Dairy Price Risk Management:
Session 7 – Cash Forward Contracting and
Some Advanced Strategies
Cooperative Extension – Ag and Natural Resources
1
Farm and Risk Management Team
Last Update: May 1, 2009
Cash Forward Contracting


2
Milk contracts
Cheese-based contracts
Fixed Price Forward Contracts
3

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.
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:
Plus
Less
Plus
4
Federal order payment (component value +/SCC adjustment + PPD)
Plant-specific premiums
Hauling and other deductions
2,000 Cwt. X ($14.00-$13.50) = $1,000
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.

5
SO…… Cash forward contracting is identical in
concept to hedging. The plant assumes the
role of broker
Minimum Price Forward Contracts
6

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.
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:
Plus
Less
Plus
Less
7
Federal order payment (component value +/SCC adjustment + PPD)
Plant-specific premiums
Hauling and other deductions
2,000 Cwt. X ($13.00-$12.00) = $2,000
2,000 Cwt. X $.50 insurance charge = $1,000
Minimum Price Forward Contract – What
Does Plant Do?
8

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
Cheese-based Forward Price Contracts
9

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
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:
Plus
Less
Plus
10
Federal order payment (component value +/SCC adjustment + PPD)
Plant-specific premiums
Hauling and other deductions
2,000 Cwt. X (($1.50 - $1.35) X 10) = $3,000
Advanced Hedging Strategies
11

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____________________________________________
B. Mechanics:
Performance Bond?________
Buy a _________ __________Class III Put @ ___________
(month)
(Strike)
Strike Price
-Premium
Floor
______
______
=Minimum Price
______
(Premium)
Ceiling
_______
C. Results:
Announced Class III
_________
_________
_________
+
__________Put Gain/[Loss]
___________
___________
___________
=
Net Price
_________
_________
_________
Net Cash Price
Buy a Put Option
Premium
Strike Price
Market price @ settle
Roll up to Futures
A. Objectives:
Outlook____________________________________________
B. Mechanics:
Performance Bond?________
Buy a _________ __________Class III Put @ ___________
(month)
(Strike)
(Premium)
LATER: If ________Trigger hit, Sell futures (Keep or offset _______ Put)
Futures
-Premium (Net)
Floor
______
______
=Minimum Price
______
Ceiling
_______
C. Results:
Announced Class III + Futures Gain/[Loss]
_________
___________
_________
___________
_________
__________
+ _______Put Gain/[Loss]
_________
_________
_________
= Net Price
__________
__________
__________
Net Cash Price
Roll up to Futures
Case II: Keep Put
Case I: Offset Put
Premium
Strike Price
Market price @ settle
Roll up to Put
A. Objectives:
Outlook____________________________________________
B. Mechanics:
Performance Bond?________
Buy a _________ __________Class III Put @ ___________
(month)
(Strike)
(Premium)
LATER: If ________Trigger hit, Buy _________ _______Put @ _______
(month)
(strike)
(Premium)
Offset _______ Put @ __________
Strike Price
- _______Premium
- _______Premium
Floor
______
______
______
=Minimum Price
______
Ceiling
_______
C. Results:
Announced Class III + ______Put Gain/[Loss]
_________
___________
_________
___________
_________
__________
+ ______Put Gain/[Loss]
= Net Price
_________
__________
_________
__________
_________
__________
Net Cash Price
Roll up to a Put
(Net) Premium 2
Premium 1
Market price @ settle
Strike Price 1
Strike Price 2
Cash Contract – Buy a Call
A. Objectives:
Outlook____________________________________________
B. Mechanics:
Performance Bond?________
Forward sell _________ Milk @ ___________
Buy a _________ ________ Call @ _____________
(month)
(Strike)
Contract Price
-Premium
Floor
______
______
=Minimum Price
______
(Premium)
Ceiling
_______
C. Results:
Announced Class III:
_________
_________
_________
Forward Cash Price
___________
___________
__________
+ _______Call Gain/[Loss]
= Net Price
_________
__________
_________
__________
_________
__________
Net Cash Price
Cash Forward Contract/Buy a Call (Synthetic Put)
Call Premium*
Cash Forward Contract Price
*At strike price = cash
forward contract price
Strike Price
Market price @ settle
Sell a Call
A. Objectives:
Outlook____________________________________________
B. Mechanics:
Performance Bond?________
Sell a _________ __________Class III Call @ __________
(month)
Strike Price
-Premium
=Maximum Price
(Strike)
Floor
______
(Premium)
Ceiling
_______
_______
_______
C. Results:
Announced Class III
_________
_________
_________
+
__________Call Gain/[Loss]
___________
___________
___________
= Net Price
_________
_________
_________
Net Cash Price
Sell a Call Option
Call Premium
Strike Price
Market price @ settle
Short Fence (Buy put/Sell Call)
A. Objectives:
Outlook____________________________________________
B. Mechanics:
Performance Bond?________
Buy an Out of the Money ________ _________Class III Put @ ___________
(month)
(strike)
(Premium)
Sell an Out of the Money ________ _________Class III Call @ ___________
(month)
(strike)
Strike Price
- Put Premium
+ Call Premium
Floor
_______
_______
_______
Ceiling
_______
_______
_______
= Min/max Price
______
_______
(Premium)
C. Results:
Announced Class III + _______Put Gain/[Loss]
_________
___________
_________
___________
_________
__________
+ ________Call Gain/[Loss]
_________
_________
_________
= Net Price
__________
__________
__________
Net Cash Price
Short Fence (Split-Strike Synthetic Futures)
Call strike +/net premium
Put strike +/net premium
Put
Strike Price
Call
Strike Price
Market price @ settle
Roll down Futures to Put
A. Objectives:
Outlook____________________________________________
B. Mechanics: Sell
Performance Bond?________
_________ Class III futures @ __________
(month)
(Price)
Later: If ________Trigger hit, Offset (Buy) futures and
Buy a _________ __________Class III Put @ ___________
(month)
(Strike)
Strike Price
+ Futures Gain
- Put Premium
Floor
_______
_______
_______
= Minimum Price
_______
C. Results:
Announced Class III + Futures Gain/[Loss]
_________
___________
_________
___________
_________
__________
(Premium)
Ceiling
________
+ _______Put Gain/[Loss]
_________
_________
_________
= Net Price
__________
__________
__________
Net Cash Price
Roll Down Futures to Put
Futures Price for
short sell
Futures gain less
put premium
Strike Price
Market price @ settle