A volatile closing basis prevents class I hedgers from locking in a minimum price. The closing basis is composed of an "acceleration" and "mover" effect. The mover effect always works to the producer's advantage unlike the acceleration effect. This research discusses hedging strategies to minimize the acceleration effect.Marketing,

Kilmer, Richard L.

Uryasev, Stanislav

Zylstra, Michael J.

English

Research Papers in Economics

 
 
HEDGING CLASS I MILK:  THE “ACCELERATION” AND 
“MOVER” EFFECT 
 
 
Michael J. Zylstra 
Food and Resource Economics Department 
PO Box 110240 
University of Florida 
Gainesville, FL 32611 
mzylstra@cv-access.com 
 
Richard L. Kilmer 
Food and Resource Economics Department 
PO Box 110240 
University of Florida 
Gainesville, FL 32611 
rlkilmer@mail.ifas.ufl.edu 
 
Stanislav Uryasev 
Industrial and Systems Engineering Department 
PO Box 116595 
University of Florida 
Gainesville, FL 32611 
uryasev@ufl.edu 
 
Abstract 
 
A volatile closing basis prevents class I hedgers from locking in a minimum price. The 
closing basis is composed of an “acceleration” and “mover” effect. The mover effect 
always works to the producer’s advantage unlike the acceleration effect. This research 
discusses hedging strategies to minimize the acceleration effect. 
 
Key words: Risk Management, Futures, Milk, Dairy 
 
Selected paper for presentation at the American Agricultural Economics Association 
Meetings Denver, Colorado  August 1-4. 
 
 
Copyright 2004  by Michael J. Zylstra, Richard L. Kilmer and Stanislav Uryasev. All 
rights reserved. Readers may make verbatim copies of this document for non-commercial 
purposes by any means provided that this copyright notice appears on all such copies. Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    2 
Milk Pricing 
Milk prices are a function of three factors.  The Federal Price-support policy (price 
floor), the Federal Milk Marketing Order (FMMO) policy, and the over order premium.  
The price-support policy is implemented through government purchases of storable 
products. The Commodity Credit Corporation (CCC) purchases butter, nonfat dry milk 
(NFDM), block cheddar, and barrel cheddar.  Theoretically the CCC buys products 
during times of low prices and sells back product during periods of high prices  thus 
acting as a market stabilizer benefiting both consumers and producers.   The prices paid 
by the CCC are parameters calculated in order to ensure a price of $9.90 per 
hundredweight of delivered raw milk standardized at 3.67% butterfat.  The relationship 
between the support price for butter and nonfat dry milk is called the butter powder tilt.  
If the CCC accumulates product and does not foresee prices elevating to a level where the 
product can be sold, the USDA can opt to adjust the relationship between the price of 
NFDM and butter.   
The FMMO sets minimum prices based on utilization and geography.  The milk 
price a processor can purchase raw milk at is based on the processor’s utilization of the 
raw product.  Processors that bottle milk pay a higher price and processors that make 
manufactured products, such as cheese and butter, pay a lower price.  The FMMO system 
works in a similar manner as the milk price-support program (both establish a minimum 
price), except for the fact that the FMMO is tied to wholesale market prices of dairy 
products and adjusts monthly to compensate for changes in market conditions.   The 
marketing order establishes a blend price which is based on utilization in each of the four 
classes and is equal to the minimum price a producer can be paid for delivered raw milk.  Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    3 
The difference between the milk price-support and the blend price is that the blend price 
is adjusted monthly to reflect changes in monthly wholesale product demand while the 
milk price-support can only be changed through a congressional mandate. 
Problem Statement 
The Chicago Mercantile Exchange offers futures and options contracts based on 
the class III market.  The problem facing class I milk producers is whether or not it is 
feasible to cross hedge net income based on the class I market with a portfolio of futures 
and/or options contracts that are based on the class III formula price.  Our study considers 
the minimum risk level attainable to the class I producer under different scenarios.   
The “Acceleration” and “Mover” Effect   
  The effective class one mover price for a class I hedger equals 
  ( ) ,, Effective Class IMover
I III III
tt l T v T SF F − =+ − % % ,  
where the class I spot mover for time t equals 
I
t S % and  ,
III
tl T F − equals the price at time t-l on a 
futures contract expiring at time T, and  ,
III
vT F % is the price on the same contract at the time 
class I prices are released, v.  The expression above can then be rearranged to show that 
the producer’s ability to lock in a price is a function of the closing basis.  Figure 1 
illustrates the historical class III enter price versus the effective class I mover when the 
hedge is set  to 6 (l=6) months prior to expiration.  The number of months a contract 
remains on the board has varied over time.  Selecting a lag of 6 months allowed for the 
inclusion of all months from January 1999 to December 2003 while maintaining a 
respectable hedging interval. Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    4 
$10
$11
$12
$13
$14
$15
$16
$17
Jan2000 Jun2000 Nov2000 Apr2001 Sep2001 Feb2002 Jul2002 Dec2002 May2003
D
o
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l
a
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s
 
