Regulatory Watch. A new Option to hedge price risk

MCX, India’s largest commodity exchange, saw its shares zoom last week following news of SEBI flagging off options trading. But wait, it could be not less than six months before the first option contract goes live, say sources in the know of things.

There are many reasons for this. First, a consensus has to be arrived at on commodities that can be allowed to trade in the options segment. The contract specifications — the underlying, the option style, the settlement procedure and trading cycle — have also to be decided. Further, the regulator will have to check the internal control systems of exchanges to see if their risk management system is robust. Time would also be required to educate market participants about the new product and see that there are enough option writers for market making so that the contracts are liquid. The SEBI circular that was released in the evening of September 28 was silent on the finer details of the new product. Business Line spoke to various commodity experts and members of SEBI’s Commodity Derivatives Advisory Committee to understand the likely framework for these option contracts.

Options are derivative contracts which give the buyer the right to buy (in case of call option) or sell (in case of put option) a specific asset (a commodity here) at a particular price (called strike price) in future. The consideration for exercising the right, paid upfront by the buyer, is called the ‘premium’. These contracts can be used for hedging by farmers, commodity processors and middlemen to hedge the price risk by taking a view on future price. There are two parties to an option contract — a buyer and a seller (also called the writer). The buyer of an option is the one who by paying the option premium buys the right to exercise his option on the seller. The seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises his right. So, clearly, the game is risky if you are a seller in an option contract- as your profit is limited to the premium amount but loss unlimited. But, for all hedgers – be it the farmers or commodity users who will be buying a put option or a call option the risk is limited to the premium. If prices are not favourable to them, they can leave the contract to expire. Say suppose, a farmer who is harvesting his crop wants to lock-in the current price fearing crash in prices in the harvest season, he can buy a put option.

SEBI has not listed out commodities which will be allowed to trade in the options segment. Commodity broking houses say a few from the non-agri side including gold, silver, energy and metals and from the agri side, such as mustard seed, refined soy oil and guar may get the green flag. G Chandrasekhar, a commodity sector specialist, however, doubts if the regulator will hurry to open up the floor to more than two/three commodities. In non-agri sector, gold/silver or even crude oil may see options come in, but, in agri, the regulator is expected to tread more cautiously.

Options, being derivative contracts, should have an underlying. Vijay Sardana, a commodity market expert, says, “All commodity derivatives have to reflect the spot prices. In the US, commodity options follow futures price because there is no spot market as such. They don’t have a mandi system like we have here, so in CBOT the options follow futures price. But, our issue is, today the polling is done by exchanges and we have to review the process before we launch options that use this price. But unlike the US, since we have an option, the regulator may consider spot prices too…”

Settlement in options can be done through cash settlement or by delivery. But, experts feel that a delivery-based settlement will help the genuine users of the platform. In commodity futures currently, all open positions on the expiry date are settled compulsorily through physical delivery.

The regulator will also have to specify if the options will be American or European style. European options are those that can be exercised only on the expiration date. American options let the option holder exercise his right at any time during the contract. Gopal Naik, Professor of IIM Bangalore, also a commodity market expert, says, “We will have to try and see which style works out for us. To start with it may be as European options”.

For a farmer or a commodity processor who buys a put or a call option, the loss is limited - this is what makes this instrument more attractive than a futures contract for hedging price risks. For example, if a farmer growing maize can buy a put option to sell 10 MT of maize at ₹1,450 per quintal, five months from now. Two scenarios can out play for him. If the price of maize goes down to ₹1,325 per quintal, he can exercise his option, making a profit of ₹125 per quintal. This will offset the notional loss he will incur when he sells the product in the physical market. In the event of the price of maize going up to ₹1,520, he can choose to not exercise his option.

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