Pricing and Hedging Options on Seasonal Commodities Without Futures
Summary
The document asks how to value an option on fresh corn that will not be harvested until after the option is arranged. In a market with a matching futures contract, that future is the natural instrument for hedging the option; physical corn available now is not the relevant hedge for a later delivery. The question highlights the difficulty of applying replication arguments when the underlying commodity cannot yet be traded.
If no suitable futures contract exists, the response says exact replication is unavailable. A valuation can still be made by assuming a price process and volatility, but hedging then carries basis risk. One proposed approach is proxy hedging with a correlated nearby-month corn contract, switching to the target month once it becomes tradable. If no such corn contract exists, a related commodity such as wheat may serve as a proxy. The answer gives no pricing model, correlation estimates, or evidence of hedge performance, so proxy effectiveness is uncertain.
Key ideas
- A futures contract matching the option’s delivery period can provide the hedge for a seasonal commodity option.
- Physical commodity that is unavailable until harvest cannot directly replicate exposure before harvest.
- Without a suitable derivative, full replication is not possible, though model-based valuation remains possible.
- A nearby corn contract or correlated commodity can be used as a proxy hedge, with basis risk.
- A hedge may need to be rolled into the target-month contract when it begins trading.
Tags
Full text
# How do you price an option on fresh corn? # How do you price an option on fresh corn? I'm preparing for quant interviews, and I had this question for myself. I'm not actually trading corn options. My goal here is just to better understand how to deal with these kinds of options. According to this, corn's "peak season lasts from May through September." Suppose corn is only picked May through September. In December of this year, someone (a warehouse?) would like to buy an option on fresh corn picked in June of next year. According to Shreve's Stochastic Calculus for Finance II, the price of an option is derived from replicating the option by trading in the money market and the underlying asset. In December of this year, we cannot trade fresh corn that won't be picked until June of next year. How do we replicate the option? If your answer depends on the existence of a market for other corn derivatives, what if these markets don't yet exist? ## Answer by Juan Ignacio Gil (score 4, accepted) https://quant.stackexchange.com/a/69023 Ideally, you should have a futures market, so you can hedge your option using the corresponding future. That is actually the right instrument to hedge and replicate, not physical corn picked in December. I imagine such a contract exists, but, for the sake of the exercise, let's assume it doesn't. In the absence of a futures contract, you cannot fully replicate the option. You can still price it doing assumptions on the price dynamics and volatility, but, if you want to hedge, you will need to do proxy hedging, using a very correlated instrument. If you have the May contract, you can use that to hedge, and then as soon as the June contract starts trading, close your May position and open your June hedge. Another possibility, if there is not a May contract yet, is to use a very correlated commodity (wheat, perhaps).
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