Empirical Evaluation of Selected Hedging
Strategies for Cattle Feeders
William D. Gorman, Thomas R. Schuneman, Lowell B. Catlett,
N. Scott Urquhart, and G. Morris Southward**
Several hedging strategies for fat cattle are compared using actual feedlot performance information for a period of 6.5 years and 747 pens of fat cattle. Results show that
cattle feeding was not profitable (a $24.50 per head cash market loss) but a carefully
chosen hedging strategy could have reduced the loss by 50 percent.
This article reports the results of a study
which simulated using selected hedging
strategies on pens of cattle fed in a commercial feedlot over a period of approximately six
and a half years. The simulation process allows estimates of profits (losses) from using
the live cattle futures contracts for hedging
purposes under near "real world" conditions.
Producers, feedlot operators, and investormanagers have been using the futures market
for hedging live cattle since its inception in
November, 1964. They can use the live cattle
futures for hedging in a variety of ways.
Hedging all or only a portion of the cattle
when they are placed on feed, hedging all or
part of the cattle using a selected economic
indicator, or hedging and subsequently releasing the hedge according to a specific
criteria based on technical trading practices
are just a few generalized examples of how
cattle feeders may use the live cattle futures
market for hedging purposes. These methods
are typically referred to as hedging
strategies.
The performance of various hedging
strategies involving the use of live cattle futures has been the topic of several research
William D. Gorman, Thomas R. Schuneman and Lowell
B. Catlett are respectively Professor, former Graduate
Assistant and Associate Professor in the Department of
Agricultural Economics and Agricultural Business at
New Mexico State University. N. Scott Urquhart and G.
Morris Southward are Professors in the Department of
Experimental Statistics at New Mexico State University.
reports, popular articles, and professional
economic articles, [Heifner, 1973; Leuthold,
1974; McCoy and Price, 1975; Menzie and
Archer, 1973; Price, 1976; Purcell, 1977; and
Purcell and Riffe, 1980]. The above authors
specified and evaluated selected hedging
strategies. The evaluation criteria generally
consisted of comparing profits (losses) and
variance of profits of the specified hedging
strategies with what would have happened if
each of the strategies were used for hedging
cattle on feed over a period of several years.
Typically the strategies were compared with
profits or losses that would have happened if
the cattle were fed but not hedged. The
strategy that resulted in the greatest average
profits and/or lowest variance in profits over
the period of time was judged to be the best
strategy. Strategies that resulted in higher
average profits or lower variance in profits
(losses) than the no hedge position demonsrated the possible value of hedging by cattle
feeders.
All of the above studies estimated profits
and or losses from feeding cattle, the no
hedge position, by assuming that groups of
cattle were fed for a specific number of days
under average or typical conditions for a
period of years. Most studies placed equal
numbers of cattle on feed at regular intervals
such as every week throughout the evaluation period. Actual prices occurring at the
time were used to estimate the cost of the
feeder cattle going into the feedlot, cost of
199
December 1982
feed, and value of fed cattle at the time they
were marketed. Typical or average feed conversion ratios and standard feeding periods
were also employed.
The evaluation process used in these studies to measure the effectiveness of the various hedging strategies and the relationship of
the strategies to the no hedge strategy by
necessity, held many factors constant that
could have under real world conditions affected the relative profitability of the hedging
strategies. The unique feature of the research
described in this article was that most of the
factors controlled by assumptions in previous
studies were not controlled because actual
feedlot data were used.
Analysis Procedure
Using actual profits and losses resulting
from pens of cattle fed in a commercial feedlot for a period of years as a basis for measuring the effectiveness of selected hedging
strategies rather than profits or losses under
assumed feeding conditions allowed variation
resulting from the following situations to enter into the evaluation process:
1. The pens of cattle, under actual feeding
conditions, rarely match up exactly
with the total weight of multiples of
40,000 pounds (the amount of one live
cattle futures contract); hence, it is not
possible to completely hedge the pens
of cattle. Each pen was either overhedged or under-hedged depending
upon the relationship of the estimated
total pounds of fed cattle to be marketed from each pen and the number of
futures contracts that would result in
the closest number of total pounds. For
example, a pen containing 100 head of
steers that are expected to weigh 1,050
pounds on the average when sold results in 105,000 pounds of live cattle.