P
e
r
 
H
u
n
d
r
e
d
w
e
i
g
h
t
Class 3 Enter Price
Effective Class I Mover
 
 
Figure 1. The class III enter price versus the effective class I mover 
The difference between the effective class I mover and the class III enter price equals the 
closing basis.   The closing basis can be decomposed into the mover and acceleration 
effect represented in figure 2. Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    5 
-0.5
0.5
1.5
2.5
3.5
4.5
Jan2000 Jun2000 Nov2000 Apr2001 Sep2001 Feb2002 Jul2002 Dec2002 May2003
D
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s
 
p
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H
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w
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g
h
t
Mover Effect
Acceleration Effect
Closing Basis
 
Figure 2. Decomposing the closing basis into the acceleration and mover effect 
Class I prices are based on the maximum of the class III and class IV advanced 
prices.    If the producer locks in the class III price and the advanced class IV price ends 
up being the mover then the there exists positive pressure on the  positive closing basis 
which works towards the producers benefit.   For this study this is referred to as the 
“mover effect.”  Historically linear regression reveals that 94.77% of the variation in the 
closing basis can be explained by the “mover effect.”  The remaining variation is caused 
by the “acceleration effect.”      
Advanced prices are based on two NASS weekly survey periods instead of four or 
five NASS weekly survey periods.  Furthermore, the advanced pricing factors (survey 
prices based on 2 weeks of a NASS survey data for manufactured dairy products) are 
released on the Friday before the 23rd of the month unless this date is a Friday.
1  Class III 
and class IV prices are released on the Friday prior to the 5th of the following month 
                                                 
1 http://www.ams.usda.gov/dyfmos/mib/prc_rls_date_03.pdf Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    6 
unless this date is a Friday.  The different release dates coupled with the different survey 
period can cause current class III price to diverge from the advanced class III price.  For 
this study divergence that is due to these factors is called the “acceleration effect.” 
While the “mover effect” only works towards the producer’s advantage the “acceleration 
effect” can work towards the producers detriment.  Therefore any hedging strategy that is 
employed should attempt to minimize the “acceleration effect.”  The acceleration effect is 
minimized when producers use futures lagged by one month (i.e. hedge November milk 
with an October futures contract) and round turn their position on the day that the class I 
mover is released.   
“Acceleration” Effect Under Various Round Strategies 
The producer’s ability to lock in a price is determined solely by the closing basis.  
The closing basis can be broken down into two components the mover effect and the 
acceleration effect.  The mover effect only works in the producer’s advantage while the 
acceleration effect introduces the possibility of a negative closing basis which can reduce 
the producer’s effective price.  Producers’ should seek a strategy that maximizes the 
explanatory power of the mover on closing basis.  Producers control the date that they 
offset their short positions and they also control the contract that is used to hedge.  This 
section will detail the hedging effectiveness of six different hedging strategies. 
Assume that a producer attempts to hedge class I milk production for a month 
ending at T using futures at time period T-6.  The price that the producer attempts to lock 
in equals  6,
III
TT F − , where T also equals the date that the futures contract expires.  The 
effective price for that producer then equals the class I mover 
I
v C , where v equals the date 
that the class I mover is released, plus the gain on futures.  The gain on futures equals Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    7 
6,
III
TT F − - ,
III
vT F .  Since the producer already knows  6,
III
TT F −  the producers effective price is 
determined solely by the difference between the stochastic 
I
v C  and  ,
III
vT F .  This difference 
can also be referred to as the closing basis.  Given the nature of the pricing relationship 
between the class I and class III market it is expected that the closing basis will usually 
be positive.  This result is expected because the class I mover is based on the maximum 
of the class III and class IV advanced prices.  However, when the historical data is 
considered it is found that this is not the case.  Consider figure 1 which plots the effective 
price versus the class III enter price for a class I hedger who attempts to lock in the class I 
mover six months prior to the date it is released.  Figure 1 is drawn based on the 
assumption that the producer is hedging the mover using lagged class III futures contract 
and offsetting the position on the day that the class I mover is announced. 
  In general the effective class I mover is greater than the class III enter price.  
However on March 2002 and on November 2002 the effective price was less than the 
class III enter price.  This result occurred because 
I
v C  was less than  ,
III
vT F .   This is 
plausible because of the acceleration effect.  The acceleration effect results because 
I
v C  
and  ,
III
vT F  are based on different survey periods.   
  The mover effect was calculated as the maximum of the difference between the 
class IV advanced price and the class III advanced price and zero.   The acceleration 
effects of  the following six different strategies were evaluated.   
•  Current futures, offset on the day the first NASS survey, used to calculate the 
class I mover, is released 
 
•  Current futures, offset on the day the second NASS survey, used to calculated 
the class I mover, is released 
 Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    8 
•  Current futures, offset on the day the class I mover is released. 
 
