1 Farm and Risk Management TeamCooperative Extension – Ag and Natural Resources

Dairy Price Risk Management:Session 7 – Cash Forward Contracting and Some Advanced Strategies

Last Update: May 1, 2009

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Cash Forward Contracting

Milk contracts Cheese-based contracts

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Fixed Price Forward Contracts

Offer a fixed price for a given month, quarter, or year for contracted volume (usually limited to some percentage of expected sales).

Price offer may be for a base milk price (equivalent to the class III price) or for milk component prices (for butterfat, protein, and other solids).

If the announced class III price (or component price) is less than the contract price, then your milk check is increased by the difference times your contracted quantity. If the announced price is higher than the contract price, a deduction equal to the difference is applied.

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Fixed Price Forward Contract - Example

In January, contract 2,000 hundredweight (200,000 pounds) of July milk with plant at base price of $14.00

July Class III price is announced at $13.50

July Milk Check: Federal order payment (component value +/- SCC adjustment + PPD)Plus Plant-specific premiumsLess Hauling and other deductionsPlus 2,000 Cwt. X ($14.00-$13.50) = $1,000

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Fixed Price Forward Contract – What Does Plant Do?

January: Sign forward price contract with producer; immediately sell CME Class III milk contract at $14.10*

August: Cash settle July futures contract at $13.50 and pocket $1,200. Pay producer $1,000.

* Note that plant price offer will be less than futures price by the amount necessary to cover brokerage and other costs.

SO…… Cash forward contracting is identical in concept to hedging. The plant assumes the role of broker

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Minimum Price Forward Contracts

Offer a set of minimum prices for a given month and associated producer charges per Cwt. to ensure the minimum prices (the higher the minimum price, the higher the charge).

Minimum price offers are usually for for a base milk price equivalent to the Class III price.

If the announced Class III price is less than the contract minimum price, then your milk check is increased by the difference times your contracted quantity. If the announced price is higher than the contract minimum, you receive nothing.

Your milk check is reduced by the contract producer charge times the volume contracted regardless of the announced price.

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Minimum Price Forward Contract - Example

In January, contract 2,000 hundredweight (200,000 pounds) of July milk with plant at a minimum base price of $13.00. Plant “insurance” charge is $0.50 per hundredweight

July Class III price is announced at $12.00

July Milk Check: Federal order payment (component value +/- SCC adjustment + PPD)

Plus Plant-specific premiumsLess Hauling and other deductionsPlus 2,000 Cwt. X ($13.00-$12.00) = $2,000Less 2,000 Cwt. X $.50 insurance charge = $1,000

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Minimum Price Forward Contract – What Does Plant Do?

January: Sign minimum price contract with producer; immediately buy 1 CME July $13.00 Class III put at $.35. Pay broker $700.

August: Settle July $13.00 put at $12.00 and pocket $2,000. Pay producer $2,000 and collect $1,000 to repay premium cost and broker commission.

* Note that plant charge to ensure a minimum price will be greater than the put premium by the amount necessary to cover brokerage, interest, and other costs.

SO…… A minimum price forward contract is identical in concept to buying puts. The plant assumes the role of broker

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Cheese-based Forward Price Contracts

Offer a milk price premium or discount on a fixed volume of milk based on reported cheese prices relative to a fixed cheese price.

Plant pay price calculated in usual fashion. Premium/discount calculated by using assumed cheese yields to convert cheese value to milk value.

Plants contracting with farms have negotiated a fixed price-fixed volume contractual arrangement with a cheese buyer

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Cheese-based Forward Price Contracts - Example

In January, contract 2,000 hundredweight (200,000 pounds) of July milk under a cheese price contract at $1.50 per pound of cheese. Contract cheese yield conversion is 10:1 – one pound of cheese can be produced from 10 pounds of milk (or 10 pounds of cheese can be produced from one Cwt. of milk).

July monthly average CME block cheese price is announced at $1.35 per pound

July Milk Check: Federal order payment (component value +/- SCC adjustment + PPD)Plus Plant-specific premiumsLess Hauling and other deductionsPlus 2,000 Cwt. X (($1.50 - $1.35) X 10) = $3,000

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Advanced Hedging Strategies

Hedging examples have assumed that a hedge is placed and held until contract expiration (or placed and lifted).

Changing market conditions after placing a hedge offer changing opportunities – more sophisticated but more effective risk management.

At the same time, advanced strategies require more attention to the markets and some involve more risk than basic hedging strategies.

