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Do’s and Don’ts of Dairy Risk Management. Dr. Marin Bozic Alltech Workshops October 23-24, 2013. A real problem…. But it hurts to leave money on the table…. Agenda for Today. Goals and Principles of Dairy Risk Management Hedging with Futures and Options Using LGM-Dairy
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Do’s and Don’ts of Dairy Risk Management Dr. Marin Bozic Alltech Workshops October 23-24, 2013
Agenda for Today • Goals and Principles of Dairy Risk Management • Hedging with Futures and Options • Using LGM-Dairy • New Farm Bill Dairy Programs
Start with the end in mind. • Retirement without debt? • Prevent catastrophic losses? • Gives me headaches, but necessary evil? • Chase the highs, beat the market? • Grow faster?
A simple hedging program with puts • Buy puts consistently, do not try to guess what the price will do next • Never spend more than 50 cents on a put • Let us evaluate three strategies: • Always buy puts for milk produced THREE months from now • E.g. in January 2013 hedge April milk, in February hedge May milk, etc. • 2) Always buy puts for milk produced SEVEN months from now • E.g. in January 2013 hedge August milk, in February hedge September milk, etc. • 3) Always buy puts for milk produced ELEVEN months from now • E.g. in January 2013 hedge November milk, in February hedge December milk, etc.
Lessons Learned? • Either hedge consistently or not at all. • Plan for hedging far ahead. When prices decline, they tend to stay low for a while. If you wait for too long, the opportunity to lock in good prices may be gone. • You are likely to lose money on most of your trades. That’s OK. That does not mean that the market is full of crooks. It means that bad times come around infrequently, but when they do come, you will get back plentifully.
2006-2012 returns to at-the-money put options 1 month ahead: Cost: 0.19/bu Payout: 0.16/bu 3 months ahead: Cost: 0.68/bu Payout: 0.79 6 months ahead: Cost: 0.95/bu Payout: 1.33/bu 9 months ahead: Cost: 1.13/bu Payout: 1.59/bu
Farm bill • Two alternatives: • Senate Bill No. 954 “Dairy Security Act” • House Bill. 2642 • “Goodlatte-Scott Amendment”
Farm bill Dairy Margin • All-Milk (/cwt) - 1.0728 x Corn (/bu) - 0.0735 x Soybean meal (/ton) - 0.0137 x Alfalfa hay (/ton) • Feed ration per cwt of milk: • 30 pounds of shell corn, • 106.4 pounds of corn silage, • 14.7 pounds of soybean meal • 27.4 lbs of alfalfa hay
Subsidized Margin Insurance • Official name: Dairy Producer Margin Protection Program (PDMPP) • Two layers: • Basic Margin Protection – No-cost protection at 4.00 margin • Supplemental Margin Protection – Can buy up from 4.50 to 8.00 margin in 50 cents increments (called “Coverage Level”)
DPMPP: What triggers it exactly? • Calendar year is divided into consecutive two-month periods • Average margin must be below the purchased coverage level in order for indemnities to be due.
DPMPP: What is the payment rate? • Basic Margin Protection • The difference between the actual margin and $4.00, except that, if the difference is more than $4.00, the Secretary shall use $4.00 • Example: Larry subscribed for basic margin protection. For Jul-Aug, payment rate was $1.14 per cwt.
DPMPP: What is the payment base? • Supplemental Margin Protection: • The difference between coverage level and the greater of actual margin and $4.00. Example: Larry also subscribed for supplemental margin protection at $6.50 coverage level. For Jul-Aug, the payment rate on supplemental was $6.50- max($4.00, $2.86) = $2.50
DPMPP: What is the payment base? • Basic Production History • Highest annual milk marketings in any 1 of the 3 calendar years before program sign-up • Used in Basic Margin Protection • Annual Production History: • Actual milk marketings of the participating dairy during the previous year • Used in Supplemental Margin Protection
Dairy Market Stabilization Program Trigger: • Actual margins of $6.00 or less for each of the immediately preceding two months • Actual margin of $4.00 or less for the immediately preceding month
DMSP – what is the “penalty”? • Producer is not going to be paid for more than the greater of… • If margins were $5.00-$6.00: • 98 percent of stabilization base • 94 percent of the marketings of milk • If margins were $4.00-$5.00 • 97 percent of stabilization base • 93 percent of the marketings of milk • If margins were less than $4.00 • 96 percent of stabilization base • 92 percent of the marketings of milk
Let’s play a game… Imagine that it is January 15, 2008. Dairy Security Act has just become a law. You are the owner of ‘North Star Dairy’ a fictional large dairy operation in Minnesota that had grown to about 2000 cows at the end of 2012. You have made a decision to participate in the DPMPP/DMSP in 2008. Let’s see how did the program work for you over 2008-2012 period.
Please take a look at this device… (forget everything from 2008+)