The nearest total weight of futures contracts that could be obtained was three
contracts weighing a total of 120,000
pounds. This results in having 15,000
more pounds in futures than live cattle,
hence even though futures and live cat200
Western Journal of Agricultural Economics
tie prices move together, the feeder has
an "at risk" position of 15,000 pounds.
Should prices of fed cattle and live cattle futures increase by $5.00 per hundredweight, the increased revenue
from the sale of the fed cattle in the
cash market would not be sufficient to
offset the decline in revenue from having to purchase the three futures contracts at the higher price in order to
close out the futures. The resulting loss
attributable in this situation to not being able to place a perfect hedge in
terms of matching total pounds of live
cattle with futures contracts would be
$750. If the prices of the cash and futures markets had declined by $5.00
per hundredweight there would have
been a corresponding profit of $750.
The total weight of cattle marketed exactly matched the total weight of futures contracts in previous studies using feeding data controlled by assumptions, i.e. 120 head of 1,000 pound
steers marketed totaling 120,000
pounds and three futures contracts totaling 120,000 pounds.
2. Under feeding conditions controlled by
assumptions, costs of gains are similar
from pen to pen because common feed
prices and feed conversion ratios are
used for all pens of cattle of the same
type. Under actual feeding conditions,
feed prices and conversion ratios often
vary widely from one pen of cattle to
another. It is not uncommon to hedge
into a loss situation on a particular pen
of cattle even though it was thought to
be profitable at the time the hedge was
placed, because of substantially underestimating costs of gains. The impact of
under or over-estimating costs of gains
varies by type of hedging strategy, but
it is particularly troublesome with
strategies using profit targets based on
breakeven costs to initiate and/or release hedges. Using actual feedlot data
in the evaluation process allowed the
impact of variation in feeding costs and
Gorman, Schuneman, Catlett, Urquhart and Southward
subsequent errors of estimating breakeven costs to enter into the process.
3. Using actual feedlot data allowed measurement of the impact of feeding various weights, grades, and sex of cattle.
The futures contract is based on Choice
grade steer cattle, but possibly as many
as 40 percent of all fed cattle grade
lower than Choice and approximately
40 percent are heifers. The cash market
price spreads between Choice and
Good or other grades, between steers
and heifers, and between various
weight classes of market animals, can
change during the feeding period and
thus influence profits.
Source of Feedlot Data
A commercial feedlot with a one time
capacity of approximately 15,000 head made
all of its records available to the researchers
from the time it opened in June of 1971. The
cooperating lot feeds cattle on a custom basis
for ranchers and others interested in feeding
cattle. The owners of the feedlot also owned
about 15 percent of the cattle fed in the
feedlot during the period studied. For accounting purposes however, the ownership
of cattle on feed and ownership and operation
of the feedlot were treated as separate entities. Cattle fed by the owners of the feedlot
were treated identical to and were charged
the same rates as customer fed cattle.
Although approximately 1,000 pens of cattle were fed in the feedlot, information from
only 747 pens was included in the study.
Pens of cattle on backgrounding programs for
short periods of time before going to pasture
were eliminatd from the study as were pens
consisting of cows, bulls, and mixed steers
and heifers. In addition some 100 pens of
cattle on experimental feeding programs
were also eliminated.'
The 747 pens of cattle (58 percent steers
1The Agricultural Experiment Station of New Mexico,
Arizona and Utah had cattle on experimental trials in
the feedlot during the time period covered in the study.
