Transcript Slide 1

Livestock Gross Margin-Dairy
Craig Thomas
MSU-Extension Dairy Educator
Sanilac, Huron, Tuscola, St. Clair, Lapeer,
Genesee, Macomb, & Oakland Counties
Dairy Price Risk Management
 Coop-sponsored forward (fixed) price contracts:
 Similar to Class III short hedge: Locks in a price, no
upside potential, no daily margin requirements, flexible
contract size, administrative cost
 Coop-sponsored minimum price contracts:
 Similar to Class III put option: Establish a milk price
floor, retain upside potential, no margin requirements,
flexible contract size, cost of insurance + administrative
cost
Dairy Price Risk Management
 Traditional hedging and options strategies:
 Broad range of alternative strategies: lock in a Class III
price, establish a minimum Class III price, etc.




Contract size “lumpiness”
May be subject to margin calls & may need margin loc
Puts/calls: cost of “insurance” may be quite high
Requires established contract with a broker
Dairy Margin Risk Management
 Margin risk management establishes a floor
(minimum) on income over feed costs (IOFC).
$/cwt
 Class III put options: Creates milk revenue floor
 Feed call options: Establishes feed cost ceiling
 Bundled options strategy: you establish an IOFC floor
Milk revenue floor
Minimum IOFC
Feed cost ceiling
Dairy Margin Risk Management
 Revenue risk management establishes a floor on
income over feed costs (IOFC).
$/cwt
 Class III put options: Creates milk revenue floor
 Feed call options: Establishes feed cost ceiling
 Bundled options strategy: you establish an IOFC floor
Milk revenue floor
Minimum IOFC
Feed cost ceiling
Dairy Margin Risk Management
Does Not Limit Upside Milk Price Potential
$/cwt
Announced Class III 
Put option not
exercised
IOFCM
IOFCA
Class III Put Option
IOFCA > IOFCM
Feed Call Options
Dairy Margin Risk Management
Does Not Limit Upside Milk Price Potential
$/cwt
Announced Class III 
Put option not
exercised
IOFCM
IOFCA
Class III Put Option
IOFCA > IOFCM
Feed Call Options
Dairy Margin Risk Management
Does Not Limit Downside Feed Price Potential
$/cwt
Class III Put Option
IOFCM
IOFCA
IOFCA > IOFCM
Feed Call Options
Feed Price 
Feed call options not
exercised
Dairy Margin Risk Management
Does Not Limit Downside Feed Price Potential
$/cwt
Class III Put Option
IOFCM
IOFCA
IOFCA > IOFCM
Feed Call Options
Feed Price 
Feed call options not
exercised
Overview of LGM-Dairy
 Livestock Gross Margin Insurance for Dairy (LGMDairy)
 Insurance policy to guarantee a minimum IOFC
 Administered by USDA/RMA but purchased from firms
selling Federal crop insurance
 Crop insurance agents must be certified to sell LGM-Dairy
and have ID number on file w/Federal Crop Insurance
Corporation (see handout of approved agents)
Overview of LGM-Dairy
 Similar to bundled options (Class III put/feed calls)
except:
 LGM-Dairy has no minimum size limit
 LGM-Dairy upper limit of 240,000 cwt over any insurance
period (10 months) or insurance year
No actual options market activity

 Cheaper than bundled options due to subsidized

premiums
Premium not due until after contract matures
Overview of LGM-Dairy
 LGM-Dairy is customizable with respect to:
 Number of months insured w/one contract: 1-10 months
 Farm specific in regards to milk production & feeding

