Managing Dairy Price Risk

1
Managing Dairy Price Risk
John J. VanSickle, Director International
Agricultural Trade Policy Center UF/IFAS
2
Important Clarification

• You do not have to alter any of your current
  marketing channels.
• You will market actual milk production the way
  you normally do.
• But, using futures contracts and/or put options,
  you can have a positive impact on the stability
  and level of income on your farm.

3
Outline

• I. Dairy Price Risk Management
• II. Futures Markets
• III. Milk Put Options
• IV. The Put Option Buying Strategy

4
I. Dairy Price Risk Management
. . . Essential for producers to remain
competitive

• What it is
• Why it is needed

5
Why Price Risk Management?
6
Florida Mailbox Prices, 1995 to present
7
What Price Risk Means to You
Between now and the time you sell your milk,
prices can go up, down or sideways
8
You Can Do Nothing
If you choose to do nothing then you are willing
to accept whatever price the market happens to
give you for your milk. This is speculating! OR
. . .
9
Or, You Can Take Action -- by Using Risk
Management
10
Summary I. Dairy Price Risk Management

• Price risk has increased in recent years.
• It can have a major impact on the financial
  well-being of a dairy operations.
• Tools and strategies have been established to
  manage price risk.
• Trading futures contracts and put options are
  simple strategies that offer many risk-reducing
  advantages.

11
II. Futures Markets
. . . A foundation for price risk management

• Futures markets provide the primary method of
  price discovery for many commodities, including
  milk. They establish the foundation for many
  price risk management strategies, including the
  use of options

12
(No Transcript)
13
Features ofFutures Contracts
14
Commodity Exchanges

• Are free and open marketplaces where buyers and
  sellers meet to trade futures and options
  contracts
• Set and enforce trading rules
• Ensure the financial integrity of the marketplace
• Are regulated by the Commodity Futures Trading
  Commission (CFTC), an agency of the federal
  government

15
Who Trades onCommodity Exchanges?
16
Milk Futures are Traded on The Chicago Mercantile
Exchange

• Common features
• Prices determined through open outcry.
• Quoted in dollars/cwt.
• Based on 3.5 butterfat
• Settlement in every calendar month
• Expiration one day prior to USDA Class III
  announcement.
• Cash-settled at expiration to announced Class III
  price (no need to worry about physical delivery)
• Futures converge at expiration to announced Class
  III price

• The ChicagoMercantile Exchange
• Milk 200,000 lb.

17
Milk Futures Price Example

• Note Milk futures contracts are traded for each
  month in the future. The only difference between
  contract months is the price and the date on
  which the contract is settled.

Closing price quotations from Chicago Mercantile
Exchange.
18
BASIS (also called Mailbox Differential)

• Relationship between your actual monthly mailbox
  milk price and the announced Class III price
• Different federal marketing orders have different
  basis
• Each producer needs to monitor his/her own basis
  and know what it has been historically
• Knowing the basis is important if you want to use
  futures and options effectively

19
Florida Basis Levels, 1995 to present
20
5 Easy Steps for Implementing the Strategy

• Step 1 -- Gather critical information.
• Step 2 -- Analyze possible hedging outcome.
• Step 3 Sell futures contract for price
  protection.
• Step 4 Offset futures contract position when
  cash milk is sold.
• Step 5 -- Evaluate results.

21
Example Jittery Joes Dairy Farm

• Date is May 25.
• Joe is considering what to do to protect revenues
  for December milk production

22
Step 1 Gather Critical Information

• Cost of Production
• Joe estimates this to be 17.00/cwt.
• Estimated Production
• Joe estimates this at 200,000 lbs. for December
• Basis (Mailbox Differential)
• Joe estimates this at 4.91/cwt.
• Current Futures Prices
• Joe gets information for December futures from
  his broker (see data)

23
Step 2 Evaluate Target Price for December
futures

Futures Price 12.15 Basis 4.91 Target Price
17.06
Compare target price against production costs of
17.00
24
Step 3Establish Price Protection

• Decide on quantity
• Joe decides on a single 200,000 lb. Contract.
• Places order with broker
• Joe sells December futures contract for
  12.15/cwt .
• Receive report from broker
• Maintain margin account with broker
• Joe posts 1000 margin account with broker to pay
  commissions and to insure the integrity of his
  trade

25
Step 4Collect Payment when Price Drops
26
Step 5Evaluate Results

• Compare estimate of basis to actual
• For Joe, actual basis was 5.00/cwt. compared
  with estimated 4.91/cwt.
• Use information in future price risk management
  decisions.

Net price after hedge
17.15 17.15
27
Summary II. Futures Markets

• Futures contracts make or take delivery (or the
  cash equivalent) for a commodity for some month
  in the future,
• Futures are traded on open, regulated exchanges,
  such as the CME,
• Different kinds of traders with different
  opinions and motivations trade futures,
• Milk futures are quoted by delivery month in
  /cwt.,
• A knowledge of the BASIS (Mailbox Differential)
  is needed to use milk futures in effectively
  managing price risk.

