The Hindu Business Line : Futures prices in US

This is with reference to the article “Life on an American farm” (Business Line, September 24). It is unclear why the farmer should be unable to deliver against his shorts, whatever the cash and futures prices at expiry. On delivery, the farmer would get the price contracted for — that is, there is price certainty for him. The farmer would be short-changed only if he were to close out his futures position and sell in the cash market.

In that case, given the price differential between futures and cash markets, the farmer’s final realisations would be lower than the price fixed in the original (short) futures contract. But, why should the farmer try this at all when he can deliver under his short position and obtain price certainty?

The problems arise when, post-hedging, market prices move such that the hedger feels that he should have waited or not hedged at all. But in attempting to time the market, the farmer moves from the realm of hedging to speculation. It is then difficult to avoid the perception of being short-changed.

Further, the following two factors dilute the statement about the continued existence or strength of the price differential between cash and futures, since such differential would be arbitraged away.

a. The generally easy availability of finance in the past few years (not counting the past year)

b. No significant reduction in the physical availability of commodities as there have not been any serious crop failures in America in the past few years.

T. B. Kapali Chennai

Harish Damodaran clarifies:

It is true that if farmers can deliver against their short positions, they will get the futures price they had initially contracted. But the complaint that American farmers make is that the exchange rules do not compel buyers or ‘longs’ of futures contracts to take delivery on settlement.

If futures contracts cannot be delivered on — with the exchange having insufficient designated delivery points or setting conditions restricting the numbers who are qualified to make/receive delivery — it will lead to divergence between futures and cash prices. So, on the one hand, you have index fund buyers rolling over their long-only positions, while, on the other hand, there are farmers who are unable to deliver against their shorts at harvest.

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