PRELIMINARY

DRAFT – TO BE
QUOTED WITH
PERMISSION
FROM AUTHORS
Commodity Derivative Market and its Impact on Spot Market
Golaka C Nath∗ and Thulasamma Lingareddy∗∗
Abstract
Nation wide trading in commodities futures in India was introduced for many
agricultural
commodities and later trading in futures was banned for few commodities
due to pressure
on spot prices of these commodities. The paper studies the impact of futures
trading in
three important commodities which were banned by the government from
trading in
futures and their impact on spot prices. The study uses simple linear
regressions,
correlations, Granger Causality tests to find the answer. The study also tries
to find if the
seasonal/cyclical fluctuations in these commodities prices have been
affected by the
introduction of futures in those commodities. Hodrick-Prescott filter is used
to
differentiate the general trend and seasonal/cyclical fluctuations in prices.
The finds that
in India future trading in the selected commodities had apparently led to
increase in
prices of commodities like urad but the same may not be statistically
true for other
commodities. However the study finds that introduction of futures in
selevcted
commodities have not helped in reducing seasonal/cyclical fluctuations in
prices. It also
finds that futures have increased the volatilities in the spot market for some
of the
commodities.
This Draft: January 2008
∗ Contact: Golak.nath@gmail.com
** tlingareddy@ccilindia.co.in) The views expressed in this paper are personal views of
authors and not
necessarily the views of the organization where they work.
Commodity Derivative Market and its Impact on Spot Market
A well developed spot commodities market with pure commercial interest
helps in
discovering the true price of commodities. An effective spot market is a
barometer for
efficient pricing mechanism as it is the market which is made of direct
participation from
farmers/producers, intermediaries, wholesalers, consumers, investors, etc.
However, spot
market will heavily depend on physical market infrastructure as well as cost
of moving
goods from one place to another, tax rate applicable to the particular
commodity, etc.
Traditionally agricultural commodities in India are in the domain of federal
states and
each state has its own tax and relief package for the commodities.
Agricultural marketing
has also been in the domain of federal Sates. Organised marketing of
agricultural
commodities has been promoted in the country through a network of
regulated markets.
Most of the federal States have enacted APMC Act to provide for regulation
of
agricultural produce markets. While by the end of 1950, there were 286
regulated
markets in the country, the same is 7,521 as of 31.3.2005. Besides, the
country has
27,294 rural periodical markets, about 15 per cent of which function under
the ambit of
regulation. These regulated markets have helped in mitigating some of the
problems, but
the rural markets by and large remained out of its developmental ambit.
Agriculture
sector needs well functioning markets to drive growth, employment and
economic
prosperity in rural areas of the country. In order to provide dynamism and
efficiency into
the marketing system, large investments are required for the development
of post harvest
and cold chain infrastructure nearer to the farmers’ field(reason why
cyclical prices volatility has not reduced)
. Enabling policies need to be put
in place to encourage procurement of agricultural commodities directly from
farmers to
establish linkage between the farm production and the retail chain and food
processing
industries. Amendment to the State APMC Act for deregulation of marketing
system in
the country is required to promote investment in marketing infrastructure
and to facilitate
a national integrated market. However, at present, the spot market remains
fragmented
and State specific and rural markets which contribute to the lion share of
physical
marketing infrastructure are projected as a market that enables movement
of agricultural
product directly to consumers from producers.
In the back drop of this, commodities derivative markets with nation-wide
connectivity
were introduced in India in 2003. Commodities derivatives market is not new
in India but
the scope was limited in older version of commodities derivatives market.
The older
commodities derivatives markets were restricted to few traders and had very
little
activity. The new generation commodities derivative markets brought new
technology
through which trading was conducted for various commodities including
agricultural
commodities. The new commodities derivative markets started with the
option of cash
and physical deliveries but brokers have opted for cash settlement and
hence physical
delivery is negligible. This fact supports the theory of limited physical market
infrastructure to support cost effective physical deliveries. Further, majority
of farmers in
India traditionally produce mainly for consumption and hence farmers have
not generally
participated in commodities derivative markets. Today, commodities
derivative markets
in India are dominated by speculating traders and brokers.
A well-developed and effective commodity derivatives market facilitates
price discovery
and thereby reduces price risk associated with extreme seasonal variations
in demand and
supply of commodities. Futures prices are generally referred as predictors of
future spot
prices (Samuelson, 1965) and tend to provide direction to spot prices
thereby helping in
price discovery as well as minimization of price fluctuations. Hence, price
determination
in derivatives markets becomes crucial as it sends signals to spot markets of
the
underlying commodities and the efficiency of a futures exchange depends
upon their
ability to ensure that the prices of the contracts traded on the exchange
reflect supply and
demand (World Bank, 1996). If the futures’ prices do not reflect the
prevailing demandsupply
situation due to any reason then they may tend to disseminate wrong signals
to the
spot markets and thereby lead to increase in price risk. In addition, increase
in price risk
could be witnessed in the conditions of deficit supply of commodities. A
similar concern
was expressed by the Khusro Committee in its report
“when everyone is expecting a price rise, both trend wise and seasonally, it
may
be thought that there are no dissenting opinions. All opinions would seem to
converge over a price rise. It is thought that under these circumstances if
speculators enter the futures market, they would also be buyers rather than
sellers
and their buying activity may further aggravate the price rise. The futures
prices
will then stand above the spot prices and would be rising over time” (GoI,
1980).
Govt. of India decided to suspend the futures trading in urad, tur and wheat
in early 2007
when the spot prices spurted significantly after introduction of futures
contracts in these
agricultural products. It was suspected that the futures trading in these
commodities had
led to increase in price risk of the underlying commodities and thereby
contributing to
inflationary pressure.
Commodity Derivatives in India
Commodity derivatives markets in India had a long history of more than a
Century since
the inception of Bombay Cotton Trade Association Ltd in 1875. Although they
flourished
after the independence particularly in the early 1960s, the shortages
cropped up in the
mid 1960s due to the war in 1965 and natural calamities, has led to ban of
futures trading
in 1966 in most of the commodities except pepper and turmeric.
Subsequently, based on
the recommendation of the A. M. Khusro Committee (1980) futures trading in
some
commodities like gur, potatoes and castorseed was permitted in the early
1980s.
Following this, the Kabra Committee (1993) recommended to permit futures
in 17
commodities and unanimously opined against granting permission for
futures in wheat,
pulses, nonbasmati rice, tea, coffee, dry chillies, maize, vanaspati and sugar,
on the basis
of a case-by-case review of the suitability of each commodity in the light of
its present
and likely position in the coming years (Kabra, 2007).
Nevertheless, the government issued notification on 1.4.2003 stating that
“Futures trading
can be conducted in any commodity subject to the approval /recognition of
the
Government of India. However, 91 commodities are in the regulated list and
they have
been notified under section 15 of the Forward Contracts (Regulation) Act.
Forward
trading in these commodities can be conducted only between, with, or
through members
