Understand Dairy Futures and Options
It's important to understand some basics about these financial risk management tools and the dairy industry itself.
Global demand for protein has been rising for some time. Rising income levels in emerging markets have led to changes in diet, incorporating more meat, eggs and milk. In recent years, the strongest growth in consumption of dairy products has come from emerging Asian markets, particularly China.
On the supply side, some major producing countries such as the US or India can move from being a net exporter to a net importer of dairy over short periods of time. Adding yet more volatility to the picture is the bank financing cycle. Cows represent major capital expenditure for farmers, and banks have moved from a cycle of easy to tight credit in dairy farming.
Volatility in the global dairy industry is widely expected to continue as global demand increases on the back of a growing awareness of milk's nutritional value and improvement in living standards in developing economies (and demand for proteins). This volatility, as a result of the spur in demand and multiple unpredictable supply side factors, creates a difficult operating environment for all those in the dairy supply chain.
Globally, about 378 billion litres of milk is processed each year into a variety of products. Dairy trade is worth an estimated US$140 billion annually. The export market is dominated by milk powder, with approximately 2 million tonnes of Whole Milk Powder (WMP) traded annually.
What are Futures?
A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given asset at a specific date in the future at a price agreed today. All terms of the contract are standardised, other than the price.
The benefits of trading futures include virtual elimination of counterparty credit risk, ability to set prices in advance and an ability to adjust volume in the open market. NZX Dairy Futures are cash settled, meaning greater flexibility and facilitating increased volume from speculators and hedgers.
Cash settlement of a futures contract means participants don't have to implement complicated delivery mechanisms or risk having to make, or take, delivery of a product when trading in the futures market. Cash settlement is particularly preferable for dairy commodities where food safety criteria, and the actual delivery process, are complex and not globally standardised.
Hedging with Futures (Buyer Hedge)
Let’s say a GlobalDairyTrade (GDT) buyer in July is looking to purchase 100 tonne of Skim Milk Powder (SMP) in October for December delivery (i.e. the purchaser will buy the C2 contract period in October). The buyer is concerned about prices rising.
The GDT buyer can hedge against rising prices of SMP by purchasing 100 SMP October futures contracts and does so at a price of US$4,600/t.
At the first GDT event in October the trader buys 50 tonne of SMP Medium Heat Contract 2 at a winning price of US$5,000/t. At the second event the trader buys the remaining 50 tonne of SMP Medium Heat Contract 2 for US$5,200/t. The GDT Buyer has purchased 100 tonne of SMP for the average price of US$5,100/t
The average C2 winning price of the two GDT events in October also determines the settlement price of the SMP October futures contract (US$5,100), hence the futures contracts expire and settle to a price of US$5,100/t.
The GDT buyer makes a profit on their futures position of US$500 (US$5,100 (futures settlement price) less price initially paid for the futures contract, US$4,600). While the buyer has had to pay US$5,100/t in GDT, the profit made in the futures market offsets the purchase price paid creating an effective purchase price of US$4,600 (US$5,100 (price paid in GDT) – US$500 (profit on futures) = US$4,600 (effective price paid)).
The below table demonstrates the result if price rises or falls:
|Futures Price Paid||4,600||4,600||4,600|
|SMP Price Paid in GDT||4,200||5,100||5,500|
|Effective SMP Purchase Price||4,600||4,600||4,600|
If price falls the loss in the futures market offsets the gain in the physical market. If prices rise the gain in the futures market offsets the loss in the physical market. The buyer is not looking to beat the market; instead, the buyer is looking for price certainty in a volatile environment, thereby mitigating risk.
What are Options?
An option is the right, but not the obligation, for the purchaser, to buy or sell an underlying asset at a price agreed today at a set date in the future.
There are five key components of an option:
The underlying asset of an option is what is delivered if the option is exercised. This could be shares or commodities or a futures contract. The NZX WMP options deliver WMP futures.
There are two types of options:
- A call option gives the holder (purchaser) of an option, the right but not the obligation, to buy the underlying asset at the exercise price; and
- A put option gives the holder (purchaser) of an option, the right but not the obligation, to sell the underlying asset at the exercise price.
Exercise Price (Strike Price)
This is the price you receive, or pay for the underlying asset (i.e. WMP Futures) when you exercise your option. For example, if you are the buyer of a US$4,500 WMP call option, when you exercise that option you are entitled to purchase a WMP Futures contract from the option seller at a price of $4,500.
This is the date at which all unexercised options expire. Each option has a range of different expiry months to choose from. As one month expires a new option with a later expiry date is created.
Option buyers pay a price for purchasing an option known as the premium.
NZX Dairy Futures and Options
NZX Dairy Futures and Options are designed to manage risk and smooth out volatility and are intended to create price certainty, transparency and a forward view of market sentiment.
By trading on the futures and options market, dairy participants create price certainty, a fundamental competitive advantage in a volatile market. For a processor, hedging ensures certainty for themselves and the farmer over prices paid for liquid milk, as well as certainty over forward sales prices. It also means purchasers can secure supply and manage their own price risk, providing certainty over future purchase prices.
Price certainty is achieved by entering equal and opposite positions in the physical and futures markets. Any loss in the physical market will be offset by a profit in the futures market and vice versa (physical and futures market prices tend to move together i.e. mirror each other). The purpose is not to make a profit or avoid a loss in either market, but to lock in price ahead of time.
NZX Dairy Futures are exchange listed and cash settled to GDT prices.
Cash settlement of a futures contract means trading is much simpler and easier. It means participants don't have to implement complicated delivery mechanisms or risk having to make, or take, delivery of a product when trading in the futures market. Cash settlement is particularly preferable for dairy commodities where food safety criteria, and the actual delivery process, are complex and not globally standardised.
|Code Source||WMP Futures||SMP Futures||AMF Futures|
|Six Financial Information||WMPF||SMPF||AMFF|