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

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

2. Volatility vs Risk Producers Processors • Have (or will have) a commodity to sell • Do not like when price goes down. • Downside risk • Upside potential • Short futures position. • Will want to buy the commodity at some point in future • Do not like when price goes up. • Upside risk. • Downside potential. • Long futures position.

3. Risk-Reward Diagram: Unhedged Production

4. Put Option Contract • Put option gives option contract holder a right, but not the obligation to sell the underlying asset at a pre-negotiated price. • Underlying asset in a case of agricultural commodities is just a futures contract. • Pre-negotiated price is called the strike price. • Like with any insurance contract, policyholder must pay up-front for the privilege of having the insurance policy. That fee is called option premium.

5. Put Option Contract On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31.

6. Risk-Reward Diagram: Put Option

7. Risk-Reward Diagram: Put Option Breakeven Point: Strike – Premium = $14.32 Put Premium Paid: $0.68 Put Strike Price: $15.00

8. Trade-off: Strike vs. Premium

9. Hedging with Options

10. Comparing Futures, Options, and Luck

11. Put Option Contract Using Futures Using Put Options Futures + Expected Basis _______________ Expected Net Selling Price Strike price + Expected Basis ̶ Option Premium _________________ Expected Minimum Net Selling Price

12. Put Option Contract On October 13, 2008, February 2009 Class III Milk Futures Price was $15.31. Minnesota Expected Basis: $1.36

13. 2009 Hedging Example (Minnesota)

14. 2009 Hedging Example (New York)

15. Hedging August 2011 NY Mailbox Milk Price

16. 2011 Hedging with Puts (NY)

17. Call Option Contract • Call option gives option contract holder a right, but not the obligation to buythe underlying asset at a pre-negotiated price. • On Oct 31, 2013, Jan ’14 • Class III Milk Futures traded at • $17.40. Call premiums were:

18. Profit from a long futures position

19. Profit from a long call position

20. Protecting the milk purchase price

21. Reducing Costs of Option Strategies Date: 10/13/2008 Feb ’09 Futures: $15.31 Buy $14.00 put for $0.31 Sell $17.00 call for $0.28

22. Call options: buyers vs sellers Call option buyer Call option seller • holding options • Pays premium up-front • No margin required. • Can buy a futures contract at the strike price if he so chooses, but he does not have to do it. • selling = writing options • Receives premium up-front • Has to maintain a margin account • Must sell a futures contract at strike price if option holder demands so.

23. Short Call Option Position

24. Reducing Costs of Option Strategies

25. Reducing Costs of Option Strategies

26. 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: • 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 now • E.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.

27. When Should I Hedge?

28. Hedging with Puts: 3-Months Out

29. Hedging with Puts: 7-Months Out

30. Hedging with Puts: 11-Months Out

31. A Simple Hedging Program with Puts

32. Why Does this Work?

33. Why Does this Work?

34. Why Does this Work?

35. 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.