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If the supply is going to go down considerably(say because in Southern India its going to rain a bit too much thus destroying the wheat crop), the wheat farmers will be geared up to produce more wheat that season to compensate for the fall in supply thereby fulfilling the demand of the market. Thereby benefitting both the consumer and the farmer.
Similarly if its going to rain pretty well and it will result in sufficient harvest, the farmers will produce less, put less money on the crop and it will create a bountiful harvest.
Wouldn’t this foresight into the future going to help the poor farmers. Unfortunately we face two problems in realization of this scenario.
- You don’t have such a psychic ability.
- You cannot just convince the farmers out there that what you are telling them is true
That is, there is no such psychic ability possessed by anyone who can predict the future demand and supply with accuracy. The closest to such a prediction you can come to, is to study weather, study the crop cycles, study the soil, and then make an educated prediction. Even when you are able to make such a prediction you face the problem of convincing the farmers. Why should farmers believe you who says that there will be a shortage of Wheat coming harvest season, or believe me who says that there will be an abundance of wheat this harvest season. There must be a solution to this problem.
I bet the way most Indians are educated to think will think of a centralized government solution of this problem. One possible solution which was given to me by someone really smart went something like this:
Govt should organize a national level exam(on the scale of IAS-Indian Administrative Services exam), to find out the most intelligent soil, agriculture, wheat scientists and form a group which will then issue advisories on how much wheat the farmers must produce. This committee must be kept away from the political pressures, and must be paid very highly so that we are able to attract the most intelligent IITians-Agro scientists etc etc.
The problem with the above solution is, that it simply is the worst possible solution of the problem, it is so bad that its just going to worsen the problem. As long as the “National Advisory Committee” gives good recommendations its good, but when they will screw up which will happen more often than not, its going to create disaster. Plus it is actually no different than the Central Planning we have followed from Independence till 1990s, I am sure that gave us some amazing results. Also it basically excludes 99.99% of other people who could have been right.
So what’s an alternate more efficient solution? Wouldn’t it be better if every individual can take part in this process of prediction the wheat prices in future? Not only anyone wishing to take part must be able to take part, it should work more efficiently than handing out the power to a few individuals. It must penalize the participant if their prediction turns out to be wrong, and must give more weight to the prediction of an accurate individual.
The system would basically allow the farmers to sell wheat at a fixed price on a future date. That is if a farmer is producing wheat for the harvesting of June 09, and currently it is Jan 09, then he must not worry about the uncertainty of the wheat prices in future. Someone must assure him the price he is going to get.
Ladies and Gentlemen, presenting Commodity Futures.
Let me first explain you the concept of Futures contract. In finance a futures contract is a standardized contract to buy and sell a standardized quantity of commodity at a future date at a market determined price. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
In simple words, if I am a wheat farmer, and you are a wheat price speculator, buy the wheat from me now, which will be delivered to you on a future date when the harvest occurs. If you think in the future the wheat price is going to be $700 per quintal, then lets sign a contract where you pay me $700 per quintal, and I will deliver to you wheat on that future date. If on that future date, the price of wheat is $700 or more, you make profit, if its less than $700 then you make loss. In either case the headache from my head of worrying about the future wheat demand is gone. My work as a farmer is now to simply grow wheat, and not worrying about the trading of the wheat.
This is a much better way to discover the future prices of any commodity compared to putting the burden on the poor farmers, or to give the task to one elite intelligent group of Oxford graduates. In this way anyone in the market can take part in the price discovery of the commodities. The risk of wheat prices plummeting has been taken off from the farmer, and is handed to the guys who are more focused on the task of predicting the future prices. If they succeed they make the profit, and they will trade even more futures and become larger contributor in the price discovery. If they fail they will be penalized for making the wrong prediction.
Futures trading is not new to the world. In fact from wikipedia entry on Futures:
The origins of futures contract can be traced to Ancient Greece, in Aristotle’s writings. He tells the story of Thales, a poor philosopher from Miletus who developed a “financial device, which involves a principle of universal application.” Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and many presses were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a large quantity of money.
