Road Block to Risk Management - How Federal Milk Pricing Provisions Complicate Class 1 Cross-Hedging Incentives

In 2000 the USDA introduced new methods to price milk used to produce class 1 bev- erage milk in the U.S. This shift in the dairy policy complicated hedging incentives by exposing traders to basis risk and increasing milk price uncertainty. We use empir- ical analysis to compute generalized optimal hedge ratios and estimate autoregressive models to forecast the basis associated with cross-hedging class 1 milk using exchange traded milk futures. The results indicate that while milk futures contracts do provide risk management opportunities for cash market participants, market participants are trading price risk for highly variable basis risk. Exchange traded milk futures contracts only capture a portion of the variance in the beverage milk cash price, the closing basis fails to converge to some predictable level, and for risk-averse agents basis reduces the utility gained from hedging. Policy and market options may be considered to improve risk management in the beverage milk sector. These options include: allow forward contracting in class 1 milk, alternative price discovery methods, and the introduction of an exchange traded _x000D_uid milk contract.