Ass2 Derivatives

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MONEY & CAPITAL MARKETS Assignment No.02

Department of Banking & finance (074094) 1

SRI LANKAN AGRICULTURAL SECTOR

The majority of Sri Lankas poor live in rural areas and depends on agriculture for their

livelihood. The reverberating point is that they are poor; unable to participate in society in the

manner worthy of their contributions and unable to benefit from development. Agriculture is the

most important sector of the Sri Lankan economy. The government vision of agriculture is; An

agriculture sector is contributing to regionally equitable economic growth, rural livelihood

improvement, and food security through efficient production of commodities for consumption

for agro-based industries and for exporting competitively to the world market.

About 80 percent of Sri Lankas population lives in its rural areas and the rural poor

account for 95 percent of the country are poor. Agricultures share (including estate) in the GDP,

which has continuously declined is about 18%. The contribution from agriculture sector to

employment is about 30%.The agriculture sector is the cornerstone in Sri Lanka's economy with

more than 70% of the population living in rural areas depending on agriculture for their

livelihoods. The agricultural productivity has remained relatively stable, except for rice which

has reached near self sufficiency in the recent years.

However, the growth in this sector has been slow. Swift agricultural productivity growth

is fundamental for reducing poverty in Sri Lanka as nearly 90% of the poor live in the rural

agricultural economy. Therefore, rapid development in food production while protecting the

environment, water resources, and bio-diversity needs to be given high priority in the

development strategies. This includes removal of existing policy and regulatory constraints

which have hushed growth in the agricultural sector.

The Government aims to promote agricultural

production by implementing technically sound,

economically viable, environmental friendly and socially

acceptable programmes to promote sustainable

agricultural development with efficient and effective utilization of resources.


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THE PADDY CULTIVATION

Agriculture in Sri Lanka mainly depends on rice production and rice is the main crop and

farming rice is the most important economic activity for the majority of the people living in rural

areas. The paddy field cultivation also one of main employment of people of Sri Lanka.There

are two growing seasons; Yala" season and "Maha" season. Sri Lanka sometimes exports rice

but not in recent years. During the last 5 decades the rice sector grew rapidly and output more

than tripled, reaching the highest ever output of 2.9 million metric tons in 1999. Increases in the

area under cultivation, and improved productivity due to the modernization of agriculture are the

main reasons for an increase in production.

Around 1.5 million hectares of land is cultivated in Sri Lanka for paddy in 2008/2009 maha: 64%

of which is cultivated during the dry season and 35%

cultivated during the wet season. Around 879,000 farmer

families are engaged in paddy cultivation in Sri Lanka. They

make up 20% of the country's population and 32% of the

employment. In some areas farmers cultivate paddy only in

Maha season and grow other vegetables in Yala.

OTHER FRUITS AND VEGETABLE CULTIVATION

Fruits & Vegetable sector in Sri Lanka is another industry for development of rural economy.

The majority of the population involved in agriculture is small producers or home garden

suppliers. While identifying the opportunities in international and local market, the present

development programmes are targeted to establish small farm cluster companies merged with

exporters or marketing enterprises to expand productivity,

promote convenient products, increase sustainable farm income,

etc.


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THE CHENA CULTIVATION

Chena cultivation is main employment of dry zone villages in Sri Lanka. Mainly there is

only one time farmers cultivate in the Chena of one year. But some cultivate two times in Chena.

Chena cultivation is somewhat different than paddy field cultivation. Farmers grow various types

of vegetables in Chena.Farmers can earn a lot of money from it.

Normally People start Chena cultivation from

September and after growing the harvest and if there is

much time for cultivate another vegetable they cultivate

short time vegetable. In January they finish Chena

cultivation. Most times the Chena is attacked by wild

animals. The most danger animals are pigs and monkeys. The farmers pay there much attention

about these types of animals and they stay all the nights in the Chena.

However they earn much money from Chena and some buy vehicles and other

things. Something that the Chena cultivation is lazy word but I like to tell you they don't know

what is the fun ofit.

PRICE FLUCTUATIONS IN AGRICULTURE SECTOR


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There are many challenges for agricultural sector in Sri Lanka.

Strategies and policies are weak.

Heavy public sector regulatory interventions in commodity and input/factor markets:

Destructive impact of civil conflict and natural desasters

Weak delivery of services in rural areas:

Bad Weather condition

Such challenges are caused to fluctuation in agro products.There may be some other reasons specially

cause to price fluctuations in agro products.

Seasonality

Seasonality of cultivation & harvesting is major reason for price fluctuation. Farmers cultivate

agricultural commodity which has large demand when they begin to cultivate. Accordingly, if it


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is consider the vegetables, most of the farmers have persuaded to cultivate similar type of

vegetable.

Ex: If there are a huge demand for onions all the farmers take loans/ borrowing &

spend on cultivating onions. As a result , when the time of harvesting supply of the

onions increase & therefore prices are gone down. In that case farmers have to incur

losses.

On the other hand, due to seasonality there can be a shortage of certain vegetables which

demanded by consumers. In this scenario increase prices of the vegetables. It is good for

farmers & intermediaries. But, it is badly affected to consumers (household & caterings).

