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  • Impact of Commodity futures on price ofunderlying commodity Financial Economics Project Submitted to Dr. S.Chattopadhay Studied by: Saket Rathi - 2010197 Debashish Bagg -2010298 Arun Goyal -2010054
  • Impact of Commodity Futures on prices of underlying commodity Financial Economics ProjectExecutive 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 thenlook into introduction of commodity future in India and how it has influences the price market of basecommodity. The basis of calculation of actual prices in commodity market is WPI index, where as thefutures is the average calculated on prices of different futures that are running in the week. The frequencyof data used for this study is weekly data.Introduction: Commodity derivatives have had a long and a chequered presence in India. Commodityderivative market has been functioning in India since the establishment of Cotton Trade Association in1875 barely about a decade after they started in Chicago. However, many feared that derivatives fuelledunnecessary speculation and were detrimental to the healthy functioning of the markets for the underlyingcommodities. After independence, commodity options trading and cash settlement of commodity futureswere banned in 1952. A further blow came in 1960s when, following several years of severe draughts thatforced many farmers to default on forward contracts, forward trading was banned in many commoditiesconsidered primary or essential. Consequently, the commodities derivative markets dismantled andremained dormant for about four decades until the new millennium when the Government, in a completechange in policy, started actively encouraging the commodity derivatives market. Since 2002, thecommodities futures market in India has experienced an unprecedented boom in terms of the number ofmodern exchanges, number of commodities allowed for derivatives trading as well as the value of futurestrading in commodities, which might cross the $ 1 Trillion mark in 2006. However, there are severalimpediments 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 impacton prices of underline commodities. Some studies [3] like the report submitted to government of Indiafrom a group of expert comments that the relative price increase in the Post Exchange period is muchmore when compared to the pre exchange period. S. Bose [1] comments that introduction of futuresmarket has aggravated prices of underlining commodities. Nath and Lingareddy [4] find that both averageprice change and spot price volatility of urad, gram and wheat were higher by statistically significantmargins during October 2004 to January 2007 as compared to either the pre-futures period January 2001to September 2004 or during February 2007 to October 2007 when futures trading in some of thesecommodities was suspended. Later studies like that of Mukherjee [2] conclude saying that the futuresmarket 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 Indiaand compare it to its volatility pre exchange era. As the data available is weekly no conclusion on the veryshort term volatility can be commented. It is also assumed that the futures quoted shows and captures themarket sentiment and feelings depending on the present and all past available information. Data sourcefor WPI is Ministry of statistics and programme implementation [5] and Nasdaq [6] is used for futurecontract prices.[Type text] Page 2
  • Impact of Commodity Futures on prices of underlying commodity Financial Economics ProjectComparison: The first commodity to study was wheat. Figure 1 shows percentage changes in the WPI of wheatand percentage change in the Wheat future. 0.04 0.02-1E-17 09-01-2010 09-07-2010 09-01-2011 09-07-2011 -0.02 -0.04 Percentage change in WPI Percentage change in Wheat Futures 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 oneto one replica of the percentage fluctuations in the Wheat futures market. Next figure is a comparison ofaverage future price quoted every week and the actual WPI that has been exhibited by commodity understudy (i.e. wheat) in the last two years 2010-11. Average price of futures quoted every 1310.00 182 WPI of Wheat 1250.00 176 week 1190.00 170 1130.00 164 02-01-2010 02-07-2010 02-01-2011 02-07-2011 Average future quoted every week Actual WPI Figure 2: Average value of futures quoted and actual value of WPI for wheat[Type text] Page 3 View slide
  • Impact of Commodity Futures on prices of underlying commodity Financial Economics Project Figure 2 also replicate the same findings that the future value fluctuations and change in WPI is areplica of each other except for a few deviations here and there which are due to the relative mismatch ofsupply and demand in-house and international future prices effecting local market. 0.030 0.025 Change in Wheat Futures 0.020 0.015 0.010 0.005 0.000 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 2001 2010 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 and2010 here represents year’s pre-era and post trading era. It can be observed that high amount offluctuation is seen in the post–introduction period’s data i.e. 2010’s data when compared to data of 2001year. A multimodal regression equation is used to explain the relation of WPI of wheat and its futuresquotes 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.[Type text] Page 4 View slide
  • Impact of Commodity Futures on prices of underlying commodity Financial Economics ProjectMan 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 aresummarized 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 havevaried a lot after introduction of commodity futures, in the same place variances of rice have almostremain constant and that of commodity like Barley have reduced drastically. Hence the introduction ofcommodity futures has mixed effect on the underlying commodity market. It also can be said that its notonly the future trading prices of the commodity market that might have been the cause of the volatilitythat we observe in the commodity market but also other factors like future expectation of drought andrainfall 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 inthe model to make it more conclusive.Limitations: The main limitation that this study suffers is that the data is not adjusted to demand and supplycycle of the underlying commodity that can be seen in agricultural markets. Effect of volume of trading isneglected in the present study that is very much emphasized by Mukherjee [2]. Effect of International[Type text] Page 5
  • Impact of Commodity Futures on prices of underlying commodity Financial Economics Projecttrade 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[Type text] Page 6