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Extension > Agriculture > Dairy Extension > Marketing > For hedging, having the milk production to back up the contract is important

For hedging, having the milk production to back up the contract is important

Margot Rudstrom

Published in Dairy Star December 9, 2006

Hedging with Class III milk futures contracts can be used to fix the Class III price you receive for your milk. The contracts trade daily on the Chicago Mercantile Exchange. When hedging with futures contracts, it is important to have the milk production to back up the contract. Think of it like this. Since a Class III futures contract volume is 200,000 pounds, I am agreeing to sell 200,000 pounds of milk at a specified price. The hedge works by having gains (losses) on the futures contract being offset by losses (gains) in the cash market.

Let's assume I am a smaller dairy operation. It is important to understand what happens when I hedge more milk than I produce. Is it possible to hedge if I don't have 200,000 pounds of milk to hedge in a given month and what are the financial implications?

Figure 1

Figure 1: Class III July 2006 Futures Contract Settle Price January 3-Janaury 20, 2006

Let's look at July 2006 as an example. In January 2006, the July 2006 Class III futures contract price was in the top 1/3 historically for July. When the price started to decline on January 19th, I decide it is time to sell a futures contract. My broker is able to sell a July Class III futures contract on January 20th for $12.94.

Where did I end up? On Friday, August 4th, 2006, the announced Class III price for July was $10.92. With hedging, losses (gains) on the cash markets are offset by gains (losses) in the futures market. On January 20th, I was expecting the July Class III cash price to be $12.94. It ended up being $2.02 less than I expected. The futures contract I sold for $12.94 settled for $10.92. Think of the cash settle price of the futures contract as the price you need to pay to buy back the contract. I sold a contract for $12.94 and then bought it back for $10.92, making $2.02.

Date Cash market Futures market
January 20, 2006 Estimated cash price for July 2006 Class III is $12.94 Sell a 200,000 futures contract for $12.94
August 4, 2006 Announced Class III Price for July is $10.92 Futures contract settles for $10.92
Gain/loss $10.92 - $12.94 = -$2.02 $12.94 - 10.92 = +$2.02

What happens if I hedge and I don't have 200,000 pounds of milk for the month to cover a Class III futures contract? Let's say my monthly milk production is 100,000 pounds and I hedge a 200,000 pound contract. In my example, the gain on my futures contract was $4,040 ($2.02/cwt x 2,000 cwt). The loss on the cash market was $2,020 ($2.02/cwt x 1,000 cwt). Being overprotected or hedging more milk than I produce is OK if the milk price declines.

Suppose the announced Class III price for July went up $2.02 over what I was expecting back on January 20th. I have a gain of $2.02 in the cash market and a loss of $2.02 in the futures. I sold a futures contract for $12.94 and I have to buy it back (it cash settles) for $14.96. On the cash side, I had a gain of $2,020 ($2.02/cwt x 1,000 cwt milk produced). On the futures side, I had a loss of $4,040 ($2.02/cwt x 2,000 cwt). Being overprotected (hedging more milk than I produce) leads to a loss if the milk price increases.

Date Cash market Futures market
January 20, 2006 Estimated cash price for July 2006 Class III is $12.94. Sell a 200,000 futures contract for $12.94
August 4, 2006 Announced Class III Price for July is $14.96 Futures contract settles for $10.92
Gain/loss $14.96 - $12.94 = +$2.02 $12.94 - 14.96 = -$2.02

When considering hedging there are some things to keep in mind. First, hedging will fix the Class III price received. On a price per hundredweight, any gains (losses) on the cash market will be offset by losses (gains) in the futures market. Second, there is an important message if there is not sufficient milk production behind the hedge. If I hedge more milk than I produce and the Class III prices increases, I will have a loss because I don't have enough milk in the cash market to offset the loss in the futures market. Therefore, it is important to understand the financial implications of being over-protected when hedging.

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