Hedging Efficiency PDF

HEDGING
EFFICIENCY
A Comparative Assessment of
MCX vis-à-vis Global Exchanges
Occasional Paper Series No.2/2013

© MCX, 2013.
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While every effort has been made to assure the accuracy of the information carried in this Occasional Paper, any affirmation of facts herein
shall not create an express or implied warranty that any example or description is correct.
Inside
Abstract 1
1. Introduction 2
2. Research Objectives and Methodology 3
3. Estimation and Results 5
4. Summary and Conclusions 7
Appendix 1:
Results of Regression Analysis and Tests of Stationarity 8
Appendix 2:
Analysis of the Results of Regressions 20
References 28
Abstract
The national level commodity derivative exchanges in India have grown at an appreciable rate
in a short span since their inception in the early 2000s to acquire premium positions in the league
of global benchmark exchanges. This growth can be attributed to the absence of an alternative
market mechanism for stakeholders to manage their risks arising from commodity price
volatility.
The Multi Commodity Exchange of India Limited (MCX) has emerged as the leading exchange
with 87%* share of the Indian commodity futures market. Moreover, MCX also ranks among the
top 3 exchanges# in the world in terms of the number of futures contracts traded. Globally,
hedging effectiveness of futures contracts has emerged as an important determinant in
evaluating their success as also that of the exchange offering them. Hence, when an Indian
commodity exchange, viz. MCX, has emerged as among the top-ranked exchanges, the curiosity
naturally arises:
Ÿ Measured in terms of hedging efficiency, how effective is the MCX platform for hedging?
Ÿ How does the hedging efficiency of MCX’s liquid commodity contracts compare with their
international counterparts?
This research answers these questions. This paper concludes that in commodities as diverse as
gold, aluminium, copper and crude palm oil, hedging efficiency of MCX’s futures contracts are
comparable with those of the global benchmark exchanges.
Source:
* Forward Markets Commission (FMC)
# World Federation of Exchanges (WFE/IOMA) Derivatives Market Survey 2012
HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 1

1 Introduction
The history of understanding and managing risks is closely intertwined with
the history of human civilisation. Risk management is a concept that dates
back thousands of years, when early merchants and traders tried to identify
and deal with manageable risks and evaluate their costs (Bernstein, 1996).
Traditionally, individuals and firms have resorted to a host of risk
management measures to mitigate the impact of risks on their economic
activities. However, with the evolution of the market, stakeholders began to
use this institution to manage risks, largely through its transfer from the risk-
averse to the risk-taking entities. The availability and proliferation of risk-
embedded financial products which could be traded in the market lent
sophistication to the risk management practice.
Currently, the application of statistical by taking opposite and equal positions in

and mathematical tools in measuring the physical and derivatives markets,
and managing risks has led to a paradigm simultaneously. Commodity derivative
shift in the entire risk management exchanges facilitate participants to
function. The contribution to mathematical take positions suitable for undertaking
modelling by Harry Markowitz (mean- hedging, and disseminate prices of both
variance theory of portfolio selection) and the derivatives and spot markets for
others in the 1950s provided a framework this purpose. Hence, exchanges have
for portfolio selection and quantifying the emerged as one of the most important
risk-return trade-off (Merton, 1995). Thanks institutions in the price risk management
to the advancement of financial risk function of any stakeholder.
management, market-based tools such
While hedging has generally proved to be
as futures, options, swaps, swaptions
one of the most popular techniques for
and various combinations of such
risk management, it is imperative
instruments have enabled some of the
to test its efficiency, and estimate its
most effective risk management practices
effectiveness as a risk management
today. These tools are not only cheaper
tool in a quantitative manner. This paper
than the alternatives, but also are some
attempts to test the platforms where
of the most effective instruments in
hedging is available and compares/
managing risks, especially those arising
contrasts their performance on suitable
from volatility of prices, including
parameters of 'efficiency'. Using well-
commodity prices. As a result, 'hedging'
established methodologies to estimate
against price volatility using derivative
the hedging efficiency of various futures
instruments has emerged as one of
contracts traded on India's largest commodity
the most popular techniques of risk
exchange — Multi Commodity Exchange
management in recent times.
of India Ltd ( MCX), we compare them with
At the most basic level, hedging is the those of the global exchanges, which are
act of mitigating risks arising from price setters in the respective
unforeseen future prices of commodities commodities.

2 Research Objectives
and Methodology
Research objectives
The primary objective of the paper is to determine the hedging efficiency of

specific commodities traded on MCX and compare them with global
benchmark exchanges.

