How Much Would You Pay to Resolve Volatility Risk in Agricultural Commodity Markets?

Abstract

This article investigates the pricing of volatility risk in agricultural commodity markets. We show theoretically that the cost of bearing volatility risk can be measured using returns to delta-neutral straddles. Using a sample of options for five commodities (corn, soybeans, Chicago wheat, live cattle, and lean hogs) for 2002–2016, we provide the following findings. First, returns to delta-neutral straddles are negative, ranging between –0.87% and –0.06% per day, suggesting that investors are willing to pay a cost to avoid volatility risk. Second, volatility risk is priced mainly at short maturities (within 2 months) but is negligible at longer maturities, and this term structure of volatility risk prevails in all markets. Last, volatility risk is more pronounced on the day immediately preceding the U.S. Department of Agriculture (USDA) announcements but is not effectively explained by economic or commodity specific factors.