Mean-reversion in income over feed cost margins: evidence and implications for managing margin risk by US dairy...

With the increased volatility of feed prices, dairy farm managers are no longer concerned with managing only 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 an understanding of the behavior of IOFC margins. To that end, we have constructed 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, that is, the sequence of forward margins for consecutive calendar months, all observed on the same trading day. What is apparent from the shapes of these term structures is that both in times when margins were exceptionally high and in times when they were disastrously low, market participants expected that a reversal back to average margin levels would not come quickly, but rather would take up to 9 mo. Slopes of the forward margin term structure before and after most of the major swings in IOFC indicate these shocks were mostly unanticipated, whereas the 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 mo before futures contract maturity. As a case study, we analyzed risk management strategies for managing IOFC margins that used Livestock Gross Margin for Dairy Cattle insurance contracts and created 2 farm profiles. The first one represents dairy farms that grow most of their feed, whereas the second profile is designed to capture the risk exposure of dairy farms that purchase 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 4 different risk management strategies and found that optimal strategies that were founded on the principles delineated above succeeded in reducing the decline in IOFC margins in 2009 by 93% for the Home-Feed profile and by 47% for the Market-Feed profile, and they performed substantially better than alternative strategies suggested by earlier literature.