Hedging Fat Cattle
and 42 percent heifers) varied in number,
conversion rates, in-weights, out-weights,
breeds, and length of time on feed.
Feedlot Information Collected
Feedlot "summary sheets", which showed
actual costs, prices, and profits for individual
pens of fed cattle were obtained for each of
the 747 pens of cattle. The summary sheets
also reported the sex, weights, numbers, and
dates the cattle were placed on feed and
marketed; costs of the feeder animals, feed,
and medical treatment; and feed conversion
rates and costs per pound of gain. The feed
cost category on the summary sheet included
the cost of the feed ingredients plus a charge
ranging from $12 to $17 per ton of feed fed
for the use of the facilities (actual custom
feeding charges over the study period), utilities, labor, management and a contribution
to profit to the feedlot owners.
Tabulations of the profits (losses) realized
for each pen on the summary sheets provided
the information for the "no hedge" strategy,
i.e. feeding cattle with no regard to futures.
In the same manner, information on average
profits from feeding steers versus heifers during the period was obtained by sorting by sex
before tabulaton.
Futures Information
For the study, daily futures prices were
adjusted for the difference between the reported Omaha cash price and the Texas/New
Mexico cash price for Choice grade fed
steers, and for the spread between prices for
steers and for heifers in order to arrive at
appropriate "Localized" futures prices.
Brokerage fees for buying and selling futures contracts, which increased during the
period, were charged against hedging
strategies at the rate of $36, $40, or $50 per
roundturn for each contract hedged, depending on the year and the month cattle were
placed on feed. Interest on margin deposits
for futures contracts was calculated daily using a 10 percent annual rate.
Hedging calculations included sales of contracts when cattle were expected to be fin201
December 1982
ished or the closest month beyond, if a contract was not available in the expected delivery month. Daily closing prices on the first
day following a purchase or sale in the cash
market were used as the futures market trading prices.
Since contracts are usually traded only in
40,000 pound units (a standard contract), it
was necessary to establish the decision rule of
one futures contract for each 40,000 pounds
of expected delivery weight, or the weight
closest to it. For example, one contract was
considered sold if expected delivery weight
was 40,000 to 64,000 pounds; and two contracts if 65,000 to 104,000 pounds.
The Simulation Process
The simulation process involved using information from the feedlot records to predict
the quantity of feed needed and the length of
time the animals would be on feed for various
in-weights and sex of cattle. An estimate of
the quantity of feed needed was necessary to
estimate feeding costs, and days on feed was
needed to estimate interest expense and the
date the cattle would be ready for slaughter.
Both of these items of information were
needed for implementing the hedging
strategies. The expected market weight of
each pen fed and the projected days on feed
were specified as functions of in-weight and
sex of the cattle, and the season of the year.
The function was estimated by applying least
squares regression to the historical feedlot
data.
The complete historical record on each
pen of cattle fed was available to the researchers, but the simulation procedure involved using only that part of the information
that was available at the time the pens of
cattle were placed on feed. Information on
total gain, date marketed out of the feedlot,
profit or loss, and other facts that are not
known until the cattle are marketed and the
pen is closed out was not used in the simulation process prior to the time the information
would be available. Information on these
items which were needed in the hedging
strategies were estimated in order to simu202
Western Journalof Agricultural Economics
late, as near as possible realistic conditions.
A simplified description of the sequential
steps of the simulation process is as follows:
1. Information was obtained on sex, average in-weight, date, and number of animals in the pen from the feedlot records
as each pen was placed on feed.
2. Total feedlot gain, feeding cost, interest
expense, and days on feed for each pen
were estimated using the regression
equations developed from the historical
data.
3. The date the animals would be ready
for market and the total market weight
of the pen were estimated.
4. The breakeven price for each of the
pens was estimated. Prices for corn and
alfalfa hay (f.o.b. the feedlot) prevailing
at the time the pen was placed on feed
were used to estimate the feeding costs.
