Mean-reversion in Income over Feed Cost Margins:Evidence and Implications for Managing Margin Risk by U.S. Dairy Producers Report as inadecuate




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With increased volatility of feed prices dairy farm managers are no longer concerned withmanaging just milk price volatility but are considering the adoption of risk managementprograms that address income over feed cost (IOFC) margin risk. Successful margin riskmanagement 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 sequenceof forward margins for consecutive calendar months, all observed on the same trading day. Whatis apparent from shapes of these term structures is that both in times when margins wereexceptionally high and when they were disastrously low, market participants expected that areversal back to average margin levels would not come quickly, but would rather take up to 9months. Slopes of the forward margin term structure prior to and after most of the major swingsin IOFC indicate these shocks were mostly unanticipated, while time needed for recovery tonormal margin levels was successfully predicted. This suggests that IOFC margins may exhibitslow mean-reverting, rather than predictable cyclical behavior, as is often suggested in thepopular press. This finding can be exploited to design a successful catastrophic risk managementprogram by initiating protection at 9 to 12 months prior to futures contract maturity. As a casestudy, we analyze risk management strategies for managing IOFC margins that utilize LivestockGross Margin for Dairy Cattle (LGM-Dairy) insurance contracts. We created two farm profileswhere the first one represents dairy farms that grow most of their feed. The second profile isdesigned 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 wascharacterized by exceptionally poor IOFC margin conditions. We analyzed the dynamics ofrealized IOFC margins in 2009 under four different risk management strategies, and found thatoptimal strategies that are founded on principles delineated above succeeded in reducing thedecline IOFC margins in 2009 by 93% for home-feed and 47% for market-feed profile, andperformed substantially better than alternative strategies suggested by earlier literature.

Keywords: risk management ; income over feed cost margin ; Livestock Gross Margin for DairyCattle program

Subject(s): Agricultural Finance

Risk and Uncertainty

Issue Date: 2012-08

Publication Type: Working or Discussion Paper

PURL Identifier: http://purl.umn.edu/132379

Total Pages: 25

Series Statement: Staff Paper

P12-6

Record appears in: University of Minnesota > Department of Applied Economics > Staff Papers





Author: Bozic, Marin ; Newton, John ; Thraen, Cameron S. ; Gould, Brian W.

Source: http://ageconsearch.umn.edu/record/132379?ln=en







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