Why does the CME now offer two Milk contracts? The Milk (Class III) was changed from the BFP in January 2000 to conform to the new component pricing structure of the dairy "reform" legislation for milk used in the manufacturing of hard cheeses. It has provided an excellent risk management tool for the cheese- milk industry. The CME added the Class IV Contract in July 2000 in response to industry comments dealing with the hedging of butterfat risks using the revised Milk (Class III) contract. The "reform" legislation changed the price relationships of Class III cheese-milk with the other classes, making the CME Milk contract not as closely correlated as was the old BFP. Also, since the component formulas for Class II Milk are similar to the Class IV, the addition of the Class IV provides a direct hedge for ice cream, yogurt and other perishable manufactured products, along with firms whose processing accumulates butterfat inventory. And as an added benefit, the Class I (fluid milk product) users will have the option of using either the existing Milk (Class III) or the new Class IV, depending on their outlook for cheese and butter price relationships. Producers hedging on their own in areas with a high Class I & II utilization, and their cooperatives who offer them forward contracts, will have a more reliable hedge with the Class IV. Cooperatives may also combine the existing Milk contract with Class IV contracts to "fine tune" their forward contracts to their producers. In addition, the combination of the current Milk and the new Class IV will expand hedging opportunities to the entire California dairy industry. Traders will also be able to spread the Class III against the IV depending on their outlook for butter and cheese. How does the Milk Class III price relate to the historical price information of the BFP? The CME “Milk” contract replaced the “BFP Milk” contract in January 2000, to properly reflect the price of milk used in the manufacturing of cheese under the revised government federal pricing classification system for all uses of milk. The CME Milk contract is cash settled (monthly) to the Class III National Agricultural Statistics Service (NASS) announced price, released no later than the fifth day of following month. All other aspects of trading the contract remain the same. 1 Consult your broker for additional information or specific requirements, policies and procedures. 2 Trading times may vary; consult the CME for holiday schedule. Class III Monthly Averages and Ranges, 1995 to 2000 8.50 10.30 12.10 13.90 15.70 17.50 ($/cwt.) Hi 16.27 13.32 12.81 13.09 13.77 13.92 14.77 15.79 16.26 16.04 16.84 17.34 Lo 10.05 9.54 9.54 9.41 9.37 9.46 10.66 10.13 10.76 10.02 8.57 9.37 Avg 12.60 11.66 11.84 11.49 11.18 11.68 12.60 13.25 13.73 12.85 12.11 12.31 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Why have milk prices become so volatile? The lowering of price supports by the government, along with increased demand, mainly for cheese and cheese products, have brought about a price equilibrium between the supply of milk and the uses of milk. Thus, any seasonal changes in the production or demand for milk and milk products create volatile price swings. Milk Production vs. Commercial Consumption 105 119 133 147 161 175 (billion lbs.) Production 115 120 123 121 123 128 133 136 140 135 143 143 143 144 148 148 151 151 154 155 154 156 157 163 168 Commercial Use 114 116 116 119 120 119 120 122 122 127 130 133 136 135 139 139 141 145 150 155 155 157 160 165 169 75 76 77 78 79 80 81 82 83 84 85 86 87 89 90 91 92 93 94 95 96 97 98 99 00 0.0 5.0 10.0 15.0 20.0 25.0 30.0 pounds, except fluid milk, which is in gallons Milk & cream (gal) Butter Amer. cheese Non-American Cheese Total cheese Cottage cheese Ice cr eam Lowf at ice cream NFDM Whey Per-capita consumption, 1980 vs. 1999 1980 1999 How does the new Class IV relate to the CME Milk Class III contract? The simplest answer is to define the pricing structure of the two classes of milk. The Class III is milk used in hard cheeses and the Class IV is milk used for butter and dried milk products. A more complex answer would define the method derived by the USDA’s NASS Agency in calculating the pricing formulas for the two classes of milk. (See both USDA NASS release dates and formulas at the back of Primer). Of significance (to both hedgers and traders) is the price relationship of the major milk component of cheese (protein) which constitutes Class III pricing and butter (butterfat), which constitutes Class IV pricing. Class III vs. Class IV 10.50 11.20 11.90 12.60 13.30 14.00 JFMAMJJASOND ($/cwt.) Class III Class IV How is the Class III Milk price established? NASS conducts weekly industry-wide surveys on cheese, whey, and butter cash transactions. These prices are volume-weighted and incorporated into a pricing formula to determine the monthly Class III price for milk with 3.5% butterfat. On Friday of each week, the USDA reports the changes in the average prices from the prior week. Both traders and hedgers can monitor this information to gain insight as to the final cash settled price. How is the Class IV Milk price established? NASS uses weekly industry-wide surveys on butter, whey, and nonfat dry milk cash transactions. These prices are volume-weighted and incorporated into