the LDP drops out of the hedging decision. No more direct price protection is available in
government programs at this point.
From Figure 9, the pattern for target price variation is different than for the loan rate.
From $0 to $2.86, hedge ratios decrease at an increasing rate as more price protection from
government programs becomes available, implying an increasing substitution effect of LDP for
hedging. When the loan rate is $0, hedging is the only way to reduce price risk and the optimal
hedge ratio for each year reaches the highest possible level of around 0.78. This maximum level
is determined by the correlation between the cash and futures prices as well as the transaction
cost level. Also as the loan rate increases, hedge ratios for the later years drop faster than those
for the earlier years. Again, this is because early resolution of risk is preferred to late resolution.
From $2.86 to $3.92, the impact of the CCP’s target price enters the hedging decisions
but takes effect step by step. From a target price level of $2.86 to almost $3.52, the CCP does not
impact hedging. The hedge ratios essentially remain at the same level. This is from the impact of
the $0.52 direct payment (PD)11. Starting from $3.52, the target price begins to exceed the
threshold. Hedge ratios drop rapidly until finally reaching 0.30~0.42, indicating an increasing
influence from CCP on the risk management decisions and a greater substitution of CCP for
hedging.
In summary, optimal hedging is sensitive to variations in the LDP loan rate and the CCP
target price. Results indicate a strong substitution effect from the government LDP and CCP for
hedging in terms of price risk protection. The impacts appear somewhat stronger in the later
years than in the early years.
11 As defined early, CCP takes effect after a “trigger price” is reached, i.e. CCPt = 0.85 × 0.935 × Et-1(Yt)
× max[0, PT- PD - max(Pt ,LR)] therefore CCP > 0 only if PT- (PD + max(Pt ,LR)) > 0. When PT is greater
than LR but (PT - max(Pt ,LR)) less than PD of $0.52, CCP always yields a zero value. So there is no
income improvement to the farmer.
26
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