This assumption was realistic since the
feedlot allows feeder customers to lock
in feed ingredient prices through prepayments.
5. Decisions on hedging were made according to the rules for each hedging
strategy (discussed in a subsequent part
of this article).
6. Actual information on feeding costs,
breakeven price, total feedlot gain, date
marketed and profit or loss for each pen
was obtained after the cattle were marketed and -the pen closeout records
were prepared.
7. Profits or losses from the futures transactions for each pen were tabulated.
8. The cash market and futures market
profits or losses were summed across all
pens for each hedging strategy.
The first pen used in the simulation
process was placed on feed June 1, 1971 and
the last pen of cattle was placed in feed
January 3, 1977.
Hedging Strategies
Six hedging strategies were tested (table
1). Strategy 1 was a simple "no hedge" while
Gorman, Schuneman, Catlett, Urquhart and Southward
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December 1982
strategy 2 was a "routine hedge" such that
each pen of cattle was hedged at the beginning of the feeding period and the hedge
held until the cattle were sold. These two
strategies were included as benchmarks or
reference points for other strategies.
Strategies 3-6 are a combination of profit
targets, moving averages, regression equations and selective profitability measures.
Strategy 3 uses the estimated breakeven cost
equations and profit targets. The estimated
breakeven cost of each pen was calculated
and compared to the localized futures price
and various profit targets ($1.50-3.00 per
hundredweight). If the various profit targets
were met, then the cattle were hedged and
the hedge retained until the cattle were sold;
otherwise the cattle remained unhedged.
Strategy 4 used both the 3 and 10 and 4 and
18 day moving averages in conjunction with
estimated breakeven costs and profit targets.
The strategy allowed for the hedge to be
lifted and placed several times during the
feeding period. A regression equation was
used for strategy 5 to calculate a tolerance
interval. The interval predicts where the
next day's futures price will be, within
specified limits, using the previous eight
days' prices. This strategy, like strategy 4,
allowed for hedges to be lifted and placed
during the feeding period. The last strategy,
strategy 6, was designed to allow for not
placing cattle on feed if the profit target was
not met. If the profit target was met then the
cattle were placed on feed, hedged, and the
hedge kept throughout the feeding period.
Analysis of Results
The period studied was separated into two
phases, for analysis: the period from June 1,
1971 to August 13, 1973 when prices were
generally increasing, and from August 14,
1973 to January 3, 1977 when there were
large fluctuations in cash market prices along
with a slight downward trend in overall
prices.
All 747 pens of cattle were used to test
strategies 1 through 5 and 242 pens were
used for strategy 6. Because of the difference
204
Western Journalof Agricultural Economics
in concept and resulting number of pens in
the analysis, results of strategy 6 are discussed separately and are not reported in the
tables with the other strategies.
Strategy 1 -
No-Hedge
The average cash market loss was - $24.50
per head over the 6.5 years (Table 2). Not all
the pens lost money; feeding was profitable
with approximately a third of them. Feeding
steers gave higher frequencies of large profits
and large losses, but the mean loss per head
was only slightly greater for steers (- $25.10)
than for heifers (-$23.60). The mean loss
was higher with steer pens than with heifer
pens during the period when live cattle cash
market prices were fluctuating or decreasing
(Table 3). During the period of increasing
prices steer pens yielded a smaller average
loss than heifer pens, -$11.70 per head for
steers and -$26.60 per head for heifers.
Strategy 2 -
Routine Hedge
The routine hedge would have yielded a
mean futures market profit of $4.30 per head
for the entire time (Table 2). This offset 18
percent of the - $24.50 per head average loss
in the cash market and reduced the combined loss to -$21.20 per head. Slightly
more than 50 percent of the pens of cattle
would have been hedged profitably, but not
profitably enough to offset the unprofitable
hedges and losses in the cash market. Hedging the 433 pens of steers would have resulted in an average loss of $1.40 per head in the
futures market; where as hedging the 314
pens of heifers would have yielded an average profit of $12.20 per head in the futures
market.
