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A Study on Commodity Market Behaviour, Price

Discovery and Its Factors

ARTICLE in SSRN ELECTRONIC JOURNAL · JANUARY 2012

DOI: 10.2139/ssrn.1988812

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 A STUDY ON COMMODITY MARKET BEHAVIOUR, PRICE
DISCOVERY AND ITS FACTORS
Mihir Dash
Abhishek Solanki
Shobana T.

ABSTRACT
Commodity markets have been gaining importance in recent years, giving participants an
opportunity to go for forward contracting and hedging. In particular, derivative markets have
attained more than eighteen times in trading volume when compared to the spot markets.

This paper provides an overview of the commodity market in India and its participants, and
analyses twelve commodities that are traded in MCX (Multi Commodity Exchange), in terms of
price discovery of the spot and futures markets using GARCH model. It also analyses the impact of
trading volume, inflation and other macroeconomic factors on spot and futures price movements.

Keywords: commodity markets, price discovery, GARCH model, trading volume, inflation,
macroeconomic factors.

INTRODUCTION
The commodity market is very dynamic, offering the opportunity of forward contracting and
hedging, and witnessing activity almost eighteen times higher in volume as compared to the spot
market. However, awareness of the commodity market is less when compared to the stock market.
This is mainly due to the huge investment that is required in order to hedge and trade, even though
only a small margin amount is required. Three multi-commodity exchanges have been set up in
India to facilitate commodity trading for the retail investors. They are the Multi-Commodity
Exchange (MCX), the National Commodity and Derivatives Exchange (NCDEX), and the National
Multi-Commodity Exchange (NMCE).

Commodity prices are typically characterized by substantial volatility. The uncertainty that
accompanies price volatility affects traders whose trading strategies are based, in part, on short-
term volatility movements, and investors interested in hedging an underlying diversified portfolio
of commodities. In particular, producers need to manage their exposure to fluctuations in the prices
for their commodities. They are primarily concerned with fixing prices on contracts to sell their
produce; hence the existence of futures markets.

METHODOLOGY
The primary objectives of the study were to analyse the long term volatility of each commodity, to
compare volatility between different commodity groups, to examine the effect of inflation and
volume on the prices of the commodities, and to understand the fundamental and technical factors
affecting the price of each commodity.

The data used for the study consisted of the daily closing prices of twelve commodities in Indian
market taken for a period 2003-11. This period was chosen, as the Indian commodity market was
revived in 2002. The data is taken from the MCX1, due to very thin trading in the NCDEX. The
commodities were categorized into precious metals (gold and silver), base metals (aluminium,

1
http://www.mcxindia.com/SitePages/BhavCopy.aspx

Electronic copy available at: http://ssrn.com/abstract=1988812

copper, nickel, zinc and tin), energy (natural gas and crude oil), and agri-products (channa, wheat
and pepper).

To examine the volatility dynamics, the study uses the GARCH (1, 1) model (Bollerslev, 1986).
The GARCH (1, 1) model is given by: rt     t , . In the academic
literature, the GARCH (1, 1) process is perceived as a realistic model for volatility. The forecast
variance from the GARCH (1, 1) model can be interpreted as a weighted average of three different
variance forecasts. The first is a constant variance that corresponds to the long-run average. The
second is the forecast that was made in the previous period. The third is the new information that
was not available when the previous forecast was made. This could be viewed as a variance
forecast based on one period of information. The weights on these three forecasts determine how
fast the variance changes with new information and how fast it reverts to its long-run mean.

The parameters of the GARCH model are: µ, the long-run mean returns of the commodity; α, the
persistence of returns shocks; β, the persistence of volatility shocks; w, the regression constant; and
vL, the long-run volatility. In particular, α+β measures the persistence of returns and volatility
shocks; if greater than unity, it implies that there is no recovery from shocks, leading to non-
stationarity.

The GARCH model has been used extensively to model volatility in commodity prices. Many
studies have used GARCH modelling to investigate the effect of futures price volatility on spot
price volatility (Kamara, 1982; Antoniou and Foster, 1992; and Gulen and Mayhew, 2000). Yang et
al (2005) examined the lead-lag relationship between futures trading activity (volume and open
interest) and spot price volatility for major agricultural commodities, finding that unexpected
increase in futures trading volume unidirectionally causes an increase in spot price volatility for
most commodities. Several studies also examine factors influencing specific commodity markets.
Pindyck (2004) examined the behavior of natural-gas and crude-oil price volatility using GARCH
modeling, but found mixed results concerning their inter-relationships. Ates and Wang (2007)
examined the role of fundamentals in inter-temporal pricing relations in natural gas and heating oil
spot and futures markets.

