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Please use this identifier to cite or link to this item: http://purl.umn.edu/132379

Title: Mean-reversion in Income over Feed Cost Margins:Evidence and Implications for Managing Margin Risk by U.S. Dairy Producers
Authors: Bozic, Marin
Newton, John
Thraen, Cameron S.
Gould, Brian W.
Keywords: risk management
income over feed cost margin
Livestock Gross Margin for Dairy Cattle program
Issue Date: 2012-08
Series/Report no.: Staff Paper
P12-6
Abstract: With 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.
URI: http://purl.umn.edu/132379
Institution/Association: University of Minnesota>Department of Applied Economics>Staff Papers
Total Pages: 25
Collections:Staff Papers

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