Strategy 3 -
Selective Hedge
The selective hedge with a $3 profit target
would have yielded a mean futures market
profit of $11.50 per head but this was not
sufficient to offset the average cash market
loss of -$24.50 per head.
This strategy, however, would have reduced the cash loss by almost 50 percent, for
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Hedging Fat Cattle
Gorman, Schuneman, Catlett, Urquhart and Southward
During the increasing price phase,
Strategy 4 would have yielded an average
futures market profit of $15.80 per head.
Because the steer pens in that time experienced a relatively small mean cash market
loss, - 11.70 per head, a mean profit of $3.30
per head would have resulted.
For the decreasing price phase, approximately equal average futures market profits
would have resulted for both steers and heifers, $10.60 per head and $10.80 per head,
respectively. During this period, however,
the average cash market losses were much
greater for steers than for heifers.
a mean combined net loss of -$13.00 per
head fed. Over two-thirds of the pens would
have been hedged sometime during the feeding period with selective hedging (Table 4).
On the average, hedging with this strategy
would have been profitable (futures market
only) for both steers and heifers, and also for
both the increasing and decreasing price
phases of the cattle cycle.
Strategy 4 -
Moving Averages
Strategy 4 (with the $5 and $3 futures
profit limits for lifting the hedge) would have
resulted in the highest average futures market profit of all the strategies tested, $12.30
per head (Table 2). The average combined
loss would have been -$12.20 per head
(Table 3). Fifty-eight percent of the pens fed
were hedged with 59 percent of the hedges
being profitable (Table 5).
Strategy 5 -
Tolerance Intervals
The tolerance interval strategy was not as
accurate a predictor of price trends in the
futures market as was the moving average
technique. A mean futures market profit of
TABLE 4. Number of Roundturns for Individual Pens of Cattle for Specified Hedging
Strategies.a
Strategy
1 No Hedge
2 Routine Hedge
3 Selective Hedge
4 Moving Averages
5 Tolerance Intervals
Profit Target
Limits
($/cwt.)
0
1
2
3
4
---
747
0
NA
747
NA
NA
NA
NA
NA
NA
3
5 and 3
5 and 3
217
313
262
530
429
269
NA
5
163
NA
0
38
NA
0
15
Number of Roundturns
aA roundturn is defined as selling a futures contract and subsequently buying an offsetting contract.
TABLE 5. Frequency of Pens Traded (Hedged) Versus Profitable Trades for Specified Hedging Strategies.
Strategy
Profit Target
Limits
----- $/cwt.) -----
1 No-Hedge
2 Routine Hedge
3 Selective Hedge
4 Moving Averages
5 Tolerance Intervals
Pens
Tradeda
Profitable
Tradesb
------------------(percent) -------------------
---
0
100
0
56
3.00
5.00 and 3.00
5.00 and 3.00
71
58
65
57
59
64
aPens traded in the futures market as a percent of all pens fed.
bProfitable trades in the futures as a percent of pens traded.
207
Western Journalof Agricultural Economics
December 1982
$7.20 per head for the tolerance interval
strategy would have reduced the mean cash
loss by 30 percent to - $17.30 per head. This
strategy was not successful during the increasing price phase of the cattle cycle resulting in an average loss in the futures market of
-$1.40 per head. The decreasing price
phase produced a mean futures market profit
of $11.20 per head.
Strategy 6 - Investor-Feeder Strategy
Only 242 of the possible pens of cattle met
the strategy conditions and hence would
have been placed on feed and hedged with
this strategy. An average futures market profit of $18.10 per head would have resulted on
the 242 pens. This profit in the futures would
have offset the average cash market loss of
- $4.81 per head to produce an average combined (cash and futures market) profit of
$13.25 per head over the period.
