The best option

The total value of trades in India’s commodity exchanges amounted to over Rs 180 lakh crore last fiscal. But how much of it would have benefited farmers, processors or traders with genuine underlying interest in the commodities traded is a moot point. True, the exchanges do convey future price signals, enabling these players to take more informed decisions on production and inventory. Even so, their low levels of direct participation for hedging risks have earned for the commodity futures market, the odium of a place patronised largely by speculators and fly-by-night (‘dabba’) traders.

This, hopefully, will now change with the Government approving the Forward Contracts (Regulation) Amendment Bill, which, among others, allows trading in options — contracts giving the right to buy or sell commodities — that are better suited for farmers and small businesses to hedge against price volatility. A farmer wishing to secure himself of an assured price for his produce when it hits the market could, no doubt, do so now by entering into a ‘futures’ contract at the prevailing rate in the exchange. In the event of a fall in prices at harvesting time, the farmer is still assured of a realisation equivalent to the initial futures contract price, with the shortfall in the cash market (against physical delivery) being offset by gains from his exposure in the futures market. But this is not altogether a satisfactory solution for two reasons. One, it requires the farmer to keep his exposure open over a time horizon identical to the cultivation cycle of his produce — a difficult task given the vagaries of nature. Compounding it is the added burden of having to put up monies upfront, amounting to a percentage of the financial value of his contract, as ‘margin’ for unforeseen contingencies.

There are no such complications in options, giving the right to sell or buy at a particular date sans any obligation to exercise it. A wheat farmer who feels prices may fall from Rs 15 to Rs 10 between today and April next can buy an option to sell at, say, Rs 13 six months from now. If spot prices fall to Rs 10 in April, the farmer will exercise the put option to sell at Rs 13. But suppose unseasonal rains push up prices to Rs 16, he will simply sell in the physical market. The only cost to be paid for this flexibility is the option premium, which is all the farmer forgoes in case of not exercising the right. Since the premium is fixed and known, he can easily assess the pros and cons of buying an option that works like a minimum support price. Products such as options — plus permitting banks and financial institutions to trade in derivatives, at least to hedge price risks on their commodity loans portfolio — are the way forward to make exchanges relevant to primary producers, processors and other ‘physical market’ players. These will also create the right kind of integration between the country’s financial and commodity markets.