Buying Futures for Protection Against Rising Dairy Prices

Those involved in buying milk and dairy products are aware of the risks they face from a potential price increase. Market participants, such as dairy manufacturers, processors, food companies and restaurants, are concerned about the impact an increase in price could have on their business and are constantly seeking ways to mitigate this risk and protect their bottom line.

Fortunately, due to the availability of CME Group Dairy futures and options, there are many strategies that buyers can employ. This module will discuss buying futures as a hedge against rising dairy prices. For simplicity, the examples will not account for the dairy basis or futures transaction costs.

Say that it is May and the buyer for a food company is planning to purchase cheddar cheese to use in the manufacture of their product. The current price for cheese is $1.75 per pound.

The buyer knows that his business will be profitable if he pays $1.75 for cheese, however, he is concerned about the possibility of an increase in cheese prices by the time he is ready to make his purchase in November. He decides to hedge his upcoming purchase by buying, or going long, November Cheese futures at $1.75, which allows him to lock in a purchase price of $1.75 per pound.

Assume the cash cheese price increases to $2 per pound. This is 25 cents per pound higher than the buyer was anticipating in May. However, the 25-cent gain he makes when he offsets his long futures position by selling November Cheese futures will give him a net purchase price of $1.75 per pound, which is the cash price of $2 minus the 25 cents on the futures position. Note that this is 25 cents lower than the cheese price in the cash market.

If the price for cheese goes down, the buyer will still pay $1.75 per pound for the cheese he needs. Suppose the cheese price falls from $1.75 to $1.50 by November. The buyer would purchase cheese locally at $1.50 and simultaneously offset his futures position by selling November Cheese futures at $1.50. Even though he could purchase his cheese at a lower price, the buyer lost 25 cents on his futures position. This equates to a net purchase price of $1.75, which equals the cash price of $1.50 plus the 25 cents loss on the futures position. Under this scenario, where hedging with futures provided protection against rising prices, but did not allow him to take advantage of a lower price, it may appear on the surface that hedging was a losing proposition for the food company buyer. However, remember his original goal at the beginning of this process: to lock in a price of $1.75 per pound for his cheese purchases. By hedging with futures, he accomplished what he intended when making the decision to hedge. Relinquishing the chance at a lower price in exchange for securing price protection, knowing that the price could just as easily have increased, is a trade-off that a futures hedger is willing to make.

No one can predict the future, but hedgers can take steps to manage it. Buying dairy futures allows those who need protection against rising prices to acquire the peace of mind of knowing that they took steps to manage the risk involved in purchasing milk and dairy products for their business.