was no need for
options, and that options were only useful to speculate on biased values of
futures prices and options.
A price bias is defined as a situation where an agent’s expectation of the
futures price at the end of the period differs from the price of the futures contract
(i.e., E(j3)*f). Since the premium of the option is dependent on the expected
value of the futures price at the end of the period (viz., f), and the expected

33
value of the option (as perceived by the agent) depends on the agent’s
expectation of the end of period futures price (fl), then, as in Lapan, Moschini,
and Hanson, we can express the value of a single-period put option as follows:

E()= $(K—p) h(p;=,a)dp and

premium r = f(K_p) g(p; =f a)dp (4.3)

where g(p) and h(p) are the respective marginal distributions of the futures price
with a mean of and a variance of °‘.
Inkeeping with LMH, note that both
distributions share the same variance, thus any speculative motive based on
differing perceptions of expected volatility or variance is precluded.

4.2.2 Safety-first Model

Similar to the general expected utility model, if the agent has a revenue
function equal to that of equation (4.1), then his/her objective function can be
described as below:

max E[it; x, z] = ff1ty.Kp f(b, p) dpdb +

S fv=O f(b, p) dp db
(44)
subjectto Pr(t itt) y

The agent maximizes his expected revenue via his futures and option contract
position but is subject to a probability constraint. The constraint states that the
probability of an agent’s revenue falling below a predetermined level (‘L) cannot
exceed a preset probability denoted above as y. This model is essentially
Telser’s safety-first model, except that it has been enhanced by introducing
options in the decision making process.

34
 As in (4.2), equation (4.3) represents the expected revenue depending on
whether futures prices fall above or below the exercise price of the put option.
Also similar to the expected utility model above, futures price biases are
incorporated into the model.

4.3 Evaluating a Safety-first Model

Important to the use of any model is the establishment of the intuition
behind the theory through some geometric interpretation. Whereas the expected
utility model involves a straight-forward maximization problem of a concave
objective function, the safety-first model has a less obvious interpretation. One
means of evaluating the safety-first model is to use the common method of
stochastic dominance.
2 First-degree stochastic dominance (FSD) states that if
action F, with a cummulative distribution function (CDF) of F(it) is preferred to
action G with a CDF G(it) if
F(rc)G(it) Vit, where ic€ [a,b] (4.5)
Figures 4.2 illustrates the CDF’s for three different hedging strategies for the
case of a ten percent upward futures price bias: (i) short futures and long put
combination, (ii) short futures only, (iii) short futures and short put option
combination. Using the FSD method to evaluate these various
strategies, one can see that they all satisfy the safety-first “disaster” level of
revenue (denoted here as itL) 10 percent of the time. Hence, given that the
constraint is met by all three of the strategies, the optimal strategy must be the
CDF with the largest amount of area above it. Visually, this is difficult decision to
make, since different strategies dominate at differing levels of revenue.

2For an indepth discussion of various levels of stochastic dominance see either Anderson (1979,
pp. 51-53) or King and Robison (1984, pp.69-72).

35
Figure 4.2 Cummulative density functions under an upward price bias

0.9

0.8
Shorttilures cnd Long Put Combnaflon
0.7

. 0.6

0.5
2
O_ 0.4

0.3

0.2 ulures Only

0.1

In Figure 4.3, the optimization problem is represented in two-dimensional

futures (X) and options (Z) space for when a price bias exists. The elliptical area
of the graph is defined as the iso-probability frontier, which represents the locus
of X and Z combinations that strictly satisfy the safety-first constraint. Any point
within this closed set satisfies the constraint, thus comprising the feasible region.
The objective function of the safety-first model is depicted as the iso-revenue line
in Figure 4•33
The slope of the iso-revenue line can be derived by totally differentiating
equation (4.1) as follows:

1t
dt =—dx+—dz= 0
az
0=(f—p)dx+(7—r)dz where Y=K—7

Re-arranging terms
dx (V—r)
slope=—=— (4.6)
dz (f—p)

Figure 4.3 is similar to that of Telser (1955) Figure 1 except that he plots out hedged and
unhedged stocks.

36
To maximize expected revenue, the agent would choose combinations of X and
Z that push the iso-revenue line in the direction of the two arrows illustrated in
Figure 4.3. However, the agent must remain within the feasible region of the iso-
probability frontier; therefore, the optimal hedging combination is at a point
where the two are tangent to each other.

Figure 4.3 Tangency condition for maximization

F utures (short)

line

lso-Probcbllhiy F roner
(i.e.,scteiyconslrdn1

Options (long)

In Figure 4.4 the relationship between the size of the feasible region and
the size of the price bias is illustrated. One can observe two major effects.
Firstly, as the size of the bias increases (not in absolute terms) the feasible
region increases in size, and therefore the number of option and futures
combinations satisfying the iso-probability frontier also increase. Secondly, as
the price bias increases, the absolute value of the slope decreases. An increase
in the price bias causes the denominator (f—fl) to increase at a quicker rate
than the numerator (—r). Therefore, if the slope diminishes as the bias

37
becomes larger, the optimal strategy may vary from option/futures combinations
A, B, C, or D. In other words, the agent will normally take a short futures
position, but may alternate between a long or short option position depending on
the price bias.

Figure 4.4 Feasible regions under varying bias

(shal
LcrPi1veBi

S rrdl

cpms (shatpiD

cplcns (lcng put)

In summary, as highlighted in Figure 4.5, this study evaluates two

decision making rules as applied to a single-period framework. In both models
the DM, who has a given quantity of a commodity, can hedge against a potential
loss of revenue by entering into a futures contract and/or an option contract.
The DM of the first model is an expected utility maximizer with an exponential
utility function exhibiting constant absolute risk aversion (CARA). The DM of the
second model makes decisions based on the safety-first rule of Telser. He

38
maximizes expected revenue subject to the constraint that the revenue does not
fall below a pre-specified level of revenue with more than a given likelihood.
Both of the models allow for upward (positive) and downward (negative) futures
price biases. This means that the agents can speculate on the expected value
of the futures price, but not the volatility.

Figure 4.5 Model summary

Single-period hedging model

with futures and options
under two alternative
decision-making rules

Max E (it)
subject to safety-first probability
constraint
Pr (2t ) ‘Y

39
 CHAPTER 5 EMPIRICAL MODELS

In this chapter, the theoretical models of Chapter 4 are re-specified for the
case where the cash and futures prices are joint normally distributed.
Expressions are derived for: the probability constraint; the expected utility
expression (for both the exponential and linear utility functions); and the value of
a single period option contract. Also, the parameter requirements of the models
are discussed and several methods of obtaining them are analyzed.

5.1 Empirical Model Derivation

5.1.1 Expected Utility Model
If the cash price b and the futures price p are joint normally distributed,
then equation (4.2) can be restated as (see Appendix 1):

E[UJ = —exp{_A[fr + (K —r)z]}

I / — —\ A2r22 22
*explAj(x + z)p — yb)÷-y[y a,, — 2py(x + z)a,,o +(x + z) a

*
EK—+A(pya,,a—(x+z)a)
— expt—A[ — rz]
[
*exp{A(x_yb)+4i[y2a —2pyxa,,a +x2a]}

* 1— ( K —
+ A(pya,,o
op
— xo)

)
(5.1)

In (5.1) p, is the mean futures price and 1 is the mean spot price, and are

the respective variances of p and b. The correlation coefficient between p and b

is denoted p. The parameter A represents the Arrow-Pratt measure of risk

40
aversion and I(.) is the cumulative density function (CD F) of a standard normal
distribution.

5.1.2 Safety-first Model

Unlike the expected utility model above, the safety-first model as depicted
in equation (4.4) requires two functions to be constructed: (i) the objective
function, and (ii) the constraint. The objective function in the safety-first model is
simply an expression for expected profits. The constraint limits the probability of
falling below a specified level. To specify the objective function for the case of
normally distributed prices, substitute the appropriate functions represented by
the two states of single-period revenue, (i.e., v=K-p and and integrate.
The resulting expression can be written as (see Appendix 5):

K-p K—p
E(;x,z)=by+(f—)x+z (K_)*
G) O)

-z (K_f)*1K_+p1Kap (5.2)
apJ aj
where cp(.) denotes the PDF of the standard normal distribution.

All of the other variables in equation (5.2) are as defined in Chapter 4.

Equation (5.2) allows for the case where futures price biases exist. If no biases
exist, (i.e., f=) then the z[.] terms will cancel each other, and the (f—)x
term will equal zero. Further simplification leaves, E(it;x,z)=by
which is the expected spot price multiplied by the agents production.
To derive an expression for the constraint, it is necessary to transform the
distribution function of the random variable it to a distribution function composed
of the random variables b and p. One technique which can be used for this

41
 purpose is the cumulative-distribution-function 1
technique. Using this method
one can perform the conversion of the cummulative function of revenue (FJI[ltL])

as follows:

°°
1k—P

FL)Pr(t1tL)=Pr(b+p7tL)= J$f(b,p)dbdp=J $f(b,p)dbdp (5.3)

—

However, for the specific case of this paper’s two-state revenue function,
it is necessary to incorporate the fact that the upper limit of integration (the value
of b) is dependent upon whether the futures price p is above or below the strike
price of the put option K. Therefore equation (5.3) can be redefined as:

(1k i 2P> (lk—P1 P2P)’

Pr(7uTUL)=
$ $ f(b,p)dbdp+J $f(p)dbdp (5.4)

where the above parameters are defined as follows:

& =fx+(K—r)z 2 =—(x+z)
a forp<K

13
=
1fx—rz for pK

Equation (5.4) is still a general expression which must be specified for

empirical use. When b, p are joint normally distributed with means
variances and are correlated by a factor which we will denote as p, then

an expression for (5.4) can be derived and written as (see Appendix 4):

F(itL; X,Z) = ff (m) (A

1 [m])d7u + - (5.5)

where =bY—(X+Z)+j’X-i-(K—r)Z K-.(YPab )

1
a)@—
2 _bYXp+JXrZ
= o +Y
2
(X+Z) a +2p(X÷Z)YaPob
2
= X
a +Y
2 a +2PXYGPab
2

1For a detailed exposition of this technique, please refer to Mood, Graybill, and Boes, pp. 181-
188. A more basic analysis is provided by Freund and Wapole, pp. 226-230.

