Price Discovery of the Indian Commodity Market

Since the introduction of Future trading in the commodity exchanges in India, it has reduced the volatility in the market. It has not only discovered the Future spot price of different commodities however it has provided an opportunity to hedge the risk against the adverse price movement in the commodity. The present study explains the relationship of future and spot price of different commodities Gold, Silver Channa, Zeera, Zinc, and Natural Gas including the crude oil and their inter-relationship. It also examines the relationship between the future and spot price of two commodity exchanges in India. It finds out the possibility of arbitrage gain to between the two commodity exchanges of India i.e. MCX, and NCDEX. It is revealed that there is a positive correlation between future and spot prices of the commodities. It was also observed that there is possibility of arbitrage in those commodities which are traded at both NCDEX and MCX.


Traditionally, commodity futures contracts are settled by physical delivery. A seller with an open position at contract expiration must make deliveries to liquidate the position. Similarly, a buyer must take deliveries to liquidate an open position held at the contract maturity. In spite of high transportation, inspection, and storage costs, this settlement specification was adopted to ensure the convergence between spot and futures prices at the contract expiration date. As a result, the futures price will converge to the cheapest deliverable grade. This creates additional uncertainty, the so-called delivery risk, which leads to a larger basis risk (Leuthold, 1992). The risk transferring and price discovery functions of a futures market are damaged. Since the advent of stock index futures contracts and the forward market Commission (FMC) allows for the possibility of cash settlement specifications. Under this system, a futures contract is settled by a cash payment transfer. The payment is dictated by a cash index. Consequently, the effectiveness of a cash-settled futures contract hints on the construction of a reasonable index. An optimal index should reflect the market conditions. Heterogeneity and non-storability of agricultural commodities create difficulties in constructing an appropriate cash index. As a result, commodity futures contracts continue to rely for the most part on physical delivery settlement. Further trading in the commodity derivatives in different Exchanges provides an opportunity to hedge their risk and arbitrage gain from the difference in the price of these commodities.

Historical background

The futures trading in commodities in India started in the later part of 19th century when the first commodity exchange, viz.. the Bombay Cotton Trade Association Ltd was set up for organizing futures trading. The early 20th century saw the mushrooming of a number of commodity Exchanges. The principal commodity markets functioning in pre-independence era were the cotton markets of Bombay, Karachi, Ahmedabad and Indore, the wheat markets of Bombay, Hapur, Karachi, Lyallpur, Amritsar, Okara and Calcutta; the groundnut markets of Madras and Bombay; the linseed markets of Bombay and Calcutta; Jute and Hessian markets of Calcutta; Bullion markets of Bombay, Calcutta, Delhi and Amritsar and sugar markets of Bombay, Calcutta, Kanpur and Muzaffarnagar. The history of organized commodity derivatives in India goes back to the nineteenth century when the Cotton Trade Association started futures trading in 1875, barely about a decade after the commodity derivatives started in Chicago. Over time the derivatives market developed in several other commodities in India. Following cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay (1920). However, many feared that derivatives fuelled unnecessary speculation in essential commodities, and were detrimental to the healthy functioning of the markets for the underlying commodities, and hence to the farmers. With a view to restricting speculative activity in cotton market, the Government of Bombay prohibited options business in cotton in 1939. There were no uniform guidelines or regulations. These were essentially outcomes of needs of particular trade communities and were based on mutual trust and faith. They were regulated by social control of close-knit groups and whenever such control failed, there would be a crisis. In order to provide constant vigil to prevent crisis, rather than combat these after they occurred, a comprehensive legislation was enacted by the Bombay State in 1947 in the form of the Bombay Forward Contracts Control Act. On adoption of the Constitution of the Republic, the subject, “Stock Exchanges and Futures Markets” was included in the Union List and a central legislation called Forward Contract (Regulation) Act 1952 was enacted which provided the legal framework for organizing forward trading in the country and provided, inter alia, for recognition of Exchanges. This framework continues to exist even today. One of the important features of this Act is to notify a commodity for prohibition or regulation of forward contract. Under these provisions, a large number of commodities were notified for prohibition during the 1960s which left only a handful of insignificant commodities open for forward trade. This scenario continued for about four decades although the Dantawala Committee(1966) and Khusro Committee (1980) had recommended steps to revive futures trading in more agriculture commodities. Subsequent to liberalization of Indian economy in 1991, a series of steps were taken to liberalise the commodity forward markets. This found expression in many reports and studies of committees and groups to recommend reforms in commodity futures market. The Kabra Committee (1994), the earliest post-1991, recommended opening up of futures trading in 17 selected commodities, although it was not unanimous regarding some of these. Importantly, this committee was unanimous in recommending that futures trading not be resumed in case of wheat, pulses, non- basmati rice, tea, coffee, dry chilli, maize, vanaspati and sugar. For most of these, it recommended that case by case reviews of suitability of each commodity be carried out in light of developments in the future. UNCTAD and World Bank joint Mission. In the Report “India: Managing Price Risk in India’s Liberalized Agriculture: Can Futures Market Help? (1996) highlighted the role of futures markets as market based instruments for managing risks and suggested the strengthening of institutional capacity of the Regulator and the exchanges for efficient performance of these markets. This report also noted that government intervention was pervasive in some sensitive major commodities like wheat, rice and sugar and was of the view that future markets in these commodities were unlikely to be viable because of this. Another major policy statement, the National Agricultural Policy, 2000, also expressed support for commodity futures. The Expert Committee on Strengthening and Developing Agricultural Marketing (Guru Committee: 2001) emphasized the need for and role of futures trading in price risk management and in marketing of agricultural produce. This Committee’s Group on Forward and Futures Markets recommended that it should be left to interested exchanges to decide the appropriateness/usefulness of commencing futures trading in products (not necessarily of just commodities) based on concrete studies of feasibility on a case-to-case basis. It, however, noted that: “All the commodities are not suited for futures trading.