profiles (amounts & types of feeds)
Percentage of monthly IOFC (production) covered
 0-100% of certified milk production each month
 Percent coverage can vary across months
Overview of LGM-Dairy
 LGM-Dairy premiums are subsidized
 Premiums equal long run expected indemnity + 3%
 Premium subsidy
Deductible
Subsidy
Deductible
Subsidy
($/cwt)
(%)
($/cwt)
(%)
$0.00
18%
$0.60
31%
$0.10
19%
$0.70
34%
$0.20
21%
$0.80
38%
$0.30
23%
$0.90
43%
$0.40
25%
$1.00
48%
$0.50
28%
$1.10-$2.00
50%
Overview of LGM-Dairy
GMG
AGM
IND
Gross Margin Guarantee
Actual Gross Margin
Indemnity
AGM
PREM
EGM
DL
Expected Gross Margin
Deductible Level
Actual Gross Margin
Premium
Cost
EMR
EFC
AMR
AFC
Expected Milk Revenue
Expected Feed Cost
Actual Milk Revenue
Actual Feed Cost
EMP
ECC
ESC
Expected
Class III
Price
Expected
Corn
Cost
Expected
SBM
Cost
CME
CME
Corn
Futures
SBM
Futures
CME
Class III
Futures
TM
EFQ
Target Marketings
Expected Feed Quantity
CME
CME
Actual
Class III
Price
Settlement
Actual
Feeds
Costs
Settlement
Policy Rules
Exogenous Data
Producer Data/Decision
Overview of LGM-Dairy
 Expected Gross Margin (GM) = expected market
value of milk minus expected feed cost
 Gross Margin Guarantee (GMG) = GM minus
deductible
 One GMG (and GM) per contract
 Evaluated over entire contract period
Overview of LGM-Dairy
 Actual Gross Margin (AGM) = Actual market value of
milk minus actual feed cost
 One AGM per contract
 Evaluated over entire contract period
 Indemnity (payout) occurs if:
Overview of LGM-Dairy
 Class III, corn, and SBM futures markets used as
information source to determine:
 Expected prices
 Actual prices
 Importantly…
 No actual farm prices are used
 No futures market transactions
 No local basis used to adjust prices
Overview of LGM-Dairy
 Once LGM-Dairy is purchased you have established
an IOFC floor for the insured milk production
 Determined using expected prices
 Feed usage based on corn & SBM equivalents (adjustable)
 IOFC floor also adjusted by deductible selected
Overview of LGM-Dairy
 At sign-up producer declares milk production and
feed equivalents to be insured
 Must certify milk production when contract matures
 Producer defines expected feed usage using corn
(energy) and SBM (protein) equivalents
 Wide range for allowable declared feed equivalents
 Corn:
 SBM:
0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk)
1.61 – 26.00 lbs/cwt of milk
 Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)
Overview of LGM-Dairy
 At sign-up producer declares milk production and
feed equivalents to be insured
 Must certify milk production when contract matures
 Producer defines expected feed usage using corn
(energy) and SBM (protein) equivalents
 Wide range for allowable declared feed equivalents
 Corn:
 SBM:
0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk)
1.61 – 26.00 lbs/cwt of milk
 Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)
LGM-Dairy: Expected Gross Margin
 All feed valued as if purchased even if homegrown
 Feed prices: Corn (CME futures), SBM (CME futures)
 Milk price: CME Class III futures
 Standardized milk:
 Importantly:
12.5% solids (3.5% fat, 3.1% protein, 5.9% OS)
the gross margin guarantee (GMG) is
for the entire contract period whether contract is for
1, 2, …9, or 10 months
LGM-Dairy: Purchasing
 LGM-Dairy is available for purchase each month
 12 contracts offered each year
 Each contract covers 1 to 10 months
 Purchase period starts at end of last business Friday of
each month (after numbers crunched ~6:00 PM EDT)
 Feb 25th, Mar 25th, Apr 29th, etc.
 Purchase period ends at 9:00 EDT the next day (Saturday)
 ~27 hour sign-up window
 Work with your agent well ahead of time!
LGM-Dairy: Coverage Calendar
 Hypothetical insurance strategy:
Purchase insurance
at the end of March
By rule: no coverage the
month after purchase
Mar '11
Purchase
at End of
Month
Production
Coverage
Apr '11
Contract Length: 1-10 months
May '11
Jun '11
Jul '11
Aug '11
Sep '11
Oct '11
Nov '11
Dec '11
Jan '12
Feb '12
1
2
3
4
5
6
7
8
9
10
0%
0%
0%
0%
No
Insurance Contract Period
Coverage
No
Coverage
50%
0%
80%
40%
30%
0%
LGM-Dairy: Coverage Calendar
 All 10 months of expected prices are known at signup
 Expected milk, corn, and SBM prices are the average of
last 3 days of futures settlement prices for each
month/commodity including the sign-up Friday
LGM-Dairy: Coverage Calendar
March
Sunday
6
Monday
7
Tuesday
Wednesday
Thursday
1
2
3
8
9
10
Futures market
settlement prices on
16
these 15
3 days determine
expected prices
13
14
17
20
21
22
23
24
27
28
29
30
31
Friday
4
Saturday
5
Insurance
sign-up
period:
11
12
~27 hrs from 6:00 PM
Friday till 9:00 PM Saturday
18
19
(EDT)
25
26
Limited funds, first come, first served; sign-up early!
LGM-Dairy: Coverage Calendar
 Producer chooses amount of gross margin not
covered by insurance (i.e., deductible)
 Portion of gross margin (GM) unprotected
 Program allows $0 to $2.00/cwt deductible on GM
 Higher deductibleLower premium
 Producer assumes more risk
 Subsidy increases with higher deductible
LGM-Dairy: Premium Subsidy
Deductible
Subsidy
Deductible
Subsidy
($/cwt)
(%)
($/cwt)
(%)
$0.00
18%
$0.60
31%
$0.10
19%
$0.70
34%
$0.20
21%
$0.80
38%
$0.30
23%
$0.90
43%
$0.40
25%
$1.00
48%
$0.50
28%
$1.10-$2.00
50%
 No subsidy for a 1-month contract.
To receive
subsidy must have target marketings in 2 or
more months of an insurance period. The
subsidy % is the percentage by which
premium is reduced.
Determining Actual Prices and Gross Margin
 Actual prices determined as futures contracts expire
over insurance contract period
 Actual price = Class III, corn & SBM average futures
settlement prices from 1st, 2nd, and 3rd days prior to
futures contract last trading day
 Actual gross margin (AGM) =

