Wheat “Smile”-Commodity risk management

Wheat“Smile”. Commodity risk management

Black-Sea is crucial in the commodity trade especially for Energy and Grains. The Ukrainian crisis increases probabilities of tail events or extreme events in Wheat. Here comes the challenges: Dealing with the constant flow of news and opinions in these markets, determining what event or market condition outweighs on other factors. To overcome these limitations, I propose an existing alternative: using the prints of the Options on Futures to gauge the degree of uncertainty and greed in the commodity market.

What are volatility smiles ? The smile is a quantified measurement of the implied market volatility for puts and calls options at different strikes. If market volatility were neutral, the implied volatility values for puts and calls at each strikes prices would form a U or a V smile shape.

If fear or greed are in the market, a skew will appear in the smile. In laymen’s terms, the skew reflects market’s perception of tail risk, the risk that the commodity might plunge or rise by two or more standard deviation below or above the mean. Let’s see the smiles for oil and wheat commodity options.


Wheat  Smile

What the wheat smile revealed us during february: Wheat came back at a reasonable price for the market, the wheat smile had a very steep skew to the right (red graph below): Bet was categorically on the rise.  The typical hedger like the food company,  should have read a warning for margin calls and a higher costs of acquisition for wheat. Ukraine wasn’t totally in the portrait; it was before Yanukovych fled Kiev.

wheat volatility smiles

At the time of writing, we are in the middle of the ukrainian crisis and sweltering temperatures in the Southern Plains deepened fears about weather damage to the U.S. HRW wheat crop. The skew is still to the right (graph on the right) , this is bullish. However,  the smile has flattened, reflecting the cost to protect long positions.

A big company exposed to a wheat price rise such Kraft Foods has the 3 following options. 1. Do nothing, pay more for their wheat, accept thinner gross margin. 2. Transfer the price risk to its customers and lose market share 3) hedging its wheat buying program but also facing losses from daily margin calls.

The U.S CME is believed to be the wheat global benchmark and a leading indicator for the world markets. After the previous rally on the CME, Wheat exports window to Euro-Med (the arb) for U.S is closed and sales have shifted to the U.S domestic market. Black Sea wheat on a FOB basis is more than $50/MT lower than their its equivalent U.S HRW.

Why reported Ukrainian cash wheat prices are getting lower despite they’re technically at war ?

The ukrainian economy is bankrupt and with the collapse of the internal demand, I suggest that more grain is freed for exports explaining the relative weakness of ukrainian wheat vs world wheat. A part of the answer may also lies in freight rates. There is no free-lunch, if it’s more risky to berth at Ukrainian Black-Sea ports, charterers have to pay a lump sum bonus. Ukraine’s Currency is in Free Fall, hryvnia has lost 28 percent since the beginning of January.  Idea: wheat importers such Egypt’s General Authority For Supply Commodities (GASCare getting more wheat through buying wheat in Hryvnia than buying from U.S GC in dollars. Most importantly,  sellers in Ukraine resumed active selling of grain to empty storage capacity for the new grain crop.

Contract Performance Risk

As I said here,  to mitigate the Ukraine risks, buyers are preparing to find alternative supply sources. The wheat rally induces moral hazard: when prices rise subsequent to their contracted price, sellers get an incentive to find a way to default and sell higher to another buyer.  see  Seagrain LLC v Glencore Grain BV [2013].

Political turmoil in the Black Sea and deteriorating winter wheat conditions in the U.S. were the primary catalysts for the wheat rally, which ignored the more-than-adequate global stocks.” -Soren Schroder

The primary catalyst to move global stocks to the global demand will be higher prices. The market conveys a message: expect to pay more for your wheat and margins calls if you count on mean reversion.

© 2014 The Trade, Shipping and Finance Wizard


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