Milk Futures

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Milk Futures Options Workshop

• James Mintert, Ph.D.
• Professor Extension Ag. Economist, Livestock
  Marketing
• Kansas State University

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Prices Follow A Consistent Pattern Each Year
Seasonal Price Indices in Kansas
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Monthly BFP Prices, 1962-99
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Milk Prices Are More Variable Than In The Past
Monthly BFP Prices, 1962-99
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Milk Prices Are More Variable Than In The Past
Monthly BFP Prices, 1962-99
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Futures marketsallow you to manage some of your
input (corn, soybean meal) and output (milk)
price risk
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Why Do We Need A Futures Market?

• To discover price
• To provide a location where ALL market
  participants can interact
• To disseminate information

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How Are Futures Prices Determined?

• The futures price is simply what a buyer is
  willing to pay and a seller is willing to accept
  for a product.
• The exchange (CME, NYBT, CBOT) itself does not
  set prices.

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What Is A Futures Contract?
An agreement between a buyer and a seller to
receive or deliver a product on a future date at
a price they have negotiated TODAY.
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Contract standardized with respect to

• Delivery Period (timing)
• Contract Size (quantity)
• Quality of the Product

The only negotiable terms are price and the
number of contracts involved in each trade.
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CME Milk Futures contract specs
Commodity BFP Milk Exchange CME Size
2000 cwt. 500 cwt. Months All
Cows (Monthly) 126 (at 19,000 lbs)
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CME Milk
Settlement In Every Contract Month Contract
expires 1 day prior to USDA Class III price
announcement Cash settled contract at expiration
to the announced Class III price This process
causes the futures price to converge to the Class
III cash price.
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June 1999 BFP futures convergence
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December 1999 BFP futures convergence
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December 1998 BFP futures convergence
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Entering and Exiting A Futures Position
Initial or How to Entry
Position Exit Buy (long) Sell Sell
(short) Buy
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What Happens As Futures Prices Change?
Once youve established a long (buy) or short
(sell) position in the futures market, the value
of your position (gain or loss) changes each time
prices change.
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How Much Can I Gain Or Lose In The Futures Market?
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How Much Can I Gain Or Lose In The Futures
Market?
11.75 - 9.50 2.25/cwt (change in 90 days)
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How Much Can I Gain Or Lose In The Futures Market?
11.75 - 9.50 2.25/cwt x 2000
4500/contract ? 126 head 35.71/head
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Hedging using the futures market
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What Is Hedging?

• Hedging is using the futures market as a
  temporary substitute for an intended cash market
  transaction.

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What Is Hedging?

• Hedging is using the futures market as a
  temporary substitute for an intended cash market
  transaction
• If you intend to sell milk in the cash market,
  you could hedge the sale of the milk prior to the
  cash market sale date by selling a futures
  contract. When you make the cash market sale,
  offset your futures position by issuing an order
  to buy a futures contract.

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What Is The Purpose Of Hedging?

• To ensure price protection against adverse market
  moves.
• To reduce the risk of price fluctuations that can
  affect the value of a commodity.
• Effective hedge price received/paid equals what
  you thought it was going to be.

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How Does Hedging Work?
1) A Hedge involves taking a futures position
opposite, but equal in size to, a cash
position. 2) Selling futures in advance of
future cash market sales. 3) Buying futures in
advance of future cash market purchases.
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Basis

• Basis defines the relationship between your local
  cash price and the futures market
• Mathematically,
• basis cash price - futures price

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Basis

• In milk,
• basis mailbox price - futures price
• To forecast basis, need a basis history
• Historical relationship between your mailbox
  price and Class III

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Forward Pricing Example
On February 25, a producer anticipates selling
237,500 pounds of milk in July. July BFP milk
futures are trading at 11.68. The producer
thinks prices will fall and wants a hedge
against lower prices.
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Expected Net Sale Price

• 11.68 current futures price
• (0.00) expected basis
• - 0.03 commission
• 11.65 ENSP (expected net sale price)

