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

2. K-State Research & Extension Seasonal Price Indices in Kansas Prices Follow A Consistent Pattern Each Year

3. K-State Research & Extension Monthly BFP Prices, 1962-99

4. K-State Research & Extension Monthly BFP Prices, 1962-99 Milk Prices Are More Variable Than In The Past

5. K-State Research & Extension Monthly BFP Prices, 1962-99 Milk Prices Are More Variable Than In The Past

6. K-State Research & Extension Futures markets allow you to manage some of your input (corn, soybean meal) and output (milk) price risk

7. K-State Research & Extension Why Do We Need A Futures Market?  To “discover” price  To provide a location where ALL market participants can interact  To disseminate information

8. K-State Research & Extension 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. K-State Research & Extension 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. K-State Research & Extension Contract standardized with respect to: Delivery Period (timing) Contract Size (quantity) Quality of the Product

11. K-State Research & Extension CME Milk Futures contract specs CommodityBFP Milk ExchangeCME Size2000 cwt. 500 cwt. MonthsAll Cows (Monthly)126 (at 19,000 lbs)

12. K-State Research & Extension 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. K-State Research & Extension June 1999 BFP futures convergence

14. K-State Research & Extension December 1999 BFP futures convergence

15. K-State Research & Extension December 1998 BFP futures convergence

16. K-State Research & Extension Entering and Exiting A Futures Position Initial or How to Entry PositionExit Buy (long)Sell Sell (short)Buy

17. K-State Research & Extension 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. K-State Research & Extension How Much Can I Gain Or Lose In The Futures Market?

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

20. $11.75 - $9.50 = $2.25/cwt x 2000 = $4500/contract  126 head = $35.71/head How Much Can I Gain Or Lose In The Futures Market?

21. K-State Research & Extension Hedging using the futures market

22. K-State Research & Extension What Is Hedging? l Hedging is using the futures market as a temporary substitute for an intended cash market transaction.

23. K-State Research & Extension What Is Hedging? l Hedging is using the futures market as a temporary substitute for an intended cash market transaction l 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. K-State Research & Extension What Is The Purpose Of Hedging? To ensure price protection against adverse market moves.To ensure price protection against adverse market moves. To reduce the risk of price fluctuations that can affect the value of a commodity.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.Effective hedge: price received/paid equals what you thought it was going to be.

25. K-State Research & Extension 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. K-State Research & Extension Basis defines the relationship between your local cash price and the futures market Mathematically, basis = cash price - futures price BasisBasis

27. K-State Research & Extension In milk,In milk, basis = mailbox price - futures pricebasis = mailbox price - futures price To forecast basis, need a basis historyTo forecast basis, need a basis history Historical relationship between your mailbox price and Class IIIHistorical relationship between your mailbox price and Class III BasisBasis

28. K-State Research & Extension 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. K-State Research & Extension $11.68current futures price +($0.00)expected basis -$ 0.03commission -$ 0.03commission =$11.65ENSP (expected net sale price) =$11.65ENSP (expected net sale price) Expected Net Sale Price

30. K-State Research & Extension Declining Market FuturesBFP 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. K-State Research & Extension Advancing Market FuturesBFP 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. K-State Research & Extension 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. K-State Research & Extension Hedging using the options market

34. K-State Research & Extension 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. K-State Research & Extension Call and Put Options “Call” Option The right to buy “Put” Option The right to sell But, not the obligation

36. K-State Research & Extension Futures Contract Buy Sell Call Put Buy SellBuy Sell

37. K-State Research & Extension What Is A Premium? The purchase price a buyer pays and seller receives for the option.

38. K-State Research & Extension How Is The Premium Determined? Intrinsic ValueIntrinsic Value –what is the option “worth” today? –strike price versus current futures Time ValueTime Value –a residual –affected by time, volatility and interest rates

39. K-State Research & Extension Strike Premium= Intrinsic + Time Strike Premium= Intrinsic + Time 11.75 call 0.44 0.00 0.44 11.75 put 0.510.07 0.44 Premium Value -- Example July Futures @ $11.68

40. K-State Research & Extension 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. K-State Research & Extension Option Trading “ Buyer” 1) Offset (by selling) 2) Let the option expire 3) Exercise the option “Seller” 1) Offset (by buying)

42. K-State Research & Extension 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. K-State Research & Extension Expected Minimum Net Sale Price $11.75put option strike price - $ 0.51put option premium +($0.00)expected basis -$ 0.03commission =$11.21EMNSP (expected minimum net sale price)

44. K-State Research & Extension 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. K-State Research & Extension Basis … … the key to hedging (futures and options) effectiveness.

46. K-State Research & Extension What is Basis? l Basis is the difference between two prices. l In commodity marketing, basis is generally referred to the difference between a specific cash price and a specific futures price. l Mathematically: Basis = Cash - Futures l Milk: Basis = Mailbox price - BFP futures

47. K-State Research & Extension Basis l Generally is more predictable than cash or futures prices due to: è Convergence è Futures and cash prices move together (same fundamental conditions generally affect both markets) è Year-to-year stability

48. K-State Research & Extension How Should Basis be Calculated l Determine: è Location, date, quality, futures contract l Average over several years l Measure variability (risk) è Historical range (highs and lows), standard deviation, RMSE

49. K-State Research & Extension Kansas Prices vs. BFP Price, 1996-1999 Source: DFA

50. K-State Research & Extension Milk Basis in Kansas, 1996-1999 Current Cash Minus Current Futures

51. K-State Research & Extension Basis Relationships l Important to know how your mailbox price is calculated. l Current month mailbox price is determined by current and previous months class III prices. l Thus, utilization of milk will impact the manner in which basis is calculated. l & how you implement your hedging program.