Analysis of Price Risk Management Strategies in Dairy Farming Using Whole-Farm Simulations

By Neyhard, James; Tauer, Loren et al. | Journal of Agricultural and Applied Economics, May 2013 | Go to article overview

Analysis of Price Risk Management Strategies in Dairy Farming Using Whole-Farm Simulations


Neyhard, James, Tauer, Loren, Gloy, Brent, Journal of Agricultural and Applied Economics


Combinations of futures and options contracts on milk and feed were simulated to determine their influence on a representative dairy farm's ability to meet cash flow requirements and reduce the variance of net income. Compared with the reference scenario of selling milk and procuring inputs on a monthly cash basis, the risk management activities did not result in a significant change in either the level or variance of net farm income. The results suggest that on average the current marketing procedure of monthly cash milk pricing and monthly feed purchases (and pricing) produces a strong built-in natural hedge for dairy fanners.

Key Words: dairy risk, futures, hedging, options, simulation

JEL Classifications: D22, Q12, Q13

Market price volatility introduces uncertainty for both the operational and strategic management of dairy farms. A dairy manager must develop a price risk management strategy in the context of a whole farm plan that achieves the overarching strategic goals of the farm (Olson, 2004), yet very little literature is available regarding a whole-farm approach to price risk management for dairy producers; instead, most risk management research has focused on how price risk management strategies impact the variance of prices and revenues. In addition, the full costs of hedging price risk such as margin calls are typically afforded only scant attention. This lack of information regarding the full costs of various risk management strategies and their whole farm impacts forces the dairy manager to make decisions with incomplete information. This article demonstrates the potential impacts of milk and feed price volatility on the financial situation of a dairy farm and determines the potential range of costs and returns for a marketing plan consisting of a set of selective risk management strategies. The marketing plan is built on the production and financial information of the farm as well as the goals of the dairy manager. It is shown how changes in price volatility and the beginning equity of the farm may affect the net benefits of each risk management strategy. The implication is that the risk management strategy selected very much depends on the unique characteristics of the dairy farm.

Monte Carlo simulation techniques are used to simulate prices and determine how various marketing plans would impact a set of ProForma financial statements developed from dairy farm business data. The financial statements include a cash flow budget, income statement, and balance sheet. A marketing plan is developed contingent on the financial status and goals of the farm. Hedging triggers based on the milk income margins needed to maintain a positive cash flow determines when the farm will use various risk management tools. Analysis is completed using the @Risk add-in for Excel.

Review of Literature

Although there have been a number of studies that have examined risk management strategies in agriculture, there have been relatively few in the dairy industry. Maynard, Wolf, and Gearhardt (2005) used a risk-minimizing hedge ratio, with respect to futures and cash price variations, to examine how the Dairy Options Pilot Program would impact the price variance faced by farmers. Historical data on futures and options from January 2000 through February 2003 were used in a simulation and demonstrated the potential for a significant reduction in variance from the use of futures and options. Perhaps more importantly, their work presents an overview of the policy drivers and obstacles in creating markets for dairy hedging instruments. They mention the costs of the management time needed to develop marketing strategies and the discipline necessary for implementation. Another work using the basic premises of the risk minimization approach is Manfredo and Richards (2007). They used simulation techniques to examine the effects of monthly hedging on the financial statements of a dairy cooperative. Valuable insights were provided not only in applying various hedging strategies to the dairy industry, but also by presenting results through various measurements, including mean variance and value at risk (VaR), rather than a singular measure of risk reduction. …

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