Agricultural Commodity Trading: Is it Destabilizing Spot Markets?

Trading in agricultural derivatives has been a contentious issue for a long time. Researchers, regulators, producers, and investors have debated over its existence, structure, and operation. Wide fluctuations in the prices of agricultural derivatives have a deep economic and social impact on the lives of farmers. The agricultural derivative market was set up to provide a market mechanism for price discovery.

I

According to Yang and Leatham (1999), ‘In a static sense, price discovery implies the existence of equilibrium prices. In a dynamic sense, the price discovery process describes how information is transmitted across the markets.’

and risk mitigation. However, time and again, commodity trading in derivative markets has been banned for ruthless speculation and highly volatile asset prices. The efficiency of these markets to act as a price barometer for the mandis (trading hub of agricultural produce) functioning in the country has been questioned all along.

Prior to 2000, the commodities derivative markets saw a series of ban on trading in agricultural commodities. National Agricultural Policy (NAP) (2000) supported risk management and price discovery of agricultural commodities through future trading. In 2003, trading on commodity derivative exchanges got a fresh start and volumes on future markets revived. However, under political pressure and in an attempt to control rising inflation, trading was banned on certain commodities in 2007–2008. The government formed the Sen Committee in 2008 which concluded that there was no statistical evidence that future trading caused spot market destabilization.

II
Destabilization is the volatility in one market caused from speculative trading activity in another.

In financial literature, the effect of future trading on spot price destabilization has been continuously debated for various markets throughout the world. Mallikarjunappa and Afsal (2008) investigated the impact of introduction of futures trading (CNX Bank Nifty Index) and found that the market volatility had increased post introduction of future trading. Some researchers argue that commodity trading in future market has escalated the volatility of spot market by attracting uninformed traders with their high degree of leverage (Nath & Lingareddy, 2008).

Also, future market could cause distortions in the spot market as it can attract a significant amount of new hedge trading without attracting enough speculation to permit effective risk transfer (Figlewski, 1981). The pressures created in the future markets could spill over to spot markets where the dealers and other market makers end up bearing the risk transferred through both the spot and the future market. According to Yang et al. (2005), unexpected futures trading volume uni-directionally causes spot price volatility for most of the commodities. In the context of the Indian commodities market, research findings of Nath and Lingareddy (2008) state that the futures market has not helped in reducing cyclical/seasonal fluctuations in the spot market. Also, future trading has led to an increase in volatility in the spot market for some of the commodities.

However, other researchers have claimed that futures market helps to spread risk from those hedging cash positions to professional speculators who are more than willing to take the risk to make speculative gains (Bessembinder & Seguin, 1992, 1993). Bessembinder and Seguin (1992) report evidence that introduction of futures trading has caused a decline in equity volatility. Kasman and Kasman (2008) have found that the introduction of futures trading has led to stability in the Turkish stock markets. According to Figlewski (1981), although future trading has led to an increase in spot price volatility for Ginnie Mae (GNMA) securities, the instable spot market could increase hedging activity in the futures market. The study suggests existence of reverse causation.

Apart from liquidity,

III
Liquidity is the quantity of contracts bought and sold.

another variable of future trading is market depth. Market depth has been defined by Kyle (1985, p. 1330) as ‘… the ability of the market to absorb quantities without having a large effect on price’. Low price volatility is associated more with high market depth. Researchers argue that introduction of future trading improves market depth due to the existence of market makers (Bessembinder & Seguin, 1992). It improves transmission of information between future and spot market. Also, higher market depth reduces spot price volatility. The study uses open interest.

IV
Open interest is the total number of future contracts that are not closed or delivered on a particular day.

as a proxy for market depth as suggested by Bessembinder and Seguin (1993). Prior studies have documented that unexpected futures trading volume is positively related to equity volatility, and it declines with an increase in open interest (Bessembinder & Seguin, 1992). According to Bhargava and Malhotra (2007), trading volume (proxy for speculators and day traders) destabilized the market, whereas the effect of open interest (proxy for hedgers) in destabilizing the market is inconclusive.

Some research studies hold a contrarian view that open interest leads to an increase in spot price volatility. Chen et al. (1995) have modelled the differences between holding stock and future contract on the basis of investor preference for idiosyncratic benefits from holding stock. The study has shown that an increase in volatility increases with the open interest.

Although market depth has a significant relationship with price volatility, it has not been examined frequently.

This research study focuses on the role of future trading activity in destabilizing and enhancing depth of spot markets. It also examines lead–lag relationship between spot volatility and open interest. There has been considerable research on effect of future trading on spot price volatility in financial asset market.

But limited empirical evidence is available on lead–lag relationship between future trading and spot market destabilization in agricultural commodity markets. The study also investigates the interesting research question of spot trading causing future market destabilization. Any existence of future market destabilization shall have serious implications for the functioning and regulatory mechanism of the commodity trading.

Therefore, this study focuses on causal relationships between trading activity variables and volatility of spot markets.

Read the complete study here!

—Taken from Agricultural Commodity Trading: Is it Destabilizing Spot Markets? in Vikalpa: The Journal for Decision Makers