k-state research & extension milk futures & options workshop james mintert, ph.d. professor...

K-State Research & ExtensionK-State Research & Extension

Milk Futures & Options WorkshopMilk Futures & Options Workshop

James Mintert, Ph.D.James Mintert, Ph.D.

Professor & Extension Ag. Professor & Extension Ag. Economist, Livestock MarketingEconomist, Livestock Marketing

Kansas State UniversityKansas State University


Seasonal Price Indices in KansasSeasonal Price Indices in Kansas

Prices Follow A Consistent Pattern Each YearPrices Follow A Consistent Pattern Each Year


Monthly BFP Prices, 1962-99Monthly BFP Prices, 1962-99


Monthly BFP Prices, 1962-99Monthly BFP Prices, 1962-99

Milk Prices Are More Variable Than In The Past


Futures marketsFutures marketsallow you to manage some of allow you to manage some of

your input (corn, soybean meal) your input (corn, soybean meal) and output (milk) price riskand output (milk) price risk


Why Do We Need A Futures Market?Why Do We Need A Futures Market?

To “discover” priceTo “discover” price

To provide a location where ALL To provide a location where ALL market participants can interactmarket participants can interact

To disseminate informationTo disseminate information


How Are Futures Prices Determined?How Are Futures Prices Determined?

The futures price is simply what a The futures price is simply what a

buyer is willing to pay and a seller is buyer is willing to pay and a seller is

willing to accept for a product.willing to accept for a product.

The exchange (CME, NYBT, CBOT) The exchange (CME, NYBT, CBOT) itself does not set prices.itself does not set prices.


What Is A Futures Contract?What Is A Futures Contract?

An agreement between a buyer and a An agreement between a buyer and a

seller to receive or deliver a product seller to receive or deliver a product

on a future date at a price they have on a future date at a price they have

negotiated TODAY.negotiated TODAY.


Contract standardized with respect to:Contract standardized with respect to:

• Delivery Period (timing)

• Contract Size (quantity)

• Quality of the Product

The only negotiable terms are price and the number of contracts involved in each trade.


CME Milk Futures contract specsCME Milk Futures contract specs

Commodity BFP Milk

Exchange CME

Size 2000 cwt. 500 cwt.

Months All

Cows (Monthly) 126(at 19,000 lbs)


CME MilkCME Milk

Settlement In Every Contract MonthSettlement In Every Contract Month

Contract expires 1 day prior to USDA Contract expires 1 day prior to USDA

Class III price announcementClass III price announcement

Cash settled contract at expiration to Cash settled contract at expiration to

the announced Class III pricethe announced Class III price

This process causes the futures price to This process causes the futures price to

converge to the Class III cash price.converge to the Class III cash price.


June 1999 BFP futures convergenceJune 1999 BFP futures convergence


December 1999 BFP futures convergenceDecember 1999 BFP futures convergence


December 1998 BFP futures convergenceDecember 1998 BFP futures convergence


Entering and Exiting Entering and Exiting A Futures PositionA Futures Position

Initial or How toEntry Position Exit

Buy (long) Sell

Sell (short) Buy


What Happens As Futures What Happens As Futures Prices Change?Prices Change?

Once you’ve established a “long” Once you’ve established a “long”

(buy) or “short” (sell) position in the (buy) or “short” (sell) position in the

futures market, the value of your futures market, the value of your

position (gain or loss) changes position (gain or loss) changes

each time prices change.each time prices change.


How Much Can I Gain Or Lose In The Futures Market?

$11.75 - $9.50 = $2.25/cwt (change in 90 days)


$11.75 - $9.50 = $2.25/cwt

x 2000 = $4500/contract

126 head = $35.71/head



Hedging using the futures Hedging using the futures marketmarket


What Is Hedging?What Is Hedging?

Hedging is using the futures market as a Hedging is using the futures market as a temporary substitute for an intended cash temporary substitute for an intended cash market transaction.market transaction.


What Is Hedging?What Is Hedging?

Hedging is using the futures market as a Hedging is using the futures market as a temporary substitute for an intended cash temporary substitute for an intended cash market transactionmarket transaction

If you intend to sell milk in the cash market, If you intend to sell milk in the cash market, you could hedge the sale of the milk prior to you could hedge the sale of the milk prior to the cash market sale date by selling a the cash market sale date by selling a futures contract. When you make the cash futures contract. When you make the cash market sale, offset your futures position by market sale, offset your futures position by issuing an order to buy a futures contract.issuing an order to buy a futures contract.