Spot and future market :

Spot market is a market of commodities or securities in which goods are sold for ready cash and delivered immediately is known as Spot Market. Spot market is real time market for instant sale of commodities like grain, gold and other precious metals, Ram chips etc. It is a spot market because transactions take place on the spot. For example merchants and traders go to the fields and buy the standing crop or the freshly reaped crop at the spot. Since cash changes hands it is also called a Cash Market and since stock is physically delivered it is also called physical market. The contract entered in the spot market becomes immediately effective. Prices are settled at current prices. The primary activities of buying and selling are carried out in spot market. A spot market can operate only where necessary infrastructure is available. Thus internet provides a spot market for securities. Grains, cotton and other agricultural commodities are traded at the farms. While spot market provides a ready market for the farm produce which reduces the farmer’s cost on transportation and warehousing, not to speak of the legal hurdles that the farmer has to face in commodity movement, there is a wide gap between the farm gate price and consumer price. The traders enjoy monopoly and there is less transparency in pricing. Unless the farmer has complete knowledge about the prevailing price, he would be put to insufferable loss.

As opposed to spot markets, deals are stuck for future action in the future markets. A future contract can be defined as a type of financial contract wherein parties agree to exchange financial instruments like securities or physical commodities for future delivery at a particular price. Future contract is a standardized contract to buy at a future date at a certain price. The Commodities in the future market can be reasonably expected to be delivered within a month or so. Future market is not a ready market like a spot market. Future market does not involve primary activity and it is speculative in nature. In the future market, deals are stuck at forward prices. A future contract gives the holder the obligation to buy or sell. Both parties to the contract must fulfill the contract. Here everything is in a fluid state until the security or commodity reaches the buyer’s hands and the consideration reaches the other party. The future date is called delivery date and a final settlement date. The pre set price is called futures price. The price of the underlying asset on the delivery date is called the settlement price. Future traders are traditionally two groups- hedgers who have an interest in the commodity being traded like farmers, producers and consumers and speculators who seek to make profit by predicting market moves. Future market is full of risk because anything might go wrong at any stage and the transaction may become invalid or void. Stock markets all over the world are highly volatile and the value of the traded security may go down at any time. Similarly if a commodity like crude oil is traded, the happening of the future event may be subject to political equations between the two countries; unrest in a neighboring country may delay the delivery. Thus the future market does not meet the safety requirement of business. Trading in future market is not for the risk averse. It is only for those who trust others and their own luck. A very small percentage of future contracts turn to physical delivery.

