dairy futures guide futures guide.pdf · or to invest) and where and how to trade dairy futures....

Dairy Futures Guide

essential information

1

Introduction 2

Dairy Commodities 4

Global Dairy Market 5

Futures - The Basics 6

Using Dairy Futures - Value To Customers 9

Using Dairy Futures - To Manage Risk 11

Dairy Market Information and Data 13

Contract Specification 14

Getting Started 15

DISCLAIMER

The information contained in this document is a guide only. This publication is for information only and does not constitute an offer, solicitation or recommendation to acquire or dispose or an opinion related to acquiring or disposing of any financial product, investment or to engage in any other transaction. Those wishing either to trade in or to clear or settle any products made available by NZX Limited (NZX) or its subsidiaries, including New Zealand Clearing and Depository Corporation Limited (NZCDC) and its subsidiaries, or to offer and sell them to others should consider their legal, tax, financial and regulatory position, including the relevant market rules, and the risks associated with such products before doing so. All information, descriptions, examples and calculations contained in this publication are for guidance purposes only, and should not be treated as definitive. Participation in, and trading on, any NZX market or NZCDC’s clearing house is subject to compliance with the relevant rules and procedures, and this document is not a substitute for those rules. No part of this publication may be redistributed or reproduced in any form or by any means or used to make any derivative work without written permission from NZX. NZX (including its subsidiaries, and its and their respective directors, officers, employees, contractors and agents) shall not be liable (except to the extent required by law) for the use of the information contained in this document however arising in any circumstances connected with trading, clearing and settlement or otherwise. NZX is not responsible for any errors or omissions contained in this publication.

NZX Limited © 2010

CONTENTS

2

This guide provides information on dairy commodities and the dairy

industry, NZX Dairy Futures (how they might be used to manage risk

or to invest) and where and how to trade Dairy Futures.

NZX Limited (NZX) is a dynamic market operator with integrated services in information, markets and

markets infrastructure.

NZX is the hub of trading in New Zealand debt and equity markets, bringing buyers and sellers together through

its Trayport GlobalVision electronic trading platform. World class clearing and settlement services will be

provided by NZ Clearing Corp.

Futures trading at NZX will initially be centered around Dairy Futures.

NZX believes information is a core building block in the successful development of markets. To support Dairy

Futures, we have integrated a wide range of news and data services, for agricultural commodities under our NZX

Agri brand. See page 11 of this guide for more information.

Introduction

DAIRY FUTURES GUIDE - ESSENTIAL INFORMATION

Dairy products are amongst the most important of all traded food products. Milk matters to people everywhere. Traded dairy

products are equally fundamental and trade is dominated by a few particular dairy commodities: Whole Milk Powder (WMP), Skim

Milk Powder (SMP), Butter, Anhydrous Milk Fat (AMF) and Cheese.

Of these, WMP and SMP are the most basic and important - containing all the vital proteins. New Zealand is a major global

player in these products, exporting 95% of its milk production in the form of dairy commodities1. Nearly half of all WMP exports

come from New Zealand.

1 Source: Dairy NZ, 2010

Dairy Commodities

Milk Powder

Milk powder manufacture involves the gentle removal of water

under stringent hygiene conditions, retaining all the desirable

natural properties of the milk - colour, flavour, solubility and

nutritional value. Whole (full cream) milk contains, typically,

about 87% water and skim milk contains about 91% water.

During milk powder manufacture, this water is removed by

boiling the milk under reduced pressure at low temperature in

a process known as evaporation.

The resulting concentrated milk is then sprayed in a fine

mist into hot air to remove further moisture, resulting in a

fine powder.

Milk is a perishable product. Milk is processed into finished

goods such as dried milk powder that can be stored for several

years and is traded globally.

New Zealand manufactures more than 100 varieties of spray-

dried milk powder to meet the diverse and special needs of

customers. Milk powders may vary in their gross composition

(milk fat, protein, lactose), the heat treatment they receive

during manufacture, powder particle size and packaging.

Special “high heat” or “heat-stable” milk powders are required

for the manufacture of certain products such as recombined

evaporated milk.

Milk powders of various types are used in a wide range of

products such as baked goods, snacks and soups,

nutritional drinks, chocolates and confectionery, ice cream

and infant formulae.

Approximately 13 kg of WMP or 9 kg of SMP can be made

from 100 litres of whole milk.


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Global demand for protein has been rising for some time.