In the modern times, Futures trading has been around in America for over two centuries. In 1848, the Chicago Board of Trade (CBOT – the world’s first modern futures exchange) was formed. In India the futures trading has been going on with some big government support since 2002. In terms of trading volume Mumbai Stock Exchange is world’s largest stocks and futures trading exchange.
- National Commodities and Derivatives Exchange(NCDEX) - Wiki - A regulated online commodity exchange based in Mumbai.
- Multi Commodity Exchange of India Ltd(MCX) - Wiki - An independent commodity exchange based in Mumbai with 84% of Market Share in 2008.
Lets take an example of what a Wheat futures contract specifications in India consists of.
http://www.ncdex.com/product/Agro_product.aspx?comm=WHE
Name of commodity - Wheat
Ticker Symbol - WHTSMQDELI
Unit of Trading - 10 Metric Tonnes (That is one contract deals with 10 metric tonnes of wheat)
Quotation Price - Rs per Quintal (This means that if you read the price of Wheat contract Rs 830, it means that on the delivery date market thinks the price is going to be Rs 830 per quintal).
Tick Size - 20 paisa (that means the price of Futures contract can go up and down by 20 paisa or more.
Delivery center - Delhi (once the Futures contract expires you can take the delivery of the contracts from Delhi delivery center)
There are many other things involved with trading commodities, the details of which are out of scope of this article. The conclusion I wanna put in is that Grain futures trading can be a very powerful way to actually serve the people, to help the poor farmers by taking the risk off their hands, as well as make a living while doing that. There are tremendous risks involved with futures trading and you might lose all your capital in it. So instead of trying to become all out commodity trader, try to hedge your wealth with a real job.
Before you become any kind of trader I would suggest you to read this book by Nicholas Taub:
http://en.wikipedia.org/wiki/The_Black_Swan:_The_Impact_of_the_Highly_Improbable
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1 views9 Responses to “Help poor farmers, speculate on grain Futures!”
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Reality Says:
May 10th, 2009 at 6:11 pmWe have to face the facts. Our agricultural policy is that of Earl Butts, Richard Nixon’s Secretary of Agriculture and a deeply pocketed in agri-business. He remade our farming system to favor large corporate farms over small family farms. This policy was extended by Ronald Reagan to the extent that small family farmers became alkost extinct in the 1980s. Butz’s corporate farming model is not longer sustainable, since it requires too much energy. We must get back to small, efficiently run farms that produce the food needed by people living in that region and employ techniques that are much less dependant on petro-chemicals.
GP Says:
May 14th, 2009 at 9:01 amNice article ! I guess you should also write article on -
“What are the best ways to educate poor farmers about commodities market and commodities futures and how
they can be convinced to enter into it !”
renegade_division Says:
May 14th, 2009 at 9:40 amThey don’t have to enter the commodity futures market. You totally missed the point of the article.
GP Says:
May 15th, 2009 at 8:35 amhmm..so how they are suppose to reap benefits of commodities futures? ( here I mean probable benefits as in future options you got to be prepare for losses as well)….OR its just for those rich highly educated MBA grads farmers/commodities traders who are very well aware of financial instruments [:-)] ?
I think bottomline of your article is — “commodities futures” as solution to the issue you elaborated at the beginning of article . But what about “For whoem” and “How” part of the issue? ….
One more thing - I guess you should also read/recommend - “Fooled by Randomess ” to the readers - By Taleb. ..good one!
renegade_division Says:
May 15th, 2009 at 12:03 pmGP Said:
See that’s why I am trying to say here. You the highly educated MBA Graduate(although I fail to see which part of an MBA degree teaches you trading), is going to do the trading, take the risks of the the price fluctuations in YOUR HAND, from the Farmer.
The farmer gets the benefit of not having the risk of price uncertainty in his hand.
Lemme elaborate. Take for instance doing any business. When you start doing the business there are two possibilities, you make it big, and become the next billion dollar company, or you lose it all and become bankrupt. Usually when you do good market research, you reduce your chances of becoming bankrupt. But there is still some uncertainty whether you will be able to make profit or make loss.
Wouldn’t it be great if someone took that risk from your hand. That is they promise you a certain amount of price even before you start producing anything?? That will surely reduce the risk on your capital. If you are getting a good price for your product you will go ahead and start producing.