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Declining Market
Futures BFP cash February 25 Sell
futures 11.68 ------ July Sell cash
milk 10.55 Buy back futures 10.55 ------ Fut
ures profit 1.13 ------ Less commission -
0.03 Total Return 1.10
10.55 11.65
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Advancing Market
Futures BFP cash February 25 Sell
futures 11.68 ------ July Sell cash
milk 12.70 Buy back futures 12.70 ------ Fut
ures profit - 1.02 ------ Less commission -
0.03 Total Return - 1.05
12.70 11.65
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Potential Results
Futures Profit/Loss Cash Sale Price on
Futures Proceeds Hedge Price 14.00 -
2.35 14.00 11.65 13.00 -
1.35 13.00 11.65 12.00 -
0.35 12.00 11.65 11.00
0.65 11.00 11.65 10.00
1.65 10.00 11.65
Initial position sold futures _at_ 11.68
Includes commission of .03/cwt.
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Hedging using the options market
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What Is An Option?
A contract that gives the buyer the right but
not the obligation to buy or sell a futures
contract at a specific price within a certain
time period. Specific price is the strike price
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Call and Put Options

• Put Option
• The right to sell

• Call Option
• The right to buy

But, not the obligation
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Buy Sell
Call Put
Buy Sell Buy Sell
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What Is A Premium?
The purchase price a buyer pays and seller
receives for the option.
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How Is The Premium Determined?

• Intrinsic Value
• what is the option worth today?
• strike price versus current futures
• Time Value
• a residual
• affected by time, volatility and interest rates

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Premium Value -- ExampleJuly Futures _at_ 11.68
Strike Premium Intrinsic Time 11.75
call 0.44 0.00 0.44 11.75 put
0.51 0.07 0.44
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How Are Options Exercised?

• A buyer exercises an option when he decides to
  buy or sell the underlying commodity by taking a
  futures position.

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Option Trading

• Buyer
• 1) Offset (by selling)
• 2) Let the option expire
• 3) Exercise the option
• Seller
• 1) Offset (by buying)

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The Producer
On February 25, a milk producer expects to sell
237,000 pounds of milk in July. July BFP milk
futures currently are trading at 11.68. The
producer expects prices to fall by July and wants
protection against a declining market, but would
like to take advantage of price increases.
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Expected Minimum Net Sale Price
11.75 put option strike price -
0.51 put option premium (0.00) expected
basis - 0.03 commission
11.21 EMNSP (expected minimum net sale
price)
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Potential Results

• July futures 11.68
• July put option 11.75 strike price
• 0.51 premium
• Fut. Prem Options Net Price
  Net Price
• Price - Cost (bu.) Int. Value Received
  w/o Opt.
• 14.00 - 0.51 0.00 13.46
  14.00
• 13.00 - 0.51 0.00 12.46
  13.00
• 12.00 - 0.51 0.00 11.46
  12.00
• 11.00 - 0.51 0.75 11.21
  11.00
• 10.00 - 0.51 1.75 11.21
  10.00
• Assumes commission is 0.03/cwt.

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Basis the key to hedging (futures and
options) effectiveness.
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What is Basis?

• Basis is the difference between two prices.
• In commodity marketing, basis is generally
  referred to the difference between a specific
  cash price and a specific futures price.
• Mathematically Basis Cash - Futures
• Milk Basis Mailbox price - BFP futures

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Basis

• Generally is more predictable than cash or
  futures prices due to
• Convergence
• Futures and cash prices move together (same
  fundamental conditions generally affect both
  markets)
• Year-to-year stability

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How Should Basis be Calculated

• Determine
• Location, date, quality, futures contract
• Average over several years
• Measure variability (risk)
• Historical range (highs and lows), standard
  deviation, RMSE

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Kansas Prices vs. BFP Price, 1996-1999
Source DFA
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Milk Basis in Kansas, 1996-1999Current Cash
Minus Current Futures
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Basis Relationships

• Important to know how your mailbox price is
  calculated.
• Current month mailbox price is determined by
  current and previous months class III prices.
• Thus, utilization of milk will impact the manner
  in which basis is calculated.
• how you implement your hedging program.