Literature review:

The issue of price discovery on futures and spot markets and the lead-lag relationship are topics of interest to traders, financial economists and analysts. Although futures and spot markets react to the same information, the major question is which market reacts first. Several studies examine whether the returns of index futures lead the spot index.In the literature, several studies attempted to compare the impact of derivatives markets in comparison to buffer stock schemes that had been favoured since 1930s and highlighted that derivatives markets offered a more effective and welfare raising method of dealing with price volatility (Gilbert, 1985). By taking a position in the derivatives market, the producer can potentially offset losses in the spot market. However, with regard to the stabilization effect of futures trading on the spot prices, the evidence is mixed. Newbery (1990) observes that since forward markets reduce risk, they encourage fringe firms to supply more output and thus, reduce the spot price. Furthermore, forward markets concentrate trading in one location and reduce information and other transaction costs, which can also lower prices. Similarly, Netz (1995) and Morgan (1999) concluded that the level of inventories held in the spot market will be determined by the basis3and will ensure a more efficient process of private storage, which in turn, ensures a smoother pattern of prices in the spot market. According to Turnovsky and Campbell (1985), since forward markets reduce the price risk of holding inventories, larger inventories are held and prices tend to stabilize as a consequence. Conversely, Kawai (1983) shows that when the storage is subject to shocks, increased storage can destabilize prices. It is also revealed that risk reduction encourages producers to undertake more risky investment projects, and risky investment destabilise spot prices (Newbery, 1987). Similarly, Cox (1976) finds that in many markets, forward trading is stabilising whereas Figlewski (1981) and Simpson and Ireland (1985) conclude that opposite is true. Schroeder and Mintert (1988) extend the above analysis to price data of Amarillo, Kansas City, Dodge, and Illinois Direct. While Amarillo, Kansas City and Dodge City are three of the twenty-seven reporting stations included in USFSP, Illinois Direct is not. Hedging risk was reduced in all the four markets, with the greatest reduction for steers that meet the contract weigh specifications. Note that both Elam (1988) and Schroeder and Mintert (1988) adopt the cash index as a proxy for the futures price, an approach that may be reliable only during the maturity month. Kenyon, Bainbridge, and Ernst (1991) apply actual post cash settlement futures price data. Using Oklahoma City and Southwest Virginia auction data as cash prices, they find the basis variance was smaller after the introduction of cash settlement when compared to physical delivery. However, the reductions in variance are not statistically significant. An analysis of the basis forecasting error, using Virginia data, also suggests that cash settlement provides little improvement. On the other hand, cash and futures prices have become more highly correlated since the adoption of cash settlement.

It has been found that cash settlement improved the hedging function of both futures contracts; see, for examples, Kenyon, Bainbridge, and Ernst (1991); Rich and Leuthold (1993); Kimle and Hayenga (1994); Ditsch and Leuthold (1996); Lien and Tse (2002); and Chan and Lien (2002, 2003). This paper, instead, analyzes the effects of cash settlement on the price discovery function of a futures market as applied to both feeder cattle and live/lean hog cases. More specifically, the feedback measures proposed by Geweke (1982) will be used to compare the relationships between spot and futures prices before and after cash settlement was in place. Varangis and Larson (1996) cited several examples in the case of cotton and oil in Mexico and Algeria, where group of producers is represented by an agent who trades on their behalf. In doing so, minimum prices for output could be guaranteed and thus, risk is reduced for an individual trader for the cost of a small premium. Other such examples are provided by Claessens and Duncan (1993) and World Bank (1999). According to Pennings and Leuthold (1994) hedging effectiveness is related to trading volume and this relationship is more prominent when the hedging effectiveness takes market depth risk into account. Having evaluated the hedging effectiveness by taking into account basis risk and market depth risk and analysing the overall risk reduction capacity of the derivatives contract, they concluded that hedging effectiveness is an important determinant in explaining the derivatives contract volume. Hedging effectiveness is related to the service design- the core business of derivatives exchange. According to them, the factors, which influence the use of derivatives are perceived performance, risk attitude, perceived risk exposure, market orientation, etc. In the finance literature, several factors such as firm’s risk exposure, its growth opportunity, the level of wealth, managerial risk aversion, financial distress costs and the accessibility to financing influence the adoption of commodity derivatives (Visvanathan, 1998 and Koski and Pontiff, 1999). Several authors identify experience, education, enterprise size, expected income change from hedging as factors influencing the use of derivatives contracts (Patrick, et al, 1998). In India, derivatives trading was strangulated owing to ban/prohibition from time to time. The trading has picked up only in recent time, particularly after 2002. For some primary commodities fortnightly prices data are available since 1996-97, whereas for some commodities such as cotton, sugar, rubber, metals, etc, they are available for latest years (2003 and 2004) on a daily basis. With the limited data in hand, this study attempts to assess the performance of commodity derivatives markets in India. The studies exploring the price discovery role and the lead lag relationship between futures and spot prices have followed a procedure that is based on price series being non-stationary (Asche and Guttormsen, 2002), i.e., to test the existence of a long-run relationship between the spot and future prices by investigating whether the data series are co-integrated.