28
III. Milk Put Options
. . . A tool producers can use to manage
downside price risk
29
Options on Futures
30
For Producers, a Put Option is Like an Insurance
Policy
31
Insurance Comparison (Cont.)
32
Insurance Comparison (Cont.)
33
Features of Milk Options

• Traded through open outcry along side futures
  contracts
• Milk options expire on the same day as milk
  futures
• CME milk put option contracts
• 200,000 lb.

34
Milk Put Options

• Many put options at different prices called
  STRIKE PRICES are associated with each delivery
  month.
• Strike prices are established by the exchanges.
• Each put option (delivery and strike price) has a
  unique PREMIUM.

35
The Strike Price

• The price at which a put buyer has the right to
  sell milk futures.
• Are established by the exchanges at 0.25/cwt.
  intervals.
• If below the futures price, put strike prices
  are Out-of-the-Money.
• If above the futures price, put strike prices
  are In-the-Money.
• If closest to the futures price, put strike
  prices are At-the-Money.

36
The Premium

• The cost of an option in dollars per cwt. as
  determined by open outcry.
• May vary throughout the day as futures prices
  change.
• Put premiums generally fall as futures prices
  rise and rise as futures prices fall.

37
The Premium (Cont.)

• Intrinsic value is the difference between futures
  price and strike price for in-the-money puts
  only.
• Time value is the amount of the premium above the
  intrinsic value.

38
Calculating a Floor Price Using Puts

• An estimated floor price can be determined by
  considering
• Strike Price
• Put Premium
• Basis

39
Total Cost of an Option

• Total dollar cost of a buying a put option
  includes the premium per cwt. multiplied by the
  size of the contract.
• In addition, a commission is charged by brokers
  for filling option orders.

40
Opening and Closinga Put Option Trade

• To Open
• Buy. Pay the put option premium and commissions
  to broker.
• To Close
• Do nothing. A Put option will automatically
  expire on the expiration date if it has no value.
• Exercise. Some put options may be exercised
  prior to expiration. All put options with value
  at expiration will be automatically exercised and
  the amount credited to your account.
• Sell. A put option may be sold at any time
  before the expiration date if it has value. Your
  broker will credit your account for the value of
  the put after a sale.

41
SummaryIII. Milk Put Options
42
IV. The Put OptionBuying Strategy
. . . A simple method of insuring milk revenues
43
The Purpose of the Strategy
44
5 Easy Steps for Implementing the Strategy

• Step 1 -- Gather critical information.
• Step 2 -- Analyze possible floor prices.
• Step 3 -- Establish price protection.
• Step 4 -- Collect a payment for price declines.
• Step 5 -- Evaluate results.

45
Example Jittery Joes Dairy Farm

• Date is May 25.
• Joe is considering what to do to protect revenues
  for December milk production

46
Step 1 Gather Critical Information

• Cost of Production
• Joe estimates this to be 17.00/cwt.
• Estimated Production
• Joe estimates this at 200,000 lbs. for December
• Basis (Mailbox Differential)
• Joe estimates this at 4.91/cwt.
• Current Futures Prices
• Joe gets information for December futures from
  his broker (see data)
• Current Put Options Premiums
• Joe gets information for December put options
  from his broker (see data)

47
Step 2 Choose an Appropriate Strike Price

Strike Price 12.00 Basis 4.91 Premium -
0.92 Floor Price 15.99 Strike Price
12.25 Basis 4.91 Premium - 1.10 Floor
Price 16.06 Strike Price 12.50 Basis
4.91 Premium - 1.22 Floor Price 16.19


Compare floor prices and premiums against
production costs of 17.00
48
Major Advantages of Buying a Put Option
49
Step 3Establish Price Protection

• Decide on quantity
• Joe decides on a single 200,000 lb. Contract.
• Places order with broker
• Joe buys a 12.25 December Put at 1.10/cwt.
• Establishes floor price of 16.06
• Receive report from broker
• Deliver premium payment to broker
• Joe sends 2,200 plus commissions
• (1.10/cwt. times 2000 cwt. 2,200 plus
  commissions)

50
Step 4Collect Payment when Price Drops
51
Step 5Evaluate Results

• Compare estimate of basis to actual
• For Joe, actual basis was 5.00/cwt. compared
  with estimated 4.91/cwt.
• Use information in future price risk management
  decisions.

Net price after put 16.15 18.20
52
SummaryIV. The Put Option Buying Strategy

• Step 1 -- Gather critical information.
• Step 2 -- Analyze possible floor prices.
• Step 3 -- Establish price protection.
• Step 4 -- Collect payment for price declines.
• Step 5 -- Evaluate results.

53
The ResultJubilant Joes Dairy Farm

• Jittery Joe becomes Jubilant Joe! Why?
• . . . because he can
• MANAGE
• his price risk rather than leaving his business
  to chance.

54
SummaryManaging Dairy PriceRisk Using Milk Put
Options

• I. Dairy Price Risk Management
• Essential for producers to remain competitive
• II. Futures Markets
• A foundation for price risk management
• III. Milk Put Options
• Tools producers can use to manage downside
  price risk
• IV. The Put Option Buying Strategy
• A simple method of insuring profit margins

55
Managing Dairy Price Risk
John J. VanSickle, Director International
Agricultural Trade Policy Center UF/IFAS