A USER'S GUIDE TO UNDERSTANDING BASIS AND BASIS BEHAVIOR IN MULTIPLE COMPONENT FEDERAL ORDER MILK MARKETS

What are the general ideas behind a futures contract price and the concept of the Basis calculation? The Class 3 milk futures contract traded at the Chicago Mercantile present opportunities for you to forward price your milk if your milk is pooled in a multiple component market such as Federal Order #33. The use of a Class 3 or Class 4 milk contract allows a producer to forward price the butterfat, protein and other solids components of his milk production in multiple-component pricing federal orders or to forward price butterfat and skim in fat/skim federal order markets. Using the futures instruments to protect against uncertain market prices is a new revenue management tool for the dairy industry. Likewise, the use of a Class 3 or Class 4 contract allows a dairy product manufacturer (buyer of liquid milk) to forward price the butterfat, protein and other solids components of his liquid milk needs to protect against rising prices. The use of futures markets to accurately forward price milk either as an output or as an input necessitates that one must know the relative cash price/futures price relationships that are captured in what is called basis. This article will define the general concept of basis as it is used in futures and options markets and how it can be calculated for a milk producer who intends to use Class 3/4 futures contracts as a means to hedge against price declines in a multiple component market. The focus in this paper will be on the Class 3 futures contract and to multiple-component Federal Order markets. The use of the other class contract, the Class 4 futures contract, raises additional issues and will be discussed in a sequel to this paper.