The Pricing and Social Value of Commodity Options

Abstract

Commodity options are the right to buy or sell a specified quantity of a commodity, or commodity futures contract, at a specified price. The publicity surrounding several "boiler room" scams involving unwary buyers has given commodity options a bad name. Currently, only a handful of firms sell legitimate commodity options. Commodity options can, however, offer social benefits not provided by other investment vehicles. For example, they have several advantages over futures contracts. Their prices reflect information more quickly and fully than the prices of futures contracts. They allow investors to eliminate the risk of margin calls by paying an option "premium" up front. They allow producers and investors to hedge quantity, as well as price, risk for seasonal crops; using futures contracts, a farmer can form a perfect riskless hedge only if he knows exactly how much of a commodity he will have after a future harvest. Furthermore, the distribution of returns on options, which ensures that only the premium is lost regardless of how much futures prices fall, may attract to commodity option markets investors who need to hedge their assets against volatile fluctuations in price. The Securities and Exchange Commission and the Commodity Futures Trading Commission have recently moved to allow exchange trading of commodity options. Organized exchange trading may be expected to increase trading in, hence expand the social benefits of, commodity options. Exchange trading might also improve price "efficiency" in option markets. Tests using a variant of the Black-Scholes formula for option pricing indicate that, under the current system of private firm market-making, commodity option prices do not always accurately reflect all available information.