Demand for protein is very income-sensitive. Rising income

levels in emerging markets have led to changes in diet,

incorporating more meat, eggs and milk. In recent years, the

strongest growth in consumption of dairy products has come

from emerging Asian markets, particularly China.

On the supply side, some major producing countries such

as the US or India can move from being a net exporter to a

net importer of dairy over short periods of time. Adding yet

more volatility to the picture is the bank financing cycle. Cows

represent major capital expenditure for farmers, and banks

have moved from a cycle of easy to tight credit in

dairy farming.

Volatility in the global dairy industry has been unprecedented

over the last five years. This is widely expected to continue as

global demand increases on the back of a growing awareness

of milk’s nutritional value and improvement in living standards

in developing economies (and demand for proteins), including

large players like China. This volatility, as a result of the spike in

demand and multiple unpredictable supply side factors, creates

a difficult operating environment for all those in the dairy

supply chain.

Globally, dairy trade is worth an estimated US$140 billion

annually1. This figure represents a variety of end products

including liquid and powdered milk. The export market is

dominated by milk powder. With over US$13.8 billion of Whole

Milk Powder (WMP) produced globally in 2009, WMP dominates

the milk powder export market and is the pricing benchmark for

the dairy industry worldwide2.

1 Source: FAOSTAT, 2007 2 Source: Global Trade Atlas, 2009

Global Dairy Market


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globalDair y T rade average WMP spot contract Agrifax WMP

Graph: Whole Milk Powder Prices

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The primary advantages of the NZX Dairy Futures market are:

The ability to manage risk through the creation of price certainty (hedge);

Price discovery, creating market transparency; and

Forward view of market sentiment.

In order to understand Dairy Futures, it is important to

understand some basics about derivatives. If you are an expert,

skip this section. Simply, futures and options are financial

products known as derivatives.

Derivatives: A derivative is a risk transfer agreement,

the value of which is derived from the value of an underlying

asset. A Dairy Future is in effect, a risk transfer agreement,

the value of which is derived from the value of a dairy

commodity product traded in the physical dairy market, such

as WMP or SMP.

Futures: A futures contract is a legally binding contract

to buy or sell a standardised product, at a fixed price, for

cash settlement or physical delivery on a given date in

the future. In the case of Dairy Futures, the standardised

product is the dairy commodity from which it is derived. For

example, a Global WMP Future is a legally binding contract

to buy or sell WMP at a fixed price for cash settlement in the

future. The same is true of a Global SMP Future.

Options: An option is the right, but not the obligation, to

buy or sell something at a fixed price in the future. This price

is called the “strike price”. There are two types of options:

A – call option gives the holder of an option the right but

not the obligation to buy the underlying asset at the

strike price; and

A – put option gives the holder of an option the right but

not the obligation to sell the underlying asset at the

strike price.

An option on a future (e.g. a Global WMP Option), gives the

holder of an option the right, but not the obligation, to buy or

sell a Global WMP Future at a set price in the future.

NZX Dairy Futures Market

As a futures exchange, NZX is the central marketplace in

New Zealand that facilitates the trading of futures between

participants. An efficient robust market supported by a world

class clearing system (NZ Clearing CorpTM) participants

can be assured of transparency and strong risk management

when they trade with NZX.

The NZX Dairy Futures market allows participants to manage

price risk by creating opposing positions in the futures and

physical market, effectively neutralising any movement in price.

Participants can open a position by buying or selling and close a

position by carrying out an opposing trade, i.e. open with a sell,

close with a buy.

NZX Dairy Futures will be exchange listed and cash settled to

globalDairyTrade (gDT) prices. Cash settlement of a futures

contract means trading is much simpler and easier. Participants

do not have to implement complicated delivery mechanisms

or risk having to make, or take, delivery of the underlying

product to which the futures contract relates. Cash settlement

is particularly preferable for dairy commodities where food

safety criteria, and the actual delivery process, are complex and

not globally standardised.

An important aspect of futures markets is that while they are

representative of the price of the physical product (e.g. WMP),

they operate separately to trading activity in the physical

market regardless of the way the contract is settled. Futures

markets are not generally used as a means to buy or sell

physical product.

Futures - the basics


6

Standardised futures contracts have set expiry dates. In the

case of Global WMP Futures, the contracts will expire each

calendar month. Global WMP Futures will be cash settled. Cash

settlement is the difference between the price at which the

trade was entered and the reference price at expiry.

