Can Farmers Really Participate in Futures Market?
Risk
and uncertainty are integral to the production environment of agriculture because
the quality and the quantity of output that results from a given set of inputs are generally not
known. Since agriculture is prone to events beyond the control of the farmers such
as weather, insects and diseases the production or yield risk is high. Price
uncertainty is also a normal feature of farming. Agricultural operations are biological
in nature hence, there is a considerable time lag between sowing and harvest.
However, production decisions have to be made well in advance of realizing the
final product. Market prices are not known at the time these decisions have to
be made. The consequence of incorrect anticipation can be potentially ruinous
to the farmer.
Some
risk management strategies such as crop diversification reduce the risk with in
the farm’s operation. Crop insurance scheme is one way to protect against
production loses. Contract farming offers the opportunity for the farmers to
transfer the market risk or price risk to the buyer. Risk management is not a
matter of minimizing risk but of determining how much risk a farmer can take
given the alternatives and preferable tradeoffs. Mnimum Support Price (MSP)
programme by the government is one of the ways by which Indian farmers are
protected against market volatility. However, price support programme is only
available for major crops not all crops are covered
Future
trading is another way through which farmers can have insulation against price
volatility. It is an institutional mechanism to trade risk. A primary use of
futures contract involves shifting risk say, from a farmer who desires less
risk (the hedger) to a party who is willing to accept the risk in exchange for
an expected profit. However, it is not easy for the farmer leave alone the
Indian farmer to participate in the future trading given the knowledge,
infrastructure and the size specifications in the contract.
Future Contract
A
future contract is an agreement priced and entered on an exchange to trade at a
specified future time a commodity or other asset with specified attributes. To
make trading possible the exchange specifies certain standardized features they
include the quantity to be delivered, delivery month, delivery location,
acceptable quality or grades of the commodity. It is important that future
contracts are standardized because it enables the traders to focus on one
variable namely price. Standardization
makes it possible for traders anywhere to trade in these markets and know
exactly what they are trading.
There
are a number of ways future contracts can be used in marketing agricultural
commodities. Future contracts can be a temporary substitute for an intended
transaction in the cash market that will occur at a later date. This is called
hedging. Hedging is buying and selling futures contracts as a protection
against unfavourable price changes. A short or selling hedge is used when the
farmer plans to sell a commodity at some future date that is the farmer is concerned
that the price may fall at that time in the spot market. A long or buying hedge is used when the farmer
plan to buy a commodity at a future date as he expects the price might increase
at that date in the spot market.
Future trading
We
will try to understand the mechanics of hedging by an example of a hypothetical
farmer in Punjab growing potato and trading it on the Multi Commodity Exchange
of India (MCX) platform. The farmer can sell a potato future contract on the
MCX platform for delivery of a standard quality and quantity of potatoes in the
month they would be sent to the market, if the crop is sown in October the
farmer can sell them for a price that would be prevailing at the time of
harvest i.e. in the month of February. If after having sold a futures contract
potato prices fall on the physical market below the level at which he sold on
the futures he can either deliver the potato against his contract or because
the contract is standardized close out his position by buying out an equal
number of futures contracts. The prices of futures contract might have fallen
as the physical prices decline to reflect the value of potatoes delivered to
the market. The difference between the price at which he sold and the price at
which he purchased is the benefit the farmer got by trading in the futures.
Suppose
our farmer in Punjab plants 5 acres of potatoes in October with an expected
production of 30 metric tonnes. At the time the February price of potato the
farmer guesses would be say Rs 350 per quintal. The farmer feels that he can
earn a reasonable profit at that price. Since farmers have no control over
price, by sowing potato the farmer is essentially betting that the price of
potato will not decrease between the planting and harvest time. He can hedge
this bet by selling in the futures at the current futures price quoted which is
Rs 350 per quintal. Since the contract specification at MCX is for 30 MT and
the farmer expected a production of 30 MT from his 5 acres he would sell one
future contract.
