Financial Risk Management

Pricing of Orchard Forwards

Article Details

Pub. Date	: Sep, 2021
Product Name	: The IUP Journal of Financial Risk Management
Product Type	: Article
Product Code	: IJFRM30921
Author Name	: Rahul Rangotra
Availability	: YES
Subject/Domain	: Finance Management
Download Format	: PDF Format
No. of Pages	: 7

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Abstract

The paper analyzes the applicability of the conventional Cost of Carry (COC) model for pricing orchard forwards in India. Firstly, the paper discusses the assumptions of the COC model and the reasons for its non-applicability in orchard forwards. Secondly, it tries to develop a methodology to estimate the inputs required to apply the COC model in the case of orchard forwards in India. The major problems in using the model are estimating the spot price of the orchards, information asymmetry between the orchard owners/farmers and the dealers and assessing the COC. In the end, the model is modified so that it can be applied to calculate the price of orchard forwards.

Introduction

In India, a large number of farmers earn their livelihood from orchards. They always pray for a good harvest and high market price but lack professional knowledge of finance and financial markets. Without knowing the markets, most of the orchard owners sell the complete orchards in the forward market for one, two, or maximum for three years. The buyer (mostly dealers) of the orchard takes the responsibility to maintain it. Dealers are more knowledgeable than the farmers. They have information on demand and supply, transportation and storage cost, access to the different wholesalers in the country, etc. So, due to asymmetric information, dealers can earn a higher share of profit.

Further, for various reasons, existing forward pricing models in finance literature cannot be directly used to calculate the price of orchard forwards. This paper analyzes the applicability of the traditional Cost of Carry (COC) model for pricing orchard forward contracts. Also, an attempt is made to answer one crucial research question: how to calculate the forward price in the case of orchard forwards? (forward in which complete orchard, whether it is apple, almond or walnut or any other orchard, is an underlying asset). The paper tries to present a modified model to make it applicable in the case of the orchards in India in particular and orchards in other parts of the world in general.