Developing agriculture and capital markets in Bangladesh using derivatives

8/12/2019 Developing agriculture and capital markets in Bangladesh using derivatives

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Developing agriculture and capital markets in Bangladesh using derivatives

Irfan Ahmed

BUS 498.2

Dr. Mahbub Majumdar, Associate Professor

September 15, 2011


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AbstractWell-functioning markets provide choices and our agriculture and capital markets, need

development. For a country like Bangladesh derivatives can facilitate the growth of thesemarkets, by unbundling the risks associated with stocks and commodities. Traders will have theability to create efficient portfolios. The markets can become more complete and liquid.

Agricultural markets play a key role in the lives of poor people in Bangladesh. As a result, thedevelopment of efficient agricultural markets may have a large impact on the economicopportunities of rural households. The price volatility of rice (annualized standard deviation ofmonthly changes in the log of retail prices) in Bangladesh is high (17 percent) compared to 10.2percent in India (Mumbai) and 4.1 percent in China and small farmers bear the brunt of this risk.High retail prices do not prove to be an opportunity for farmers in Bangladesh. This representsthe unwillingness of the policy apparatus to adapt to a dynamic, innovating system. Bangladeshshould not wait for aid solutions, or cookie-cutter foreign expert policy prescriptions. In order forour economy to be structurally adjusted, the government has to remove itself from the businessof buying and selling which it does rather inefficiently and let market forces act. In this paper Ihave tried to show how a commodity exchange would be a simple application of the price

discovery mechanism in the context of rice, and how it can help protect farmers from the risk ofthe value of their crop going below the cost price of their produce. There were talks ofintroducing commodity derivatives but critics say that the government might have shelved theidea due to resistance from the business community.

The capital markets in Bangladesh are currently characterized by high costs of trading,wide bid-ask spreads, high volatility and inaccurate prices. According to my calculations, thecrash was a 6.36 standard deviation event (one out of 4.83 billion trials). The index was down by9% in a single day. An options market may play an important role in eliminating costly lower-tail outcomes that might cause financial distress or interfere with investment plans.


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Developing agriculture and capital markets in Bangladesh using derivatives

1. Introduction

Bangladesh has to learn that markets do not happen by themselves. Market prices are

well known to efficiently collect and aggregate diverse information regarding the economic

value of goods, services, and firms, particularly when trading financial securities (Hayek, 1945).

Getting markets right is not just about price incentives, but also investing in the right

infrastructure and the appropriate and necessary institutions to create favorable conditions in the

market. Well-functioning markets provide choices. Derivatives such as futures and options

would enable those who buy and sell commodities and securities in the market to manage price

risks, leverage returns and to discover the price at which those contracts settle as the due date for

fulfilling the contract approaches. Growth in derivatives turnover is also positively related to

trade, financial activity and per capita income(Mihaljek and Packer, 2010).

In this paper I have tried to show how a commodity exchange would be a simple

application of the price discovery mechanism in the context of rice, and how this approach may

yield significant advantages over traditional methods of trading. The traditional methods can be

more costly to implement, more time-consuming, and susceptible to high variability in prices.

Rouwenhorst and Gorton (2005) have shown that the average return of commodity futures

between 1959 and 2004 at 11% was almost equal to that of equities. Also, commodity futures

have historically been less risky than stocks, both in terms of volatility and downside risk.

Similarly, an options market may play an important role in quantifying risk and eliminating

costly lower-tail outcomes that might cause financial distress or interfere with investment plans.


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2. Literature review

The literature on derivatives is vast and addresses a broad set of instruments, many that

are beyond the scope of this papers main focus.However, there are several strands of literature

that are relative to my paper. The simple commodity exchange model for rice I have described

later is closely related to the literatures in rational expectations models with asymmetric

information and experimental markets. Also, behavioral critiques that have been leveled against

the efficient markets hypothesis in the financial economics literature (see, for example, Shefrin,

2005) apply to simple commodity exchange model as well. The results of Manaster and

Rendleman (1982), based on daily data, seemed to indicate that price changes in option markets

lead price changes in stock markets. Theoretical work has also advocated options as a useful tool

that allows investment managers to utilize information better, manage risk, and reduce

transaction costs (Stoll and Whaley, 1985).

