Instability of commodity prices has always been a major concern of the producers as well as the consumers in an agriculture -dominated country like India. Farmers’ direct exposure to price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise profitable activities. There are various ways to cope with this problem.
Apart from increasing the stability of the market, various factors in the farm sector can better manage their activities in an environment of unstable prices through derivative markets. These markets serve a risk -shifting function, and can be used to lock -in prices instead of relying on uncertain price developments.
There are a number of commodity-linked financial risk management instruments, which are used to hedge prices through formal commodity exchanges, over -the-counter (OTC) market and through intermediation by financial and specialized institutions who extend risk management services. (see UNCTAD, 1998 for a comprehensive survey of instruments) These instruments are forward, futures and option contracts, swaps and commodity linked -bonds. While formal exchanges facilitate trade in standardized contracts like futures and options, other instruments like forwards and swaps are tailor made contracts to suit to the requirement of buyers and sellers and are available over-the counter.
In general, these instruments are classified (as shown in figure-1.1) based on the purpose for which they are primarily used for price hedging, as part of a wider marketing strategy, or for price hedging in combination with other financial deals. While forward contracts and OTC options are trade related instruments, futures, exchange traded options and swaps between banks and customers are primarily price hedging instruments. In the case of swaps between intermediaries and producers, and commodity linked loans and bonds (CL&BS) price hedging are combined with financial deals.
Forwards contracts are mostly OTC agreements to purchase or sell a specific amount of a commodity on a predetermined future date at a predetermined price. The terms and conditions of a forward contract are rigid and both the parties are obligated to give and take physical delivery of the commodity on the expiry of contract. The holders of forward contracts face spot (ready) price risk. When the prevailing spot price of the underlying commodity is higher than the agreed price on expiry of the contract, the buyer gains and the seller looses. The futures contracts are refined version of forwards by which the parties are insulated from bearing spot risk and are traded in organize exchanges. A detailed discussion on the futures contracts is presented in the next chapter.
Both forwards and futures contracts have specific utility to commodity producers, merchandisers and consumers. Apart from being a vehicle for risk transfer among hedgers and from hedgers to speculators, futures markets also play a major role in price discovery.
Typology of risk management instruments
The price risk refers to the probability of adverse movements in price s of commodities, services or assets. Agricultural products, unlike others, have an added risk. Many of them being typically seasonal would attract only lower price during the harvest season.
The forward and futures contracts are efficient risk management tools, which insulate buyers, and sellers from unexpected changes in future price movements. These contracts enable them to lock-in the prices of the products well in advance. Moreover, futures prices give necessary indications to producers and consumer s about the likely future ready price and demand and supply conditions of the commodity traded. The cash market or ready delivery market on the other hand is a time-tested market system, which is used in all forms of business to transfer title of goods.
2.1 MCX become First Exchange to Commence...