Similarly when you buy a commodity future from a farmer he is promised a specific price(determined by the demand supply for that future commodity) for a specific quantity of commodity on a future date.
Benefits to the farmer: He does not have to worry whether his produce will lose value on that future date of production. If you are a farmer and you start planting the seeds for wheat, you know what price you will get for this wheat by looking at the current price of that future wheat. IF you like that price you can sell that future contract right now and get that money today. Then you are contractually obliged to deliver that amount of wheat on that future date.
The farmer does not have to trade in futures, only sell them to take the benefit from a farmer’s perspective.
Benefits to the guy who can predict the wheat price: This guy if he is correct will pocket the price difference, in whichever direction he thinks the price will move.
Rolf Krake Says:
May 19th, 2009 at 2:12 amThe Simpsons interpreting the Fountainhead mocking public education
Wonderful to see
http://www.youtube.com/watch?v=_CEX1P8MZnI
keshav Says:
August 27th, 2009 at 10:43 amYou told that the farmer has to sell at some cost which ‘ll be predicted.
But some cases may lead to loss to farmers -
1.what if the predicted wheat price is very low, or the wheat rate is intentionally made low (corruption) ?
neither the farmer sells it nor the buyer buys it rite…
2. What if theres no harvest itself (due to floods or drought) ?
3. The farmer doesnt get any profit if the actual price is high. So hes getting loss in this case. (Though your idea avoid suicides, I’m thinking of the next step !).
keshav´s last blog ..THE GREATEST FRAUD OF ANDHRA PRADESH…
renegade_division Says:
August 27th, 2009 at 1:20 pm@Keshav Said:
I am not sure how there is corruption in a free market transaction? Corruption takes place when you entrust someone with someone else’s property. For example if your hire manager to take care of your restaurant, now there can be corruption or if there is a public official involved.
Coming to the second point. If the predicted wheat price is too low, the farmer will not sell the futures contract. Remember this is not just a prediction but the farmer has to agree upon the sale and buyer has to pay farmer that money. I mean I could predict the wheat prices to be Rs 10 per kg but its not really a prediction because I am not exchanging a contract.
So there is no such thing as “intentionally made low”, the whole intention of a futures contract buyer is to get the least price for his contract. If wheat’s usual price in Summer is Rs 20 per kg, and I am offering in Jan, the farmer a price of Rs 5 per kg, the farmer has no reason to accept that contract. But remember farmer would be taking the risk onto himself by not accepting that offer.
Of course once no farmer is willing to sell their wheat at Rs 5, the speculator has to offer a higher price.
If there is no harvest then Farmer will have to pay the speculator either the price of the wheat in the market or that much wheat bought from somewhere else. This may sound horrible, but remember farmer is literally farming from the money he got from the sale of futures contract. So if the futures contract holder paid him Rs 10 per kg, and the contract was for 1000 kgs, then farmer got Rs 10,000 to grow wheat. Farmer will use Rs 7,000-8,000 from it to grow the wheat(rest is suppose to be his profit), if all the wheat goes away at the wheat prices on the day of delivery is Rs 40 per kg then farmer must pay Rs 40,000 or Rs 40,000 worth of wheat to the futures contract holder.
It may sound like a bad condition but then remember that uncertainty about the prices was taken away. If farmer cannot produce that much wheat then farmer is screwed. This screwup happens in rare conditions. Although price fluctuations happen way too much. So overall farmer is in a benefit than loss.
Now if farmer wants to reduce his loss in case of market thinking rain is going to greatly reduce the prices then Farmer can buy a futures contract any time he wants. For example if you are a Farmer and you sold Apr Futures in Jan to deliver 1000 kg of wheat at Rs 10 per kg, and now in Feb the prices have gone to Rs 30 per kg, then you can buy the contracts back to cover your position now, you re took the risks involved with price fluctuations(with a small loss). But then now you are actually involved in prediction business.
That’s correct, the farmer will not any profit if the actual price is high. But then farmer will not have any loss if the actual price is low either. If farmer wants to take the risk in his own hand he is free to do so but then he might commit suicide if he fails.
Just consider it as buying price insurance. You give up the risk of price going down too low so you give up the profit of price going high too.
Responding the questions of an IAS aspirant | Reason for Liberty Says:
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