Everyone knows there is a lot of risk in commodity prices right now. However, people often struggle to figure out exactly how much. We can borrow some basic finance concepts and publicly available information to quantify this risk.
Figure 1 These are corn and soybean price risk distributions (as of April 21st). You can analyze the areas under the curves (you can read more details here) to determine that there a 15% chance of corn going below $3.00/bu and a 13% chance of soybeans going below $8.00/bu.
For this analysis, we leverage the fact that known options prices reflect the uncertainty in the price of the underlying asset. For example, on April 21st, Dec-16 corn futures were trading at $4.03. An option to buy Dec-16 corn for $4.30 was trading at $0.24. What determines the price of that option? In part, the uncertainty in corn price. If corn prices are very uncertain, then there is a greater chance that corn prices will go up, and therefore the option would be worth more. If corn prices were absolutely certain (i.e. we knew that corn prices were going to stay at exactly $4.03), then the option wouldn’t be worth anything, since you wouldn’t ever exercise it . Using options prices to calculate price risk is a commonly used procedure in finance, and it is even used to determine crop insurance rates (a great summary article on how it is used to calculated crop insurance premiums can be found here). For now, we’ll just stick with the punchline: option prices can be used as a measure of the market’s estimation of price risk.
One striking thing about the price ranges in Figure 1 is their width: the fact that corn prices could range between $2 and $6 is what makes farming one of the riskiest businesses. However, farmers have many tools to reduce that risk: forward contracts, hedging, and insurance are some of the more common ones. As a simple example, let’s examine the effect of forward contracts on our risk model:
Many growers at this point have already forward-sold a good portion of their 2016 crop. We can use our risk model to calculate their final price risk by combining the known value of their sold crop with the risk associated with the unsold crop. Before the sale, there is a 15% chance that your final price would be under $3/bu. After the sale, you’ve reduced the risk your final crop price being below $3/bu to 0.4%. Of course, you have also limited your potential upside while reducing your downside risk.
Figure 2 Effect of forward sales on price risk on Dec-16 corn, before and after selling 50% of the crop at today’s price for 2016, assuming the same April 21st prices used above.
Managing risk is a key component of successful farming – as important as the agronomics and operational aspects. Market prices of futures and options contain a lot of useful information about price risk, and you can use this data to drive real marketing decisions. It is clear that with the current market conditions, the farmers who know how to evaluate risk will be ahead of their peers, and more quickly earn the trust of their lenders.