KIKOS: New exotic derivative for reducing economic cost of agricultural produce procurement

Abstract

The Indian government has a public distribution system in place which undertakes the procurement and the distribution of essential commodities viz, Wheat, Rice, Sugar and Kerosene through a network of Fair price shops on a recurring basis. It is one the major tools of the Government of India to ensure food grains to be available at affordable prices to the public and also to ensure food security for the poor. It is a major tool used by the government for poverty eradication and provides a safety net to the poor who are nutritionally at risk. The system with about 5 Lakh fair price shops is one of the largest distribution systems of its kind in the world. Procurement is a very important component of this distribution system, the central government along through the food corporation of India was responsible for procurement, however now the procurement responsibility is shared between the central and the state governments. FCI and the state agencies procure food grains at the minimum support price (MSP). The MSP is announced by the Government of India well before the marketing season for these commodities start. Purchase centres are allotted by State Govt. among the procuring agencies i.e. FCI and State Govt. Agencies. The purchase centres are allocated by the State Government concerned. The farmer is free to sell his produce tot other traders and food grains dealers, which they do when the price offered by such dealers and traders is greater than the MSP. The commodities thus procured are sold to above poverty line and below poverty line citizens of India directly at a fixed price that has been pre decided by the Government of India or these grains are allocated to various food schemes like the mid day meal scheme across India. As these prices are usually less than what they would be if all costs till point of sales are accounted for , Government of India makes good these losses suffered on account of the PDS by grants made through the food subsidy route. Increased economic costs are faced by FCI and state agencies when the underlying price falls below the MSP, so that the procurement agencies buy food grains at prices above the market levels. This risk is easily hedge able by using commodity options, but the same have been banned in India. This paper looks at structuring a new exotic derivative product that can help the central and state agencies hedge this risk. The paper also outlines the potential size of the benefits associated by using the product, and also suggests a pricing method.