Ecohorts Blog


Managing Financial risk in Farming

Posted in Finance in Farming by Administrator on the April 6th, 2008

Introduction

Spring is probably the most celebrated season in the world. As it breaks the spell of winter in the Himalayan foothills the bloom in Cherry, Plums, Almonds, Pear and Apple trees is delighting the senses. Have a closer look around yourself (Is it really a happy time?) the deeds of mankind or perhaps the unforgiving cycles of nature have changed the outlook for the farming communities. There is anxiety in the eyes, the coffee house and neighborhood cafes are buzzing with bad news about hailstorms, excessive rains and other natural calamities ruining the bloom of spring and in turn hopes and livelihoods of millions, who depend on it.

Lately, the above scenarios have become more and more frequent. It is brewing a socio-economic crisis in the region. There is an exodus from rural areas to the cities in search of alternative career options for the younger generation. Rural unemployment is a major issue. This is creating additional pressure on the cities which are not equipped to handle such a large influx of migrants; the result is urban slums and poverty, food shortages due to reduced lands under cultivation.

Role of Finance

Firstly, farming needs to be looked at as a business (especially by farmers). Cutting edge farm technology is being put to use to improve productivity and quality of produce. On the one hand, the race for cutting edge farm practices and on the other hand there has hardly been any effort by the Government, financial institutions, development agencies or NGOs to reach out to the farmers and educate them about the financial instruments that are now so widespread in the west.

The only financial instruments Government has offered for decades are “crops loans” (or their variants) that have played a part in crippling the farming communities into debt traps and ultimately the Government into a Fiscal mess.

The recent drive by Himachal Pradesh Government, to include Apple and Citrus fruits in the Agriculture Insurance scheme is a positive step. I would like to discuss some Financial Instruments currently available and effectively used around the world that should be put to better use by the farming communities.

“Risks to farm revenues come from two sources: prices and yields. When both prices and yields are insured, so is the product of the two, farm revenues.” President Clinton, Economic Report to Congress, February 1995.

The key risks identified in the above statement are:
Price Risk: This refers to the impact of demand and supply equation of the markets. The supply is related to production risk, owing to weather conditions (deeds of God).The Government is providing minimum support prices for key crops and hence covering the costs to some extent. However, the support prices won’t even cover the cost of production and post harvest expenses in most cases. Price risks can be effectively managed by derivative instruments.

Production Risk:This should be considered as a complicated form of Price Risk because if the farmer doesn’t have the produce his revenues will be zero. Insurance can clearly cater to production risks.

The key instruments worth a discussion are as follows. Please note they are complicated financial instruments and the following discussion is just a brief introduction and shall not be considered conclusive in any way.

1. Crop Insurance
2. Futures and Options
3. Weather Derivatives

  • 1. Crop Insurance:
  • Crop Insurance is the simplest instrument for farmers. It’s purchased by farmers and others to protect themselves against natural disasters viz. hail storms, floods, droughts or the loss of income due to price fluctuations. The two key types of crop insurance are:

    Crop Yield/produce Insurance:

      Hail Storms:

    In the west (Germany and France) hail insurance was started by Co-operatives. Since hail is generally a limited peril and financial risk to private insurance companies is manageable; this has since been in the private domain in developed markets.

      Multi-calamity Insurance:

    This covers the larger/broader perils of drought, floods, disease etc. The earliest of such insurance was implemented in the U.S (1938). These are generally subsidized or provided by Government agencies.

    Crop Income/Revenue Insurance:

    This generally covers the price fluctuations that are rampant during the peak season. These are generally for intra season drops in prices rather than historical benchmarking. Historically benchmarked price support is generally offered by Government agencies and may more appropriately be classed as “support price.”

  • 2. Futures and Options:
    • a. Futures:

    In Finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell an underlying (e.g. Apples, Corn etc.) at a certain date in future at a pre-determined price. The price is called the futures price. The price of the underlying asset (e.g. Apple) on the date of delivery is called the settlement price and the due date of the contract is called the settlement date. Both parties to the contract must settle the contract on the future date.

    This instrument can be explained through an example:

    Example -1: An Orchardist growing Apples toils in his farm and provides all required nutrition to his trees throughout the year without the knowledge of his returns; they could be NIL or a fortune. Moreover, he depends very heavily on weather Gods. To mitigate his risk the farmer can look at the futures price of Apples in the futures market and can decide to sell his produce before harvest at the futures exchange.

    In the event of a bumper crop and current markets prices are low (over-supply) he can resort to the futures contract and still make the expected amount of money. If, the opposite happens i.e. bad crop, leading to high prices in the market he is likely to lose money on the deal. But in either case he can pass through the growing period with peace of mind that he will at least fetch the contracted price.

    The above example is simplified to clarify the concept. Now we can add another dimension of flexibility i.e. the farmer (himself or through traders) being able to trade his contract at the futures exchange and adjust his position according to his crop or market expectations.

      b. Options

    Options like futures are financial instruments which convey a right but not an obligation to engage in a future transaction of an underlying asset (e.g. Apples, corns etc.). Each option contract has a buyer (holder) and a seller (writer). They seller of the contract (writer) has the obligations to honor the contract if the buyer (holder) of the contract exercises his option to transact. However, if the buyer of the contract does not exercise the option, it expires. The assets don’t change hands and nothing is paid.

    For the privilege of having the flexibility to exercise the option, the buyer pays a small premium to the seller. This is not refunded if the buyer chooses not to exercise his option. This implies the financial risk of the buyer is limited to the Option premium paid; while the seller bears unlimited financial risk.

    Options can be of 2 types:

    Call Options: An option contract that gives the holder (buyer) the right to buy a certain quantity of an underlying asset (e.g. Apples) from the writer (seller) of the option, at a specified price (the strike price) up to a specified date (the expiration date).

    Put Options: This option contract gives the holder (buyer) the right to sell a certain quantity of an underlying asset to the writer (seller) of the option, at a specified price (strike price) up to a specified date (expiration date).

  • 3. Weather Derivatives
  • Weather derivatives are derivative financial instruments that can be used to manage financial risk associated with adverse weather conditions. The key difference from other derivatives like Futures and Options is that weather derivatives don’t have an underlying asset (like Apples etc. above) that can be priced. This is because we will be dealing with Rain, Snow, temperature etc. Farmers can use weather derivatives to hedge against poor crops due to bad weather conditions.

    In the light of the above discussion it is the prerogative of the Government to provide the institutional infrastructure for these instruments. These financial instruments are bound to add a cost element to farm operations (Insurance premiums etc.) but they will bring unprecedented financial security to the farming communities and save the Government from massively uneconomical fiscal measures like subsidies, writing off agri-loans etc.

    Ecohorts aims to play an important part in influencing Government policy in this area and the support of the scientific and farming community is of paramount importance.

    Additional Information:

    1. In India the principal agency involved in crop Insurance is Agriculture Insurance Company of India Ltd. (http://aicofindia.nic.in/file_1.html)
    2. ICICI Lombard also launched weather Insurance.
    3. Weather Risk Management Services (WRMS) — a weather insurance company is launching weather trading platform in India by June/July of this year.

    Vikram S.Thakur
    Shell Petroleum, Finance Operations
    U.K.

    One Response to 'Managing Financial risk in Farming'

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    1. pkachal2007 said,

      on April 13th, 2008 at 2:39 am

      The article on crop insurance is highly informative and is the current requirement of the farmers to save them from the vagaries of nature.

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