a pricing formula to determine the monthly Class IV price for milk with 3.5% butterfat. On Friday of each week, the USDA reports the changes in the average prices from the prior week. Both traders and hedgers can monitor this information to gain insight as to the final cash settled price. What are the classifications of Milk? Class I Milk used to produce fluid milk products, such as bottled milk. Class II Milk used to produce soft manufactured dairy products such as cottage cheese, ice cream and yogurt. Class III Milk used to produce cream cheese and hard manufactured cheese. This is the type of milk reflected in the CME milk contract. Class IV Milk used to produce butter and all dried milk products. This is the type of milk reflected in the CME Class IV contract. How to Trade CME Milk Futures Contracts – (Reference Class III or Class IV Futures Contract Specifications) The following examples and illustrations of “How to Trade Futures Contracts”, “How to Trade Milk Options”, “Hedging CME Milk Futures” and “Hedging with CME Milk Options” relate to both the CME’s Milk (Class III) contract and the new Class IV. Likewise, the principles are the same for Buy/Sell hedgers pricing Class I milk, using either of the two contracts. Benefits The CME Milk futures and options contracts offer easy entry into futures and options markets. The Milk futures and options contracts trade each month, can be offset at any time, or can be held through contract expiration and be automatically offset at the USDA’s announced price for Class III and IV Milk. What is a Futures Contract? A futures contract is a legally binding obligation to buy or sell a commodity that meets set grades and standards on some future date. Type of Positions Price Advantage In: To Offset Position 1 Sell = Short Down Markets Buy Back Contract (Loses in up markets) Buy = Long Up Markets Sell Back Contract (Loses in down markets) Futures Example: Buy low/sell high, or vice versa As a speculator, if you think prices are going higher, then you would buy Milk futures. If you think prices are moving lower, then you would sell Milk futures. To close out or offset your trade, take the opposite position. 1 All futures contracts require a fulfillment, or binding obligation, on the part of the trader at some time before the contract expires. Traders of the Milk contract may fulfill contract obligations by offsetting in the futures market (entering an opposite trade order) any time prior to contract expiration, or by accepting an automatic offset at the Class III announced price on the date of the announcement. Although it's risky, it's that easy. Let's look at an example. What happens if it's April and July CME Milk futures are at $12.00 per hundredweight, and you either buy or sell! In April, trade July futures at $12/cwt If July Prices Assuming you bought at $12 Assuming you sold at $12 (to close: sell) (to close: buy) $13 $1 profit $1 loss $12 $0 $0 $11 $1 loss $1 profit If prices move by $1/cwt., a speculator may experience either a $2000 ($1 x 2000/cwt.) per contract profit or loss. Note: Brokerage commission is not included in example. A hedger uses futures in a different way. While speculators take the risk, a hedger locks in a known price for milk. The profit or loss on the futures position would virtually counteract gains or losses in the cash position. (See How to Trade CME Milk Futures and Options). Trading Example Each open Milk futures contract must be backed by a performance bond (margin) account. As prices move, money will be transferred into or out of your account during each trading session. You may be asked to post more performance bond funds, if prices move too far against your position. Of course, if prices move in a positive way for you, your account is credited accordingly. The following example is based on $1,000 performance bond requirements and a maintenance margin of $800 for each Milk contract. (Margins are subject to change so check with your broker.) A trader opens an account and deposits $1,000 initial margin; his account balance is $1,000. If he buys (goes long) a June Milk contract at $12.00, and the price closes up one cent at $12.01, his account balance increases to $1,020. If the Milk market closed down one cent at $11.99 at the end of the day, his account balance decreases to $980. Similarly, a trader selling (going short) a June Milk contract at $12.00 would see a decrease of $20 in his account balance if the contract closed up one cent and an increase of $20 if the Milk contract month closed down one cent. Margining a Futures Trade Along with the performance bond requirements, the exchange also sets a minimum maintenance margin for each commodity. This level is set as a “trigger” point for margin calls. In the above example (initial margin $1,000 and the maintenance $800), the trader’s account balance would have to drop $220 ($1,000 - $220 = $780) or (11 cents x $20) to have an account balance below $800 and be subject to a margin call. The trader would be obligated to meet the call to re-establish the account balance to 1,000, or be subject to automatic removal from the market. Commodity Brokers All Milk trades you make must be placed through a registered commodity broker. Brokers charge a commission on each transaction. They can advise you which