Agricultural commodities derivatives markets in India

Susan Thomas

March 6, 2007

Susan Thomas

Agricultural commodities derivatives markets in India

The development of Indian agricultural derivatives markets
Local markets for futures on agricultural commodities have been recorded to be around from the 1800. These were banned in the late ’60s, and revived in the early ’80s. After the successful equity market reforms of ’90s, the commodities derivatives regulator tried to replicate similar reforms for the commodity derivatives markets. This effort got significant support in 1999 when the Government of India (GOI) suggested that the Minimum Support Price (MSP) as a price hedging instrument could be replaced with derivatives markets. However, the condition was that these markets were liquid and efficient, backed by prevailing best practices of trading, clearing and settlement.
Susan Thomas Agricultural commodities derivatives markets in India

The development of Indian agricultural derivatives markets
Local markets for futures on agricultural commodities have been recorded to be around from the 1800. These were banned in the late ’60s, and revived in the early ’80s. After the successful equity market reforms of ’90s, the commodities derivatives regulator tried to replicate similar reforms for the commodity derivatives markets. This effort got significant support in 1999 when the Government of India (GOI) suggested that the Minimum Support Price (MSP) as a price hedging instrument could be replaced with derivatives markets. However, the condition was that these markets were liquid and efficient, backed by prevailing best practices of trading, clearing and settlement.
Susan Thomas Agricultural commodities derivatives markets in India

The development of Indian agricultural derivatives markets
Local markets for futures on agricultural commodities have been recorded to be around from the 1800. These were banned in the late ’60s, and revived in the early ’80s. After the successful equity market reforms of ’90s, the commodities derivatives regulator tried to replicate similar reforms for the commodity derivatives markets. This effort got significant support in 1999 when the Government of India (GOI) suggested that the Minimum Support Price (MSP) as a price hedging instrument could be replaced with derivatives markets. However, the condition was that these markets were liquid and efficient, backed by prevailing best practices of trading, clearing and settlement.
Susan Thomas Agricultural commodities derivatives markets in India

The institutions at the national commodity exchanges: electronic. both MCX and NCDEX trade guar seed. Commodity derivatives are physically settled – different from equity. Susan Thomas Agricultural commodities derivatives markets in India .State of the Indian commodity derivatives markets Three national. transparent trading and clearing with novation – same as equity. However. Initial evidence: local exchanges that were successful before the national exchanges were established. These compete on trading commodities: for example. multi-commodity exchanges from end 1994. Local exchanges trading a single commodity still exist. continue to retain their business. both NCDEX and NMCE trade pepper. recent evidence suggests that local exchanges are steadily losing to the national. multi-commodity exchanges.

both NCDEX and NMCE trade pepper. Local exchanges trading a single commodity still exist. multi-commodity exchanges. transparent trading and clearing with novation – same as equity. The institutions at the national commodity exchanges: electronic. However. recent evidence suggests that local exchanges are steadily losing to the national. continue to retain their business. These compete on trading commodities: for example. Initial evidence: local exchanges that were successful before the national exchanges were established. Susan Thomas Agricultural commodities derivatives markets in India .State of the Indian commodity derivatives markets Three national. both MCX and NCDEX trade guar seed. multi-commodity exchanges from end 1994. Commodity derivatives are physically settled – different from equity.

Susan Thomas Agricultural commodities derivatives markets in India . recent evidence suggests that local exchanges are steadily losing to the national. Local exchanges trading a single commodity still exist. Initial evidence: local exchanges that were successful before the national exchanges were established. continue to retain their business. both NCDEX and NMCE trade pepper. both MCX and NCDEX trade guar seed. multi-commodity exchanges. The institutions at the national commodity exchanges: electronic. These compete on trading commodities: for example.State of the Indian commodity derivatives markets Three national. transparent trading and clearing with novation – same as equity. However. multi-commodity exchanges from end 1994. Commodity derivatives are physically settled – different from equity.

Susan Thomas Agricultural commodities derivatives markets in India . Local exchanges trading a single commodity still exist. The institutions at the national commodity exchanges: electronic. These compete on trading commodities: for example. However. multi-commodity exchanges from end 1994. multi-commodity exchanges. continue to retain their business. Initial evidence: local exchanges that were successful before the national exchanges were established. Commodity derivatives are physically settled – different from equity. both MCX and NCDEX trade guar seed. transparent trading and clearing with novation – same as equity. recent evidence suggests that local exchanges are steadily losing to the national.State of the Indian commodity derivatives markets Three national. both NCDEX and NMCE trade pepper.

900 11.100 (26%) (74%) Susan Thomas Agricultural commodities derivatives markets in India .000 4.500 15.000 35.Average daily volumes on financial markets Market Equity spot Equity derivatives Bond market Commodity derivatives of which Agriculture Non-agriculture Average Daily Volumes (in Rs. crore) 9.000 3.

