Marin BozicUniversity of Minnesota – Twin Cities

Guest Lecture at Ridgewater College, Feb 26, 2014

Dairy Risk Management in 60 Minutes

Why is There A Lot of Risk in Dairy?

S

D

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Quantity

Price

Why is There A Lot of Risk in Dairy?

1 21 41 61 81101

121141

161181

201221

241261

281301

321341

361381

4010

5

10

15

20

25

IOFC Margins Feed Prices All-Milk Prices

U.S

Dai

ry IO

FC M

argi

n, /

cwt

What Can be Done About Volatility?

• Sell your product when the price is good? • Can do with corn; not with milk – continuous production

• Grow your own feed?• Less exposure to feed price risk; but price of land may be

expensive

• Ride out the bad times?• Large equity needed

• Use financial instruments to design desired risk/reward profile• Forward contracts, futures, options, etc.

Dairy Futures and Options

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

Dairy Futures and Options

Class III Milk Futures

Fundamentals of Futures Contracts

• Futures contract is a promise to do a certain deed at a specified time in the future.

• Contract between you and… who? o The exchange stands as the counterparty to any

contract, and guarantees that promises will be honored

o That’s why you never hear people saying “I signed a futures contract to buy good X”. Instead, they would say “I sold a futures contract”.

A Standardized Product

Attribute ValueContract Size 200,000 lbs (2,000 cwt)Price Quotation $/cwtMin. Price Move $0.01/cwt ($20/contract)Daily Price Limit $.75/cwt ($1,500/contract)Months Traded All MonthsOpen Contracts 24 MonthsPosition Limits 1,500 contractsLast Trading Day One business day before USDA

Class III Price AnnouncementSettlement Cash-settled against USDA

Class III

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.

Promise to do What?

• Corn futures:• You will deliver 5,000 bushels of corn to a specified location• In reality, you will most likely close the position before the

contract matures.

• Class III futures:• Cash settled.

Risk-Reward Diagram: Short Futures Position

Risk-Reward Diagram: Unhedged Production

Risk-Reward Diagram: Unhedged Production

What Happened? 1. Futures Market

1) You sold (shorted) a Feb 2009 Class III contract on 10/13/2008 when the futures price was $15.31.

2) On 02/27/2009, USDA announces that Feb ’09 Class III milk price is $9.31

3) Your contract is settled – as if you buy it back for $9.31. You made $6.00 profit per cwt, or $12,000 per

contract.

What Happened? 1. Milk Check

Economic downturn accelerated in autumn of 2008. February 2009 Class III milk price was 9.31, and average February 2009, mailbox price for Minnesota was 11.82, or 5.89 below what was expected in early October 2008.

Gains in One Market will Offset Losses in AnotherOctober 13, 2008 February 27, 2009Sell 1 Feb ’09 Class III milk

contract @ $15.31/cwtClass III milk contract expires

@ $9.31/cwtExpected milk check basis + $2.40 / 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 + $2.40

$17.71

futures priceexpected basis

expected price

$11.82+ $6.00

$17.82

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

realized price

Option Contracts

• Gives the holder the right, but not the obligation to do something.

• Real estate: “…owner gives a prospective buyer the right to buy the owner’s property at a fixed price within a certain period of time. The prospective buyer pays a fee (the agreed on consideration) for this option right.”• Filmmaking: “When a screenplay is optioned, the

producer has purchased the "exclusive right" to purchase the screenplay at some point in the future, if he is successful in setting up a deal to actually film a movie based on the screenplay.” (Wikipedia)• Employee stock option: Employees get the right to

purchase the company stock at a fixed price. If they work well, stock price will go up, and their option will make them profit.

Option Contracts

• Options give right to futures contracts, not physical commodities• Call option: the right to buy a specific futures

contract at a pre-specified price termed the strike price• Put option: the right to sell a specific futures

contract at a specific strike price

Example: On October 5, 2011, December 2011 Class III futures price was $16.53. The right to buy (call) this contract for $17.50 could be obtained for 35 cents. A put option, the right to sell this futures contract for $16.00, could be obtained for 47 cents.

Risk-Reward Diagram: Put Option

Trade-off: Strike vs. Premium

Hedging with Options

Comparing Futures, Options, and Luck

Reducing Costs of Option Strategies

Puts Calls$13.00 $0.11 $15.50 $0.94$13.50 $0.19 $16.00 $0.55$14.00 $0.31 $16.50 $0.40$14.50 $0.47 $17.00 $0.28$15.00 $0.68 $17.50 $0.20$15.50 $0.94 $18.00 $0.13$16.00 $1.24 $18.50 $0.09$16.50 $1.58 $19.00 $0.06

Date: 10/13/2008Feb ’09 Futures: $15.31

Buy $14.00 put for $0.31Sell $17.00 call for $0.28

Reducing Costs of Option Strategies

Reducing Costs of Option Strategies

Reducing Costs of Option Strategies

When Should I Hedge?

Consider this simple risk management program:

• Buy Class III Milk puts consistently, do not try to guess what the price will do next

• Never spend more than 50 cents on a put

Let us evaluate three strategies:1) Always buy puts for milk produced THREE months from now

E.g. in January 2013 hedge April milk, in February hedge May milk, etc.