3. Overview of Bangladesh and Elsewhere

According to information gathered by the IMF between 2000 and 2010 Bangladesh grew

at an average of 5.75 percent (constant prices). Despite this modest indicator, stringent regulation

has dampened the development of the countrys agriculture and capital markets.

Figure 1.Source:International Monetary Fund


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incentives and expectation of price changes. Rice prices shot up all over the country and the

ability to buy food fell among rural laborers, who typically lead a hand-to-mouth existence.

Bereft of wages following disruptions to agricultural activities due to the floods in the Northern

district, those workers could not buy much food and became victims of starvation. Information

that influences the ability to procure food should form the basis of policies.

Most Bangladeshis today, by far, are farmers [48.1 percent of total employment in 2005],

and most of Bangladesh's farmers are, by and large, small farmers in terms of land that they

operate [0.05 hectares per person, compared to 0.14 in India and 0.08 in China] and very small

farmers in terms of the capital they have at their disposal.

Table 1.

Tractors per sq. km of agricultural land

Bangladesh 0.0333 2006

China 0.3187 2006

India 1.4048 2003

Japan 40.7230 2005

Source:World Bank

Note. Due to the paucity of data the third column of Table 1 lists the most current instances in which both tractor and agricultural land data were

available.

Even though sixty two percent of agricultural land in Bangladesh is irrigated, compared

to ten percent in China, Bangladeshi farmers use some 165 kilograms of fertilizer per hectare,

compared to 468 in China.

The small farmer in Bangladesh today lives a life without much choice, and therefore

without much freedom. Even though productivity has increased over the years, farmers

livelihoods are still predetermined by the conditions of grinding poverty. Farmers come to the

market when prices are lowest, with the meager fruits of their hard labor, just after the harvest,


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because they have no choice. They come back to the market maybe months later, when prices are

highest and food is scarce, because they have to feed their families and have no choice.

Poor people spend a large proportion of their income for buying rice. The level of rice

production and prices is thus an important factor in determining the progress that can be made.

Keeping the price of rice low and affordable to the poor is imperative to poverty reduction and

currently there is a sustained upward trend in rice prices.

The real question is how these markets can be developed in Bangladesh to harness

innovation and entrepreneurship. The import value of agriculture products in 2006 was triple

what it was 1990. In order for our economy to be structurally adjusted, the government has to

remove itself from the business of buying and selling which it does rather inefficiently and let

market forces act.

Like its agriculture, Bangladesh's markets are highly under-capitalized and inefficient. It

is likely that only a fraction of agricultural output produced in Bangladesh even reaches the

market. Bangladesh's markets are weak not only because of congestion and telecommunication,

but also because of the virtual absence of necessary market institutions such as market

information, grades and standards, and reliable ways to connect buyers and sellers. The only way

people know what they are getting in terms of the quantity and the product quality is if they take

a look at what is inside the sacks. That actually has huge implications for the ability of markets

to quickly respond to price signals, and for instance, situations where there are deficits. It also

has very high cost implications. Another factor that may have cost implications is that grain

changes hands in its trajectory from the farmer to the consumer.

The literature suggests transaction costs of reaching the market, and the risks of

transacting in rural agriculture markets, are extremely high (see, for example, Gabre-Madhin,


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2001). Despite market liberalization in 1996, the persistence of high transaction costs have

resulted in limited arbitrage and weak investments by private traders, leading to weak

responsiveness to price signals and high price volatility, all of which have a negative impact on

smallholder producer livelihoods.

Table 2.