Linking arbitrage to hedging efficiency Susan Thomas Agricultural commodities derivatives markets in India .

no-arbitrage is defined when the futures and the spot price move in tandem. Susan Thomas Agricultural commodities derivatives markets in India . In the context of commodity futures.Can the commodity derivatives be used for hedging price risk? Derivatives contracts can be good hedging instruments when they are efficiently priced. We measure efficiency as the outcome of a no-arbitrage condition.

Can the commodity derivatives be used for hedging price risk? Derivatives contracts can be good hedging instruments when they are efficiently priced. no-arbitrage is defined when the futures and the spot price move in tandem. Susan Thomas Agricultural commodities derivatives markets in India . In the context of commodity futures. We measure efficiency as the outcome of a no-arbitrage condition.

no-arbitrage is defined when the futures and the spot price move in tandem.Can the commodity derivatives be used for hedging price risk? Derivatives contracts can be good hedging instruments when they are efficiently priced. We measure efficiency as the outcome of a no-arbitrage condition. In the context of commodity futures. Susan Thomas Agricultural commodities derivatives markets in India .

We define basis as Basis = rfutures − rspot Basis should be very small.Basis and basis risk behaviour We operationalise this as analysing the behaviour of returns on the futures contract vis-a-vis returns on the spot. and have a low volatility if no-arbitrage conditions hold. Susan Thomas Agricultural commodities derivatives markets in India . then there should be a very high correlation between the two. If the no-arbitrage condition is satisfied.

If the no-arbitrage condition is satisfied.Basis and basis risk behaviour We operationalise this as analysing the behaviour of returns on the futures contract vis-a-vis returns on the spot. Susan Thomas Agricultural commodities derivatives markets in India . then there should be a very high correlation between the two. and have a low volatility if no-arbitrage conditions hold. We define basis as Basis = rfutures − rspot Basis should be very small.

as well as. and that the export-oriented market prices dominate production-oriented market except in the harvest season when the relation was reversed. using the same principle of no-arbitrage conditions being satisfied. one export-oriented and another production-oriented. The behaviour of the basis and basis risk across two different markets. The examination included identifying: 1 2 The flow of information between futures and spot prices. Ramaswamy and Singh (2006) examine the use the soyoil futures contract for hedging purposes. They find that futures dominate spot prices. Susan Thomas Agricultural commodities derivatives markets in India . They find that there are very low arbitrage opportunities in this market.Efficiency on the traditional futures markets Thomas and Karande (1999) examined efficiency of the castor-seed futures markets in India.

The behaviour of the basis and basis risk across two different markets. and that the export-oriented market prices dominate production-oriented market except in the harvest season when the relation was reversed. as well as. using the same principle of no-arbitrage conditions being satisfied. Susan Thomas Agricultural commodities derivatives markets in India . Ramaswamy and Singh (2006) examine the use the soyoil futures contract for hedging purposes. The examination included identifying: 1 2 The flow of information between futures and spot prices.Efficiency on the traditional futures markets Thomas and Karande (1999) examined efficiency of the castor-seed futures markets in India. one export-oriented and another production-oriented. They find that futures dominate spot prices. They find that there are very low arbitrage opportunities in this market.

but it is not a binding constraint in the price discovery process.Examining basis for contracts on the new exchanges We analyse the basis for five commodities that trade on the national multicommodity exchanges. These are: 1 Guar seed: This is the commodity where there has been the longest period with significant liquidity. 2 3 4 5 Susan Thomas Agricultural commodities derivatives markets in India . Jeera : This is one of the newest contracts on the electronic exchange in terms of it’s liquidity buildup. Channa : A commodity that does have an MSP. Wheat: One of the essential commodities where the government maintains a minimum support price (MSP). Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties.

Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties. Jeera : This is one of the newest contracts on the electronic exchange in terms of it’s liquidity buildup. Channa : A commodity that does have an MSP. 2 3 4 5 Susan Thomas Agricultural commodities derivatives markets in India . Wheat: One of the essential commodities where the government maintains a minimum support price (MSP). These are: 1 Guar seed: This is the commodity where there has been the longest period with significant liquidity.Examining basis for contracts on the new exchanges We analyse the basis for five commodities that trade on the national multicommodity exchanges. but it is not a binding constraint in the price discovery process.

2 3 4 5 Susan Thomas Agricultural commodities derivatives markets in India . Channa : A commodity that does have an MSP. Wheat: One of the essential commodities where the government maintains a minimum support price (MSP).Examining basis for contracts on the new exchanges We analyse the basis for five commodities that trade on the national multicommodity exchanges. These are: 1 Guar seed: This is the commodity where there has been the longest period with significant liquidity. Jeera : This is one of the newest contracts on the electronic exchange in terms of it’s liquidity buildup. but it is not a binding constraint in the price discovery process. Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties.

