Time-varying hedge ratios: A principal-agent approach

We use the classic agency model to derive a time-varying optimal hedge ratio for low-frequency time-series data: the type of data used by crop farmers when deciding about production and about their hedging strategy. Rooted it? the classic agency framework, the proposed hedge ratio reflects the context of both the crop farmer's decision and the crop farmer's contractual relationships in the marketing channel. An empirical illustration of the Dutch ware potato sector and its futures market in Amsterdam over the period 1971-2003 reveals that the time-varying optimal hedge ratio decreased from 0.34 in 1971 to 0.24 in 2003. The hedging effectiveness, according to this ratio, is 39%. These estimates conform better with farmers' interest in using futures contracts for hedging purposes than the much higher estimates obtained when price risk minimisation is the only objective considered.