Annualized standard deviation of monthly changes in the log of retail prices of rice

Bangladesh (National Average) 0.1697 Aug 05- May 11

Bangladesh (Dhaka) 0.1817 Aug 08-Jul 11

China (Average of 50 main cities) 0.0409 Mar 09- Jul 11

India (Delhi) 0.0899 Feb 00- Jul 11

India (Mumbai) 0.1022 Feb 00- Jul 11

Source:Food and Agriculture Organization

The price volatility (retail) of rice in Bangladesh is high (17 percent) compared to 10.2

percent in India (Mumbai) and 4.1 percent in China and small farmers bear the brunt of this risk.

For their part, small farmers, who produce the bulk of our agricultural output in Bangladesh

come to the market with virtually no information at all- trusting that they are going to have some

sort of demand for their produce, and completely at the mercy of the merchants at the nearest

local market they know, where they are unable to negotiate better prices or reduce their risk.

Buyers and sellers here operate within narrow market channels, that is, only those channels for

which they can obtain information and in which they have a few trusted trading partners.

The variation in rice prices from year to year is as much as 46 percent annually. This kind

of market risk is inconceivable, and has direct implications for not only the incentives of farmers

to invest in higher productivity technology, such as modern seeds and fertilizers, but also direct

implications for food security.


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A farmers food security will be threatened if the price of the cash crop at harvest is

lower than expected or the retail price of food is higher than expected. Perishable crops imply

additional risk because their prices are more volatile, so the sale prices are more uncertain; the

crops may spoil before sale, and, in the absence of competition, farmers dont have the option of

returning to the market for better prices another day, so they may be forced to accept very low

prices.

Figure 2.Rice pricesSource:Food and Agriculture Organization

As can be seen from figure 2, in Bangladesh, wholesale and retail prices were

substantially higher than producer prices around the market. During the period (2000-2008),

wholesale prices and retail prices were higher than producer prices by 91.8 percent and 96.7

percent, respectively, compared to 42.7 and 61.5 in India. High retail prices did not prove to be

an opportunity for farmers in Bangladesh. Between 2005 and 2008 producer price represented

52.12 percent of retail price in Bangladesh, compared to 80.14 percent in India. The average

difference between retail prices and producer prices for Bangladesh during the period was 151.69

USD per ton compared to 60.63 in India.

The correlation between producer price and production between 1999 and 2008 was 0.73

for Bangladesh, which was statistically significant (p


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prices are typically dictated by supply, but it can be attributed to the gap that exists between

consumption and production and/or pricing inefficiencies.

4.2 Simple Commodity Exchange Model

Now the commodity exchange itself, the concept, is not new to the world. Trading futures

started in Japan on an island in Osaka called Dojima in the late 1600s. Dojima was the rice

center for Japan. The rice merchants would bring their rice to Dojima and sell them there. There

were big warehouses for rice, which would store it. Even though rice was harvested a few times

a year, people needed the food for the whole year and it had to be stored. That means there was a

storage business, as you had to keep it away from moisture, rot and vermin. It is a very important

business for any country. If it were not rice it would be some other grain. When people buy and

sell grain, they are thinking out at least how long the cycle is for one harvest. So, lots of contracts

were signed to buy and sell rice, but typically at some future date. There were lots of forward

contracts and lots of people trading in these. People would travel around from one warehouse to

another and they would get a different price from one or the other. They would wonder about the

price and would have trouble knowing the price, so someone had an idea to create a marketplace

for forward contracts. People would not have to go around a hundred different warehouses to try

and find the best price; also they would find out what the real price was.

Another thing they did in Osaka to create the central market was to standardize the rice.

They made a standard form of rice for delivery in their contract, which is important as there are

many kinds of rice, but they picked one and said this is what all our contracts are about.

Moreover, they had experts who could tell whether it was.

The futures market not only standardized the rice, but they standardized delivery dates

and delivery locations. It might not have been the rice you wanted or the date you wanted, yet


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somehow the market got going and got very big. It had a standard price and a liquid market. The

price in the futures market was the meaningful price. What ended up happening was that

everyone wanted to trade in the futures market and it became a huge market and then everyone

started watching the futures price.