The
initial margin for a hedger and the maintenance margin on the contract are 6
percent as per the contract. The farmer would need to deposit at least Rs 6300
with a clearing organization to cover the margin for the contract sold.
Everyday the contact would be marked to the market that is if the market moves
in farmer’s favour (future prices declines) on a particular day the farmer’s
margin account would be credited with the accrued profit of that day. On the
other hand, if the future price rises the margin would be debited with the
accrued losses. In case at any time the margin account falls below Rs 6300 the
farmer would be required to deposit additional amount to bring back the account
to Rs 6300. This process goes on let us say till the crop is harvested. The
farmer got 30 MT he expected and the crop in general had been good as it is a
normal year (that is other potato farmers also got good yield) hence the price
had declined to say Rs 300 per quintal. The farmer has 30 MT of potatoes with
him and he has sold 30 MT at the futures market. Now the farmer can unwind his
position in two ways. One is to make delivery as per the terms of contract. In
this case delivery location is the cold storages in Agra. This means the farmer
has to incur transportation cost from his village in Punjab to Agra. This would
be prohibitively costly.
However,
most of the futures contracts are liquidated by squaring off the position
rather than delivery as the mechanism to deliver may be inconvenient to the
farmer. The farmer in our example can take an equal and opposite position in
the futures market by buying one contract at the current price of Rs 300 per
quintal. The farmer’s margin account increased by Rs 15,000 (Rs 50 per quintal
x 300quital or 30 MT). The future trade has given the farmer a profit of Rs 50
per quintal. The farmer can sell the potato he has harvested at the nearby
mandi at the spot price of Rs 300 per quintal. Considering that the farmer had
received Rs 350 per quintal in the futures market even though he sold the
potato for Rs 300 per quintal in the spot market he had effectively received Rs
350 per quintal for his crop.
On
the other hand, if the price of potato rises to Rs 400 per quintal the farmer
will lose Rs 50 per quintal on the future but will be able to sell the potato
at Rs 400 per quintal in the spot market. Thus the effective price he receives
would be Rs 350 per quintal. This does not mean the hedge was not successful.
Sometime the price goes up and sometimes down with hedging, however, farmer
will be at least aware of his returns despite the volatility in price.
Farmers and Future Trading
Theoretically
it is possible as described above for the farmer to hedge against price risk
using futures contract. However, farmers’ participation in futures market even
in advanced economies is low. This is mainly because of “lack of know how, lack
of collateral for margins, small scale of operations and too cumbersome to
execute, monitor and administer hedging transactions by small producers” Let us
examine the factors that hinder the farmers in participating in the future
trading.
Membership Fee
To
participate in future trading it is necessary that one become the member of the
commodity exchanges or trade through members. The cost to become a member is
very very high (Table 1). The admission
fee alone in MCX is Rs 5 lakhs and 10 lakhs for the two categories of members
whereas it is Rs 15 and 25 lakhs in NCDEX. Besides, there are annual fee,
maintenance charges, VSAT cost etc, Therefore, farmer had to go through the
firms or individuals who are already members to take part in the trade. This
involves commission to be paid to the firm. The larger the traded volume the
commission would be proportionately lower but in case of the farmer who is not
a speculator the trading volume would be low dictated by his land size and
expected yield. Therefore, the cost would be high for him.
Marked to Market
Margin
Commodity
exchanges require its members to deposit and maintain in their accounts a
certain minimum amount of funds for each open position held. These funds are
known as margin and represent a good faith deposit that strives to provide
protection against losses in the market. The clearing house collects margins
directly from the members of the exchange who in turn are responsible for the
collection of funds from their clients. Therefore, the farmer had to maintain a
deposit of the amount as specified in the contract with his firm for each of
his position. As the margin is marked to the market that is daily fluctuation
in the price is calculated and adjusted to the account the farmer had to
deposit additional money whenever such situation arises.
