1 Farm and Risk Management Team Cooperative Extension – Ag and Natural Resources Dairy Price Risk Management: Session 5 – Hedging With Futures Last Update May 1, 2007

2 Your Price Forecasts

3 Why the Interest in Dairy Futures?  Change in federal dairy policy: From 1950 to 1981, the dairy price support was based on parity, and market prices tended to closely match support prices. So market prices were stable and predictable. Since 1981, dairy price support levels have been determined by congress, and by 1990, support prices were below the cost of production for most dairy farms. So market prices are driven by market conditions and are volatile and unpredictable.

4 Milk Price Risk

5 Seasonal Milk Price Variation

6 What are Futures Markets and Futures Contracts? Organized auction markets “Commodity” traded is specified commodity or commodity price index at specified time in the future Buy a futures contract  Long  commitment to take delivery Sell a futures contract  Short  commitment to make delivery

7 What are Futures Markets and Futures Contracts (2)? For cash settled futures contracts (most dairy contracts), commitment is to make up in cash any difference between the settlement price and the contract price  If settlement price ends up higher than contract price, then shorts pay difference (sold low and bought high  If settlement price ends up lower than contract price, then longs pay difference (bought high and sold low)

8 What are Futures Markets and Futures Contracts (3) ?  Futures contracts can be fulfilled in two ways: Hold to maturity and take or make delivery (deliverable contracts) or cash settle against settlement price. Offset – buy a contract if short or sell a contract if long. This is also known as liquidating a contract or lifting a hedge.

9 Who Trades Futures?  Hedgers  Interest in trading futures is to protect cash market price objective  Speculators  Interest in trading futures is to make a profit from trading futures

10 How do you Trade Futures?  Open a broker account  Place an order with your broker  Post performance bond (Margin)

11 Who regulates Futures Markets?  Exchanges are self-regulating, with oversight authority in:  The Commodity Futures Trading Commission (CFTC)  Industry futures associations (e.g., National Futures Assn.) also help enforce rules and maintain integrity.

12 What Are you Trading When you Trade the CME Class III Contract? Trading Unit2,000 Cwt. Price Quotation$/Cwt. Min. Price move$0.01/Cwt ($20/contract) Daily Price Limit$0.75/Cwt. ($1,500/contract) Months TradedAll Position Limits750 contracts/month* Last Trading DayDay before Announcement SettlementCash *Can be increased in expiration month

13 Reading the Charts (April 24., 2009) Daily Settlements for Class III Milk Futures (FINAL) Trade Date: 04/24/2009 MonthOpen HighLowChangeSettleVolumeOpen Apr ' B10.77A May ' Jun ' Jul ' Aug ' Sep 'o Oct ' Nov ' Dec ' Jan '

14 Hedging With Futures Take a futures market position that is equivalent to your cash market position at the time the futures contract expires (Dairy Farmer  sell milk in September  take short futures position in September contract) Locks in contract price*, BUT: May receive more or less than if unhedged Example: Feb 3:Expect to market 200,000# of milk in Sept. SELL 1 Sep futures $14.85 Sep 1:Sell milk at $14.00 Settle 12.85$.85 $12.85  *DOES NOT CONSIDER BASIS, BASIS RISK, OPPORTUNITY COST OF PERFORMANCE BOND (MARGIN) OR BROKER COMMISSIONS

15 Hedging Examples (1) Date/Action Feb. 2 Sell 1 Sep Class $ Expected basis is Broker commission (round turn) is.05. Expected September farm milk price is $16.00 ($ $ $0.05) Case I: Price falls by September; No basis change Oct.1 - Class III price announcement is Sell milk to (Class III Basis) +/- Futures gain/loss +.85 (14.85 – 14.00) - Commission -.05 = Net milk price (Actual basis equal to expected basis) Case II: Price rises by September; Basis WEAKENS ($1.00 instead of expected $1.20) Oct. 1 - Class III price announcement is Sell milk to (Class III Basis) +/- Futures gain/loss - 15 (14.85 – 15.00) - Commission -.05 = Net milk price (less than expected by the amount the basis weakened)

16 Hedging Examples (2) Date/Action Feb. 2 Sell 1 Sep Class Expected basis is Broker commission (round turn) is.05. Expected September farm milk price is Case I: Price falls by September; Basis STRENGTHENS Sept. 2 Class III price announcement is Sell milk to (Class III Basis) +/- Futures gain/loss (14.85 – 13.00) - Commission -.05 = Net milk price (more than expected by the amount basis strengthened) Case II: Price rises by September; No basis change Sept. 2 Class III price announcement is Sell milk to (Class III Basis) +/- Futures gain/loss (14.85 – 16.00) - Commission -.05 = Net milk price (Actual basis = expected basis)

17 Margin and Margin Calls Need to deposit MARGIN (performance bond) with broker to cover any paper losses when you sell futures contracts If price moves against your position (rises after you’ve sold), then you may need to deposit additional margin There are initial margin and maintenance margin requirements – maintenance margin is smaller Margin requirements are less for hedgers than for speculators Initial margin for hedges is about 3-5 percent of the contract value, depending on exchange and broker

18 Example of Margin Requirements DateFutures Price Dollar ChangeResulting Margin Balance Margin Call New Margin Balance Feb 2 (Trade)$14.85-$700- Feb 10$14.92-$140 (-.07 * 2,000 Cwt.) $560- Feb 20$15.12-$400 (-20 * 2,000 Cwt.) $160$540$700 Mar 1$17.00-$3,760 (-1.88 * 2,000 Cwt.) $-3,060$3,760$700 Mar 2$16.00+$2,000 (1.00 * 2,000 Cwt) $2,700- Aug 23$ ,000 (+2.00 * 2,000 Cwt.) $6,700- Overall Change-$0.85+1,700+$6,000-$4,300 (Initial margin is $700; Maintenance margin is $550)

19 Example of Long Hedge Date/Action May 1: Need 10,000 bushels of corn in December to restock commodity bin. Dec. corn contact on CBT is $3.50/bushel. Buy 2 Dec Usual local basis in December is (.15). Round-turn broker commission is $50/contract, or $0.01/bushel. Price objective is $3.50 – $ $0.01 = $3.34/bushel Case I: Corn futures price rice falls by December; Basis STRENGTHENS to zero ($0.15) Dec.1: CBT Dec. Sell 2 contracts Net Corn Cost Buy corn form local 3.40 ($3.40 minus 0.00 basis) +/- Futures gain/loss Commission -.01 = Net corn price 3.49 (price objective + amount basis strengthened ) Case II: Corn futures price increases; No basis change Dec. 1: CBT Dec Sell 2 contracts Net Corn Cost Buy corn from local 3.65 ($3.80 minus 0.15 basis) +/- Futures gain/loss Commission -.01 = Net corn price 3.34 (price objective)

20 Summary Futures markets: Organized auction markets for futures contracts with well-defined enforced rules of conduct. Futures contracts: Method of buying or selling a commodity “before the fact.” Hedging with futures contracts helps achieve a price objective by offsetting cash market losses with futures market gains. At the same time, hedging offsets cash market gains with futures market losses. “Locking in a price” means just that.