Market indicators

IMPLIED VOLATILITIES

During the last bout of market upheaval over 2006-2008, Food Outlook regularly examined the evolution of implied volatility to gain an insight into which direction global markets for several key commodities are likely headed. With concerns resurfacing about the prospect of another prolonged round of escalating prices, this edition revisits this important metric.

Measuring Implied Volatility

Implied volatility represents the market's expectation of how much the price of a commodity is likely to move in the future. It is called "implied" because, by dealing with future events, it cannot be observed, and can only be inferred from the prices of derivative contracts such as "options".

An "option" gives the bearer the right to sell a commodity (put option) or buy a commodity (call option) at a specified price for a specified future delivery date. Options are just like any other financial instrument, such as futures contracts, and are priced based on the market estimates of future prices, as well as the uncertainty surrounding these estimates. The more divergent are traders' expectations about future prices, the higher the underlying uncertainty and hence the implied volatility of the underlying commodity.

Does implied volatility matter? Prices of derivative commodities are determined by underlying expectations and uncertainties about such expectations, pertinent to the market and the commodity. Hence, implied volatility, as reflected or inferred by the prices of derivative contracts, is an important component of the price discovery process and is a barometer as to how traders expect prices to evolve in the shorter term.

 

Implied volatilities for wheat and maize have been creeping up steadily over the past two decades. High implied volatility now appears to have become a more permanent feature in their markets than was the case in the past. The persistence of volatility reflects the continued uncertainty in how market fundamentals have unfolded and how they are likely to unfold. A detailed examination of the recent past, however, shows that implied volatility for both commodities may have stabilized and more importantly, reached a turning point.

At the peak of the turmoil in international wheat markets, implied volatility for the commodity climbed to 55 percent and spiked again in March 2009, before falling to a two-year low in September. The evolution of implied volatility in the international maize and soybean markets tended to mirror that of wheat, but the degree of upward movement has been less pronounced: maize and soybean volatility surged in March of this year to around 45 and 46 percent, respectively, but since then has declined.

In November 2009, implied volatility stood at 35 percent for wheat, 31 percent for maize and 33 percent for soybeans. These percentages are a measure of the deviation in the futures price (six months ahead) from underlying expected values. Under reasonable assumptions, one can say 'the market estimates with 68 percent certainty that prices will rise or fall by 35 percent for wheat, 31 percent for maize and 33 percent for soybeans'. In a similar vein, the likelihood that prices will exceed their current values by more than 50 percent in six months time is perceived to have a probability of around 2 percent, in other words quite unlikely.

To put these indications into a wider perspective, implied volatility has undergone a gradual moderation in the past six months, suggesting that markets are a little more assured than they were last year.