42
f
(
1it) is the pdf of a univariate normal distribution with mean ,
and variance a,

a
=
1 X÷Z, and a
=X respectively.
2

5.2 Model Parameter Requirements

This section discusses alternative techniques for obtainging emprical
estimates of the parameters specified above. Statistical estimates of the means
,p, variances and the correlation coefficient p will allow one to conduct

commodity specific analysis; in the case of this paper, canola trading at the
Winnipeg Commodity Exchange.

5.2.1 Review of Techniques

Since the introduction of mean-variance models for use with commodity
futures by both Johnson (1960) and Stein (1961), there have been a plethora of
studies which provide econometric methods to derive the parameters needed for
a “risk or variance minimizing” optimal hedge ratio from time series data. As
previously mentioned, the optimal hedge, as derived using portfolio theory, is
defined as the covariance of the spot and futures prices divided by the variance
of the futures price (let it be denoted as H*=abp/o). Ederington (1979) was one

of the first to use an ordinary least squares technique to estimate the optimal
hedge in the case of Government National Mortgage Association (GNMA) and T
bill futures contracts. He suggested that one could derive H* through the simple
regression of spot price levels (B) on futures price levels (P) as follows,
B=a+bP÷e (5.6)
Where the b (the slope coefficient) is defined in classical linear regression to be
equal to or in this case, the risk minimizing hedge ratio.

43
 With the advent of this estimation method there later evolved a myriad of
questions and debate over such issues as: should equation (5.6) be estimated
using price levels, price changes, or the ratio of spot market returns to futures
market returns; should the data be daily, weekly, monthly etc.; should the data
be corrected for heteroscedasticity and/or serial correlation?
Myers and Thompson (1989) suggest that the simple regression is just a
special case of a more generalized linear, reduced form, equilibrium model
which they define as follows:
b.=X.
a
1 +u, (5.7)
p, .=X
1
.j1+v, (5.8)
where is a vector of variables at time (t-1), which can be used to forecast the
spot price (b )and the futures price (Pt.) Possible variables to be included are
spot and futures prices, production, storage, exports, consumer income, and
other factors. The a and f3 are vectors of unkown parameters, and u and v are
random shocks with a mean of zero and serially uncorrelated.
By estimating equations (5.7) and (5.8) and collecting their respective
error term vectors (u and vi), one can create the necessary variance-covariance
matrix. Unfortunately, due to the lack of data available on factors other than spot
and futures prices, this method was not used in this study.

5.2.2 The Forecast Error Method

The method used in this study to determine the correlation between the
spot and futures prices, so as to be able to use this parameter as a measure of
basis risk, follows that of Peck (1975) and Rolfo (1980). In Rolfo’s article on
deriving optimal hedge ratios for the case of cocoa producing countries, he
employs a method of forecast errors as a means of capturing a measure for
uncertainty in both price and quantity. He defines a forecast error as being “the

44
difference between realized and forecast prices divided by the forecast price.”
This differs slightly from Peck, who does not divide the forecasting error by the
forecast price. Rolfo suggests that by doing this one allows for differential rates
of historical inflation. Hence, using Rolfo’s method one can define the
forecast errors for the spot price and the futures price as follows,

8
P f
Eb=, (59)

What equation (5.9) suggests is that the best one-step ahead predictor of both
spot prices 1
] ) and futures prices ]
(E[b+ o+
1
(E) are the current values of each
variable.

5.2.3 Parameter Estimation

As indicated above, both models require parameter estimates for the
mean spot and futures prices (b,), the variance (a ,o ) of both price series
and in addition, the covariance (ap) of the two prices in order to derive the

correlation coefficient (p ). Therefore, using the Rolfo’s forecast method one

can define the variance of spot and futures prices as follows,

= Var(Eb)
(5.10)
a =Var(,,)

where 8 b’ and 8 represent the forecast errors of spot and futures prices
respectively. Assuming that the forecast price is an unbiased predictor of the
realized price
, then the variance of the forecast errors is simply equal to the
2
sum of the squared forecast errors and the covariance is the sum of the
dot-products of the forecast errors (8,, .) divided by the number of
observations less one (N-i) for correction purposes.

2 By assuming that the forecast price is an unbiased predictor of the realized price, it is implied
that, on average, the forecast error will have a mean of zero.

45
 In this study, the necessary forecast errors are calculated for canola
trading at the Winnipeg Commodity Exchange [WCE]. The data span a ten year
period during the years 1981-1990. The spot price data are the daily closing
cash prices of Number One Canada canola with the basis in-store Vancouver.
The futures price data are the daily futures pices as recorded at the WOE for
Number One Canada canola.
As described in chapter 2, it is assumed that in July, the farmer enters the
futures market with a contract which matures in January. After harvest in
September, the farmer offsets his position in the futures market and sells his
crop to the local elevator. Hence, following the Rolfo model, one can re-define
equation 5.9 for this particular scenario as,

— bsept — 1
f — Psept —

b,sept
8 — p ‘ Ep,sept
— p
Jjul JjuI

Table 5.1 below, shows the variances, co-variances, and correlation of

spot and futures forecast errors for an individual year and the entire time series
(1981-90) for the months of September and October. Note how most of the
correlational values hinge around the mid to high 0.9 values. Two outliers occur
during the 1984 production year. If one assumes that the farmer has the
opportunity to offset his/her position in either September or October, then this
study will use an average of the September and October correlation values as
estimates of the basis relationship between spot and futures prices after harvest.
Thus following this procedure, the base case scenario will have a basis risk of p
equal to 0.95. The lower basis risk values can be used as a means of testing the
models’ sensitivity. Having the basis risk value, one still requires an estimate of
the standard deviation of the spot and futures price at the time of the offset.

46
Table 5.1 Forecast error statistics for Seotember and October (1981 -90)
September October
Year 2
E
b
p
8 P€ p
5 P€
81 0.0051 0.0139 0.0082 0.9737 0.0057 0.0084 0.0069 0.9992
82 0.0022 0.0204 0.0062 0.9191 0.0054 0.0241 0.0113 0.9909
83 0.11760.0911 0.1035 0.9991 0.1024 0.0776 0.0890 0.9985
84 0.0008 0.0033 0.0014 0.8252 0.0006 0.0008 0.0004 0.6375
85 0.0075 0.0097 0.0083 0.9785 0.0235 0.0249 0.0242 0.9995
86 0.0090 0.0182 0.0128 0.9973 0.0055 0.0106 0.0076 0.9967
87 0.0037 0.0077 0.0051 0.9549 0.0017 0.0016 0.0012 0.7665
88 0.0066 0.0110 0.0082 0.9616 0.0205 0.0283 0.0240 0.9982
89 0.0028 0.0090 0.0049 0.9695 0.0054 0.0114 0.0078 0.9939
90 0.0036 0.0109 0.0061 0.9761 0.0035 0.0088 0.0055 0.9921
81-85 0.0267 0.0277 0.0255 0.9391 0.0275 0.0272 0.0264 0.9251
86-90 0.0052 0.0114 0.0074 0.9719 0.0073 0.0121 0.0092 0.9495
81-90 0.0151 0.0157 0.0186 0.9346 0.0166 0.017 0.0187 0.9626

To obtain the standard deviation of the spot and futures prices one first
finds the variance of each price as a function of its forecast error. Thus re
arranging equation (5.9),
b = f(1 +eb), and p = f(1 + e) (5.12)

Treating b, p, e,, and e as random variables, one can derive the variances of
the expressions in (5.12) as,
var(b) = f
*v(e)
2
var(p) = f
*v(e)
2 (5.13)

If f the mean price in July, is assumed to equal 5.0 then the standard deviations
as displayed in table 5.2 can be calculated.
3 It would seem that the price data
from the period 1981 to 1985 is responsible for a greater proportion of the
volatility for the entire time series spanning 1981-90.

Due to stability problems when models with exponential functions have ‘large’ exponents, f was
assigned a value of 5.

47
Table 5.2 The standard deviations for September and October.

Time Period September October

SD of futures SD of spot SD of futures SD of spot
81-85 0.81 70 0.8325 0.8300 0.8248
86-90 0.3606 0.5347 0.4288 0.5519
81-90 0.61 44 0.6264 0.6442 0.6519

As a simplification, this study will, in the base case, assume that the
standard deviation of the futures and spot prices are equal and that they both
equal a value of 0.8. Although this is a higher value than that derived for the
period 1981-90, and lower than 1981 -85, it is felt that the value of 0.8 provides a
sufficient balance of the two periods, and that any further analysis can involve an
investigation of the sensitivity of the models to values around the base value.

