This paper studies the impact of introducing commodity futures contracts on the volatility of the underlying commodity, in the Indian context. Empirical methods, namely, GARCHX, Granger causality, and forecast error variance decomposition are used to examine the validity of one of the recurring arguments made against futures markets, that they give rise to price instability. Empirical evidence from GARCHX methods suggests that in wheat, turmeric, sugar, cotton, raw jute and soybean oil, the nature of spot price volatility has not changed with the onset of futures trading. However, in wheat and raw jute, there has been a weak destabilizing effect from futures to the spot with the onset of futures trading. Granger causality tests show that an unexpected increase in futures trading volume unidirectionally causes an increase in cash price volatility for wheat, turmeric, sugar, raw jute and soybean oil. Likewise, there is a causal effect from unexpected increase in open interest to cash price volatility for wheat, turmeric, raw jute and soybean oil. These findings are in line with researches done elsewhere that state that futures trading has a destabilizing effect on agricultural commodities.
Many
economists believe that futures trading is a cause of greater
price variability rather than a response to that variability.
It has been written in the literature that speculators have
a tendency to take prices away from their economic equilibrium
levels. This is one of the common arguments made against commodity
futures markets. This argument has important implications
to policymakers and to those responsible for regulating commodity
futures trading. A related and equally important policy issue
is whether companies and financial institutions should hold
commodity futures only for hedging purposes. At times when
fluctuations are large, they can easily call into question
the collective rationality of the market. The question to
be answered is—whether volatility is `collective irrationality'
or is it `consistent with the natural actions of informed
investors'. Earlier economists have argued theoretically that
speculation would be unprofitable in the aggregate, because
a small group of smart and well-informed speculators could
earn supernormal profits at the expense of other non-informed
speculators. In other words, there will be unwarranted price
volatility. However this argument maintains that, there exist
money to be made by buying at the trough and selling near
the peak. In a nutshell speculators do not have the information
of the "proper" price but usually operate by selling
when the prices begin to fall and buying when they begin to
rise. This will result in accelerating both upward and downward
movements, or even increase the amplitude and frequency of
fluctuations. Then there is a contradictory view that futures
market was initiated because there was a need to reduce the
price risk. It also helped in effective price discovery, providing
a hedging environment and hence to improve the overall market
efficiency. By providing investors with hedging protection,
financial futures help investors to immunize their portfolios
against interest rate risk. Hence investors are saved from
liquidating their cash positions, which saves them from losses
and saves the market from further downward pressure. Moreover,
futures trading could enhance information, which is an important
factor that determines the level of prices. Futures markets
are more centralized and their exchanges could be seen as
centers of clearing information. Information could be relative
to cash and futures prices, demand and supply of commodity
or financial instruments, volume of futures trading, current
liquidity of the market, and news about withdrawals from storage
or potential purchases. This news can be accessed by cash
investors also. A direct result of such disclosure will be
better decision-making, based on more information, and prices
that are representatives of fundamental economic conditions. |
