Dairy Futures and Options Tutorial

Final Comments About the Use of Hedging as a Risk Management Tool

Below is an example of a dairy farm operator who enters into a short hedge by selling Class III futures contracts on the Chicago Mercantile Exchange (CME). Suppose in June, this operator is interested in locking in the price he is to receive for 200,000 lbs of his September milk production. The producer knows his cost of production and the quality of milk typically produced during that month. The producer then checks the price of the September Class III contract currently (in June) trading at the CME. On June 15th, the day he is evaluating the market, the September Class III contract is selling for $13.00. Given the quality of his production relative to that used in the calculation of the Class III and other local premiums (e.g, his mailbox-Class III basis), he determines that $13.00 is likely to generate an acceptable return. The producer by selling a September Class III contract in June at $13.00 effectively locks in this price. The following Table shows the resulting outcome if the announced September Class III turns out to be lower or higher than $13.00/cwt.

Cash Market
Actual September Class III
Change in Cash Market
Lower Higher
$11.20 $13.75
Futures Market
Sept Futures Selling Price (June)
- Futures Purchase Price (Actual Sept. Class III)
= Gain (Loss)

- $11.20

- $13.75
Commission $0.05 $0.05
Net Class III Price Received $11.20 + $1.80 -$0.05
= $12.95
$13.75 - $0.75 -$0.05
= $12.95

If the September Class III is announced at $11.20, the producer earns $1.80/cwt less for his milk in the cash market. Since the Class III contract is a cash settle contract, when the futures position is settled against the Class III, the producer gains $1.80 per futures cwt covered by the two futures contracts. When the futures market gain is applied to the announced September Class III, the result is a net Class III which equals the expected hedge price except for the commission paid for undertaking the futures transaction. A similar but opposite pattern of gains and losses is obtained when the announced Class III is higher than that secured by undertaking the hedge.

The following figure provides a comparison of the Class III price received with and without hedging at alternative announced September Class III prices. Without hedging the blue line shows the Class III the producer receives is whatever the market dictates.
The solid red line shows that via hedging the producer has locked in $12.95/cwt Class III for the hedged milk regardless of what occurs in the cash market. This is the one limitation of hedging. Once you lock in a price, you cannot capture any of the benefits of favorable price movements in the cash market. (Note that in this example, we have not analyzed the impact on the producer’s mailbox price.
As shown above, the net mailbox price is determined by changes in the mailbox-Class III basis over the June-September period).