Transcript Document

Introduction to Managing Price
Risk in the Dairy
Marin Bozic
University of Minnesota-Twin Cities
NCCIA Annual Meeting, Rochester, MN
October 12, 2011
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Marin Bozic
Dairy Foods Marketing Economist
University of Minnesota-Twin
Cities
• Education
• B.A. Macroeconomics, University of Zagreb
• Ph.D. Agricultural and Applied Economics,
University of Wisconsin-Madison
• Past Research
• Agricultural Futures and Options (Risk Analysis)
• Dairy Supply Models
2
Research Program
(i) Products & processes:
evaluation of the economic value
of new product development,
and processing investments
(ii) Consumer insights: elicitation
of consumer preference and
willingness to pay for new dairy
food products
(iii) Price analysis: analyzing
markets existing and new dairy
food products
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The Game Plan
1. Introduction and Forming Groups
2. Causes of Price Risk in the Dairy Sector
3. Overview of Milk Pricing
4. Introduction to Futures and Options
Break
4. Dairy Futures and Options
5. Group Work
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Source: Jesse & Cropp – Basic Milk Pricing Concepts for Dairy Farmers
5
6
Sep, 2011
Jan, 2011
May, 2010
Sep, 2009
Jan, 2009
May, 2008
Sep, 2007
Jan, 2007
May, 2006
Sep, 2005
Jan, 2005
May, 2004
Sep, 2003
Jan, 2003
May, 2002
Sep, 2001
Jan, 2001
May, 2000
Sep, 1999
Class III Milk
Dairy Prices: An Opportunity or a Third Class
Rollercoaster?
25.00
20.00
15.00
10.00
5.00
0.00
Year-on-year change in the U.S. milk
production
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Supply & Demand for Basic Dairy
Products
Price
S
D′
D
Quantity
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Elasticity in the short and long run
10% change in price  %
change in production
1yr
5yrs
10yrs
0.9%
4.1%
8.9%
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Causes of price volatility in the dairy
sector
• Inelastic demand
• Inelastic supply in the short run (but much more
elastic in the long run)
• Tax treatment of farm income
• Slow transmission of price signals to farmers?
• Consolidation? Are bigger farms slower to react?
• Exports?
– Melanin contamination in China
– NZ droughts
– Korea foot-and-mouth
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Volatility and risk
• Price Volatility does not necessarily mean price
risk
– Do I as a consumer have a milk price risk? No, I am
facing volatile prices, but there is no investment that
can be jeopardized by an unforeseen price change
• Price risk comes from the fact that dairy is
capital intensive (herd, equipment) and revenue
stream for the duration of investment is highly
uncertain, and events could be so adverse that
the farm goes out of business
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What can be done about volatility?
• Sell it when the price is good?
– Can do with corn; not with milk – continuous production
– Can do with some cheeses, but quality changes with aging;
market for aged cheese may saturate quickly
• Pass it on?
– For processors - make allowances allow for near perfect
pass-through
• Grow your own feed?
– Less exposure to feed price risk; but price of land may be
expensive
• Use financial instruments to design desired risk/reward
profile
– Forward contracts, futures, options, etc.
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How is milk priced?
• Uncle Sam and orderly marketing of milk
– Federal Milk Marketing Orders
“FMMOs are fundamentally aimed at equalizing
competition between proprietary handlers and
producers and promoting a greater degree of
stability in marketing relationships. Such a system
effectively prevents a concentrated processing sector
from exercising noncompetitive market power over
milk producers by establishing minimum prices that
all processors must pay for milk.”
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How is milk priced?
• Wholesale prices of dairy products are surveyed
– Cheddar cheese
– Dry Whey
– Nonfat dry milk
– Butter
• Prices of milk components are inferred based on
technology and economics
– Technology: e.g. Van Slyke formula
– Manufacturing costs: make allowances
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How is milk priced?
• Use of milk
– Fluid beverage
– Soft products (yoghurts)
– Hard products (cheese)
– Powders & fractions
 Class I
 Class II
 Class III
 Class IV
• Where does the value of milk come from?
– Milkfat, proteins, solids
– Quality
– Location
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Milk Pricing in
Federal Milk Marketing Orders
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One cheddar to rule them all…
• Most milk in upper Midwest
used for cheese manufacture
• Most cheese priced based on
CME spot cheddar cheese
price (blocks and barrels)
• Producers interested in
hedging milk price
• Processors and buyers
interested in hedging cheese
price
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1. Class III Futures
2. Class IV Futures
3. Nonfat Dry Milk Futures
4. International Skim Milk Powder Futures
5. Dry Whey Futures
6. Butter Futures
7. Cheese Futures
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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?
