There’s a good story in the NY Times called “Price Volatility Adds to Worry on U.S. Farms.” It details the difficulties that some growers of corn, soybeans, and wheat have experienced using futures contracts to hedge their price risk. There’s concern from some farmers about the traditionally smooth system for risk transfer and price discovery at the Chicago Board of Trade (CBOT), where futures contract prices are supposed to expire very close to the underlying cash price at delivery time. I’ll detail this problem in a few minutes, after we review why the system has actually worked very efficiently for over a century to stabilize food prices and keep farmers in business.

For nearly 150 years, farmers have been able to lock in a selling price for their grains months before harvest by trading futures contracts at the CBOT. For instance, if a farmer in May sees that the September corn contract is trading at a price he considers an attractive selling price for delivery of his summer harvest, he can sell 1 futures contract for every 5,000 bushels he wants to hedge. The one major downside to this transaction is that if the futures price rises while the hedge is on, the farmer will be liable for the difference every day. In other words, if he sold at $4.00 per bushel and the futures price rises to $4.50, then his broker will require this difference to be paid by funds in the farmer’s margin account as his positions are “marked-to-market,” or settled “zero-sum” so that every profitable position is paid by a corresponding unprofitable one. The upside, of course, is that the farmer can take advantage of any price rise in the corresponding cash market at harvest time, and the losses on the futures hedge will be very closely offset by the gains in the cash market sale at delivery of his harvest. Most people immediately react by saying “why bother to hedge at all?” Well, that is the “uncertainty factor” that every hedger faces—you lock in a selling price today to control future price risk, and the tradeoff for escaping lower prices is that you might miss a higher selling price later. And we all know that insurance, as an antidote to uncertainty and risk, has a price.

Now, the recent problem, according to the NY Times, is that some grain futures contracts have expired with prices significantly above the underlying cash market, resulting in greater losses than farmers should expect from their hedging plans. Generally, futures contracts for physical commodities, like soybeans, oil, and even gold, often trade at a premium to the cash market. This is because a futures contract is an agreement to buy or sell the given commodity at a set price on some future date, and the producers or holders of the commodity not only have price risk uncertainty to deal with but they also have certain fixed costs between now and the delivery date of that contract. So, things like storage, insurance, and interest rates get factored in to the future price and add to something known as the cost of carry—which is essentially the difference in price between the cash commodity and the futures contract for delivery of that commodity at expiration. This is considered its forward, or future, fair value because it is the price at which neutral market participants would be indifferent about buying or selling the commodity in the future. The non-neutral market players, namely hedgers and speculators who either have price risk or a price opinion, will be the traders moving the futures market around its fair value as they are usually not indifferent about price. So, as the cash market moves up and down, the futures price moves with it in a relatively stable spread, unless of course uncertainty and risk rise and cause the futures price to rise farther above the cash price.

One other dynamic is very important here—each day that passes reduces the cost of carry ever so slightly, and as both markets gyrate in tandem, their prices eventually converge, or come closer together, at expiration of the futures contract. Why is this so? Because if you think of the purpose of a futures contract as being a substitute for, or guide to, the fair value of a given commodity in the future, you can expect that it will be just like the cash on the day of its expiration. But this expectation isn’t left solely to the whims of the market. The legally enforced terms of the futures contract bring a mechanism to the market that normally motivates buyers and sellers to move the futures price to converge with the cash price.

That enforcement mechanism is the threat of delivery, and this is how futures exchange clearing houses guarantee contract performance. Those who are long futures contracts must take delivery of the physical commodity and those who are short the contract must make delivery—or else their account funds, or collateral such as T-bills, would be seized and they could be fined and barred from trading indefinitely. Since the threat of delivery, backed by the financial authority of the exchange clearing house, has “teeth,” no buyers would continue to be long the futures at expiration at a price higher than they could simply buy the cash commodity, and no sellers—primarily hedgers—would continue to be short the futures contract at a price below the cash market. And large market participants like grain elevators would have the capability to take advantage of arbitrage opportunities, where they could sell overpriced futures and buy the cash commodity, or buy underpriced futures and sell to the cash market. The profit and loss motivations of all these players move them to move the futures price and the cash price closer and closer together as we near expiration. The participation in futures markets from all types of hedgers and speculators creates a giant auction of market opinion that we call price discovery. And this is why futures markets have worked so well for so long as various hedgers are able to transfer their risk to speculators large and small.

So how did this normally smooth-functioning risk transfer and price discovery system come into question recently? Well the Times doesn’t have an exact answer and we may not know for some time until more research is done. Some say that the participation of large institutional investors and hedge funds is driving futures prices beyond the capabilities of cash market players to conduct the arbitrage that would force convergence. That may or may not prove to be the case here. On a percentage basis, the differences between cash and futures may not be that large. And the ability of sophisticated cash market operators with the facilities to conduct cash-futures arbitrage may be hindered by other transaction and delivery costs.

But, one factor that is often found in extreme market dislocations is the combination of rising prices and rising volatility. The Times does a good job of describing the nature and impact of prices and volatility upon each other. Using data from the CME Group and Bloomberg, they describe how implied volatility in wheat futures options spiked to historic levels not seen since 1980, when the price of wheat surged above $11 earlier this year. Implied volatility, as opposed to a historical measure of past price fluctuation, is the volatility that option prices indicate is trading in the market, and it is a key indicator of market uncertainty and risk concerning future prices. When hedgers and speculators are paying more for options than their typical fair value based on historical volatility, it provides opportunities for traders. Learn more about option volatility by visiting the OptionsPhysics page at www.OptionsNews.com