All NZX Dairy Futures will be cash settled.

NZX selected cash settlement rather than physical delivery for

NZX Dairy Futures as physical delivery can restrict participation.

Cash settled futures contracts are much simpler, and enable

much wider and deeper participation.

NZX Dairy Futures Product Set

The NZX Dairy Futures market is intended to have as its

baseline product set:

Global Whole Milk Powder (WMP) Futures;

Global Skim Milk Powder (SMP) Futures;

Global Anhydrous Milk Fat (AMF) Futures; and

Options against both the WMP and SMP Futures

The first product to be launched will be the Global WMP Future.

Each of the NZX Dairy Futures will have as their reference

price the price set on the globalDairyTrade (gDT) auction. As

stated earlier, NZX Dairy Futures will have expiry dates and the

contracts will expire each calendar month.

Futures - the basics CONTINUED


7

Using Dairy Futures - value to customers

A wide range of participants in the dairy and financial sectors

can benefit from using NZX Dairy Futures. Some of the largest

groups are outlined below.

Dairy Processors

For any dairy processor the foundation to its business is the

ability to secure, retain and increase the supply of milk. Providing

certainty in advance over the price paid for either all or part of

that milk supply means the processor can make investment and

production decisions ahead of time with a much greater degree

of confidence. The ability for a processor to provide fixed price

contracts to farmers will undoubtedly be a drawcard in retaining

supply and attracting new farmers.

Dairy Buyers

Providing certainty in advance over the price received/paid for

dairy commodities means the processor and the purchaser can

better plan for the future and have confidence over sales and

delivery of product. This certainty helps to retain and grow the

purchaser customer base and means the processor can lock in

price for supply. Locking in revenue lines means you can also

lock in cost lines.

Farmers

Farmers are the bedrock and most important players in the

industry. As one farmer said to us “cows are machines for

turning grass (or grain) into milk”. For each litre of milk produced,

depending on where in the world they farm, that litre will go to

produce a mix of WMP, SMP, AMF, cheese, or other value added

product. The prices for the ingredients - WMP, SMP, AMF are all

highly correlated. If the price for WMP falls today, the amount of

money farmers receive as a payout will also fall shortly. There is

a definite and strong correlation between the price of WMP and

the payout farmers receive for their milk. NZX Dairy Futures, in

particular, the Global WMP Future, will for the first time provide

farmers with a daily, transparent indication of sentiment around

dairy commodity prices, and provide the opportunity to lock in

a portion of production. By using Global WMP Futures to hedge,

farmers can take the downside risk out of their cash flow

position. While their processor may also hedge, Global WMP

Futures give farmers control of their cashflow, and assist them to

minimise downside.

Banks

Banks in rural countries and communities have a direct line into

agriculture. Around the world, banks work with farmers to provide

lending facilities, as well as hedging tools for currency and

interest rates. Banks, like their customers, like to have stable

cash flows, and to reduce payment risk as far as possible.

Given the volatility in the milk price, and hence in farmers’ cash

flows, NZX Dairy Futures will give banks a product they can

provide to farmers. Improving cash flow certainty is in both the

banks’ and farmers’ best interests. At a macro level, banks

around the world have a significant amount of capital allocated to

the dairy sector. NZX Dairy Futures provide products for banks to

manage their portfolio exposure to the dairy sector as a whole.

Funds

More and more funds are starting to recognise the importance

of dairy to the global political economy and as a traded product.

NZX Dairy Futures provide funds with a product set to gain

exposure to long-term trends in dairy and demand for proteins,

and thus to expand their portfolios to include this very

important sector.


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Using Dairy Futures - to manage risk

NZX Dairy Futures are designed to manage risk and smooth

out volatility and are intended to create price certainty,

transparency and a forward view of market sentiment.

By trading on the NZX Dairy Futures market, participants can

create price certainty. The ability to create price certainty for

a participant is a fundamental competitive advantage in a

volatile market. For a processor, hedging ensures certainty

for themselves and the farmer over prices paid for liquid milk,

as well as certainty over forward sales prices. This hedging

activity also offers purchasers the ability to secure supply and

manage their own price risk, providing certainty over future

purchase prices.

Price certainty is achieved by entering equal and opposite

positions in the physical and futures markets. Any loss in the

physical market will be offset by a profit in the futures market

and vice versa (physical and futures market prices tend to

move together i.e. mirror each other). The purpose is not to

make a profit or avoid a loss in either market, but to lock in

price ahead of time.