What Is The Purpose Of Hedging?What Is The Purpose Of Hedging?

• To ensure price protection against To ensure price protection against adverse market moves.adverse market moves.

• To reduce the risk of price fluctuations To reduce the risk of price fluctuations that can affect the value of a commodity.that can affect the value of a commodity.

• Effective hedge: price received/paid Effective hedge: price received/paid equals what you thought it was going to equals what you thought it was going to be.be.


How Does Hedging Work?How Does Hedging Work?

1) A Hedge involves taking a futures position opposite, but equal in size to, a cash position.

2) Selling futures in advance of future cash market sales.

3) Buying futures in advance of future cash market purchases.


Basis defines the relationship between Basis defines the relationship between your local cash price and the futures your local cash price and the futures marketmarket

Mathematically, Mathematically,

basis = cash price - futures pricebasis = cash price - futures price

BasisBasisBasisBasis


• In milk, In milk,

• basis = mailbox price - futures pricebasis = mailbox price - futures price

• To forecast basis, need a basis historyTo forecast basis, need a basis history

• Historical relationship between your Historical relationship between your mailbox price and Class IIImailbox price and Class III

BasisBasisBasisBasis


Forward Pricing ExampleForward Pricing Example

On February 25, a producer On February 25, a producer

anticipates selling 237,500 pounds of anticipates selling 237,500 pounds of

milk in July. July BFP milk futures milk in July. July BFP milk futures

are trading at $11.68. The producer are trading at $11.68. The producer

thinks prices will fall and wants a thinks prices will fall and wants a

“hedge” against lower prices.“hedge” against lower prices.


$11.68$11.68 current futures pricecurrent futures price

++ ($0.00)($0.00) expected basisexpected basis

-- $ 0.03$ 0.03 commission commission

== $11.65$11.65 ENSP (expected net sale price)ENSP (expected net sale price)

Expected Net Sale PriceExpected Net Sale PriceExpected Net Sale PriceExpected Net Sale Price


Declining MarketDeclining Market

Futures BFP cashFebruary 25Sell futures $11.68 ------

JulySell cash milk $10.55Buy back futures $10.55 ------Futures profit + 1.13 ------Less commission - 0.03

Total Return 1.10 + 10.55 = $11.65


Advancing MarketAdvancing Market

Futures BFP cashFebruary 25Sell futures $11.68 ------

JulySell cash milk $12.70Buy back futures $12.70 ------Futures profit - 1.02 ------Less commission - 0.03

Total Return - 1.05 + 12.70 = $11.65


Potential ResultsPotential Results

Futures Profit/Loss Cash Sale

Price on Futures* Proceeds Hedge Price

$14.00 - 2.35 + 14.00 = $11.65

$13.00 - 1.35 + 13.00 = $11.65

$12.00 - 0.35 + 12.00 = $11.65

$11.00 +0.65 + 11.00 = $11.65

$10.00 +1.65 + 10.00 = $11.65

Initial position: sold futures @ $11.68

* Includes commission of $.03/cwt.


Hedging using the options Hedging using the options marketmarket


What Is An Option?What Is An Option?

A contract that gives the “buyer” the

right but not the obligation to buy or

sell a futures contract at a specific price

within a certain time period.

Specific price is the “strike price”


Call and Put OptionsCall and Put Options

““Call” OptionCall” Option

The right to The right to buybuy

““Put” OptionPut” Option

The right to The right to sellsell

But, not the obligation


Futures Contract

Buy Sell

Call Put

Buy Sell Buy Sell


What Is A Premium?What Is A Premium?

The purchase price a buyer pays

and seller receives for the option.


How Is The Premium Determined?How Is The Premium Determined?

• Intrinsic ValueIntrinsic Value– what is the option “worth” today?what is the option “worth” today?

– strike price versus current futuresstrike price versus current futures

• Time ValueTime Value– a residuala residual

– affected by time, volatility and interest affected by time, volatility and interest ratesrates


StrikeStrike Premium Premium = Intrinsic + Time= Intrinsic + Time

11.75 call11.75 call 0.44 0.44 0.00 0.00 0.44 0.44

11.75 put11.75 put 0.51 0.51 0.070.07 0.44 0.44

Premium Value -- ExamplePremium Value -- ExampleJuly Futures @ $11.68July Futures @ $11.68


How Are Options Exercised?How Are Options Exercised?

