Marin BozicUniversity of Minnesota – Twin Cities

Guest Lectures for Cornell University - AEM3040

Dairy Risk Management

What is a futures contract?

Futures contract is a promise to do a certain deed at a specified time. If you sell corn futures contract, you have promised to deliver 5,000 bushels of corn to one of several delivery locations specified in the contract.

YOU EXCHANGE

5000 bushels of corn

Futures price at contracted time

Taking a Position

• Selling a futures contract means promising you will sell a good specified in the contract at contract maturity. That is called a short position, due to the fact that at the time you promise to sell the commodity, you do not already own it, you are short. • Buying a futures contract means promising you will

buy a good specified in the contract at contract maturity. That is called a long position.

Dairy Futures and Options

1. Class III Futures2. Class IV Futures3. Nonfat Dry Milk Futures4. Dry Whey Futures5. Butter Futures6. Cheese Futures

What is Exchanged in a Futures Contract?

Dairy futures contracts can be thought of as exchange of financial streams. For example, if you sell Class III milk futures…

YOU EXCHANGE

You pay AnnouncedClass III Milk Price

You receive Class III Milk Futures Price, as it was on the

date Futures Contract was Sold

On April 1, 2013Class III Milk Futures was

$18.82

Risk-Reward Diagram: Short Futures Position

8.509.50

10.5011.50

12.5013.50

14.5015.50

16.5017.50

18.5019.50

20.5021.50

22.5023.50

-$10.00-$8.00-$6.00-$4.00-$2.00$0.00$2.00$4.00$6.00$8.00

10/13/2008:Feb 2009 Class III Milk Futures:

$15.31

Feb '09 Class III Milk Price

Profi

t fro

m a

sho

rt fu

ture

s po

sitio

n

Class III Milk Futures

Dairy Futures and Options

Minnesota mailbox milk price was on average $1.36 higher than Class III Milk Price over 2001-2013 period.

$8.50 $13.50 $18.50 $23.50$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

R² = 0.970430284693412

Class III Price

Min

neso

ta M

ailb

ox P

rice

Basis

Basis = Cash – Nearby Futures

… in grain markets: cash corn bid at local elevator minus CME futures corn price

… in milk markets: mailbox milk price minus nearby milk futures price

Hedging ExampleOctober 13, 2008Sell 1 Feb ’09 Class III milk

contract @ $15.31/cwtExpected milk check basis + $2.40 / cwtExpected net selling price in

February 2009:

$15.31 + $1.36

$16.67

futures priceexpected basis

expected price

What Happened after you hedged?

Economic downturn accelerated in autumn of 2008.

USDA Announced February 2009 Class III milk price was 9.31

Average February 2009, mailbox price for Minnesota was 11.82, or 5.89 below what was expected in early October 2008.

Hedging ExampleOctober 13, 2008 February 27, 2009Sell Feb ’09 Class III milk

contract @ $15.31/cwtAnnounced Class III milk Price

@ $9.31/cwtExpected milk check basis + $1.36 / cwt

Feb Milk Check @ $11.82/cwtRealized basis is +$2.51/cwt

Expected net selling price in February 2009:

Realized net price in February:

$15.31 + $1.36

$16.67

futures priceexpected basis

expected price

$11.82+ $6.00

$17.82

cash salefutures change(sold at $15.31, bought at $9.31)

realized price

Risk-Reward Diagram: Unhedged Production

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

10/13/2008:Feb 2009 Class III Futures: $15.31Expected MN

Mailbox Price for 09/2009: $16.67

MN Mailbox Milk Price for Feb 2009

Announced Feb '09 Class III Price

Expe

cted

MN

Mai

lbox

Milk

Pric

e

Risk-Reward Diagram: Unhedged Production

NY Mailbox Milk Price Depends on More than Class III

August 2011 Utilization in FMMO 1

Predicting NY Mailbox Milk Price

Jan-05

Aug-05

Mar-06Oct-

06

May-07

Dec-07Jul-0

8

Feb-09

Sep-09

Apr-10

Nov-10Jun-11

Jan-12

Aug-12

Mar-13Oct-

13$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

Predicted NY Mailbox

Forecasting NY Mailbox Milk Price

Advanced Class III, IV Prices

Announced Class III, IV Prices

Max (July Class III Milk Futures, July Class IV Milk Futures)