With an exchange you do not know the counter party. You are buying and selling with

the exchange or the clearing house of the exchange. Since the exchange will honor any contract

you do not have to worry about the other side. That's another reason why futures prices are so

much more meaningful than spot or forward prices because there's no counter-party risk unless

you worry about the exchange itself.

An innovation that came about in this market was that buyers and sellers could transact

grain without actually having to physically or visually inspect the grain. That means that grain

could be traded across tremendous distances, and even across time. This innovation is at the

heart of the transformation of global agriculture markets. A rice exchange holds the promise of

determining current market price, thus allowing government to purchase without elaborate and

often costly administrative pricing formulas. It is one of the advantages of the exchange to attract

investors' money into the commodity it trades, thus relieving demands on the banking sector to

finance the trade in that commodity, much like the capital markets.

The commodity exchange model would be a simple application of the price discovery

mechanism in the context of rice, and this approach may yield significant advantages over

traditional methods of trading rice. The traditional methodologies can be more costly to

implement, more time-consuming, and susceptible to high variability in prices. The application is

motivated by the need for reliable, accurate, fast and economical means to gauge rice prices. It

relies on the belief that markets are efficient in aggregating privately held information such as


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consumer preference and expectation of consumer preference. It also uses the incentive-

compatible nature of markets, i.e. the fact that over- or undervaluing securities reduces the

market participants rewards, and the preferences of most participants to avoid time-consuming

traditional methodologies.

The essence of the rice futures trading methodology centers around the establishment of a

commodity exchange that trades rice contracts, each associated with an underlying quantity of

rice that can either exist or be at any stage of production. The most critical function would be the

settlement and clearing of trades. Commodity derivatives can involve the exchange of funds and

goods. The exchange will need to have a separate body to handle all the settlements, a clearing

house.

Upon entering the commodity exchange, each participant will maintain an initial portfolio

of cash and rice stocks. A typical objective of the commodity exchange process might be for

each participant to maximize the value of his or her portfolio, evaluated at the last price prior to

the closing of the market. Markets would typically be open for 4 hours. Participants will have the

opportunity to profit from trading and will conversely bear the risk of losing money. The

financial stakes in the model provide incentives for participants to reveal consumer preference,

process information and conduct research.

As in capital markets, commodity prices will be determined by supply and demand,

which depend on the participants evaluation of their own and others preference for the

underlying products contracts. Thus, at the market equilibrium, prices should fully reflect all

participants aggregate demand of the contracts instead of just being dictated by supply. Futures

traders would make trading decisions just as they would in a financial stock market: they will

assess the values of the contracts, sell overvalued ones and buy undervalued ones, essentially


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voting on the worth of the underlying products on the due date. In this way, a commoditys price

becomes a convenient index of a commoditys consumer value.

Market-based methods for eliciting information also have certain limitations. Unlike

typical marketing methods in which information is collected from individual buyers and

aggregated in subsequent analysis, the market method focuses on aggregate demand. Individual

heterogeneity is not captured well in the end, even though it enters the trading process in the

form of differences in commodity valuation. Commodity markets may be vulnerable to price

manipulations and speculative bubbles because the values of a commodity hinges on the

aggregate beliefs, which are endogenously determined within the same market.

Commercial speculation in agriculture has traditionally been used by traders and

processors to protect against short-term price volatility, acting as a sort of price insurance while

helping to set a benchmark price in the cash market. For commodity buyers and sellers,

commercial speculation is a form of price insurance. Non-commercial speculators will provide

capital to enable the ongoing function of the market as commercial speculators liquidate their

contract positions by paying for the contracted commodity or selling the contract to offset the

risk of other contract positions held. Non-commercial speculation is an investment, but one that

can overlap with the interests of agriculture when appropriately regulated.

