1. Price Risk Management 2. Future Contracts and Forward Contracts 3. Financing Options

1. Name – Chandresh Madhyan
Subject – Financial Institutions and Markets
Price Risk Management
Introduction
India being an agricultural country has large number of farmers who are
exposed to price fluctuations on their harvest (produce). One of the
major reasons for price fluctuations is dependence on monsoon conditions.
Compared to the industrial sector, agriculture is exposed to many
unpredictable risks and uncertainties.
Reasons for price fluctuation
1.) Crop output and quality are highly vulnerable because of out of
control factors such as climate changes and pest attacks.
2.) Risks of pilferage and deterioration also result in significant loss of
crop value during storage and transportation.
3.) Due to uncertainty in quality & quantity of output, farmers have to
face the consequences of price fluctuations.
4.) Global free trade and not so good National agricultural policy has
only added to this vulnerability for countries like India.
Price Risk Management
1.) Price risk management is vital to the success of agriculture but still
there are not enough tools/efforts made to manage this risk.
2.) Starting from stage of production till marketing and selling,
agricultural performance is highly dependent on many external
factors and variables which lead to price fluctuations.
3.) The best way to eliminate this agricultural price risk is to use Market-
based instruments which are more practical and non-intervening
option for managing agricultural price instability.
4.) This can be achieved by usage of Risk Hedging instruments or
agricultural insurance.
5.) Agricultural insurance is available in market that provides safeguard
against both price and output risk. As insurance is costly in India,
farmers should look for market instruments.

2. 6.) On other hand, these hedging instruments are cheaper and ensure
the negotiation in price before the harvest time. There are 2 types
of Hedging instruments available in market.
a.) Hedging with Forward Contract
b.) Hedging with Future Contract
7.) Forward contracts are mutual contracts that provide a customized
solution in fixing the future price of the output (agricultural produce).
8.) Similarly, futures and options contracts which are traded in an
exchange also help in fixing the future price of the produce. But they
have flexibility as compared to forward contract
9.) Basically, future and forward contracts have the same purpose: both
types of contracts allow people (farmers) to buy or sell a specific
type of produce (product) at a specific time at a given price.
10.) Below are the specific details of the contracts (forward & future), it will
show that both these contracts differ in basics.
Forward Contracts
1.) It refers to non-standardized contract between buyer and seller to
deliver a specified quantity of produce at a specified future date at
an agreed price. The agreed price is also called the delivery price and is
equal to forward price at which contract is signed.
2.) In other words, buyer has agreed to receive a product from farmer
at a future date with the price and terms for delivery already set in place.
Thus, farmer works with buyer to set the price and terms of selling.
3.) Forward contracts are private agreements between two parties and
are not as rigid in their stated terms and conditions as there is no
governing body.
4.) As forward contracts are private agreements, there are chances that a
party may fail to pay its side of the agreement.
5.) For forward contracts, settlement of the contract occurs at the end.
Forward contracts have only one settlement date.
6.) Forward contracts are frequently used by hedgers who want to eliminate
the volatility of an asset's price and delivery of the asset/cash
settlement usually takes place.

3. Forward contract explained with an example
1.) Suppose a multinational corporation Renuka Grains which is based out
of India has revenues from exports to western countries like USA. Its
export majorly comprises of wheat, which is processed in India and all
costs incurred in INR.
2.) As export sales are in USA, the depreciation of Indian rupee (INR)
against dollar can cause losses. To avoid price fluctuations (due to dollar
price) for the harvest at the time of delivery in March (6 month from
now), Renuka grains can enter into Forward contract.
3.) Renuka Grains cost of production is 70% of the sale price. Suppose the
company receives 1 million INR order and the current USD to INR
exchange rate is .017 (i.e. 1 INR = .017 USD). The cost of production
of this order will be $ 11,900 (0.017 X 1MM X 0.70).
4.) If the exchange rate stays at 0.017, then Renuka will convert the 1 MM
INR to $17,000 USD and earn a profit of 30% on cost of production.
5.) If however the exchange rate falls to 0.010 in March, Renuka will
convert the 1MM INR to only $10,000 which will result in loss of $1900
(from production cost).
6.) Conversely, if the exchange rate rises (rupee appreciates) to 0.02 six
months from today, Renuka will convert the 1MM INR to $20,000,
registering a good profit which will be over and above 30% expected
on sale of wheat.
7.) As this company doesn’t have expertise/experience in forecasting
exchange rate on produce 6 months from now, they should mitigate
risk by forward contract.
8.) This will involve Renuka Grains to enter into contract with
prospective buyer in USA, in which Renuka Grains agrees to
deliver produce (worth 1MM INR) to buyer in March (6 months from
now) in exchange for fixed number of dollars.
9.) Regardless of what is the rate at the time of delivery, the agreed
output (with quality) will be delivered to buyer and money will be received
by Renuka Grains.
Future Contracts
1.) Unlike forward contracts, future contracts are traded in exchange
houses and therefore are standardized contracts.

