Tuesday, 5 August 2014

Commodity Options: New-age MSP mechanism that can trigger a Rainbow Revolution

Options can certainly be a win-win instrument not only to hedge farmers’ risk effectively, but also by replacing expensive subsidies with an efficient market-based mechanism.

A new future for Indian farmers dawned in 1960s with the Green Revolution. Another such turning point is emerging today, with an opportunity to craft the next leap for Indian agriculture. An instrument that played a pivotal role in translating the green revolution technologies into increased food production was the Minimum Support Price (MSP) assured to farmers. Institutions such as Food Corporation of India executed this instrument, complementing the research and extension services rendered by the ICAR-led public research system.

That was half a century ago. Rapid globalization since then, coupled with increasing purchasing power, have made today’s consumers seek a variety of food products, such as vegetables, fruits, meat, and milk, going beyond the green revolution crops, namely, rice and wheat. For the farmer, this requires a paradigm shift to bring consumer-preferred traits into crops, in addition to further improvements in productivity. This implies new risks for the farmers, which cannot be dealt with by the MSP that covers only a few commodities in a few states. 
If the cost of implementing MSP in two crops and three-and-a-half states itself is so taxing on the exchequer, one can only imagine the massive resources that would be required to support at least a dozen crops spread across not less than 15 states. A new “Rainbow Revolution” is now required to take the baton from a tiring Green Revolution. Technology already exists for such a revolution; we just need a new MSP-like instrument that can cover many more crops and several states. Instead of relying on a government-administered subsidy alone, a more efficient mechanism would be to create a market-based instrument as also build and strengthen institutions that can take such an instrument to the farmers. Market-based instruments will reduce the need for the state to engage in commodity operations directly, yet giving government the power to intervene and influence prices in the public interest by participating in such a market whenever required.

Commodity derivative markets offer such an instrument. Even though there are opponents to derivatives such as futures and options, the fact remains that they provide the best safeguards to farmers, simultaneously facilitating a swifter alignment of production with demand. Today, farmers make planting choices based on the prices received for previous season’s crops. There couldn’t be a more inefficient way! Derivatives open up new possibilities for farmers by assuring them of a post-harvest price before they take a decision on what to sow.
Trading in futures is currently permitted, but it doesn’t really help the farmers manage their risk, as it ties them down with an obligation to deliver at the contracted price, even if the market moves up after harvest. Farmers are looking for an MSP-like instrument, where they are assured of a minimum price before planting a crop, and still have the choice of taking advantage of the market if prices go up later. Options provide such flexibility. By buying a put option, the farmer gets a right to sell at a pre-determined future price, but without any obligation to deliver if the market moves up. This assurance not only provides the best hedging solution to farmers, but also builds their capacity to invest in productivity-enhancing and quality-improving technology and practices, in turn raising production and containing inflation without bringing farmer incomes down.

To make this happen, the Forward Contacts (Regulation) Act needs reform to permit “options”. The high premia typically charged for options can discourage farmers from extensively participating in the derivatives market. This can be dealt with by permitting exotic derivatives like caps and collars. The government could also step in to popularize the use of options for hedging or subsidize the premia since that would entail far less an outgo than direct subsidies (see box). Given the small lot sizes of farmers, as well as the complexities involved in operating in the derivative markets, it is also important to recognize “aggregators” under the Act who could offer the simpler “options-embedded Over the Counter (OTC) contracts” to farmers.
Options can certainly be a win-win instrument not only to hedge farmers’ risk effectively, but also by replacing expensive subsidies with an efficient market-based mechanism. Do we really have a better option than permitting “options” to achieve a rainbow revolution?

Farmers Hedging in Mexico
After joining the North American Free Trade Agreement in 1994, the Mexico government moved to liberalize the agricultural sector. The government designed a sustainable programme of guaranteed minimum price through the use of options to transfer risk from growers to international markets. The Support Services for Agricultural Marketing Agency (ASERCA), a decentralized body providing commercial support to farmers, offered the farmers a chance to participate for a fixed fee in a programme guaranteeing minimum cotton price. ASERCA offered a guaranteed price and hedged its own risk by using the fee to purchase a put option on the New York Cotton Exchange (now ICE Futures US). The put option gave ASERCA the right to sell cotton on a specific future date at pre-specified price ( that is, strike price).
When the prices dropped, ASERCA paid farmers the difference between the New York price at harvest and a minimum price (equivalent to the payoff value of put option). If prices rose instead, ASERCA made no payment to farmers. By paying a fee and participating in the programme, a farmer purchased insurance against a drop in prices below a certain level. ASERCA, in effect, acted as an intermediary between producers and commodity brokers. The Mexican government, through ASERCA, subsidized 100% of the premium payment in 1994.
Source: Innovative Agricultural Insurance Products and Schemes (by Kang, M. G.)