Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014
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Dairy Risk Management in 60 Minutes. Marin Bozic University of Minnesota – Twin Cities Guest Lecture at Ridgewater College, Feb 26, 2014. Why is There A Lot of Risk in Dairy?. Price. S. D ′. D. Quantity. Why is There A Lot of Risk in Dairy?. What Can be Done About Volatility?.

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Marin Bozic University of Minnesota – Twin Cities Guest Lecture at Ridgewater College, Feb 26, 2014

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Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Dairy Risk Management in 60 Minutes

Marin Bozic

University of Minnesota – Twin Cities

Guest Lecture at Ridgewater College, Feb 26, 2014


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Why is There A Lot of Risk in Dairy?

Price

S

D′

D

Quantity


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Why is There A Lot of Risk in Dairy?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

What Can be Done About Volatility?

  • Sell your product when the price is good?

    • Can do with corn; not with milk – continuous production

  • Grow your own feed?

    • Less exposure to feed price risk; but price of land may be expensive

  • Ride out the bad times?

    • Large equity needed

  • Use financial instruments to design desired risk/reward profile

    • Forward contracts, futures, options, etc.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Dairy Futures and Options

Class III Futures

Class IV Futures

Nonfat Dry Milk Futures

Dry Whey Futures

Butter Futures

Cheese Futures


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Dairy Futures and Options


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Class III Milk Futures


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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 sold a futures contract”.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

A Standardized Product


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Promise to do What?

  • 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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Risk-Reward Diagram: Short Futures Position


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Risk-Reward Diagram: Unhedged Production


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Risk-Reward Diagram: Unhedged Production


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

What Happened? 1. Futures Market

  • You sold (shorted) a Feb 2009 Class III contract on 10/13/2008 when the futures price was $15.31.

  • On 02/27/2009, USDA announces that Feb ’09 Class III milk price is $9.31

  • 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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

What Happened? 1. 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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Gains in One Market will Offset Losses in Another


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Option Contracts

  • 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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Risk-Reward Diagram: Put Option


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Trade-off: Strike vs. Premium


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Hedging with Options


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Comparing Futures, Options, and Luck


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Reducing Costs of Option Strategies


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Reducing Costs of Option Strategies


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Reducing Costs of Option Strategies


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

When Should I Hedge?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Hedging with Puts: 3-Months Out


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Hedging with Puts: 7-Months Out


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Hedging with Puts: 11-Months Out


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

A Simple Hedging Program with Puts


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Why Does this Work?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Why Does this Work?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Why Does this Work?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

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.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

How Does 2014 Farm Bill Change the Game?

  • Key features of the Margin Protection Program for Dairy Producers:

  • Voluntary program, with no supply management or any direct disincentives for growth in low-margin periods.

  • Protects dairymen from severe downturns in the milk price, rising livestock feed prices, or a combination of both.

  • Does not impose production or gross income eligibility caps

  • Very simple and hassle-free


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

How Does 2014 Farm Bill Change the Game?

  • Actual Dairy Production Margin:

  • All-milk price minus feed ration value

  • Single, national formula, cannot be customized

  • Production History

  • The highest annual milk production over 2011, 2012 and 2013

  • Revised annually based on milk yield growth

  • Coverage Percentage

  • 25% to 90% of production history, in 5% increments

  • Coverage Level

  • $4.00/cwt to $8.00/cwt in 50 cents increments


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Actual Dairy Production Margin


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

MPP Premiums


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

MPP Premiums

  • Q: How Much Milk Can I Insure?

  • Unlike old dairy safety net based on MILC, there are no categorical limits to size of the farm. You can insure up to 90% of your production history, which is the highest of your milk marketings in 2011, 2012, and 2013.

  • Each year, your production history will

  • increase based on national growth in

  • milk yield per cow.

  • Each year, you may choose to cover 25% to 90%

  • of your production history, in 5% increments.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

MPP Premiums

Q: When does the MPP pay indemnities?


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

MPP Premiums

  • Q: Are these premiums subsidized? I do not see subsidy percentage anywhere?

Expected Margins Much Below Historical Average

Expected Margins Near Historical Average

Expected Margins Much Above Historical Average

Modestly Subsidized.

Margin Insurance Premiums are Too Expensive!

Margin Insurance Premiums are Very Highly Subsidized.


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Combining Private Risk Management Tools with MPP

Conventional wisdom: Use MPP for passive catastrophic risk protection (e.g. always buy $6.50), and private risk markets for “shallow loss” protection if you need it.

A smarter way: If USDA sets the annual enrollment date near the end of the calendar year, you will be able to glean at expected margins in the year ahead before deciding what to do:

If expected margins are sufficiently high, try to lock in profit using futures & options, and if you manage to do that, then drop MPP to low coverage level

If expected margins are low – use MPP with high coverage levels

(somewhat harder to do for large producers).


Marin bozic university of minnesota twin cities guest lecture at ridgewater college feb 26 2014

Dairy Risk Management in 60 Minutes

Ridgewater College

Wilmar, MN

February 26, 2014

Dr. Marin Bozic

[email protected]

Department of Applied Economics

University of Minnesota-Twin Cities

317c Ruttan Hall

1994 Buford Avenue

St Paul, MN 55108

Photo Credits:

Credits Slide: Zweber Family Farms, Elko, MN


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