Agricultural Commodity Trading: Is it Destabilizing Spot Markets?

Abstract

Executive Summary The future trading has been held responsible by certain political and interest groups of enhancing speculative trading activities and causing volatility in the spot market, thereby further spiralling up inflation. This study examines the effect of future of trading activity on spot market volatility. The study first determined the Granger causal relationship between unexpected future trading volume and spot market volatility. It then examined the Granger causal relationship between unexpected open interest and spot market volatility. The spot volatility and liquidity was modelled using EGARCH and unexpected trading volume. The expected trading volume and open interest was calculated by using the 21-day moving average, and the difference between actual and expected component was treated as the unexpected trading volume and unexpected open interest. Empirical results confirm that for chickpeas ( channa), cluster bean ( guar seed), pepper, refined soy oil, and wheat, the future (unexpected) liquidity leads spot market volatility. The causal relationship implies that trading volume, which is a proxy for speculators and day traders, is dominant in the future market and leads volatility in the spot market. The results are in conformity with earlier empirical findings — Yang, Balyeat and Leathan (2005) and Nath and Lingareddy (2008) —that future trading destabilizes the spot market for agricultural commodities. Results show that there is no causal relationship between future open interest and spot volatility for all commodities except refined soy oil and wheat. The findings imply that open interest, which is a proxy of hedging activity, is leading to volatility in spot market for refined soy oil and wheat. The results are in conformity to earlier empirical studies that there is a weak causal feedback between future unexpected open interest and volatility in spot market ( Yang et al., 2005 ). For chickpeas (channa), the increase in volatility in the spot market increases trading activity in the future market. The findings are contrary to earlier empirical evidence ( Chatrath, Ramchander, & Song, 1996 ; Yang et al., 2005 ) that increase in spot volatility reduces future trading activity. However, they are in conformity to Chen, Cuny and Haugen (1995) that increase in spot volatility increases future open interest. The results reveal that the future market has been unable to engage sufficient hedging activity. Thereby, a causal relationship exists only for future trading volume and spot volatility, and not for future open interest and spot volatility. The results have major implications for policymakers, investment managers, and for researchers as well. The study contributes to literature on price discovery, spillovers, and price destabilization for Indian commodity markets.

Indian Agri-Commodities Markets: A Review of Transition Toward Futures

“…Nath and Lingareddy (2008) emphasized that trading in commodity futures contributed to an increase in inflation, as results showed that during the time period of future trading, the spot price of selected commodities and their volatilities had reported a remarkable increase. This is in line with the recent findings of Gupta et al (2018) stating that future market leads to volatility in the spot market. Some studies have stated that future prices are independent and past prices have no role in the contribution of future price prediction.…”

Asset Pricing, Investment, and Trading Strategies

“…Other import studies describing various liquidity metrics and dimensions are Sarr and Lybek (2002); Fleming (2003); Goyenko et al (2009); International Monetary Fund (2015); Diaz and Escribano (2017); Broto and Lamas (2020); O'Sullivan and Papavassiliou (2019); Clancy et al (2019); Barth and Kahn (2020); Jiang et al (2020); Gupta et al (2018); Kandil (2018) and White et al (2018).…”

Wavelet-based analysis of guar futures in India: did we kill the golden goose?

“…Yang et al (2005) identified that an unexpected increase in futures trading volume leads to spot price volatility for agricultural commodities. Nath and Lingareddy (2008) and Gupta et al (2018) studied the volatility of Indian agrarian commodities and recognized that speculation and volatility in the futures market have destabilization impact on the spot market. Manogna and Mishra (2020), Maitra (2018) highlighted significant volatility spillover for GS futures markets.…”