Volatility Formation in Dairy Futures: Fundamentals, Public Information, and Processing Ambiguity

Abstract

Class III milk futures cash-settle to an administered price based on weekly component prices, creating a predictable within-month flow of settlement-relevant information. This paper studies drivers of cross-month variation in realized volatility in this formula-settled market. We separate volatility associated with upstream feed-cost and milk-supply conditions, downstream dairy-product markets, USDA public information releases, processing-related ambiguity, and market participation. Processing-related ambiguity is uncertainty about how public dairy-market signals translate into formula-settled payoffs when processing capacity, inventories, product allocation, and logistics are only partially characterized in public reports. We construct a narrative measure from USDA Livestock, Dairy, and Poultry Outlook reports and distinguish it from observable public information using release-date-aligned innovations from major USDA dairy reports. Triple-IV 3SLS estimates show that processing-related ambiguity remains an economically important predictor of realized volatility after conditioning on fundamentals and broader USDA information. Weekly release-timing specifications show stronger ambiguity effects when commercial short-side participation is elevated.