fe project

Studied by:

Saket Rathi - 2010197

Debashish Bagg -2010298

Arun Goyal -2010054

Impact of Commodity

futures on price of

underlying commodity Financial Economics Project

Submitted to

Dr. S.Chattopadhay

Impact of Commodity Futures on prices of underlying commodity Financial Economics Project

[Type text]

Executive Summary:

This project is a study that intended to study effect of introduction of commodity futures in India.

The present report starts with an introduction of history of commodity markets in India. We would then

look into introduction of commodity future in India and how it has influences the price market of base

commodity. The basis of calculation of actual prices in commodity market is WPI index, where as the

futures is the average calculated on prices of different futures that are running in the week. The frequency

of data used for this study is weekly data.

Introduction:

Commodity derivatives have had a long and a chequered presence in India. Commodity

derivative market has been functioning in India since the establishment of Cotton Trade Association in

1875 barely about a decade after they started in Chicago. However, many feared that derivatives fuelled

unnecessary speculation and were detrimental to the healthy functioning of the markets for the underlying

commodities. After independence, commodity options trading and cash settlement of commodity futures

were banned in 1952. A further blow came in 1960s when, following several years of severe draughts that

forced many farmers to default on forward contracts, forward trading was banned in many commodities

considered primary or essential. Consequently, the commodities derivative markets dismantled and

remained dormant for about four decades until the new millennium when the Government, in a complete

change in policy, started actively encouraging the commodity derivatives market. Since 2002, the

commodities futures market in India has experienced an unprecedented boom in terms of the number of

modern exchanges, number of commodities allowed for derivatives trading as well as the value of futures

trading in commodities, which might cross the $ 1 Trillion mark in 2006. However, there are several

impediments to be overcome and issues to be decided for sustainable development of the market.

Literature Survey:

There have been many studies since reintroduction of commodity futures in 2003-04 on its impact

on prices of underline commodities. Some studies [3] like the report submitted to government of India

from a group of expert comments that the relative price increase in the Post Exchange period is much

more when compared to the pre exchange period. S. Bose [1] comments that introduction of futures

market has aggravated prices of underlining commodities. Nath and Lingareddy [4] find that both average

price change and spot price volatility of urad, gram and wheat were higher by statistically significant

margins during October 2004 to January 2007 as compared to either the pre-futures period January 2001

to September 2004 or during February 2007 to October 2007 when futures trading in some of these

commodities was suspended. Later studies like that of Mukherjee [2] conclude saying that the futures

market have helped in risk mitigating and price discovery and hence needs to be supported.

Present Study:

The present study is more to measure the volatility of the commodity of futures market in India

and compare it to its volatility pre exchange era. As the data available is weekly no conclusion on the very

short term volatility can be commented. It is also assumed that the futures quoted shows and captures the

market sentiment and feelings depending on the present and all past available information. Data source

for WPI is Ministry of statistics and programme implementation [5] and Nasdaq [6] is used for future

contract prices.


[Type text]

Comparison:

The first commodity to study was wheat. Figure 1 shows percentage changes in the WPI of wheat

and percentage change in the Wheat future.

Figure 1: Percentage change of WPI and wheat futures

From the above curve it can be observed that the percentage fluctuations in WPI are almost a one

to one replica of the percentage fluctuations in the Wheat futures market. Next figure is a comparison of

average future price quoted every week and the actual WPI that has been exhibited by commodity under

study (i.e. wheat) in the last two years 2010-11.

Figure 2: Average value of futures quoted and actual value of WPI for wheat

-0.04

-0.02

-1E-17

0.02

0.04

09-01-2010 09-07-2010 09-01-2011 09-07-2011

Percentage change in WPI Percentage change in Wheat Futures

164

170

176

182

1130.00

1190.00

1250.00

1310.00

02-01-2010 02-07-2010 02-01-2011 02-07-2011

WP

I o

f W

hea

t

Aver

age

pri

ce o

f fu

ture

s quote

d e

ver

y

wee

k

Average future quoted every week Actual WPI


[Type text]

Figure 2 also replicate the same findings that the future value fluctuations and change in WPI is a

replica of each other except for a few deviations here and there which are due to the relative mismatch of

supply and demand in-house and international future prices effecting local market.

