Impact of Cash Settlement and Market Fundamentals on Feeder Cattle Basis

Abstract

With volatile cattle markets, comes substantial amounts of price risk for all parties involved in the industry. Hedging with futures markets to mitigate risk is a common practice performed by commercial producers. For this to be an effective risk management tool, the futures contract must function correctly by accurately representing the price and quality of the underlying product. Often times, commodity futures contracts are settled by physical delivery. However, two livestock contracts transitioned to a cash settled index, feeder cattle in 1986 and lean hogs in 1997, to enhance the performance of the contract and promote participation by commercial users. Eliminating high delivery costs, reducing any issues with the grading process when the product is delivered, and portraying a truer commercial value, are some of the benefits of a cash settlement index. There has been some speculation that dates back to the 1980’s regarding whether the live cattle futures contract should switch to cash settlement rather than physical delivery. This study was done to measure the impact the change to cash settlement had on the hedging ability of the feeder cattle futures contract. Even though the feeder cattle contract represents a different sector of the industry, the results still provide some insight as to whether cash settlement can be advantageous for a futures contract. The ability to forecast basis is critical when hedging with futures to manage risk. The magnitude of basis prediction error (BPE), or the difference between expected basis and actual basis, is a common method used to measure the hedging ability of a futures contract. This procedure was utilized to analyze the effects the change to cash settlement had on BPE in six different regions: Kansas, Missouri, Nebraska, North/South Dakota, Oklahoma, and Texas. Expected basis was calculated using a two, three, and four year historical average technique for each respective week to contract expiration. Other market factors were also included in the models to ensure the cash settlement adjustment was not the sole reason for BPE variations over time. To estimate the impact the different elements have on basis predictability, Ordinary Least Squares regression was used for each of the three stacked models. For the two-year historical basis prediction error model, Kansas was the only area with a statistically significant value indicating cash settlement reduced BPE by $0.18. Three states, Kansas (-$0.24/cwt.), Missouri (-$0.17/cwt.), and Texas (-$0.16/cwt.), showed a statistically significant decrease in BPE due to cash settlement for the three-year historical basis prediction error model. Also, the coefficient for Oklahoma was just slightly above the statistically significant level. However, the four-year model had moderately different results. The estimate for Kansas was statistically significant at -$0.18/cwt. meaning cash settlement reduced BPE, while the Dakotas region actually showed a statistically significant increase in BPE by $0.18/cwt. This research provides evidence that cash settlement can improve the basis predictability of a futures contract depending on the region and technique used to calculate expected basis.