Dairy Futures and Options Tutorial

What is a Basis?

An example of an actual basis series can be seen by a comparison of average Upper Midwest Mailbox prices and the announced Class III price over the 2000-2007 period. The following figure shows this relationship. If we subtract from this mailbox price series the Announced Class III we generate the Mailbox/Class III basis table which is shown in the following figure.

The usual case is that the local price that you receive or pay for your milk varies from the current futures price. This difference is referred to as your basis. Given a futures price and expected (e.g. average) basis you can estimate your expected net output price or input cost.

Suppose you are a dairy farm operator and you want to establish a short hedge, e.g., you want to lock in a price for your future milk production. Below, if you enter the current settle price for the futures contract of the month you plan to produce this milk and your expected basis for that month you obtain your expected hedge price.
Alternatively, if you are a user of farm milk, then you may want to consider adopting a long hedge strategy. If you assume a long hedge example below you can enter the current settle price for the futures month in which you plan to use this milk.

If you are a farm operator you can calculate your basis as your mailbox price minus the announced Class III. If you are a purchaser of milk such as a cheese plant, you calculate your basis as your pay price (including premiums, etc.) minus the appropriate month's announced Class III.

You use the announced Class III under both circumstances since this is what cash settles CME Class III futures contracts.

Below is a template to show how your basis is used to calculated either an expected hedged output price or input cost depending on the type of hedge chosen.

Calculation of Expected Hedged Price (Cost)

Type of Hedge Short Long

Sell Futures + Estimated Basis = Expected Hedged Output Price
+ =