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.)
|
First published in Economic Times on 5th
August 2014, at http://epaperbeta.timesofindia.com/Article.aspx?eid=31818&articlexml=COMMODITY-OPTIONS-NEW-AGE-MSP-MECHANISM-THAT-CAN-06082014005017