Examining basis for contracts on the new exchanges We analyse the basis for five commodities that trade on the national multicommodity exchanges. Channa : A commodity that does have an MSP. Jeera : This is one of the newest contracts on the electronic exchange in terms of it’s liquidity buildup. Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties. These are: 1 Guar seed: This is the commodity where there has been the longest period with significant liquidity. Wheat: One of the essential commodities where the government maintains a minimum support price (MSP). 2 3 4 5 Susan Thomas Agricultural commodities derivatives markets in India . but it is not a binding constraint in the price discovery process.

2 3 4 5 Susan Thomas Agricultural commodities derivatives markets in India . These are: 1 Guar seed: This is the commodity where there has been the longest period with significant liquidity.Examining basis for contracts on the new exchanges We analyse the basis for five commodities that trade on the national multicommodity exchanges. Channa : A commodity that does have an MSP. Wheat: One of the essential commodities where the government maintains a minimum support price (MSP). Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties. Jeera : This is one of the newest contracts on the electronic exchange in terms of it’s liquidity buildup. but it is not a binding constraint in the price discovery process.

Susan Thomas Agricultural commodities derivatives markets in India . Except for Jeera and Channa. where prices are available only from 2005 onwards. liquidity Commodity Guar seed Wheat Pepper Jeera Channa Age Old Old Old New Old Liquidity High Low Low Low RecentHigh MSP No Yes No No Yes We use data for these contracts from December 2004 to end 2006.Organising the commodities by age.

which is very liquid and is physically settled. However. the risk of this is that of a diversified portfolio. Another comparitive can be the most liquid single stock futures contract. Nifty. we identify some other Indian markets to provide benchmarks for the above commodities. Both these financial futures are very different from the commodities contracts because they are cash-settled. Susan Thomas Agricultural commodities derivatives markets in India . A last comparitive that we use is the gold futures contract.Comparitives Since efficiency and liquidity is best understood as a relative measure. We use the futures on the Tata Steel stock. The longest running as well as the most liquid derivatives Indian market is the futures market on the market index.

the risk of this is that of a diversified portfolio. Nifty. we identify some other Indian markets to provide benchmarks for the above commodities. Susan Thomas Agricultural commodities derivatives markets in India . The longest running as well as the most liquid derivatives Indian market is the futures market on the market index. Both these financial futures are very different from the commodities contracts because they are cash-settled. We use the futures on the Tata Steel stock. However. which is very liquid and is physically settled.Comparitives Since efficiency and liquidity is best understood as a relative measure. Another comparitive can be the most liquid single stock futures contract. A last comparitive that we use is the gold futures contract.

We use the futures on the Tata Steel stock. the risk of this is that of a diversified portfolio. Both these financial futures are very different from the commodities contracts because they are cash-settled. A last comparitive that we use is the gold futures contract. Another comparitive can be the most liquid single stock futures contract. Nifty.Comparitives Since efficiency and liquidity is best understood as a relative measure. However. Susan Thomas Agricultural commodities derivatives markets in India . The longest running as well as the most liquid derivatives Indian market is the futures market on the market index. we identify some other Indian markets to provide benchmarks for the above commodities. which is very liquid and is physically settled.

We use the futures on the Tata Steel stock. which is very liquid and is physically settled.Comparitives Since efficiency and liquidity is best understood as a relative measure. Another comparitive can be the most liquid single stock futures contract. A last comparitive that we use is the gold futures contract. Nifty. we identify some other Indian markets to provide benchmarks for the above commodities. Both these financial futures are very different from the commodities contracts because they are cash-settled. However. Susan Thomas Agricultural commodities derivatives markets in India . the risk of this is that of a diversified portfolio. The longest running as well as the most liquid derivatives Indian market is the futures market on the market index.

Results Susan Thomas Agricultural commodities derivatives markets in India .

672 0. Commodity Guar seed Wheat Pepper Jeera Channa ρ 0.427 0.577 0.515 Susan Thomas Agricultural commodities derivatives markets in India .Simple correlations between rfutures and rfutures Following are the correlations calculated using the entire set of data on futures and spot returns for a given commodity.549 0.

The OLS R 2 would tell us how much of the variance of the futures return is being captured by the spot (or vice-versa).Problems with the above A raw correlation includes both the systematic and the unsystematic correlation between the two. we examine the OLS regression of futures on spot returns for the above. Thus. The OLS coefficient would tell us the systematic comovement between the futures and spot returns. Susan Thomas Agricultural commodities derivatives markets in India . What we would prefer to use is a regression of the futures returns on the spot returns.