market orders to use and help provide both fundamental and technical information on market price outlook. To locate a broker, you might ask around, or give us a call. How to Trade Milk Class III or Class IV Options Options Benefits Options on agricultural futures are relatively new, beginning back in October 1984. They offer many advantages. For buyers of options on CME Milk (Class) futures, these include: • Limited losses • Unlimited profits • No performance bonds (margins) An option is the right, but not the obligation, to buy or sell a futures contract at a specific price. The cost of an option is the premium, which is paid up front. Speculators buying options can only lose the premium paid, if wrong; but can profit substantially if right. Hedgers buying options also have limited loss, but unlimited gain potential. Thus, hedgers can use options to protect their cash position from adverse price moves, while retaining most of the gain in cash value from favorable price moves. The buyer of a Milk option has four choices: • Offset the option (sell back the same option (put or call) and receive the gain in value) • Simply let the option cash settle at expiration and collect gains in value • Exercise the option (take the futures position) • Let the option expire Options on Futures Because Milk options are based on Milk futures, their technical specifications are almost identical. Options on milk futures are listed in the same trading months as futures contracts. New Terms Trading options is just as easy as trading futures with a lot of flexibility. There are two kinds of options: • Put: The right to sell a futures contract • Call: The right to buy a futures contract Puts increase in value if prices fall, and decrease in value if prices rise. Puts give the buyer (holder) the right to exercise into a sell (short) futures position at a fixed price. Calls increase in value if prices rise, and decrease in value if prices fall. Calls give the buyer (holder) the right to exercise into a buy (long) futures position at a fixed price. The strike price (exercise price) is the fixed price at which the holder of an option has the right to take a futures position. As noted, buyers of fluid milk puts or calls may choose from many strike prices at 25-cent intervals. For example, if futures are at $12, there would be strikes both above and below $12, such as $12.50, $12.25, $12.00, $11.75, $11.50, etc. The premium (quoted in $/cwt.) is the cost of a milk option. Thus a $.50 premium would cost $1,000 ($.50 x 2000 cwt.) per contract. Buyers of options can only lose the premium paid. The premium value will change every time the underlying futures price changes. Put Example Say it's April and July Milk futures are at $12/cwt. What happens if you buy a July $12 put for $.50/cwt.? Answer: In July, the $12 put will have value if futures prices fall below $12.00: if prices go above $12.00, however, they will expire worthless. In April, July futures = $12/cwt. Buy July $12 put at $.50/cwt. PREMIUM Futures in July Value of $12 put – Paid Price Results $14 $0 – $.50 $ .50 cost $12 $0 – $.50 $ .50 cost $10 $2 – $.50 $1.50 profit A speculator selling back a $12 put would have a $3000 ($2.00 x 2000 cwt. – $.50 x 2,000 cwt. premium cost) per contract profit if futures prices fell $2. There would be a $1000 ($.50 x 2000 cwt.) per contract cost if prices stayed the same or rose $2 (commission not included). A hedger uses put options in a different way. If prices fall, the option profit protects a minimum selling price or acts as an insurance policy for milk. If prices rise, the option loss (cost of premium) is offset by the better cash selling position. Call Example In the same situation as before, a July $12 Milk call may be worth $.50/cwt. in April. What would happen if you bought it? Answer: In July the $12 call will have value if prices stay above $12, or expire worthless if the futures price falls below $12. In April, July futures = $12/cwt. Buy July $12 put at $.50/cwt. PREMIUM Futures in July Value of $12 put – Paid Price Results $14 $2 – $.50 $1.50 profit $12 $0 – $.50 $ .50 cost $10 $0 – $.50 $ .50 cost A speculator selling back a $12 call would have a $3000 per contract profit if futures prices rose $2. There would be a $1000 per contract loss if prices stayed the same or fell $2 (commission not included). A hedger uses call options in a different way. If prices rise, the option profit protects a maximum purchase price for milk. If prices fall, the option loss (cost of premium) is offset by the better cash buying position. Hedging with CME Milk Class III or Class IV Futures Hedging with Milk Futures The CME Milk Futures contract offers easy entry into futures and option markets. Futures and option contract months will be listed for each month of the year, providing both producers and users a chance to lessen the pricing impact of the monthly USDA’s Class III announcement. Producers concerned about their milk checks declining in the future can sell milk futures; while users of milk and milk products can protect against rises in the milk price by buying futures. It is as simple as that! How to Hedge with Milk Futures All futures contracts are traded the same way. Both hedgers and traders need to establish a futures/options account with a commodities