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Reaping rich dividends

Futures contracts enable farmers to sell the crop at specific price for delivery on a future date. Inherent limitations in futures trading will make it attractive for farmer cooperatives too. Dr Chiragra Chakrabarty & V Venkat Giridhar tell us more...

india Updated: Dec 12, 2007 23:58 IST

Over 70 per cent of farming expenses occurs at least four months before the actual harvest season. As there is considerable time gap between the initial spending on seeds, fertilisers and pesticides on one hand and revenue from harvest on the other, farmers are vulnerable to commodity price fluctuations. Usually, during harvest season, the prices of commodities tend to decline due to over supply. This may result in heavy losses to farmers.

The forces of supply and demand determine price of goods in a competitive market. For agriculture products, as the demand is generally price inelastic (being necessities, their demand will not change much even if the price is higher), supply conditions hold the key. Historically, the prices of agricultural products are volatile due to unpredictable weather conditions. This has made farmers look for alternatives to reduce the risk.

Mitigating risk

Futures contracts enable farmers to sell the crop at specific price for delivery on a future date. Clearinghouses of commodity exchanges guarantee the execution of these derivative instruments. A farmer, who is uncertain about the price of his produce during the forthcoming harvest season, can mitigate his risk by going short (selling a commodity without or before owning the same) in the futures market a few months before the harvest period, with a commitment to deliver the same after one’s harvest season. This will ensure that the farmer gets the price at which a certain quantity of the commodity—grains, spices, pulses, tea etc—has been sold in the futures market. This can also be called locking the price of the commodity produced by him / her and avoiding the risk of having to sell at a lower price. Due to advent of online trading and increasing reach of Internet, futures prices are continuously disseminated by national commodity exchanges through various markets. If the price available in the futures market is not remunerative enough to the farmer, then he can change his cropping plan at the beginning of the season itself.

Farmer cooperatives

Due to small landholdings of majority of the farmers (over 76 per cent of landholdings are less than 2 hectares) and a high level of illiteracy, farmer cooperatives can play a major role in aiding groups of farmers to mitigate price risk. Such cooperatives need to appoint market experts for understanding mechanics of hedging (securing against risks) using futures contracts (margin payments, mark-to-market settlement process, seasonal cycles, basis risk, etc). The historical price trends of commodities need to be researched before taking up positions in commodity futures markets. Farmer cooperatives also enable bunching of contracts to take positions in the contracts, the unit cost of which is usually high.

Farmers having sizeable production can also directly become clients of member / broker of the national commodity exchanges. In such circumstances, the credibility of the member/broker needs to be ascertained (to minimize credit risk for the farmer). In many instances, brokers may tend to mislead farmers forcing them to take speculative positions (resulting in possible losses to the farmer). Inherent limitations in futures trading would make it attractive for farmer cooperatives to play a major role in mitigating risk collectively for farmers.

Dr Chiragra Chakrabarty is Vice-President and Head, Center of Academia (Training and Consultancy), MCX and V Venkat Giridhar, Senior Manager - Training, MCX. The views expressed here are of the authors, and may not reflect those of the Multi-Commodity Exchange of India.