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Jul 13, 2012 ||
Tim Doar ||
The heat wave in late June and early July in the Midwestern United States did nothing to help existing drought conditions throughout the region. This fact informed the USDA decision this week to lower expectations for U.S. corn supply following earlier expectations for the highest planted corn acreage in more than 75 years and record yields for corn.
The combination of these events has increased volatility in the agricultural commodities markets, which historically react to extreme weather events and USDA supply demand estimates more than almost any other factors. The bigger concern to many market participants and consumers is the severe effect continued drought – and hence, lower supply – can have on food prices in the near future.
Situations like this often bring up questions about the relationship between volatility and margins – deposits that guarantee the performance of derivatives contracts. To better understand this, it’s helpful to review the general approach to margins, as well as the specific factors that trigger volatility and make the ag markets unique.
Margins are intended to protect participants whichever way the market moves, and are set based on volatility, not the price of a commodity. CME Clearing is responsible for setting prudent margin levels for a diverse set of products, and continually reviews multiple factors to determine the adequacy of margin levels at any given point in time. Agricultural products are one of the most dynamic asset classes we service in terms of market volatility. A few reasons for this are:
1. The supply for the products is essentially fixed at certain points in the year. While there may be growing or weakening demand for corn, the supply is often difficult or impossible to adjust to meet changes in demand. In addition, because of seasonal factors associated with agricultural crops, there are unique price movements that take place. Over time this seasonality lends itself to market price expectations based on a historical set of price movements. These seasonal factors can play an underpinning role in the price direction of the market.
2. The agricultural markets rely heavily on weather. Because of this unique property, good weather, bad weather or even a variety of weather reports can move the market in a short period of time. A prolonged drought or flood, for example, could impact supplies and lead to additional price volatility.
3. The USDA also plays a critical role. Since food safety and security have been important to market participants and consumers for many years, there is a correlation to agriculture being among the most studied and most recorded asset classes in the world. The United States and many other countries have sophisticated methods of tracking food and feed production and assessing the current demand for such goods. The USDA releases a variety of reports, including its monthly World Agricultural Supply and Demand Estimates and Crop Production, which farmers, producers, processors, distributors, and other end users monitor to ensure that the food and feed our country needs is going to be produced.
Each of these factors can move the market substantially in the short term while a combination of them can help to determine the final market price daily. Because of these unique volatility possibilities, our risk management group diligently reviews the markets and, by requiring appropriately conservative margin levels, ensures that no undue risk is entered into the clearing system.
Let’s take soybeans as an example. We have made several changes in margin in recent weeks to adjust to volatility in the marketplace. By the close of business Wednesday, June 27th, the margin when a position is initiated was $4,500. Throughout the life of that trade, we would expect $3,000 in maintenance margin would be kept at the clearing house. By the close of business Tuesday, July 10th, the margin when a position is initiated was $5,063, and we would expect open positions to keep $3,750 in maintenance margin at the clearing house.
The relationship of these margin figures to volatility can be seen in the following chart, where orange reflects volatility in the soybean market, and the gray area reflects margin:
As CME Clearing President Kim Taylor wrote here last year about margins:
“They aren’t a means to move a market one way or another, or to encourage or discourage participation from one kind of market participant or another. Rather, margin is one of many risk management tools that help us assess overall portfolio risk to protect market participants and the market as a whole.”
We use both a systematic approach that incorporates historical volatilities, implied volatilities, seasonality, and future price change expectations as well as market intelligence and agricultural expertise to determine appropriate margin levels. By understanding how these factors and others can impact the price of agricultural products the margins can be better adjusted to ensure that adequate coverage is obtained while not hindering the potential for price discovery. The overall setting of margins based on the understanding of the market makes our markets a safer place to trade agricultural commodities.
Kim Taylor on understanding margin changes
John Labuszewski on making sense of volatility
Quick facts on margins from CME Clearing
Tim Doar is managing director and chief risk officer for clearing house risk at CME Group.
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