Technology
The
commodity is traded on line so there are a large number of buyers and sellers
(sort of perfect competition) and no individual influences the price. This
helps in correct price discovery -- one of the major roles of the commodity
exchanges. For the farmer to track the prices and take part in trading he must
not only have some preliminary understanding of the computers and internet but
also have access to them nearby his village. No need to emphasis the point on
computer literacy and rural connectivity to highlight the handicap farmers
faces to really participate in trading in futures market.
Lot Size and Delivery
The
exchange specifies the lot size for each contract for different commodities
(Table 2). If the farmer is not
delivering the commodity at the end of the contract period but decides to
square off the position as the potato farmer in our example lot size may not be
an issue for the farmer. However, in case the farmer decides to deliver, say a
potato farmer near Agra takes a futures contract to hedge against the risk and
at the end of the contract period he may wish to deliver at the designated cold
storage then lot size is going to be a deterrent for the farmer to participate
in the trade. In case, crop production is affected due the vagaries of the
weather, pest or disease and is lost the farmer had to buy the crop and deliver
it to the designated cold storage. The contract also specifies the quality of
the commodity to be delivered therefore it is the responsibility of the farmer
to ensure the quality of his crop to meet the specification mentioned in the
contract. There are costs involved for assaying the quality which has to be
borne by the farmer.
Role for an Aggregator
In
order for future trading to be really used as a risk management tool for the
benefit of the farmers it is often suggested to have an aggregator. These
aggregators can pool the requirement of the farmers and canalize them in
exchange platform. For this the aggregator has to be a neutral player who does
not have any trading interest but earns a fee from such transactions. It could
be a producer’s cooperative, an NGO or farmers’ association. The key issue in
making available hedging instrument to farmers especially small farmers would
necessarily mean building institutions that will allow retailing of risk management
instruments to them. In other words, there needs to be institutional
arrangements so a large entity can pool risk from many small farmers and hedge
them. The Task Force on Plantations in its submitted report to the Government
of India recommended forming of cooperatives by small growers to trade in
futures. The proposed system would allow the aggregation of price risks of
these producers.
Constraints for an
Aggregator
Though
there is role for an aggregator there may be several constraints that might
confront it to effectively pool the requirements of the farmers and manage the
risk at the exchange platform. Let us take a scenario where 25 farmers with an
average holding of 6 acres coming together to form a cooperative or association
to act as an aggregator for the purpose of hedging against price risk Let us assume the farmers are taking two
crops in a year- basmati rice and potato. The production is say 105 tonnes of basmati
rice with the yield of 7 quintals per acre and 900 tonnes of potato with a
yield of 6 quintals per acre from the 150 acres owned by the farmer members.
The cooperative must first open a trading account with a firm (brokerage) having
a membership in the exchange, as is evident from Table 1 it would be very costly
even for a cooperative. The lot size of
the futures in rice is 10 MT per contract. The cooperative can enter into
future for 10 contracts of rice and assuming that the price is Rs 1200 per quintal
the value for 100 tonnes is Rs 12,00,000 at 8 percent initial margin (as per
the contract specification of the exchange)
the cooperative need to deposit Rs 96,000 with the firm. The expected
production of potato from the 150 acres of the members is 900 tonnes. The
cooperative can trade in 30 contracts at the rate of 30 MT per contract.
Assuming a price of Rs 350 per quintal the 30 contracts value would be Rs 31,
50,000 and the cooperative at 6 percent initial margin needs to deposit Rs 1,
89,000 with the firm. For the two crops the initial margin worked out to be Rs
2, 85,000 and for each farmer it is Rs 11,400. This seems to be a reasonable
amount. As the cooperative also need to maintain the marked to market margin
farmers must be in a position to pay the additional sum required as and when
required.
The
co-operative need to invest in infrastructure facilities such as computer with
VSAT connection with UPS power back up to operate in the village. This is
technically feasible as demonstrated by the ITC’s e choupal initiative. However,
considering the size of the farm and the volume traded it may not be
financially viable for the members to invest on the facility.