of recognized associations. The commodities other than those are
conventionally referred
to as 'Free' commodities and forward trading in these commodities can be
organized by
any association after obtaining a certificate of Registration from Forward
Markets
Commission”. But, options and other derivative instruments are still not
permitted for
trade in Indian commodity markets.
Further, the government has also granted permission to set up modern
national
commodity exchanges in 2002. This step has led to the revival of futures
markets after
nearly 40 years and the national exchanges equipped with modern
technology helped in
taking futures markets to many targeted participants which were possibly
outside the
domain in the earlier era.
As a result, three national level and 21 regional futures exchanges have
become
operational providing trading platform for commodity futures. Total
commodities traded
on futures exchanges can be categorized into two major groups’ viz.,
agricultural and
non-agricultural commodities. Non-agricultural commodities can be further
categorized
into bullion/ precious metals, base metals, energy and polymer products
while
agricultural commodities can be grouped as cereals, oils & oilseeds, pulses,
fibres,
plantations, spices and others that include guarseed, mentha oil, potato,
sugar etc.,
Table 1: Trends in volume trade on futures exchanges
2002-03 2003-04 2004-05 2005-06 2006-07
Turnover
(Rs. crore)
66,530 129363 571759 2134471 3327633
Growth
(per cent)
92.8 94.4 342.0 273.3 55.9
Source: Annual Reports, Ministry of Food and Consumer Affairs, Delhi
Volumes on the national exchanges have picked momentum rather quickly
(Table 1) and
almost tripled consistently for two years in 2004-05 and 2005-06. Although
the growth
persisted in the subsequent period, it has apparently decelerated to about
55 per cent in
2006-07. Besides this, the functioning of futures markets has also come
under scrutiny
during 2006-07 due to some aberrations noted in trading of agricultural
commodities.
Subsequently, the government has ordered for delisting of futures contracts
in urad, tur,
wheat and rice during January and February 2007 with the suspicion that
futures trading
in these commodities has been contributing for the rise in prices of these
essential items.
Considering these developments in Indian commodities futures market, an
attempt is
made to investigate whether the futures trading in the selected commodities
has led to rise
or fall in spot prices and volatilities. Further, the study also tries to
understand as to
whether introduction of futures in agricultural commodities like wheat, gram
and urad
has removed seasonal/cyclical fluctuations in India.
The study is presented in four sections. First section provides overview of
Indian
Commodities Market, second section provides review of relevant literature
and the third
one gives the methodology used in the study and the fourth one discusses
about results.
I. INDIAN COMMODITIES DERIVATIVES MARKET
All the committees (including Khusro Committee-1980, Kabra-1993 and the
World
Bank-UNCTAD-1996) that studied the prospects of Indian commodity
derivatives
markets have strongly opposed the introduction of futures’ trading in
foodgrains and
sugar in view of the existing government controls and inadequate domestic
supply
situation in case of pulses. The presence of substantial government controls
on cereals
markets and inadequate domestic supply particularly in case of pulses
restrict the free
market movements and thereby hamper price discovery process in those
commodities.
Further, there are control price mechanism exists for sugar, rice and wheat
which are
made available to consumers through public distribution system. Further,
there is
minimum support price mechanism for procurement in case of the above
food grains
along with minimum support price (MSP) for pulses (procurement in case of
pulses is
virtually nil which may be due to lack of adequate supply that forces the
market price to
be higher than the MSP). There are regulatory limitations on imports and
exports of these
commodities. In case of food grains, most of the imports are routed through
Government
agencies. Sugar is also covered under free-sale quota declared by
government on regular
basis.
On the other hand, although the government has allowed futures trading in
all
commodities notifying a specific list of 91 as “regulated” and the rest as
“free
commodities”, the suitability of a commodity for trading in futures was
clearly described
by the Forward Markets Commission as follows (www.fmc.gov.in/faq).
“The market for commodity should be competitive, i.e., there should be
large
demand for and supply of the commodity - no individual or group of persons
acting in concert should be in a position to influence the demand or supply,
and
consequently the price substantially.
The market for the commodity should be free from substantial
government
control. The government intervention may adversely affect the price
discovery
process.
The commodity should have long shelf-life and be capable of
standardization and
gradation”.
In the light of these arguments, the economic rationale behind the
introduction of futures
trading in food grains, including wheat, rice, gram, urad and tur, was
analysed and
presented in the following paragraphs.
Market size:
The first and essential characteristic of a commodity for trading in futures
markets is the
sufficiently large market size so that prices cannot be influenced through
purposive
manipulation of demand and supply of the underlying commodity. The
supply and
demand data for the selected food grains are presented in Table 2. Since
there were no
precise estimates for demand, National Sample Survey Organization (NSSO)
estimates of
consumption were used to derive rough estimates of consumption demand.
The
consumption estimates were used to understand the balance of demand and
supply.
An overview of domestic production of the selected food grains indicated
that only rice
and wheat have sizeable and competitive markets while the markets for
pulses appear to
be relatively small with a deficit in domestic supply. The total market size of
urad and tur
during the lean season comes to about Rs 50 and Rs 100 crore respectively
across all the
markets in the country. In addition, the domestic production of urad and tur
is grossly
inadequate to meet the consumption demand and the imports account for
about 35 per
cent and 16 per cent of domestic supply respectively. Majority of these
imports come
from Myanmar on which no authenticated data for demand and supply are
available.
Initially, the futures contracts in urad and tur were offered exclusively for the
imported
variety but later modified to allow domestic varities. The total size of the
markets, as can
be seen from Table 2, is still very small.
Table 2: Trends in supply of major pulses
Value of output
(TE 2005-06)
Production
(TE 2005-
06)
Imports Stocks in
off-season
(25%)
Per capita
availability
Per capita
consumption
(2004-05)
(Rs Crore) % MMT MMT MMT Kg/year Kg/year
Urad 2089 0.45 1.4 0.5 0.4 0.93 1.2
Tur 3995 0.86 2.5 0.4 0.6 2.7 3.6
Gram 8612 1.85 5.6 0.3 1.4 3.5 3.1
Wheat 46808 10.1 74.9 5.5 18.7 54.1 53.3
Rice 74861 16.1 92.7 - 23.2 78.2 68.5
Notes:
1. Value of output is taken at current prices and the share indicates the proportion of
individual commodity
to the total agricultural output
2. TE 2005-06 indicates the triennium ending 2005-06 as the data were taken as averages of
recent three
years (2003-04, 2004-05 and 2005-06)
Source: Central Statistical Organisation, Department of agriculture and Cooperation, DG of
Foreign Trade,
GoI and Foreign Agricultural Service, USDA.
Government intervention
Traditionally food grains supply and demand has been regulated by the
government. The
RBI has a strong control over banks on “food credit”. However, slowly some
of the
commodities are coming out of controls. The controls had been implemented
to support
the farming of the commodities. Minimum Support Price mechanism is in
vogue for a
long time which gives the price at which Government will procure food grains
from
farmers. Government has been intervening to a large extent in the wheat,
rice and sugar
markets through procurement and open market sale operations whenever it
felt necessary
as these three commodities are backbone of Public Distribution System in
the country. A
concern was expressed in the report of the World Bank
“Indian agricultural policies for rice, wheat and sugar do not satisfy any of
the
minimum rules, making futures markets impossible. For other agricultural
commodities, notably cotton, oilseeds and their derived products, several
