Managing price risk through futures markets

Abstract

This report makes a comprehensive survey of the risks facing Indian farmers and attempts to present methods of dealing with these risks. It looks at the prevailing situation in India and makes recommendations regarding the steps that may be taken by the government to enable farmers to hedge their risks in the most efficient and cost-effective manner possible. Two types of risk are most important for farmers: price risk and yield risk. These risks would best be hedged against using futures and insurance products, respectively. The models for the same have been drawn up for tomatoes. This could serve as a model for other agricultural commodities too. The tomato farmers in India have a low selling power for their produce because of their small holdings and also because of the large production made throughout India. This necessitates an introduction of futures contracts which would be preferred over forwards. The expected volume traded is high because of the high price volatility of tomato prices almost free from government intervention and also the huge number of buyers and sellers of the commodity. However, there are some challenges in setting this. An easy access to these markets is found to be the biggest hurdle in many of the existing futures market. It was seen that intermediaries in the form of banks, brokers or association of farmers of an area would avoid this and also allow the banks to hedge the credit risk of farmers (which depends onthe price received by them) taken up by them. A small contract size, acceptance of warehouse receipts, fewer exchanges trading in tomatoes and providing infrastructure for all these would assist in establish liquidity in the system, and hence better price discovery and lower basis risk.Insurance is seen as a business that would help the farmers pass the other risks (e.g. Yield) to the company. In this, Moral Hazard and thus, reinsurance availability were seen to be big obstacles. To overcome this, the insurance companies need to design policies that would minimize the moral hazard (e.g. ICICI Lombard introduced Weather Insurance). To reduce risk it is recommended that insurance companies maintain a well diversified portfolio in terms of crops involved and the geography covered too. They should also consider offering their services to a group rather than individuals to reduce the moral hazard risk involved. Also there should be a global database of individuals who seem to collect large sums from insurance companies so that they can be charged higher premiums and honest farmers need not be forced to pay high premiums.