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In India, agricultural products market is regulated at different levels: local, state and national.
The prices of agricultural commodities have been of concern to different regulators. The
Forward Market Commission (FMC), which has the authority and responsibility to ensure
that the prices of agricultural commodities are not manipulated, has the power to determine
the commodities which need varieties of price discovery mechanisms. Derivative products
are permitted in certain commodities under the Forward Contracts (Regulation) Act, 1952,
but were banned at different points of time only to be restarted in 2003. Since then commodity
futures trading has been an important instrument in the price determination process.
Price discovery is one of the prominent economic functions of derivatives market—it
helps in pricing cash or spot transactions based on the prices of futures market. Establishing
reference price from which the spot prices are formed is a crucial issue in price discovery, and
this requires an understanding of whether spot or futures market absorbs the new information
set (Gardbade and Silber, 1982). Theoretically, in an efficient market system, the price of an
asset should move simultaneously to spot and futures markets. This is because in an efficient
market, new information should be captured simultaneously by both the markets. Due to the
fact that the futures price is the price determined in an agreement (futures contract) to
supply a specified quantity of a commodity, there will be a close relationship between the
prices of futures contract and spot prices (Hernandez and Torero, 2010). In particular, according
to the non-arbitrage theory, there is a clear relationship between spot and futures market. As
per the cost-of-carry relationship theory, price movements in spot and futures market are
highly influenced by a common set of information and hence the law of one price should be active (Hasbrouck 1995), and if there is a mismatch between the price of two markets and the
law of one price does not hold, such deviation is attributed to transaction cost (Protopapadakis
and Stoll, 1983 and Goodwin, 1990). However, due to several market frictions and market
microstructure effects, there will be disparity in the price of an asset in spot and futures
markets. Since the cost of trading in derivatives market is comparatively less than the spot
market, the ‘informed’ traders may act first in the derivatives market and therefore price
difference may exist in the spot and futures market.
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