Individual correlation coefficients for the components from January 2005 until June 2013 show the following:
High correlations exist for the state’s principal crops, corn and soybeans. The index has a 0.86 correlation to corn and 0.83 to soybeans. Those tight correlations occur despite an approximate $6 and $12 range per bushel price for the two commodities.
The significance of the income-producing crop is apparent when viewing the much lower correlation with wheat. Wheat is a non-productive agricultural factor for Iowa and as suspected, displayed a low correlation. Similarly, high correlations are witnessed for U.S. T-note and gold futures. The strong interest rate results are indicative of the prolonged downward rate cycle experienced in the viewed period. Inflation expectations seem truly to have been captured in gold’s price action.
Multivariate regression analysis, using gold, corn, soybean and five-year T-note futures to estimate the Peak Soil Iowa Cropland Value Index, can be seen in “Comparing markets” (below). The monthly coefficient of determination between the actual index value and the predicted value of the commodity basket, known as the R-squared, is 0.85. The predicted value is replicated with optimal weightings as determined by the regression analysis.
The discovered R-squared implies that 85% of the variation in the index can be explained by the replication model, while the remaining 15% can be attributed to unknown variability. This demonstrates that farmland values in crop-dominant states can synthetically be reproduced with a basket of existing futures contracts. The analysis specifically indicates that the farmland index can be hedged with a replication for much shorter time periods than formerly thought.
Farmland is an essential natural resource that has thus far been ignored as a commodity. This is surprising considering that farmland has greater long-term strategic value than oil and natural gas.
Acceptance of replications practicality opens the door to democratize the asset class. Investing in farmland will not be as daunting or restrictive and limited to long-only strategies. With farmland as a tradable commodity, new opportunities open for the financial and agricultural communities. Product development will accelerate into other geographic regions with investment and risk-management tools becoming more readily available. With hedging capabilities in place and the market opened to the institutional investor, farmland will become a more efficient, liquid and transparent commodity.
The 1970s witnessed the beginning of the financial futures revolution. Currency, gold, crude oil (NYMEX:CLJ14) and interest rate futures were all presented as innovative new concepts. The introduction of cash settlement with the Chicago Mercantile Exchange Eurodollar contact paved the way for hedging equity exposure. Contracts mimicking stock indexes, not possible with a physical delivery, could now simply cash settle.
A cash-settled farmland futures contract can be derived from a market-accepted index, such as the Peak Soil Iowa Cropland Value Index. From there, indexes can be designed to meet the needs of farmers and investors in other locations and with differing land characteristics. The possibilities are vast, with cropland, range land and even timberland indexes possible.
In “Exchanges and Regulators let traders down in 2013,” Futures, February 2014, Steve Zwick points out how difficult current times are for the futures industry. But in that same issue, Hilary Till notes that transforming innovation has occurred in stressful times, in “Futures Industry: A story of crisis and opportunity.” It’s time for the reappearance of prudent innovation in the marketplace.
Paul Kanitra has 30+ years of fixed income, commodities and real estate experience. He is the founder of Peak Soil Indexes and is working on the development of farmland indexes and derivative products. Reach him at firstname.lastname@example.org.