Figure 3: volatility of Wheat pre and post commodity futures

Figure 3 shows that the volatility in the WPI index over a period of 52 weeks each. 2001 and

2010 here represents year’s pre-era and post trading era. It can be observed that high amount of

fluctuation is seen in the post–introduction period’s data i.e. 2010’s data when compared to data of 2001

year.

A multimodal regression equation is used to explain the relation of WPI of wheat and its futures

quotes for the years 2010-2011 is as follows.

In the above equation

: is the mean price index of trading for wheat during 2010-2011.

: is the lowest price of trading for wheat during 2010-2011.

: is the highest price of trading for wheat during 2010-2011.

: is the WPI index of trading for wheat during 2010-2011.

: is the random Gaussian white mean error term in the above equation.

0.000

0.005

0.010

0.015

0.020

0.025

0.030

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52

Chan

ge

in W

hea

t F

utu

res

2001 2010


[Type text]

Man squared error in the equation is 0.586. Similar study is extended to other commodities Turmeric,

Chilies, Raw cotton, Barley and Rice. Results for the above study for Wheat, Rice and Barley are

summarized in the following table.

Table 1: Competition of variance in price pre and post to introduction of commodity futures

Years Wheat Rice Barley

1998 6.653983 5.998493 11.61055

1999 7.388773 9.394229 20.04812

2000 2.208727 3.270574 23.37361

2001 1.702146 2.540343 7.499245

2002 2.55251 2.759074 18.56519

2003 3.722594 2.929841 14.25267

2004 4.778196 2.389857 10.14578

2005 4.222326 3.449303 7.898226

2006 11.82445 3.139657 7.38665

2007 5.672514 4.460608 5.310718

2008 4.009675 8.555152 4.908789

2009 13.69645 7.950866 4.159723

2010 8.985843 1.991212 4.586627

From the above table it can be seen that there commodities like wheat whose variances have

varied a lot after introduction of commodity futures, in the same place variances of rice have almost

remain constant and that of commodity like Barley have reduced drastically. Hence the introduction of

commodity futures has mixed effect on the underlying commodity market. It also can be said that its not

only the future trading prices of the commodity market that might have been the cause of the volatility

that we observe in the commodity market but also other factors like future expectation of drought and

rainfall etc.

Conclusion:

It can be concluded that the price of trading of futures do have effect on the volatility of WPI i.e.

spot price of the underlying commodity in some cases. More data and parameters needs to be included in

the model to make it more conclusive.

Limitations:

The main limitation that this study suffers is that the data is not adjusted to demand and supply

cycle of the underlying commodity that can be seen in agricultural markets. Effect of volume of trading is

neglected in the present study that is very much emphasized by Mukherjee [2]. Effect of International


[Type text]

trade and level of cartelization that happens in the agricultural commodity market as pointed by Bose [1]

is also neglected.

References:

1. S. Bose, “The Role of Futures Market in Aggravating Commodity Price Inflation and the Future

of Commodity Futures in India”, ICRA Bulletin, March 2009.

2. K. N. Mukherjee, “Impact of Futures Trading on Indian Agricultural Commodity Market”,

Working paper, National Institute of Bank Management, Social science research network,

February 2011.

3. Anonymous, “The impact of futures trading on agricultural commodity prices”, Report submitted

to Ministry of consumer affair, 2008.

4. G. C. Nath, and T. Lingareddy, “Commodity Derivative Market and its Impact on Spot Market”,

Social science research network, February 2008.

5. Future Prices, http://www.ncdex.com/Market_Data/Future_price.aspx

6. WPI, http://mospi.nic.in/Mospi_New/site/home.aspx

http://www.ncdex.com/Market_Data/Future_price.aspx

http://mospi.nic.in/Mospi_New/site/home.aspx

fe project

Business