Actual milk revenue – Actual feed costs
If total GMG > total AGMindemnity paid
 Total refers to sum over all insured months in contract
 Only 1 possible indemnity per contract
Determining Actual Prices and Gross Margin
March
Sunday
Monday
Last March corn/SBM
trading day
Tuesday
Wednesday
Thursday
1
2
3
Friday
Saturday
4
5
Settle prices used to calculate
actual March corn/SBM prices
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
27
28
29
30
31
Settle prices used to calculate
actual March Class III price
Last March Class III
trading day 26
25
Premium Billing/Indemnity Payment
 Clarification of USDA Memo:

Mar '11
Purchase
at End of
Month
Production
Coverage
PM-10-067
Assume contract purchased in March 2011 w/coverage
chosen for May, July, Aug, and Sep w/$5,500 total premium.
Apr '11
May '11
Jun '11
Jul '11
Aug '11
Sep '11
Oct '11
Nov '11
Dec '11
Jan '12
Feb '12
1
2
3
4
5
6
7
8
9
10
0%
0%
0%
0%
No
Insurance Contract Period
Coverage
No
Coverage
50%
0%
80%
40%
30%
0%
 Assume indemnity of $4,500.
 Two options: 1) producer pays net due ($1,000) end of Sep,
or 2) producer receives $1,000 indemnity ~late Oct and pays
premium ($5,500) Mar 2012.
Premium Billing/Indemnity Payment
 Must file a marketing report to receive indemnity

Must submit a marketing report within 15 days of a notice of
probable loss
 Marketing report must be supported by milk sales receipts
showing evidence of actual marketings each month

In the event that the total of actual marketings are less than
75 percent of the total of targeted marketings for the
insurance period, indemnities will be reduced by the
percentage by which the total of actual marketings for the
insurance period fell below the total of target marketings for
the period.
No limits on milk production, but indemnities limited to covered
milk (240,000 cwt max)
LGM-Dairy: Summary
 LGM-Dairy is a flexible insurance program
 Don’t have to insure all months or all production
 May overlap contracts
 Substantial premium subsidies & variable deductible
 Similar to bundled options strategy using Class III
puts and corn/SBM calls
 Coverage amount much more flexible (no lumpiness)
 Drawbacks
 Short sign-up window at end of each month
 Must wait for indemnity until end of last covered month;
after last actual price is determined
LGM-Dairy: Example
 Farm characteristics:
 500 milk cows w/25,200 lbs. milk sold per cow
 Estimate premium costs for March 2011 contract
 For simplicity assume 2,100 lbs/cow/month (2,100 x
0.85 x 500 = 8,925 lb. milk per month)
 Expected monthly feed use
 170.4 tons corn eq.; 42.6 tons SBM eq.
LGM-Dairy: Example
 Target marketings:
Mar '11
Purchase
at End of
Month
Production
Coverage
Apr '11
May '11
Jun '11
Jul '11
Aug '11
Sep '11
Oct '11
Nov '11
Dec '11
Jan '12
Feb '12
1
2
3
4
5
6
7
8
9
10
0%
0%
0%
0%
No
Insurance Contract Period
Coverage
No
Coverage
May, July, August, September
50%
0%
80%
40%
Only partial coverage for
four months
30%
0%
LGM-Dairy: Example
 Expected Gross Margin (GM) = expected market

value of milk minus expected feed cost
Gross Margin Guarantee (GMG) = GM minus
deductible
 One GMG (and GM) per contract
 Evaluated over entire contract period
LGM-Dairy: Example
 Expected Gross Margin (May) =
(8,925 cwts X $17.27/cwt X 50%) – .5*(170.4
tons corn X $7.08/bu + 42.6 tons SBM X $358.90/ton)
 Expected Gross Margin (May) = $77,076 – $21,543 –

