1. Marin Bozic University of Minnesota – Twin Cities Guest Lecture at Ridgewater College, Feb 26, 2014 Dairy Risk Management in 60 Minutes

2. Why is There A Lot of Risk in Dairy? S D D′D′ Quantity Price

3. Why is There A Lot of Risk in Dairy?

4. 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.

5. Dairy Futures and Options 1.Class III Futures 2.Class IV Futures 3.Nonfat Dry Milk Futures 4.Dry Whey Futures 5.Butter Futures 6.Cheese Futures

6. Dairy Futures and Options

7. Class III Milk Futures

8. 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? o The exchange stands as the counterparty to any contract, and guarantees that promises will be honored o 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”.

9. A Standardized Product AttributeValue Contract Size200,000 lbs (2,000 cwt) Price Quotation$/cwt Min. Price Move$0.01/cwt ($20/contract) Daily Price Limit$.75/cwt ($1,500/contract) Months TradedAll Months Open Contracts24 Months Position Limits1,500 contracts Last Trading DayOne business day before USDA Class III Price Announcement SettlementCash-settled against USDA Class III

10. 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.

11. 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.

12. Risk-Reward Diagram: Short Futures Position

13. Risk-Reward Diagram: Unhedged Production

15. What Happened? 1. Futures Market 1)You sold (shorted) a Feb 2009 Class III contract on 10/13/2008 when the futures price was $15.31. 2)On 02/27/2009, USDA announces that Feb ’09 Class III milk price is $9.31 3)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.

16. 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.

17. Gains in One Market will Offset Losses in Another October 13, 2008February 27, 2009  Sell 1 Feb ’09 Class III milk contract @ $ 15.31/cwt  Class III milk contract expires @ $ 9.31/cwt  Expected milk check basis + $ 2.40 / cwt  Feb Milk Check @ $ 11.82/cwt  Realized basis is + $ 2.51/cwt  Expected net selling price in February 2009:  Realized net price in February: $15.31 + $ 2.40 $ 17.71 futures price expected basis expected price $ 11.82 + $ 6.00 $ 17.82 cash sale futures change (sold at $ 15.31, bought at $ 9.31) realized price

18. 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.

19. 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.

20. Risk-Reward Diagram: Put Option

21. Trade-off: Strike vs. Premium

22. Hedging with Options

23. Comparing Futures, Options, and Luck

24. Reducing Costs of Option Strategies PutsCalls $13.00$0.11$15.50$0.94 $13.50$0.19$16.00$0.55 $14.00$0.31$16.50$0.40 $14.50$0.47$17.00$0.28 $15.00$0.68$17.50$0.20 $15.50$0.94$18.00$0.13 $16.00$1.24$18.50$0.09 $16.50$1.58$19.00$0.06 Date: 10/13/2008 Feb ’09 Futures: $15.31 Buy $14.00 put for $0.31 Sell $17.00 call for $0.28

25. Reducing Costs of Option Strategies

28. 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: 1)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.

29. When Should I Hedge? Hedging Horizon What Can You Buy for 50 cents? (Option Strike) 1 month 5 cents below futures 3 months 64 cents below futures 5 months 1.08 below futures 7 months 1.44 below futures 9 months 1.74 below futures 11 months 2.08 below futures

30. Hedging with Puts: 3-Months Out

31. Hedging with Puts: 7-Months Out

32. Hedging with Puts: 11-Months Out

33. A Simple Hedging Program with Puts Hedging Horizon Number of Profitable Trades Net Profit/Loss 2007-2012 Return on Investment 2007-2012 1 month 16/74-0.14-41% 3 months 21/740.0613% 5 months 19/740.2146% 7 months 15/740.2452% 9 months 09/740.2657% 11 months 10/740.3373%

34. Why Does this Work?

37. 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.

38. 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

39. 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

40. Actual Dairy Production Margin

41. MPP Premiums Premium ≤ 4mil lbs PH ($/cwt) Discounted Premium Premium >4 M lbs. PH ($/cwt) $4.00$0.000$0.00000$0.000 $4.50$0.010$0.00750$0.020 $5.00$0.025$0.01875$0.040 $5.50$0.040$0.03000$0.100 $6.00$0.055$0.04125$0.155 $6.50$0.090$0.06750$0.290 $7.00$0.217$0.16250$0.830 $7.50$0.300$0.22500$1.060 $8.00$0.475$0.47500$1.360

42. 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.

43. MPP Premiums Q: When does the MPP pay indemnities? Consecutive Two-Month Periods 2012 Two-month Average Coverage Level & Indemnities $4.00$6.50 January7.57 February5.826.700.00 March4.94 April4.264.600.001.90 May3.41 June3.513.440.663.06 July2.74 August2.982.861.143.64 September5.51 October7.286.390.000.14

44. MPP Premiums Q: Are these premiums subsidized? I do not see subsidy percentage anywhere? Expected Margins Near Historical Average Modestly Subsidized. Expected Margins Much Above Historical Average Margin Insurance Premiums are Too Expensive! Expected Margins Much Below Historical Average Margin Insurance Premiums are Very Highly Subsidized.

45. 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: a)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 b)If expected margins are low – use MPP with high coverage levels (somewhat harder to do for large producers).

46. Dairy Risk Management in 60 Minutes Ridgewater College Wilmar, MN February 26, 2014 Dr. Marin Bozic mbozic@umn.edu 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