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. Demand for protein is very income-sensitive. 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, dairy trade is worth an estimated US$140 billion annually, representing a variety of end products including liquid and powdered milk. The export market is dominated by milk powder, with over US$15.6 billion of Whole Milk Powder (WMP) produced globally in 2010, WMP dominates the milk powder export market and is the pricing benchmark for the dairy industry worldwide.
What Are Futures?
A Future is a legally binding contract to buy or sell a standardised product, at a fixed price, for cash settlement (or physical delivery) on a given date in the future.
A future is a derivative product. A derivative is the term applied to any product that derives from another product, usually the underlying physical (also referred to as cash) market.
In the case of Dairy Futures, the standardised product is the dairy commodity from which it is derived. For example, a Global WMP Future is a legally binding contract to buy or sell WMP at a fixed price, for cash settlement in the future.
What Are Options?
Options provide the buyer of the options contract, the right, but not the obligation to buy or sell something at a fixed price in the future. This price is called the "exercise (or strike) price".
There are two types of options:
- A call option gives the holder 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 of an option the right but not the obligation to sell the underlying asset at the exercise price.
An option on a future (e.g. a Global WMP Option), gives the holder of an option the right, but not the obligation, to buy or sell a Global WMP Future at a set price in the future.
NZX Dairy Futures and Options
Dairy Futures and Options are designed to manage risk and smooth out volatility, creating 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 GlobalDairyTrade (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||WMP Options|
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