India - Having options is the best option for Indian farmers
Agricultural markets in India are undergoing profound changes. Direct benefit transfers, reduction in subsidies, liberalisation and integration are increasing uncertainty and expanding the need for risk-shifting strategies. Options can be a valuable weapon in the farmer’s arsenal in the tactical war for survival.
Across the world, the push for adoption comes when agricultural markets shift from government-regulated price stabilisation policies to a free market. A study in South Africa found that after liberalisation, 10 per cent of maize farmers directly participated in derivatives. Younger, less experienced but better educated farmers, especially those with debt and leased land, were the early adopters.
In the US, 33 per cent farmers use derivatives. In the more protected EU market, that number is between 3 per cent and 10 per cent. India’s path towards adoption must begin from a realistic understanding of what options can and cannot do. Agricultural markets are inherently unstable. Because demand and supply of crops is fixed in the short run, prices fluctuate widely within a season and from one year to the next. The price volatility in pulses — from record highs to below minimum support price — within a few months shows the high variability in farm incomes. Farmers want protection from this shortterm price risk.
The solution is to transfer the risk to someone else while marketing the crop. But the next question for the farmer is one of profitability: how does one transfer risk in a way that doesn’t eat into the margins needed to keep the farm running? Compared to mandis or contract farming, commodity exchanges are the biggest market for finding someone to pass on price risk.
Though farmers can use futures contracts for protection against price volatility, they face challenges. Hedging, by nature, limits profits when prices rise. The daily demand for margin money affects farm cash flows. Time and effort are needed for initiating the positions, rolling over and liquidation.
Options take away these pain points. Aone-time payment of premium gives the right, but not the obligation, to buy or sell a commodity to another party at a specific price on a specified date. So, for example, a chana farmer should be able to buy a put (right to sell) option in October as insurance against prices going down in March, when the harvest arrives. By paying the relatively small premium, he will insure the minimum price. If the market moves up, the premium he paid for the option will be lost.
But he will be able to capitalise on selling chana physically at higher prices. If chana prices are likely to rise, instead of waiting in expectation, the same farmer can sell in the mandi and simultaneously buy a call (right to buy) option to profit from the rise. Options are the next step after crop insurance. Crop insurance only protects farm income against loss of harvest. Options protect farm income from the harvest that is reaped.
Except in wheat and rice that have partial protection through government procurement, Indian farmers are buffeted by inefficient physical markets. Therefore, farmer producer companies and cooperatives can be encouraged to use options to manage commercial risk in the production, processing and marketing of agricultural products. Banks can extend credit to purchase price insurance.
Food inflation and food subsidy can be stabilised. Through the ability to use options, processors and merchandisers can pay farmers the best prices for their crops and give consumers lower prices for food. Call options — that give the government the right, but not the obligation, to buy, say, pulses when prices rise — will reduce the need for accumulating physical stocks and add transparency by setting clear rules for government intervention. Potential speculators will get a strong signal to desist from hoarding. Formal price risk management is not for the poorest of the poor. The main clients for such insurance will be commercial-oriented farmers. They may have small farms but they are producing a surplus that they market. They get credit and spend money on inputs.
These commercial farmers, too, will need educating. They have to understand that when you pay the premium for an option, you want to lose the money. Exactly like when we want to lose the accident insurance premium instead of wanting to collect it. Another issue is the willingness to pay. Put option premiums can be expensive exactly at the times when price insurance is most needed: that is, for longer dated periods and when price volatility is high. Options won’t reduce price volatility, but they can help manage its fallout.