To examine the impact of trading volume and inflation on commodity price volatility, the
GARCH(1, 1) model was extended to include factor terms:  t2     t21   t21   '  't21  ' 't21 ,
where ’t and σ’t2 refer to the factor returns and volatility processes. The F-test was used to test the
significance of α’ and β’ and, thus, the significance of the impact of the factor on commodity price
volatility.

FINDINGS
Some general observations from the literature about commodity prices and factors affecting
commodity prices are discussed at the outset.

Precious Metals – Gold and Silver

1. Gold prices and US Dollar are inversely related, as gold is an effective investment when the
US Dollar falls.
2. Investors generally buy gold as a hedge against economic, political, or social crises such as
investment market declines, national debt, currency failure, inflation, war and social unrest.
3. Changes in the supply of gold affect gold prices.
4. Silver prices follow gold price trends and serves as another effective investment.
5. Silver prices are also affected by other factors such as supply constraints and mine strikes.

Electronic copy available at: http://ssrn.com/abstract=1988812

Base Metals – Aluminium, Zinc, Tin, Nickel and Copper
1. Base metal prices are affected mainly by changes in inventory level, global growth and
demand in major consuming industries, including the construction, packaging, and
transportation industries, and prices of alternative metals & alloys.
2. Political unrest in the producing countries such as South America and North America also
affect base metal prices.
3. Any new production also takes years to commission as the scale of mining is large, it takes
enormous financing and requires endless environmental permissions and needs extensive
infrastructure as well.

Energy – Crude oil and Natural gas

1. The fundamental cause of crude oil price change is weather/seasonality.
2. Other factors affecting crude oil prices include OPEC output, supply and spare capacities,
currency fluctuations, US crude and products inventories data, speculative buying and
selling, Middle East supply disruptions; and crude oil prices are extremely sensitive to
supply shortages.
3. Natural gas prices tend to follow crude oil prices, and the other factors such as weather,
production, inventories, and many a times it is news-driven.
4. Crude oil is a close substitute for natural gas; hence it is been observed that the prices of
both are dependent on each other except in few of the cases where the other factors get
involved.
5. Natural gas prices rose above what was seen as their historical relationship with crude oil
prices in 2000, 2002, 2003 and late 2005. In the early 2005 and the first half of 2006,
natural gas prices seemed to fall well below this historical relationship
6. Variation in weather from the seasonal norm also affects natural gas prices, with above
normal heating and cooling degree days adding upward pressure on natural gas prices.
7. Because natural gas consumption is seasonal but production is not, natural gas inventories
are built during the summer for use in the winter. This seasonality leads to higher winter
prices and lower summer prices
8. Inventories above the seasonal norm depress prices while inventories below the seasonal
norm boost prices. Disruptions of natural gas production, such as happened during
hurricanes Katrina and Rita in US, also boosted the price.

Agro-Products – Channa, Wheat and Pepper

1. The fundamental factor that affects agro-product prices is the monsoons in India, affecting
production and supply.
2. Storage constraints also affect agro-product prices, as they are short-lived.
3. Other factors include prevailing inflation, supply constraint, increasing agricultural costs of
production, growing foreign exchange holdings by major food-importing countries, and
policies adopted recently by some exporting and importing countries to mitigate their own
food price inflation.

Spot and Futures Price Trends

The trends of spot and futures prices of some of the commodities are shown in the graphs below.
The trends of spot and futures prices follow similar patterns in all commodity prices, and suggest a
lead-lag relationship between spot and futures prices.

Electronic copy available at: http://ssrn.com/abstract=1988812

 Price in Rs. Price in Rs. Price in Rs.

100
200
300
400
500
600
700

20
40
60
80
100
120
140
160
180

0
5000
10000
15000
20000
25000

0
Date Oct 19 2006
Jan 1 2007 Date
15-Apr-06
Mar 23 2007 11-Jun-05
05-Aug-06

Figure 1 . Gold Prices

18-Oct-05
Jun 13 2007
28-Nov-06
23-Feb-06

Figure 3 . Aluminium prices

Aug 27 2007
22-Mar-07

Figure 2 . Natural Gas Prices

30-Jun-06
Oct 27 2007
16-Jul-07
06-Nov-06
Jan 19 2008
08-Nov-07 14-Mar-07
Apr 23 2008
03-Mar-08 20-Jul-07
Jul 23 2008
26-Jun-08 28-Nov-07
Oct 21 2008
20-Oct-08

Years
07-Apr-08

Years
Years

Jan 21 2009

4
14-Feb-09 11-Aug-08
Apr 13 2009
12-Jun-09 18-Dec-08
Jul 15 2009
07-Oct-09 27-Apr-09
Oct 17 2009
02-Feb-10 03-Sep-09
Jan 11 2010
Gold -Spot & Future Price

28-May-10 11-Jan-10
Apr 16 2010

Aluminium Spot & Future Price

Natural Gas - Spot & Future Price

21-Aug-10 20-May-10
Jul 19 2010
15-Dec-10 24-Sep-10
Oct 22 2010
08-Apr-11 01-Feb-11
Jan 21 2011
Spot Price

Spot Price

Spot Price
Future Price

Future Price

Future Price
 Wheat - Spot Price & Future Price

1600
1400
1200
Price in Rs.

1000
Future Price
800
600 Spot Price
400
200
0

10-Nov-09
27-Jul-05

10-Jul-06

01-Jul-09

31-Jul-10
16-Jan-10
Date

24-Mar-10
29-May-10
17-Dec-05
27-Feb-06
05-May-06

20-Sep-06

04-Sep-09

09-Dec-10
14-Feb-11
20-Apr-11
06-Oct-10
Years

Figure 4 . Wheat Prices

The next set of graphs compare commodity futures prices within the categories: precious metals,
energy, base metals, and agro-products.

Gold Vs Silver

80000
70000
60000
Price in Rs.

50000
Future Price of Silver
40000
30000 Future Price of Gold
20000
10000
0
18-Nov-05
21-Jul-04
18-Jan-05
Date

20-Mar-09

05-Mar-10

14-Mar-11
11-May-06

24-Apr-07

08-Apr-08
26-Sep-08

11-Sep-09

25-Aug-10
31-Oct-06

15-Oct-07

Years

Figure 5 . Comparison of Gold and Silver Prices

Gold and silver futures prices show similar trends, except towards the end of the period. There are
several common factors determining the prices of gold and silver in the spot market such as festival
days, auspicious days (for example, Akshaya Tirutham), which result in their co-movement.

5
 Energy Comparison

7000
6000
Price in Rs.

5000
4000 Crude oil Future Price
3000 Natural Gas Future Price
2000
1000
0
10-Nov-06

23-Nov-07

28-Nov-08

05-Nov-10
15-Jun-09

27-Jan-10
18-Jul-07

29-Jul-08
Date

14-Mar-07

29-Mar-08

07-Mar-09

14-Mar-11
20-Oct-09

31-May-10
Years

Figure 6 . Comparison of Energy Prices

Crude oil prices seem to be more volatile than natural gas prices, and there does not seem to be
much co-movement in crude oil and natural gas prices.

Base Metals Comparison

2500

2000 Aluminium Future Price

Price in Rs.

Copper Future Price

1500
Zinc Future Price
1000
Tin Future Price
500 Nickel Future Price
0
27-Nov-07

27-Jan-10
07-Jun-10
17-Jul-07
Date

08-Mar-07

08-Apr-08

23-Feb-11
14-Oct-06

07-May-09
14-Aug-08
26-Dec-08

16-Sep-09

15-Oct-10

Years

Figure 7 . Comparison of Base Metals Prices

While comparing the base metals, nickel and tin futures prices seem to follow each other, while
zinc and aluminium also follow similar trends, with a possible lead-lag relationship between them.

