Agri-Options to hedge farmers against price risk.
Sujay Subhash Valanju
Never before did the Indian agri-commodity markets looked so appealing than in the current phase, a phase that has the potential to transform agri-commodity trade. With the advent of soon to be launched Agri-Options, the field of commodity trading is at the cross roads of transformation. Touted as the ‘game changer’, agri-commodity Options sounds like a new-age tool in the hands of the value chain participants, but most importantly a solid tool in the hands of farmers, similar to a ‘safety net’(akin an Insurance plan) for hedgers who buy Options.
With the feasibility of Options having deliveries in Futures, it sums up as a great hedging tool available to the farmers. Agri-Options are set to give hedgers a form of an insurance that is determined by the strike price of the option.
The only risk that the options buyers carry is the one-time premium that they have to pay in form of this risk management tool. We are hopeful that agri-options will surely encourage more market participation, even from those quarters who intrinsically are risk-averse, but may think of trading in agri-options owing to the limited downside risk. This can also have a direct positive implication on those hedgers who had been attuned to hedge offshore, due to non-availability of options hedging choice in the country; for they will now be able to divert such offshore liquidity within the country, using Options tool.
What’s in it for a farmer?
The most important but often neglected member of the agri-value chain: a farmer is set to benefit the most from agri-Options, mainly on account of the following:
- Limited downside risk: A mere one-time premium payment makes agri-Options as an affordable tool from a farmer perspective, as just by paying this one time charge, the farmer seeks an insurance of sorts that protects the farmer interest by limiting the downside risk. Maximum cost/ loss to buyers is the premium paid.
- Unlimited upside that offers profit potential for Options buyers.
- No mark-to-market required to be paid by buyers of Options.
- Options contract resulting in Futures contract: resulting in delivery of the underlying agri-commodity with a defined settlement period (more so during the harvest season) will empower farmer with a choice and a flexibility to deliver the underlying commodity and settle the option depending on the prevailing spot prices.
What’s in it for the Government?
If the entire system of procurement by the government is being done through the system of Futures trading (or through Options trading) on the commodity exchange platform, the Government could get benefits of scheduled procurement directly from the delivery points of these exchanges, which, in turn, will help overcome the burden of maintaining FCI for stocking and delivering food grains. This will also help in minimizing food-grain wastages, as the exchange approved warehouses abided by the defined quality parameters of commodities traded on the exchange platform. Furthermore, to aid in more farmer participation in the Options trading, the government could also think of subsidizing a part of the option premium to seed in the element of confidence in the farmers and the farmer groups, as an incentive for starting to trade in agri- commodity options. There couldn’t be a better tool at the hands of the government that solidifies government intervention. For example: Call Options that gives farmers a right, but not an obligation to buy (say) pulses when prices rise will curb the need to accumulate stocks in a physical mode and make the process of government intervention more transparent and smoother. This will also jar potential speculators from hoarding of agri-commodities.
What more wonder can agri-Options do to the commodity trade?
With the expected participation of the financial institutions, it will further add depth to the market and fortify efficiency of the price transfer risk mechanism. Agri- Options could also be looked as a great ‘educative tool’ for the agri-commodity stakeholders, as it will help spread more awareness about agri- commodity trading as hedgers, farmers and other market participants will understand its benefits more easily.
Agri- Options may also do a whole lot of good to the Farmer Co-operatives and the Farmer Producer Organisations (FPOs) as it may stitch in an element of profitability as a marked ‘mind-set’ shift in a farmer psyche, as a seamless transfer of price risk, by means of Futures and Options tool, won’t eat into the margins needed to keep the farm running.
Another area that is the need of the hour is stabilization of the food inflation and food subsidy. Through using the means of agri- Options, the processors and the up-stream value-chain participants can pay farmers a fair and best price for their crops and this in turn will also give consumers lower prices for their food.
Up until now agri- commodity Futures were the only available price risk management mechanism in the commodity sector, however with the launch of agri- commodity Options, the combination of Futures and Options would offer more efficient hedging mechanism to the market participants (farmers and hedgers). Agri-Options are similar to taking an ‘Insurance cover’, as by just paying a premium, market participants can protect themselves from unfavorable price movements.
It is a proven analogy that the Futures contracts offer protection against price volatility. However, ‘hedging’ intrinsically limits profits when prices rise. Farmers in general and smallholder farmers in particular find it challenging to meet the daily demand for margin money, which affects farm cash-flows. Furthermore, the gestation timeframe required for taking positions, roll-over etc requires a certain level of understanding of the trade.
Options offer respite to farmers from such limitations, as by merely paying a one-time premium, they secure the right, but not the obligation, to sell or buy the underlying agri-commodity to another party, at a specific price, on a specific date. So, for example, a Guar Seed farmer should be able to buy a put (right to sell) option in October as insurance against prices going down in March, when the harvest arrives. By paying the relatively small premium, he will insure the minimum price. If the market moves up, the premium he paid for the option will be lost. But he will be able to capitalize on selling Guar Seed physically at higher prices. If the prices are likely to rise, instead of waiting in expectation, the same farmer can sell in the mandi and simultaneously buy a call (right to buy) option to profit from the price rise.
Now that the stage is all set for the launch of the coveted agri-Options in our country, it can rightly be termed as For the Farmers, By the Farmers!
(Disclaimer: The author is a Senior Manager, Marketing & Corporate Communications, NCDEX. Views expressed are personal. This article is intended for general academic purposes only and should not be construed as an advice for buying, selling or dealing in any commodities or its related derivative instruments.)