This paper examines the cointegration between spot and future prices of Indian agricultural commodities and thereby estimates the optimal hedge ratio and hedging efficiency of the agricultural commodities using error correction mechanism and Ederington measure respectively. The study is conducted on 10 agricultural commodities, data for which was obtained from National Commodity and Derivatives Exchange, India for the period from January 2006 to December 2011. The results indicate good amount of hedging in Indian agricultural commodity markets.

One of the significant innovations in the financial markets is the introduction of futures contracts. In India, trading in agricultural futures started in 2003 with the establishment and recognition of National Commodity and Derivatives Exchange (NCDEX). Since then, volumes of trade have been increasing on a year-on-year basis.

Hedging through trading futures is a process used to control or reduce the risk of adverse price changes. The introduction of futures contracts offers an opportunity to manage the market risk of portfolio containing both spot and future positions. The objective of hedging is to minimize the risk of the portfolio for a given level of return. Factors that influence the hedge construction and its effectiveness include basis risk, hedging horizon, and correlation between changes in the futures price and the cash price.

The application of portfolio theory to hedging attracted a great deal of attention from academics and market participants. Johnson (1960) and Stein (1961) introduced the concept of portfolio theory through hedging the cash position with futures. Ederington (1979) applied this concept in determining a risk-minimizing hedge ratio and derived a measure of hedging effectiveness. These have been followed by numerous studies.

Financial Risk Management Journal, Optimal Hedge Ratio, Hedging Effectiveness, Indian Agricultural Commodities, National Commodity and Derivatives Exchange (NCDEX), Error Correction Mechanism (ECM).