minimum conditions are satisfied. In their case, spot and futures markets can
be
allowed to develop in synergy” (World Bank, 1996).
Grading & standardization
Facilities of grading and standardization are prerequisite for futures trading
primarily so
that uniformity in the quality of the commodity exists across all the markets
and thereby
facilitating price discovery and delivery processes. Apart from the
infrastructure
requirement for grading and standardization, existence of a large number of
varieties
creates problems for futures trading as it happened in the case of non-
basmati rice.
Futures trading in rice could not gain any significant volumes due to the
presence of a
large number of region specific varieties which don’t have a common
benchmark variety
based on which the rest of the varieties can be priced with either premium or
discount.
Further, similar problem but at a lower extent could be noticed in case of
pulses as well
as wheat that creates problems during the physical delivery of these
commodities.
Thus, it is evident from the above mentioned facts that there is little
economic rationale
for futures trading in the food grains, more specifically wheat, rice, urad, tur
and chana
(gram).
Trends in agricultural futures trading
Indian commodity exchanges have the largest number of futures contracts in
agricultural
commodities compared to any other exchange in the world. Among a large
number of
agricultural commodities traded on futures exchanges, major volume has
been
contributed by only four to five commodities including guar, gram, urad and
to some
extent soya oil. Further, based on the data available from January 2005 it is
evident that
only volumes of guar seed, gram and to some extent soya oil were persistent
throughout
the period while that of other largely traded commodities including urad,
mentha oil,
pepper and jeera were shifting from one to other following the regulatory
measures such
as additional & special margins, positions limits, compulsory delivery etc.,
Table 3: Trends in turnover of agricultural commodities
(Rs crore)
Jan-Dec 2005 share Jan-Dec 2006 share Jan-Mar 2007 share
Agri 879149.1 100.0 1285372.0 100.0 245426 100.0
Guarseed 337844.9 38.4 326344.4 25.4 35766 14.6
Gram 166587.5 18.9 341035.7 26.5 40145 16.4
Urad 106012.3 12.1 145333.9 11.3 3004 1.2
Mentha Oil 19354.3 2.2 63041.6 4.9 11241 4.6
Tur All 24055.8 2.7 25696.7 2.0 2529 1.0
Soy Oil 67204.2 7.6 85861.6 6.7 28331 11.5
Guargum 35301.8 4.0 15980.5 1.2 1458 0.6
Soyseed 14493.9 1.6 22145.4 1.7 8620 3.5
Pepper 9213.0 1.0 60905.8 4.7 31891 13.0
Jeera 10879.8 1.2 33124.5 2.6 38241 15.6
Wheat 9072.7 1.0 28828.8 2.2 1409 0.6
R Chillies 3431.3 0.4 35432.6 2.8 6805 2.8
Source: Market Review, FMC (www.fmc.gov.in)
On the other hand, wheat and tur gained only about 2-3 per cent of total
volumes in
agricultural category and that too for only a short period. Thus, urad and
gram have
contributed for a major portion of volumes among foodgrains.
II. LITERATURE REVIEW
Survey of relevant literature on the impact of future trading on spot prices
indicated that
majority of them compared spot market volatility before and after the
introduction of
futures trading while some of them have investigated the impact of futures
activity on
spot volatilities.
Kamara (1982) compared cash market volatility before and after the
introduction of
futures trading and found that the introduction of commodity futures trading
generally
reduced or at least did not increase cash price volatility.
Further, Singh (2000) investigated the hessian cash (spot) price variability
before and
after the introduction of futures trading (1988-1997) in Indian markets using
the
multiplicative dummy variable model and concluded that futures trading has
reduced the
price volatility in the hessian cash market.
Slade and Thille (2004) assessed the levels and volatilities (means and
standard
deviations) of the spot prices of the six commodities that were traded on the
London
Metal Exchange in the 1990s. The theories that they examined could be
grouped into four
classes. The first considered how product–market structure and forward–
market trading
jointly affect the spot–market game, the second explored the links between
product–
market structure and spot–price stability, the third assessed whether forward
trading
destabilizes spot prices, and the last related the arrival of new information to
price
volatility and the volume of trade. They found support for traditional market–
structure
models of the price level but not of price stability. In addition, increased
forward trading
was associated with lower prices. Further, although they found a positive
relationship
between increased trading and price instability, the link appeared to be
indirect via a
common causal factor.
Worthington and Helen (2004) examines the relationship between futures
and spot
electricity prices for two of the Australian electricity regions in the National
Electricity
Market (NEM): namely, New South Wales and Victoria. A generalized
autoregressive
conditional heteroskedasticity (GARCH) model is used to identify the
magnitude and
significance of mean and volatility spillovers from the futures market to the
spot market.
The results indicated the presence of positive mean spillovers in the NSW
market for
peak and off-peak (base load) futures contracts and mean spillovers for the
off-peak
Victorian futures market. The large number of significant innovation and
volatility
spillovers between the futures and spot markets indicates the presence of
strong ARCH
and GARCH effects. Contrary to evidence from studies in North American
electricity
markets, the results also indicate that Australian electricity spot and futures
prices are
stationary
On the other hand, Yang et al (2005) examined the lead-lag relationship
between futures
trading activity and cash price volatility for major agricultural commodities.
Granger
causality tests and generalized forecast error variance decompositions
showed that an
unexpected and unidirectional increase in futures trading volume drove cash
price
volatility up. Further, a weak causal association between open interest and
cash price
volatility was also established.
However, Nitesh (2005) studied the implications of soy oil futures in Indian
markets
using simple volatility measures and concluded that the futures trading was
effective in
reducing seasonal price volatilities but did not brought down daily price
volatilities
significantly.
Sahi (2006) also studied the impact of introducing futures contracts on the
volatility of
the underlying commodities in India. Empirical results suggested that the
nature of
volatility did not change with the introduction of futures trading in wheat,
turmeric,
sugar, cotton, raw jute and soy oil. Nevertheless, a weak destabilizing effect
of futures on
spot prices was found in case of wheat and raw jute. Further, results of
granger causality
tests indicated that unexpected increase in futures activity in terms of rise in
volumes and
open interest has caused increase in cash price volatilities in all the
commodities listed.
The study has confirmed the notion of destabilizing effect of futures trading
on spot
prices of commodity.
Sahi and Raizad (2006) studied the impact of commodity futures on welfare
and inflation
in the economy. They have estimated the efficiency of futures using the
Johansen’s
Cointegration for different forecasting frequencies. Their results suggested
that the wheat
futures were not efficient even in the short term. Further, they concluded
that the price
discovery was poor and the higher volumes in futures markets had a
significant causal
impact on inflation.
III. DATA AND METHODOLOGY
The study covers three important commodities: urad, gram and wheat. All
these
commodities are used are staple diet in all parts of India though not
produced in all parts
of the country. Spot price data for the analysis of trends in pre and post-
futures trading
were not available from any authenticated and reliable sources particularly
for the period
prior to futures trading. Hence, the Wholesale Price Index (WPI) series,
compiled and
published by the Central Statistical Organisation (CSO), were taken for the
commodities
under study covering a period from January 2001 to August 2007. Apart from
prices,
commodity-wise futures volumes were collected from the websites of the
respective
exchanges and the forward Markets Commission (FMC).
Linear Regression
The following linear regression was used to study factors influencing the spot
prices.
allcommo foodgrains dummy
urad urad gram pulses
tt
t tt t
***
***
456
1123

β β β
α β β β
++
= + + + + −
---1
allcommo foodgrains dummy
gram gram urad pulses
tt
ttt t

***
***
456
123 1

β β β
α β β β
++
= + + + +
− ---2

allcommo foodgrains dummy

wheat wheat rice cereals
tt
ttt t

***
***
456
123 1

β β β
α β β β
++
= + + + +
− ---3

The prices in their first differentials have been used for the study. We
strongly believe
that there is an economic rationality for establishing a relationship between
the price of
urad and the price of other pulses. The inclusion of prices of foodgrain as
well as all
agricultural commodities in the regression is to understand the effect from
general price
rise in foodgrains and other agricultural commodities. The price of
commodity like urad
is dependent on price of other substitute items like pulses and chana (gram)
as well as its
own previous prices. Similarly, the price of wheat is expected to be
influenced by the
price of rice (a close substitute) and other cereals(like systematic
and unsystematic risks are taken same way the ris
in prices can be done by increase in prices in all
commodities and also cyclic and seasonal changes
do affect prices also so co-efficient of
determination can also be used ). The price rise may be a
general rise
due to increase in price of other food items and other commodities. Since we
have used
weekly prices, we have taken the previous week’s price of the commodity
into the
regression equation. The dummy variable is used to find out if the event of
introducing
futures contract had any impact on the price movements of the
commodities. The dummy
variable will take the value “0” or “1” corresponding to the period of
presence or absence
of futures trading respectively.
Granger Causality test
Testing of causal relations between two stationary series Xt and Yt (in bi-
variate case) can
be based on the following two equations
tkt
p
tkkk
p

tkk Y= + Y+ X+ u = − = − __ 011 α α β
tkt
p
tkkk
p

tkk X = ϕ + ϕ Y + φ X +ν = − = − _ _ 0 1 1
Where p is a suitably chosen positive integer; α k‘s and β k‘s, k = 0, 1, …, p
are constants;
and u t and vt are usual disturbance terms with zero means and finite
variances. The null
hypothesis that Xt does not Granger-cause Yt is not accepted if the β k’s, k>0
in equation
(2) are jointly and significantly different from zero using a standard joint test
(eg. an F
test). Similarly, Yt Granger-causes Xt if the ϕ k’s, k>0 coefficients in equation
(3) are
jointly different from zero (Nath, 2003).
This test will help to understand if there is a bi-directional impact flowing
from one to
other prices and vice versa. Apart from prices, the test is also used for
understanding the
relation between volumes and prices of urad, gram and wheat.
III. DISCUSSIONS AND RESULTS
General Trend and Cyclical and Seasonal Variations of the
Commodities
The prices of commodities under our study have moved in upward and
downward
directions depending on many factors – the most important being the supply
and demand
factors for respective commodities. All the three commodities are generally
consumed in
the final form but a small part of the total production is diverted to make
other food
products for commercial use. Since the scope of derived products for
commercial use
from these three commodities is limited, we strongly believe that the
demand and supply
is purely consumption driven. Further, these three commodities are generally
not
exported from India.
Like any agricultural product, the commodities under our study face
seasonal/cyclical
fluctuations. The Hodrick-Prescott Filter methodology was used to filter out
the transitory
components of the fundamental series. This is used to decompose the
variables in the
prices into trend and stationary components, which are respectively induced
by real and
nominal shocks. The technique suggests that the real shocks cause
permanent changes in
prices whereas nominal shocks only cause temporary effects on the real
prices. It is thus
supposed that if one can observe the values of a series yt through yT and it is
possible to
decompose the series into a trend (μt) and a stationary component yt - μt,one
can solve a
minimisation problem for the deviation of yt from μt. Hence with the following
sum of
squares, for instance;
the problem is selecting the { μt } sequence which minimises this sum of
squares. In the
minimisation problem, λ is an arbitrary constant reflecting the penalty of
incorporating
fluctuations into the trend. Increasing the value of λ acts to smooth out the
trend. With
λ =0, the sum of squares is minimised when yt = μt, i.e. the trend is equal to
yt itself. And
as yt _ _, then the trend approaches a linear time trend. Intuitively, for larger
values of
λ , the Hodrick-Prescott decomposition forces the change in the trend i.e.
(∆ μt + ∆ μ t) to
be as small as possible.
Chart-1 gives the trend component arrived using Hodrick-Prescott
decomposition along
with the spot prices. The seasonal/cyclical component arrived using Hodrick-
Prescott
decomposition is given in Chart-2.
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Axis Title
Chart - 1: Commodities Prices - Trend Component and Spot Prices
urad gram Pulses food commo
TrenUrad TrendGram TrendPulses Trendfoodgrains TrendCommodities
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13-01-2001 13-01-2002 13-01-2003 13-01-2004 13-01-2005 13-01-2006 13-01-2007
Axis Title
Chart-2 Seasonal /Cyclical Component of Commodity Prices
Cyclurad Cyclgram Cyclpulses Cyclfood Cyclcommo
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13-01-2001 13-01-2002 13-01-2003 13-01-2004 13-01-2005 13-01-2006 13-01-2007
Spot Prices
Chart 3 - Trend of Spot Price of food coomodities
Wheat rice cereals food commo
TrenW TrendR TrendC Trendf TrendCom
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Axis Title
Chart 4 : Seasonal/Cyclical fluctuations in food commodities
CyWheat Cyrice Cycereals Cyfood Cycommo
Trends in spot prices during pre- and post-futures trading periods
In order to find the impact of futures trading on price volatilities, the period
of study was
divided in to three distinct phases:
PI-covers prior to futures trading (Jan 2001 to Sept 2004),
PII-covers futures trading in all the three commodities (Oct 2004 to Jan
2007) and
PIII- covers post-ban period (Feb 2007 to Oct 2007).
Trends in spot prices during pre- and post-futures trading periods were
studied in order to
find whether the futures trading has any influence on spot prices of urad and
gram. Prices
(WPI) of the selected commodities were juxtaposed with volumes traded on
futures as
depicted in Chart 5.
Urad: Though urad futures contract was introduced in July 2004 it started
trading
actively from January 2005 onwards. However, there was a spurt in futures
trading
volumes after September 2005. Coinciding this, there was a distinct sharp
rise in prices of
urad and consequently that of pulses as a whole. But, no significant change
in production
of urad was noticed in the corresponding period. There is no data to support
any
abnormal increase in consumption demand for the same.
Nevertheless, the volumes dipped sharply from April 2006 on account of the
measures
taken by the exchanges under the directions of FMC. The measures included
the hike in
margins to an extent of about 45 per cent in the form of additional, special
and initial
margins. Subsequently, the FMC has directed the exchanges in April 2006 to
stop
introducing fresh contracts of the existing urad futures that allow trade
exclusively in
imported (Burmese) variety of urad.
However, on the directions of the FMC, the exchanges once again introduced
the
modified contracts of urad on July 14, 2006. The modified urad futures
allowed the trade
in both desi as well as imported varieties. Consequently, the volumes have
once again
moved moderately up in the subsequent months. However, before the
volumes could
pickup further momentum, rumors of ban turned the market participants
apprehensive
and cautious and lead to a moderate fall in volumes during November and
December
2006. Nevertheless, the ban came into effect from January 23, 2007.
Incidentally, urad
prices have also posted a declining trend from November 2006 onwards.
Gram: On the other hand, futures contracts of gram were introduced in April
2004 but
gained considerable volumes only after September 2004. Similar to the case
of urad, a
spurt in volumes was noticed in the case of gram as well from June 2005
onwards with a
corresponding but moderate rise in spot prices though there was no
significant change in
production. The WPI of gram has crossed 150 mark in July 2005 after a gap
of nearly
three years (November 2002) and continued to rise thereafter though at a
slow pace. The
FMC directed the exchanges from the early 2006 to impose regulatory
measures such
imposition of position limits, margins (additional & special), reducing the
daily price
variation limits etc., in order to control extreme price fluctuations. However,
the volumes
showed wide fluctuations corresponding to the regulatory measures. The
spot prices of
gram continued to rise steadily until November 2006 and started declining
thereafter.
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Date
Spot Price
Chart - 5: Trend in Prices and Futures Volume in Urad and Gram
urad gram Pulses commo gram vol urad vol

Wheat: in the case of wheat futures, co movement of futures volumes and

spot price rise
was noticed for a very brief period. Wheat contracts were started trading in
July 2004 but
the volumes remained at about one million MT a month until the later half of
2005.
However, a spurt in volumes was seen in January 2006 (off-season) with a
corresponding
rise in prices. The volumes continued to grow until May 2006 and declined
thereafter
while the prices receded in April with start of wheat marketing season.
Nevertheless, the
volumes of futures trading declined thereafter rather steeply and
consistently despite a
persistent rise in prices. Although the spurt in futures volumes was coincided
with rise in
prices for a brief period, the fall in wheat production consistently for two
years (2004-05
and 2005-06 to about 68 million tones from 71 million tones) could have
contributed for
increase in wheat prices. However, empirical evidence to that extent was
explored and
presented in the subsequent sections.
Tur and Rice: although futures contracts for tur and rice were introduced in
2004, no
significant trading activity was noticed and hence detailed analysis could not
carried out
for the same.
Nevertheless, it is evident from Chart-5 that there was a distinct rise in urad
prices in the
period of futures trading. Further, the steep rise in urad prices has also
pushed prices of
pulses. Further, the spurt in spot prices was observed in post futures trading
period even
in the case of gram though less distinct compared to that in urad. No specific
pattern of
association between wheat prices and futures volumes was noticed from the
trends
plotted in Chart 6. In order to test the significance of the apparent trends,
further
statistical tests such as correlation, regression and granger causality tests
were carried out
and the results are presented in the following sections.
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May-05
Sep-05
Jan-06
May-06
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Jan-07
May-07
Volume (000 MT)
WPI
Chart 6: Futures volumes vs spot prices-cereals
wheat cereals rice commo wheat vol

Spot price variations in the presence and absence of futures

The results as presented in Table 4 indicated that the average change in
prices of urad,
gram and pulses was negative prior to futures trading and became positive
uniformly
across the three variables in PII but once again turned negative in PIII. This
apparently
suggests that the prices of uard, gram and pulses have increased in the
period when
futures trading were allowed in these commodities and declined in the other
two periods
of pre-futures trading and post-ban of futures trading in urad. Similar results
were found
in case of wheat. The average change was distinctly higher during the period
of futures
trading (PII) than that in PI and PIII. The standard deviation of price changes
have also
gone up in PII and declined in PIII, across the three variables and more
prominently in
case of urad indicating the increase in volatilities.
Table 4: Average changes and volatilities in prices
Period Urad Gram Pulses Wheat Cereals Food
grains
Commodities
Average change in prices
Panel I P-I -0.168 -0.054 -0.012 0.023 0.027 0.023 0.093
Panel II P-II 0.463 0.39 0.303 0.179 0.114 0.14 0.079
Panel III P-III -0.296 -0.45 -0.211 -0.019 0.083 0.026 0.073
Standard Deviation (volatility)
Panel I P-I 1.716 1.226 0.827 0.641 0.404 0.389 0.202
Panel II P-II 2.544 1.306 1.174 0.847 0.347 0.349 0.215
Panel III P-III 1.756 1.284 0.784 0.775 0.3 0.336 0.157
PI-Jan 2001 to Sept 2004
PII-Oct 2004 to Jan 2007
PIII-Feb 2007 to Oct 2007
Further, the results of sample variances (F) tests and two sample t-tests
indicated that the
observed increase in average price changes and volatilities in the second
period (P-II)
compared to the first (P-I) as well as the third period (P-III) were found to be
statistically
significant in case of urad, gram, wheat, pulses and to some extent cereals.
Table 5: Results of two-sample t-tests
P-I & PII P-II & P-III P-I & P-III
F-stat t-Statistic F-stat t-Statistic F-stat t-Statistic
Urad 0.457* -2.434* 0.476** -1.910** 0.961 0.371
0.000 0.008 0.013 0.031 0.416 0.356
Gram 0.886 -3.061* 0.967 3.131* 0.916 1.606
0.226 0.001 0.480 0.001 0.353 0.055
Pulses 0.499* -2.601* 0.446* -2.861* 0.893 0.663
0.000 0.005 0.008 0.003 0.376 0.254
Wheat 0.572* -1.773** 0.837 1.303 1.463** 0.320
0.000 0.039 0.267 0.097 0.052 0.375
Cereals 1.352** -2.058** 0.745 0.510 0.551** 0.988
0.033 0.020 0.148 0.305 0.016 0.163
1. Two sample t-tests of unequal variances were conducted when the F
turned
statistically significant or else two sample t-tests of equal variance were
conducted
2. * and ** indicates significant at 1% and 5% level.
3. Figures in italics indicate the ‘_’ values
Thus, the average price levels as well as volatilities of urad, gram, wheat and
consequently pulses and cereals were significantly higher in the period
where futures
trade in all the three commodities was allowed.
Impact of Futures on Spot prices
Linear regression analysis was carried out to test the statistical significance
of the
apparent impact of futures trading on spot prices of urad, wheat and gram.
In view of the
significant associations noticed in correlation analysis, regressions were tried
with all the
variables including their lags. A dummy was introduced to indicate the period
of futures
trading. Results of the best fit are presented below
Urad: The coefficients of urad with one lag, prices of gram and pulses were
found to be
significant at one per cent level (Table – 6). However, the negative sign of
the coefficient
of urad with one lag needs further probe for a precise explanation. One
possible reason
could be the high volatilities in urad prices as the variables considered were
changes and
not the actual values.
Table 6: Results of regression for urad
Variables Coefficient Std. Error t-Statistic Prob. Significance
Intercept -0.145 0.085 -1.709 0.088
Lag Urad -0.093 0.031 -3.006 0.003 *
Gram -0.615 0.063 -9.793 0.000 *
Pulses 2.076 0.088 23.563 0.000 *
Food grains 0.218 0.193 1.130 0.259
All-commodities -0.556 0.318 -1.749 0.081
Dummy 0.278 0.136 2.041 0.042 **
* and ** indicates significant at 1% and 5% level
R-squared 0.688
Adjusted R-squared 0.682
Durbin-Watson statistic 2.187
n 345
On the other hand, the dummy variable turned statistically significant at five
per cent
level suggesting that there was a moderate impact on spot prices of urad
during the period
of futures trading in urad. Thus, the null hypothesis is rejected and the
alternate
hypothesis saying that the trading in futures has a moderate influence on
spot prices of
urad is accepted.
Gram: Further, only the coefficients of urad and pulses were found
statistically
significant at one per cent level (Table-7). The dummy variable bifurcating
the pre and
post-futures trading turned out to be statistically not significant suggesting
that there was
no significant direct impact of futures trading on spot price changes of gram.
The
apparent rise in prices in the post futures trading period could be on account
of other
reasons like mismatch in demand and supply.
Table 7: Regression results for gram
Coefficients t Stat P-value Significance
Intercept -0.081 -1.112 0.267
Dummy 0.112 1.116 0.265
Lag Gram 0.028 0.501 0.617
Pulses 1.331 16.047 0.000 *
Foodgrains 0.163 1.085 0.279
All-commodities -0.084 -0.340 0.734
Urad -0.359 -9.671 0.000 *
* indicates significant at 1%
R Square 0.526
Adjusted R Square 0.512
Observations 345
Wheat: The dummy variable representing the presence of futures trading
was not found
statistically significant (Table-8). The estimates of wheat with one lag, rice
and cereals
were found statistically significant at 5%, 1% and 1% respectively.
Table 8: Results of regression for wheat
Variables Coefficient Std. Error t-Statistic Prob. Significance
Intercept -0.03 0.02 -1.10 0.27
LagWheat 0.05 0.03 1.86 0.06
Rice -1.08 0.06 -18.32 0.00 *
Cereals 2.16 0.15 14.35 0.00 *
Foodgrains -0.04 0.15 -0.26 0.79
All commodities 0.03 0.10 0.25 0.80
Dummy 0.03 0.05 0.67 0.50
* indicates significant at 1% level
R-squared 0.753
Adjusted R-squared 0.749
Durbin-Watson statistic 2.01
n 345
Thus, the regression analysis gives some clear hints about the influence of
futures on spot
prices particularly of urad. However, the signs of the coefficients especially
the lagvariables
need further explanation as they have not turned out to be in the expected
lines.
It is expected that futures trading helps in reducing seasonal/cyclical
fluctuation in price.
We wanted to find out if this has happened in case of the above
commodities. We kept
our basic regression intact but used only seasonal/cyclical component of the
prices to
study if the introduction of futures trading in those commodities has helped
in reducing
the seasonal/cyclical fluctuations. The results are given in Table-9.
Table 8: Results of regression for Seasonal/Cyclical Fluctuations in
Urad
Variables Coefficient Std.
Error
t-
Statistic
Prob. Significance
C -0.265 0.294334 -0.90034 0.3686
CYCOMMO -1.40853 0.230666 -6.10636 0 *
CYFOOD 0.288686 0.162117 1.780723 0.0759
CYGRAM -0.56721 0.049784 -11.3934 0 *
CYPULSES 1.925991 0.107904 17.84903 0 *
DUMMY 0.660495 0.494661 1.335246 0.1827
LAGCYURAD 0.383617 0.032735 11.71886 0 *
* indicates significant at 1% level
R-squared 0.900166
Adjusted R-squared 0.898383
Durbin-Watson
statistic 1.370383
n 344
We find that the seasonal/cyclical fluctuations is not affected by the
introduction futures
i.e. futures have not helped the cyclical/seasonal fluctuations in urad (Table-
8). The result
is similar in case of gram (Table-9).
Table 9: Results of regression for Seasonal/Cyclical Fluctuations in
Gram
Variables Coefficient Std.
Error
t-
Statistic
Prob. Significance
C -0.01646 0.141126 -0.11663 0.9072
LAGCYGRAM 0.78274 0.022895 34.18777 0 *
CYURAD -0.10247 0.01933 -5.3013 0 *
CYFOOD 0.084549 0.072121 1.172323 0.2419
CYPULSES 0.461531 0.060997 7.566408 0 *
CYCOMMO 0.135523 0.109558 1.236991 0.217
DUMMY -0.16131 0.2067 -0.7804 0.4357
R-squared 0.953421
Adjusted R-squared 0.952589
Durbin-Watson
statistic 1.492494
n 344
We also did the similar exercise for wheat and found that the results are
similar to gram
and urad (Table 10).
Table 10: Results of regression for Seasonal/Cyclical Fluctuations in
Wheat
Variables Coefficient Std.
Error
t-
Statistic
Prob. Significance
C 0.029333 0.0862 0.340286 0.7339
LAGW 0.591375 0.030487 19.39787 0 *
CYFOOD 0.527844 0.110018 4.7978 0 *
CYCOMMO -0.18311 0.074073 -2.47206 0.0139
CYCEREALS 0.659783 0.113346 5.82097 0 *
CYRICE -0.60923 0.056219 -10.8368 0 *
DWHEAT -0.10525 0.126168 -0.8342 0.4048
* indicates significant in 1%
R-squared 0.947148
Adjusted R-squared 0.946205
Durbin-Watson
statistic 1.022307
n 344
Results of Granger causality tests
Futures activity-Spot Prices: It is evident from the results of Granger
causality tests
(Table-11) that futures volumes had a significant causal impact on spot
prices in case of
wheat and urad. However, in case of gram the causal relation from volumes
to prices was
not found significant while spot prices found to have a mild causal effect on
volumes of
gram.
Table 11: Results Granger causality tests between volumes and prices
Null Hypothesis: F-Statistic Prob. significance
Volume of URAD ----->Spot price 3.427 0.002 *
Spot price of URAD ----->Volume 0.927 0.475
Volume of Gram -----> Spot price 0.714 0.638
Spot price of Gram ----->Volume 2.328 0.031 **
Spot price of wheat ----->Volume 3.928 0.000 *
Volume of wheat ----->Spot price 1.789 0.027 **
* and ** indicates significant at 1% and 5% level
Further, to test the causality among gram, urad, pulses and foodgrains, pair-
wise Granger
causality tests were conducted on both price changes as well as volatilities.
The results showed (Table – 12) that change in urad has a significant
influence on total
pulses prices and vice-versa while that of gram has significant causal
influence on urad as
well as on pulses. Thus, when there was a steep rise in urad prices during the
post-futures
trading period, prices of pulses also went up correspondingly though at a
lower pace.
Table 12: Granger causality results for price changes
Null Hypothesis: F-Statistic Prob. Significance
_PULSES ----->_GRAM 0.660 0.6196
_GRAM ----->_PULSES 2.721 0.0296 **
_URAD ----->_GRAM 1.367 0.2449
_GRAM ----->_URAD 4.073 0.0031 *
_URAD ----->_PULSES 2.534 0.0401 **
_PULSES ----->_URAD 5.424 0.0003 *
_ wheat ----->_ cereals 0.455 0.841
_ cereals ----->_ wheat 0.774 0.590
* and ** indicates significant at 1% and 5% level
Thus, futures activity in terms of volumes has a positive and significant
causal effect on
volatilities in spot prices of urad and wheat while the same could not be
established in
case of gram. On the other hand, price changes in urad were caused by
changes in both
gram and pulses prices whereas urad prices did not have causal impact on
gram prices.
Spillover of Volatilities
Correlations among price volatilities of urad, gram, pulses, foodgrains and
allcommodities
were studied to check the spillover of volatilities. The volatilities were
estimated using an IGARCH method with the decay factor (Lambda) of 0.94
and plotted
in Chart 3, the scale on X-axis indicates number of weeks starting from the
first week of
January 2001 to August 2007.
Urad prices have shown significant volatility followed by gram compared to
other prices
in our study. As apparent in Chart 7 below, the volatility was higher during
the period of
futures trading. The same came down after the futures were banned.
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Volatiliyu (%)
Chart 7 : Volatility of Commodities Prices
Vola_urad Vola_gram Vola_pulses Vola_food Vola_commo
Correlation of volatilities indicated that there was a significant spillover of
volatilities
among pulses and foodgrains. Flow found to be strong and significant from
urad to
pulses, pulses to foodgrains, urad to foodgrains and from gram to pulses as
presented in
Table 13.
Table 13: Descriptive Statistics and Correlation Coefficients of Volatilities
N Mean Std Minimum Maximum
Volatility urad 345 1.99 0.70 0.85 4.01
Volatility gram 345 1.23 0.36 0.58 2.31
Volatility pulses 345 0.94 0.29 0.53 1.93
Volatility foodgrains 345 0.38 0.08 0.19 0.53
Volatility commo 345 0.21 0.05 0.13 0.34
Vola_urad Vola_gram Vola_pulses Vola_food Vola_commo
Volatility urad 1
Volatility gram 0.071 1
Volatility pulses 0.803* 0.509* 1
Volatility foodgrains 0.529* 0.292* 0.602* 1
Volatility all-commo -0.155* -0.498* -0.271* -0.254* 1
* Indicates significant at one per cent level
Vola : indicates volatility
Results of granger causality tests (Table – 14) of volatilities among the
selected variable
indicated that there was a spillover of volatilities. The causality tests were
found
statistically significant from volatilities of gram to pulses and urad to pulses
but urad to
foodgrains showed a mild short term relationship.
Table 14: Granger causality results for price volatilities
Null Hypothesis: F-Statistic Prob. significance
VOLA_URAD ----->VOLA_FOOD 2.407 0.0923 ***
VOLA_FOOD ----->VOLA_URAD 0.201 0.8179
VOLA_PULSES ----->VOLA_GRAM 1.565 0.2112
VOLA_GRAM ----->VOLA_PULSES 3.440 0.0337 **
VOLA_URAD ----->VOLA_PULSES 3.191 0.0429 **
VOLA_PULSES ----->VOLA_URAD 1.002 0.3684
** and *** indicates significant at 5% and 10% level
Vola : indicates volatility
CONCLUSIONS
Using dummy variables, the study finds that the introduction of future
trading in the
selected commodities had apparently led to increase in price of commodity
like urad but
the same is not true for wheat and gram. The spot prices of all three
commodities under
study have increased in the post futures period though except for urad, the
dummy
variables are not found statistically significant. The spot prices of these
commodities
declined after the ban on futures trading was introduced. However, the price
volatility
increased significantly during the period when futures were allowed. There
has been a
sharp fall in volatility after the ban of futures in these commodities. Although
gram prices
too have posted a moderate rise in the post-futures trading period, the
impact was not
found statistically significant. Although a similar increase was observed in
case of wheat,
steep fall in supply coinciding the same period thus bringing ambiguity in the
inference.
The study also finds that the introduction of futures in commodities under
our study has
not affected the seasonal/cyclical fluctuations of the commodities under our
study.
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