August Class III Milk Futures, August Class IV Milk Futures

August 2011 Utilization in FMMO 1

Hedging August 2011 NY Mailbox Milk PriceApril 1, 2011 September 2, 2011Sell Jul’11 Class III milk

contract @ $17.32/cwt July Class III milk contract @

$21.39/cwtExpected Mailbox Milk Price $20.56/ cwt

Expected Basis over Class III Milk: $3.24/cwt

Aug Milk Check @ $21.92/cwtRealized basis is +$0.53/cwt Realized net price in August:

$21.92- $4.07

$17.85

cash salefutures change(sold at $17.32, bought at $21.39)

realized price

Minnesota Mailbox Milk Price – Class III Milk Price

Jan-05

Aug-05

Mar-06Oct-

06

May-07

Dec-07Jul-0

8

Feb-09

Sep-09

Apr-10

Nov-10Jun-11

Jan-12

Aug-12

Mar-13Oct-

13-$2.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

MN

Mai

lbox

Min

us

Anno

unce

d Cl

ass I

II M

ilk P

rice

Average: $1.42 Standard Deviation: $0.62

New York Mailbox Milk Price – Class III Milk Price

Jan-05

Aug-05

Mar-06Oct-

06

May-07

Dec-07Jul-0

8

Feb-09

Sep-09

Apr-10

Nov-10Jun-11

Jan-12

Aug-12

Mar-13Oct-

13-$2.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

NY

Mai

lbox

Min

us A

nnou

nced

Cl

ass I

II M

ilk P

rice

Average: $1.40 Standard Deviation: $0.99

Hedge with a basket of Class III and Class IV contracts

Average: $1.68 Standard Deviation: $0.32

Jan-05

Sep-05

May-06

Jan-07

Sep-07

May-08

Jan-09

Sep-09

May-10

Jan-11

Sep-11

May-12

Jan-13

Sep-13

-$2.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

NY

Mai

lbox

Min

us A

vera

ge o

f An

noun

ced

Clas

s III

and

Clas

s IV

Milk

Pric

es fo

r Prio

r Mon

th

Hedging August 2011 NY Mailbox Milk PriceApril 1, 2011 September 2, 2011Sell 1 Jul’11 Class III milk

contract @ $17.32/cwtSell 1 Jul’11 Class IV milk

contract @ $19.69/cwt

Announced July Class III milk @ $21.39/cwt

Announced July Class IV milk contract

@ $20.33/cwt

Expected Mailbox Milk Price $20.56/ cwt

Aug Milk Check @ $21.92/cwt

$21.92- $2.35

$19.57

cash salefutures change

realized price

Hedging February 2009 NY Mailbox Milk PriceOctober 13, 2008 February 27, 2009Sell Jan’09 Class III milk

contract @ $15.27/cwtSell Jan’09 Class IV milk

contract @ $13.00/cwt

Announced Jan Class III milk contract @ $10.78/cwt

Announced Jan Class IV milk contract

@ $9.59/cwt

Expected Feb ’09 Mailbox Milk Price

$16.16/ cwt

Feb Milk Check @ $11.72/cwt

$11.72+ $3.95

$15.29

cash salefutures change (gain on Class III: $4.49, gain on class IV: $3.41)

realized price

Hedging with Futures: Summary

By selling futures contracts, you reduce your milk price risk. Ideally, gains on the hedging account will just compensate for the decline in mailbox milk price.

Basis risk is the risk that losses on the hedging account will not be compensated for by a proportional increase in cash prices. Basis risk can be reduced by a proper choice of futures contracts used to hedge, but can never be fully eliminated.

If basis risk is much smaller than price risk, then hedging makes sense, even if it is “noisy” from time to time.