The concept of risk premiums is a great tool for understanding how financial markets attempt to balance the probabilities of an uncertain future. We can see risk premiums in many markets, from crude oil to corn. Like most aspects of financial markets, risk premiums are fleeting and difficult, if not impossible, to calculate with any confidence. They can, however, give us a conceptual model to understand better how and why particular markets display certain tendencies.

The corn futures market is an excellent example of how and where the concept of risk premiums can give us a handy insight into the way a market behaves. To explain the concept of risk premiums, let’s grossly oversimplify the corn market by whittling the harvest-time price of corn in any given year down to only two possible prices, $3.00/bushel and $8.00/bushel. Then to determine what that final price is, we will rely on the outcome of one variable, ideal season versus drought. If we assume droughts happen one out of every five years (20% of the time) – it should easy for us to calculate the fair price of corn before planting season begins. To do so, we would use a simple expected value calculation (a concept we introduce in the article “Coining Some Terms”):

(Price in ideal season times probability of ideal season) + (Price in drought times probability of drought) = Current Fair Price

Or using the numbers in our example:

($3.00 x 0.80) + ($8.00 x 0.20) = $4.00

Given that, it should be intuitive that as the season passes and the probability of drought becomes more or less, prices will drift higher or lower in response. If we compare this conceptual model to what we see in real-world corn pricing, it matches fairly well. Often, we have a higher price for fall corn in the spring than we do in the fall – because, more often than not, we do not experience a drought.

What might be less intuitive is how this conceptual model might explain the upside volatility we see in the corn market. Let's break the season down into 100 days (because it makes the math is easy), then make each day either an ideal or a drought day. If we assume that 50 days into the growing season, we’ve seen either all ideal days or all drought days, our probabilities will change. If we further assume that this change happens in a straight-line fashion, the market should cut the chance of one outcome or the other in half. The math looks like this:

First half of season all ideal:

($3.00 x 0.90) + ($8.00 x 0.10) = $3.50

First half of season all drought:

($3.00 x 0.40) + ($8.00 x 0.60) = $6.00

While this is by no means an exact representation of the market’s pricing mechanism, it provides us with an excellent way to understand price movements. In this model, drought days mean more than ideal days. Drought days have a larger impact because there is so much more ground to cover in terms of reaching the more distant price from our initial expected value. Based on this model, each ideal day should yield a $0.01 drop in prices, while each drought day should bring a $0.04 rise in prices.

Can we gain anything from looking at this model? Not anything predictive, but it does give us an excellent descriptive view to incorporate into our risk management plans. We should expect adverse conditions to have a more significant and faster impact on prices than ideal conditions. Expecting this can help us be mentally prepared for the markets to go a little haywire – as they inevitably will. Understanding that inevitability allows us to stay disciplined and execute our strategy when it happens. When dealing with uncertainty, it’s important to have a disciplined strategy like the one at the heart of our Quartzite Precision Marketing program for grain and soybean producers.

At Quartzite Risk Management LLC (Quartzite), we see discipline as one of our biggest strengths. We have seen a lot, and we understand that preparation and experience make heat-of-the-moment decisions more comfortable, and more importantly, better. At Quartzite, we help our clients develop, understand, and stick-to their risk management plans. That way, when emotions are running high, we are more likely to stay disciplined and have a significant impact on our clients’ bottom lines and their longevity. Contact us today to see if we can help you.