Prof. Alfons Weersink spoke about "Price Volatility, Margin Calls and Hedging Decisions"...

Posted on Thursday, April 29, 2010

Prof. Alfons Weersink spoke about "Price Volatility, Margin Calls and Hedging Decisions" at the 2010 CAES Workshop on Risk Management in Vancouver, B.C. on April 12, 2010.

Title: Price Volatility, Margin Calls and Hedging Decisions
Speaker: Alfons Weersink, University of Guelph
Co-author: Getu Hailu, University of Guelph

Abstract: The recent rise in crop prices that occurred in the fall of 2006 was the beginning of an unprecedented level of volatility in agricultural markets since 1970s’. Corn prices on the Chicago Board of Trade (CBOT) rose from less than $2 per bushel in September of 2006 to almost 4 times that price in the spring of 2008. Similar price spikes occurred in the soybean market and the wheat market but within a shorter time frame. While the large jump in prices may have ‘benefited farmers’ who had seen years of declining real and nominal prices, the sudden change in the market caused havoc for consumers, particularly the urban poor in developing countries. Higher food prices in developing countries spawned concerns over the "silent tsunami" that was spreading over the less fortunate who could not afford adequate nutrition. In an attempt to deal with the food crisis, answers were sought to what caused the sudden change in commodity markets. A number of factors contributed to the rise in prices experienced in 2007-2008 (Weersink et al., 2008). The stock-to-use ratio had fallen to historic lows for most crops as production levels had flattened over the years in response to continued low prices. Poor harvests then occurred in some major exporting countries along with the culmination of several demand-side forces. The US dollar fell relative to other currency increasing the purchasing power of commodity buyers. These buyers were increasingly from countries such as China and India which were experiencing GDP growth that was several times the global average. In addition, renewable fuel mandates, particularly in the US, represented a new demand source that now diverts over one-third of the US corn crop.

Speculators were and continue to be a popular target for explaining dramatic price swings experienced in the commodity markets. It became common for political leaders and media to argue that commodity index investors (CITs) and other large institutional investors exerted a destabilizing influence on prices, particularly after a submission by Michael Masters to a US Senate sub-committee in the summer of 2008 (Masters 2008). Although there is some debate about whether commodity index traders have caused the change in agricultural commodity prices, or whether the volatility in agricultural commodity prices attracted CITs, there is an agreement that these markets have become more volatile. Subsequently, there have been demands for regulatory intervention to lessen the impacts of speculative trading on the assumption that the actions of index traders destabilize commodity prices.

Given the increase in commodity price volatility to rise, it is important to explore the effect of the rise in futures price volatility and market-to-market risk (liquidity risk) on risk management by agricultural producers. The purpose of this study is to examine the implications of a rise in volatility for the risk management performance of the futures market. Specifically, we aim to answer the question: What are the implications of the anomalies (price convergence problems) between futures and cash prices and the recent extreme futures price volatilities on optimal hedging strategies by crop producers? We theoretically derive optimal hedge ratio and then simulate under alternative values for the model parameters. The optimal hedge ratio is derived by extending the model developed Pannell et al. (2008) who used mean-variance framework. We consider a two-period model with three-trading dates.

We showed that the aversion to mark-to-market risk reduces the optimal hedge ratio. As well, a rise in the level of volatility of the futures prices has a negative influence on the optimal hedge ratio. Thus, if the alleged destabilization effect of CITs takes the form of higher market volatility, it makes the derivative markets less reliable and more costly as risk management tools for producers, grain elevators, and processors alike. Further, the intermediate losses as a result of high margin calls may force producers to terminate their hedging programs, and in the extreme cases businesses may be forced to shut down. The result is consistent with the observation that small and midsized elevators were disappearing during high commodity prices volatility, and big grain elevators were refusing to buy crops in advance from farmers because of costly hedging. Producers who are using futures hedges must be aware of the possibility for liquidity risk (i.e., fund required for margin financing) resulting from a margin call if the futures price moves significantly "against" a hedge position before contract expiration date.