Hedging-Effectiveness of Milk Futures Using Value-At-Risk Procedures

The effectiveness of the Class III Milk futures market is analyzed in terms of the reduction in Value-at-Risk (VaR) for milk producers located in four regions: Wisconsin, Northeast, Florida and California. Constant hedge ratios are estimated using Myers and Thompson's (1989) generalized conditional hedge ratio technique, and time-varying hedge ratios are estimated using an exponentially weighted moving average method. After defining milk price risk as the deviation of the actual milk price from its expected value, the effectiveness of uniform hedging strategies in the Class III milk futures market is assessed using three popular methods for VaR calculations: the parametric method, the historical method, and the Monte Carlo simulation method. The results suggest that uniform hedging strategies can reduce substantially the VaR of milk cash price for appropriately chosen hedge length and hedge signals. For example, a uniform hedge placed seven months prior to delivery and triggered at $11.00 cwt reduces the mailbox price tail risk more than the same uniform hedging established four months before delivery. As expected the higher the Class III utilization the more effective hedging seems. The magnitude of the hedging effectiveness seems to depend more on the hedge length and the hedge trigger than on the methodology used to obtain the hedge ratio or the VaR.