48
 CHAPTER 6 SIMULATION RESULTS AND IMPLICATIONS

In Chapter 5 the data requirements for the empirical models were

discussed. This chapter involves the evaluation of both the safety-first and
expected utility models using the base case parameters derived in Chapter 5
and additional sensitivity analysis. This is then followed by a comparison of the
results of the two different decision making beliefs.

6.1 Expected Utility Model Results

Using the parameter estimation results from Chapter 5 one can define the
following base case scenario:
Y=1, b=5, Y=
,
5 ,
8
Ob=Op=O. K=5, f=5.2, p=O.95, A=O.5

This base case implies a small futures price bias of 4 percent and a fairly low
level of basis risk (p=O.95). The level of risk aversion is obtained via sensitivity
analysis of the model to varying levels of A, and roughly represents a median
point.
Table 6.1 below provides a summary of the results of the EU model under
alternative scenarios. Beginning with the standard no futures price bias case
(i.e., no speculative motive) the farmer will hedge a proportion of production
equal to the ratio of the co-variance between the spot and futures price divided
by the variance of the futures price. Using values from the base case, the
optimal hedge involves using 0.95 futures and no options 1
contracts. This result
is the standard hedging rule as discussed by Johnson (1959-60) and Stein
(1961), where the optimal hedge is equal to the ratio of the covariance of the
spot and futures prices and the variance of the futures price.

1 Note that the optimal futures X*=O.95 is equivalent to the basis risk (p=O.95). This is due to the
fact that the standard deviation of the futures price and spot price are equivalent.

49
 Now, if an upward futures price bias of 4 percent is introduced, the
expected utility maximizer will “overhedge” , (i.e., hedge more than his cash
position), in the futures market, hence X*=1 .58. As one would expect, when the
parameters of the model are varied, the optimal futures positions also change.
Increasing the base cases’standard deviation (volatility) of the spot and futures
prices from 0.8 to 1 .25 ceteris paribus induces a fall in the optimal futures
position from 1.58 to 1.21. This reflects the added risk involved holding a
greater unhedged position (i.e., speculating with an the open position), when the
joint distribution of prices has a greater volatility or variance.

Table 6.1 Optimal futures and option positions under various scenarios.

Futures position (X*) Option position (Z*)

No bias 0% 0.95
Base case 1.58
Bias -4% 0.33
Higher SD (aD=ab=l .25) 1.21
Higher basis risk (p=O.82) 1.45
Lower basis risk (p=O.99) 1.62
Lower risk aversion (A=0.1) 4.08
Higher risk aversion (A=1 .0) 1.26

A similar relationship between the optimal futures position and the

parameter being varied can be found for the instances of a higher basis risk or a
higher risk aversion. By increasing the basis risk to a value of 0.82 from the
base case value of 0.95, the hedge ratio falls to 1 .45 futures contracts. The fall
in the amount hedged is a result of the reduced certainty of the expected change

50
in the spot price over time as the futures price changes. Recalling chapter one,
as the basis risk increased (lower p) then the resulting revenue distributions
were more volatile.
An increase in A (Arrow-Pratt risk aversion) from 0.5 to 1.0 means that the
agent is more averse to risk and derives a both lower and negative marginal
utility (U”(it)<0). Alternatively, if A is lowered to 0.1 or if p is raised to 0.99, the

agents optimal futures position increases. However, note that all the optimal
hedge postions in Table 6.1 share one characteristic. That is, all the optimal
option positions are approximately equal to zero, (actual values are very small
positive and negative values). This result is in contrast to the comparative static
results derived by Lapan, Moschini, and Hanson (LMH, 1991), where they found
that:

The optimal hedging strategy involves using only futures, and the amount
of futures is determined by the covariance of cash and futures prices.
However, if futures prices and/or options premiums are perceived as
biased, options are typically used along with futures. Thus, in this model
options are appealing more as speculative tools to exploit private
information on the price distribution, and less so as an alternative hedging
instrument. (p.74.)
Thus, the LMH results are not very significant or valuable in this particular case.

6.2 Results from the Safety-first Model

6.2.1 Base Case
Similar to the expected utility model, the base case will be a function of
the same initial parameter values:
Y=1, b=5, =5, ab=crP=O.
8 K=5, f=5.2, 95
p=O.
In addition, the base case assumes that the agent has a limiting revenue (EL)

equal to 4.0, and a probability threshold (y) of 0.15. That is, the farmer wants the
assurance that his revenue does not fall below the limiting revenue (e.g., a

51
mortgage payment on the farm, the cost of production) of 4.0 more than 15
percent of the time.
Figure 6.1 is an illustration of the two-dimensional analysis technique
described in Chapter 4, where the iso-probability frontiers are de-lineated in a
futures (X) and options (Z) space (i.e., points on this curve show combinations of
futures and options positions that give rise to an equal probability of falling below
the revenue threshold). An initial observation is that as the magnitude of the
positive futures price bias increases, then the potential combinations of X and Z
which satisfy the feasible region also increase. As discussed in Chapter 3 and
illustrated in that chapter’s Figure 3.1, this study’s interpretation of the
relationship between the safety-first’s objective function and its constraint is
similar to that of Telser (1955) except that he examines the behavior of a hedger
who has a choice between or a combination of hedged (futures) and unhedged
(spot) stocks.
A second, important observation is that the bottom loci of the iso
probability frontiers tend to share the same (X, Z) co-ordinates. This can be
explained by examining the expected revenue relationship as the futures position
(X) approaches zero. As X approaches zero, the expected revenue is
dependent primarily on expected spot prices as small changes in the futures
price f has little impact on it.

52
Figure 6.1 Feasible regions: base case and alternate futures price biases

Futures (short)
5

Base Case

Bias +0.4%
(0.91,2.91)

-o -4 -2 a

Options Options
(short put) (iong put)
-2

-3 Bias -4%
(-1.55. 2.12)

As introduced in Chapter 4, the objective of the agent is to maximize

revenue subject to the probability constraint. Thus, the agent would like to push
out the iso-revenue line in the direction of the arrows shown in Figure 6.1, yet
remaining within the feasible region of the constraint. The optimal point or
hedging combination for the hedger is at the point where the objective function
and the constraint are tangent. In the base case scenario, the optimal point is
that of 1.31 short futures contracts and 3.83 long put options. However, if
futures prices are biased in a downward direction (f < fl’), the optimal values
occur on the underside of the feasible region even though the slope of the iso-
revenue line has not changed. The reason for this result is that the agent feels
that the futures contract is underpriced, then, in order maximize expected
revenues the agent would take a long futures position or certainly reduce his/her
short position from the unbiased case. In Figure 6.1, the point of tangency for

53
when a 4% downward bias exists is where the optimal position is a long futures
of 1 .55 contracts and 2.12 long put option position.
In Figure 6.2 , the payoff of the optimal X, Z combination for the base
case scenario of Figure 6.1 is contrasted with other combinations which,
although are not the optimal points, do comprise points on the base cases iso-
probability frontier. Of the three strategies, the short futures and short put option
position of (3.62, -2.2) is the least desirable. Even though the strategy gives the
agent the largest net selling price for a futures price realization of 5 (point A), it
fails to provide the agent with higher payoffs than the other two when the futures
price realizations are below or above their expected value. Also, if the futures
price was to rise to a value above 7.5 then the net selling price would be
negative and the agent potentially could suffer infinite losses. It is for this reason
that an implicit constraint is included along with the safety-first model’s
constraints. The additional implicity constraint is one which precludes the desire
of the agent to choose an infinite combination of futures and options that will on
average satisfy the probability constraint and maximize expected revenue, but
potentially make the hedger susceptable to potentially infinite losses.

54
 Figure 6.2 Payoff of the base case and alternatives

30

Futures only
25 (2.11,0)
Average Net
Selling Pric
0 Base Case
(1.31,3,83)

15

10

0
0.5 4.5 5 5,5 6 6.5 7 7.5 8

-5 Realized Futures price

Short Futures
Short Put Options (3.62. -2.2)

In contrast, the optimal base case strategy of X=1.31 and Z=3.83, which
has the lowest average net selling price when the futures price realization equals
5, enables the agent to have very high net selling price when the futures price
falls below 5.0 into the “low risk” region.
2 In addition, this strategy provides the
agent with protection against any potentially low net selling price realizations in
the “high risk” regions. In other words, the base case scenario is the ideal tactic
whether the realized futures prices are above or below the expected value.

2 difference between the net selling price of the base case strategy and the futures only
strategy when the futures price equals 5 is the amount of the option premium which shifts the
payoff downward.

55
Figure 6.3 Optimal hedge payoffs for varied biases

30

25
Average
Sng Bose Case
Price 20 (1.31,3,83)

Realized Futures Price

Figure 6.3, illustrates the payoffs for the optimal hedges under the base
case scenario, an upward bias of 0.4% and a downward price bias of 4%. As
shown, the base case of (1.31, 3.83) involves the use of a larger quantity of both
futures and put options as compared to the case of the upward bias of 0.4%.
However, the base case also comprises a greater proportion of options than the
0.4% upward bias case. This is exemplified by the increased slope of the base
case s payoff function for futures price realizations below 5.0. The increase in
the use of options relative to futures as the size of the upward bias increases,
suggests that an option is a more efficient tool to use when both “safety” and
speculative gains are a concern of the agent. Notice how the payoff function for
the case where there is a downward bias of 4% is essentially a mirrored image
of the base case. This is because with a downward price bias of 4% the agent
feels that the price of the futures contract is under valued; thereby, the agent is

56
wishing to capitalize on the instance that the futures price rises before the
futures contract is offset.