Buy a Put

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Buy a _________ __________Class III Put @ ___________ (month) (Strike) (Premium)

Floor Ceiling Strike Price ______ _______-Premium ______

=Minimum Price ______

C. Results:

Announced Class III + __________Put Gain/[Loss] = Net Price _________ ___________ _________ _________ ___________ _________ _________ ___________ _________

Market price @ settleStrike Price

Net

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Premium

Buy a Put Option

Roll up to Futures

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Buy a _________ __________Class III Put @ ___________ (month) (Strike) (Premium)

LATER: If ________Trigger hit, Sell futures (Keep or offset _______ Put)

Floor Ceiling Futures ______ _______-Premium (Net) ______

=Minimum Price ______

C. Results:

Announced Class III + Futures Gain/[Loss] + _______Put Gain/[Loss] = Net Price _________ ___________ _________ __________ _________ ___________ _________ __________ _________ __________ _________ __________

Market price @ settleStrike Price

Net

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Premium

Roll up to Futures

Case I: Offset Put

Case II: Keep Put

Roll up to Put

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Buy a _________ __________Class III Put @ ___________ (month) (Strike) (Premium)LATER: If ________Trigger hit, Buy _________ _______Put @ _______ (month) (strike) (Premium) Offset _______ Put @ __________

Floor Ceiling Strike Price ______ _______- _______Premium ______- _______Premium ______

=Minimum Price ______

C. Results:

Announced Class III + ______Put Gain/[Loss] + ______Put Gain/[Loss] = Net Price _________ ___________ _________ __________ _________ ___________ _________ __________ _________ __________ _________ __________

Market price @ settle Strike Price 1

Net

Cas

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Premium 1

Roll up to a Put

(Net) Premium 2

Strike Price 2

Cash Contract – Buy a Call

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Forward sell _________ Milk @ ___________

Buy a _________ ________ Call @ _____________ (month) (Strike) (Premium)

Floor CeilingContract Price ______ _______-Premium ______

=Minimum Price ______

C. Results:

Announced Class III: Forward Cash Price + _______Call Gain/[Loss] = Net Price _________ ___________ _________ __________ _________ ___________ _________ __________ _________ __________ _________ __________

Market price @ settleStrike Price

Net

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Call Premium*

Cash Forward Contract/Buy a Call (Synthetic Put)

Cash Forward Contract Price

*At strike price = cashforward contract price

Sell a Call

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Sell a _________ __________Class III Call @ __________ (month) (Strike) (Premium)

Floor Ceiling Strike Price ______ _______-Premium _______ =Maximum Price _______

C. Results:

Announced Class III + __________Call Gain/[Loss] = Net Price _________ ___________ _________ _________ ___________ _________ _________ ___________ _________

Market price @ settleStrike Price

Net

Cas

h Pr

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Call Premium

Sell a Call Option

Short Fence (Buy put/Sell Call)

A. Objectives:

Outlook____________________________________________ Performance Bond?________

B. Mechanics: Buy an Out of the Money ________ _________Class III Put @ ___________ (month) (strike) (Premium)

Sell an Out of the Money ________ _________Class III Call @ ___________ (month) (strike) (Premium) Floor Ceiling Strike Price _______ _______- Put Premium _______ _______+ Call Premium _______ _______

= Min/max Price ______ _______

C. Results:

Announced Class III + _______Put Gain/[Loss] + ________Call Gain/[Loss] = Net Price _________ ___________ _________ __________ _________ ___________ _________ __________ _________ __________ _________ __________

Market price @ settle PutStrike Price

Net

Cas

h Pr

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Short Fence (Split-Strike Synthetic Futures)

CallStrike Price

Put strike +/- net premium

Call strike +/- net premium

Roll down Futures to Put

A. Objectives:Outlook____________________________________________ Performance Bond?________

B. Mechanics: Sell _________ Class III futures @ __________ (month) (Price)

Later: If ________Trigger hit, Offset (Buy) futures and

Buy a _________ __________Class III Put @ ___________ (month) (Strike) (Premium)

Floor Ceiling Strike Price _______ ________+ Futures Gain _______ - Put Premium _______ = Minimum Price _______

C. Results:Announced Class III + Futures Gain/[Loss] + _______Put Gain/[Loss] = Net Price _________ ___________ _________ __________ _________ ___________ _________ __________ _________ __________ _________ __________

Market price @ settleStrike Price

Net

Cas

h Pr

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Roll Down Futures to Put

Futures Price for short sell

Futures gain less put premium