What is in this article?:
Price risk and volatility
In addition to the market's estimate of the expected value of the crop, a measure of the price risk is also needed to calculate the cost of insuring against revenue shortfalls. Option markets provide the market's estimate of the cost of insuring against price declines or increases of various magnitudes, and in combination with the futures prices, provide a means to recover the entire price distribution describing possible future prices.
The method used by RMA is related to the Black-Scholes option pricing model which relates the expected cost of insurance to the probabilities associated with all possible outcomes and their payoffs. The term "implied volatility" is derived from an approach that observes actual option values and tests for the measure of volatility that would most nearly result in the observed prices – in essence, the volatility implied by the observed prices. It can be expressed in a form analogous to the standard deviation of prices – a form that is more easily interpreted as percentage price movements and their associated probabilities of occurrence. A common rule of thumb is that about two thirds of the possible outcomes occur within one standard deviation of the average or expected value. Thus, if the projected price or expected value were $6 and the implied volatility indicated a standard deviation of $1.20 then there is a two-thirds probability that prices will be between $4.80 and $7.20. Of course, higher volatility or more likely larger price movements result in higher values of insurance, and lower volatilities result in lower costs of insurance.
There are numerous commercial services available that report the implied volatilities associated with options and RMA uses one of these as the source of their starting value of price risk.