Dairy Price Risk Management:Session 5 – Hedging With Futures Cooperative Extension – Ag and Natural Resources Farm and Risk Management Team Last Update May 1, 2007
Why the Interest in Dairy Futures? • Change in federal dairy policy: • From 1950 to 1981, the dairy price support was based on parity, and market prices tended to closely match support prices. So market prices were stable and predictable. • Since 1981, dairy price support levels have been determined by congress, and by 1990, support prices were below the cost of production for most dairy farms. So market prices are driven by market conditions and are volatile and unpredictable.
What are Futures Markets and Futures Contracts? • Organized auction markets • “Commodity” traded is specified commodity or commodity price index at specified time in the future • Buy a futures contract Long commitment to take delivery • Sell a futures contract Short commitment to make delivery
What are Futures Markets and Futures Contracts (2)? For cash settled futures contracts (most dairy contracts), commitment is to make up in cash any difference between the settlement price and the contract price • If settlement price ends up higher than contract price, then shorts pay difference (sold low and bought high • If settlement price ends up lower than contract price, then longs pay difference (bought high and sold low)
What are Futures Markets and Futures Contracts (3) ? • Futures contracts can be fulfilled in two ways: • Hold to maturity and take or make delivery (deliverable contracts) or cash settle against settlement price. • Offset – buy a contract if short or sell a contract if long. This is also known as liquidating a contract or lifting a hedge.
Who Trades Futures? • Hedgers Interest in trading futures is to protect cash market price objective • Speculators Interest in trading futures is to make a profit from trading futures
How do you Trade Futures? • Open a broker account • Place an order with your broker • Post performance bond (Margin)
Who regulates Futures Markets? • Exchanges are self-regulating, with oversight authority in: • The Commodity Futures Trading Commission (CFTC) • Industry futures associations (e.g., National Futures Assn.) also help enforce rules and maintain integrity.
What Are you Trading When you Trade the CME Class III Contract? *Can be increased in expiration month
Hedging With Futures • Take a futures market position that is equivalent to your cash market position at the time the futures contract expires (Dairy Farmer sell milk in September take short futures position in September contract) • Locks in contract price*, BUT: May receive more or less than if unhedged • Example: Feb 3: Expect to market 200,000# of milk in Sept. SELL 1 Sep futures contract @ $14.85 Sep 1: Sell milk at $14.00 Settle futures @ 12.85 $ .85 $12.85 • *DOES NOT CONSIDER BASIS, BASIS RISK, OPPORTUNITY COST OF PERFORMANCE BOND (MARGIN) OR BROKER COMMISSIONS
Margin and Margin Calls • Need to deposit MARGIN (performance bond) with broker to cover any paper losses when you sell futures contracts • If price moves against your position (rises after you’ve sold), then you may need to deposit additional margin • There are initial margin and maintenance margin requirements – maintenance margin is smaller • Margin requirements are less for hedgers than for speculators • Initial margin for hedges is about 3-5 percent of the contract value, depending on exchange and broker
Example of Margin Requirements (Initial margin is $700; Maintenance margin is $550)
Summary • Futures markets: Organized auction markets for futures contracts with well-defined enforced rules of conduct. • Futures contracts: Method of buying or selling a commodity “before the fact.” • Hedging with futures contracts helps achieve a price objective by offsetting cash market losses with futures market gains. At the same time, hedging offsets cash market gains with futures market losses. “Locking in a price” means just that.