SOUTHERN JOURNAL OF AGRICULTURAL ECONOMICS DECEMBER, 1973 LOCATION BASIS VARIABILITY EFFECTS ON SLAUGHTER CATTLE HEDGING IN THE SOUTH AND SOUTHERN PLAINS*

Location basis variability is a matter of potential concern to livestock producers who contemplate the use of livestock futures contracts as hedging devices and who are removed from a designated futures contract delivery point. Recent attention has been given this problem by Heifner [3] in an analysis of minimum-risk hedging ratios for cattle and hogs, among other commodities, in which measures of risk-shifting effectiveness were generated for comparison among locations. Heifner found no significant differences among locations for either cattle or hogs, indicating that location basis variability is not a significant factor for these commodities. Using a somewhat different approach, and a different set of markets and time frame, the author [1] came to the same conclusion for slaughter hogs in the South. Results obtained for slaughter cattle, however, are somewhat at variance with the findings reported by Heifner. These results and their interpretation are the subject of this paper. The concept of location basis variability is fairly straight-forward. Location basis is the price differential between a local cash market and a futures contract delivery point. Basis variability results from fluctuations in this differential. Hedgers who have access to the delivery market tend to be insulated from its effect by the delivery option and the consequent tendency for cash and futures prices to converge as futures contracts mature. For hedgers in distant markets, however, delivery is not a practical option, so that any difference between the price differential expected at the placement of a hedge and the actual differential experienced upon lifting it causes a deviation in results from those anticipated. Thus, location basis variability can add an increment of risk for the distant hedger, reducing the effectiveness of hedging as a risk-averting device. Location basis variability is not theoretically inherent in the situation of a distant hedger but depends rather on the nature of spatial competition. In perfectly competitive spatial markets, price change will be reflected simultaneously across the spatial price surface, leaving differentials along the surface unchanged. These differentials reflect spatial patterns of supply and demand and transfer and exchange costs. In theory, they change only as these underlying factors change. In the real world, however, leads and lags in price change can occur, and some markets may be isolated from minor price fluctuations that occur in others. In a broad national market such as exists for beef cattle, price differentials tend to be maintained over time, but this does not exclude the possibility of temporary fluctuations which could cause location basis variability to occur. The existence and magnitude of location basis variability is, therefore, an empirical question. While there are a number of ways to measure location basis variability, the method adopted in this study was a direct comparison of hedging revenue variances. If it can be shown that price variances among markets are • not significantly different from one another, then differences in hedging revenue variances between a delivery point market and distant markets can be ascribed to location-related factors. To anticipate a bit, no significant differences in cash market price variances for choice steers were found among the markets studied,but significant differences in hedging revenue variances were found.