Case Number: 5-407-754, Year Published: 2008
HBS Number: KEL343
Regression Analysis, Options, Price Volatility, Insuring Revenues for Family Business, California Dairy Industry
The financial success of dairy farms depends critically on the price of their main output, milk. Large volatility in the price of milk poses a considerable business risk to dairy farms. This is particularly true for family-run dairy farms. The question then arises: how can a farm owner hedge the milk price risk? The standard approach to establish a price floor for a commodity such as milk is to purchase put options on commodity futures. At the Chicago Mercantile Exchange, farmers can buy put options on the price of a variety of milk products. However, the price a farm receives for its milk depends on many factors and is unique to the farm. Thus, a farmer cannot directly buy put options on the price he receives for the milk his farm produces. Instead the farmer needs to determine which of the options available for trade at the Chicago Mercantile Exchange offer the best hedge for his own milk price. The assignment in this case is to examine historical data on several prices of milk products and the milk price received by a family-run dairy farm in California. Students need to find the price that is most closely correlated to the farm's milk price and to then choose options with the appropriate strike price that serve as the best hedge for the farm's price risk.
The objective of the case is to expose students to an interesting but simple finance application of linear regression analysis. To reach the case solution, students must run several simple linear regressions, then use the best regression model they find for some additional analysis. They need to make a prediction for the dependent price variable and analyze the prediction interval in order to achieve the desired objective outlined in the case. By completing the case, students will acquire a good understanding of their regression model and its usefulness for helping the protagonist make an important decision for his business.
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