Weather condition is another reason for fluctuating price of agricultural commodities.

Weather condition of a country is uncontrollable factor that affect to especially for the

agricultural zone. It can be favorable or unfavorable. Though there is a favorable

condition in cultivating period it should be worst when become to harvesting period.

If weather condition is encouraging particular agricultural commodity it will pricing in

fair manner. But, if the weather condition is affected to the nurturing prices of those agro

products may increase rapidly. Sudden flood, Heavy rain or drought can be destroy the

crop & it cause to rapid increase of the prices of particular products.

Economic condition of the country is affected to the price fluctuations in agriculturalproducts. If there is any down turn in economy, prices of commodities go down. With this

situation farmers cannot obtain real price for their harvest. They have to incur huge losses


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due to failure of trading & pricing their products. Conversely there is inflationary effects

prices of commodities go up rapidly. Here consumers have to face difficulties when

looking for buying products. They have to spend lots of money on the agro products what

they want.

Accordingly, both of these price movements are influenced on various parties. When prices

are declining farmer will suffer & when prices are increasing consumers will suffer. But,

both cases intermediaries are beneficial.

Rice cultivation is done in seasonalmanner as yala & Maha. Farmers cultivate paddy just

in these two seasons in required amount. When starting to grow paddy there is a price for each

kind of rice. But, this price is not fixed. It is volatile with the time due to various reasons as

mentioned above. Therefore, farmer has a risk regarding the price fluctuations when the time of

harvesting.

So as with the connection of vegetable products. Price exists during the period of starting the

plant will be differing in advance.

In some times in the year, production is not fulfilling the entire requirement in the country, due

to destroy crops/ deficiency of producing & so on. At that time there is a excess demand & prices

are gone up rapidly. To overcome this issue the government may decide to import necessary

commodities & this may cause to move prices again, especially to downward. Because, with the

absolute advantages government can import & trade for lower price in local market. This affect

to pricing system of local existing products.

So, these price fluctuations influence both producers & consumers of agricultural products. Still

there are intermediaries who take the benefits of price increasing of agro product, producers

(farmers) suffer with law pricing of their productions.


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When we summarize above issues and challenges, we can see various kinds of reasons cause to price

fluctuations in agricultural commodities in Sri Lanka. Some are listed below.

General Economic Condition Weather condition Seasonality of cultivation & harvesting

Political factors

General Economic condition

General economic conditions in the country are affected to the price fluctuations in agricultural

products. Due to the various social, economical and political factors, always economic conditions are

changed day by day. If there is any down turn in economy, prices of commodities go down. With this

situation farmers cannot obtain real price for their harvest. They have to incur huge losses due to

failure of trading & pricing their products. Conversely there is inflationary situation; prices of

commodities go up rapidly. Here consumers have to face difficulties when looking for buying

products. They have to spend lots of money. Therefore price fluctuations are occurred.

Political factorsDue to the political decisions in the country, price fluctuations are occurred. As example; prices of

coconut are rapidly increased day by day, because political people get a decision to import these items.

Therefore these decisions affect to the price fluctuations in the country.

Seasonality of cultivation & harvesting


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This is major reason for this fluctuation. Generally, Farmers cultivate agricultural commodity which

has large demand when they begin to cultivate.

On the other hand, due to seasonality there can be a shortage of certain agricultural products which

demanded by consumers. In this situation increase prices of the products. It is good for farmers &

intermediaries. But, it is badly affected to consumers (household & caterings).

Weather condition

This is another reason for fluctuating price of agricultural commodities. Weather condition of a

country is unmanageable factor that affect to especially for the agricultural zone. If weather condition

is encouraging particular agricultural commodity it will pricing in fair manner. But, if the weather

condition is affected to the nurturing prices of those agro products may increase rapidly. Heavy rain or

lack can be destroy the crop & it cause to rapid increase of the prices of particular products.

Here consumers have to face difficulties when looking for buying products. They have to spend lots of

money. Therefore price fluctuations are occurred. It can be favorable or unfavorable. Though there is a

favorable condition in cultivating period it should be worst when become to harvesting period.

DERAVATIVES

Colombo Stock Exchange and its regulator reiterated their commitment to pursue the introduction of

derivatives trading soon, a development much talked about, though less action has been taken, at a recent

forum.

What Does Derivative Mean?


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A security whose price is dependent upon or derived from one or more underlying assets. The derivative

itself is merely a contract between two or more parties. Its value is determined by fluctuations in the

underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies,

interest rates and market indexes. Most derivatives are characterized by high leverage. There are many

kinds of derivatives.

The most common are;

Forwards Futures Options SWAPS

Forwards

A forward contract is an agreement between two parties to buy or sell an asset at a certain time in the

future at a certain price.

Futures

Futures were designed to solve the problems that existed in the forward markets such as Counter party

risk and Liquidity. Futures contracts are standardized forward contracts that are traded on an exchange.

Futures are tradable securities in the market. Buyer and seller can buy and sell futures through their

brokers.

