Looking into the futures markets: What are they really for?

First things first - contrary to popular opinion, the main reason farmers and grain traders use futures markets is not to hedge spot price and basis risks, but to ensure the profitability of the storage business. The scientific literature mainly discusses the minimum variance hedge ratio, which aims...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Prehn, Sören, Glauben, Thomas, Loy, Jens-Peter
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2021
Subjects
Futures market
Hedging
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Summary:First things first - contrary to popular opinion, the main reason farmers and grain traders use futures markets is not to hedge spot price and basis risks, but to ensure the profitability of the storage business. The scientific literature mainly discusses the minimum variance hedge ratio, which aims at minimizing spot price and basis risks. In practice, however, it is of little use to farmers and grain traders and has the potential to yield negative economic consequences. Minimum variance hedging (MVH) leads to over-hedging on inverse markets and under-hedging on carry markets. In both cases, the costs of storage cannot be (adequately) covered. It is therefore not surprising that farmers and grain traders do not actually use MVH. On a carry market, a good strategy is to trade the basis. The opposite is true for inverse markets where hedging on futures markets does not make sense. Here, it is better to follow a rather speculative strategy that takes account of price trends. In a nutshell: buy on a weak basis and sell on a strong basis (carry market), or speculate (inverse market).