RESEARCH OBJECTIVES & METHODOLOGY
Hedging Efficiency: Hedging Efficiency measures the degree to which the simultaneous gains or losses in
the physical market are equalised by the respective losses or gains in the futures market – thereby ensuring
effective ‘lock in’
Optimal Hedge Ratio - the number of units of the futures asset to sell per unit of the spot asset held.
The equation obtained is given

below.
THE REGRESSION EQUATION

3 Estimation and Results
Estimation
Daily price time series data of generic contracts of commodities such as

Gold, Aluminium, Copper and Crude Palm Oil which are comparable
with the one on MCX, have been obtained from the respective global
benchmark exchanges.
SELECTED COMMODITIES AND Table 1

THEIR FUTURES CONTRACTS AT EXCHANGES
Commodities Futures Contracts at Exchanges

Gold MCX 1 Kg, COMEX 100 troy ounces.
Aluminium MCX 5MT, LME 25 MT
Copper MCX 1 MT, LME 25 MT
Crude Palm Oil MCX 10 MT, BMD 25 MT
A Dickey-Fuller test is an econometric test to acertain whether a certain kind of time series data has
an autoregressive unit root. The augmented Dickey–Fuller (ADF) statistic, used in the test, is a
negative number. The more negative it is, the stronger the rejection of the hypothesis that there is a
unit root at some level of confidence.

ESTIMATION & RESULTS
Results
COMEX (CME)
• COMEX is one of the most important
Adopting the aforestated methodology, the optimal hedge ratio commodity exchange platforms in
and hedging efficiency has been evaluated. The results are the world for futures and options
trading in gold and other precious
provided in Table 2. Further, F-test was conducted to compare the metals.
hedging efficiencies of commodity contracts at MCX with the • In 1933, the COMEX (Commodity
corresponding contracts at the global benchmark exchanges. Exchange, Inc ) was established
through the merger of four small
exchanges; the National Metal
Exchange, the Rubber Exchange of
HEDGE RATIOS AND HEDGING EFFICIENCY OF MCX Table 2 New York, the National Raw Silk
Exchange, and the New York Hide
VIS-À-VIS THE GLOBAL EXCHANGES Exchange. Later, on August 3, 1994,
Commodities/ Period Hedge Ratio Hedging Hedge Ratio Hedging the NYMEX (New York Mercantile
Exchanges βF Efficiency (%) βF Efficiency (%) Exchange) and COMEX merged under
the NYMEX.
R2 R2
MCX COMEX • Today, COMEX is owned by the CME
Gold Monthly 1.03 98.7 1.00 99.8 group and operates as Designated
Contract Markets (DCM) of the group.
Weekly 0.89 89.5 0.99 98.9
LME
MCX LME • The London Metal Exchange (LME) is
Aluminum Monthly 1.01 99.0 0.99 99.9 the world's largest commodity
Weekly 0.97 97.0 1.00 99.4 exchange in options and futures
contracts for base and other metals.
MCX LME • The London Metal Market and
Copper Monthly 1.00 99.4 0.99 99.9 Exchange Company was founded in
Weekly 1.03 97.7 0.99 99.9 1877, but the market traces its origins
back to 1571 and the opening of the
Royal Exchange, London. In July 2012,
MCX BMD LME's shareholders voted to sell the
Crude Palm Oil Monthly 1.01 99.5 0.98 99.0 exchange to Hong Kong Exchanges
Weekly 0.99 94.4 0.88 90.3 and Clearing.
Details of the above results are in Appendices 1 and 2 • The LME offers futures and options
contracts for aluminium, aluminium
alloy, NASAAC (North American
Special Aluminium Alloy), cobalt,
copper, lead, molybdenum, nickel,
steel billet, tin and zinc.
Bursa Malaysia
• Bursa Malaysia previously known as
Kuala Lumpur Stock Exchange dates
back to 1930 when the Singapore
Stockbrokers' Association was set up
as a formal organisation dealing in
securities in Malaya.
• Since 1980, Bursa Malaysia has
emerged as the world's significant
palm oil futures trading hub. Crude
palm kernel futures and crude palm
oil futures are primarily traded on
Bursa Malaysia in Malaysian Ringgit
(MYR) and US Dollar denominated
contracts.

4 Summary and Conclusions
From the price analysis of a broad range of commodities traded on MCX and
the global benchmark exchanges, it is evident that the hedging efficiency of
MCX is not only high but also compares favorably with international
exchanges, both for weekly and monthly prices.
Hence, MCX is at par with its international also reflect on the attractiveness of the
counterparts in terms of hedging exchange-traded commodity futures
efficiency and emerges as an efficient market in India as an efficient platform for
platform for price risk management for a price risk management. The availability of
wide range of commodities across such risk management platform within
agriculture, base metals and bullion the economy, at the domestic business
segments. hours and at domestically denominated
The results bear testimony to not just the currency has arguably contributed to this
well-connectedness of the futures and attractiveness and reinforced its efficiency.
physical commodity markets in India, but
HEDGING EFFICIENCY OF MCX AT PAR WITH GLOBAL EXCHANGES
COMEX LME BMD MCX

