WHAT’S BEHIND THE MYSTERIOUS UPWARD SKEW IN AG OPTIONS?


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 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.


An often-asked question in economics is: Are markets efficient? It’s a difficult question to answer with certainty because the answer depends, in part, on how one defines efficiency. In its strongest form, efficiently priced forward curves would correctly anticipate the future evolution of spot prices. This, however, has never been the case. Weaker forms of efficient market hypothesis hold that there is no risk-free arbitrage available in markets, which, in turn, suggests that forward curves are at least non-biased estimates of future spot prices. This is to say that future spot prices have a 50-50 chance of being above or below previous market expectations.


When it comes to agricultural products markets, the futures curves appear to adhere to the weak form of efficient market hypothesis: corn, soybean and wheat spot prices are roughly as likely to rise above as to fall below the levels suggest by futures curves. However, for options markets there is the mystery of the persistent upside skew.


In corn, soybean and wheat futures options markets, traders consistently


price a much greater probability of extreme upside risk than extreme downside risk. When measured in terms of implied volatility, out-of-the-money call options usually cost more than similarly out-of-the-money put options. CME’s new CVOL tool measures Up Volatility (the implied volatility of options with strike prices above the at-the-money price) and Down Volatility (the implied volatility of options with strike prices below the at-the- money price) separately. The difference between the two (up vol – down vol) reveals the skew of the options markets.


Since January 2007, corn futures options have skewed upward 95.8% of the time. The same has been true in soybean futures options 83.7% of the time, while in the wheat futures market up volatility has exceeded down volatility 88.4% of the time(Figures 1, 2 and 3).


Such pricing would, of course, be justifiable, if corn, soybean and wheat futures prices demonstrated a greater likelihood of extreme up moves than extreme down moves. This, however, has generally not been the case. Looking back over the past


five decades as well as the 2020s up to March 1, 2023, the daily returns of futures prices show little to no evidence of a greater tendency for extreme upside than extreme downside moves. In fact, during the 2010s and so far during the 2020s, corn and soybean futures prices have demonstrated more extreme daily price declines than increases (Table 1). Wheat futures have shown a slight tendency to have more extreme up moves than down moves but nothing like what has been suggested consistently in the wheat options markets for the past 16 years.


So, what’s behind the tendency of options traders to price out-of-the-money calls higher than out-of-the-money puts? The answer might point to structural factors in the agricultural options market that boils down to two potential root causes.


First, consider the natural buyers and sellers of futures on crops such as corn, soybeans and wheat. On one side of the ledger, you have a relatively small number of large corporations that purchase, process and deliver the crops to consumers. These entities tend to be highly sophisticated and may be inclined to purchase call options to protect themselves versus the risk of extreme up moves in prices.


On the other side of the ledger, there are hundreds of thousands of farmers. Many of them sell futures to lock in current forward prices for their expected harvests.


16 | ADMISI - The Ghost In The Machine | Q1 Edition 2023


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