6.2.2 Sensitivity of the Probability Threshold

Figure 6.4 Reduce the probability threshold to 10 percent

4
Bias ÷4%
Base Case

-6 -4 -2 6
Put Options
(short) —1

- ‘Put Options
-2
(long)

A number of results are expected when the probability threshold is

reduced to 10 percent as displayed in figure 6.4. Firstly, the magnitude of the X
and Z combinations which satisfy the constraint should decrease; which they do
when comparing the positive bias of 4% scenario to the base case. Secondly,
one would expect the behavior of the agent to be more “risk averse”; thereby,
witness a reduction in his optimal futures position. This response does occur;
however, in addition to a reduced futures position the agent takes an increased
options position. One might expect the opposite to occur. Figure 6.5 below
illustrates why the optimal hedging strategy of (1.05, 4.04) under a 4 percent

57
upward bias is superior to the strategy of (1.23, 3.6) which involves the use of
fewer futures and options contracts, yet satisfies the probability constraint. Once
again, the payoff for the (1.05, 4.04) hedge gives a higher payoff when futures
price realizations are below 5.0 and creates a superior floor price to that of the
alternative (1.23, 3.6) strategy when prices are above 5.0. As before in figure
6.3, the optimal strategy under a downward price bias of 4 percent (-1.50,2.33),
involves a payoff which is a mirrored image of the upward bias case.

Figure 6.5 Payoff for lower probability threshold of 10 percent

25
Bias +4%
(1.05.4.04)
20 /
Average N t
Selling Piic
:“:N. / B’‘as 4°!
-

Bias +4%
(1.23,36)
5. —— —

0 I I I I I I I I I I I I
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8
Realized Futures Price

6.2.3 Variation of the Volatility

Figures 6.6 and 6.7 represent the optimal hedge strategies and their
respective payoffs when the standard deviation of futures and spot prices is
increased from 0.8 to 1.25. One can observe from Figure 6.6 that with an
expansion of the standard deviation, which implies a higher level of volatility, the
size of the feasible region declines from the base case. In conjuction with the

58
 smaller feasible region, the optimal hedge of X* and Z* is also reduced.
However, note that the relative point on the iso-probability frontier has not
changed from the base case. This is because the slope of iso-revenue line has
not changed with the increased volatility of prices. Also, unlike Figure 6.1, the
iso-probability frontiers do not share the same lower locus of points.

Figure 6.6 An increase in the standard deviation to 1.25

5
Futures (short)
Bias +4%
4 (1.17, 1.92)
Base Case
(1.31, 3.83)

-I
-6 -4 -2 4 6
Put Option (short)
Put Options
(long)

-2

When a downward bias of 4 percent exists, the result contrasts the results
of the previous scenarios. Instead of purchasing put options, the agent sells
them. In other words, with an increased volatility of futures and spot prices the
agent feels that there is less risk involved in speculating with options (short
position) than with futures (long position). However, this result is obtained by
implicitly constraining the X and Z to combinations which do not give rise to
payoffs which fall below zero. This can be seen in the payoff diagram of Figure

59
6.7. The payoff line for the bias -4% case remains above zero for all futures
price realizations.

Figure 6.7 Increase the standard deviation to 1.25

30 Base Case
Bias +4% (1,31,3.83)
25 (1,17, 1.93)
Average Bias -4%
Net 20
-
.. (1,73,-1.89)
Selling
Price 15

o
I 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8
‘-5

Realized Futures Price

Also note that when the standard deviation is increased from the base
case, the optimal payoff strategy is less steep in the “low risk” region and flatter
in the “high risk” area. The optimal strategy must have a flatter payoff than that
of the base case because the distribution of the net selling price around the
mean is more volatile.

6.2.4 Varation of the Basis Risk

Figure 6.8 shows how the optimal hedging strategies vary from the base
case when the amount of basis risk is increased or decreased. As one might
expect, when the basis risk is decreased (p=O.99) a larger quantity of X and Z
will satisfy the feasible region. The opposite occurs when the basis risk is
increased (p=O.82). Not only do the available combinations of X and Z satisfying

60
 the safety-first model’s probability constraint decrease under increased levels of
basis risk, but the optimal strategy is to use fewer long puts and more short
futures contracts.

Figure 6.8 Higher and lower basis risk

Futures (short)
5

High Basis Risk

(1.50,2.52, p=O.
)
82
Low Basis Risk
)
99
p=o.

-6 -4 -2 6
Put Options (short)

Figure 6.9 below shows how the agent will choose a strategy which
sacrifices higher net selling prices at low futures price realizations (reflected in
the reduced slope of the payoff in this region) in order to obtain overall higher net
selling prices when futures prices exceed 5.0. This is a necessary tactic
because the distribution of the net selling price is more disperse when the basis
risk is higher; thus, an increased probability of the net selling price dipping below
zero exists.

61
Figure 6.9 Payoff diagram for high and low levels of basis risk

30

Low Basis Risk

(1.18, 4.54, )
99
.
0
P High Basis Risk
Selling Price (1.5,2.52, p=O.
)
82
20

10

5 (1.31,3.83)

0
0 0,5 1 1.5 2 2.5 3 3.5 4 4,5 5 5.5 6 6.5 7 7.5 8
Reaized Futures Price

6.2.5 Alternating Strike Prices

Finally, Figure 6.10 illustrates how the feasible region are modified when
the strike price of the put option is alternated. The most obvious observation
that can be made is that the feasible regions pivot around two points on the
futures (X) axis. This is not a surprising result, given that changes in the strike
price of the option should have no effect on the level of futures contracts which
make the probability constraint binding.
As the strike price is raised by 4 percent, the optimal X increases from the
Base Case, but the optimal Z decreases. The opposite occurs when there is a
downward bias of 4 percent.

62
Figure 6.10 Feasible region under higher and lower strike prices

6
Futures (short)
5 strike price =5.2
(1.74, 2.02) Base Case
strike price=4.8
(1.31,3.83)
(1,24,5.71)
I’

/
-8 -6 -4 -2 8
Put Options -1
(short) Put Options
(long)
-2

-3

6.3 Summary of Safety-first Results

Table 6.2 provides a summary of the results shown graphically above. As
before, positive (negative) futures value corresponds to a short (long) position.
The opposite is true for the put option values where a positive (negative) values
implies a long (short) put option position. One conclusion that can be made
about the results derived from the safety-first model is that the optimal hedging
positions tend to be fairly sensitive to the parameter combination. One instance
in particular is where the volatility of the futures price and cash price is raised to
a standard deviation value of 1.25 from 0.8 (this raises the coefficient of variation
from 0.16 to 0.25). Under the assumptions of higher futures price volatility and a
downward futures price bias of 4 percent exists, the optimal hedging position
involves taking a short futures position combined with a short put position. As
mentioned previously, this contradicts the general results of a short futures and
long put position as obtained from varying the other model parameters from the

63
base case. In closing, the extreme behavior of the safety-first model under
varying parameter values prevents one from making any general
recommendations for an agent such as a farmer.

Table 6.2 Summary table of safety-first model results

Level of Futures Put option

bias position (X*) position (Z*)
Base case +4% 1.31 3.83
-4% -1.55 2.12
Lower probability threshold (y=O.1) +4% 1.05 4.04
A 0/
/0 -1.50 2.33
Increased volatility (a=1 .25) +4% 1.17 1.92
-4% 1.73 -1.89
Higher basis level (p=O.99) +4% 1.50 2.52
Lower basis level (p=O.82) +4% 1.18 4.54
Higher strike price (k=5.2) +4% 1.74 2.02
Lower strike Drice (k=4.8) +4% 1.24 5.71

64
 CHAPTER 7 SUMMARY AND CONCLUSIONS

7.1 Summary
Agricultural commodity prices have through history behaved in a
potentially highly volatile manner; thus, leading to the placement of high levels of
financial risk on producers, processors, exporters, and other agents involved in
the procurement and/or sale of these commodities.
For some time, the availability of futures contracts has provided these
agents with a risk management tool. Basically, by entering the futures market
via a futures contract the agent is able to substitute price risk for basis risk The
argument being that basis risk is generally less than price risk. In the early
1980’s option contracts on commodity futures were made available on some the
U.S. commodity exchanges. Options provided an agent with an additional risk
management tool. Options can be used with futures or on their own. The
advantage of using option contracts is that an option allows for a variety of
revenue distributions not previouly available with only futures. This is because
the option is like insurance coverage, the holder of the contract can either
exercise the option or not. The drawback of this arrangement is, like insurance
coverage, that the holder of the option must forego a premium even if he does
exercise the option.
This study has attempted to evaluate how a decision maker, such as a
farmer, might use futures contracts and options on those contracts as a means
of managing price risk. Two contrasting models were used for this purpose. An
expected utility model and a safety-first model. The safety-first model was that of
Telser, except enhanced to include not only futures but options as well. Both
models are based upon a single-period framework where at the beginning of the
period the agent enters the futures and option markets and places a hedge. At

65
the end of the period the agent offsets his futures position and sells his
commodity in the spot market. The single-period model was formulated such
that the agent could speculate on the futures price bias and not the volatility of
the option price.
Once the empirical models were defined, then the parameters were
derived for the models using canola data obtained from the Winnipeg
Commodity Exchange. A technique utilized by Rolfo (1980) was used to obtain
the necessary parameters from the data. The data series spanned a ten year
period froml98l to 1990. Optimal hedging results from the two models were
derived under alternative parameter scenarios which involved varying levels of
basis risk, futures and spot price volatilities, and risk aversion.

