Hedging strategy for ethanol processing with copula distributions

- Ethanol producer's input and output hedging strategies were evaluated.
- Model evaluates ethanol producers' margins and risk.
- Optimal hedge ratios were estimated for three alternative strategies including traditional hedge, linear dependence, and copula dependence.
- Utility, margins, risk, and hedge ratios varied by strategy and type of dependence.

It has become important for ethanol producers to hedge input and output price risks. The purpose of this paper is to analyze an ethanol-producing firm's strategy to reduce price risks for inputs and outputs. Corn is the primary input, and the outputs are ethanol, corn oil, distillers' dried grains (DDGs), and renewable identification numbers (RINs). A theoretical model is developed including margins and risk is measured using value at risk (VaR). An empirical model is developed and extended to VaR using copulas to analyze the marginal distribution and dependence structure for input and output prices on margins. Efficient frontier curves analyzing VaR with and without copula are discussed. The results compare varying risk-strategy measures for long corn, short corn, and combining short and long corn. Sensitivity analyses are conducted for functional changes in the margin as a result of ethanol price changes.