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agri industry: Concept of hedging in the agri industry

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agri industry: Concept of hedging in the agri industry

The reason d’etre for commodity derivatives is two-fold: 1) the Efficient Price discovery due to the wide participation of the entire value chain and institutional participants 2) the Hedging of price risk that underlying commodity product throws up due to global demand- supply through the use of the derivatives.

The various participants such as agricultural commodity processors, traders, millers and aggregators hedge their commodity price risk by using agri-commodity derivative products available on recognised exchanges in India.

Prices for farm products rise and fall due to changes in the supply or demand fundamentals, real or perceived, for that product. Periods of tight supplies usually cause high prices. Periods of excess supply can cause low prices.

NEED OF HEDGING IN AGRI SECTORHedging, by strict definition, is the act of taking positions opposite in the cash and futures markets. To understand what a hedge is first to recognize that there are 2 markets: ⦁The cash market is the physical market where farm production is actually bought and sold ⦁ The commodity futures market is the paper market where futures contracts are bought and sold

There are 2 types of hedges: ⦁ Sell hedge – also known as a short hedge ⦁ Buy hedge – also known as a long hedge

USE OF DERIVATIVES FROM SOYA INDUSTRYSoya Industry: Soybean seeds are crushed to extract crude soya oil. Crude soya oil is processed further to produce refined soya oil. In the process of extraction, defatted cake or soymeal is generated. Soya meal is used as animal feed . India is one of the largest producers of soybean, it imports soya oil to satisfy its edible oil requirements

These three commodities have different types of usage and demand patterns. A diverse group consisting of farmers, crushers, soya flour/soya nuggets manufacturers, exporters of soya meal, importers of soya oil, animal feed manufacturers, and poultry and fish farmers are part of the soybean complex.

Hedging for FPOFarmers does not often have stored grain or marketable livestock on hand at a time when the price is high. Hedging, using futures contracts, is an alternative way to lock in prices in higher-priced periods. While the Farmer Producer Organisation ( FPO ) and farmers, the producers of agricultural commodities regularly face price and production risks. Therefore when they undertake sowing / growing the commodity, rather than speculating on price trend after harvest they need to use derivatives for reducing the price risk and the price yield is important for them.

For instance, a farmer intends to plant a field of soybean. Even before seeding, he acquires or buys soybean production with inputs of fuel, fertilizer, seed and chemicals, and his land and labour. When he buys these inputs, he has bought a Soybean crop. In other words, he has bought a piece of the cash soybean market. If at some time during the growing season, he hedges the crop by selling futures contracts, he then has an opposite position in the cash market (bought production) and the futures market (sells futures).

The hedge locks in the price by taking the opposite position in the futures market (sell) to what he has (buy) in the cash market. If the sell hedge is in place, a drop in the price of soyabean futures (and the value of cash soybean) will make the growing, or cash grain, worth less, but the seller’s short futures hedge will be worth more. The money lost in one market and the money made in the other will balance each other off very closely.

Most grain producers would use a short hedge to protect against falling prices.

SOYABEAN EXPORTER: Another example of a buying hedge would be a soybean EXPORTER who has sold soybean to a foreign buyer but still has not purchased it in the cash market. In this instance, the grain exporter would use a buying hedge to protect against a price rise in the cash market until purchases are contracted in the cash market to cover the export sale.

HEDGING FOR PROCESSOR Agri processing units use derivatives to protect their margins on processing rather than price movements of underline. For example, they can buy raw materials or commodities from a futures exchange to keep raw material costs in check if they feel prices may go up in future or sell processed commodities on a futures platform to ensure realisations are ensured if they see prices falling in future.

CRUSHING MARGIN: The “crush margin” is an important parameter which many companies consider in deciding whether they should sell soybean or crush soyabean to sell soy oil and soymeal.

The crush margin is calculated as follows:

CRUSH MARGIN: = price of soya oil + price of soymeal – {price of soybean + crushing cost of soybean + refining cost of crude soyaoil}.

If the crush margin is positive, crushing and selling soyaoil and soyameal is beneficial, while with a negative crush margin a crusher would be better off selling soybean.

(The author is the President of Commodity Participants Association of India (CPAI))

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