7.2 Conclusions
The results from the maximization of the expected utility model suggests
that an agent will (when futures or option price biases exist) hedge an amount
equal to that of the co-variance of the spot and futures prices divided by the
variance of the futures price. If a price bias exists in the futures market, then the
agent takes the same futures position as the no bias case and then speculates
on the bias by either taking an additional position or reducing his existing one;
this depends on the direction of the bias.
In general, increased volatility, uncertainty, or aversion to risk leads to a
reduced open speculative position when in the presence of a positive futures
price bias. Of course, the opposite occurs when these factors are lower than the
base case. The most interesting result of this model is that unlike the
comparative static result of Lapan, Moschini, and Hanson (1991), put options do
not figure into the optimal hedge even when there is a speculative component to
the hedge.

66
 An opposite result is obtained under the safety-first model. With this
model, options are always used as a means of speculating on the upward and
downward future price biases. Other results are similiar to the expected utility
model’s.
In general, as the price bias increases, so do the overall futures and put
option positions. When the price bias is reduced or is in the downward direction,
then the short futures is reduced as is the long put option position. In some
cases, the short futures positions may change to a long positions. When the risk
level is reduced (in the safety-first model this is represented by the level of the
probability threshold) the hedging agent increases his long put position and
lowers his optimal futures position. When the volatility or standard deviation of
futures prices is increased, the agent’s response is to reduce his futures and
options positions. However, when the bias is negative, the agent increases his
futures position and writes put options instead of purchasing them. This
illustrates the rather sensitive nature of the safety-first model to parameter
changes. As the amount of basis risk increases (decreases) the agent takes a
larger (smaller) futures position and lowers (raises) his put option position.
One weakness of the safety-first approach is that even though the “safety”
requirement is being met, the return of a given hedging combination may have
on occasion a very extreme outcome which could involve a large financial loss.

7.3 Restrictions and Further Research

A number of assumptions made in this study may prohibit the
comprehensive generalization of the hedging results. In the case of the
expected utility model, the results could differ significantly if one assumed a
different utility function from that of the exponential and its constant absolute risk
aversion. Also, the assuming away of transaction costs and margins

67
requirements may be a strong deterant for agents, since this may involve the
need for capital of which they do not have. Certainly, if borrowing is required
then it is not obtained at a free rate. In the safety-first model there was an
instance where the hedger choose to write put options instead of purchase them.
When writing the option the seller is required to place a margin same as the
hedger in the futures market. Another drawback of the study involves the perfect
divisibility of the contracts. Of course, in the real world this is not the case and
the lumpiness of the contract sizes may lead to increased vulnerability to the
hedger if the amount he desires to hedge is in-between the two contract sizes.
By relaxing the assumption of no output uncertainty for the case of a farmer
could modify the results because of the farmer’s hesitation to hedge Xof his crop
in case producer fell below X and the farmer would have to payout the
deficiency. This uncertainty could lead to an increased use of options because
of its contingent exercise aspect.
Further enhancements to the methods used here could include the
allowance for a multi-period model (perhaps a stochastic dynamic programming
model) and further research on the expected utility model to identify why the
results of this study contradict those given by Lapan, Moshini, and Hanson
(1991).

68
 REFERENCES

Anderson, Jock R., (1979): “Perspectives on Models of Uncertain Decisions.” In

Risk, Uncertainty, and Agricultural Developement. J. Roumasset et al.,
eds. New York: Agricultural Development Council.

Anderson, R.W. and J.P. Danthine, (1983): “Hedger Diversity in Futures

Markets.” Economic Journal, 93: 370-389.

Atwood, J.A., M.J. Watts, G.A. Helmers, and L.J. Held, (1988): “Incorporating
Safety-First Constraints in Linear Programming Production Models.”
Western Journal Agricultural Economics, 13(1): 29-36.

Benninga, S., R. Eldor, and I. Zilcha, (1984): “The Optimal Hedge Ratio in
Unbiased Futures Markets.” Journal of Futures Markets, 4: 1 55-59.

Bollerslev, T., R.Y. Chou, and K.F. Kroner, (1992): “ARCH modelling in finance:
a review of the theory and empirical evidence.” Journal of Econometrics,
52: 5-59.

Bond, Gary E., Stanley R. Thompson, and Benney M. S. Lee, (1987):

“Application of a Simplified Hedging Rule.” Journal of Futures Markets,
7(1): 65-72.

Bullock, David W. and Dermot J. Hayes, (1992): “Speculation and Hedging in

Commodity Options: A Modification fo Wolf’s Portfolio Model.” Journal of
Economics and Business, 44: 201-221.

Chavas, J.P. and R. Pope, (1982): “Hedging and Production Decisions Under a
Li near Mean-Variance Preference Function.” Western Journal Agricultural
Economics, 7: 99-110.

Chicago Board of Trade, (1989): The Commodity Trading Manual. Board of

Trade of the City of Chicago.

Cox, J., and M. Rubinstein, (1985): Options Markets. Englewood Cliffs, NJ:
Prentice-Hall.

Ederington, Louis H., (1979): “The Hedging Performance of the New Futures
Markets.” Journal of Finance, 34: 157-70.

Freund, John E. and Ronald E. Walpole, (1980): Mathematical Statistics,

Englewood Cliffs, New Jersey: Prentice-Hall.

69
Grant, D., (1985): “Theory of the Firm with Joint Price and Output Risk and a
Forward Market.” American Journal of Agricultural Economics, 67: 630-
35.

Hauser, Robert J., and James S. Eales, (1987): “Option Hedging Strategies.”
North Central Journal of Agricultural Economics, 9(1), 123-134.

Hauser, Robert J., and James S. Eales, (1986): “On Marketing Strategies with
Options: A Technique to Measure Risk and Return.” Journal of Futures
Markets, 6: 273-88.

Hauser Robert J., and Dane K. Anderson, (1987): “Hedging with Options under
Variance Uncertainty: An Illustration of Pricing New-Crop Soybeans.”
American Journal of Agricultural Economics, 67: 38-45.

Herbst, A.F., D.D. Kare, and S.C. Caples, (1989): “Hedging Effectiveness and
Minimum Risk Hedge Ratios in the Presence of Autocorrelation: Foreign
Currency Futures.” Journal of Futures Markets, 9(3): 185-197.

Hore, J.E., (1985):Trading on Canadian Futures Markets, 2nd. ed., Toronto:

Canadian Securities Institute.

Johnson, Leland, (1959-60): “The Theory of Hedging and Speculation in

Commodity Futures.” Review of Economic Studies, 27: 139-51.

Johnson, Norman L., and Samuel Kotz, (1970): Continuous Univariate

Distributions, Vol I., Boston: Houghton Mifftin Co.

Kahi, K.H., (1983): “Determination of the Recommended Hedging Ratio.”

American Journal of Agricultural Economics, 65: 603-5.

Kataoka, Shinji,(1 963): “A Stochastic Programming Model.” Econometrica, 31(1-

2): 181-1 95.

King, Robert P. and Lindon J. Robison (1984): “Risk Efficiency Models,” In Risk
Management in Agriculture, Peter J. Barry, ed. Iowa: Iowa State
University.

Ladd, George W. and Steve D. Hanson, (1991): “Price-Risk Management with

Options: Optimal Market Positions and Institutional Value.” Journal of
Futures Markets, 11(6): 555-562,

Lapan, Harvey., Giancarlo Moshini, and Steve D. Hanson, (1991): “Production,

Hedging, and Speculative Decisions with Options and Futures Markets.”
American Journal of Agricultural Economics, 73(1): 55-65.

70
Markowitz, H., (1959): Portfolio Selection: Efficient Diversification of Investments.
New York: John Wiley and Sons.

Meyer, J. (1987): “Two Moment Decision Models and Expected Utility

Maximization.” American Economic Review, 77: 421-30.

Meyer, J. and J. Robison, (1988): “Hedging Under Output Price Randomness.”

American Journal of Agricultural Economics, 70 : 268-72.

Mood, A., F.A. Graybill, and D.C. Boes, (1974): Introduction to the Theory of
Statistics, 3rd ed., Toronto: McGraw-Hill Publishing Company.

Myers, Robert J. and Stanley R. Thompson, (1989): “Generalized Optimal

Hedge Ratio Estimation.” American Journal of Agricultural Economics,
71(4): 858-68.

Patrick, G.R., P.N. Wilson, P.J. Barry, W.G. Boggess, and D.L. Young (1985):
“Risk Perceptions and Management Responses: Producer-Generated
Hypothesis for Risk Modelling.” Southern Journal of Agricultural
Economics, 2: 231 -38.

Peck, A., (1975): “Hedging and Income Stability: Concepts, Implications, and an
Example.” American Journal of Agricultural Economics, 57(3): 410-19.

Pyle, D. and S. Turnovsky, (1970): “Safety-First and Expected Utility

Maximization in Mean-Standard Deviation Portfolio Analysis.” Review of
Economic Statistics, 52: 75-81.

Ritchken, Peter H., (1985): “Enhancing Mean-Variance Analysis with Options.”

Journal of Portfolio Management, 11: 67-71.

Rolfo, J., (1980): “Optimal Hedging under Price and Quantity Uncertainty: The
Case of a Cocoa Producer.” Journal of Political Economy, 88: 100-116.