Susan Thomas Agricultural commodities derivatives markets in India .Problems with the above A raw correlation includes both the systematic and the unsystematic correlation between the two. The OLS R 2 would tell us how much of the variance of the futures return is being captured by the spot (or vice-versa). The OLS coefficient would tell us the systematic comovement between the futures and spot returns. What we would prefer to use is a regression of the futures returns on the spot returns. Thus. we examine the OLS regression of futures on spot returns for the above.

The OLS R 2 would tell us how much of the variance of the futures return is being captured by the spot (or vice-versa). What we would prefer to use is a regression of the futures returns on the spot returns. Susan Thomas Agricultural commodities derivatives markets in India . The OLS coefficient would tell us the systematic comovement between the futures and spot returns. we examine the OLS regression of futures on spot returns for the above.Problems with the above A raw correlation includes both the systematic and the unsystematic correlation between the two. Thus.

What we would prefer to use is a regression of the futures returns on the spot returns. Thus. The OLS R 2 would tell us how much of the variance of the futures return is being captured by the spot (or vice-versa). The OLS coefficient would tell us the systematic comovement between the futures and spot returns. we examine the OLS regression of futures on spot returns for the above.Problems with the above A raw correlation includes both the systematic and the unsystematic correlation between the two. Susan Thomas Agricultural commodities derivatives markets in India .

33 0.813∗∗ 0.Regression of rfutures on rfutures Commodity Guar seed Wheat Pepper Jeera Channa β 0.30 0.50 0.515∗∗ Adjusted R 2 0.884∗∗ 0.893∗∗ 0.453∗∗ 0.26 Susan Thomas Agricultural commodities derivatives markets in India .24 0.

This implies that at different periods. Another problem is that there are often contract specification changes.Problems with interpreting the above One problem is that the entire period of data includes highly variable periods of liquidity for each commodity. wheat. we examine just the last two months of futures trading for each of the above.. Susan Thomas Agricultural commodities derivatives markets in India . Eg. there would be different amounts of arbitrage available. Therefore. These are adjustments made to the contract by the exchange in response to poor liquidity on an existing contract.

. Eg. Another problem is that there are often contract specification changes. there would be different amounts of arbitrage available.Problems with interpreting the above One problem is that the entire period of data includes highly variable periods of liquidity for each commodity. we examine just the last two months of futures trading for each of the above. Therefore. Susan Thomas Agricultural commodities derivatives markets in India . This implies that at different periods. These are adjustments made to the contract by the exchange in response to poor liquidity on an existing contract. wheat.

611∗∗ 0.455∗∗ Adjusted R 2 0.rfutures on rfutures for the last two months Commodity Guar seed Wheat Pepper Jeera Channa β 1.62 0.22 Susan Thomas Agricultural commodities derivatives markets in India .06 0.009∗∗ 0.710 0.33 0.991∗∗ 0.25 0.

455∗∗ 1.611∗∗ 0.62 0.056∗∗ Adjusted R 2 0.009∗∗ 0.98 Susan Thomas Agricultural commodities derivatives markets in India .25 0.003∗∗ 1.33 0.Comparing with benchmarks Commodity Guar seed Wheat Pepper Jeera Channa TataSteel Nifty β 1.06 0.710 0.991∗∗ 0.99 0.22 0.

The data above would suggest that cash-settled contracts tend to be more amenable to no-arbitrage conditions than physically settled contracts. Susan Thomas Agricultural commodities derivatives markets in India . Wheat and Channa show the worst signs of poor hedging prospects. Both Jeera and Pepper have a high β but a low R 2 which is endemic of poor liquidity.Inferences Guar Seed shows the best signs of low arbitrage opportunities and good hedging prospects.

Both Jeera and Pepper have a high β but a low R 2 which is endemic of poor liquidity. Susan Thomas Agricultural commodities derivatives markets in India . Wheat and Channa show the worst signs of poor hedging prospects. The data above would suggest that cash-settled contracts tend to be more amenable to no-arbitrage conditions than physically settled contracts.Inferences Guar Seed shows the best signs of low arbitrage opportunities and good hedging prospects.

The data above would suggest that cash-settled contracts tend to be more amenable to no-arbitrage conditions than physically settled contracts. Susan Thomas Agricultural commodities derivatives markets in India .Inferences Guar Seed shows the best signs of low arbitrage opportunities and good hedging prospects. Both Jeera and Pepper have a high β but a low R 2 which is endemic of poor liquidity. Wheat and Channa show the worst signs of poor hedging prospects.

Wheat and Channa show the worst signs of poor hedging prospects.Inferences Guar Seed shows the best signs of low arbitrage opportunities and good hedging prospects. The data above would suggest that cash-settled contracts tend to be more amenable to no-arbitrage conditions than physically settled contracts. Susan Thomas Agricultural commodities derivatives markets in India . Both Jeera and Pepper have a high β but a low R 2 which is endemic of poor liquidity.

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