Role of Futures Trading in Agricultural Marketing
Author: Dr Ravindra Singh Shekhawat

Post independence, agriculture became a vibrant sector of the economy. Green Revolution technology was introduced in mid 1960s, which, by 1990s spread to almost all parts of the country depending upon the conditions suitable for adoption of such technology. Agriculture is the engine of development of Indian Economy. The contribution of agriculture and allied sector was estimated to be 13.7 percent in the Gross Domestic product (GDP). But in any agriculture-dominated economy, like India, farmers face not only yield risk but price risk as well. Over past two decades, farm produce prices have been more volatile than the prices of manufactured goods.

A central problem of agricultural markets in India has been price instability which has a negative impact on economic growth, income distribution, and on the poor (Srikanth T. and Rani A.R. 2007). The uncertainty of commodity prices leaves a farmer open to the risk of receiving a price lower than the expected price for his farm produce. Globally, futures contracts have occupied a very important place to cope this price risk. Futures contracts are originally developed as new financial instrument for price discovery and risk transfer. Changing economic environment, increasing commodity uses through value-addition at different stages, increasing number of market participants, changing demand and supply position of agricultural commodities and growing international competition requires wider roles for futures markets in the agricultural economy. While well developed spot markets are sine qua none to a well developed market system, the presence of futures markets on an electronic trading platform does at least in theory gives immediate benefits (Srikanth T. and Rani A.R. 2007).

It was only in the year 2003, that through a notification by the Forward Market Commission (FMC), three multi-commodity exchanges were set up and future trading in commodities were permitted again, since then it has been expanding. Forward Contract (Regulation) Act 1952 defines three types of contracts i.e. ready delivery contracts, forward contracts and options in goods.

Ready delivery contracts are contracts for supply of goods and payment thereof where both the delivery and payment is completed within 11 days from the date of the contract. Such contracts are outside the purview of the Act.

Forward contracts, on the other hand, are contracts for supply of goods and payment, where supplies of goods or payment or both take place after 11 days from the date of contract or where delivery of goods is totally dispensed with.

The forward contracts are further of two types, viz., specific delivery contracts and other than specific delivery contracts. The specific delivery contracts are those where delivery of goods is mandatory, though delivery takes place after a period longer than 11 days. Specific delivery contracts are essentially merchandising contracts entered into by the parties for actual transactions in the commodity and terms of contract may be drawn to meet specific needs of parties as against standardized terms in futures contracts.

The specific delivery contracts are again of two sub-types viz., the transferable variety where rights and obligations under the contracts are capable of being transferred and the non-transferable variety where rights and obligations are not transferable.

Forward contracts other than specific delivery contracts are generally known as futures contracts, though the Act does not specifically define the futures contracts. Such contracts can be performed either by delivery of goods and payment thereof or by entering into offsetting contracts and payment or receipt of amount based on the difference between the rate of entering into contract and the rate of offsetting contract. Futures contracts are usually standardized contracts where the quantity, quality, date of maturity, place of delivery are all standardized and the parties to the contract only decide on the price and the number of units to be traded. Futures contracts are entered into through the Commodity Exchanges.

Options in goods means an agreement, by whatever name called, for the purchase or sale of a right to buy or sell, or a right to buy and sell, goods in future and includes a put, a call, or a put and call in goods. Options in goods are prohibited under the present Act. An option contract is the right (but not the obligation) to purchase or sell a certain commodity at a pre-arranged price (the "strike price") on or before a specified date. For this contract, the buyer or seller of the option has to pay a price to his counterpart at the time of contracting, which is called the "premium, if the option is not used, the premium is the maximum cost involved. When prices move favourably, this right will not be exercised, and therefore, the purchase of options provides protection against unfavourable price movements, while permitting to profit from favourable ones. Option can give the right to buy or sell a certain amount of physical commodity, or, more commonly, they can give the right to buy or sell a futures contract.

Many countries have been establishing and promoting commodity futures markets. In India also, where the futures markets had been in a dormant stage for a long time, the interest in these markets have been revived and efforts are being made to promote futures markets in the country for their wider role in the changing economic environment. At present, the futures and derivatives segment is growing at an exponential rate, which is a positive sign of development (Easwaran and Ramasundaram, 2008).

Futures trading perform two important functions of price discovery and risk management with reference to the given commodity. It is useful to all segments of the economy. It is useful to producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best suits him. Farmers can derive benefit from futures markets as follows:
  • By participating directly/indirectly in the market to hedge their price risks and
  • To take benefit of prices discovered on the platform of commodity exchanges by taking rational and well informed cropping/marketing decisions
It enables the consumer get an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making futures contracts. Price risk managements function is useful to the stakeholders in managing risk associated with the physical market. The price signals emanated from the futures markets can provide useful inputs to the farmers and policy makers in taking appropriate decision. It can help farmers in taking appropriate decisions to minimise the impact of scarcity on the consumers and surpluses on the producers. The futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered in to an export contract, it enables him to hedge his risk by operating in futures markets. The true measure of price discovery function lies in the extent of the reliability of the futures price as reference price for futures sales and purchases in the physical markets. The greater is, such use of futures price as reference price by the physical market functionaries, stronger will be the correlation between the prices in the physical and futures markets. The high correlation, in turn, ensures the efficacy of the futures markets for price risk management. It also facilitates stocking and production planning for the various market functionaries. Hence, providing a vital tool to the policymakers and planners in designing their pricing policies and investment plans for efficient allocation of resources in different farm sectors and infrastructure (Pavaskar, 2009).

The National Agricultural Policy 2000 (NAP), sought to “enlarge the coverage of futures markets to minimize the wide fluctuations in commodity prices as also for hedging their risk”. Some observers have noted that the benefit of futures trading, farmers may have been limited due to their lack of awareness. It is true, that the direct participation of farmers on the futures platform has been limited, in India as elsewhere. The availability of a futures price not only improves the bargaining power of farmers but also gives him the choice to decide on the timing of his sale. A key advantage of futures trading is that the exchanges provide the guarantee system that protects futures users from contract default. The guarantee system used at futures exchanges also severs the direct relationship between buyer and seller, so that each is free to buy and sell independently of the other. Commodity futures have immense potential to become a separate asset class for the retail investors. It is also observed that commodities futures have been less volatile compared with equity and bonds, thereby providing an efficient portfolio diversification option (Sairam A. and Pasha M.F., 2008).

References:

Srikant, T. and Rani, R. A. 2007. Performance of Commodity futures in India: The Way Ahead. In: Velmurugan, P. S., Palanichamy, P. and Shunmugam, V. eds. Indian Commodity Market (Derivatives and Risk Management). 1st ed. Serials Publications, New Delhi.

Easwaran, R. S. and Ramasundaram, P. 2008. Whether Commodity Futures Market in Agriculture is Efficient in Price Discovery? - An Econometric Analysis. Agricultural Economics Research Review. 21 (Conf. Spcl.): 337-344.

Pavaskar, M. and Kshirsagar, A. 2009. Pricing and Marketing efficiency in Cotton and the Need for Risk Management. Takshashila Academia of Economic Research, Mumbai. 52-61.




About Author / Additional Info:
Working as Scientist, Agricultural Economics at ICAR-IASRI, New Delhi