here is little disagreement in the literature that hedging can be an effective T risk management tool for agricultural firms. However, when placing a hedge the hedger must determine the futures position to take to offset the price risk on his current or anticipated cash position. When direct hedges are placed (e.g., corn cash position hedged in corn futures) the hedged quantity to cash quantity ratio, or hedge ratio, is often assumed to be 1. However, in instances involving cross hedging (hedging a cash commodity in a different but related futures market) the hedge ratio may deviate significantly from 1 because the prices of the two commodities may not change 1 for 1. Therefore, the hedge ratio should be empirically estimated. Disagreement arises on the best procedure to estimate minimum risk hedge ratios; namely, whether to use cash and futures price levels, price changes, or percentage price changes in the estimation process.' *No senior authorship is assigned. We have benefitted from the suggestions of D. Starleaf, R. Dahlgran, D. DiPietre, two anonymous JFM reviewers, and NCR-134 Conference participants. Errors remain the responsibility of the authors. Journal Paper No. J-12184 of the Iowa Agriculture and Home Economics Experiment Station, Ames, Iowa. Project No. 2740.
'The variability in cash and futures prices may not be identical and therefore the optimal hedge ratio is not always represented by a unit-for-unit hedge (hedge ratio of 1) between cash and futures. This is particularly true when cross hedging is considered because the cash and futures prices are for different commodities, with different price levels and variabilities. The minimum risk hedge ratio thus represents the futures position for a given cash position in order to minimize the risks associated with unequal price changes in the cash and futures markets during the duration of the hedge (basis risk).