OPTIONS:A Critical Missing Link

inIndia’s Commodity Market

By:-Pushpika Vyas(148938)

1. Introduction

The incidence and management of ‘risks’ are inseparable parts of the modern society, an offshoot of the rising levels of complexity of modern societies, manifested in innovations in production organization, rapid changes in technology and growing interconnectedness in economic relations which are driven by forces of globalization.

Much of modern finance is about assessing and quantifying such risks through assignment of probabilities to unknown events and possible outcomes.

At the same time, the evolution of the market as an institution has also thrown up instruments that help manage the impact of uncertain events on other economic activities.

The trading of which allows the market participant to ‘lock in’ prices of the underlying, thereby having substantive control over associated cash flows.

Among exchange-traded products, futures and options and their variants have emerged as the most popular derivative instruments.

Developing economies, governments of the day, often with assistance from multilateral organizations such as the IBRD (International Bank for Reconstruction and Development), have been promoting the use of exchange-traded derivatives for risk management, particularly of small stakeholders such as farmers.

Such promotion takes the form of either setting up and operationalizing commodity exchanges in the domestic economy, or facilitating hedging by domestic constituents in an international exchange.

Use of futures and related derivative products, This attraction, together with their ability to create customized strategy through derivative products suited for specific risk management requirements, make options an attractive hedging instrument.

2. Emergence of commodity options

In ancient times, transactions contracts with embedded option features were important to commerce. Because trading on samples was common in medieval goods markets, an agreement for a future sale would typically have a provision that would permit the purchaser to refuse delivery if the delivered goods were found to be of inferior quality when compared to the original sample.

The first documentation of such a use of options occurred in Holland in 1634.

Tulips were a status symbol among the 17th century Dutch aristocracy, and, during this time, it was common practice for wholesalers to sell tulips for future delivery.

1970s, present-day options trading on the floor of an exchange began in April 1973 when the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) for the sole purpose of trading options on a limited number of New York Stock Exchange-listed equities.

COMMODITY OPTIONS IN DEVELOPING NATIONS – A GLIMPSE

Brazil: Shortly after the inception of commodity options in US in 1982, BM&FBOVESPA launched options trading in gold in 1986. This was followed by launch of options in coffee and live cattle in early nineties.

Argentina: Like in the case of Brazil, Mercado A Termino De Buenos Aires and Rosario Futures Exchange from Argentina launched options trading in several agricultural commodities such as wheat, corn and others in nineties.

South Africa: SAFEX from South Africa have initiated trading in commodities options in a phased manner. It started by launching options in wheat in 1997, yellow maize in 1998, sunflower seeds in 1999 and so on.

3. Benefits of commodity options trading

Some of the reasons behind popularity of options , especially from the perspective of small hedgers are as follows:

a) There are no margin calls for option purchasers. Instead the purchaser has to pay a one-time fee/premium upfront to the writer (option seller).

b) Along with the knowledge of how much one has to pay to buy options, the option buyer is also aware of the risks.

c) Options are also more flexible, as they offer the flexibility to take advantage of any positive price advances.

d) There are a number of ways in which an options position can be closed: Offsetting, Exercising and Expiration.

e) Options represent a form of price insurance, the cost of which is the option premium determined during its trading.

a) Positive spill-overs of options trading corroborated by research studies:-

used as a tool for price risk management, presence of active commodity options trading in an economy brings about lot of other benefits – for the market participants as well as for the economy at large.

Improved information transmission. Improves market liquidity and hence associated benefits. More than just price risk - Hedging production risk as well. Complements futures trading.

b) Need for options by farmers and SMEs in India

The incidence of risk arising from commodity price volatility is very high in India, the vulnerability to which falls disproportionately on the small stakeholders in the commodity economy.International and Indian agricultural markets and finds that Inter-year variability in prices is generally lower in Indian market compared to the International markets. But intra-year variability in Indian agricultural prices is equal to if not greater than international markets.To mitigate such risks, the government regularly intervenes in the agriculture market by a slew of policy and administrative measures.Several studies in India and abroad confirm that owner-managers of SMEs are either ignorant or unable to manage their risks, mainly due to their size, and need specialized training on the techniques needed to manage them effectively.

due to the high cost of such instruments and lack of knowledge fluctuating raw material prices is one of the major challenges faced

by the SMEs across several SME clusters in India. Banks in India, widely perceived as one of the most important

agencies of development. On the other hand, farmers producing the right quality and sufficient

quantity to meet the exchange contract. The role of facilitators such as banks in enabling such market

inclusion of farmers and other small participants is paramount. To start with, as has been the case in some countries, the government may even consider subsidizing a part of option premium for farmers willing to hedge their exposure on commodity exchanges.

4. India’s Food Security:How options can be a more effective

instrument The execution of much of various policy is shouldered by the

Food Corporation of India, or FCI. The operation of the FCI has been facilitated by various

government policies such as concessional credit and transport, budgetary support, etc.

• FCI has done well, but current scenario needs strategic rethink.

• Time to take stock of existing policies.• How derivatives can offer a potential solution

Use of derivatives can lead to price stabilization

A well-regulated commodity derivatives market tends to stabilize prices of traded (especially agricultural) commodities by arresting their price volatility.

A well-functioning food grains futures market, along with a competitive spot market, provide the necessary signals to farmers, traders, consumers and the government to take appropriate decisions on resource allocation for production and marketing and to take appropriate actions to minimize risks associated with temporary shocks to food grains availability.

5. Immediate need for options in India In the Forward Contracts Regulation Act, 1952 (or, FCRA), does

not permit any derivative product other than futures. Options have long been awaited by the Indian commodity market

and it is expected that its existence would boost overall market participation, especially the hedging community.

Make the commodities market more robust and efficient. The combination of options & futures – both risk management tools

can give market participants the leverage of futures with the safety of options.

Once options trading in commodities are allowed, banks will be able to hedge their exposure of the collateral placed with them against which loans are extended to farmers/processor.

Availability of options would create the opportunity for banks to offer new, innovative and customized derivative products, suiting the hedging requirements of their clients, possibly enmeshing credit products with hedging products.

The Dalian Commodity Exchange had launched mock trading of options on agricultural futures in 2012.

In union budget 2016-2017, Finance minister Arun Jaitley indicated the launch of new products in commodity derivatives, in his budget speech . This led to a sharp rise in stock prices of the only listed exchange in the space, Multi Commodity Exchange of India Ltd (MCX), which gained 6.2% to Rs.818.10 soon after the announcement.

The market expects the regulator to introduce products like options and index trading.

It will bring in liquidity and depth into the commodity derivatives market.