EFFICIENCY
EFFICIENCY
EFFICIENCY
EFFICIENCY
HEDGING
Fig 2: Hedging Efficiency of MCX

Appendix 1:
Results of Regression Analysis and Tests of Stationarity (ADF)
GOLD
Regression on Weekly Average Data
MCX
COMEX
Regression on Monthly Average Data
MCX
COMEX

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / GOLD
ADF on MCX Weekly Prices
ADF on MCX Monthly Prices

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / GOLD
ADF on COMEX Weekly Prices
ADF on COMEX Monthly Prices

ALUMINIUM
MCX
LME
MCX
LME

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / ALUMINIUM

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / ALUMINIUM
ADF on LME Weekly Prices
ADF on LME Monthly Prices

COPPER
MCX
LME
MCX
LME

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / COPPER

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / COPPER
ADF on LME Weekly Prices
ADF on LME Monthly Prices

CRUDE PALM OIL
MCX
BMD
MCX
BMD

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / CRUDE PALM OIL

APPENDIX 1: RESULTS OF REGRESSION ANALYSIS AND TESTS OF STATIONARITY (ADF) / CRUDE PALM OIL
ADF on BMD Weekly Prices
ADF on BMD Monthly Prices

Appendix 2:
Analysis of the results of Regressions
GOLD
Analysing daily data for the nearest trading month Gold 1 Kg
generic contract on MCX and Gold 100 troy ounces. generic
contract on COMEX for the period January 1, 2009 to April 30,
2012, we evaluate and determine the optimal hedge ratio and
hedging efficiency. After conducting the unit root test for spot
and futures prices for both weekly and monthly data, time series
regression has been undertaken taking changes in spot price as
the dependent variable and changes in futures price as the
independent variable.
MCX
35000
30000
25000
20000
15000
10000
5000
All prices are in INR/ 10 grams.
0
1/1/2009 1/1/2010 1/1/2011 1/1/2012
Futures Price Spot Price
COMEX
2000
1800
1600
1400
1200
1000
800
600
400
200
All prices are in USD/Troy ounce.
0
1/1/2009 1/1/2010 1/1/2011 1/1/2012
Data Source: Bloomberg

APPENDIX 2: ANALYSIS OF THE RESULTS OF REGRESSIONS / GOLD
HEDGING EFFICIENCY OF GENERIC GOLD AT MCX AND COMEX Table 3

MCX COMEX
*Significant at 5% confidence level
Hedging efficiency increases as we move up from weekly to monthly averages.
RESULTS OF F-TEST ON WEEKLY DATA Table 4

F-Test
Markets MCX COMEX
R square value 0.895691 0.989623
Degrees of freedom 174 172
Numerator 0.000276237
Denominator 0.000599477
F test statistic value 0.460796643
Critical F test value at 5% C.L 1.25
Since F-test statistic value < Critical F value at 5% Confidence Level (CL), hence we cannot
reject the null hypothesis. Thus, the hedging efficiency of MCX is statistically equivalent to
the hedging efficiency of COMEX.
RESULTS OF F-TEST ON MONTHLY DATA Table 5

F-Test
Markets MCX COMEX
R square value 0.987987 0.998713
the hedging efficiency of COMEX.
RESULT:
Hedging efficiency of generic gold contract at MCX is comparable to corresponding
contract COMEX.
4

ALUMINIUM
Analysing daily data for the nearest trading month Aluminium 5
MT generic contract on MCX and Aluminium 25 MT generic
contract on LME for the period January 1, 2009 to April 30, 2012,
we evaluate and determine the optimal hedge ratio and hedging
efficiency. After conducting the unit root test for spot and futures
prices for both weekly and monthly data, time series regression
has been undertaken taking changes in spot price as the
dependent variable and changes in futures price as the
MCX
140
120
100
80
60
40
20
All prices are in INR/ kg.
0
1/1/2009 1/1/2010 1/1/2011 1/1/2012
LME
3000
2500
2000
1500
1000
500
All prices are in USD/MT.
0
1/1/2009 1/1/2010 1/1/2011 1/1/2012

APPENDIX 2: ANALYSIS OF THE RESULTS OF REGRESSIONS / ALUMINIUM
HEDGING EFFICIENCY OF GENERIC ALUMINIUM AT MCX AND LME Table 6

MCX LME

F-Test
Markets MCX LME
R square value 0.909181 0.994817
Numerator 0.0002489
the hedging efficiency of LME.

F-Test
Markets MCX LME
R square value 0.990752 0.99911
thehedging efficiency of LME.
RESULT: Hedging efficiency of generic Aluminium contract at MCX is comparable to

corresponding contract at LME.