Options

Wheat

ForwardsFarmer Bread Marker

Trade Date; Dec 15 2010

Settlement Date; Jan 15 2011

Sells Buys
http://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Futures_contract


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0

Options mean exercising or ignoring a right to sell or buy the underline assets. In other words Option is

an instrument which we can use with combine of other instruments. There are two types of options.

Call option Put option

SWAPS

Contracts to exchange cash (flows) on or before a specified future date based on the underlying value of

currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. Payment obligations,

and there are basically two types.

An interest SwapIn here the exchange involves payment denominated in the same currency. The value of the

interest rate payment to be exchanged is based upon a specific amount of principle know as

the national principle amount. In a typically interest rate swap one party agrees to pay the

other party a fixed interest rate payment at a specified dates.

A currency SwapIn here the exchange involve two different currencies.

Solutions from Derivatives

Forward contract

A forward contract is an agreement between two parties to buy or sell an asset at a certain time in the

future at a certain price. Price fluctuation is a major problem today. To solve this problem, people involve

with agricultural sector can use derivatives. The one of the major derivative product is forward contract.

In here people can buy forward contract to secure them from price fluctuations. It can be deeply explained

by following example.

Example; Farmer decided to make a contract with buyer about his paddy production (rice)


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1

Underlying asset

Quantity

Contract Price

Contract Date

Settlement Date

Settlement Type

Paddy production (Rice)

1000kg

Rs.90 per kg

March 04, 2011

May 20, 2011

Cash

Will give 1000kgs paddy Accept 1000kgs of paddy

Will accept Rs.90 per kg will pay Rs.90 per kg

Here farmers obligation is to deliver paddy production and buyers obligation is to pay relevant money

to the farmer.

Now, we assume on the settlement date, price is Rs.70 per kg. But forward contract price is Rs.90 per kg.

Price is decreased by Rs.20 today than the contract price. But buyer has an obligation to pay agreed price

to the farmer. Although buyer can pay only Rs.20 to the farmer. Because after paying that amount of

money, he can buy paddy production from market at market price which is Rs.70 per kg. Then farmer can

sell their production at market price. Therefore he hasnt any fearabout their trade prices. Because there

is a forward contract between farmer and seller. Therefore farmer manages price risk arises from price

fluctuation.

According to above example,

On May 20, 2011 (settlement date)

Market price of paddy is Rs.70 per kg

FarmerBuyer

(Whole sellers, small exporters & etc.)


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Contract price is rs.90 per kg Difference between two prices is Rs.20 Who gains from the forward contract? By how much?

Therefore, according to above example we can identify how to face price fluctuation in the market by

making forward contract. When the price is decreased farmer doesnt any fear about that. Because he can

cover his price fluctuation by making contract according to their needs and wants.

Therefore this is a good method to agricultural sector people to solve their major problems.

Farmer receives Rs.20 per kg. From the Buyer (Cash Settlement)

Farmer sells the paddy in the market at Rs.70 per kg (Position)

Rs.70 + Rs.20= Rs.90 per kg


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Futures Contract

Future contract is another derivative instrument in derivative market. Futures were designed to solve

problems that existed in the forward market. Because forward contract is involved with high counter party

risk than the futures. Because there is OTC (Over The Counter) contracts.

OTC is Contracts that are traded directly between two parties, without going through an exchange or

other intermediary. The OTC derivative market is the largest market for derivatives, and is largely free-

for-all with respect to disclosure of information between the parties, since the OTC market is made up of

banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult

because trades can occur in private, without activity being visible on any exchange.

But when we consider the futures, it is more applicable than the forward. Because futures are done

through the exchanged traded.Exchange-traded derivative contracts (ETD) are markets where individual

trade standardized contracts that have defined by the exchange. A derivatives exchange acts as an

intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a

guarantee. Therefore farmer can buy future to maintain their price fluctuations. It can be described by

using following example.

Example; Farmer buy a future to sell his vegetables to the buyer in the market.

Here underlying asset is vegetable. Farmer has to find a broker to sell their vegetables to the buyer in fair

price. Therefore farmer can sell their products through this broker in standardized manner. First both

buyer and seller have to deposit some amount of money as initial margin within the exchange. So that

sellers as well as buyers are protected from future price Fluctuations. Because they will protect from

falling prices through the exchange. With relating to rise of price and fall of price farmer can sell products

without any loss.

Therefore this is most appropriate than the forwards. Because trade is done through the exchange. Due to

this reason, transparency is occurred. And also futures are standardized contracts and counter party risk is


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absent. Therefore reduce complexity and settlement is guaranteed by a clearing corporation. And also

there is marked to market settlement every day. It also cause to reduce risk of final settlement.

Options

In call option buyer has a right to buy the underlying asset & seller has an obligation to sell the assets at a

strike price. Farmers can engage in call option contract with buyers. They promise a fixed price for

vegetables/ rice when entering into contract & buyer has a right to buy those things in the future date as

well as seller has an obligation to sell.

Therefore by engaging derivative market people involve with agricultural sector can maintain their price

fluctuation and risk in suitable manner.

Documents

Ass2 Derivatives