The Securities Exchange Board of India has banned futures and options trading in a host of agriculture commodities including chana, mustardseed, soya bean and its derivatives, crude palm oil, moong, paddy (Basmati) and wheat for a period of one year. The government seems to have initiated this step to curb inflation.
Commodity futures are market instruments to achieve price discovery, market price stabilisation and price risk management. Ours is an agricultural economy and fluctuation in prices during the harvesting period has always been a major concern for the farming community. Futures trading provides assurance to farmers about price discovery. Any farmer faces the risk of fall in prices when it is harvest season for a particular commodity.
In the absence of a futures market, farmers will be forced to sell their produce in the cash market at the prevailing price, which may not be to their advantage. Alternatively, they have to store their produce and wait for a proper price, during which period they would run out of funds.
It is also true that all farmers do not participate directly in the futures market. But they take advantage of price signals from the derivative market and this enables them to decide about the cropping patterns based on price signals.
The farmers come to know the crops for which there is huge demand and for which the demand is lukewarm. Removing the derivatives market for agricultural commodities will make the farmers clueless about future demand and supply.
There are various reasons for the general inflationary trend in the economy. It may emanate from the supply or the demand side. Increase in the prices of agricultural products can be mostly attributed to failure of crops, or to the reduced area of cultivation for that particular commodity, exporting a sizeable quantity the same or even hoarding. But the price rise can in no way be attributed to futures trading.
When a commodity is traded in the futures market, its price discovery is efficient and the demand-supply relationship automatically sets in for a longer time-frame.
There was a significant upsurge in the prices of some of the agri-commodities from the middle of 2006 to the first quarter of 2007.
In response to the public outcry against the futures markets, on January 23, 2007, the Forward Markets Commission ( FMC) de-listed two commodities — urad and tur, both pulses — from trading on futures exchanges out of concern about rising food prices. Later, on February 27, 2007, FMC limited the trading in wheat and rice futures to squaring off until the expiration of running contracts, for similar reasons.
A need was felt to study the working of the futures markets with the specific objectives of knowing the impact of commodity futures on spot price volatility.
The National Institute of Agricultural Marketing (under the Ministry of Agriculture) has published a research report, ‘Impact analysis of commodity futures on spot prices and risk management in essential commodities’.
Two crops — wheat and maize — were selected for the study. Wheat being the major staple food crop and futures for wheat was banned. Maize is also a cereal crop for which futures trade was continuous. Secondary as well as primary data were used for the study.
The main finding of the study was that there has not been any significant change in the spot price volatility after the introduction of futures trading for both wheat and maize. However, the coefficient after futures ban in wheat was found significant.
Banning futures trade is not a solution to arrest inflation.
The writer is a retired banker