Reducing risk is critical for sustainability of any business. Lower risk attracts mainstream investment, financing, and human capital to the business. In agriculture, two key tools for reducing risks are commodity derivatives for hedging price risks and insurance for protection against weather and other damage-related risks.

In the absence of such tools, agriculture remains a risky venture¬–a parlous state of affairs for a sector that employs almost half of the country’s workforce. 

To hedge against volatile prices, farmers and farmer producer organisations need to systematically sell futures, while processors and end users of agricultural commodities need to buy them. 

With price volatility and such natural demand for hedging products, one would expect widespread participation in these markets. Yet these markets have turned moribund in the last decade, culminating in Securities and Exchange Board of India’s ban of futures on seven key commodities in 2021-22. 

What ails agriculture commodity futures, beyond the ban?

While reasons for the ban have not been clearly articulated, it appears that the consensus centers on a narrative that speculators dominate these markets. This supposedly results in futures contracts that do not effectively serve the end-user requirement of risk transfer and leads to inflation.  

While the latter - that speculative activity in agriculture commodity futures results in inflation - has been challenged by several researchers, the former idea, which ascribes the poor risk transfer capabilities of such futures to speculator activity has not been similarly discussed due, at least in part, to the technical nature of the subject.

Agricultural commodity futures, in an attempt to be more inclusive, allow the short position holder at expiry to deliver the underlying commodity at multiple locations. 

For instance, the last traded soybean futures contracts prior to the ban required the short position holder to deliver soybeans at Indore. However, the shorts could, at their choice, also deliver at Akola, Latur and Kota if they accepted some adjustments to the settlement prices they received in exchange for delivering at these alternate locations. 

Prima facie, this appears to be a wonderful feature, seemingly allowing nationwide participation instead of delivery only at Indore. However, the fact that prices in these locations are quite different and that price moves of soybeans in these locations are not well correlated to the price moves in Indore can create enormous complexities in the context of this product design.

The key insight that is overlooked by those who are not aware of the technicalities involved is that this ability provided to short position holders to choose their delivery location is in the nature of an embedded financial option that carries economic value. The option is “embedded” because its value is incorporated into the price of the futures contract, and is not tradeable independently of the futures contract - much like the call option in callable bonds. 

A buyer of a soybean futures contract, therefore, necessarily takes a position in a package of derivatives – a simple futures contract to deliver at Indore along with a short position in an option that allows the switching of delivery from Indore to one of the three other centres.  

If the economic value of the option becomes large, then this package of derivatives will no longer have the price characteristics of a simple futures instrument expected by most participants who believe they are trading a futures contract only. 

This embedded option takes on large values whenever it is economically favourable for the short position holder to deliver at one of the alternative delivery centres instead of at Indore – or, when one of the Akola, Latur or Kota markets becomes the “cheapest to deliver”, in industry parlance. This is wholly dependent on the relative prices of the commodity at these locations. 

The outcomes of excessive embedded option values can be severe. Research in this area is rather technical, and hence relatively sparse particularly in India, but reveals the following key insights.

Poor hedging effectiveness – When the cheapest to deliver location changes, the futures contract no longer tracks the Indore price and tracks the cash price in the cheapest to deliver location instead. Those in Indore who have used the futures contract to hedge suddenly find that the contract trades at a price very different from expectations that is disconnected from the Indore cash price. They are no longer hedged despite having put on a hedge. The hedgers in the cheapest to deliver location are not better off either as the cheapest to deliver location can change again to another just as suddenly – resulting in enormous “basis risk”, to use another industry parlance. In trying to be useful for many, the contract becomes useful to none. Hedgers everywhere then rightfully abstain from using the contract as it cannot help them hedge risk, resulting in declining volumes of futures, as has been seen in the decade prior to the ban. 

Blaming speculation mistakenly – Since the futures price no longer moves in tandem with the Indore price, this decoupling is often understandably but erroneously ascribed by those unaware of these price dynamics to speculative activity,  though it can be easily explained by the high values taken by the embedded option due to changes in the cheapest to deliver location. It is likely that such gaps in understanding have propagated the widespread belief of speculator dominance in these markets, whereas anecdotal evidence points in exactly the opposite direction.

Increased systemic risk – Most commodity exchanges use some variant of SPAN, or Standard Portfolio Analysis of Risk, to set margins for participants. The margining mechanism is the bedrock in an exchange to be able to guarantee performance of trades. If margins are mis-estimated, the entire exchange ecosystem is subjected to significant risks that are not explicitly measured and accounted for. This is likely the case now with little recognition of the additional risk posed by embedded options, leading to frequent ad hoc margin revisions for these contracts.

In effect, the product design featuring embedded options is at the heart of many of the problems that appear to plague this market - a case of the embedded options tail wagging the futures dog. 

Critics may point to the fact that this very design is used successfully in other geographies, for instance in the CBOT Wheat and Corn Futures markets in the US. However, it must be noted that the cash markets for these contracts are integrated with highly-correlated price changes. In contrast, Indian agricultural markets are fragmented and are regulated by state governments. Prices in cash markets often move independently of each other, rendering the design incompatible without appropriate modifications to keep option values in check for the most part.

Finally, it is unrealistic to expect relatively unsophisticated users of these contracts such as farmers, producer organisations, and processors to understand such a complex package of derivatives that arguably even professionals would struggle with. 

Regulators have recently rationalised equity options trading where it was felt they were detrimental to market participants. Perhaps it is time to do so for agricultural commodity futures, with a better understanding of what went wrong, to revitalise a much-needed part of the national agricultural infrastructure. This is critical given that it can help about half of India’s workforce.