Disclaimer: This web page is designed to aid farmers with their marketing and risk management decisions. The risk of loss in trading futures, options, forward contracts, and hedge-to-arrive can be substantial and no warranty is given or implied by the author or any other party. Each farmer must consider whether such marketing strategies are appropriate for his or her situation. This web page does not represent the views of Kansas State University. 
Disclosure:  Dr. Barnaby’s research was the basis for the privately developed Crop Revenue Coverage.

Is the Open Interest in the Option and Futures Markets Sufficient to Measure Price Volatility and set Price Election for CRC and RA?[1]

Revenue Insurance Base Prices.  Revenue insurance base prices for setting guarantees on the 2004 wheat contracts are based on very “thinly traded” markets.  Currently, the base price for Portland wheat is based on September 2004 Chicago Board of Trade (CBOT) wheat contract plus an estimated basis.  The current open interest in the CBOT 2004 September winter wheat futures contract is 45 contracts (as of 09/02/03 ).  Under Crop Revenue Coverage (CRC) procedures there is a requirement for an open interest of at least 50 contracts.  Otherwise, one uses the July 2004 CBOT wheat futures contract to set the Portland base price for guaranteeing 2004 revenue insurance wheat contracts.  The CRC procedure requires at least 15 days of prices in the average price used to set the Portland 2004 wheat base price. 

Currently for the Portland 2004 base price, July futures prices have been substituted for September futures prices starting on August 22 in order to meet the 15 day price average requirement.  The July futures price will continue to be used until the September 2004 contract open interest exceeds 50 contracts.  The basis is defined as the difference between August Portland cash prices and the nearby CBOT wheat futures contract.  The 5 year average basis is then added to the average futures price measured from August 22 (August 15 if the market meets the open interest requirement) through September 14.

The July 2004 and September 2004 are trading very close to the same price so there will be little difference in the revenue offers for CRC on Portland 2004 wheat contracts.  Even with the substantially higher volume in the July 2004 contract by comparison the December 2003 CBOT wheat contract has an open interest over 96,000 contracts.  However, the July 2004 or September 2004 futures prices are clearly the best estimate for setting revenue guarantees on the 2004 wheat crop because these contracts are new crop offers. 

Kansas and other hard red winter wheat States 2004 revenue insurance wheat guarantees are based on the July 2004 Kansas City Board of Trade (KCBOT) futures contract.  Currently, there are approximately 1,400 open interest contracts in the July 2004 KCBOT winter wheat contract.  By contrast the December 2003 opened interest is over 55,000 contracts.

Implied Volatility.  Under the new premium setting mechanism for CRC an implied volatility value will be utilized in setting the CRC premiums for the first time.  The implied volatility value as measured by the option market has always been used in setting the Revenue Assurance (RA) premiums.  RA for Kansas and other winter wheat States uses the implied volatility in the option market for the harvest contracts on the KCBOT and the CBOT.  The measurement period is the last five trading days prior to September 15 so it is possible that the option trading volume will increase over current values.  However, currently the July 2004 wheat option market trading is extremely thin.

The CBOT July 2004 wheat futures contract ( 09/02/03 ) closed at $3.37.  The at-the-money July option is the $3.40 strike ( 09/02/03 ).  The RA procedure for setting premiums requires using the implied volatility based on the July 04 option being evaluated using the at-the-money options.  However, there is no open interest in the at-the-money put option and under current procedure no value would be calculated.  The call option on July 04 CBOT winter wheat at the $3.40 strike had an open interest of 8 contracts.  The most actively traded option on the CBOT July 04 winter wheat contract was the $3.10 put option, which is 30 cents out-of-money.  The $3.10 put options had an open interest of 1,000 contracts and a trading volume of 100 contracts ( 09/02/03 ).  However, the current RA procedure does not allow the use of the out-of-the-money option for calculating implied volatility. 

The Kansas City option market is also very thin.  The Kansas City July 04 futures closed at $3.42 and the at-the-money $3.40 put option had an open interest of 7 contracts.  The at-the-money $3.40 call had an open interest of zero contracts.  The most actively traded option on the July 04 Kansas City Board of Trade wheat futures contract is the $3.70 call that is 30 cents out-of-the-money.  The $3.70 call had an open interest of 150 contracts and a trading volume of 185 contracts.  However, current RA procedure would not allow the use of the more actively traded option for setting implied volatility used to set final RA premiums on the 2004 wheat crop. 

It is assumed the RA implied volatility for the CBOT will be used to set CRC premiums on Portland 2004 wheat because there currently is no active trading of at-the-money September options.  The total open interest in the September 2004 CBOT wheat option market is 3 contracts that are 40 cents out-of-the-money.

Unless the volume increases over the next week, the question has to be, “Is this open interest in the option market used to measure price volatility for CRC and RA reasonable?” 

A Future Change.  RMA is suggesting they plan to calculate the implied volatility in the future based on the volatility in the futures market rather than use the current method based on the option market.  This would allow one to calculate the theoretical value of the option, but it may not trade for that value.  However, the July futures is a more active market than the July option market so this maybe a better measure of market risk than the information provided by a few option trades.