Using futures and option contracts to manage price and quantity risk: A case of corn farmers in central Iowa

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Lei, Li-Fen
Major Professor
Arne Hallam
Donald Liu
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The Department of Economic Science was founded in 1898 to teach economic theory as a truth of industrial life, and was very much concerned with applying economics to business and industry, particularly agriculture. Between 1910 and 1967 it showed the growing influence of other social studies, such as sociology, history, and political science. Today it encompasses the majors of Agricultural Business (preparing for agricultural finance and management), Business Economics, and Economics (for advanced studies in business or economics or for careers in financing, management, insurance, etc).

The Department of Economic Science was founded in 1898 under the Division of Industrial Science (later College of Liberal Arts and Sciences); it became co-directed by the Division of Agriculture in 1919. In 1910 it became the Department of Economics and Political Science. In 1913 it became the Department of Applied Economics and Social Science; in 1924 it became the Department of Economics, History, and Sociology; in 1931 it became the Department of Economics and Sociology. In 1967 it became the Department of Economics, and in 2007 it became co-directed by the Colleges of Agriculture and Life Sciences, Liberal Arts and Sciences, and Business.

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  • Department of Economic Science (1898–1910)
  • Department of Economics and Political Science (1910-1913)
  • Department of Applied Economics and Social Science (1913–1924)
  • Department of Economics, History and Sociology (1924–1931)
  • Department of Economics and Sociology (1931–1967)

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The overall objective of this study is to examine the optimal responses of a risk-averse corn producer to price and quantity risks within a framework where both futures and option contracts are available as risk management tools. The corn farmer is selected as a representative decision maker because corn is the most important crop in Iowa;Numerical techniques are used to solve the expected utility maximization problem for the corn producer. In forming his subjective probability distributions about random variables, the farmer is assumed to predicate output which will be sell to cash market at a later date and use futures and put options to hedge against the risk associated with his cash position. To decide the optimal hedging strategy, the farmer also makes predictions on the cash, futures, and option prices prevailing at the end of period. Optimal positions are obtained for three scenarios: (1) the producer considers only futures, (2) the producer considers only put options, (3) the producer considers both futures and put options as risk management tools. Comparative static results regarding the impact of model parameters such as frame size, risk attitudes, price levels, and price variances on the optimal solution are then examined. The access values of futures, options, and futures-and-options added to the producer are computed based on the concept of certainty equivalent;The optimal solution indicates that put options are used not only as for hedging purpose but also as speculative tools. From hedging standpoint, however, the option market offers no additional benefit to the expected utility maximizing producer if futures contracts are already in use;The access values added to the corn producer show that the futures contracts have a greater value to the producer than does the option contracts. The primary factors determining the access value of options are farm size, the variability of prices, and the level of risk aversion.

Wed Jan 01 00:00:00 UTC 1992