Roy, A.D., (1952): “Safety-First and the Holding of Assets.” Econometrica, 20:
431-449.

Sakong, Yong, D.J. Hayes, and Arne Hallam, (1993): “Hedging Production Risk
with Options.” American Journal of Agricultural Economics, 75: 408-415.

Samuelson, P.A. (1970): “The Fundamental Approximation Theorem of Portfolio

Analysis in Terms of Means, Variances and Higher Moments.” Review of
Economic Studies, 37: 425-35.

Sapp, S. (1990): Iowa Cattle Production: A Survey of Iowa Cattle Producers in

1990. Ames, IA: Iowa State University.

71
Sephton, Peter S., (1993): “Optimal Hedge Ratios at the Winnipeg Commodity
Exchange.” Canadian Journal of Economics, 1: 175-193.

Shafer, Carl E., (1993): “Hedge Ratios and Basis Behaviour: An Intuitive
Insight?” Journal of Futures Markets, 13(8): 837-847.

Stein, J.L., (1961): “The Simultaneous Determination of Spot and Futures

Prices.” American Economic Review, 51: 1012-25.

Telser, L., (1955-56): “Safety-First and Hedging.” Review of Economic Studies,

23: 1-16.

Tobin, J., (1958): “Liquidity Preference as Behavior Towards Risk.” Review of

Economic Studies, 26: 65-86.

Witt, Harvey J., Ted C. Schroeder, and Marvin L. Hayenga, (1987): “Comparison
of Analytical Approaches for Estimating Hedge Ratios for Agricultural
Commodities.” Journal of Futures Markets, 7(2): 135-146.

Wolf, A., (1987): “Optimal Hedging with Futures Options.” Journal of Economics
and Business, 39: 141-58.

Young, Douglas L., (1984): “Risk Concepts and Measures for Decision Analysis.”
In Risk Management in Agriculture. Peter J. Barry, ed., Iowa: Iowa State
University Press.

72
 APPENDIX 1 THE DERIVATION OF THE UNCONSTRAINED OPTIMAL
HEDGE

Case I:
Assume that the cash and futures prices are perfectly correlated (i.e.,
b=p). From before we know that the general representation of a decision maker’s
profits are defined as follows.

1K-i fp<K
It = py + (f - p)x + (v r)z
- where v
= K

Alternatively,

1 =
It (y-x-z)p + fx + (K-r)z
= (y-x)p + fx -rz

Equivalently,

t + N
p
1 1 =

2 = t
it p + N
2 2
wheret (y-x-z)
=
1 =(y-x)
2
t
N= fx+(K-r)z 2
N = fx-rz

Deriving Expected Utility of Profits

Assumptions:
(i) futures price is normally distributed with a mean value of and a
variance of a.

(ii) the decision maker’s utility function is as follows:

U=eAit where A > 0 risk averse
A <0 risk prefering

73
Given the information above, one can derive an expression which denotes a
decision maker’s expected utility of profit as a function of his/her position in both
the futures and options markets.
E[U]=E{_e} (A1.1)

E[U]=_Je1 f(p)dp — Je2f(p)dp (At2)

Equation (Al .2) is equal to the sum of the expected utilty of profits when
the futures price lies below its strike price 1
(E[U
1 ) and the expected utility of
profits when the futures price lies above its strike price (E[U
]. From this point
2
onward we will work with the E[U
] portion of equation (Al .2) since analogous
1
statements can be made for the later half, 2
(E[U
] .

We can redefine E[U

] as follows:
1

1
E[U J = C f
1 e’ f(p) dp where 1 = — e’
(A1.3)
13 =—Ati

1 2a)
Since f(p)= e
‘2ita

then one can one can restate (Al .3) in the following manner,

K
]=C
1
E[U fe 2
d p (AlA)
J27to -

Similarly,

74
 K
1
J=C
1
E[U fe 2
’ ’dp (Al.5)

Re-arranging (Al .5),

v -

1 i(P—P)——i —i—
1=C
1
E[U e”Je dp (Al.6)
2ta

Re-arranging the exponent of the natural exponential function,

_J[(_)2
_2a13
(
1 p_)] (Al.7)

We want to re-organize the above expression (Al.7) in such a manner

that we can derive the moment generating function (m.g.f.) of a single, normally
distributed random variable.
By completing the square on (p—fl) in (Al .7) we have,

)2
‘[(p —2o13 (p— )÷o —a] (Al .8)

Simplifying (Al .8),

1(.2)2122
(Al.9)

Substituting (Al .9) into (Al .6),

1 K
1
J’2’°’
1
E[U
e =C
Jq2ita e “
dp (Al.lO)

Note that the integrand is the probability density function (p.d.f.) of a normally
distributed random variable with a mean of -i-3 a and a variance of a.
1

Therefore,

75
 ]=C e1
1
E[U 1K0 Op
(A1.1 1)

Where I(.) is the cumulative density function of the standard normal distribution.
Analogously,

c3
]=C
2
E[U
$
K
2
e ‘
dp

—c
— 2
e2P2P* 2
(
1
a p_(+
)”i
(A1.12)
where C
2 = — e2 and 12 = — 2
At

Case II: When the spot price and futures price are not perfectly correlated.
Once again we can define the profit function for the two possible states (exercise
option versus not exercising) as follows:

= (y-x-z)p ÷ fx + (K-r)z ifp< K

2 =
it (y-x)p + fx -rz ifp K

We can re-define it and 2

it as,

it 1
p-i-N
12
b+t
11
=t
2
it ’+t
2
t
2
p+N
221
where 11
t =y t =—(x+z) 1 =fx-i-(K—r)z
N
121 =3’ 22
t = —x 2
N = ft — rz

Now we can define the decision maker’s expected utility of profits in the following
manner,

E[U] = —
J $ e f(b,p)dp db —$ $ K-°
e2f(b, p)dp db
(A1.13)
= 2
]
1
E[U
] -i-E[U

76
Working with E[U
] we have,
1

]=C
1
E[U 1 J Jeh1b12P
f(b,p)dpdb

where C
1 = —e -Aj’
13 1
=—At
(A1.14)
1312 = 12
—At

Manipulating the integral expression,

2
exP{13iib+1
P _ 3i [2
h_2PhbhP+h]}dPdb
2
2ltabaP..SJ1—p ( P
= b—b =
where hb and h (A1.15)

Re-working the exponent of the natural exponential function by multiplying

and 1312 by a ratio of ab/ab and a/a respectively. Then by both adding and

subtracting f3
b and
11 1312 we have,

13llab(a13llb+131PP[a]+1312P_ )[hP+2PhbhP
1
(
2 2 +hP] (A1.16)

= 13 ii
1 + 13Hli + 13
oh + 1312k
12
— 2(1
2
[ hp + 2phbhP + h] (Al .17)

Given equation (Al .17), we can re-write (Al.l5) as,

27ObOg1 2
eh1b412P
aboPJ SexP{13llabhb + 13
oh
12
2(1 P
[h — 2phbhP +
—
—
2

(Al.18)

77
 b-b
Since we defined h,, = and h = then by differentiating we have

dhb=-’-db, dh=-i-dp
ap

Now we can substitute the above differentials into equation (Al.18) and re
express it as,

ePhh12PobaPf$ exP{llabhb ah
1
+ 2 — 12 [h —2phbhP dhPdhb

(Al.19)
Re-working the exponent of the integrand in (Al .19)

— 2phbhP + h — 2(1 p
— )llabhP
2 — 2(1 — p2)i
a
2 php] (Al .20)
— 2(1 —

We can re-write (Al .20) as follows

1

2 —
—Kb!) 2 )+(h _Kpi)2J+(ia
p(hb Kbj)(hP —K
1 P11l2Gbap
2
+ a)
12
-i-

where
Kbl llGb+PI
I
3 2GP

1
K = Gb
1
3
PI1 a
12
+l3

(A1.21)
By replacing the exponent of the integrand in (Al .19) with (Al .21) we arrive at

3
P
+
a
2
l llf +a)
baP
]=C
1
E[U 2

*
exP{ [(hb —KbI)
2 2 —2p(hb Kbl)(hP —K
)
1 +(h _K
)2]}dpdb
1
2(i_p2)

1 See Appendix 2 for a more thorough derivation.

78
 (Al .22)
Note that the integrand in (Al .22) is the p.d.f. of a bivariate joint normal
distribution with the means Kbl , K and variances of one. Therefore we are

able to write equation (Al .22) as

1I
E[U = C *ex{
1 }*

(K—(-i-plloboP l2Gp
where is a special case of Pl

(Al .23)

Analogously,
—

221
b P+13
21
13 ‘
—

2
+
l
2 ab
23P
2
+
2
2 2GGp
1I
l +1
220p
3
]=C
E[U
*
2exp * 1

where C
2 = —e

121 = 21
At
122 =

(Al .24)
Therefore,

[K_
]]
2
K
2 *exp{
c i + 22
2 P+ + +

(Al .25)

79
Now substituting back in for the 1
C
s
T , 1s and the K
s.
1

E[U] = —exp{_A[fx + (K — r)z]}

* exp{_Ay b + A(x + + +[A2y2o — y(x + z)abaP + A

2
2pA 2 (x + z)
2a J}
pAy app + A(x+
Z)O)l_exp{_A[ft _rzj}
[ J
* exp{_Ay b + Ax + [A2y2a y
2 x abap + A2x2a]}
2pA —

* l_1K_(_PAYabap+Axa
) (A1.26)
Gathering the A’s

E[U] = _exp{_A[fr + (K r)z}} —

1• /
*expAj(x+ — —\ A2r2 2 22
z)p —yb)+---[y 0
b — 2py(x+z)oboP +(x+ z) a

* —
+ A(pyaba —(x
+ z)a)1 exp{_A[fr —rz]}
L ]
*exp{A(x_y)÷i[y2a —
pyxabaP +x2a]}
2

* l1K(pyab.px0
a” ) (A1.27)

80
 APPENDIX 2 THE DERIVATION OF EQUATION A1.20

Beginning with (Al .20) and then completing the square on both hb, lz (see Mood

et al, p.165).