Hedging Examples

NZX Dairy Futures are tools to manage price risk through

the practice of hedging. Hedgers are not attempting to beat

the market; the purpose of hedging is to lock in a price. The

following are examples only, and are not a recommendation or

the giving of an opinion relating to the acquisition or disposal

of NZX Dairy Futures.

In the NZX Dairy Futures market a participant can open a

position by buying or by selling.

Producers (sellers) are effectively “long” in the physical WMP

market before they fix a delivery price with buyers. Buyers are

effectively “short” in the physical WMP market before they fix

a delivery price with sellers.

See hedging examples over page.

Sell = Short hedge

Buy = Long hedge

A producer is at risk of the price falling.

A buyer is at risk of the price rising.


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Short hedge example: (Zero basis and fees)

Suppose it is April and a producer decides to hedge WMP to be sold in August because there is a risk the price could fall.

(Remember that futures and cash prices move in a similar direction and so a profit in one market is offset by a loss in another).

The producer sells one August Global WMP Futures contract at USD3,900/t.

If the price declines in the futures and cash market (as they tend to move in the same direction):

August Futures PriceProfit/Loss on

Futures

WMP Physical (Cash)

Price

Profit/Loss on

Physical (Cash)Net Purchase Price*

USD3,700/t +200 USD3,700/t -200 USD3,900/t

USD3,400/t +500 USD3,400/t -500 USD3,900/t

If the opposite happens, i.e. futures and cash market prices rise:

August Futures Price Profit/Loss on

Futures

WMP Physical (Cash)

Price

Profit/Loss on

Physical (Cash)

Net Purchase Price*

USD4,400/t -500 USD4,400/t +500 USD3,900/t

USD4,100/t -200 USD4,100/t +200 USD3,900/t

In both of the above scenarios, the gain/loss in one market is offset by a loss/gain in another. Therefore, in either of the above,

the producer has created price certainty for themselves ahead of time.

Using Dairy Futures - to manage risk CONTINUED

Sell High, Buy Low


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Using Dairy Futures - to manage risk CONTINUED

Long hedge example: (Zero basis and fees)

Suppose it is April and a manufacturer decides to hedge WMP to be bought in August because there is a risk the price could rise.

The manufacturer buys one August Global WMP Futures contract at USD3,900/t.

Assume the price rises in the futures and cash market:


Futures

WMP Physical (Cash)

Price

Profit/Loss on

Physical (Cash)

Net Purchase Price

USD4,400/t +500 USD4,400/t -500 USD3,900/t

USD4,100/t +200 USD4,100/t -200 USD3,900/t

If prices decline:


Futures

WMP Physical (Cash)

Price

Profit/Loss on

Physical (Cash)

Net Purchase Price

USD3,700/t -200 USD3,700/t +200 USD3,900/t

USD3,400/t -500 USD3,400/t +500 USD3,900/t

The goal of the hedger is not to beat the market but to create price certainty ahead of time. Therefore in either case the loss in

one market is offset by the gain in another, effectively setting a price ahead of time.

Buy Low, Sell High


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When hedging, a participant takes into account factors such

as the cost of trading (exchange and broker fees),

the cost of access to market (networks and software),

capital dedicated to margin and the liquidity of the product

traded. A risk management strategy can be designed to

achieve the participant’s goals, and the hedge can be

managed throughout its life to ensure optimal performance

in a dynamic and volatile market.

Futures prices are mainly driven by prices in the physical

(cash) market, however information and data points which

support views on future price movements are essential.

NZX provides a multitude of key data points, views and

commentary to help traders price NZX Dairy Futures.

gDT Data

NZX Dairy Futures will be accompanied by a direct feed

of gDT data from the gDT platform. The data on the NZX

data feed will include current and historical data. Users

of NZX data can be sure to have the latest, most current

information, equal with any direct user on the gDT platform.

Agrifax

Agrifax is New Zealand’s leading provider of independent

information for the agribusiness sector. It provides timely

and accurate data, insightful analysis as well as monitoring

services for global market trends and commodity prices.

Leading manufacturers, exporters, importers, economists,

financial and farm advisers and farmers in New Zealand and

internationally subscribe to Agrifax.

