Profit margin hedging in the New Zealand dairy farming industry

Abstract

This paper explores the effectiveness of Whole Milk Powder futures to protect the net profit margins of New Zealand dairy farms. The proposed strategy for farms suggests selling futures contracts when the current futures price (adjusted for basis risk and commissions) is above the break-even price. We use historical data from 2011 to 2017 and simulate a profit margin hedging strategy with a target price that covers total cash expenses of a representative farm. We find that the representative farm’s payout for this strategy is statistically higher than the continuous hedging and no hedging strategies after accounting for brokerage fees and basis risk. Additionally, we apply the strategy using actual farm-level data and demonstrate that the strategy helps to reduce discretionary cash variance by 35%, semi-variance (downside risk) by 76% and decreases chances of financial distress by 16%. Moreover, we document that the strategy increases mean discretionary cash for farms by 39% and that farms with a high level of leverage experience the biggest improvement. We estimate that if the strategy was adopted by all New Zealand dairy farms over the five year period, it could have generated an additional income of NZD 0.53 billion yearly, on average.