Traders however, may form false beliefs that could cause prices to deviate from their

fundamentals and all of the behavioral critiques that have been leveled against the efficient

markets hypothesis, in the financial economics literature (for example, Shefrin, 2005) apply to

commodity markets as well. A frictionless market in which all information is freely available and

investors agree on its implications is not descriptive of markets met in practice, but the

conditions for a frictionless market is not necessary for market efficiency as long as prices reflect


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available information. As long as traders take account of all a available information, even large

transaction costs that inhibit the flow of transactions do not in themselves imply that when

transaction do take place, prices will not fully reflect available information. Similarly the market

may be efficient if sufficient numbers of investors have ready access to available information.

Disagreement among investors about implications of given information does not in itself imply

market inefficiency unless there are investors who can consistently make better evaluations of

available information than are implicit in market prices (Fama, 1970). These are however

potential sources of inefficiency. For these reasons, the market method must be applied with

caution, and the consistency of the results should be checked through other means of validation.

The efficient markets hypothesis can however inform a lot of regulation in the futures

market. The Securities and Exchange Commission and other agencies that regulate financial

markets have shown some faith in the efficient markets hypothesis.

Figure 3.

The blue line is the actual DGEN stock price index going back to 2003. The prices are

daily for Dhaka. I think it is better than the DS20 because the DS20 has only 20 stocks and

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

DGENorrandomw

alkw

ithtrend


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DGEN has four out of the five categories of listed shares and is representative of most of the

market. The circuit breaker mechanism whereby trading is halted until further notice from the

SEC is tied to the movement of the DGEN (+/- 225 points).The blue line here is history.

That pink line is a random walk which I generated on excel, because there's a random

number generator on Excel. I used the random number generator and plugged it into this formula

= (+ ). Past price information is already incorporated and the next price

movement is conditionally independent of past price movements. I put an upward trend to the

random walk because I think there is an uptrend to the stock market.

Figure 4. Correlogram of DGEN index (close), for the full period (2003-11)

Figure 4, obtained by acf(DGEN$Close), exhibits a gradual decay in the autocorrelations,

due to the trend, as expected. A gradual decay from a high serial correlation is also a notable

feature of a random walk series. The point here is that the pink and blue lines earlier look kind of

similar. It really looks like the market we have had. It might appear that the markets are crazy but

they are not. It is just that the market responds only to new information. New information is, by

its essence, unforecastable. The random walk is the efficient markets model that says you cannot

profit by trading because you just cannot predict the changing price.

0 5 10 15 20 25 30

0.0

0.4

0.8

Lag

ACF


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The idea is that the only way you can beat the market is to get information that nobody

else has. Therefore, they feel that maybe their primary mission is to regulate the flow of

information to make sure that it is an even playing field so that everyone has access to

information at the same time. For example in the capital markets, the Securities and Exchange

Commission requires that when a corporation publishes information that is relevant to the value

of their stock, they have to put it out to everyone at once or there is rules about what that means.

The greatest level of vulnerability may occur when traders have a poor sense of their own

preference or of those of other people. This might occur, for example, if derivatives are too new

for traders to grasp, or when the information available prior to trading is unclear or confusing (as

I demonstrated in one instance earlier).

The simple commodity exchange model is closely related to the literatures in rational

expectations models with asymmetric information and experimental markets. In a standard

asymmetric information rational expectations model (Grossman, 1981), heterogeneous agents

with diverse information trade with each other and, under certain conditions, the market will

converge to an equilibrium in which prices fully reveal all relevant information, i.e., information

aggregation and dissemination occur successfully. The most important criterion for convergence

is that agents condition their beliefs on market information. In particular, agents make inferences

from market prices and quantities about other agents private information.

For instance, traders who possess superior information about the products or have high

confidence in their beliefs can be considered insiders. On the other hand, traders who have little

knowledge or opinion of the commodities can be regarded as the uninformed. The interaction

between the insider and uninformed constitutes information dissemination. What is intriguing

about this scenario is that even when a subset of traders ignores the underlying information about


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the commodity and only focuses on market information, the market still converges to efficient

prices that aggregate all the relevant information and beliefs.