[h: — 2PhbhP + — 2(1 —

P jlGbhb
3 — 2(1 )13 + (1— p
ah
12 2 )3
o + 2(1 r
1 2 12
I3 + (1—p
1
)P13t
abaP 2 )13
a]
2
)
2
2(1—p — —

+ 2pI3Ill
abaP +
2

(A2.1)
Now we can re-arrange the term in square brackets into the form of
—2puv+v First let,
2
u
.
ii = Jib + Kb
v = h +K
uv = hbhP + hbKP + hPKb + KbKP

= h h1b’<b + K
+2
= + 2hK + K
(A2.2)
Then placing the above expressions into the u 2 form we have,
2 —2puv-i-v
h, hbKb + K, +
+2 + 2hK + K — 2phh — 2phbKP — 2phPKb — 2pKbKP (A2.3)

Re-arranging (A2.3),

— 2
b
1
P ”p + + f2[h,K,, + hK — phbKP — phpKbj + K + K — 2
p KbKP } (A2.4)

working with the [.1 term in (A2.4) we can re-write it as,

hb[Kb—PKPj+hP[KP —pKb] (A2.5)

Using equation’s (A2.5) format, we can make a similar arrangement using the [.]
term in (A2.l).
_2[(1 —
2 )13 lab/lb +
p 2 )13
(1—p oh
12 J (A2.6)

From the relationship described in (A2.5) and applying it to (A2.6) we can state
the following,

81
 Kb —pK = 2 )I
—(1—p 110b
3
(A2.7)
K —pKb =

Taking the above system of equations in (A2.7) we can solve for Kb, K.

Kb 2
=pKP—(1—
) f3llab p
(A2.8)
K = pKb —(1— 12
)13
2
p
a
through substitution we can solve the equations in (A2.8) such that,

Kb = (1 P
)
2 I3llab + — 12
)
2
p
a f3 +pKb]

= —(llab

(A2.9)
K = —(12oP +p11Ob)

Given (A2.9) we can define the rest of the terms in {.} of equation (A2.4).
K = p
2
+
1
3
1 12
2ab0P
1f f3
+p
a

= 1i2°p 3
p1 l2ObOp
2
+
1 Pi1b
(A2.1O)
= 131112abaP + 13
+P
2 lll2aboP + PIl
2

Substituting the terms in (A2.1O) into the remaining terms in the {.} of (A2.4)
then,

K, +K —2pKbKP = 13° 3
p
2
+
l
jpbap
lI
f2 r3 1
+p
o f3 3
2
+p
a P
2
i
i PzPp
i1
I ÷1
iP
3
o +P
1
_2p[pf3 120b0p + pI3
131113120b0p + 11I
2 3 aJ
2

(A2.11)
Gathering the similar terms,
f
l
3 lab —P
I
23lab 3
j
p
2
i if +1
ppp 3 13 2
1Pp 2
—p
a 13ll13l
3
—2p
abaP (A2.12)
Factoring out the term (1-p
) we have
2

2 )13lab + (1—p
(1—p 2 )132° + (1—p
2) 1 l1l
3
P
2 abap
2

(1— p2)[lab + 2Plllpbap + 13120p]

(A2.1 3)

82
Note that (A2.13) is essentially the term added to [.] in (A2.l). Therefore we
have now derived an expression which is equivalent to (Al .20) in a quadratic
form.

83
 APPENDIX 3 DERIVING THE VALUE OF A SINGLE-PERIOD OPTION

First we let

G=Jpf(p)dp
(A3.1)
where f(p) is the probability density function for a normally distributed random
variable p (price). We can re-write equation (A3.1) in the following manner,

G=ff(p)dp $P K dp
$f(p)dp
-

K
(A3.2)
where
$ f(p) dp is the CDF of the normal distribution evaluated at k.
According to Mood et al. (p.124), the expression (.) in equation (A3.2) is
the probability density function (p.d.f.) of a truncated normal distribution with p
restricted between -oo and K. Therefore, the term [.] becomes the expected
value of the random variable p when p’s distribution is a truncated normal
distribution.
Johnson and Kotz (p.81) describe how one can transform the expected
value of a random value --whose distribution is a truncated normal distribution-
into an expression which is a function of the p.d.f. and c.d.f. of a standard normal
distribution. The expected value of p is given by

84
 E(p)=p. + 0
-

a) \a
where P(.) c.d.f. of the standard normal
cp p.d.f. of the standard normal (A3.3)
A, B the lower and upper limits of the integral

Substituting the upper and lower limits from equation (A3.2) into (A3.3), and
noting that the lower bound --equalling infinity-- reduces (A3.3) to

(K-u)
E(p) =
—
(A3A)

Therefore,

G=
(A3.5)

G (A3.6)

We can define the value of a single period option as the difference between the
strike price (k) and the price of the underlying asset summed over all potential
prices. Alternatively,

E()= J(K-p)f(p)dp
(A3.7)
wherep-’ N(i.i, 02)

Equivalently,

85
 v= K Jf(p)dp
- Sf() dp (A3.8)

Given that the first integral in equation (A3.8) is equal to F(.) -- the c.d.f. of the
standard normal distribution-- we can then substitute both F(.) and equation
(A3.6) into (A3.8) resulting in,

K t)
v =
KF(K)_
a
(A3.9)
where F(K)

Therefore,

=
+ cp(1<Ja
v (K_)4(”J (A3.1O)

is the value of a single period option as a function of the mean futures price, its
variance and the strike price.

86
 APPENDIX 4 DERIVATION OF THE SAFETY-FIRST PROBABILITY
CONSTRAI NT

Deriving an expression for Pr(it) when prices are joint normally

distributed via the cumulative-distribution-function technique.

(i) Consider the following profit function for when the price (p) of an underlying
asset is below and then above the strike price (K).

Jâ 3
p-i-&
2
+&
b p<K
3
+
1
‘j3
p
2
b+13
13 pK

where b and p have a joint normal distribution of f(b,p) with means , j5

variances of a a and are correlated by a value of p.
,

(ii) Therefore, for a given and p, we can define the following expression,

(—â, (—1 2P)’

a3 3
p
Pr(7t)=J f(b,p)dbdp
+ J Jf(b,p)dbdp (A4.1)

where t’ =
3
=W
1
a =
l3 =131/133
(A4.2)
2
a = 3
/
2
a cc 132 132/133

= 1 +a
(a p+b)—b
2
define U(b) and dU = (A4.3)
ab a,,

The substitution of (A4.3) into equation (A4.1) requires a change in the limits of
integration; as follows,

1 ÷a
a 1
p
2 +(n_a 2
—a
p )—
1_
U[b]=U[(_& P)r]U{ —a
2 1
(A45)
= ( -)/a,, when p<K

87
Analogously,
U[bj = —
—
= — 5)/a (when p K) (A4.6)

Re-arranging (A4.3) into the following form,

b-
= U(b) - (A4.7)

Now lets define

q=PP , dq=
ap

= K-
where the limit of integration is c(K) (A4.8)
ap

Re-arranging (A4.8) with q as the argument and p as the value of the function
and then substituting into equation (A4.7) we can define the following
relation ships,

b—b +c
(
2 qap
=U(b)_[1

1
-
0
=U-ã
qã
1 °2-
where = — + —
p
b
0 °b

a
°1 2

Substituting (A4.8), (A4.5) into (A4.1) we have the following expression for when
(p.K)

—1 , [(u_ao_ajq)2_2p(u_ao_a
q
1 )q+q2]
1
$ $ 2icl—p 2
’
2
e dUab dqo (A4.1O)

Making analogous substitutions for when (pK)

88
 —1 2
i -2 (u_o_.iq)q+q2]
dUob dqa (A41 1)
I 2n1 —
2 abap
p

K— **
Letting k= , — , 1
t = and substituting them into (A4.1O)

and (A4.11) respectively, we have,

1 1
expl 2 {(u_&
02 0 _aiq)q÷q2]}dudq
q) —2p(U—&
1
—&
2(1—p)

1 +q2]}dudq
+ exp 1
2
{
[
2(U
1 — — 2p(U — 1
q)q
2 — —

(A4.1 2)
Expanding the expression within the exponent fo the first half of (A4.12) we can
re-define it as follows:

—1 U2
1
2(1_p2)[
0 +0
u(a q)+(& + 2
1
à 0 + aiq)q+q2J
q) —2pUq+2p(&
1
& (A4.1 3)

Gathering the terms in [.] of (A4.13):

q 21—2
—
[(U2 0
2Uc( cx + 1
p& + i) 2q(Uã
2
—

—
+ 2)
— —
—
— pã + pU)l
)
2
2(1p (A4.14)
-2
where U
2 — 0+
2Uä = (U —

If we define the following relationships:

(U—a
2
)
0 U—ã
2
)
0 1 _(1_p2)l
[i+a +2p&
+ 2
p
(l+a+
) (UO)
al_p (A4.15)
2
1—p = 1
1+ä+2pà