•  Lagged futures, offset on the day the first NASS survey, used to calculated the 
class I mover, is released 
 
•  Lagged futures, offset on the day the second NASS survey, used to calculate 
the class I mover, is released and 
 
•  Lagged futures, offset on the day the class I mover is released 
 
The closing basis is plotted against the mover effect using strategy three in  
figure 2.    For this study the difference between the closing basis and the mover effect is 
called the acceleration effect.  When different strategies are used the closing basis and 
therefore the acceleration effect changes.  The acceleration effect for the current (lagged) 
futures strategies are presented in figure 3 (4). Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    9 
-$2.30
-$1.30
-$0.30
$0.70
$1.70
$2.70
$3.70
$4.70
J
a
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2
0
0
0
N
o
v
2
0
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S
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J
u
l
2
0
0
2
M
a
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2
0
0
3
Lag 0, Nass 1
Lag 0, Nass 2
Lag 0, Class I
 
 
Figure 3.  The acceleration effect for strategies using current futures 
-$2.30
-$1.30
-$0.30
$0.70
$1.70
$2.70
$3.70
$4.70
J
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3
Lag 1, Nass 1
Lag 1, Nass 2
Lag 1, Class I
 
 
Figure 4. The acceleration effect for strategies using lagged futures 
Strategy three uses the lagged futures offset on the day class I prices are released.  When 
strategy three is used nearly 95% of the closing basis is explained by the mover effect. Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    10 
Conclusion 
The class I producer’s ability to lock in a minimum price is a function of the 
convergence of the class I mover and the class III futures price.  To summarize, this 
research has found that when the hedge position is set using a lagged futures position and 
is lifted on the day the class I mover is released, the probability of convergence (or 
divergence in the producer’s favor) is maximized.  Furthermore convergence is more 
likely in certain months than others.  This result occurs because during some months, five 
weeks of survey data are used to calculate the class III price while during other months 
only four weeks of survey data are used.  Months in which only four weeks of survey 
data are used to calculate the FMMO class III prices are more likely to converge.  This 
result occurs because the two NASS surveys used to calculate the class I price carry more 
relative weight in months where only four surveys are used.  These results lead to the 
conclusion that the sensitivity of the hedge to these factors is primarily a function of the 
perishable nature of milk.  Non storable commodities have erratic basis patterns, which 
make the effectiveness of the hedge very sensitive to the date the producer offsets his or 
her hedge position. 
Even when setting a hedge using lagged futures and offsetting on the date class I 
prices are released, convergence is not assured for three reasons.  First of all, the class I 
mover is based on the maximum of the class III and class IV mover (mover effect).  
Secondly, the class I mover is based on a shorter survey period than the class III price 
(acceleration effect) and third, the class I mover is released on a different day than the 
class III price (acceleration effect).  The closing basis results from divergent prices on the 
day that class I prices are released.  The closing basis is composed of a mover effect, Hedging Class I Milk:  The “Acceleration” and “Mover” Effect    11 
which only benefits producers, and an acceleration effect which can work to the 
producers disadvantage.  The recommended strategy of using lagged futures and 
offsetting the position on the day the class I mover is released was derived by minimizing 
the detrimental conditional value at risk of the acceleration effect. 
Empirically the recommended strategy minimized the producers exposure to the 
acceleration effect.  This research concludes that the sensitivity of closing basis to this 
strategy is a function of the bulkiness and perishability of fluid milk.  Given the non 
storable nature of milk NASS surveys can vary significantly from month to month 
yielding an erratic basis.  This variation yields an acceleration effect.   
The implication is that policies might be considered in order to reduce the acceleration 
effect would be to include more than two weeks of NASS survey data in the computation 
of class I prices.  Increasing the number of survey periods (so long as the additional 
survey period was used to calculate class III prices for the same month) would reduce the 
detrimental impact of the acceleration effect; however this policy would also compromise  
the advanced nature of the class III prices.  Another policy initiative that would also 
reduce the acceleration effect would be to reduce the number of surveys used to calculate 
class III prices so that more consistency exists between the surveys used to calculate the 
class I mover and the class III prices.  However this policy could be prone to 
manipulation because processors could time their sales to coordinate with survey months 
thus reducing prices for producers during those months. 
 
 
 

HEDGING CLASS I MILK: THE "ACCELERATION" AND "MOVER" EFFECT

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