Hedging salmon price risk

ABSTRACT

Salmon price is highly volatile and hard to predict, which obscures planning decisions and raises financing costs for market participants. This study considers hedging the spot price uncertainty with salmon futures contracts. It uses a new framework of hedging under square loss, consisting of a new objective function, an optimal hedge ratio and a measure of hedging effectiveness. The new framework aims at minimizing the expected squared forecast error. It generalizes the classical minimum variance hedging as it relaxes the assumption of known expected prices. The salmon futures contracts deliver satisfactory hedging performance, albeit constrained by low liquidity. Therefore, I suggest holding the contract through maturity rather than closing the futures and the spot positions simultaneously. This strategy alleviates the liquidity issue and saves transaction costs. All things considered, hedging with salmon futures is a moderately effective way of handling the salmon price uncertainty.

KEYWORDS:

• Futures
• hedging
• risk
• salmon price
• square loss
• uncertainty

Acknowledgments

I thank Luca Barbaglia, Marius Bausys, Mindaugas Bloznelis, Arnar Mar Buason, Aytac Erdemir, Ole Gjølberg, Ronald Huisman, Jonas Lisauskas, Thilo Meyer-Brandis, Erik Smith-Meyer and members of the Norwegian Center for Commodity Market Analysis for valuable discussions and feedback. Comments by journal editors and anonymous referees also helped improve the manuscript considerably. All remaining errors are mine.

Notes

Fish price volatility in general is also of policymakers’ concern (Dahl & Oglend, 2014).

This section is available in greater detail in Supplemental Material. Also, see Bloznelis (2017a) for a dedicated theoretical work on hedging under square loss with applications in commodity markets.

In this work, the notion of uncertainty is different from the notion of risk. Risk arises when the price generating mechanism is known but is stochastic, such as a roulette or a dice throw. Meanwhile, uncertainty refers to situations where the mechanism is unknown, regardless of whether it is deterministic or stochastic. (However, the term risk will appear in fixed expressions such as price risk, risk reduction, and risk management).

The salmon futures contracts are traded not only until the end of the underlying month (in this case, January) but also for up to two additional weeks (in this case, until the second week of February).

I am not aware of previous studies mentioning the M strategy, thus the design of the strategy might be a new contribution to the hedging literature.

See Bloznelis (2016a) for results from alternative specifications of the conditional mean and variance models, and performance comparisons across different models and weight classes of salmon.

A detailed theoretical comparison of RRESFE and RRMSFE with RRV is available in supplemental material and in Bloznelis (2017a).