Before
trading at the beginning of each crop season the members should work out the
cost of cultivation and arrive at a consensus on the expected returns to enable
the cooperative to lock in on an agreed price in the future. In case the price
falls in the spot market member farmers would be happy. The cooperative would
buy equal number of contracts to close or square off the position. The accrued
differential that is between the spot price and the futures is credited to the
cooperatives trading account. The cooperative then distributes the amount in
proportion to the land holding and yield. The farmers sell their harvest in the
spot market at the declined price but as they got the accrued amount from the
cooperative due to the hedging operation they would be getting effectively the
original price at which they agreed to lock in. In case the price rises in the
spot market and the society by buying squares off the position, now the
resultant loss should be paid by the cooperative and the farmers are expected
to pay in proportion to their land holding and yield. Let us take the example
of potato we used for the single farmer. If the locked in price is Rs 350 per
quintal and the current price is Rs 400. The society by squaring off incurs a
loss of Rs 50 per quintal and had to pay the exchange Rs 4,50,000. The member
farmers sell their potato at Rs 400 per quintal and are expected to pay the
society Rs 50 per quintal to pay off the exchange. This is difficult to achieve
as members may not pay the society. They may under state the yield to pay less
to the society and over state the yield if they had to get the accrued benefits
of hedging. With the kind of cooperative spirit and few success stories it
would not be pragmatic to think cooperatives or farmer’s association can successfully
play the role of an aggregator for a long period on a sustainable basis. “Hedgers must have a mindset that says I got
what I expected therefore I am satisfied even when they could have done better
without hedging or a fellow farmer gets a better price.” It would be hard to expect
an individual farmer in a cooperative setting to have such a mind set.
In
case the cooperative follows the delivery model the quality specification as
defined in the contract would be difficult to maintain across the 25 farmers.
Further, apportioning the cost of assaying that is quality test among the
members in proportion to their land holding or yield would not be easy. Objectively
maintaining quality and rewarding the member had been a major weakness of the producers’
cooperatives in India. If the lot is rejected on quality grounds the member may
accuse the cooperative of bias. Further, it would be difficult for the
cooperative to ensure the lot size if the farmer is not replacing his rejected
lot by purchasing from outside or paying the cooperative to make good the
shortfall from other sources. Similar situation might arise when there is a
crop failure as the member farmer had to arrange for the crop with the quality
specification mentioned in the contract to enable the society to fulfill its
obligation with the exchange.
To
sum up, it is theoretically possible for the farmer to manage price risk
through future trading. However, in practice farmers even in advanced countries
are not using futures to hedge against risk. In India apart from lack of
technical knowhow, small size of holdings resulting in high transaction cost dissuade
the farmers to trade in futures. The suggestion to have an aggregator who can
pool the requirements of the farmers and trade in the exchange platform though
seems an attractive proposition has its own set of constraints. At best futures market may be helpful to
farmers indirectly by way of better price discovery rather than for risk
management.
Table 1 Membership Fee in
the Two Major Commodity Exchanges (Amount in Rupees)
Deatails
|
MCX*
|
NCDEX
|
||
Trading
cum clearing member (deposit based)
|
Institution
Clearing Member
|
Trading cum clearing member
|
Professional
Clearing Membership
|
|
Admission
Fee
|
5,00,000
|
10,00,000
|
15,00,000
|
25,00,000
|
Interest
Free Security Deposit
|
50,00,000
|
50,00,000
|
15,00,000
|
25,00,000
|
Processing
Fee
|
10,000
|
10,000
|
5,00,000
|
|
Annual
Subscription
|
50,000
|
50,000
|
--
|
1,00,000
|
Annual
insurance fee
|
5,600
|
5,600
|
--
|
--
|
VSAT
cost
|
1,65,000
|
1,65,000
|
--
|
--
|
Advance
maintenance charges
|
--
|
--
|
50,000
|
1,00,000
|
Net
worth requirement
|
--
|
--
|
5,00,00,000
|
5,00,00,000
|
*
MCX has another category called trading cum clearing member (non deposit based)
where the admission fee is 10 lakhs and the security deposit is 15lakhs
