Ag economist says his colleagues should take the time to analyze futures curves, option spreads and cash market basis
Agricultural economists are ignoring much of the rich data readily available in crop markets, says one analyst.
They should delve deeper into the prices and spreads between prices to better understand and analyze crop markets.
“Hopefully this paper will inspire agricultural economists to expand their way of thinking and their toolkit when analyzing commodity prices in the midst of various types of global crises,” writes agricultural economist James Vercammen of the University of British Columbia.
If analysts looked at futures curves, option spreads, volatility gauges, cash market basis and other readily available price data they could see further into the complexities of agricultural markets.
“Information-rich commodity prices reflect a great deal about market beliefs, and it shows how simple methods can be used to extract these beliefs along several different dimensions,” he wrote in an article in the April issue of the Canadian Journal of Agricultural Economics.
Vercammen looks at both continental derivatives markets and a local cash market to show the unique perspectives various prices can provide for what’s going on inside an agricultural commodity market. He looks specifically at soft red winter wheat, which is the foundation of both the main Chicago wheat futures contract (and associated options contracts) and representative of the kind of wheat physically traded in the London, Ont., area.
“The price of options on commodity futures provides important signals about the market’s estimate of future price volatility,” said Vercammen.
It’s not just overall volatility that is revealed by option spreads and premiums, but also where traders see the greatest risk of volatility, he added.
“The price premium for out-of-the-money call options relative to out-of-the-money put options initially increased but then decreased as traders changed their minds about whether the right tail or the left tail of the price distribution contained the most significant source of risk,” he said about one situation.
Futures price spreads between contract months can show “how the wheat futures market simultaneously deals with the short-term spike in demand for wheat by processors and an anticipated long-term slump in market fundamentals due to rising stocks and an emerging global recession.”
So too does cash market basis reveal local demand compared to overall demand, as well as the impact of currency swings between the local cash market currency and the currency of derivatives contracts.
None of these measures are foreign to traders, crop market analysts or informed farmers, but according to Vercammen they are less considered within the agricultural economics profession.
“Analyzing the changing steepness of the forward curve, plotting a time series of implied volatility values, and determining how the skewness of an option’s volatility smile changes in response to a crisis that affects both supply and demand is not routine in the agricultural economics discipline,” said Vercammen.
That’s something that should change, he added.