The present study investigates the hedging effectiveness of commodity futures contracts for spices and base metals by employing cointegration and error correction methodology with different maturity time horizons varying from one month to three months, i.e., maturity month, nearby month and far month. The optimal hedge ratios are calculated from Ordinary Least Squares (OLS) regression and Error Correction Model (ECM). It is found that the futures market dominates in price discovery in nearby month contracts. In far month contracts, there is no long-term relationship between spot and futures prices for turmeric and cardamom. In case of base metals, futures market leads spot market for all the three contracts. This study supports that futures price representing the collective market opinion is considered as reference price for spot market players like traders, farmers and other stakeholders in commodity trading domain. Hedging effectiveness is also measured at various maturity periods. The results suggested that only 40% of contracts are suitable for hedging. It is generally found that there is no significant difference in hedging performance between far month and nearby month maturity periods for spices, while in the case of base metals slight variation is seen in hedging performance among different maturity periods. Further, there is not much difference in the estimates of hedging effectiveness obtained from OLS method and ECM. It is found that for far and nearby maturity periods hedging is more effective, which has some important implications for hedging strategy. These findings are helpful to risk managers, farmers, stakeholders and policy makers.

Hedging is one of the main functions of the futures market and also the reason for the existence of futures markets. The main purpose and benefit of hedging on the futures markets is to minimize possible revenue losses associated with adverse cash price changes. The risk of price variability of an asset can be managed by the mechanism of hedging. The hedging activity can be considered as exchanging price risk for basis risk. The basis is defined as cash price minus nearby futures price. The basis between a futures contract and its underlying commodity is an important measure of the cost of using the futures contract to hedge. Basis risk is attributed to location, quality and timing discrepancies between commodities traded in the cash market and that deliverable on futures contracts. Normally, the basis does have some variability, however, and hedging cannot completely eliminate price risk. It will reduce price risk, but only as long as the basis variability is less than the cash price variability (Carter, 1984).

The effectiveness of a hedge becomes relevant only in the event when there is a significant change in the value of the hedged item. According to Pennings and Meulenberg (1997a), a determinant in explaining the success of financial futures contracts is the hedging effectiveness of futures contracts. According to Ghosh (1993), factors that influence the hedge construction and its effectiveness include basis risk, hedging horizon, and correlation between changes in futures prices and cash prices.

Johnson (1960) and Stein (1961) introduced the concept of portfolio theory through hedging cash positions with futures. The portfolio approach recognizes the existence of basis risk and determines the optimal futures position by minimizing the variance of spot-futures portfolio. The application of portfolio theory to hedging has attracted a great deal of attention from academicians, regulators and market participants. Ederington (1979) applied this concept in determining a risk minimizing hedge ratio and derived a measure of hedging effectiveness. Ederington defined hedging effectiveness as the reduction in variance. The objective of a hedge is to minimize the risk of a given position. This risk is represented by the variance of returns. The hedge ratio that generates the minimum portfolio variance should be the optimal hedge ratio, which is also known as the minimum variance hedge ratio. This has been followed by a number of studies like Figlewski (1984), Myers and Thompson (1989) and Myers (1991). One of the important theoretical issues in hedging is the determination of the optimal hedge ratio and hedging effectiveness. The optimal hedge ratio can differ significantly depending upon the time horizon and estimation techniques used.

Financial Risk Management Journal, Hedging Efficiency, Commodity Futures Markets in India, Ordinary Least Squares, Error Correction Model, Review of Empirical Studies, Data Description and Methodology, OLS Regression Method, Error Correction Model, Estimating Hedging Effectiveness, Empirical Results, Hedge Ratio and Hedging Effectiveness of Spices.