6
GARCH estimates
The GARCH estimation for the sample commodities yielded the results shown in the tables below:

GARCH_ Spot price volatility

commodity µ ω α β vL α+β
GOLD 0.1369% 0.000035 0.224591 0.485181 0.0121% 0.709772
SILVER 0.0000% 0.000001 0.197837 0.802063 1.2000% 0.999900
CRUDE OIL 0.1907% 0.000003 0.236472 0.761892 0.1834% 0.998364
NATURAL GAS 0.5361% 0.000004 0.235309 0.764591 3.8000% 0.999900
ALUMINIUM 0.0000% 0.000001 0.225371 0.774529 0.5000% 0.999900
COPPER 0.0000% 0.000000 0.198013 0.791987 0.0000% 0.990000
NICKEL 0.0128% 0.000378 0.136099 0.836513 1.3787% 0.972613
ZINC 0.0000% 0.000050 0.199761 0.732666 0.0740% 0.932427
TIN 3.9466% 0.000001 0.189827 0.810073 1.0000% 0.999900
CHANNA 0.0100% 0.000129 0.139354 0.858605 6.3223% 0.997960
WHEAT 0.0000% 0.000050 0.224076 0.765924 0.5000% 0.990000
PEPPER 0.0000% 0.000050 0.199061 0.790939 0.5000% 0.990000

GARCH_ Futures price volatility

commodity µ ω α β vL α+β
GOLD 0.1000% 0.000000 0.210594 0.789306 0.2000% 0.999900
SILVER 0.8683% 0.000007 0.004248 0.972910 0.0306% 0.977158
CRUDE OIL 0.0000% 0.000001 0.211214 0.788686 1.1000% 0.999900
NATURAL GAS 0.1942% 0.000021 0.194054 0.780876 0.0846% 0.974930
ALUMINIUM 0.0000% 0.000050 0.199761 0.732666 0.0740% 0.932427
COPPER 0.0000% 0.000002 0.221229 0.778671 1.8000% 0.999900
NICKEL 0.0132% 0.000173 0.000659 0.758801 0.0718% 0.759460
ZINC 0.0000% 0.000050 0.199761 0.732666 0.0740% 0.932427
TIN 0.2589% 0.000002 0.200349 0.797804 0.0920% 0.998153
CHANNA 0.1083% 0.000044 0.000000 0.820840 0.0243% 0.820840
WHEAT 0.0000% 0.000001 0.202620 0.797280 1.1000% 0.999900
PEPPER 0.0233% 0.000031 0.393426 0.527992 0.0393% 0.921418

The GARCH estimates indicate that long-run mean returns of tin, natural gas, silver, channa, crude
oil, and gold were appreciable, while that of aluminium, copper, zinc, and wheat were negligible.
The long-run volatility of zinc and gold were low, while that of the other commodities were
relatively high, especially that of channa and natural gas. The ARCH coefficient for most
commodities was close to 20%; for spot price volatility, α varied between 13.61% (for nickel) to
23.64% (for crude oil), while for futures price volatility, α varied from 0.00% (for channa) to
39.34% (for pepper). The GARCH coefficient for most commodities was close to 80%; for spot
price volatility, β varied between 48.52% (for gold) to 85.86% (for channa), while for futures price
volatility, β varied from 52.80% (for pepper) to 97.29% (for silver). The overall persistence for
most commodities was close to 99%; for spot price volatility, α+β varied between 70.98% (for
gold) to 99.99% (for several commodities), while for futures price volatility, α+β varied from
75.95% (for nickel) to 99.99% (for several commodities). Thus, both spot and futures price
volatility were significantly responsive to shocks.

Effect of trading volume:

The effect of trading volume on commodity futures price volatility was tested using an augmented
GARCH(1, 1) model. The results are shown in the following table.

commodity F-statistic p-value

GOLD 19.0565 0.0018
CRUDE OIL 82.5671 0.0000
COPPER 10.9655 0.0075

7
The results indicate that the effect of trading volume on futures price volatility was significant for
all three commodities (gold, crude oil and copper).

Effect of inflation:
The effect of inflation on commodity futures price volatility was also tested using an augmented
GARCH(1, 1) model. The results are shown in the following table.

commodity F-statistic p-value

GOLD 0.2523 0.8572
CRUDE OIL 49.3000 0.0001
NATURAL GAS 0.1568 0.9215
PEPPER 0.3657 0.7807

The results indicate that inflation had a significant effect on the crude oil futures price volatility,
but no significant effect on futures price volatility of gold, natural gas, and pepper.

DISCUSSION
The study explores commodity prices from several different angles. First, there is the possibility of
lead-lag relationships between commodity spot and futures prices, as seen from the similarity of
their trend patterns. Yang et al (2005) had examined such lead-lag relationships for agricultural
commodities, and had found that changes in futures trading volume uni-directionally causes
increase in spot price volatility. Further studies can address the issue of spot-futures volatility
effects for other commodities.