4. 2.) The clearing (exchange) houses assure that the transactions
committed are fulfilled and this reduces the probability of non-
payment (risk) to almost never.
3.) The agreement between the parties has a short position - the party
(farmer) which agrees to deliver a commodity and a long position - the
party (buyer) which agrees to receive the commodity.
4.) The other characteristic of future contract is that their settlement and
delivery is quite different.
5.) These future contracts are traded in exchange (market) daily, it means
that they can change hands daily which and are settled day by day
until the end of the contract date. Thereby, settlement for futures
contracts can occur over a range of the dates before the final date of
contract.
6.) As futures contracts are quite frequently speculated by buyers who
want to put money on the direction in which price of the
commodity will move. Because of this, the contracts are usually closed
out prior to maturity and delivery usually never happens.
7.) Pricing in future markets is done based on bids and offers that are
matched through computerized systems or open cry system.
8.) Everything is specified in every futures contract - the quantity,
quality of the harvest (different quality of commodity is traded), the
price per unit, and the date and method of delivery.
9.) The price of a futures contract is represented by the agreed-upon
price of the underlying commodity that will be delivered in the future.
Future contract explained with an example
1.) In the example explained, the value of the contract is 10 quintals of rice
at a price of Rs. 25,000 per quintal.
2.) Rice farmer needs to plan and secure a selling price for next season's
harvest and earn profit. Suppose the cost (to farmer) to harvest a
quintal (100 kg) of rice is Rs. 20,000 and the date of delivery is May
next year.
3.) With the future contracts for rice being traded and negotiated at
Rs. 25,000 per quintal, farmer can earn profit of Rs. 5000 per quintal.

5. 4.) Under the future contract, farmer would sell the May futures contract
for 25,000 and the buyer would accept the delivery of 10 quintals
(size of contract) in May.
5.) If the price of rice on exchange falls to Rs. 18,000 per quintal, farmer
will still earn profit of 5000 per quintal because the buyer of the
contract has agreed to pay the amount of Rs. 25,000 per quintal.
6.) On other hand, if the price of rice on exchange increases to Rs.
30,000 per quintal, the rice farmer would still receive 25,000 per quintal.
In such case, it is the buyer who benefits when rice price increases
above Rs. 25,000. Buyer will pay the price of the contract Rs. 25,000
per quintal and immediately sell the rice in market for Rs. 30,000
and earn a profit of Rs. 5000 per quintal.
7.) With this method, farmers can safeguard themselves from price
fluctuations for future harvests and other hand, speculators can
benefit from hedging their positions in an opposite direction.
Conclusion
Both the instruments, forward contracts and future contracts are
extensively used by farmers across the world to secure the price for
their harvest.
Though these instruments are available in India but due to lack of
knowledge and education, farmers in India end up selling their produce
cheaper or through the middle agents in the market.
Government of India should take initiatives to help farmers secure
the price for their harvest through these instruments and it would be
win-win situation for both farmers as well as speculators in future options
market.

6. Financing Options
Introduction
To grow their business, companies are in constant need of funds. At
times, the future growth of these businesses (companies) is hampered by
lack of funds.
Financing is more difficult for a company which has not made enough
profits in past. No investor wants to risk their money in a company if
they don’t see huge profits in it.
So there are very limited options of financing as these companies that seek
capital for growth are not good applicants to borrow additional capital.
This may be due to instability of the company's earnings or because of
existing debt levels of company.
Need for growth capital
1.) For growth, the companies need expansion capital.
2.) Being matured company, it needs capital to expand or enter new
markets, restructure operations, new product development,
purchase new equipments or to finance an acquisition. This
financing should happen without hampering the control of the existing
business.
3.) These companies look for expansion capital in order to finance a
transformational event in their lifecycle.
Funding Options
1.) As the companies are not much established and lack in scale, they
generally have very few options/channels to secure capital for growth.
Such companies should structure the flow of funds through below
options. This will help them grow and plan their business expansion as
required.
a.)Common Equity
b.)Hybrid Securities
2.) Mostly growth capital is done through common equity but few
investors prefer Hybrid securities over common equity. Hybrid
securities have a contractual return (interest) in addition to ownership
rights in company.
3.) Growth capital is also provided by a variety of other sources i.e. private
equity and venture capital. The financers that provide expansion
capital to companies rely on both equity and debt sources. These
instruments include private equity, late-stage venture funding,

