Characterizing Distributions of Class III Milk Prices: Implications for Risk Management

Abstract

Descriptive statistics and time-series econometric models are used to characterize the behavior of monthly fluid milk prices. Prices in April, May and June appear to be more variable than those in subsequent months, and the spring-time prices are perhaps skewed. Econometric models can capture the historical behavior of spot prices, but forecasts converge to the marginal distribution of the sample prices in about six months. Futures prices for Class III milk have the expected time-to-maturity effect and converge to the respective monthly distributions of the cash prices at contract maturity (as they must, since the contracts are cash settled). Thus, econometric models and futures quotes provide similar information about price behavior at contract maturity. Routine hedges in futures, especially those made four or more months prior to maturity, reduce the variance of returns, but over a period of years, lock-in an average return. While econometric models and futures quotes provide imprecise forecasts, they can be used in conjunction with historical data to determine whether expected prices are high relative to past experience. This may assist with making decisions about selective hedging. Likewise, historical evidence may be useful in evaluating expected returns from the use of put options. Results from simple hedging strategies using either futures or puts are illustrated, but more work is needed to evaluate optimal portfolios for dairy farmers.