A buyer exercises an option when A buyer exercises an option when

he decides to buy or sell the he decides to buy or sell the

underlying commodity by taking a underlying commodity by taking a

futures position.futures position.


Option TradingOption Trading

““Buyer”Buyer”

1) Offset (by selling)1) Offset (by selling)

2) Let the option expire2) Let the option expire

3) Exercise the option3) Exercise the option

““Seller”Seller”

1) Offset (by buying)1) Offset (by buying)


The ProducerThe Producer

On February 25, a milk producer On February 25, a milk producer

expects to sell 237,000 pounds of milk in expects to sell 237,000 pounds of milk in

July. July BFP milk futures currently are July. July BFP milk futures currently are

trading at $11.68. The producer expects trading at $11.68. The producer expects

prices to fall by July and wants prices to fall by July and wants

protection against a declining market, protection against a declining market,

but would like to take advantage of price but would like to take advantage of price

increases.increases.


Expected Minimum Net Sale Price

$11.75 put option strike price

- $ 0.51 put option premium

+ ($0.00) expected basis

- $ 0.03 commission

= $11.21 EMNSP

(expected minimum

net sale price)


Potential ResultsPotential Results

July futures:July futures: $11.68$11.68

July put option:July put option: $11.75 strike price$11.75 strike price

$0.51 premium$0.51 premium

Fut.Fut. Prem Prem Option’s Net Price Net Price Option’s Net Price Net Price

PricePrice - - Cost (bu.)Cost (bu.) + + Int. Value Int. Value = = Received* Received* w/o Opt.w/o Opt.

$14.00 - 0.51 + 0.00 = $13.46 $14.00$14.00 - 0.51 + 0.00 = $13.46 $14.00

$13.00 - 0.51 + 0.00 = $12.46 $13.00$13.00 - 0.51 + 0.00 = $12.46 $13.00

$12.00 - 0.51 + 0.00 = $11.46 $12.00$12.00 - 0.51 + 0.00 = $11.46 $12.00

$11.00 - 0.51 + 0.75 = $11.21 $11.00$11.00 - 0.51 + 0.75 = $11.21 $11.00

$10.00 - 0.51 + 1.75 = $11.21 $10.00$10.00 - 0.51 + 1.75 = $11.21 $10.00

* Assumes commission is $0.03/cwt.* Assumes commission is $0.03/cwt.


Basis …Basis …

… the key to hedging (futures … the key to hedging (futures and options) effectiveness.and options) effectiveness.


What is Basis? What is Basis?

Basis is the difference between two Basis is the difference between two prices.prices.

In commodity marketing, basis is In commodity marketing, basis is generally referred to the difference generally referred to the difference between a specific cash price and a between a specific cash price and a specific futures price.specific futures price.

Mathematically: Basis = Cash - FuturesMathematically: Basis = Cash - Futures

Milk: Basis = Mailbox price - BFP futuresMilk: Basis = Mailbox price - BFP futures


BasisBasis

Generally is more predictable than Generally is more predictable than cash or futures prices due to:cash or futures prices due to:

ConvergenceConvergence

Futures and cash prices move Futures and cash prices move

together (same fundamental together (same fundamental

conditions generally affect both conditions generally affect both

markets)markets)

Year-to-year stabilityYear-to-year stability


How Should Basis be CalculatedHow Should Basis be Calculated

Determine:Determine: Location, date, quality, futures Location, date, quality, futures

contractcontract

Average over several yearsAverage over several years

Measure variability (risk) Measure variability (risk) Historical range (highs and lows), Historical range (highs and lows),

standard deviation, RMSEstandard deviation, RMSE


Kansas Prices vs. BFP Price, 1996-1999Kansas Prices vs. BFP Price, 1996-1999

Source: DFASource: DFA


Milk Basis in Kansas, 1996-1999Milk Basis in Kansas, 1996-1999Current Cash Minus Current FuturesCurrent Cash Minus Current Futures


Basis RelationshipsBasis Relationships

Important to know how your mailbox Important to know how your mailbox price is calculated.price is calculated.

Current month mailbox price is Current month mailbox price is determined by current and previous determined by current and previous months class III prices.months class III prices.

Thus, utilization of milk will impact the Thus, utilization of milk will impact the manner in which basis is calculated.manner in which basis is calculated. & how you implement your hedging & how you implement your hedging

program.program.

k-state research & extension milk futures & options workshop james mintert, ph.d. professor...

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