Click here to see Agrifax Dairy Reports:

http://www.nzxagri.com/agrifax

Agri Inform

Agri Inform produces NZ Dairy Exporter, Dairy Week,

New Zealand Farmers Weekly and many more weekly and

monthly news publications. All are respected for leading

the way in the provision of management information and up

to date news of value to the dairy industry and the wider

agribusiness sector. Click here for more information:

http://www.nzxagri.com

Australian Crop Forecasters

ACF publishes monthly subscription reports on

Australian grain supply and demand. Australian Crop

Forecasters has a long standing in the Australian grain

market as the lead provider of high quality and independent

crop forecasting services.

Click here to see a range of ACF reports:

http://www.cropforecasters.com.au/

Dairy Market Information and Data


12

GLOBAL WMP FUTURES

Unit of Trading 1 tonne (MT)

Price basis USD/tonne

Minimum Price Movement

(Tick Size and Value)

$5 per tonne ($5)

Daily Price Limits 10% above or below the previous Trading Day’s Daily Settlement Price

Contract Months Every calendar month out to 18 months are available for trading

Trading Hours 08:00 hrs - 16:00 hrs NZST/NZDST

Last Trading Day Trading shall terminate on the last business day preceding the first gDT Auction of the

month i.e. trading in the March WMP Futures Contract will expire on the last Business

Day immediately preceding the first gDT Auction in April (See Expiry Calendar contained

in the Contract Terms and Administrative Procedures - NZX Derivatives Market Contract

No 1 (“Contract T&Ps”))

Final Settlement Cash settled to the Final Settlement Price calculated by NZX according to an average

of winning prices for Whole Milk Powder, Regular - NZ, Contract 1 in gDT Auctions as

stipulated in the Contract T&Ps

Clearing House New Zealand Clearing Limited

Common Trading Facilities Block Trading Facility √

Exchange for Physicals Facility √

Exchange for Swaps Facility √

Common Trading Facilities

Minimum Volume Thresholds

Minimum Volume Thresholds for each Contract or Class of Contracts are specified in

Part B Appendix One of the Procedures

Exchange Code WMPF

View vendor codes

Cross Transactions Minimum Time

Period

15 seconds

Position Limits 20,000 Open Positions in any Contract Month

Exchange Rule The Contracts are Traded on the NZX Derivatives Market and subject to the NZX

Derivatives Market Rules and Procedures

Contract Specifications


This is an Individual Contract Specification for the purpose of the NZX Derivatives Market Rules (“Rules”) as amended or supplemented from time to

time. Capitalised terms used herein have the meanings given in the Rules, Procedures and the Contract T&Ps unless otherwise defined. The information

published here does not substitute the Rules, Procedures or Contract T&Ps. This Individual Contract Specification shall not constitute investment advice

nor an offer, invitation, solicitation or recommendation to engage in any transaction. NZX and its subsidiaries take no responsibility for any errors or

omissions or losses, direct, consequential or otherwise arising from actions based upon this information. Before entering into any transaction you

should take steps to ensure that you understand the transaction and have made an independent assessment of its appropriateness in light of your own

objectives and circumstances. You should also consider seeking advice from independent advisers. globalDairyTrade “gDT” is an internet-based electronic

trading platform for cross-border trade in physical commodity dairy products operated by an independent trading manager. For further information on

globalDairyTrade go to www.globaldairytrade.info © NZX Limited 2010 all rights reserved

13

To trade NZX Dairy Futures, you must trade through an NZX

accredited broker. A list of accredited NZX Derivatives Market

Participants is available on www.dairyfutures.com.

Once you have chosen a participant, you will need to open an

account with that participant. Those participants may offer

advice and in many cases may provide you with electronic

trading software for trading and data purposes.

Firms wanting to become an accredited NZX Derivatives

Market Participant must choose the participant status most

appropriate to their business model. All trades on the NZX

Derivatives Market must be cleared through an NZ Clearing

Corp accredited Clearing Participant. Financial Institutions

and Firms can choose to become accredited as a clearer

themselves, or clear trades through a third party clearer - a

General Clearing Participant. For additional information on

NZX Derivative Market Participant categories and NZ Clearing

Corp applications, please go to www.nzx.com.

NZX understands that, with increasing volatility in the dairy

industry and the emergence of new risk management tools

like NZX Dairy Futures, there is a great need for traders and

participants to become comfortable with using these tools.

Please visit our website www.dairyfutures.com to access

other materials that can help you to become better informed

about trading NZX Dairy Futures.

Getting Started


dairy futures guide futures guide.pdf · or to invest) and where and how to trade dairy futures....

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