Milk price futures and options
In response to the need for risk management tools for NZ's dairy industry NZX has developed milk price futures and options contracts.
We encourage you to read the materials on this page to learn more about risk management prior to considering trading these products.
Derivatives contracts carry risk and operate differently to fixed milk price schemes offered by some milk processors.
NZX encourages all parties to seek advice prior to trading.
Questions and Answers
Milk price futures and options are complicated financial tools. Potential users should make sure they understand how these contracts work before using them and seek advice from a broker.
Milk price risk can potentially be managed in a number of ways but many of the tools that are available to European or US farmers are now available to NZ farmers.
Not every farmer will need or wish to manage their milk price risk. The need for risk management tools may be greater in farm businesses that carry high levels of debt and/or have high operating costs. Personal attitudes towards risk also play a part - some people are comfortable taking on high levels of risk but many are not. Many farm businesses use fixed interest rates to manage their interest rate risk. Locking in a milk price through the use of a fixed milk price offered by a milk processor or via milk price futures or options can provide a similar level of security as a fixed interest rate does.
Using a futures contract to fix the milk price means you no longer have to worry about the milk price falling but if the milk price lifts you won't benefit from the higher price. An options contract can protect you against the milk price falling but allows you to benefit if the milk price goes up.
NZX has developed milk price futures and options contracts to address growing demand from farmers and purchasers of milk products who wish to manage risk relating to price fluctuations. Both futures and options contracts can be used to mitigate the financial risks associated with a variable milk price.
A futures contract is an agreement between a buyer and a seller to make delivery of goods or an asset at an agreed date in the future but at a price agreed today. Milk price futures help to provide you with certainty about the milk price for some or all of the milk you produce. Put simply the amount of money you gain or lose in the futures market will largely offset the loss or gain in the price your milk processor pays you for the milk you supply.
Options contracts act like an insurance policy, giving the buyer of the contract the right, but not the obligation, to buy or sell something. In the case of NZX's milk price options, as a farmer you could buy an option to give you the right to sell a milk price futures contract. The right to sell is referred to as a “put” option. You would buy a put option to protect against the possibility of the milk price falling below a specific price (known as the strike price) but you still retain the right to benefit from any increase in the milk price.An option contract has an expiry date and if you don’t want to sell the option at the strike price because the milk price has gone up you can let the contract expire and waive your right to sell on the futures market.
If you are a dairy farmer and you want to manage your milk price risk you would sell milk price futures at the time you want to fix your milk price. This is what is known as a short hedge. Your broker will help you to develop a hedging strategy that meets your business objectives.
The price is determined by the market i.e. those who are buying and selling milk price futures. For every contract that is brought or sold there must be both a willing buyer and seller. Buyers of futures contracts can place a "bid" and a seller can make an "offer". When a bid and offer is at the same price then a transaction can occur.
If the farmgate milk price moves up or down you will effectively end up with the price that you initially sold the futures contract for.
At the beginning of the season the first forecast Farmgate Milk Price for the new season is announced at $6.50/kgMS.
Your broker tells you that there is a bid (someone wanting to buy) up to 50 ‘lots’ of milk solids (one ‘lot’ equates to 6,000 kg’s milk solids) at $6.50/kgMS in the new season's contract. You decides to sell 10 lots or the equivalent of 60,000 kgMS at the price offered.
As the season progresses, the milk price falls and the Farmgate Milk Price at the end of the season is announced at $5/kgMS (also being the final settlement price of the futures contracts).
So what has happened? The dairy company will pay you $5/kgMS instead of the $6.50/kgMS originally forecast. But this loss is offset by the gain in the futures market. The futures contracts sold in May at $6.50/kgMS will be settled against the Farmgate Milk Price of $5/kgMS. So you lost $1.50/kgMS in your payment from your milk processor but you gained $1.50/kgMS in the futures market. So you end up with the equivalent of $6.50/kgMS for the 60,000 kgMS which you hedged.
Take the same example above but this time the Farmgate Milk Price at the end of the season is announced at $8/kgMS.
So what has happened? The dairy company will pay you $8/kgMS instead of the $6.50/kgMS originally forecast. But this gain is offset by the loss in the futures market. The futures contracts sold in May at $6.50/kgMS will be settled against the Farmgate Milk Price of $8/kgMS. So you gained $1.50/kgMS in your payment from your milk processor but you lost $1.50/kgMS in the futures market. So you end up with the equivalent of $6.50/kgMS for the 60,000 kgMS which you hedged.
|Milk price (per kg MS)||Falls||Rises|
|Futures price in May (beginning of the season)||$6.50||$6.50|
|Farmgate milk price announced at end of the season||$5.00||$8.00|
|Profit or loss on futures contract||+$1.50||-$1.50|
|Effective milk price||$6.50||$6.50|
You can trade milk price futures and options contracts at any time of the season. Futures contracts are available for three seasons so you can potentially hedge your milk price risk for three seasons in advance.
You can sell (or buy) as many milk price futures contracts as you like providing there is a willing buyer (or seller) offering the quantity of contracts you require, at a price that suits you. Each lot (1 contract) is equivalent to 6,000 kg MS therefore you can only trade in multiplies of 6,000 kg MS.
When you trade futures and options through a registered exchange (such as NZX) you will never know who is taking the other side of the deal. Milk processors are likely to use milk price futures and options to hedge their risk, but you may also be trading with a speculator - someone who is willing to take on the milk price risk that you don't want.
The use of milk price futures and options contracts is not limited to those who actually sell milk (dairy farmers) or those who buy milk (milk processors). But anyone who is trading these contracts who is not a buyers or seller of milk will not be hedging their milk price risk, instead they will be a speculator.
Futures contacts can be traded at anytime. So if you initially 'sold' a milk price contract (to hedge your milk price risk) you could then 'buy' the same number of futures contracts and these two positions would cancel each other out. However the price is likely to have moved in the time between the two trades occurring which may or may not be in your favour depending on what is happening in the market.
Milk price futures and options and fixed milk price schemes both offer ways to manage milk price risk. So they serve a similar purpose but how they achieve this is quite different. Futures and options are complex tools which must be traded through a broker. In the case of a fixed milk price scheme you deal directly with your dairy company.
All parties must trade through an NZX Derivatives Participant (a broker). You should seek advise from a broker to:
(1) Develop a hedging strategy (this can be done through a broker or independent adviser).
It is important that you understand your objectives, the different products on offer and in particular the trading fees, charges and margins.
(2) Open an account
This requires you to provide basic company information, fund the account and impose trading limits.
(3) Start trading
This can be done over the phone with an NZX Derivatives Participant (broker).
Fees are charged on a per contract basis and generally vary depending on the trading participant (broker). Please consult your broker directly to learn about their fees.
In addition to fees futures contracts are subject to "margin calls" (see more details below) whereas options come with an upfront cost.
In the futures market, margin refers to the initial deposit of good faith made into an account in order to enter into a futures contract.
When you open a futures contract, your broker will advise the minimum amount of money that you must deposit into a margin account. This original deposit of money is called the initial margin. Initial margin for NZX Dairy Futures is generally between 5-15% of the value of the traded contract but broker margin requirements may differ from this.
When your contract expires (or you choose to close it), you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. The amount in your margin account changes daily as the market fluctuates in relation to your futures contract.
The initial margin is the minimum amount required to enter into a new futures contract, while the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
Funding margin accounts does have cash flow implications so you should discuss this with your broker and banker.
To learn more about the contracts, click to download the following documents: