Integration of Spot and

Futures – Challenges
and Way Forward

Dr. Raushan Kumar Dr. C. S. C. Sekhar

Assistant Professor, Professor, Institute of
Zakir Husain College Economic Growth,
(Evening), University of Delhi
University of Delhi

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 COMMODITY INSIGHTS YEARBOOK 2018

Raushan Kumar is an assistant professor with Department of Economics, Zakir Husain Delhi College (eve),
University of Delhi. He received his B.A. (hons.) degree in Economics from Ramjas College, Delhi University;
M.A. and M.Phil. degrees in Economics from Jawaharlal Nehru University; and M.Sc. degree in Economics
and Financial Economics from University of Nottingham, United Kingdom. He has recently submitted his
Ph.D. thesis in Department of Economics, Delhi School of Economics. His research interests are in the areas
of agrarian issues, futures markets, applied econometric time series and forecasting, and has
publications in international and national refereed journals. Raushan Kumar may be reached at
raushanecondse@gmail.com.
C. S. C. Sekhar is currently Professor of Economics at the Institute of Economic Growth (IEG) and Honorary
Director of Agricultural Economics Research Centre, University of Delhi, India. He received his Ph.D in
Economics from the Delhi School of Economics and degree in Law (LL.B) from Delhi University. His areas of
teaching and research are Applied Econometrics, agricultural markets & price formation, international
commodity markets and agri trade. His other areas of interest include political economy and issues related to
governance. He is a recipient of the prestigious Fulbright-Nehru Senior Research Fellowship in 2012-13; DK
Desai Award for the best research paper in Agricultural Economics in 2003 and was also a medal finalist at
the GDN (Global Development Network) conferences in 2004 and 2008. Several of his research papers have
appeared in national and international journals of repute. He also contributes articles on contemporary
issues to popular national newspapers regularly.

There are two important social benefits efficiency of both futures and spot
Spot and futures markets are two of futures markets – hedging1 and price markets. Therefore, better efficiency in
segments of commodity market. discovery. Price discovery is the these two markets could benefit all the
Futures market helps in price capability of the market to determine market participants, viz., traders,
discovery and risk management accurate equilibrium prices (Garbade millowners, consumers, farmers, etc.
through hedging. Both spot as well and Silber 1979, 1983). Price discovery
as futures market function in the context of spot and futures The agricultural and allied sector
separately, however, the effective markets suggests that the two markets contributes to 16.1 percent of India’s
performance of these two markets in have a long-term relationship. There GDP, and it provides employment to
themselves and compared with may be short term deviations from this 54.6 percent of the workforce
other, will boost the overall working long-term relationship, but arbitrage (Government of India 2018). There are
of the commodity ecosystem, and will restore the long-term relationship. numerous sources of income for
benefit all market participants. In If there is disequilibrium between the agricultural households, however, a
this study we examine the spot and futures markets, the major part of their income comes from
integration of both spot and futures ‘dominant’ market stays put, whereas agricultural and allied activities.
markets for agricultural as well as the ‘satellite’ market usually (always) In spite of the considerable growth2 in
non-agricultural commodities. adjust towards it. As a result, the agricultural sector, the continuous and
satellite market reveals the price in the permanent increase in farm income
dominant market with a lag (Kumar remains a formidable task. The status
INTRODUCTION 2017). quo of the farmers, more specifically,
There are two segments of agriculture needs to be examined anew.
commodity market – the spot and Given that the futures markets perform
futures market. While these two their economic role of price discovery, Doubling Farmers’ income, therefore,
markets function differently from it implies that at the time of expiry of has come to the centre stage of policy
each other, they are futures contracts, futures price equals formulation at present. Despite the
interdependent as futures market spot price. However, the spot prices of fact that there are several ways of
is anchored on the spot market. a commodity determined in a increasing farmers’ income – for
In this study we focus on the competitive manner on a pan-India instance, by increasing yield, bringing
integration of spot and futures electronic spot exchange will definitely efficiency in input use, changes in
market for agricultural and non- improve the convergence of futures cropping pattern, there is still
agricultural sectors. and spot prices, and thus improve the considerable possibility of better price

1. Mitigation of price risk known as hedging.

2. There has been an increased demand for high value commodities, and also higher international price for agricultural commodities.

75
 COMMODITY INSIGHTS YEARBOOK 2018
realizations by the farmer. In order to
make certain that farmers get better
prices, there is a need to set up
transparent liquid, and efficient spot as
well as futures market.
Participants in both agricultural and
non-agricultural sector make use of
commodity market for various
purposes, for instance, price discovery,
hedging, meeting export requirements,
production and stock management,
transparency in dealings, safety against
inflation, etc. In order to deliver these
benefits in a continuous manner, it is
essential that the both spot and futures
market are integrated. This integration
will help the spot market participants
to derive the maximum advantages (in
terms of hedging and marketing) from
both markets.
The paper is organized as follows.
Section 2 describes the need to
integrate futures and spot market, and
provides its theoretical underpinnings.
Section 3 discusses the literature
review - price discovery in Indian spot-
futures markets. Section 4 discusses
the challenges, suggestions for the
integration of agricultural futures and
spot markets. Finally, Section 5
describes the non-agricultural
commodities: Challenges, suggestions
for the integration of futures and spot
markets.
NEED TO INTEGRATE FUTURES AND
SPOT MARKET: THEORETICAL
JUSTIFICATION
Spot price is the market price that is
paid for immediate delivery of the
commodity.
transparency
safety against
inflation
production and
stock management
It is different from futures price, which
is the agreed-on price that is paid upon
for delivery of the product in future.
The futures price and the spot price of
a commodity are related by cost of
carry relationship. The cost of carry is
the net cost incurred in possessing a
futures contract. Theoretically, futures
price is equal to sum of the spot price
and carrying charge (Working 1948).
The carrying charge is the cost of
carrying the commodity from the date
of purchase to the date of delivery of
the commodity. Carrying charge includes
financing costs, storage costs, etc.
If there is a violation of the cost of carry
relationship, then there exist a
profitable and risk-free arbitrage
opportunities. For instance, if the spot
price is less than the futures price, then
arbitrageurs will purchase physical
wheat and sell wheat futures at higher
price at the same time.
Arbitrageurs then deliver the physical
wheat in accordance with the obligation
of futures contracts. The profit to the
arbitrageurs would be the difference
between selling price and purchase
price minus any cost incurred in either
the transaction or in the delivery of the
product on the expiry of futures
contract (Edward and Ma 1992, p.80).
Futures markets perform the economic
role of hedging and price discovery.
Role of Futures Market in Price
Discovery
Futures markets are beneficial for our
society because they perform the
economic function of price discovery.
The trading of futures contracts take
USES OF
THE
COMMODITY
DERIVATIVES
MARKET
76
place in a competitive and transparent
manner on organized exchanges.
Usually, trading of a number of futures
contracts on a crop occurs
simultaneously, and the delivery time of
each contact is not the same. Therefore,
at any given time, there are several
contracts for that crop. For instance,
there can be 5 futures contracts for
wheat at any point in time.
Delivery to each contract can happen
in one of the next 5 months.
Subsequently, at any time, there are
five prices of wheat futures contracts
(Edward and Ma 1992, p.164). These
prices are the outcome of competitive,
open and transparent trading in the
organized exchanges. These contract
prices point towards the underlying
demand and supply for a crop, both at
the present and in the future.
This process of revealing information
about spot prices, and of making it
accessible to the whole world is
referred to as the price discovery. It has
two dimensions. First, it gives
information about current spot prices.
Second, it also gives information about
expected spot prices.
(a) Current Spot Prices
In spot markets, dealers trade the
commodities. These dealers quote
their own prices. These prices differ
from one other either due to
different geographical locations or
consumers are ignorant about the
price differential. For instance, a
mill owner must survey all the
‘mandis’ (auction markets) so that
he procures the wheat at lowest
price discovery
hedging
meeting export
requirements
 COMMODITY INSIGHTS YEARBOOK 2018
price from the dealer. But, surveying
the mandis is both time consuming
and expensive. The mill owners can
compare the spot price of the
wheat with the futures prices
(nearby contract) which are easily
accessible. If the price of the nearby
futures contract and spot price is
different, then arbitrage will take
place. Thus, the difference between
spot and futures prices cannot be
over and above the amount
necessary to effect the spot-futures
arbitrage3. We can say that futures
price for a commodity ensures that
spot price of that commodity will
remain the same in a region, or will
not differ by more than the
transportation costs incurred in
moving the commodity from one
place to other.
Therefore, the spot price of a
commodity reflects its centralized
demand and supply, and this has
been brought about by futures
contract for that commodity. The
homogeneity and accurateness of
the spot prices in revealing
centralized demand and supply is
welfare improving because it helps
individuals to avoid expensive
searches in assuring themselves
that they are paying reasonable
prices.
(b) Expected Spot Prices
Futures markets also give
information about the expected
spot prices. There is simultaneous
trade of several futures contracts,
each calling for delivery at different
points in future. Therefore, futures
prices reflect the expectations
about the spot prices at various
points in the future. It also implies
that futures prices reflect the
expectations about the demand
and supply of the commodity at
various points in the future. Futures
prices that are lower (higher) than
current spot prices indicate the
expectation that there will be
relative surplus (shortage) of the
product in future.
The information about the future
spot price will benefit the society in
3. Futures price = spot price plus carrying charge.
two ways. First, expected spot price
determines the storage decisions.
Higher futures prices indicate the
requirement for higher storage,
while lower futures prices signal
towards reducing the current
inventories.
Second, advance information based
on the futures price (expected spot
price) has its impact on the
economic decisions such as
production and consumption. The
knowledge about the expected
spot prices helps in smoothing the
supply and demand over time.
Higher futures prices indicate the
requirement for more production of
the commodity in the future, and
low futures price signal the need for
less production in the future.
In the same way, futures prices
provide indications to consumers
also. The consumers can choose
between the current consumption
and future consumption, based on
the signals from future prices
(Edward and Ma 1992).
SOME IMPORTANT WORK ON INDIAN
SPOT-FUTURES MARKETS
Sahadevan (2002a, 2002b) finds that
the futures market does not perform its
role of price discovery and hedging in
agricultural commodity markets. The
problems with exchanges and
regulators are stumbling blocks in the
growth of futures markets in India. Naik
and Jain (2002) examined six
agricultural commodities traded on
various regional exchanges and find
that these markets are still in nascent
stage and are not performing their
77
Futures markets also give
information about the
expected spot prices.
There is simultaneous trade
of several futures contracts,
each calling for delivery at
different points in future.
economic functions of price discovery
and hedging. Kabra (2007) supports
these conclusions that the futures
market have not proved to be an
effective instrument of risk
management and price discovery for
the benefit of all the stakeholders.
Dasgupta (2004) firmly refutes these
findings. Dasgupta finds that there is
clear correspondence between spot
and futures prices but an increase in
profit by increasing price is not
possible because of a larger
proportionate increase in production.
The study also finds that an
unnecessary hoarding will increase the
carrying cost leading to a lower
responsiveness of inventory to futures
prices.
Karande (2006) examined the causal
relationship between spot and futures
castor seed market, and found the
unidirectional causal relationship from
futures to spot market. Iyer and Pillai
(2010) examined the price discovery
role of futures prices in six
commodities, and found that futures
markets perform its role of price
discovery in five out of six
commodities.
Mahalik, Acharya and Babu (2010) have
investigated the price discovery and
volatility spillovers in Indian futures
and spot commodity market. They
have taken the data from June 2005 to
December 2008 and employed
Augmented Dickey-Fuller (ADF) test,
Phillip Perron (PP) test and error
correction model (ECM). They have
found that the price discovery takes
place in futures market and not in spot
market in Indian commodity market.
 COMMODITY INSIGHTS YEARBOOK 2018

Shihabudheen and Padhi (2010) commodity futures markets perform its there is the issue of data relating to the
analysed the price discovery and role of price discovery. agricultural production and prices.
volatility spillovers for six commodities, Lastly, there is the problem of price
viz., gold, silver, crude oil, castorseed, Kumar (2017) examined the dynamic volatility.
cumin and sugar. They found the relationship between spot and futures
causal relationship from futures to spot prices of agricultural commodity. He Roadmap for Integration of Spot and
market for all crops except sugar. employs linear as well as non-linear Futures Agricultural Commodity
(non-parametric) causality test on both Markets
Ali and Gupta (2011) investigated the spot and futures returns. He finds The authorities need to take certain
efficiency and price discovery in twelve nonlinear causal relationship from measures to overcome the above
agricultural commodities. They find the futures to spot returns, but no challenges and integrate the spot and
causal relationship from futures to spot evidence of nonlinear causality from futures markets. These measures are
market in some commodities, spot to spot to futures returns. classified into short term, medium and
futures in some commodities, and long term5.
bidirectional causal relationship in CHALLENGES, SUGGESTIONS FOR
some agricultural commodity markets. INTEGRATION OF AGRICULTURAL The short-term measures are as
Sekhar and Hashim (2013) find little FUTURES AND SPOT MARKETS follows. First, there is need for reforms
evidence of futures prices leading to a There are following challenges in the in spot market. There is need to reform
rise in spot price in wheat and soya integration of spot and futures the APMC Act. The change in APMC6
markets although some effect of markets. First, there are legal issues. Act is needed on the lines of
futures price on spot market cannot be There is lack of central law in the Agricultural Produce and Livestock
ruled out in the chana market. Some country for establishment of pan-India Marketing Act (APLM)7. Second,
useful references to work on futures electronic spot market. In addition, farmers should be allowed to sell their
markets in other countries, particularly there are multiple regulators in produce through multiple nodes. Third,
the US, can be found in this study. commodity market. SEBI4 regulates the authorities should set up Pan-India
commodity futures markets whereas electronic spot exchange. Fourth, there
Aggrawal, Jain and Thomas (2014) the state governments control the is need to develop warehouses and
investigated the price discovery and agricultural spot markets. Second, the storage infrastructure. Fifth, there is a
hedging effectiveness of Indian present APMC Act allows the farmers need to set up Farmers’ Producers
commodity futures market. The study to sell their products through only Organizations (FPOs). The average land
takes six agricultural commodities and notified mandis. This deprives the holdings in India is very small.
two non-agricultural commodities. The farmers to get better price through Therefore, the farmers are not able to
study finds that Indian commodity alternative channels. Third, there is the reap the benefits of economies of
futures markets perform its role of problem of small landholding size in scale. In addition, small farmers sell
price discovery. Sehgal, Ahmad and India. Besides, small farmers sell their their product in market yard where
Deisting (2014) examined price product in market yard where they get they get low prices. Through FPOs,
discovery and volatility spill over in low prices. Fourth, there is the problem farmers will be empowered.
Indian agricultural commodity of warehouses. Fifth, there is the Furthermore, there should be
markets. They also find that Indian problem of assaying facilities. Sixth, exemption of stock limit in FPOs under