In the Indian commodity derivatives markets, most of the price series are found to be non-stationary with no tendency to revert back to an underlying trend value as they typically exhibit ‘random walk’ properties, i.e., today’s prices cannot be used to predict future prices. However, differencing the data runs the disadvantage of losing information about underlying long run relationships between prices. Thus, the relationship and co-movement between the prices is examined in a co-integration framework in which linear combinations of non-stationary variables could be identified. Recent studies have shown mixed results on futures trading and its influence on spot price volatility, depending on the commodity and the underlying market conditions. Golaka C Nath and Tulsi Lingareddy, in the Economic & Political Weekly, have referred to a number of authors on the issue. The Abhijit Sen panel has now said that the data available to it was not sufficient to come up with conclusive evidence on the connection. These include Kamara (1982) who found that introduction of commodity futures trading generally reduced or at least did not increase cash price volatility, Singh (2000) who probed Hessian cash price variability before and after the introduction of futures trading (88-97) and concluded that the futures market has reduced the price volatility in the Hessian spot market, Dasgupta (2004) who found a co-movement among futures prices, production decisions and inventory decisions, Yang (2005) who showed that an unexpected increase in futures trading volume caused an increase in spot price volatility and Sahi (2006) who suggested that the volatility had not changed with the introduction of futures in wheat, turmeric, sugar, cotton, raw jute and soya oil. The Abhijit Sen panel has now said that the data available to it was not sufficient to come up with conclusive evidence on the connection. Sen, however, suggested in separate note that a ban on wheat, rice, toor and urad trading should continue, singling wheat for special mention.

