Amid a strong rebound in global economic activity and concerns about drought in the U.S., Brazil and the Black Sea region, the prices of corn, soybeans and wheat have soared to levels not seen since 2012 and 2013.
One important question that investors can ask before they gain exposure to a market is: What scenario is already embedded in the price? In markets, every price tells a story about what marginal price setters believe about the future. The current pricing of futures and options markets tells a complex story about what scenario investors implicitly favor for corn, soybeans and wheat.
The simplest story is told by futures price curves. For all three commodities, these curves are pointing downward (Figures 1 and 2). This is especially true for corn and soybeans, though a little less for wheat. Essentially, traders in these markets favor a scenario in which prices moderate after roughly doubling for corn and soybeans, and rising more than 50% for wheat.
It’s important to realize, however, that futures price curves are not a forecast. Rather, these curves are akin to a highly likelihood – the most probable scenario in the subjective (and ever-changing) view of traders among a potentially infinite number of scenarios. While futures curves give one a sense of what market participants think might be the most likely scenario, they don’t tell anything about how confident market participants are in that particular outcome. This is where options markets come in.
Thirty-day at-the-money (ATM) corn options have been showing some of the highest implied volatility since 2008 to 2012, while 30-day wheat options have also been showing elevated levels of volatility (Figure 3). Meanwhile, implied volatility on soybean options has been in a more ordinary range typical of the post-2012 period (Figure 4).
But there is more to options than 30-day ATM volatility: there is also the term-structure of volatility (how traders price volatility for different options expiry dates) and the skewness of options (how traders price extreme upside versus extreme downside risks). For corn and wheat, traders see the current period of exceptionally high volatility moderating as we move into late 2021 and early 2022. Rather than remaining in the 35-40% implied volatility range that one finds for 30, 60 and 90-day options, traders price volatility for the six-month period from now (180-day volatility in 180 days) between 20% and 25%. They also price a drop off in soybean volatility as well (Figure 5). In short, traders see a high risk of exceptional volatility in agricultural product prices over the summer, followed by a return to levels of implied volatility that are more typical of the 2013-2019 period.
Implied volatility is not, however, symmetric and crop options traders often see a greater risk of extreme upside volatility than extreme downside volatility. The current moment is no exception. Out-of-the-money (OTM) calls on corn, soybeans and wheat are considerably more expensive than OTM puts, with strike prices at equal distance from the current price for the underlying futures contract. As such, although traders see a decline in corn, soybean and wheat prices over the rest of 2021 and into 2022-23 as being the most likely scenario, they are more concerned about extreme upside risk to that scenario than they are about extreme downside risk (Figures 6 and 7).
In figures 8, 9 and 10, we put together the information from the futures curve along with the options term-structure and skew. The result is a breathtakingly wide set of possibilities embedded in market prices. In these charts, the futures curve can be understood as the maximum likelihood scenario, but the probability of markets following that most probable scenario is close to zero. According to standard probability models, there would normally be a 68% chance that the outcome would fall within one standard deviation of the futures curve and a 95% chance that it would fall within two standard deviations. There would be a 2.5% chance of prices rising more than 2 standard deviations away from the expected mean and a 2.5% probability that they might fall below -2 standard deviations from the expected mean.
What is impressive about these scenarios is how wide they are. While traders might see moderate downside risk to crop prices as the most probable scenario, when one fleshed out their full probability distribution from options prices, one can see anything from prices dropping back to lows not seen since 2000 to prices hitting new record highs. Much will clearly depend on weather outcomes over the next few years.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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