Profit Margin Hedging

Some extension economists and others often recommend profit margin hedging in choosing thetiming of crop sales. This paper determines producer’s utility function and price processeswhere profit margin hedging is optimal. Profit margin hedging is shown to be an optimalstrategy under a highly restricted target utility function even in an efficient market. Althoughprofit margin hedging is not the optimal rule in the presence of mean reversion, it can still beprofitable if prices are mean reverting. Simulations are also conducted to compare the expectedutility of profit margin hedging strategy with the expected utility of other strategy such as alwayshedging and selling at harvest strategies. A variance ratio test is conducted to test for theexistence of mean reversion in agricultural futures prices process. The simulation results showthat the expected utility of profit margin hedging strategy is highest. The paired difference testsfor the profit margin hedging and other two strategies shows that the expected utilities of profitmargin hedging strategies are not significantly different from those of always hedging strategy,but are significantly different from those of selling at harvest strategy except when thetransaction cost is considered. The results of variance ratio test indicate that there is littleevidence that futures price of wheat follows mean reverting process.