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Should Dairy Farmers Consider Basis Before Deciding To Participate In New MPP-Dairy?

Basis Risk Could Create More Financial Uncertainty, Make It Difficult To Determine What Price Floor MPP-Dairy Is Actually Protecting

Urbana, Champaign, IL—How basis may be considered by dairy farmers when making decisions
about whether or not to participate in the Margin Protection Program for dairy producers (MPP-Dairy) is the focus of a recent paper by John Newton of the University of Illinois department of agricultural and consumer economics.

MPP-Dairy is a new, voluntary program which makes payments when the national average income-over-feed-cost margin index falls below a farmer-selected coverage level, Newton explained. Different coverage options reflect a producer’s ability to indemnify different margin levels (from $4.00 to $8.00 per hundredweight) and different coverage percentages of the farm’s milk production (from 25 percent to 90 percent).

In short, Newton noted, MPP-Dairy functions as a USDA-sponsored put option, and is a financial loss management program which provides assistance to dairy farmers when the national measure of farm income, i.e., the MPP-Dairy margin, falls below a farmer-selected threshold.

Recently, traders and market analysts have encouraged dairy farmers to consider the difference between their actual farmgate prices for milk and feed and the national averages used in the MPP-Dairy margin formula, i.e., their “basis,” before making a participation decision.

That is, dairy farmers with lower (higher) cash prices for milk or higher (lower) cash prices for feed relative to the national averages should consider purchasing higher (lower) levels of MPP-Dairy coverage.

If basis between the cash margin and the MPP-Dairy margin is constant, then the price series will fluctuate identically (perfect correlation) and there is no additional risk from the hedging strategy, Newton explained.

However, if the basis is not constant and varies from month to month, then price changes in the cash margins may not be offset by price changes in the MPP-Dairy margin index, creating the potential for unanticipated gains or losses from MPP-Dairy. Basis risk would create additional financial uncertainty and make it difficult to determine what price floor MPP-Dairy is actually protecting, Newton noted.

The implicit assumption of MPP-Dairy in determining safety net payments for dairy farmers is that the same amount of mlik is produced each bi-monthly period, all milk is priced the same, and all dairy farm operations use the same allocation of ingredients to feed their dairy animals.

However, across the US, not only do milk and feed prices differ considerably but so too does farm productivity, Newton pointed out. As a result, margins vary considerably from month to month and from farm to farm.

Due to this variation, Newton said it is important to understand how farmgate margins relate to the MPP-Dairy index to assess risk exposure related to basis.

In order to analyze how basis may impact how MPP-Dairy ultimately performs in protecting a price floor, mailbox milk price data and state-level prices of corn and alfalfa hay was collected from USDA. Using the MPP-Dairy margin index formula, the milk, corn, soybean meal and alfalfa hay prices were then used to approximate state-level margins.

Newton found that the state-level approximations of margins follow the US MPP-Dairy margin closely. State-level cash margins are “highly correlated” with the national MPP-Dairy margin, i.e., correlation levels are greater ...more

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