Fed Cattle Basis Risk under Grid Pricing

Abstract

Hedging risk in fed cattle markets has become increasingly important as producers face elevated price volatility and market uncertainty. This challenge is particularly pronounced for producers marketing cattle using grid pricing systems, which reward or penalize producers based on carcass attributes such as yield grade, quality grade, and carcass weight. Grid pricing has expanded rapidly over the last decade to represent about 70% of fed cattle marketings. Despite its prominence, little is known about how basis risk changes when cattle are priced using grids instead of traditional live or dressed pricing. With more variable factors impacting realized net price, we expect basis risk increases when cattle are sold on a grid. While grid pricing offers opportunities to capture premiums for higher-quality cattle, it also exposes producers to downside risk due to discounts applied to cattle that do not meet desired specifications. Managing this dual exposure to both price and quality-related premium/discount risks requires quantifying the price risk managed through traditional live or dressed price hedging. It also involves understanding the risk that remains due to varying cattle quality and associated grid component value variation. Results will inform producers using grid pricing of unhedgeable risk using traditional price risk management tools of futures and Livestock Risk Protection. Depending on the magnitude of elevated price risk, additional price risk management instruments might be warranted to manage price risk more effectively. For example, developing a Choice-Select spread or other price risk management market may be valuable. The objectives of this thesis are to quantify how fed cattle hedging risk has changed and to identify the main determinants of hedging risk for grid-priced fed cattle. A key measure is basis risk, the difference between the realized and predicted basis under various fed cattle valuation systems, and the uncertainty of cattle quality. Unique to this study is the adjustment of the predicted basis based on how cattle are priced and the expected quality distributions of cattle of varying quality and premiums/discounts, providing an essential contribution to better understanding contemporary fed cattle basis risk. Hedging risk changes as uncertainty on cattle quality and premiums and discounts are introduced: 1. We start by quantifying traditional weekly basis risk for cash-negotiated cattle over 20 years (2005-2024). This provides a baseline to illustrate historical trends and the evolution of basis risk. 2. Next, risk is quantified on a weekly basis for constant cattle quality (used broadly here to include quality grades, yield grades, carcass weights, etc.), letting premiums and discounts vary over time. Constant carcass quality distributions are averages based on more than 10,000 pens of packing plant grid carcass data obtained from commercial feedyards. This step enables us to determine how introducing varying premiums and discounts affects traditional hedging risk. 3. The analysis then incorporates quality and premium variability over time assuming producers have perfect foresight of quality of each pen hedged. To accomplish this analysis, a random pen of cattle is selected each week from the commercial feedyard data noted above. In this way, quality variation is introduced, but since it is assumed that the producer perfectly anticipates the quality of each pen, there is no quality uncertainty. This segment enables incremental measurement relative to the previous scenario of how introducing quality variation impacts hedging risk and premium/discount variation over time. 4. Finally, imperfect quality guesses are introduced by adding random errors to predicted quality distributions based on the above-referenced feedyard data. This segment enables incremental variation from above scenarios adding quality uncertainty. My approach highlights increasing complexity and variability in basis risk as grid pricing systems dominate the market. Understanding this complexity is critical for producers because it directly impacts the effectiveness of traditional risk management tools. Producers, policymakers, and market participants must recognize these dynamics to develop innovative tools and strategies that better address the unique risks posed by grid pricing. Price risk management in fed cattle markets is of greater importance than ever, with high price levels and elevated price risk. However, traditional hedging instruments are designed for hedging commodity cattle sold using negotiated cash prices. However, with grid pricing, valuing cattle based on carcass merit has become the dominant fed cattle valuation method, and the basis risk for cattle hedging is poorly understood. Traditional hedging instruments enable only base price protection but do nothing to manage varying premiums and discounts on uncertain cattle carcass quality. This study will demonstrate how basis risk changes as cattle are grid-priced and quantify the amount of price risk unhedged for grid-valued cattle. The study will also explain how much of this variation is due to premium/discount variation and uncertainty about varying cattle quality. The findings will provide critical insights for evolving price risk management tools for cattle producers and inform policymakers in designing LRP risk management programs. Depending on the extent of unhedgeable risk identified, new price risk management tools or institutions may be needed to mitigate the increasing price risk associated with grid pricing.