Although this strategy was profitable for an
investor-feeder, it was not as profitable as it
appeared at the time the 242 pens were
placed on feed. If a perfect hedge had been
realized each time, the investor-feeder
would have made a combined cash and futures market profit of approximately $3 per
hundredweight, corresponding to his profit
target, or about $27 to $30 per head, depending upon the market weight of the cattle.
Average profit would actually have been only
approximately half of the amount estimated,
indicating that there were problems.
The cause of the lower profits was one or a
combination of the following factors: 1) accuracy of estimating breakeven costs; 2)
changes occurred in the basis during the
feeding period (local and futures prices); 3)
the gross weight of cattle marketed was not
equal to the gross weight of the futures contract (error in estimating total gains); 4) the
cash market prices and the futures market
prices (adjusted for location bases) did not
coincide when the cattle were marketed; or
5) a combination of the above.
208
Remarks
On the average, feeding cattle in the study
feedlot was not profitable during the 6.5
years studied. The average cash market loss
was -$24.50 per head. A carefully chosen
hedging strategy, however, could have reduced the average loss on the 747 pens studied by nearly 50 percent. Because both cash
and futures market profits varied greatly over
time and by sex of animal fed, certain hedging strategies proved highly profitable under
particular circumstances. But none of the
strategies designed for the operator interested in keeping his feedlot full would have
resulted in an average futures market profit
greater than the average cash market loss.
The investor-feeder could have profitably fed
cattle so long as he fed only those pens that
could be profitably hedged in the futures
market when they were placed on feed, at a
price of at least $3 above estimated breakeven costs.
These results compare favorably with other studies. Menzie and Archer concluded in
their study that not all pens of cattle should
necessarily be hedged and that feeding and
hedging only when "projected returns" exceeded estimated costs of feeding involves
almost no risk at all. These results verified
that not all pens of cattle should be necessarily hedged but showed that some risk remained even when estimated breakeven
costs techniques were used. This study reinforces Purcell's finding that moving average
strategies consistently produce superior results over other strategies and that some
selective hedging program is needed in lieu
of either a "no hedge" or "routine hedge"
program.
The period of the study was characterized
by wide fluctuations in prices for cattle and
feed grains. In addition, the study period
included only part of a cattle price cycle. A
longer period might produce different results.
Gorman, Schuneman, Catlett, Urquhart and Southward
References
Gorman, William D. et al. Evaluation of Selected Hedging Strategies for Cattle Feeders. New Mexico State
University Agricultural Experiment Station Research
Report 396, November 1979.
Heifner, Richard G. Hedging Potentialin Grain Storage
and Livestock Feeding. Washington, D.C.: U.S. Department of Agriculture, Agricultural Economics Report No. 238, January 1973.
Leuthold, Raymond, "Price Performance on Futures
Market of a Non-Storable Commodity: Live Beef Cattle." American Journal of Agricultural Economics,
56(1974):271-79.
Hedging Fat Cattle
Menzie, Elmer L. and Thomas F. Archer. Hedging as a
Marketing Tool for Western Cattle Feeders. The University of Arizona Agricultural Experiment Station
Technical Bulletin No. 203, May 1973.
Price, Robert V. "The Effects of Traditional and
Managed Hedging Strategies for Cattle Feeders." Unpublished M.S. thesis, Department of Agricultural
Economics, Kansas State University, 1976.
Purcell, Wayne D. "Effective Hedging of Live Cattle."
Commodities. July 1977.
Purcell, Wayne D. and D. Riffe. "The Impact of Selected Hedging on the Cash Flow Position of Cattle
Feeders." Southern JournalAgricultural Economics,
12(1980):85-94.
McCoy, John H. and Robert V. Price. Cattle Hedging
Strategies. Kansas State University Agricultural Experiment Station Bulletin No. 591, August 1975.
209
December 1982
210
Western Journal of Agricultural Economics