An anti-volatility shield for small players

Dr V Shunmugam | Updated on January 16, 2018

PO26_ Big_small_man


Options are the right choice for SMEs to manage risk

Amidst all policy efforts came one of the results of a litmus test, which showed India jumping 16 ranks to occupy the 39th rank on the World Economic Forum’s (WEF) Global Competitiveness Index 2016-17, becoming the second most competitive BRICS economy.

One of the factors on which countries were ranked in the above-mentioned Index was the perception of business people towards risks and the way they manage risks.

A major risk a commodity-intensive country like India and its economic stakeholders face is commodity price risk — the risk arising from volatility and uncertainty in commodity prices. One of the sectors that bear the brunt of commodity price volatility is the Micro, Small, and Medium Enterprises (MSMEs).

MSMEs contribute about 8 per cent to the country’s GDP and employ more than 15 per cent of the workforce — the second largest after the agricultural sector with a 40 per cent share in total exports in value terms.

Cost-effective protection

Given that in the last five years (2011-2015), prices of gold, silver, crude oil, copper and lead have witnessed an annualised price volatility from a minimum of 15 per cent to a maximum of 30 per cent, it could have potentially thrown many SME users of these commodities out of business or at least challenged their business model, as reflected in the accumulated NPA burden in the banking sector.

In such a context, the regulatory decision to allow options in commodities will be a blessing in disguise amidst this commodity price volatility. Option, a financial derivative contract, is a cost-effective hedging tool for smaller players like MSMEs, equivalent to that of price protection insurance bought by paying a ‘premium’.

The structural characteristics of options that make them particularly suitable for small players include — absence of daily margin call for the options buyer; easy way to account for, i.e. just booking the expenses on buying options paying ‘premium’; ability to take advantage of any unexpected positive price movement.

Once options on commodities are introduced, the MSME manufacturers/processors, will be able to protect themselves from any unfavourable commodity price movement in a cost-effective manner. Besides, the deployment of appropriate risk management strategies by MSMEs using commodity options can bring down their risk perception in the eyes of their lenders, i.e. banks, and other informal sources.

Additionally, the availability of options can create opportunities for banks to offer new, innovative, and customised risk management products.

Options’ lower transaction costs and their being similar to pure insurance products can attract diverse participation. As a result, adding options to the commodity derivatives kitty can add to the strength of price discovery and information transmission in the derivatives markets.

The author is Head - Research & Planning, MCX. Views are personal.

Published on December 25, 2016

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