This document studies the impact of commodity futures trading on prices of underlying commodities in India. It analyzes weekly price data for wheat, rice, and barley from 1998-2010 both before and after the introduction of commodity futures exchanges in 2003. The results show that futures prices closely tracked changes in wholesale price indices, indicating futures influence spot prices. Volatility tended to increase for some commodities after futures trading began. However, the study has limitations and more research is needed to account for other supply and demand factors.

1. Impact of Commodity
futures on price of
underlying commodity
Financial Economics Project
Submitted to
Dr. S.Chattopadhay
Studied by:
Saket Rathi - 2010197
Debashish Bagg -2010298
Arun Goyal -2010054

2. Impact of Commodity Futures on prices of underlying commodity Financial Economics Project
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.
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3. Impact of Commodity Futures on prices of underlying commodity Financial Economics Project
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.
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 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.
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
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4. 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 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.
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 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.
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5. Impact of Commodity Futures on prices of underlying commodity Financial Economics Project
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
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6. Impact of Commodity Futures on prices of underlying commodity Financial Economics Project
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
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