Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040

1. Dairy Risk Management Marin Bozic University of Minnesota – Twin Cities Guest Lectures for Cornell University - AEM3040

2. 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

3. 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.

4. Dairy Futures and Options Class III Futures Class IV Futures Nonfat Dry Milk Futures Dry Whey Futures Butter Futures Cheese Futures

5. 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 Announced Class III Milk Price You receive Class III Milk Futures Price, as it was on the date Futures Contract was Sold On April 1, 2013 Class III Milk Futures was $18.82

6. Risk-Reward Diagram: Short Futures Position

7. Class III Milk Futures

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

9. 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

10. Hedging Example

11. 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.

12. Hedging Example

13. Risk-Reward Diagram: Unhedged Production

14. Risk-Reward Diagram: Unhedged Production

15. NY Mailbox Milk Price Depends on More than Class III August 2011 Utilization in FMMO 1

16. Predicting NY Mailbox Milk Price

17. Forecasting NY Mailbox Milk Price August 2011 Utilization in FMMO 1 Advanced Class III, IV Prices Announced Class III, IV Prices August Class III Milk Futures, August Class IV Milk Futures Max (July Class III Milk Futures, July Class IV Milk Futures)

18. Hedging August 2011 NY Mailbox Milk Price

19. Minnesota Mailbox Milk Price – Class III Milk Price Average: $1.42 Standard Deviation: $0.62

20. New York Mailbox Milk Price – Class III Milk Price Average: $1.40 Standard Deviation: $0.99

21. Hedge with a basket of Class III and Class IV contracts Average: $1.68 Standard Deviation: $0.32

22. Hedging August 2011 NY Mailbox Milk Price

23. Hedging February 2009 NY Mailbox Milk Price

24. 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.