Dairy Futures and Options Tutorial

Hedge Examples Assuming Zero Basis Risk

In the following worksheet we begin to illustrate basic hedging
principles. As a first step, we assume that the futures contract
price equals the cash price over the time in which the hedge strategy
is in effect. That is, the basis is zero.

Basis: Defined as the difference between your local cash price
and the futures price on a particular sale date.

In the first example we present a template for looking at the effect
of a short hedge (e.g., you are long in the cash product in that you
own the product). In the second example we present the template for a
long hedge (e.g. you are short the cash product in that you need the
actual product).

Given the assumption of zero basis, to show how one locks in a
particular cash price all one has to do is enter the sell (purchase) and purchase
(sell) futures price at the time of initiating the hedge strategy in the worksheet.
It is important to note that we have also assumed zero commission costs.
These will be discussed later.

Example of a Short Class III Hedge With Zero Basis Risk

Under a short hedge, you sell a futures contracts to cover
your long position in the cash market. If you are a dairy farm operator selling
milk to a cheese plant you are long in Class III milk.

In the example below all you have to enter is the initial Class III
futures sale price and the settle price that you purchase back
this futures contract which will be the announced Class III price
if you do not lift the hedge prematurely.

With the above assumption of zero basis risk, the expected cash price
equals the actual hedged price. In reality, there will be some basis
risk resulting in a divergence between expected sale cash price and
actual hedge price.

The Actual Hedged Selling Price of your product is the net price
you receive for your cash product after taking into account the
profits or losses earned in the futures market segment of your hedge.

Class III Futures Market Class III Cash Market
+ Sell $ Expected Class III Announced Price Represented by Futures Price $0.00
- Buy $ Actual Un-Hedged Class III Announced Price $0.00
=Gain $0.00

 

Short Hedge Results
Actual Selling Price in cash market $0.00
+ Futures Market Gain $0.00
= Hedged Selling Price $0.00

Example of a Long Class III Hedge With Zero Basis Risk

Similar to the short hedge example, with zero basis risk

Class III Futures Market Class III Cash Market
Buy $ Expected Class III Cash Purchase Price Represented by Futures Price $0.00
+ Sell $ Actual Un-Hedged Class III Announced Price $0.00
=Gain $0.00

 

Long Hedge Results
Actual Purchase Price $0.00
- Futures Market Gain $0.00
= Hedged Purchase Cost $0.00