When a hedge becomes a risk: The recent rally in corn prices.

Commodities markets have been quite agitated in May. The tremors felt on May 5 have not dissipated and recent data on the US economy, the risks of inflation in China’s and the protracted debt crisis in the EU left many traders wary. Prices of precious metals, industrial metals and oil have all dropped. So far, grains, led by corn, have held their value pretty well.

Corn is now being planted to be harvested in August. Weather is the main factor affecting the progress of planting and yields (#bushels per acre), and consequently a key driver of prices for new corn. Estimates indicate that the planting season is behind schedule, and that flooding of the Mississippi has destroyed some fields. Lower expected yields and acreage put further strains on an already historically tight ratio of stocks-to-usage – a measure of supply and demand.

Presumably these facts should have a greater impact on the incoming crop season (new corn). Yet, the recent sharp rally in corn prices occurred in nearby contracts (July futures) rather than in December futures contracts. Why is old corn more bullish than new corn?

One hypothesis is that momentum traders jumped back into corn with an emphasis on the most liquid contract, the nearest to maturity one. This is by no means clear after looking at the open interest and the CFTC data on the Commitment of Traders, which indicates a decline both in short and long positions by speculators.

The lower forecasted yields for new corn might suggest to some that a larger fraction of old corn should be stockpiled for delivery later in the year. But the term structure of futures prices is saying the opposite. Futures prices have become more sharply backwardated, with prices for July delivery rising faster than prices for December delivery. That is a signal that the value of prompt delivery has grown more than the value of storage for future delivery.

The lower forecasted yields do suggest that many farmers need to adjust their hedge positions. Many farmers are now over-hedged, having taken positions based on the earlier yield forecast. Quantity risk complicates the simple textbook model of hedging, requiring both a smaller hedge ratio, but also the dynamic adjustment of the hedge ratio as new information arrives. A farmer who fails to trim the hedge is exposed to more risk than a farmer who makes the needed adjustment. Of course, in this case, over-hedged farmers will find it expensive to liquidate a portion of their hedge since the price has risen and they must repurchase the position at a loss. But it is better to recognize that loss now and be properly repositioned going forward.

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