Futures Trading and Spot Market Volatility: Evidence from Indian Commodity Markets

Abstract

In the context of emerging Indian commodity futures markets, this paper empirically examines the effect of futures trading activity (trading volume ; proxy of futures liquidity) on spot price volatility for seven agricultural commodities (guar seeds, turmeric, soya bean, black pepper, barley, Maize and Castor Seed).We decompose the futures volume  into expected and unexpected components using Hodrick–Prescott filter (HP filter) .To clearly understand the destabilization effect, the relationship of  the unexpected liquidity of futures market is done with Unexpected volatility of spot market returns which is estimated by taking the residuals of the GARCH model. We find that unexpected futures trading volume is Granger causing spot price volatility and are significant for five out of seven agricultural commodities (Guarseed, Turmeric, Soybean, Maize and Castor Seed), consistent with Bessembinder and Seguin (1992).We find reversed effect for one commodity i.e. Pepper the effect of spot volatility on futures trading and for Barley no causality is revealed either from future to spot or Vice-Versa. Besides being of interest to the participants, this study is likely to be useful in addressing the concerns of policy makers in India on alleged destabilizing effect of futures markets on spot prices as for emerging futures markets. Commodity exchanges must be strengthen and put under strict and active monitoring for early detection of anomalous trading behaviour. Financial autonomy and adequate powers should be given to Forward Market Commission to penalise any insider trading and price manipulations, this will minimize price distortions. The Government support shall lead to market growth and overall economic development.