In this study, an attempt has been made to identify the relationship between the spot price and the level of futures trading in the Indian commodity market using Granger causality test. For a better explanation of causality, the procedure of forecast error variance decomposition has been used. The study indicates that for most of the commodities there is a causal relationship between unexpected futures trading volume and spot price volatility. Furthermore, there is a weak form of causality between spot price volatility and unexpected futures open interest.

In the commodity market, risk and price innovation are managed by commodity derivatives. To manage the demand and supply of food and raw materials, it is necessary to store them for future use. This storage activity can be made profitable through forward contract. However, forward contract results in price risk. So, there is a need for price risk management. Future contract helps in managing price risk. Since seller/buyer can sell/buy the specified amount of a commodity at a specified price (called future price) on a specified future date, future contracts provide insurance to investors regarding the future value of their commodities. To determine future price, investors compare the current future price to the expected spot price at the maturity of the contract. This decision is taken based on the demand and supply status of the commodity. The current future price will be set at a higher level when the maturity of the contract spot price is expected to be higher relative to the current spot price and vice versa.

Spot and futures markets are closely related and supposed to move together. However, empirical evidence shows that one market reacts faster to information, while the other reacts slowly. As a result, a lead-lag relation is observed. Futures trading has some advantages over the trading of commodity as it has highly liquid market, low margins, leverage position, easily available short position and rapid execution. Garbade and Silber (1983), Bessembinder and Seguin (1992), Asche and Guttormsen (2002), Zapata et al. (2005), Karande (2006), and Iyer and Mehta (2007) reported that future market moves faster than spot market and hence leads the cash market. The opposite scenario is that the change in the price of the commodity, for some reason, would be reflected in the subsequent change in the futures price. Silvapulle and Moosa (1999), and Iyer and Mehta (2007) reported that spot price leads the futures price. Another cause of price change in the spot market is the level of futures trading. Stein (1987) reported that the amount of speculations in future trading has a greater impact on cash market volatility.

Applied Finance Journal, Dynamic Relationship, Trading, Price Volatility, Evidence, Indian, Commodity Market, GNMA, International Petroleum Exchange (IPE), National Commodity Exchange (NCDEX).