7. hedge funds etc. Even the traditional firms invest in growth capital
where debt funds are less as compared to equity funds. Investors
usually invest in growth capital in either of below conditions of the
company.
• Company that is having positive cash flow or is profitable or
approaching profitability in near future.
• Company does not have initial institutional investments and is
owned by founder.
Common Equity (Stock) Capital Option
1.) Company should issue stocks either in open market through IPO or
for investments through private institutes.
2.) Stock will take the form of shares of either common stock or
preferred stock. These shares represent the right of ownership in a
business based on the number of stock a person owns.
3.) The stock of a company is nothing but ownership rights of the investors in
company. It represents the assets of the company which will remain
after discharge of all claims such as secured and unsecured debt
and is due to stock holders.
4.) To issue equity, company needs to do the due diligence to comply
with IPO or investment norms stated by financial regulator in
their country.
5.) It needs to fix the number of equity to be issued and the base price
of equity. This will be determined on the kind of capital company needs
for its growth.
6.) Company can issue different classes of shares and each having
distinctive ownership rules, privileges and share values.
7.) Preferred stock are different from common stock i.e. they do not carry
voting rights but entitled to get regular dividends before any
dividend is issued to other shareholders.
8.) Company can also plan to get funds by issuing equity to its
employees who know the potential of the company.
9.) Based on the capital required, company will issue the number of
shares. If the company floats an IPO, it will be then a public traded
company. Shareholders will get dividend as and when company
makes profit and also shares can be sold in exchange for money. It
is just that equities will change hands. Shares of stock holders cannot be

8. withdrawn from the company in a way that is intended to be harmful to
the company's creditors.
10.) Company can make use of similar approach for any future need
of capital. It can issue additional shares as authorized by existing
shareholders.
Hybrid Securities Capital Option
1.) Companies can also issue Hybrid securities to for their growth
capital needs.
2.) Hybrid securities are group of securities which has combination of
elements of both group of securities i.e. equity & debt. They pay a
fixed rate of return (interest or dividend) until a certain period at
which point the equity holder can convert the security into
underlying share. In this case, equity holder is assured of cash flow and
option to convert to underlying share.
3.) The other form of secured equity is convertible bonds which are
issued in market. These bonds can also help company raise the required
funds.
4.) This company needs to study and analyze its market, balance sheet,
cash flow statement and profits to decide the kind of equity to be
issued in market and its quantity and price.
Company can issue either common or Hybrid equity as per its need.
After issuing the equity in market, company will get the required capital
to expand its business or enter new markets or for new product
development.
Equity fund is simplest and quickest way of getting funds from the
market for companies which do not have enough profits to showcase to
investors. Similar approach is to be followed for any future capital
needs of the company. This would help company scale and move to much
larger profits.
Finance Stages of established firms
There are different stages at which finance is needed and provided to
firms. It starts with funding the idea of a new venture to funding an
established company.
1.) The first stage funding is at seed stage which represents the initial
capital required for product or service development, market
research and recruitment. This fund comes from entrepreneur savings,
from friend and family. It is also called preliminary round of funding.

9. 2.) The second stage funding is when venture is to be launched full
fledged. At this stage, business sees its first revenues but no profit.
It is also known as Series “A” round of investment. The sources of
fund at this stage are usually Venture Capitalists.
3.) Once the company is established and the business model is successful,
it requires series “B” round of investment or second stage of
funding. This funding is required by company to further develop their
marketing plan, hire more resources and manage and establish
strategic alliances in the market to grow.
4.) The next stage is more towards securing line of credit from banks.
At this point, cash flow of company is at break-even. No investors are
involved at this stage of the company.
5.) Further the company needs third round of funding for increasing
their profits and revenues which is also called the series C round
of funding. At this stage, company wants to expand its operations at a
faster pace. Internal Funds (profits and lines of credit) available
with the company are not sufficient enough to support the
development of new assets and increase the company’s
capabilities/scalability required for stronger growth of sales.
During this stage, the company seeks to raise external round of
capital from investors, finance companies and banks. This capital
will be used to ramp up existing operations and help establish the
company to a signification position in the market. The source of
capital at this stage is institutional or corporate investors or funds.
6.) There are other companies which after the Series A and B round
funding, look forward for plans to be acquired or issue public IPO
of common stock. This will help them grow their business and further
establish in market. This stage of funding is usually for short term debt
and also known as bridging or mezzanine financing.
7.) Company should be clearly aligned for each stage of funding. The firm
should be valued and accordingly funds should be raised. Having
too many rounds of funding can dilute the stake of founders in the
company.
8.) Also excess funding from banks or other finance companies can hamper
company’s growth because of interest paid to them.
9.) It is also important for company to avoid an early IPO if the firm's
positioning in the industry is not assured.

10. 10.) Some of the firms attain growth through internally generated
funds and avoid external investors. The idea is to know your business
plan (growth track), analyze the sales and profit benchmarks and be wise
in valuing at each stage.
Conclusion
The most important point in funding is to spend the time necessary to
prepare detailed business plans for both operational as well as
financial requirements, incase of external funding.
Investors, finance companies and banks are interested in studying the
company’s business plans before funding them. So companies
should strike a balance between its growth plans and funds
options from external sources. Setting the right tone on business plans
with the investors is key for good funding.