Mean-reversion in Income over Feed Cost Margins:Evidence and Implications for Managing Margin Risk by U.S. Dairy Producers
AbstractWith increased volatility of feed prices dairy farm managers are no longer concerned with managing just milk price volatility but are considering the adoption of risk management programs that address income over feed cost (IOFC) margin risk. Successful margin risk management should be founded on understanding of the behavior of IOFC margins. To that end, we construct forward IOFC margins using Class III milk, corn and soybean meal futures prices. We focus on the characteristics of the term structure of forward IOFC margins, i.e. the sequence of forward margins for consecutive calendar months, all observed on the same trading day. What is apparent from shapes of these term structures is that both in times when margins were exceptionally high and when they were disastrously low, market participants expected that a reversal back to average margin levels would not come quickly, but would rather take up to 9 months. Slopes of the forward margin term structure prior to and after most of the major swings in IOFC indicate these shocks were mostly unanticipated, while time needed for recovery to normal margin levels was successfully predicted. This suggests that IOFC margins may exhibit slow mean-reverting, rather than predictable cyclical behavior, as is often suggested in the popular press. This finding can be exploited to design a successful catastrophic risk management program by initiating protection at 9 to 12 months prior to futures contract maturity. As a case study, we analyze risk management strategies for managing IOFC margins that utilize Livestock Gross Margin for Dairy Cattle (LGM-Dairy) insurance contracts. We created two farm profiles where the first one represents dairy farms that grow most of their feed. The second profile is designed to capture the risk exposure of a dairy farm that purchases all their dairy herd, dry cow, and heifer feed. Our case study of this program encompasses the 2009 period which was characterized by exceptionally poor IOFC margin conditions. We analyzed the dynamics of realized IOFC margins in 2009 under four different risk management strategies, and found that optimal strategies that are founded on principles delineated above succeeded in reducing the decline IOFC margins in 2009 by 93% for home-feed and 47% for market-feed profile, and performed substantially better than alternative strategies suggested by earlier literature.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University of Minnesota, Department of Applied Economics in its series Staff Papers with number 132379.
Date of creation: Aug 2012
Date of revision:
Contact details of provider:
Postal: 231ClaOff Building, 1994 Buford Avenue, St. Paul, MN 55108-6040
Phone: (612) 625-1222
Fax: (612) 625-6245
Web page: http://www.apec.umn.edu
More information through EDIRC
risk management; income over feed cost margin; Livestock Gross Margin for Dairy Cattle program; Agricultural Finance; Risk and Uncertainty;
This paper has been announced in the following NEP Reports:
- NEP-AGR-2012-09-22 (Agricultural Economics)
- NEP-ALL-2012-09-22 (All new papers)
- NEP-RMG-2012-09-22 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Leigh J. Maynard & Christopher Wolf & Matthew Gearhardt, 2005. "Can Futures and Options Markets Hold the Milk Price Safety Net? Policy Conflicts and Market Failures in Dairy Hedging," Review of Agricultural Economics, Agricultural and Applied Economics Association, vol. 27(2), pages 273-286.
- Bamba, Ibrahim & Maynard, Leigh J., 2004. "Hedging-Effectiveness of Milk Futures Using Value-At-Risk Procedures," 2004 Conference, April 19-20, 2004, St. Louis, Missouri 19028, NCR-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
- Fortenbery, T. Randall & Cropp, Robert A. & Zapata, Hector O., 1997. "Analysis of Expected Price Dynamics Between Fluid Milk Futures Contracts and Cash Prices for Fluid Milk," Journal of Agribusiness, Agricultural Economics Association of Georgia, vol. 15(2).
- T. Randall FORTENBERY & Robert A. CROPP & Hector O. ZAPATA, 1997. "Analysis Of Expected Price Dynamics Between Fluid Milk Futures Contracts And Cash Prices For Fluid Milk," Staff Papers 407, University of Wisconsin Madison, AAE.
- T. RANDALL FORTENBERY & ROBERT A. CROPP & Hector O. Zapata, 1997. "Analysis of Expected Price Dynamics Between Fluid Milk Futures Contracts and Cash Prices for Fluid Milk," Wisconsin-Madison Agricultural and Applied Economics Staff Papers 407, Wisconsin-Madison Agricultural and Applied Economics Department.
- Newton, John & Thraen, Cameron S. & Bozic, Marin, 2013. "Whither Dairy Policy? Evaluating Expected Government Outlays and Distributional Impacts of Alternative 2013 Farm Bill Dairy Title Proposals," 2013 Annual Meeting, August 4-6, 2013, Washington, D.C. 153750, Agricultural and Applied Economics Association.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (AgEcon Search).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.