legal issues

the present APMC Act allows the farmers to sell their products
through only notified mandis
CHALLENGES FOR small farmers sell their product in market yard where
INTEGRATION OF they get low prices

AGRICULTURAL the problem of warehouses

FUTURES AND
problem of assaying facilities
SPOT MARKETS
the issue of data relating to the agricultural
production and prices

the problem of price volatility

4. SEBI stands for Securities and Exchange Board of India.

5. Short term measures can be implemented in less than a year, medium is one to three years and long-term measures require more than three years to implement the suggestions.
6. APMC stands for Agricultural produce market committee.
7. Ministry of Agriculture and Farmers’ Welfare, GoI has drafted the APLM act in association with state governments.

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 COMMODITY INSIGHTS YEARBOOK 2018

India does not have any yard stick for non-agricultural

CHALLENGES FOR commodity prices
INTEGRATION OF the spot market for non-agricultural commodities is
not organised
NON AGRICULTURAL
non-existence of regulator for non-agricultural commodities
FUTURES AND barring oil and natural gas

SPOT MARKETS high cost of trading in futures markets

ECA, 1955. Finally, procurement of markets. Therefore, authorities should spot market. However, the futures
agricultural commodities by the not disrupt the futures trading due to market is legalized by the Securities
government agencies should be in reasons such as production shortage, Contracts Regulation Act, 1956 (SCRA),
accordance with variations in price volatility, etc. and SEBI regulates it.
production and market arrivals. This
will help in stabilising the agricultural The long-term measures are as Second, storage facility is crucial
commodity prices. follows. First, farmers get better prices for the commodities. Warehousing
from assayed goods vis-a-vis non- Development and Regulatory
The medium-term measures are as assayed goods. Authorities should start Authority (WDRA) is the main agency
follows. First, the task to register and awareness programs among the for regulating storage for agricultural
control warehouses should be assigned farmers regarding the benefits of commodities, however, there is
to Warehousing Development and assayed goods. Second, authorities no such agency for non-agricultural
Regulatory Authority (WDRA). This will should develop the assaying facilities commodities barring oil and natural gas.
help in establishing a strong and in mandis, and it should be economical.
standardized warehousing infrastructure. Finally, there is high cost of trading in
Second, a number of warehouses Third, electronic exchanges should be futures markets (Government of India
should be set up all over India. Third, encouraged to enable direct selling by 2018). It discourages the market
the warehouses industry should be farmers. In addition, electronic participants from taking position in
given the status of infrastructure exchanges should be exempted from futures markets.
industry. Fourth, there is a need to paying fees to APMCs. Finally, with the
build up institutions that will collect intention of providing advantages of Roadmap for Integration of Spot and
and disseminate the spot prices data. eNAM8 to farmers, every eNAM should Futures Non-agricultural Commodity
There are wide fluctuations in prices of have cost effective warehouse facilities Markets
agricultural commodities. Therefore, in order to ward off distress sale. Also, We can integrate the spot and futures
authorities should announce advisories buyers should make prompt payment markets by taking the following
based on demand and price forecasts to farmers. measures. These measures are again
to stabilise the prices. classified as short term, medium term
NON-AGRICULTURAL COMMODITIES and long term. The short-term
Fifth, authorities should start option - CHALLENGES, SUGGESTIONS FOR measures are as follows. First, there is
trading in agricultural markets because THE INTEGRATION OF FUTURES AND no separate central government
it will further enhance the process of SPOT MARKETS ministry to control precious metals,
price discovery. Sixth, there is a need In case of non-agricultural gems and other non-ferrous metals. In
for greater participation of institutions commodities9, both spot and futures order to facilitate the growth of these
such as banks, mutual funds, insurance markets operate in isolation, however, sectors, there should a separate
companies, and Foreign Financial both markets are integrated with regulating ministry.
Institutions (FIIs), etc., in the international prices. This might be
commodity futures markets. It will because India does not have any yard Second, a few commodities like coal
enhance the liquidity of the futures stick for non-agricultural commodity and lead require superior and more
contracts. Seven, authorities should prices (Government of India 2018). nature friendly transport system
rationalise the cost of trading in the because transportation of such
futures markets. The Challenges in the integration of commodities have undesirable impact
spot and futures non-agricultural on the natural environment.
Finally, discontinuation in futures markets are as follows. First, the spot
trading affects the confidence of market for non-agricultural The medium-term measures are as
market participants, and which in turn commodities is not organised. There is follows. First, there is a lack of
impacts the efficiency of the futures no particular law related its trade in standardised storage facility for non-
8. eNAM stands for Electronic National Agriculture Market.
9. The non-agricultural commodities include gold, silver, aluminium, copper, lead, cobalt, zinc, crude oil, gasoline, etc.

79
 COMMODITY INSIGHTS YEARBOOK 2018

agricultural commodities. Producers
have their own warehouses which are
not regulated. WDRA should develop
rules for monitoring of warehouses
storing non-agricultural commodities.
Second, there should be greater
emphasis on recycling of base metals
and precious metals to remove the
problems of shortage and higher
prices. Furthermore, it will also create
new employment opportunities.
Authorities should make a clear policy
for the recycling of the scraps and
promote this industry with up-to-date
techniques.
Third, there is a need to develop
electronic commodity spot exchange
(similar to eNAM) for non-agricultural
commodities. It will help in better price
discovery.
The long-term measures are as
follows. First, in order to promote the
overall growth of these sectors,
authorities should build up ancillary
infrastructure, for instance, assaying,
refining and testing facilities, etc.
Second, Free Trade Agreements (FTA)
with some of the South Asian
neighbouring nations have
unfavourable impact on domestic
manufactures. Therefore, government
need to review the FTA. Third, research
and innovation should be given
priority in the field of non-agricultural
commodities. This will make the Indian
commodities competitive vis-à-vis
other international markets.

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