Introduction of Commodity Options in India: Quantitative analysis of possible pitfalls and benefits associated and demand estimation

Abstract

The producers of commodities have since ages faced a lot of problems because of price volatility, and the impact of this volatility has been greatest in the less developing countries (Sapsford and Morgan, 1994) as compared to the developed markets. The price volatility arises because the demand for many of the primary commodities in inelastic and the supply changes year to year depending on what the output has been. This price volatility can have enormous implications for the producers especially the ones who are smaller producers. It can cause a huge swing in their incomes. This risk o price volatility arises due a number of factors including weather climatic variations, quantity risk and a number of other factors that affect agricultural output.In the past their have been many programmes to provide cushion to the producers from price volatility. The main ones being crop insurance and providing a minimum price for various crops (Minimum Support Price in India). These measures have been made possible in various countries by the support of the government in the form o subsidies etc. These government interventions have been subject to a lot of flak because of two reasons 1) They cause dead weight loss and result in other social costs and 2) They give unfair advantage to producers of develop countires who can get a lot of subsidy and thus make exports so cheap that it becomes impossible for developed countries to compete. The WTO is lobbying heavily to get reduce agricultural subsidy for this reason.Given this background, the commodity derivative market serves as an excellent alternative for producer risk hedging without leading to the problems associated with traditional programmes. And thus there has been a shift towards developing more commodity exchanges for this purpose, with a number of commodity exchanges set up across the globe. These markets have time and again proved after being set up that they play a significant role in smoothening price volatility and guiding investment decisions.