Balanced Dairying: Production, Volume 20, Number 2, [Spring 1997] Page: ATTACHMENT
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behave a certain way if they do not lock in a price by
hedging or forward contracting.
FORWARD CONTRACTS
The easiest way to lock in a forward price is
to shop around for a forward contract. Behind every
forward contract is a futures contract. Forward
contracts are common for feed purchases, but are
offered for milk by only a limited number of milk
cooperatives. The firm offering forward contracts
must offset the risk or lock in a desired profit.
The individual offering a forward price
contract has locked in a price in the futures market.
Forward contracts do not work without the futures
market to offset the forward contract risk. Many
times, producers feel rushed into a forward contract
because of threatened feed price increases or a
possible drop in milk prices. However, the dairy
producer placing a hedge in the futures market has
more control in setting a desired price.
Futures contracts are traded for products that
can be standardized. The contract defines, time,
place, weight, quantity, quality, and form of the
commodity traded. For example, the corn futures are
traded for December, March, May, July, and
September deliveries of 5,000 bushels of number 2
yellow corn. The contracts are traded on the Chicago
Board of Trade. Trading ends seven business days
before the last business day of the delivery month.
Fluid milk contracts are traded for February,
March, April, June, August, October, and December
delivery of 50,000 pounds of Grade A milk at 3.5
percent butterfat. The contracts specify delivery
FOB Madison district, which includes specific
counties in Illinois and Wisconsin, close to Madison,
Wisconsin. Milk futures are traded on the Coffee,
Sugar and Cocoa Exchange, and the Chicago
Mercantile Exchange.
Dairy producers have two objectives for
entering the futures market: 1) protect themselves
from increasing feed prices and, 2) protect
themselves from falling milk prices. Their goal is to
guarantee a margin that allows them to cover all cash
outflows for a given production period. Outflows
include all production expenses, loan payments,
family draws, and a charge for replacing capital
items. Since milk is harvested every day, but sold on
a monthly basis, producers are inclined to protect
monthly milk prices.
Protecting feed prices involves planning, but
it is not a difficult process. The producer mustdecide when and what feed commodities to purchase.
Futures contracts only exist for corn, oats, soybeans,
soybean meal, wheat, canola, and barley. Dairy
producers feeding other protein and energy sources,
can calculate a basis between the cash price for the
commodity and most closely related futures price.
For example, the producer could hedge dry distillers
grains using the corn futures, and hedge whole
cottonseed using soybean futures.
There are two ways to enter the futures
market: 1) buying or selling futures contracts, and 2)
buying options. Trading futures contracts requires
putting up initial margin and potentially meeting
margin calls if the market moves against the futures
position taken by the hedger. Options are more like
price insurance. A producer buys options, without
putting up margin money, but the buyer pays an
option premium. The risk of loss using options is
limited to the size of the option premium.
BASIS
A producer who wants to hedge must
understand the basis. To lock in input and output
prices the producer must determine the basis between
the local cash price and the futures contract price.
The basis is defined as the cash price minus the
futures price at the time the feed is purchased or
milk is sold.
Calculate the basis for feed FOB the feed
delivery point. The basis for milk needs to be
calculated at the producer's designated milk market.
The gross area price on a producer's milk check is
the cash price for milk.
There are three important things to keep in
mind when calculating the basis:1) Use historical price data to calculate the
basis.
2) Always calculate the basis to correspond
to the time the hedge is lifted or completed. For
example, suppose it's January of this year, and the
producer wants to hedge 5,000 bushels of corn
needed for feed in September. He buys a September
corn futures contract in January. In September the
hedge is lifted. In other words, the futures contract is
sold and 5,000 bushels of corn is purchased. The
basis for corn is the average difference between the
September cash price FOB delivery point over the
past several years and the closing September futures
price over the past several years,
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Texas Agricultural Extension Service. Balanced Dairying: Production, Volume 20, Number 2, [Spring 1997], periodical, Spring 1997; College Station, Texas. (https://texashistory.unt.edu/ark:/67531/metapth1624292/m1/3/: accessed June 26, 2024), University of North Texas Libraries, The Portal to Texas History, https://texashistory.unt.edu.; crediting UNT Libraries Government Documents Department.