COPPER
Analysing daily data for the nearest trading month Copper 1 MT
generic contract on MCX and Copper 25 MT generic contract on
LME for the period January 1, 2009 to February 29, 2012, we
evaluate and determine the optimal hedge ratio and hedging
prices for both weekly and monthly data, time series regression
has been undertaken taking changes in spot price as the
dependent variable and changes in futures price as the
MCX
500.0
450.0
400.0
350.0
300.0
250.0
200.0
150.0
100.0
50.0
All prices are in INR/ kg.
0.0
1/1/2009 1/1/2010 1/1/2011 1/1/2012
LME
12000
10000
8000
6000
4000
2000
All prices are in USD/MT.

0
1/1/2009 1/1/2010 1/1/2011 1/1/2012


APPENDIX 2: ANALYSIS OF THE RESULTS OF REGRESSIONS / COPPER
HEDGING EFFICIENCY OF GENERIC COPPER AT MCX AND LME Table 9

MCX LME
Hedging efficiency increases as we move up from daily data to weekly and monthly
averages.

F-Test
Markets MCX LME
R square value 0.97721 0.999599
Numerator 6.82591E-05

F Test
Markets MCX LME
R square value 0.994098 0.999957
Numerator 8.37E-05
RESULT:
Hedging efficiency of generic copper contract at MCX is comparable to corresponding
contract at LME.

CRUDE PALM OIL
Analysing daily data for the nearest trading month Crude Palm Oil 10
MT generic contract on MCX and Crude Palm Oil 25 MT generic
contract on BMD for the period February 1, 2009 to April 30, 2012, we
evaluate and determine the optimal hedge ratio and hedging
prices for both weekly and monthly data, time series regression has
been undertaken taking changes in spot price as the dependent
variable and changes in futures price as the independent variable.
MCX
700
600
500
400
300
200
100
All prices are in INR/10 kg.

0
2/3/2009 2/3/2010 2/3/2011 2/3/2012
BMD
4500
4000
3500
3000
2500
2000
1500
1000
500
All prices are in MYR/MT.
0
2/3/2009 2/3/2010 2/3/2011 2/3/2012
Data Source: Bloomberg Futures Price Spot Price

APPENDIX 2: ANALYSIS OF THE RESULTS OF REGRESSIONS / CRUDE PALM OIL
HEDGING EFFICIENCY OF GENERIC CPO AT MCX AND BMD Table 12

MCX BMD

F-Test
Markets MCX BMD
R square value 0.903712 0.944804
the hedging efficiency of BMD.

F-Test
Markets MCX BMD
R square value 0.990281 0.995754
Numerator 7.60139E-05
the hedging efficiency of BMD.
RESULT:
Hedging efficiency of generic crude palm oil contract at MCX is comparable to
corresponding contract at BMD.

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HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 4 29

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HEDGING

Occasional Paper Series No.2/2013

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 1

Currently, the application of statistical by taking opposite and equal positions in

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 2

The primary objective of the paper is to determine the hedging efficiency of

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 3

The equation obtained is given

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 4

Daily price time series data of generic contracts of commodities such as

SELECTED COMMODITIES AND Table 1

Commodities Futures Contracts at Exchanges

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 5

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 6

HEDGING EFFICIENCY OF MCX AT PAR WITH GLOBAL EXCHANGES

COMEX LME BMD MCX

Fig 2: Hedging Efficiency of MCX

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 7

Regression on Monthly Average Data

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 8

ADF on MCX Weekly Prices

ADF on MCX Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 9

ADF on COMEX Weekly Prices

ADF on COMEX Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 10

Regression on Monthly Average Data

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 11

ADF on MCX Weekly Prices

ADF on MCX Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 12

ADF on LME Weekly Prices

ADF on LME Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 13

Regression on Monthly Average Data

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 14

ADF on MCX Weekly Prices

ADF on MCX Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 15

ADF on LME Weekly Prices

ADF on LME Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 16

Regression on Monthly Average Data

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 17

ADF on MCX Weekly Prices

ADF on MCX Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 18

ADF on BMD Weekly Prices

ADF on BMD Monthly Prices

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 19

Data Source: Bloomberg

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 20

HEDGING EFFICIENCY OF GENERIC GOLD AT MCX AND COMEX Table 3

*Significant at 5% confidence level

Hedging efficiency increases as we move up from weekly to monthly averages.

RESULTS OF F-TEST ON WEEKLY DATA Table 4

RESULTS OF F-TEST ON MONTHLY DATA Table 5

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 21

HEDGING EFFICIENCY: A COMPARATIVE ASSESSMENT 22

HEDGING EFFICIENCY OF GENERIC ALUMINIUM AT MCX AND LME Table 6

*Significant at 5% confidence level

Hedging efficiency increases as we move up from weekly to monthly averages.

RESULTS OF F-TEST ON WEEKLY DATA Table 7