Alternatively, individual traders may form their own beliefs about the commodity,

acknowledging that market prices will depend on aggregate beliefs. This is similar to the

information aggregation scenario in which there are no insiders, but where all traders are

partially informed. Even in this case, where no single trader has full information, a rational

expectations equilibrium will be reached under very general conditions (Grossman, 1981; Davis

and Holt, 1993).

The efficacy of commodity exchange markets at discovering price may not be

particularly surprising. Contract price corresponds to the average preferences of the

participants (Keynes, 1958).However, this is more accurate for describing what happens in

financial and commodities markets in the short run. After all, over the long run commodity

prices depend not only on investors subjective beliefs and expectations of others, but also on

other objective information. On the other hand, in the simple commodity exchange model

presented in this paper, the values of the commodities are derived endogenously from the

preferences of the market participants, and their expectations of others preferences, both of

which are largely subjective. To improve the reliability of commodity markets, one may need to

anchor the values of the commodity contracts to some objective fundamental variables of the

corresponding commodity or contract.

We should not try to cut-and-paste other models, but create a system uniquely tailored to

Bangladesh's needs and realities. Linking small producers to markets is widely recognized as a

valuable development trajectory. The exchange will need to operate a market information system

to disseminate prices in real time to farmers around the country, using very small aperture


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technology to bring electronic price dissemination directly to farmers. This will transform,

fundamentally, the farmers' relationship to the market. Whereas now the farmer will go to the

nearest local market and sell whatever he happens to have, without any idea of what the price

premium or anything else isfarmers will then come with knowledge of what prices are at the

market. They may start to make not only commercial marketing decisions, but also planting

decisions, on the basis of information coming from the futures price market. They will also come

to the market knowing what grades their products will achieve in terms of a price premium.

The exchange will hopefully transform farmers. It will also transform the way traders do

business. It will stop them from doing simple back-to-back, limited arbitrage to really thinking

strategically about how to move grain across long distances from deficit areas to surplus regions.

It seems very ambitious but it will create new opportunities. The initiative will require great

political will, and we will have to align the underlying legal framework.

5. Exchange-Traded Options

The capital markets in Bangladesh are currently characterized by high costs of trading,

wide bid-ask spreads, high volatility, and inaccurate prices. The size of the market is quite small

(market capitalization divided by GDP is 0.45) compared to China (0.81) and India (1.05).

You had some pretty angry investors who lost everything in the crash earlier this year.

To give a little bit of context, the crash was really an extraordinary event. According to my

calculations it was a 6.36 standard deviation event. One standard deviation happens one draw out

of three, two standard deviations one out of twenty two, three standard deviations is one out of

three hundred and seventy. A 6.36 standard deviation event happens once out of every 4.83

billion trials [1 in 1/ (1-erf(x/sqrt(2))), where erf is defined as function(x) 2 * pnorm(x * sqrt(2))

1]. In essence, this collapse in stock prices-the one-day collapse in stock prices- I think in


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Bangladesh the index, depending on which index you were looking at, was down 9% in a single

day. This one-day collapse in stock prices was a virtual impossibility. Of course, this was just a

change in stock prices; it wasn't related to any fundamental change in the economy or any

fundamental change in corporate prospects. It was just a financial event.

Figure 5.

The mean of the DGEN index dataset is also probably not stationary as the ACF earlier

did not tail off quickly. So I did some differencing to get it to become stationary. The plot of

iterated differences (Figure 5) no longer has a trend to it, but you can see these oscillating spikes,

and they keep getting larger and larger as we move from left to right which leads me to believe

that there is probably heteroskedasticity or non constant variance. The important thing to

understand here is that the variance is not constant through time; it moves around. There are high

difference periods for the index and low difference periods. I like this plot because it is

interesting. The first thing that is interesting is that, overall, the market has been remarkably

consistent for over eight years. There is only one thing that jumps out at you when you look at

this picture and that is the numbers at the end. That was the big crash earlier this year and

something went really haywire in the financial markets. It is suitably lagged so I am not sure


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exactly where it is, but something went really haywire after 2011 and the markets got

extraordinarily volatile for a while. That was a crisis period in history that shows up really well

on this picture.

