Hedgers located far from organized commodity exchanges undergo a mismatch between their local prices and exchange prices.

Hedgers located far from organized commodity exchanges undergo a mismatch between their local prices and exchange prices. what is yet to bes and options traded on the exchange may still be valuable to distant hedgers, if it be not that only to the extent that basis risk is small. Forward contracting allows hedgers to manage risk using a local delivery price, further the Commodity Futures Trading Commission has lengthy banned the sale of off-exchange options, limiting the opportunities available to hedgers. lately agricultural trade options (ATOs) have been introduced as over-the-counter option produces designed specifically for hedgers. To date, ATOs have lay the foundation of little interest from potential venders but the potential demand for these options may be substantial. This consideration develops a methodology for measuring the potential value of ATOs. It describes and quantifies the demand for corn ATOs by dint of dairy farms in Pennsylvania and estimates the value these farms might place onward ATO contracts offered locally.

Key Words: agricultural trade options, dairy farms, to comes hedging, options, risk management

Future options, and forward contracts are traditional risk management tools for controlling price risk in agriculture. coming times eliminate upside and downside risk simultaneously, while options eliminate downside risk without eliminating upside potential, in exchange for a premium paid in advance. to comes and options are highly liquid if it were not that are traded only on organized exchanges, resulting in basis risk. Distant hedgers face especially significant basis risk that dissuades them from using subsequent times and options to hedge. Forward contracts can be tailored to local conditions, still their liquidity is typically reasonable or nonexistent. Hedgers must prefer among these three risk management instruments or "goods" with different combinations of attributes: liquidity, upside potential, and basis risk.

If it were possible to provide hedgers with another alternative, their welfare might be increased. united such alternative is agricultural trade options (ATOs). ATOs are a risk management tool with the upside potential of exchange-traded options however with little or no basis risk. The end is to combine the positive aspects of options and forward contracts into a fresh product for hedgers.

For many years, the Commodity comings Trading Commission (CFTC) has banned off-exchange contracts that involve option-like payoffs. The potential for fraud and misuse has appear to beed too great to allow option-like contracts to be traded outside of the heavily regulated exchanges. merely recently has serious pressure been mounting to deregulate and allow agricultural trade options contracts to be sold to agricultural farmers and agribusinesses. Their notable proponent have included U Senator Pat Roberts of Kansas (Associated Pres 1998) U Senator Richard Lugar of Indiana, then-Treasury Secretary Lawrence Summer and Federal except Bank Chairman Alan Greenspan (Associated Pres 2000)

ATOs are option contracts sold by means of licensed merchants, such as banks and grain elevators, to hedgers who negotiate bourns directly with the merchant. ATOs provide the upside potential of options contracts without significant basis risk. Another advantage of ATOs is that they do not mandate fixed contract sizes, in the same manner small farms and businesses can tailor ATOs to their individual needs

ATOs have been available (in theory) since the CFTC began a three-year pilot program in June 1998 unless the number of merchants licensed to trade them has been negligible. individual possible reason for the dearth of merchants is that ATOs are still highly regulated. Capitalization requirements and other regulatory requirements have been dropp or substantially reduc in late months to help promote the use of ATOs. influence to deregulate ATOs further has comeed in a continuing series of revisions to the program since its inception.

It is not at the same time clear what the eventual answer will be to deregulating ATOs, if it be not that the tools exist for a serious analysis of the potential benefits from doing for a like reason The literature on transaction expenses faced by hedgers is relatively recent Hirshleifer (1988) showed that transaction splendors drive hedgers from the market. Simaan (1993) and Lence (1995 1996) lay the foundation of opportunity costs reduce optimal hedge ratios.

Frechette (2000) treated marginal transaction require to be paid [i]or[/i] undergones as prices in a demand regularity where the hedging products are treated as uprights He developed a methodology for computing the potential value of hedging opportunities using coming eventss and forward contracts. In a related contemplation Frechette (2001) incorporated options using Lapan, Moschini, and Hanson's (1991) framework. The contribution of the at hand article is to extend this novel methodology to a four-good scheme and assess the potential value of ATOs. The application is corn purchased on Pennsylvania dairy farms for cattle feed

Pennsylvania dairy farms depict an especially interesting set of hedgers for consideration because they experience significant basis risk. Pennsylvania dairy farms are far enough east of Chicago and the large corn-producing states that the price they pay for corn to fe their cattle is frequently very different from the price at the Chicago Board of Trade. For example, during the 1997-98 studious mood period examined here, the weekly average price of corn in Western Pennsylvania was 240 higher by bushel than the corresponding nearby Chicago what may occur hereafters price. The prices move differently, thus the effectiveness of a hedge using subsequent times and options on the Chicago Board of Trade is limited-e.g., the correlation coefficient between the Western Pennsylvania weekly corn price and the corresponding weekly Chicago coming eventss price is only 0.31.