Another possibility is that of inter-relationship of spot and futures prices and trading volume, for
the same commodity, and between substitute and/or complementary commodities. Particularly
interesting is the dynamics between gold & silver, crude oil & natural gas, the base metals, and
agricultural commodities. Many studies have analysed the effect of futures price volatility on spot
price volatility (Kamara, 1982; Antoniou and Foster, 1992; and Gulen and Mayhew, 2000), and
some studies have addressed inter-commodity volatility impacts (for example, Pindyck, 2004,
studying the behavior of natural gas and crude oil volatility). Again, there is vast scope for further
research in this area.

The GARCH modelling of commodity price volatility yielded some mixed results. The ARCH and
GARCH coefficients for spot prices were close to 20% and 80%, respectively, except for the
GARCH coefficient of gold spot prices, which was considerably lower (48.52%), suggesting that
gold spot prices had lower volatility persistence than any of the other commodities. However, the
ARCH and GARCH coefficients for futures prices were very erratic. The ARCH coefficients of
channa futures (0.00%), nickel futures (0.07%), and silver futures (0.42%) were considerably lower
than that of other commodities, while the ARCH coefficient of pepper futures (39.34%) was
considerably higher. The GARCH coefficient of pepper futures (52.80%) was considerably lower
than that of other commodities, while the GARCH coefficient of silver futures (97.29%) was
considerably higher. Overall, the volatility persistence of most commodity futures prices was 90%
and above, except for nickel futures (75.95%) and channa futures (82.08%). However, the long-run
mean returns and long-run volatility estimates from the GARCH model do not seem congruous. In
particular, the long-run mean returns estimate for tin spot prices (3.95%) is extremely high. Also,
the long-run volatility of channa spot prices (6.32%) and natural gas spot prices (3.80%) is
considerably high. This suggests that the GARCH formulation used may not be appropriate for
Indian commodity markets. There is scope for further research focusing on the appropriateness of

8
more sophisticated models for Indian commodity markets, and perhaps for specific commodities
and/or commodity classes.

Another area explored in the study is the impact of trading volume and inflation on commodity
price volatility for selected commodities. While trading volume was found to have significant
impact on volatility, inflation was found to have significant impact on crude oil price volatility
only. However, the results may depend on the GARCH formulation used, and would thus have to
be investigated after the appropriate GARCH model is determined.

The study has some limitations. The research period selected for the study was 2003-11, which
includes the turbulent period of 2007-08, the aftermath of the global financial crisis, which
witnessed some “unusual” volatility. This may have affected the results. The sample selected for
the study was small, only twelve commodities from the available fifty-nine. Also, the factor testing
was performed for only a few of the commodities. There is vast scope to extend the study to
include more commodities, particularly agricultural commodities, and analyse the impact of more
macroeconomic factors on commodity price volatility.

REFERENCES
 J. C. Hull, Options, Futures and Other Derivatives
 Bollerslev, T. (1986), “Generalised Autoregressive Conditional Heteroskedasticity,”
Journal of Econometrics, vol. 31, pp. 307-327.
 Kamara, A. (1982), “Issues in Futures Markets: A Survey,” Journal of Futures Markets,
vol. 2, pp. 261–94.
 Antoniou, A. and Foster, A.J. (1992), “The Effect of Futures Trading on Cash Price
Volatility: Evidence for Brent Crude Oil Using GARCH,” Journal of Business Finance &
Accounting, vol. 19, pp. 473–84.
 Gulen, H. and Mayhew, S. (2000), “Stock Index Futures Trading and Volatility in
International Equity Markets,” Journal of Futures Markets, vol. 20, pp. 661–85.
 Yang, J., Balyeat, R.B., and Leatham, D.J. (2005), “Futures Trading Activity and
Commodity Cash Price Volatility,” Journal of Business Finance & Accounting, vol. 32,
Issue 1/2, pp. 297-323.
 Ates, A. and Wang, G.H.K. (2007), “Price Dynamics in Energy Spot and Futures Markets:
The Role of Inventory and Weather,” presented at Financial Management Association
Annual Meeting.
 Pindyck, R. (2004), “Volatility in Natural Gas and Oil Markets,” The Journal of Energy and
Development, Vol. 30, No. 1, pp. 1-19.