brokerage firm and comply with the firm's contract performance bond requirements. Your broker will assist you in the order entry procedures and any questions you may have on the milk contract specifications. Note: Even though the correlation between Class III price changes and your cash prices are close enough to offer price protection, it is unlikely that hedging will (exactly) offset cash price fluctuations. Knowing the relationship of how your price moves with the Class III price (basis) will help make your hedging transactions even more meaningful. Definition of Hedging Taking a position in futures that fully or partially offsets price risk from your present cash position. CASH FUTURES Owner of Inventory § Risk in Down Markets Seller of Contracts (Short) § Gain in Down Markets User of (Needs) Inventory § Risk in Up Markets Buyer of Contracts (Long) § Gain in Up Markets [...]... Released daily Cash butter prices Released Monday, Wednesday, and Friday Cash Nonfat Dry Milk Released daily Milk, Cheese, Butter, Nonfat Dry Milk, and Dry Whey futures and options prices Released daily USDA NASS Web Site www.ams.usda.gov § Class III and Class IV cash settlement prices for Milk, and cash settlement prices for Cheese, Nonfat Dry Milk and Whey released on fifth of the month if it is a Friday,... understanding and correctly using CME Milk options Options give the buyer price insurance against a market that takes a turn for the worse in terms of a current or anticipated cash position There are two types of options on CME Milk futures Put options act as insurance against a down market, and thus are useful to milk sellers Milk buyers can buy protection against rising fluid milk prices with call options. .. date CME Milk options expire on the business day prior to the USDA Class III and IV announcement Put Option Example (Zero Basis) Call Option Example (Zero Basis) In April, July futures are at $13, and a producer/cooperative buys a July 13 Milk put option for $.50/cwt, or $1000 total ($.50 x 2000 cwt.) What can happen in July? In April, July futures are at $13, and a dairy processor buys a July 13 Milk. .. producer or milk cooperative decides to insure the price level for milk to be sold in July in the cash market Since the price (cash) risk is in down markets, the producer or cooperative decides to sell milk futures Example: Sell 1 July Futures Contract at $13 If both futures and cash prices decline If prices increase July Cash Futures Price + Futures Gain = Selling* Price July Cash Futures Price - Futures. .. hundredweight for milk *Commissions and basis not reflected in example Hedging with CME Milk Class III or Class IV Options Milk Options – Price Insurance Do you operate a motor vehicle without carrying the proper insurance? Of course you don't! Paying insurance premiums isn't fun, but paying for damage done by a wreck is even less fun You can buy similar protection against price disaster in the milk market... market and are out only the cost of the premium Milk Call Options – Insurance Against a Rising Market Buyers of milk are protected against higher prices in the future by buying Milk call options Advantages of buying calls are: • No performance bond (margin) requirements A premium is paid in full up front • Buying calls will set a price protection level for milk you'll buy in the future • Call options. .. (needing milk) CASH FUTURES Need Milk (short) • Price Risk in Up Markets Buy Contracts (long) • Futures Gain in up Markets Long Hedge Examples (Zero Basis*) In April a dairy firm decides to insure the price level for milk to be bought in July in the cash market Since the price (cash) risk is in rising markets, the dairy firm decides to buy milk futures Example: Buy 1 July Futures Contract at $13 If both futures. .. call options Milk Put Options – Insurance Against a Falling Market Sellers of milk buy price protection against a down market by buying Milk put options Advantages of buying puts include: • No performance bond (margin) requirements A premium is paid in full up front • Buying puts will establish a price protection level for milk you'll sell in the future • Put options gain in value as the futures price... indication of where the current month Milk futures contract will cash settle Since prices of the butter and cheese cash markets at the CME are closely related to the NASS reports, traders will want to access the CME Web site for price information – specifically the CME Daily Dairy Report each day for cash and futures market price trends Sources: CME Web Site www.cme.com and www.dailydairyreport.com § §... option expires worthless, and the processor will buy milk in a lower cash market If futures are $15, the processor realizes a $2 gain which compensates for the higher cash purchase price If prices are even higher, the call gains in value to hold the price protection level of $13.50 Which price information do you track to determine CME Milk contract prices? Futures traders and hedgers can follow the . contracts. Benefits The CME Milk futures and options contracts offer easy entry into futures and options markets. The Milk futures and options contracts trade. Site www.ams.usda.gov § Class III and Class IV cash settlement prices for Milk, and cash settlement prices for Cheese, Nonfat Dry Milk and Whey released on