New cheese futures contracts offer benefits – with caveats

June 24, 2010
New cheese futures contracts offer benefits – with caveats

CME Group, the world’s leading derivatives marketplace, launched cheese futures and options on futures on June 21. For the first time, cash-settled contracts are now available on CME Globex, the exchange’s electronic trading platform.

"This contract was requested by our customers such as manufacturers and processors of cheese to better fit the needs of their risk profile," said Tim Andriesen, CME Group Managing Director of Agricultural Commodities, in a May press release heralding the futures contracts. "Many of these customers already participate in our Class III Milk and Dry Whey futures and options markets. The new cheese contracts will enable them to directly lock in future prices for cheese."

Manufacturers, processors, food companies and others have used the Class III contract to meet their hedging needs since 1996 and the Dry Whey futures contract launched in 2007. The Cheese futures will complete the "dairy crush" with which the original commodity as well as its product and byproducts can be hedged.

Cheese is made from Class III milk. Dry whey is a byproduct of processing the milk into cheese. Because of all the variables involved with cheese, and the lack of liquidity in newer markets, it’s been complicated for people to manage their risk to cheese exposure prices, said David Zaslavsky, an analyst with Downes-O’Neill.

Zaslavsky said the new contracts have ultimately made it more simple for cheese processors of all kind and sizes to be confident in locking down futures for up to 24 months.

One benefit to the new CME futures contracts is that it opens the playing field for smaller pizza chains and other cheese processors that want to hedge and predict their foodcosts, who otherwise didn’t have the buying power to do so. Bigger companies like Pizza Hut and Domino’s usually have risk management departments of their own that contract directly from the exchange instead of going through manufacturers. The tool is also good for manufacturers: In the past, they offered forward pricing or fixed-term contacts as an added value to their clients to keep them in business. Now, it’s easier for manufacturers to offer and execute that service well.

But there are still a couple of drawbacks to consider. The tool gives cheese buyers the ability to take some volatility out of their costs, while making yet another gamble. "If a pizza chain goes to a large company and purchases their cheese, paying $1.50 for 12 months; they’ve removed volatility, but not the fact that there might be an opportunity left on the table (in exchange)." Zaslavsky means that prices could drop below their secured number, and a restaurant buyer could thus be less competitive than a buyer who secured their variable foodcost at a lower rate.

The biggest caveat he issued was to understand the risks and benefits of contracts – and if not, of course, to hire an analyst. He listed some potential scenarios to consider.

"You’re using leverage and putting up a smaller amount of money to control larger amount," he said. "Lets say 20,000 pounds of cheese is $1.39, but (they’re) only asking you to put up a fraction of that as a good faith deposit for adverse move. So if someone buys futures, there’s risk there because they’re going to have to fund the margin account as it goes down. The concept is they’ll buy their physical at a much smaller price if they locked it in, which offsets that. But most important thing to avoid drawbacks is to understand what they’re going to do, what the drawbacks are. "

The new contracts will be listed monthly with each contract representing the equivalent of 20,000 pounds of cheese and the tick size of $0.001 per pound. Trading hours are Sunday through Thursday, 5:00 p.m. to 4:00 p.m. Central Daylight Time, and Friday until 1:55 p.m., with daily trading halts from 4:00 p.m. to 5:00 p.m.


Topics: Cheese, Domino's Pizza, Insurance / Risk Management, Operations Management

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