2) Always buy puts for milk produced SEVEN months from nowE.g. in January 2013 hedge August milk, in February hedge

September milk, etc.3) Always buy puts for milk produced ELEVEN months from now

E.g. in January 2013 hedge November milk, in February hedge December milk, etc.

When Should I Hedge?

Hedging Horizon

What Can You Buy for 50 cents? (Option Strike)

1 month 5 cents below futures 3 months 64 cents below futures5 months 1.08 below futures7 months 1.44 below futures9 months 1.74 below futures

11 months 2.08 below futures

Hedging with Puts: 3-Months Out

Hedging with Puts: 7-Months Out

Hedging with Puts: 11-Months Out

A Simple Hedging Program with Puts

Hedging Horizon

Number of Profitable

TradesNet Profit/Loss

2007-2012Return on

Investment2007-2012

1 month 16/74 -0.14 -41%3 months 21/74 0.06 13%5 months 19/74 0.21 46%7 months 15/74 0.24 52%9 months 09/74 0.26 57%

11 months 10/74 0.33 73%

Why Does this Work?

Why Does this Work?

Why Does this Work?

Lessons Learned?

• Either hedge consistently or not at all.

• Plan for hedging far ahead. When prices decline, they tend to stay low for a while. If you wait for too long, the opportunity to lock in good prices may be gone.

• You are likely to lose money on most of your trades. That’s OK. That does not mean that the market is full of crooks. It means that bad times come around infrequently, but when they do come, you will get back plentifully.

How Does 2014 Farm Bill Change the Game?

Key features of the Margin Protection Program for Dairy Producers:• Voluntary program, with no supply management or any direct

disincentives for growth in low-margin periods.

• Protects dairymen from severe downturns in the milk price, rising livestock feed prices, or a combination of both.

• Does not impose production or gross income eligibility caps

• Very simple and hassle-free

How Does 2014 Farm Bill Change the Game?

Actual Dairy Production Margin:• All-milk price minus feed ration value• Single, national formula, cannot be customized

Production History• The highest annual milk production over 2011, 2012 and 2013 • Revised annually based on milk yield growth

Coverage Percentage• 25% to 90% of production history, in 5% increments

Coverage Level• $4.00/cwt to $8.00/cwt in 50 cents increments

Actual Dairy Production Margin

2005

2006

2007

2008

2009

2010

2011

2012

2013

- 2.00 4.00 6.00 8.00

10.00 12.00 14.00 16.00

MPP Premiums

Premium ≤ 4mil lbs PH

($/cwt)Discounted Premium

Premium >4 M lbs. PH

($/cwt)

$4.00 $0.000 $0.00000 $0.000$4.50 $0.010 $0.00750 $0.020

$5.00 $0.025 $0.01875 $0.040

$5.50 $0.040 $0.03000 $0.100

$6.00 $0.055 $0.04125 $0.155

$6.50 $0.090 $0.06750 $0.290

$7.00 $0.217 $0.16250 $0.830$7.50 $0.300 $0.22500 $1.060

$8.00 $0.475 $0.47500 $1.360

MPP Premiums

Q: How Much Milk Can I Insure?

Unlike old dairy safety net based on MILC, there are no categorical limits to size of the farm. You can insure up to 90% of your production history, which is the highest of your milk marketings in 2011, 2012, and 2013.

Each year, your production history willincrease based on national growth inmilk yield per cow.

Each year, you may choose to cover 25% to 90% of your production history, in 5% increments.

MPP Premiums

Q: When does the MPP pay indemnities?

Consecutive Two-Month

Periods 2012Two-month

Average

Coverage Level & Indemnities

$4.00 $6.50

January 7.57February 5.82 6.70 0.00 0.00

March 4.94April 4.26 4.60 0.00 1.90May 3.41June 3.51 3.44 0.66 3.06July 2.74

August 2.98 2.86 1.14 3.64September 5.51

October 7.28 6.39 0.00 0.14

MPP Premiums

Q: Are these premiums subsidized? I do not see subsidy percentage anywhere?

Expected Margins Near

Historical Average

Modestly Subsidized.

Expected Margins Much

Above Historical Average

Margin Insurance

Premiums are Too Expensive!

Expected Margins Much

Below Historical Average

Margin Insurance Premiums are Very Highly Subsidized.

Combining Private Risk Management Tools with MPP

Conventional wisdom: Use MPP for passive catastrophic risk protection (e.g. always buy $6.50), and private risk markets for “shallow loss” protection if you need it.

A smarter way: If USDA sets the annual enrollment date near the end of the calendar year, you will be able to glean at expected margins in the year ahead before deciding what to do:

a) If expected margins are sufficiently high, try to lock in profit using futures & options, and if you manage to do that, then drop MPP to low coverage level

b) If expected margins are low – use MPP with high coverage levels (somewhat harder to do for large producers).

Dairy Risk Management in 60 Minutes

Ridgewater CollegeWilmar, MNFebruary 26, 2014

Dr. Marin Bozicmbozic@umn.eduDepartment of Applied EconomicsUniversity of Minnesota-Twin Cities317c Ruttan Hall1994 Buford AvenueSt Paul, MN 55108

Photo Credits:Credits Slide: Zweber Family Farms, Elko, MN