The investor base in developing markets at times has been quite unstable. Since dedicated

investors typically have been a smaller proportion of developing markets asset holders than

cross-over investors, this makes developing markets assets too vulnerable to shifts in investor

preferences as a result of external shocks. Involved investors would improve the performance of

the country's fixed assets. This situation underlines the importance of risk management, namely,

the strategy of eliminating costly lower-tail outcomes that might cause financial distress or

interfere with investment plans. The development of a capital market within a country would

serve to make capital more readily available, and would thereby lower firms cost of capital

(Levine, 1991) and Allen and Gale (1997) model the benefits of a developed capital market as

the ability of market participants to diversify risks. People here are inherently hard working, and

being able to minimize the risk of losing their savings should be a basic human right.

Moreover, domestic market participants are concerned with the decline in liquidity in

regional stock markets. Bangladesh has a turnover of 0.54 compared to 1.64 in China and 0.76 in

India. Low turnover is often used as an indicator of high transactions costs. Bangladesh relative

to price changes also indicated fewer trades (turnover divided by volatility is 2.38) than China

(6.24) and India (2.61). More liquid markets should support more trading with less price

movement than less liquid markets (holding all else equal). Volatile capital flows, transaction

taxes and other controls, antiquated trading and settlement systems, as well as a lack of

protection for minority shareholders' rights, have contributed to this decline.


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Options are very old too, but they have emerged more recently as very important

contracts. In fact, what they did not have anywhere until recently is an options exchange. The

problem with a traditional option is that it is a contract between two parties. If you buy an option,

you are at the mercy of this other person. You bought this option to either buy or sell and then

when the date comes you cannot find this guy. You obviously were cheated out of your money.

So that was a problem until 1973, when the first options exchange opened.

The onset of options may cause some of the informed and speculative trading to shift

from the underlying securities market to the options market given that these investors view

options as superior investment instruments. This superiority stems from their inherent leverage

and lower transaction costs. The terminology may have to be simplified, for instance, buy and

sell options instead of call and put options, and the option contract itself could use info-graphics

for ease of understanding. The settlement of contracts could be handled by the exchange or the

central depository.

The migration of informed traders would reduce the information asymmetry problem

faced by market makers resulting in an improvement in liquidity in the underlying market. In

addition, it could also be argued that the migration of speculators would cause a decrease in the

volatility of the underlying market by reducing the amount of noise trading.

If the variance were zero, however, then options would just be the intrinsic value because

there is no chance for the stock to do anything unexpected. If it is out of the money and the

variance is zero, the option is worthless. If it is in the money and the variance is zero, then it is

worth something, but it's only worth the intrinsic value. If 2is 0, the price cannot move

anywhere, so there is no problem. As 2increases, the option gets more and more valuable; if it


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7. References

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Davis, D. and Holt, C. (1993).Experimental Economics. Princeton, NJ: Princeton UniversityPress.

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. TheJournal of Finance, 25(2), 383-417.

Food and Agriculture Organization of the United Nations. (2011).Data retrieved July 30, 2011,from FAOSTAT online database.

Gabre-Madhin, E. Z. (2001). Market institutions, transaction costs, and social capital in theEthiopian grain market. International food policy research institute, Washington, D.C.

Grossman, S. J. (1981). An introduction to the theory of rational expectations under asymmetricinformation,Review of Economic Studies, 48, 541-559.

Hayek, F. (1945). The Use of Knowledge in Society,American Economic Review, XXXV,No.4; September, 519-30.

International Monetary Fund. (2011). Data retrieved July 1, 2011, from World EconomicOutlook (WEO) online database.

Keynes, J. M. (1958). The General Theory of Employment, Interest and Money, HarcourtBrace.

Levine, R. (1991). Stock markets, growth, and tax policy. The Journal of Finance,46, 14451465.

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Appendix

Figure 1a.Production of the top 9 most important food and agricultural commodities (ranked by value) inBangladesh for the year indicatedSource. Food and Agriculture Organization

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