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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.