Pricing efficiency and market success of the BFP futures and options

During the past decade, the United States dairy industry has begun a significant restructuring toward a market-driven system. This shift brings greater milk price volatility and risk to the cash market. The recent development of dairy futures and options markets on the Chicago Mercantile Exchange (CME) could prove to be an important source of price discovery and risk management for this industry in transition. This study examines the efficiency of the CME basic formula price (BFP) futures and options markets as well as the usefulness of various option pricing models in pricing these fluid milk contracts.

Several characteristics of the maturing CME BFP futures market are examined according to Black's (1986) criteria for a successful market. These characteristics include: trading volume and open interest, spot price forecasting ability, and residual risk. These characteristics together do not point conclusively to long-term market failure or indicate any market inefficiency. Rather, the characteristics indicate the potential for CME BFP futures market success.

Three alternative option pricing models are compared in this study: 1) the traditional Black model with historical 30-day volatilities; 2) the GARCH option pricing model with trading volume; and 3) the GARCH-in-mean option pricing model with trading volume. These models are compared to their performance in pricing BFP options in contrast to actual market premiums. Six option contracts are analyzed, including both in-the-money and out-of-the-money put and call options for January, April, and July 1999. The GARCH models lead to two approximations of predicted conditional volatility used in an option pricing formula. Using root mean square error as a comparison criterion, the Black model outperformed both GARCH models and their approximations in pricing most options. All models generally priced calls more accurately than puts. All models also priced out-of-the-money options more accurately than in-the-money options.

The results indicate that the BFP futures and options markets are efficient and effective risk management tools for dairy producers. The results also indicate that the traditional Black option pricing model may price a maturing market more accurately than GARCH models or their variants. Mispricing of in-the-money options is a consistent result of all models and may be related to the unique characteristics of a maturing market.