Do recent prices understate downside price risk in corn?
Summary and Commentary
Use of longer run price series when evaluating price variability suggests that corn prices are more variable than use of a shorter time period. While there are good reasons to believe that the economic structure has changed leading to less variable corn prices, considering a longer-run perspective is important for three reasons:
1. Research suggests that most people place more weight on recent time periods, discounting too heavily experience from the more distant past. In this case, more weight may be being placed on the relatively less variable price experience.
2. Models were used to predict defaults when making home mortgage loans prior to financial difficulties in home mortgage market. These models under-predicted the chance of default, thereby understating risk. One reason many of these models understated risk is that many of the models used only recent data in predictions, not including data from more distant periods in which defaults were more prevalent. Similarly, not considering the pre-World War II experience could be argued to understate variability.
3. A 40 percent decrease in price is an extreme event that occurs rarely. Estimating these extreme events present difficulties and requires a long time-series. Not being in a recent time-series does not mean that there is no chance that the event will occur.
NASS currently is estimating the 2011 MYA corn price to be $6.20 per bushel. A 40 percent decrease in price would result in a 2012 MYA price of $3.72 per bushel. The chance of this occurring is greater than zero, the chance that would result by examining price changes since 1973. Its chance of occurring likely is less than the 3 percent frequency suggested examining prices since 1866. The chance likely is close to a 1 in a 100 year event.