– The exchange stands as the counterparty to any
contract, and guarantees that promises will be
honored
– That’s why you never hear people saying “I signed
a futures contract to buy good X”. Instead, they
would say “I bought a futures contract”.
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A standardized product
Attribute
Value
Contract Size
200,000 lbs (2,000 cwt)
Price Quotation
$/cwt
Min. Price Move
$0.01/cwt ($20/contract)
Daily Price Limit
$.75/cwt ($1,500/contract)
Months Traded
All Months
Open Contracts
24 Months
Position Limits
1,500 contracts
Last Trading Day
One business day before USDA Class
III Price Announcement
Settlement
Cash-settled against USDA Class III
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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.
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What did you promise if you went
short?
• 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.
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Risk-Reward Diagram:
Short Futures Position
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Margin management or “How to
maintain trust on a daily basis”
• Suppose I sold a CME Nov-11 cheese contract on 10/3/211
when the price is $1.60.
• Next day, price changes to $1.655.
• I am loosing 5 cents per pound or $1000 per contract!
• What prevents me from just walking away?
• All debts must be settled at the end of each trading day!
• All your gains will be paid to you at the end of each trading
day as well.
• This is super attractive – for you NEVER HAVE TO PAY THE
FULL VALUE OF CONTRACT IMMEDIATELY! Just “security
deposit” we call margin, held in margin account
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Margin management or “How to
maintain trust on a daily basis”
• To get things started, small deposit it required when
you open a futures position
• At first, you pay $2,363. Then loses are subtracted from
your account daily, and gains are added.
• If your margin account falls below 1,750, you need to
deposit money to get back to initial level if you wish to
keep your position active.
• “Marked to market daily”
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Date
09-30-2011
10-03-2011
10-04-2011
Price per
bushel
Action/
Event
Sold Nov
1.6200
2011 Cheese
1.6000 Gain $400
1.6550 Lose $1,100
Margin
Action
Deposit
2,363
Margin call
$700
10-05-2011
10-06-2011
1.6850 Lose $600
1.6890 Lose $80
2,763
1,663
2,363
1,763
1,683
Margin call
$680
10-07-2011
Account
Balance
2,363
1.7380 Lose $980
Bought Nov Withdraw
2011 Cheese 1,383
(closed pos.)
2,363
1,383
0.00
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Margin Management
• The most you can loose in one day = 0.075 x 20,000 = 1,500
(there are no limits in the spot month)
• Daily price change limits are in sync with maintenance margin
levels to insure trust
• Individual traders margin accounts are managed by their
brokers.
• The brokers are held accountable for their customers
positions in the futures markets.
• Minimum margins are set by the exchange. Brokers may
require larger margins from customers.
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Cash settlement
• “There shall be no delivery of milk in
settlement of this contract. All contracts open
as of the termination of trading shall be cash
settled based upon the USDA Class III price for
milk for the particular month, as first
released.”
• Equivalent to
• short position  buying it back
• Long position  selling it back
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Cash settled contracts
• Let’s say you were short 10 Class III Sep ’11
contracts on the last trading day, 09/29/2011
• You did not have to deliver milk to anyone
• The futures price on 09/29 was $19.00
• On Sep 30, USDA announced that the Sep ’11
class III price is $19.07.
• You need to compensate the exchange $0.07 x
2,000 cwt x 10 = $1,400.
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Risk-Reward Diagram of
Unhedged Production
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Using futures to lock in a price
• You are approached by a farmer in October
2008, and he wants to lock in the price for the
milk he markets with your company for
February 2009.
• You advise him to consider selling Feb ‘09
Class III futures.
• What can he expect to happen?
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Hedging with futures
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What really happened?
1. On 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.
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What really happened?
2. 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.
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Gains in one market will offset the loss
in another
Date
Feb 2009 Futures Mailbox price
October 13, 2008 Sold for
$15.31
$17.71 (expected)
February 27, 2009 Settled at $9.31
$11.82
Gain: $6.00
Loss: -$5.89
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What a wicked game to play, to make
me feel this way…
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Gains in one market will offset the loss
in another
Date
Jun 2011 Futures
Mailbox price
Feb 22, 2011
Sold for
$17.04
$18.47 (expected)
June 30, 2011
Settled at $19.11
$20.65
Loss: -$2.07
Gain: $2.18
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Price risk vs basis risk
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Price risk vs. basis risk
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What it takes to have a functioning
futures market?