Spot and Future Prices Convergence

While numerous studies have examined the relationship between spot and future prices for various types of commodities as also for financial assets, empirical evidence in this regard is mixed. In the literature, there are two strands on the price formation process of commodity future prices. One in which, the inter-temporal relationship between cash and future prices are explained by the cost of carry of the commodity, i.e., future prices should never be less than the spot price plus storage and interest cost (Brennan, 1958 and Telser, 1958). In the case of second, future prices are split into an expected risk premium and a forecast of a future spot price (Breeden, 1980 and Hazuka, 1984). In America, price discovery efficiency of futures market has been far investigated for all types of futures viz; commodity futures, equity futures and currency futures etc. Stensis (1983), Garbade and Sibler (1983), French (1986), Chan (1992), Cheung and Fung (1997), Hall et al., (2001), Yang Jian et al., (2001), Campbell and Diebold (2002) and Isabel and Gilbert (2004) examined the causal relationship between the spot and futures price on Chicago Board of Trade (CBOT) and they observed that spot market significantly followed the futures market and the futures market price movements provides a basis for predicting the prospective spot market price changes. In this case, basis is expressed as a sum of an expected premium and an expected change in the spot price. For the future price to be an unbiased predictor of subsequent spot price, i.e., Et (P (t,T) equals zero, the future price should lead the spot price (Garbade and Silber, 1983). There are also arguments in favour of opposite hypothesis, that spot price leads future prices (Silvapulle and moosa, 1999, Quan, 1992, Moosa, 1996). The spot prices can be price leading if the convenience yield is high enough. According to Pindyck (2001), the spread between the future prices and spot price gives a direct measure of the marginal value of the storage for a commodity termed alternatively, as marginal convenience yield (MCY). Future price could be greater or less than the spot price depending on the magnitude of the net (of storage costs) MCY. For the future price to be an unbiased predictor of the spot price, the future and spot prices must be proportional that is the basis should be constant and the market is said to be efficient. For instance, Asche and Guttormsen, (2002) found that the future and spot prices in the case of gas oil formed a stable long-run relationship and the prices were proportional (basis being constant) indicating that future price leads the spot price. If a1=0, a change in the basis will be atleast partly corrected by a change in the spot price, in that case spot price will lead the future prices4. If a2=0, a change in the basis will be atleast partly corrected by a change in the future price, in which case, future price will lead the spot prices.In other words, the argument of risk reduction through hedging rests on the premise that the spot and future markets move together so that losses in one market can be made good through gains in other market. Risk reduction or price discovery function is conditioned by the fact that futures markets must be able to predict the subsequent cash price at maturity. At maturity, the future prices become equivalent to cash prices except for some transaction costs and quality premium. If the future prices are a reflection of future demand and supply conditions of the market, then they are considered to exert influence on the inventory holding. If future prices are falling, it indicates that either future demand would fall or future supply would ease. This would induce traders to reduce inventory stock, which eventually results in fall in spot prices (Singh, 2004).


The data for this paper is used is secondary in nature, which is collected from the sites of forward market commission and the MCX and NCDEX sites. The data collected is analyzed by finding out the correlation between spot and the future prices of the commodity market. For this purpose first the data is converted in to month wise data. The standard deviation of the data is calculated in order to find out the deviation from the mean. It has helped to find out the variation in the spot and future prices. It has collected the data of the total turnover of the derivative contracts and open interest in order to find out that how many transactions are settled and the correlation between the two. It will also find out the impact of future prices and spot price with help of this data. The data of MCX and NCDEX was correlated in order to find out the possibility of the arbitrage gain. The data was not available for the certain period as for that period the commodity was taken out from the trading by the government. If the markets are frictionless and functioning efficiently, changes in the log-spot prices and changes in the log-futures prices are expected to occur at same time, while the current change in the log-futures price is also expected not to be related to previous changes in the log-spot price (and vice-versa). In this paper co integration model with simple GARCH is used to examine lead-lag relationship between spot and futures. It has also used the regression analysis with linear relationship between spot and forward prices of the commodities.

Data Analysis:

This study has included details of Zeera, Zink, Channa, natural gas, silver, gold, and crude oil. It includes the data of MCX and NCDEX. The standard deviations and correlation is used as the techniques of data analysis for this paper. In order to calculate the future and spot prices this paper has used the following equations:

St− St−1 = αs+ βs(Ft−1 − St−1) +s,t

Ft− Ft−1=αf− βf(Ft−1 − St−1) +f,t

Here, the explanatory variable Ft− St is the basis. In the cost of carry model, the basis provides the cost of capital from trading date till expiration date, and should contain a negative time trend. An additional complication in the case of commodity futures markets is that the simple cost of carry model does not always hold. This paper has deterministic time trend to see whether this data forms a trend or not.

Empirical result:

The commodities which are used for this paper are Zink, Zeera, channa, natural gas, gold, silver and crude oil. These commodities are selected due to their large trading pattern and their role in commodity market. However it is found that data for certain periods were not available. The results of data for these commodities are explained below:

The data for the channa was not available for the certain period as can be seen from the table no.1 and the chart no.1. However from the available data it can be said that there is wide range of variation in the spot and prices of the commodity as s.d. (Standard Deviation) in spot and future market is 189.28 and 5425.47. It signifies that channa is a highly volatile commodity in the market. There are several reason are found but main reason was that it the ratio of open interest contracts to the total turn over. The data of NCDEX also shows the similar results but the volatility is less with regards to spot and future price and the correlation between the spot and future prices is not the same. It is observed that open interest contracts at the NCDEX are less in relation to trading at MCX. The spot and future prices are less volatile and it can help in prediction of future prices at the NCDEX.