$7,645
Expected Gross Margin (May) = $47,888
 Gross Margin Guarantee (GMG) = GM minus
deductible
LGM-Dairy: Example
 Expected Gross Margin (May) = $47,888
 Gross Margin Guarantee (GMG) = GM minus
deductible
 Gross Margin Guarantee (GMG) = $47,888 – (8,925
cwts X 50% X $1.00/cwt)
 Gross Margin Guarantee (GMG) = $47,888 – $4,463
 Gross Margin Guarantee (GMG) = $43,416
Same process used to calculate GMG’s for other months
LGM-Dairy: Example
Coverage
Gross Margin
Month
Guarantees (GMG's)
May-11
$43,416
Jun-11
$0
Jul-11
$66,479
Aug-11
$34,356
Sep-11
$26,756
Oct-11
$0
Nov-11
$0
Dec-11
$0
Jan-12
$0
Feb-12
$0
Total
$171,007
 One GMG (and GM) per contract
 Evaluated over entire contract period
LGM-Dairy: Example
 Actual Gross Margin (AGM) = actual market value of
milk minus actual feed cost
 Actual Gross Margin (May) =
(8,925 cwts X $16.64/cwt X 50%) – .5*(170.4 tons
corn X $7.35/bu + 42.6 tons SBM X $364.20/ton)
 Actual Gross Margin (May) = $74,264 – $22,365 –

$7,757
Actual Gross Margin (May) = $39,679
Same process used to calculate AGM’s for other months
LGM-Dairy: Example
Coverage
Gross Margin
Actual
GMG minus
Month
Guarantees (GMG's)
Gross Margins
AMG
May-11
$43,416
$39,679
$3,737
Jun-11
$0
Jul-11
$66,479
$55,028
$11,451
Aug-11
$34,356
$25,951
$8,405
Sep-11
$26,756
$32,220
($5,464)
Oct-11
$0
Nov-11
$0
Dec-11
$0
Jan-12
$0
Feb-12
$0
Total
$171,007
$152,878
$18,129
$23,593
 Indemnity = GMGT - AGMT = $171,007 - $152,878 =
$18,129
 One GMG and one AGM per contract
 Evaluated over entire contract period
LGM-Dairy: Example
Calculating Feed Equivalents
Understanding Dairy Markets
(future.aae.wisc.edu)
LGM-Dairy
(tab)
Supporting
Software
Spreadsheet-Based
Grain/Concentrate/Forages Feed
Conversion Program
Save to your hard disk if you have
Microsoft Excel
UW
Feed Conversion
Excel Spreadsheet
lb/cow/day
tons/month 1
Shelled corn
15.0
101.8
SBM
5.0
33.9
HMSC
8.0
54.3
Wet Distillers
3.0
20.4
WCS
4.0
27.1
Concentrate
1
A 3% loss factor added to total.
LGM-Dairy: Example
Estimating Premiums
Understanding Dairy Markets
(future.aae.wisc.edu)
LGM-Dairy
(tab)
Supporting
Software
LGM-Dairy Analyzer (V 2.0)
Opens in your browser window
LGM-Dairy: Example
LGM-Dairy: Example
Select program to use
Use previously saved data
Contract to analyze
Deductible
Method for entering feed
LGM-Dairy
Analyzer (V 2.0)
Only need to supply
four pieces of
information
LGM-Dairy
Analyzer (V 2.0)
Only need to supply
four pieces of
information
Calculate LGM Premium
LGM-Dairy
Analyzer (V 2.0)
LGM-Dairy
Analyzer (V 2.0)
LGM-Dairy
Analyzer (V 2.0)
LGM-Dairy
Analyzer (V 2.0)
Calculate
Options Cost
50% coverage; $1 deductible
LGM-Dairy
Analyzer
(V 2.0)
50% coverage; $1 deductible
LGM-Dairy
Analyzer
(V 2.0)
Item
Total Premium
LGM
Bundled
Dairy
Options
$5,604
$28,967
$0.31
$1.70
Premium/cwt
Covered Milk
Difference
$1.39
% Difference
543%
LGM-Dairy
 LGM-Dairy is definitely worth every producers
consideration regardless of farm size, production level, etc.
 Find an LGM-Dairy agent and establish a relationship
 Work with your LGM-Dairy agent well in advance of the
sign-up period so if you do use LGM-Dairy you can get your
application in early.
 The LGM-Dairy program has limited funds, RMA recently
increased LGM-Dairy funds, but still limited (first come, first
served); get it while it’s hot!