1. A standardized product
2. High enough value-at-risk
3. A diverse set of actors (buyers, sellers,
speculators)
4. Transparent pricing mechanism
5. Strong enforcement of market rules
6. A functioning market (chicken & egg problem)
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High value-at-risk
• 900 million lbs of cheese a month  90 mil cwt of
milk.
• In two months, Class III milk price can change easily by
$2/cwt up or down.
• $180 million dollars at risk just for milk used in cheese.
• Per capita US consumption: butter – 5lbs, dry whey –
3lbs, cheese 32lbs.
• Class III
– mostly reflects variation in cheese prices, but also
incorporates dry whey and butter
- Most of the time this contract is the “mover” of Class I
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A diverse set of actors
Hedgers
– Big(ger) producers
• 200,000 lbs  cca 120 cows
– Coops & private first handlers
• Aggregators of individual positions
– Processing industry
– Cheese buyers
• Cheese priced off CME cash market
Speculators & market makers
– Speculative interest follows hedging interest
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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.
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The right to obtain vs.
the right to dispose of
Call option: the right, but not the
obligation, to buy something at the
set price
Put option: the right, but not the
obligation, to sell something at the
set price
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Options in agriculture
• 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.
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Risk-reward diagram: Put option
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Trade-off: Strike vs. premium
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Hedging with options
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Comparing futures, options, and luck
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Option Premium, Intrinsic and Time
Value
$15.50 put costs $0.94 to buy.
Premium: $0.94
Strike: $15.50
Underlying futures price: $15.31
If $15.50 put is exercised on 10/13, profit on the futures market
would be 15.50-15.31=0.29  intrinsic value.
Option Premium = Intrinsic Value + Time Value
Time Value = $0.94 - $0.29 = $0.65
Time Value = value of insurance, or chance that underlying futures
price will change sufficiently to make exercising the option a
profitable action.
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Time Value, Intrinsic Value and
Moneyness
Puts
$13.00
$13.50
$14.00
$14.50
$0.11
$0.19
$0.31
$0.47
$15.00
$15.50
$16.00
$0.68
$0.94
$1.24
$16.50
$1.58
Date: 10/13/2008
Feb ’09 Futures: $15.31
Out-of-money puts
In-the-money puts
Calls
$15.50
$16.00
$16.50
$17.00
$0.94
$0.55
$0.40
$0.28
$17.50 $0.20
$18.00 $0.13
$18.50 $0.09
$19.00 $0.06
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Reducing costs of option strategies
Date: 10/13/2008
Feb ’09 Futures: $15.31
Puts
Calls
$13.00
$13.50
$14.00
$14.50
$0.11
$0.19
$0.31
$0.47
$15.00
$15.50
$16.00
$0.68
$0.94
$1.24
$17.50 $0.20
$18.00 $0.13
$18.50 $0.09
$16.50
$1.58
$19.00 $0.06
Buy $14.00 put for $0.31
Sell $17.00 call for $0.28
$15.50
$16.00
$16.50
$17.00
$0.94
$0.55
$0.40
$0.28
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Reducing costs of option strategies
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Reducing costs of option strategies
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Hedging cheese
• From 01/20 to 02/09 of 2011, cheddar blocks
at CME increased from $1.50 to $1.90
• Mar 2011 cheddar futures increased from
1.55 to 1.85 over the same period. You
manufacture Monterey Jack and age it for one
month. You wish to lock in the high price.
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Basis: Monterey Jacks vs. Cheddar (USDA)
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Exercise:
– On Feb 10, 2011, Mar ’11 cheddar futures price is $1.85.
You decide to take a position in the futures market to
protect the cheese price you believe will not go higher
than it has already. What should you do? Which contract
should you use?
– How would you calculate the price you expect to receive
for your cheese at the end of March?
– At the end of March, your contract is settled. Basis is
weaker than usual: $0.5095, while it was $0.73 from
01/2010 through 01/2011. In addition, cheddar futures
settled at 1.9722.
– Did you lose or gain money in the futures market?
– What is the implication of weaker basis?
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Exercise: Using futures to protect
cheese inventories
2011 May
1.6510
2011
Jun
1.7150
2011
Jul
1.7520
2011 Aug
1.7500
2011 Sep
1.8050
On May 10, 2011, you notice that
cheese futures price term structure is
steeper than your storage costs. You
decide to store some cheese and sell it
in September.
1) Explain how would you use futures to protect your inventories. Which
contract would you use, when would you buy/sell it?
2) Explain how would you use options strategies to limit downside risk while
maintaining (some) upward price potential?
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