The arbitrage opportunities are available in different period as can be find out from the study of table no. 1 and 3. It is to be noted that the trading in the channa was not available during certain periods. So it was difficult to find out the proper arbitrage opportunity.

Chart 1, Channa: Spot Vs Future Price at MCX

Source: Forward market commission

Chart 2, Spot and future data of channa at NCDEX

Source: Forward market commission

In the case of the natural gas it is observed there is great amount of correlation between spot and future prices during the period of observation. There is less amount volatility is observed in the spot prices as compared to the channa and other commodity. The reasons for this can be the large amount of the open interest contract. Correlation between spot price and Future price for 2006-2007 is 99.20 %, 2007-2008 is 97.80 % and 2008-2009 is 99.80 %. This data reveals that there is a high degree correlation between the spot and forward prices of the natural gas. It was further observed that the possibility of arbitrage was not available as natural gas is not traded at the NCDEX. Correlation between Open interest and total volume for 2006-2007 is 54.80 %,2007-2008 is 6.20%, 2008-2009 is 64.60 %. It can be said that in case of the natural gas spot prices can give a hint for the future prices of the natural gas. This will help the traders to take the forward position in this commodity.

Chart no. 3 Natural Gas


Spot Vs Future Price

In case of the Zinc there is very high degree of positive correlation for the period of study. It means that there is a large amount of possibility that forward rate will be the future spot market rate for that commodity. It can be seen from the data that Correlation between spot and future prices for 2006-2007 is 99.80 %, for 2008-2009 is 99.70 %. Further there is a large variation in the spot prices and forward prices of the Zera. It is also noted that there is very strong positive correlation between open interest and total volume for 2006-2007 is 93.00% but in the year 2008-2009 it is 38.40%. it means that may contract were unsettled at the due date. It also means that spot rates were not according to the expectations, so they have not honored their positions at end of day.

Further in case of Zeera also there is high degree of positive Correlation between spot and future prices for 2006-2007 is 99.00 % and 2008-2009 is 89.70 %. It means that there is a large amount of possibility that forward rate will be the future spot market rate for that commodity. It is also noted that there is very strong positive correlation between open interest and total volume for 2006-2007 is 49.40 % but in the year 2008-2009 it is 84.60%. it means that may contract were unsettled at the due date. It also means that spot rates were not according to the expectations, so they have not honored their positions at end of day. Further this correlation is opposite to that of Zink . it means that market is highly volatile and due to variation in the spot and future prices there is increase in the amount of open interest contracts.

There is very high degree of positive correlation in the crude oil spot and future prices during the period of study however it is to be noted that the data for some periods were pot available. The result can be different if the data for full period from 2006- 2009 may be available. There is high degree of volatility in the NCDEX as compared to MCX. it is an opportunity for arbitrage gain for the investors. The crude oil appears to by the volatile commodity due to it wide spread demand. Correlation between spot price and Future price for 2006-2007 is 99.80% and 07-08 is 99.9o%. Further rate of correlation between open interest and total volume for 2006-2007 is 73.40 % and 07-08 is 2.20%. it means that a large amount of volatility exist in the spot and future prices and spot follow the forward rate of the crude oil. The maximum contracts are being settled as compared to other transactions.

This commodity provides arbitrage opportunity as it is traded at MCX and NCDEX both and the variation in price can be seen from the charts given below:

Crude Oil Spot & Future Price Movement


Source: Forward market commission

In case of the silver it is observed that there is large volatility in the spot prices and spot price do not follow the forward price in some periods. Further it is observed that spot and future prices have the negative correlation. Silver does not provide opportunity for the arbitrage opportunity.

Source: Forward market commission

There is high degree of correlation in gold at MCX between spot price and Future price for 2008-2009 is 99.70 % and at the NCDEX it is very poor at 6.40%. There is low degree of correlation is find between Open interest and total volume for 2008-2009 is (31.30 %) at MCX and at NCDEX is 6.40% for the same period. The gold prices are less volatile as compared other commodity.

As for as the arbitrage is concerned there

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