Implied volatility in commodities trade

Export populism in commodities is a phenomenon which is directly connected to the country’s backwardness profile. A mandi operator claims higher place among his peer group ‘for being a supplier to an exporter’ and exporter demands highest place of pride than his domestic counterpart in social forums. These are all ingrained in a false vanity that is often attached to international trade. 

In the controlled regime, the successful exporter had to manage the ‘babudom’ to leverage the incentives and subsidies of the government. However, market orientation brought about a change in the profile of the exporters. The established players have moved out and the less established players have moved in. The moot point is whether one makes money by exporting commodities? 

Free play of the market can be seen nowhere more dominantly than in exportable commodities like soyabean de-oiled cake (DOC) and coffee market. In both these commodities, one rarely finds a back to back parity. So, how does one make money — thru positional calls? lower interest & logistical cost or by sheer luck? 

Coffee and soyabean are the largest traded commodities in international exchanges. Implied volatilities for these commodities have been creeping up steadily over the course of past two decades and now appear a more permanent feature in their markets than was the case in the past. A detailed examination of the past underscores just how volatile these markets have become and how volatility has persisted. Since the beginning of 2006, implied volatility have frequently spiked to levels well beyond 30% in these commodities, reaching well over 60% at times. The more divergent are traders’ expectations about future prices: the higher the underlying uncertainty and hence the implied volatility of the underlying commodity. 

Does volatility matter? Prices of derivative commodities that are observed today of commodities which are traded in the major global exchanges 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 where markets might be headed. 

Markets are failing under the pressure of oligopolistic powers. The companies that process and ship agricultural commodities are growing in size as they decrease in numbers. Empirical evidence shows that a growing disconnect between prices paid by the consumers and prices received by the producers. International Commodity Agreements, Buffer Stocking and government intervention have failed in past. 

In addition to seeking ways to increase stability in commodities market the government needs to re-think that in a market oriented economy, how can one limit the exposure to commodity price volatility and mitigate the detrimental effects of commodity wild price swings. To quote Friedman, “governments never learn. Only people learn”. 

Published in The Economic Times