Dairy Futures and Options Tutorial

A Review of the Steps to Hedging

  1. Know Your Costs of Production: If you use a short hedge to lock in a selling price make sure you know the costs of production. For example, if you are a dairy farm operator and use the Class III futures contract to hedge your production (e.g., you are long in the physical milk commodity) you need to make sure that the hedge price is sufficient to cover you costs of production.

  2. Contract Specifications: You can obtain detailed contract specifications from the Chicago Mercantile Exchange CME. Information can also be obtained from the UW Dairy Marketing website.

  3. Know Your Local Basis: In order to determine you net selling price or purchase cost you need to know your local basis. There are a number of alternative techniques for determining this basis including the use of basis forecasting models to an examination of recent historical patterns. In many examples illustrating the use of hedging as a risk management tool, it is assumed that the basis does not change, e.g, zero basis risk. You may want to be conservative in you estimation as to how basis will change over the length of your hedge.

  4. Performance Bond (Margin) Requirements: Remember that if you are the one doing the hedging that you need to establish margin accounts with your broker which are evaluated on a daily basis. You should be prepared, should futures prices move against your interest, to be able to cover any margin calls. If not, you may have to liquidate your position in the futures market and suffer an actual loss in the futures market transactions when you are not prepared to offset this loss with the associated cash market transactions. If your processing plant is undertaking the hedge for you (via the offering a fixed price contract) the plant is responsible for any margin calls.

  5. Include Your Hedging Costs in Your Calculations: Make sure that you include all costs in your calculation of the actual net hedging price (or cost). These costs include the direct fees that you pay to your broker for purchasing and/or selling futures contracts. A more difficult cost to include (and which we have included in previous examples) are the interest (opportunity) costs associated with the margin accounts that you must maintain with your broker. If this margin account was not required, the funds in this margin account could be invested and earn a positive interest. The forgoing of this potential income can be considered an opportunity cost of maintaining the margin account and thus undertaking the hedging strategy.

  6. Surround Yourself with Knowledgeable People: Given the uniqueness of the dairy sector, it is important for you to choose a broker that knows the dairy industry. Does the broker understand the Class III? Does the broker understand current supply/demand conditions in the dairy industry? Does the broker have access to historical dairy-related data? Is your broker a good teacher? With the dairy industry in what could be considered in the early stages of the use dairy-based futures (and options) for risk management, your broker should be willing to assist you in understanding the workings of futures markets. Your broker should be honest with respect to the risks associated with futures trading. For example, there probably going to be occasions when you receive a margin call. There still exists some basis risk. You should also obtain a banker that understands the role of futures markets and how they can be used to manage your price risk.

  7. Develop a Market Plan: You need to develop a marketing plan and stick to it. Changing your strategy midstream may generate short-run benefits but over the long-run may make you worse off. This market plan may incorporate a variety of strategies that incorporate hedging as one part.