1+ + 2p&
1 ) = (&
2
—(1—p + p)
2
and (A4.16)
(Ià —
— pà + pU = (U —
& )(ã + p)

Now we can re-write (A4.14) as:

89
 —(U—&
2
)
0 —1 r(, 0
(U-&
+p)
2
)
+(1+& 2
)q —2(&
1
+2pà
)2(1_p2)[
1
2(1+&÷2p& 1
1+&÷2p&

(A4.17)
Re-arranging (A4.17) into the form of a perfect square in the bracketed [.] term:

2
)
0
-(U-a -(1÷&+2p&
)
1 E 2 2(&
+
1 p)
+ [q (U- ã
)q+I
0 0)2]
pã
2
(l+&+
)
1 J
1
[1+a+2pa

(A4.1 8)
We can simplify (A4.18):

—(U—a
2
)
0
+
)
1
—(1+&+2pä r 0
+
1
(&
) p)U—&
l
2

(A419)
)
1
2(1+&+2pã )
2
2(1—p )
1
(1+ã+2pã j
Alternatively,

-(U—a
2
)
0
1
Lq- (&(1+ä+2p&
) j
1
)1
0
÷p)(U-&
2

)
1
2(1-i-ä-i-2pä (1—p
)
2
(A4.20)
(1+& -i-2p&
)
1

Substituting (A4.20) for the exponent in the first half of (A4.12) then we can re
write --due to the second half being analogous-- then entire expression of

(A4.12) as follows:

itr k —1 2
)
0
(U—a
L1[ 2
-i-p)(U—ä
1
(ä
)
0 1
1+?+2Pj
1 1
Pr( e
(
2 121) * dqdU
= ll2(1 + + 2p&) I 2(1p)
)
1
(1+a+2pd

_
[
1Fq
1
—1 2
)
0
(U-
1
)
1
(1++2p j
+
JJ g2t(1÷r3 +2pf3
)
1
e2(121) *
I 2n(1p2)
(1-i.+2p)
e2(1_p
1
2 21) dqdU

(A4.21)
where

90
 -1 (U-a
2
)
0
1 2(1+&+2p&,)
e
/2t(1+ä +2pà
)
1 (A4.22)

—1 2
)
0
(U-
1 2(1++2p)
e
/it(1+13 +2p13
)
1 (A4.23)

are the p.d.f.’s of the normal distribution with means a 13 and variances
) and (1÷f3 +2pf3
1
(1+&÷2p& ) respectively. Also,
1

I 0
+p)(U—ä
1
(ä
) t

1
(1+ã+2pa)
T(1_p2)/(1+a?÷2pa
)
1
]
e
2n(1_p2) (A4.24)
I )
1
(1+ã+2pã

I (÷p)(U4
)
0 1

1
—IL’ (1?÷2pi) j
2(1_p
)
2 /(1++2p,)
e
)
2
2n(1—p
I (1.i-+2p) (A4.25)

)
0
+p)(U—& )
0
+p)(U—3
are the p.d.f.’s of a normal with means (& and (13k and
)
1
(1+ã+2pä (1-i-f3+2p13
)
1

(1—p
)
2 (1—p
)
2
variances of respectively.
)
1
(1+&+2p& ‘ )
1
(1-i-3+2p3

Recall from (A4.2), (A4.9), and (A4.1 1) the following relationships:

*
1
—

0 **
&)
2
+
1
=—(a
,
a 1 = (A4.26)
0,

where a = = 3
/
2
a a , = .
3
7t/c( Aggregating these terms through

substitution, we have:

(& + ** — b
3
a -
cx2ap
ao
—

— , 1
It —
—
, 1
a = (A4.27)
3
a a
0
3 J, cx
a
3 b

Given the relationships in (A4.27) we can define:

3
+
1
It—(cX
p
2
b -I-cX
cL)
—
0
a-
= (A4.28)
a
a
3 b

91
 Substituting & from (A4.27) into the constant term of (A4.22),then:

427t(1 + + 2pã) + 2p =
+ +2
P
a Pbap
a
= +2
cYb
3
a cL
a
3 b

= 1 = cxc
427t(&cY +âa +2pâ
abaP)
3
à
2 g2it(ac +âcY +2p&
&pbcYP)
2

(A4.29)
Making the appropriate substitutions from (A4.27) into the exponent of the
natural exponential of (A4.22):

r ,-,.

lu—Ij 2
+
1
cx
p cx apbU—(cl ÷a
p
2)
1 2
)
0
(U-& L a3a
)] [
2 1+ã +
1
P
2 & — 21 — 2 &o +&o +2p&2&3aboP
X
G
3b cc
a
3 b

-I-cL
p
2 )}
“2222 (A4.30)
2 +3
X
G b +

Now if we define:
tht=&
o
3 bdU (A4.31)
If we substitute it into the integral, we need to change the limits of integration in
(A4.21) to the following:

=
÷b] = = (A432)

(**)
= ]+b]= 3it2 = (A4.33)

Solving it(U) for U:

u=r_-—i_-=
L3 Jab a
a
3 b
ab

then substituting (A4.34) into (A4.30) and combining it with (A4.29) we have:

92
 bu—(al÷a
3
[a
p
2 ]
2&4+2pâ
à
2 3baP
e
j2t(&a +
(A4.35)
+ 2pâ
abaP)
3
&
2

Now, making similar sets of substitutions for (A4.24) as with (A4.22) then:

2
P
(&
G
3
÷
2
) b)(—(ala
+pa
)a
22 22
—1 a
o
p
2
o
3
a +a
,,o
+
a
2 )&a
2
(1-.p
1
e
I ‘2 2
2it(1—p
)
2
a -I-a
2
cx o3
3
&a
p
+
c
2
O x
cx
POb
(A4.36)

If we define = b as the mean level of profits when p<K

& +â5+&
3 , and
= + + 2p&2&3oPob as the variance of profits when p<K then we can

re-write the expression (A4.21) --when making analogous statements for when p
K-- as:

(2
k
2
Pr(t e *
dqtht
= o
T
LL2 1
JM
2
( a
2
(
a
3
)b)—t
p+p
Iq—— I
ii
M2

+ff e
_{it
2 afl2
* e —j dqdit

= [(1_ Pa
ab]
3 = [(1_
where 1
M , 2
M (A4.37)

Alternatively, if we integrate with respect to q, then we obtain:

93
 K—15 — (&2aP +PG(
Ob)(t
3
n
Pr(t)=JJt) dic
M

K— (2aP+P3ob)(it—i2)

+ff
(
2 ) M
d

where Jj (t) p.d.f. of the normal distribution with mean

1 and variance
(7t)
2
f p.d.f. of the normal distribution with mean
2 and variance c
(A4.38)
c. d.f. of the standard normal distribution

Substituting for the cx’s, 13’s, and Ms, we obtain the following:

F(ltL; X,Z)= J [ii)tht +

1
)4(A - (A4.39)

where = bY—(X+Z)-i-JX+(K-r)Z K-p (Ypa, 1

a)(t
_C(
)
= bY - X+ JX rZ
- ap

= a +Y
2
(X+Z) a +2p(X+Z)Yoa
2 F(1_p2)Y2al2
a +Y
2
X a + 2pXY aPab
2
=
[ 2
j

94
 APPENDIX 5 DERIVATION OF THE SAFETY-FIRST MODEL OBJECTIVE
FUNCTION

Beginning with the standard two state dependent relationship of the

single-period revenue model defined in section 4.1 of this paper and in an article
by Lapan, Moschini, and Hanson, (shown below),

Ibv÷(f—p)x+(K—p—r)z if p<K
7C
by+(f—p)x—rz if pK

one can define the expected profits as the expectation of the two states as is
shown in equation (A5.1) below.

E(n)=$f[by+(f—p)x+(K_p)z—,]g(b,p)dbdp

+JJ[by+(f—p)x_rz]g(b,p)dbdp
(A5.1)
where g(b, p) is the joint normal density function

If one intergrates over the random variable b then one obtains,

1

E()=Jyh(p)dp+J[(f—p)x+(K—p)z—rz]h(p)dp

+$iyh(p)dp+ f[(f— p)x_rz]h(p)dp

K K
(A5.2)
14’here h(p) is the marginal density function ofg(b, p).

Further manipulating expression (A5.2),

E()= fyh(p)dp+fvh(p)dp+J(f_p)x h(p)dp+f(f—p)x h(p)dp

+zf(K p) h(p) dp rz[ Sh(p) dp

-
-
+J h(p) d] (A5.3)

1 According to Mood, Graybill and Boes (p.167), if (X,Y) has a bivariate normal distribution, then
their marginal distributions X and Y are univariate normal distributions.

95
Since J(f—p)x h(p)dp-i-f (f—p)x h(p)dp is equivalent to f(f—p)x h(p)dp which

is just the expected value of (f—5)x where denotes the randomness of p.

Given this, the bracketed term in -rz[.] equals one. Re-organizing (A5.3),

E()= y +(f -)x +zS(K -p) h(p)dp-rz

(A5.4)

Using the derivation from Appendix 3, (equation (A3.1O)) one can redefine
equation (A5.4) as,

E()=y+(f-)x+z (K_1K+p1Kap
k\a’) a}

-z (K_f)1K_+p(Kap
i%\a) apj

where cp[.] PDF of the standard normal density.

(A55)
CDF of the standard normal density.

96