Milk Futures & Options Workshop

1. Milk Futures & Options Workshop James Mintert, Ph.D. Professor & Extension Ag. Economist, Livestock Marketing Kansas State University

2. Prices Follow A Consistent Pattern Each Year Seasonal Price Indices in Kansas

3. Monthly BFP Prices, 1962-99

4. Milk Prices Are More Variable Than In The Past Monthly BFP Prices, 1962-99

5. Milk Prices Are More Variable Than In The Past Monthly BFP Prices, 1962-99

6. Futures marketsallow you to manage some of your input (corn, soybean meal) and output (milk) price risk

7. Why Do We Need A Futures Market? • To “discover” price • To provide a location where ALL market participants can interact • To disseminate information

8. 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.

9. 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.

10. Contract standardized with respect to: • Delivery Period (timing) • Contract Size (quantity) • Quality of the Product The only negotiable terms are price and thenumber of contracts involved in each trade.

11. CME Milk Futures contract specs CommodityBFP Milk Exchange CME Size 2000 cwt. 500 cwt. Months All Cows (Monthly) 126 (at 19,000 lbs)

12. 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.

13. June 1999 BFP futures convergence

14. December 1999 BFP futures convergence

15. December 1998 BFP futures convergence

16. Entering and Exiting A Futures Position Initial or How to Entry PositionExit Buy (long) Sell Sell (short) Buy

17. What Happens As Futures Prices Change? Once you’ve 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.

18. How Much Can I Gain Or Lose In The Futures Market?

19. How Much Can I Gain Or Lose In The Futures Market? $11.75 - $9.50 = $2.25/cwt (change in 90 days)

20. 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

21. Hedging using the futures market

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

23. 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.

24. 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.

25. 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.

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

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

28. 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.

29. Expected Net Sale Price $11.68 current futures price + ($0.00) expected basis - $ 0.03 commission = $11.65 ENSP (expected net sale price)

30. Declining Market Futures BFP cash February 25 Sell futures $11.68 ------ July Sell cash milk $10.55 Buy back futures $10.55 ------ Futures profit + 1.13 ------ Less commission - 0.03 Total Return 1.10 +10.55 = $11.65

31. Advancing Market Futures BFP cash February 25 Sell futures $11.68 ------ July Sell cash milk $12.70 Buy back futures $12.70 ------ Futures profit - 1.02 ------ Less commission - 0.03 Total Return - 1.05 +12.70 = $11.65

32. 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 @ $11.68 * Includes commission of $.03/cwt.

33. Hedging using the options market

34. 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”

35. “Call” Option The right to buy “Put” Option The right to sell Call and Put Options But, not the obligation

36. Futures Contract Buy Sell Call Put Buy Sell Buy Sell

37. What Is A Premium? The purchase price a buyer pays and seller receives for the option.

38. 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

39. Premium Value -- ExampleJuly Futures @ $11.68 Strike Premium = Intrinsic + Time 11.75 call 0.44 0.00 0.44 11.75 put 0.51 0.07 0.44

40. How Are Options Exercised? A buyer exercises an option when he decides to buy or sell the underlying commodity by taking a futures position.

41. Option Trading “Buyer” 1) Offset (by selling) 2) Let the option expire 3) Exercise the option “Seller” 1) Offset (by buying)

42. 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.

43. 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)

44. Potential Results July futures: $11.68 July put option: $11.75 strike price $0.51 premium Fut. Prem Option’s 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.

45. Basis …… the key to hedging (futures and options) effectiveness.

46. 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

47. 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

48. 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

49. Kansas Prices vs. BFP Price, 1996-1999 Source: DFA

50. Milk Basis in Kansas, 1996-1999Current Cash Minus Current Futures