AUTHORS: Wataru Sagisaka, Teruji Sekozawa

Download as PDF

ABSTRACT: In this study, we propose a put option on a farm product to stabilize farmer income and a call option to stabilize consumer cost. Agriculture in Japan involves many problems, including an aging and decreasing farmer population, and price competition with imports. Particularly for farm products vulnerable to insufficient sunlight and to typhoons and other inclement weather, market price tends to rise and fall, and farmer income is unstable. This in turn strongly affects market sales of processed foods made from these farm products, and on the dietary habits of and costs to us as their consumers. Although derivatives are a means of avoiding the risk of market price fluctuation, they have had little application to farm products. Futures trading on vegetables is a form of derivatives for existing farm products, but again has only been applied to a few products and only on a small scale; furthermore, a method of pricing that reflects the characteristics of farm products has not been well established. The effect of futures trading for stabilizing farmer income is therefore small, so risk to the farmer from market price fluctuation and the burden on the farmer remain large. In the present study, we take the potato as an example of a farm product with a market price liable to change, and focus in particular on potato farmers in Hokkaido, who serve as the mainstay of potato farming in Japan, and as their trading counterparts, we focus on the companies that produce and sell processed foods with Hokkaido potatoes as production material. We use as a reference data their market prices and shipment amounts over the past 20 years of trading at the Tokyo Metropolitan Central Wholesale Market, which is the main destination of potatoes produced in Hokkaido. We take as the farmer income the amount paid by the company for the potato purchases. The farmer income and the company cost vary with the market price at the time of trade. In this study, we propose a derivative for stabilization of farmer income and company cost. The farmer is given a put option to avoid the risk of the market price going below a strike price set in advance. The company is given a call option with a strike price set in advance to avoid the risk of the market price rising above the strike price. The annual farmer income and company cost are calculated from the market price and shipment amount, and the standard deviations are taken as the variations in income and cost. Under adoption of these options, the derivative is evaluated in terms of the reduction in the standard deviations of farmer income and company cost, and thus the stabilization obtained. The farmer and company option holders each pay a premium to the option provider, who obtains boundaries for the strike price and the premium pricing that will allow it to gain a certain profit. Within these boundaries, the strike prices yielding the smallest standard deviations in farmer income and company cost are calculated. When the strike prices are set, in order to gain a profit, the option provider sets the premiums as the consideration necessary for stabilization of farmer income and company cost. The derivative is evaluated on the basis of the standard deviation reductions due to holding the options and the related consideration. Trading models applicable to farm products other than potatoes are constructed by investigating the characteristics of trading on the farm product from the call and put option pricing. The effectiveness of the derivative proposed in this study at reducing the burden on the farmer is demonstrated by comparing the reductions in the standard deviations in income and cost and the related consideration to cases in which no option was adopted and in which futures trading was performed.

KEYWORDS: Derivative, Real option, Call option, Put option, Futures trading, Market analysis

REFERENCES:

[1] Black, F. and Scholes, M., “The Pricing of Options and Corporate Liabilities”, Journal of Political Economy, Vol.3, Issue.81, 1973, pp.637-654

[2] Black, F., “The Pricing of Commodity”, Journal of Financial Economics”, Vol.3, 1976, pp.167-179

[3] Cox, J., Ross, S. and M. Rubinstein, “Option Pricing: A Simplified Approach”, Journal of Financial Economics, Vol.7, 1979, pp.229-264

[4] Cox, J., Ingersoll, J. and S. Ross, “The Relation between Forward Prices and Futures Prices”, Journal of Financial Economics, Vol.9, 1981, pp.321-346

[5] Cox, J., Ingersoll, J. and S. Ross, “An Intertemporal General Equilibrium Model of Asset Prices”, Econometrica, Vol.53, 1985, pp.363-384

[6] Cox, J., Ingersoll, J. and S. Ross, “A Theory of the Term Structure of Interest Rates”, Econometrica, Vol.53, 1985, pp.385-408

[7] Jun Nakagawa and Teruji Sekozawa, “The Application of Real Options to ERP Investment Valuation”, WSEAS-System Science and Simulation in Engineering

[8] Tom Copeland and Vladimir Antikarov, “Real Options”, Monitor Group, Texere LLC, 2002

[9] Johnathan C.Mun, “Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions with Integrated Risk Management and Advanced Quantitative Decision Analytics”, 2003